Some of the best stock returns in recent years have come from fast-growing companies with debts large enough to repel traditional investors of another era. Low interest rates allowed leveraged companies like Lions Gate Entertainment (LGF), Tenet Healthcare (THC), Boyd Gaming (BYD) and others to put dollars toward growth that they would have spent on interest payments in ordinary circumstances, and their shareholders reaped the benefits.
But the cost of doing business is about to get a lot higher for heavy borrowers. Their shareholders need to do some re-evaluating to ensure that they don’t suffer the end of cheap money, too.
To be sure, a long list of companies have used the low-interest rate environment very well, to shareholder advantage. In addition to Lions Gate, Tenet and Boyd, Healthsouth (HLS), Bally Technologies (BYI), Dunkin’ Brands (DNKN), Web.com (WWWW) and United Rentals (URI) made very good money on the Fed’s low-interest rate policies. The stock charts below show these beautiful gains, most of which exceed 50% in a year.
NYSE:LGF data by YCharts
NASDAQ:DNKN data by YCharts
Each of the companies mentioned above have debt-to-equity ratios that exceed 3.7%. While not “highly-leveraged” in the traditional sense, they generally have more debt than their competitors. (YCharts recently reported rising interest rates and Dunkin'.)
Just how much and how quickly borrowing costs might rise for each company will vary by the terms and duration of their current debts. Moderate rate debt that expires in 2020 isn’t nearly as scary as loads of short-term loans that must constantly be refinanced at market rates. Collecting such details typically requires delving into the quarterly and annual regulatory filings of each company to gauge interest rate sensitivity. (Read Dunkin's 10-K, page 40 and elsewhere, for a discussion of its interest rate risk, for instance.) But for a quick idea of the worries each company might be having about its debt levels now, try charting the companies earnings compared to interest payments. If the company already pays a big percentage to interest, it’s probably particularly concerned about paying even higher rates.
There are a couple of dangers for shareholders in this scenario beyond the obvious “higher interest payments mean less cash for growth.” The company might decide to use cash that shareholders had expected for, say, a dividend increase, to pay down debt and avoid the rising rates. Or it might decide to raise cash by issuing new shares rather than taking on debt, as Duke Realty (DRE) did in January. Such offerings often are not good news for current shareholders. In Duke’s case, however, the markets seemed happier about the decision to reduce debt than worried about the dilutive effects of an offering.
NYSE:DRE data by YCharts
That sentiment may catch on. While the markets may still be willing to overlook high borrowing now, “debt” will surely become a dirtier word to investors as interest rates rise. Shareholders in some high debt companies will do just fine because the debt is well managed, the earnings are growing and the shares are fairly valued. Others will see their shares fall because investors refuse to pay premium prices for companies set to lose more money to debt service. Considering now how the value and the perceptions of these holdings might change in the new world order could stave off some regrets later.
Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at email@example.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.
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