The news this morning brought word of a major retail casualty; the J. Crew Group, which operates both J. Crew and Madewell. It announced it had filed for bankruptcy protection. Not surprisingly, the news stories also mentioned several other venerable retail names that have been brought low by the pandemic, the latest in a stream of challenges.
Leverage is one of the main reasons why J. Crew and those other retailers are having trouble getting through the pandemic and past the continuing threat from Amazon.com (NASDAQ:AMZN) and other online competitors. J. Crew will continue to operate, presuming bankruptcy allows it to get out from under the weight of its extensive debts.
Debt commitments are much wider than just retail, though. As I found when I profiled companies on the GuruFocus Undervalued Predictable list, debt is quite common. For most of these companies, such as Hanesbrands (NYSE:HBI), Ross Stores (NASDAQ:ROST) and Lennox (NYSE:LII), the debt is manageable. When we look at their weighted average cost of capital versus return on invested capital ratios, we see healthy companies because their returns are multiples of what they pay for equity and debt capital.
For many companies--and their investors--debt is a concern if not a severe worry. For example, Bloomberg.com displayed this headline on Jan. 2, well before the pandemic arrived in North America: "S&P Takes Most Bearish Stance on U.S. Corporate Debt Since 2009." At that time, players in the oil and gas industry were taking the biggest hits. In other words, there was a debt problem before the coronavirus and its arrival magnified the problem.
S&P is one of the three big ratings agencies, and like the others, the ratings they give to companies directly affect the cost of borrowing. If a company's rating goes down, it will pay more for any new or renewed debt. By paying more, it means they will have to shoulder a higher interest rate, thus pushing up its cost of doing business.
On March 27, another of the big three, Fitch, reported that it was concerned about the severity of the debt problem:
It increased its institutional term loan default rate forecast, from 3% in 2019 to 5% to 6% in 2020.
By the end of 2021, it was expecting cumulative defaults to reach $200 billion.
Covid-19 was getting the blame. They wrote: "Fitch expects the default rate to reach 8%-9% by year-end 2021 as many companies succumb to drastically lower revenue (in many cases zero). We project the cumulative impact to exceed $200 billion through 2021, which equates to 15% of the $1.4 trillion universe."
If the economy fails to bounce back, the default rate could go into double digits; it is assuming the "brunt of the impact" will be felt in 2021.
Fitch expects retail and energy defaults to approach 20% this year. For energy, it's a combination of steep declines in oil prices and the current lack of demand.
Other than retail and energy, the most challenged sectors are restaurants, casinos, movie theaters, airlines, hotels, gyms and non-food retailers.
What can we do?
Investors can protect themselves, to a greater or lesser extent, by knowing the leverage situation for individual companies. Here's a look at the financial strength metrics for Ross Stores (as of May 4, 2020):
Let's review the individual components that affect its debt risk:
Cash-to-Debt refers to the relationship between the company's short-term assets (cash, cash equivalents and marketable securities) and its debt. The ratio is calculated by dividing the assets by the debt. A ratio of 1 or higher means a company could pay off its debt with just its cash and securities on hand. For Ross, the ratio number is 0.39; is it in danger? We'll get the answer in several other metrics.
Debt-to-Equity is another ratio that spells out a relationship, in this case between both long- and short-term debt and total stockholders' equity. For Ross, the ratio spiked in 2019.
Debt-to-EBITDA refers to the relationship between a company's debt and its earnings before interest, taxes, depreciation and amortization. In other words, how much income would be required to pay off the debt. In this case, the lower the number, the better.
Interest coverage: If you wondered why Ross could have taken on so much debt recently but still get a strong mark (7 out of 10) for financial strength, part of the answer is found here. The ratio is calculated by dividing a company's operating income by its interest expenses, so 266.6 means it has enough operating income to pay its interest expenses 266.6 times over.
Altman Z-Score is a test of credit strength, based on five financial ratios that help predict whether a company will become insolvent. Although it was designed for the manufacturing industry, it has become a widespread test for the likelihood of bankruptcy. As the chart shows, Ross has a good Z-Score and is considered safe from bankruptcy.
Beneish M-Score is aimed at flushing out companies that manipulate their earnings. It is similar to the Altman Z-Score, but aims to detect earnings skullduggery rather than the possibility of bankruptcy. The chart shows Ross is not suspected of being a manipulator.
WACC vs ROIC is an important factor in financial strength considerations. For Ross, you'll note the green bar is much longer than the red bar, indicating the company can earn more with each dollar invested than it has to pay in interest (note that the words and the bars are reversed; while WACC comes first in the words, it comes second in the bars). Specifically, Ross generates ROIC of 34.53% for each dollar invested, while its weighted average cost of that dollar (capital) is 6.12%
Debt can be a powerful tool when used by a company like Ross Stores since it uses borrowed capital to increase earnings at a rate that outpaces the cost of capital. But when circumstances or bad management intervene, leverage can be the downfall of companies.
The rating agencies, not to mention many investors, are concerned about the corporate debt bubble that has arisen over the past decade, driven by low interest rates and easy lending criteria. Particularly worrisome is the Fitch's assessment that the current carnage will last well into 2021.
Investors can avoid much of that pain by selecting or increasing their allocations of stocks that have little or no debt, or are capable of handling their debts comfortably.
Disclosure: I do not own shares in any of the companies listed in this article and do not expect to buy any in the near future.
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This article first appeared on GuruFocus.