By David Sterman
Over the decades, companies have sought to find the right amount of debt to carry on their balance sheets. Just enough debt is a good thing; it can boost earnings per share since fewer shares need to be issued, and debt interest expenses can help reduce a tax bite. But too much debt can be very scary if the economy turns south.
Why is a bad economy so dangerous for companies with excessive debt loads? Just like individuals paying off personal loans, corporations with high amounts of debt are required to make fixed loan payments. If Bob has student loans to pay off, he has to make his payment every month, even if he loses his job. If the economy slumps, companies still have to make their loan payments, even though they're bringing in less money.
GM targeted roughly the same mix between debt and equity for many decades, but when the economic crisis of 2008 hit, the company's debt load suddenly became too much to manage and the venerable auto maker needed to declare bankruptcy.
In response to the economic crisis of 2008, many companies sought to trim their debt loads for fear of another recession. But as that crisis has receded from view, companies have become complacent again, piling up debt as if 2008 never happened.
The largest debt-holders are generally in financial services. It may seem scary that firms like Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM) and Citigroup (NYSE:C) each carry more than $300 billion in long-term debt, but these banks are actually far healthier than they were a few years ago. New regulations have forced them to hold a lot more cash than they did before, and the odds of another meltdown for them is much less likely than it was in 2008.
But what about non-financial firms? Since there are no regulators to monitor their balance sheets, might they be running too much risk for these uncertain economic times? Maybe, maybe not. But investors may want to steer clear of these firms at least until we're sure that the U.S. economy has not slipped back into recession.
A handful of non-financial companies carry more than $20 billion in long-term debt.
Here are six companies with the largest debt loads in the S&P 500. If the economy slumps in coming quarters and years, their high debt loads could prove toxic.
GE: A high level of debt proved to be disastrous for GE back in 2008, as the company's GE Capital division suddenly found itself without a lifeline when the Lehman Bros. collapse caused chaos in financial markets. GE relies on overnight banking transactions to roll over some of its debt. Back then, GE saw its shares fall from $25 in the summer of 2008 to just $6 in early 2009. Might lightning strike twice? Perhaps not to such extreme levels, but it's little comfort to investors that GE still carries roughly $3 in debt on its books for every dollar of equity. A deep economic retrenchment would bring this balance sheet right back into the spotlight.
Ford (NYSE:F): This auto maker managed to avoid bankruptcy in 2008 by having a bit of foresight. It sold many assets in the prior 24 months, helping to raise cash to offset any looming debt crunch. Although Ford's current $100 billion debt load seems scary, the auto maker has actually been building cash levels while paying off debts that were expected to come due in the very near-term. As a result, Ford could handle a hefty economic slowdown without raising bankruptcy fears. But it best not be too long a slowdown. If such a slowdown lasted for several years, Ford would need to slash spending to hoard cash, putting it at a disadvantage to better capitalized rivals.
Arlington Asset Investment (NYSE:AI): The biggest risk for this firm is not only a deep economic pullback, but also other unforeseen events that would require the company to spend a lot of money on paying people's insurance claims, such as environmental calamities. With $85 billion in debt on its books, this insurer would be ill-equipped to run out and raise fresh capital through the stock market.
American Express (NYSE:AXP) suffered a GE-like bruising in 2008, seeing its shares plunge 80% from the summer of 2008 to the spring of 2009. Fears that a protracted economic crisis would cause the company to collapse under its debt load dominated the business headlines, though the concerns proved unfounded. AmEx still managed to generate $4.6 billion in free cash flow in 2009, 20% below 2008 levels. Free cash flow rebounded to $7.5 billion last year. It would take a really bad economic shakeout for AmEx's debt-laden balance sheet to become an issue again.
AT&T (NYSE:T) and Verizon (NYSE:VZ): These two should be lumped together as they have very similar business models. Each has a declining landline business and a burgeoning wireless business. It would take an even faster decline in the landline business, or an all-out price war in the wireless business, for investors to fixate on the balance sheet. More than likely, both of those businesses will continue on their current trajectories -- regardless of the health of the economy -- giving their respective management teams ample time to adjust their balance sheets to any new realities.
What about your portfolio? You may want to check out all of your investments to see how much debt they carry. If you're looking for candidates to sell, then the stocks with the most debt should be at the top of your list, at least until it becomes clear that the economy isn't heading back into recession. Until then, look for companies that have a low debt load. Since low debt payments have a smaller impact on profits, these companies are safer in times of economic trouble, as well as less volatile.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.