For years, I've been hearing about the differences between good debt and bad debt. Whether it's for your education or that new pair of shoes you've been craving, all debt is bad debt in my opinion, because it represents an obligation to pay back a creditor. It's an obligation that follows you around and reminds you that you purchased something you didn't have the funds for. Can you tell I'm not a fan of carrying debt?
But that doesn't mean I don't understand that sometimes debt-financing is necessary to expand a business or make corporate buyouts possible. It's actually quite normal in the business world to run across businesses, especially newer ones, that are financing their purchases through lines of credit. The key aspect is whether or not those businesses can meet their debt obligations. The answer to this great riddle can be found in a company's cash flow.
Keep in mind that large levels of debt aren't exactly a damning factor, because strong cash flow will easily allow a company to meet its interest obligations. Using the Motley Fool CAPS Screener, I was able to come up with a couple dozen companies that currently boast a long-term debt-to-equity ratio in excess of 10. From there, I focused my attention on highly indebted companies in which the free cash flow appeared weak enough that it would cause me concern if I were a shareholder. I came up with five companies that I consider the worst offenders:
Free Cash Flow (TTM)
Caesars Entertainment (NAS: CZR)
Commercial Vehicle Group (NAS: CVGI)
Newcastle Investment (NYS: NCT)
Halcon Resources (NYS: HK)
US Airways (NYS: LCC)
Sources: Morningstar and Yahoo! Finance. TTM= trailing 12 months.
Perhaps no one in this group is rolling the dice more than Caesars Entertainment. The casino operator, which just went public a few months ago, is mired in nearly $20 billion in long-term debt -- which doesn't even count the $1.25 billion it recently priced. The interest expensing alone on that debt in 2011 was $212 million versus just $194 million in adjusted EBITDA. As Fool Travis Hoium explains, that's a big problem that is going to have Caesars shareholders on the short end of the stick sooner rather than later.
Even Caesars' earnings results have been far less impressive than its peers'. Almost 20% of its sales are derived from the Atlantic City region, which has suffered from the warmer weather, while its total sales in fiscal 2011 rose by a pitiful 0.2%. All I can say is: Beware the ides of debt.
Commercial Vehicle Group
This might seem a bit confusing because Commercial Vehicle's fourth-quarter report signaled a return to growth. Sales for the quarter rose 43% and operating income tripled. So why am I skeptical? Mainly because of the industry that Commercial Vehicle is in and the aggressive manner in which it has been adding debt.
As the company is a supplier of various vehicle parts to the heavy-duty and industrial vehicle sector, higher fuel prices and even the slightest pullback in the economy could cripple its earnings potential. Since just last year, its debt level is up by more than $70 million, and management has made it clear that it could be looking for additional buyout opportunities. Considering that it only produced $7 million in free cash flow in 2010, I'm not confident that it'll be able to cover its debt obligations in a protracted economic downturn if it keeps shopping like it's in a 99-cent store.
Given my dislike for the housing sector, it's not really a surprise that a mortgage-backed securities and CDO purchaser wound up on this list.
Newcastle has been doing its best to get back on its feet after the housing bubble and financial crisis nearly put it out of business. Its portfolio of products personally doesn't inspire a lot of faith from me, as it has very few A-rated securities. Newcastle's riskier portfolio of products could pay big dividends (no pun intended), but it also carries inherent risks that you won't see with other MBS investment portfolios. Following its many years of negative free cash flow, I see no reason to believe that Newcastle is in the clear just yet.
In February, the former RAM Energy received a recapitalization that will save it from being swallowed by debt, but that by no means puts this company in the safe zone over the long-run.
The company's proven reserves of 21.1 million barrels of oil equivalent only give the company a run life of 13.7 years. Over the past decade it has not managed more than $4 million in annual free cash flow in any given year. Now if you can explain how it's going to pay back more than $200 million in debt when it can't turn a profit and is producing less than 2% of its outstanding debt total per year in free cash, then perhaps you deserve a medal. I personally can't explain it, and that's enough reason for me to be skeptical about its prospects.
The sad news for US Airways is that without American Airlines to pick on, I feel the former now falls into the "worst of breed" category for the airline sector. It did put together a string of good quarters in 2011 and grew passenger revenue per available seat mile by 8.5%. But a 38% rise in fuel costs and $4.57 billion in long-term debt says that US Airways has a long way to go before it gains my trust.
US Airways has had a free cash outflow in seven of the past 10 years -- and one of the positive years was so marginal ($2 million) we may as well call it flat. Consumers are opting more and more for the cheapness and timeliness of regional airlines, completely bypassing national carriers. With more than 100 bankruptcies on record in the airline sector since 1990 -- two of which go to US Airways (2002, 2004) -- it's quite possible a third time could be in the cards at some point down the road for US Airways.
Just because these five companies maintain a lot of debt doesn't necessarily mean they're doomed, but it raises a yellow flag. Sound off in the comments section below with your opinion on the above companies and consider adding them to your free and personalized watchlist.
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Add Caesars Entertainment to My Watchlist.
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Add Newcastle Investment to My Watchlist.
Add Halcon Resources to My Watchlist.
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At the time thisarticle was published Fool contributor Sean Williams has no material interest in any companies mentioned in this article. Outside of a mortgage, he loathes carrying debt. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that's interest-free but full of interesting things.
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