As The Debt Party Comes To An End, Here’s How We Should Respond…

It’s a well-known fact that America’s largest publicly-traded companies are collectively sitting on close to $2 trillion in cash. I’ve cited the statistic myself on more than one occasion. For the record, that’s an increase of about $500 billion since the pandemic struck.

What’s less well known is the amount of debt these same companies carry on the books.

Walt Disney (NYSE: DIS), for example, has amassed more than $13 billion in cash and short-term equivalents. That’s a healthy stockpile. Yet, it’s small potatoes compared to the firm’s $46 billion debt load.

A comprehensive study from accounting firm Deloitte last July showed the nation’s largest corporations owed $5.8 trillion. In other words, borrowings outweigh cash positions by nearly a 3-1 margin. And yet businesses large and small continue to binge on low-cost debt, either through lines of credit or by tapping the capital markets. Reuters reports that U.S. companies just issued $130 billion in new corporate bonds during March alone.

You can understand why Wall Street syndicate desks have been so busy fielding requests to hustle newly-minted IOUs. Investment-grade bond yields bottomed below 2% last year – not quite free money, but historically cheap. So companies have been taking full advantage.

Borrowing costs have increased markedly since then. But they remain well below normal levels. According to Moody’s, the long-term average for AAA-rated borrowers is around 6.5% — even higher for those with less-than-perfect credit. Hence the mad rush to lock in cheap money before the Fed slams the window completely shut.

That’s not to say that this money hasn’t been put to good use. Some has helped refinance older more expensive debt. Some has been deployed into Capex spending budgets to pay for new expansion projects. Some has paved the way for accretive acquisitions. And there was still enough for S&P companies to fund $881 billion in share repurchases last year, a new record high.

All can contribute to a growing bottom line. Still, you’ve got to eventually pay the piper…

The Party’s (Almost) Over…

As you can see from the chart below, this intoxicating cheap money era (call it emergency stimulus if you like) has lasted for well over a decade. But the better the party, the worse the hangover. And I’m afraid the keg has run dry.

Source: Federal Reserve Bank of St. Louis

The aftermath may not be pretty to clean up. An in-depth Forbes study concluded that the average non-financial American company has tripled its debt since 2010.

Of course, that’s in aggregate. But take McDonald’s (NYSE: MCD), for example. A decade ago, the Golden Arches empire owed lenders about $10 billion. Today? $35 billion. Par for the course.

McDonalds sells far more burgers today than it did back then. And a larger horse can be saddled with more weight than a smaller one. Still, regardless of how you slice it, there is an avalanche of debt about to cascade down.

While McDonald’s will be fine, some overleveraged businesses have bitten off more than they can chew. They’ll be exposed when the next economic slump hits and earnings dive. Even for those that can effectively manage their borrowings, they exact a toll.

Make no mistake, debt has fueled the growth of many businesses in recent years (particularly in the tech sector). And that’s exactly what has the market worried right now: companies like Netflix will soon have to pay more at the pump. The video streamer has rung up a $15 billion tab and is losing subscribers.

Again, that’s not to say debt is inherently problematic. When wielded correctly, it can be a powerful tool to create shareholder value. But too much of a good thing can cause all kinds of headaches – and I’m not just talking about interest expenses. Sooner or later, the principal must be repaid as well.

If the market senses even a hint of trouble, it can get real ugly real fast. First come credit downgrades, which make it more costly to bring in fresh capital, exacerbating a cash crunch. Liquidity often tightens or dries up completely. Chief Finance Officers (CFOs) often resort to dilutive stock offerings or find some other creative source of cash, usually on poor terms. The company may even be forced to divest prized assets at fire-sale prices.

Remember when Sears had no choice but to sell its Craftsman line of tools a few years ago? That was the beginning of the end.

Needless to say, dividends (which are discretionary) are usually the first thing to get axed. And the company might not even have a choice in the matter. As we know, many bank loans and lines of credit are governed by protective covenants. Those operating restrictions are meant to protect the lender, not the investor. One of the most common is a temporary ban on dividends and buybacks until the company’s financial house is in order.

This whole process can be brutal for debtholders — and even more painful for stockholders.

It’s Time To Look For Low-Debt Companies

That’s why I roll up my sleeves and dig into the balance sheet of any prospective candidate to evaluate financial health and risk.

Fortunately, many quality companies are proactively working to slim down. And over at High-Yield Investing, we’re putting a renewed focus on companies with little (or no) debt on the books.

There are questions that must be answered. How much leverage can the business handle before becoming stressed? Are outstanding loans/notes fixed or variable? How are maturities staggered?

The less stretched the balance sheet, the more flexibility to raise dividends, repurchase stock, pursue acquisitions, and invest in new projects that will move the earnings needle.

I suggest you take a similar approach when looking at your own portfolio. In this environment, it’s more important than ever.

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