The Federal Reserve's quantitative easing efforts combined with its zero interest rate policy of the past few years have created extraordinarily cheap external financing options for corporations. Indeed, the corporate debt market has witnessed a boom in new issues at record low rates since the financial crisis subsided. This has enticed many companies to take advantage of record low rates and issue new debt "while the gettin' is good," as they say down South. This article will take a look at three such companies that may have issued a little bit too much in relation to their respective abilities to service the debt.
Church & Dwight
First up, Church & Dwight (NYSE:CHD) is a 167 year old holding company that develops, manufactures and markets a variety of personal care items that are sold in North America, Mexico, Australia and Europe. The company manufactures everything from lotion to baking powder and toothbrushes to shampoo. The company is immensely profitable, producing over 11% return on sales last year. In addition, the company repurchased $242 million worth of common shares in 2012. However, the company has taken on an additional $650 million worth of debt as of the end of 2012, taking the total owed up to $903 million including long term and short term debt.
This total represents roughly three years' worth of net income for the distributor and while the company has been growing earnings at a very respectable rate over the past several years, having to service nearly a billion dollars in additional debt for a company with $4 billion in total assets may prove to be challenging if the macroeconomic environment sours.
Church & Dwight is a terrifically profitable, very well-run company that is poised for further growth in the future. However, the stock is expensive at nearly 21 times this year's earnings estimates and a PEG ratio approaching 2.00. Add to this the enormous amount of debt financing the company absorbed during 2012 and the rosy growth picture begins to muddy a bit. The company does pay a 1.8% dividend at current levels but with the stock hitting a new high just this week, I will steer clear of C&D until such time that we get at least a moderately sized pullback.
Kraft Foods Group
Kraft Foods Group (KRFT) is the recently spun-off grocery business that was part of the newly-minted Mondelez International (NASDAQ:MDLZ) company. The company sells cheeses, various types of drinks, refrigerated meats and other consumer staple products. Kraft provided shareholders with a 9% return on sales last year but also experienced a decline in revenue from 2011. The company, after being spun off, now has negative net tangible assets, $10+ billion worth, including nearly $10 billion of debt that was capitalized to the balance sheet upon being spun off from Mondelez.
This amount represents roughly 6 years' worth of earnings for the young company and when you couple this overwhelming amount of debt with the fact that revenue and earnings both declined last year, it doesn't paint a pretty picture. In addition, the company only has about $4.8 billion in current assets so any hope for a speedy redemption of the debt won't come from existing assets.
Kraft is a very profitable but slowing business that has very questionable growth prospects. The company does pay a very nice 3.8% dividend currently, even with the stock trading near its highs. However, the stock is trading for greater than 16 times 2013 estimated earnings and sports an eye-popping PEG ratio of 2.94. With markets near all-time highs and likewise for KRFT shares, I would stay away from this company as its terrible prospects for growth mean that a forward PE of 16 is far too high. This stock should be bought as a bond equivalent only based on its robust dividend; don't expect much, if any, capital appreciation in the future.
H&R Block (NYSE:HRB) provides tax preparation and related services to the general public in the US, Canada and Australia. The company has built up a very recognizable and well-known brand in the US but has experienced declining revenues and profitability in recent years. Despite this, the company produced a 9.5% return on sales in 2012 but that was down from a more robust 14.4% in 2011. The company added $500 million of new debt in the latter part of 2012, ballooning the total of long term debt from $409 million last April to $906 million at the end of this past January.
Based on 2012 earnings, this represents roughly 3.4 years worth of profits for HRB. Given that revenues and profits are in relatively steep decline the past three years, this doesn't bode well for shareholders. Profits have declined from $479 million in 2010 to $266 million last year, or a decline of 44%.
Given that HRB is in a commoditized business where there are many competitors and pricing power is virtually nonexistent, HRB's business model is clearly not working any longer. The company is still profitable but at the rate that revenues and profits are declining, I'm not certain how much longer that will last. In addition, the company more than doubled the amount of debt it has to service last year. Despite all of this negative evidence, shares are still trading relatively near their highs for the last 52 weeks. In addition, the shares sport a forward PE ratio of 14.5 and a PEG of 1.44. I would argue those two numbers are quite high for a dying business. Whether those numbers are high or not, the company's saving grace at the moment is its robust dividend, currently clocking in at 2.8%. The dividend appears safe for now but this is no dividend aristocrat, holding HRB opens shareholders up to the immense risk that the deteriorating business faces.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.