Nothing can get a company in trouble faster than excessive debt. However, not all debt is bad. Properly utilized, debt can be an excellent way to utilize leverage to magnify the returns of investing retained capital (see this article for a less wonky explanation). But when is debt bad and when is it ok?
To start with, there is a very simple strategy: simply consider only stocks where the company carries no debt whatsoever, or has a miniscule percentage of debt to cash (less than 5%, for example). There are hundreds (perhaps thousands) of American companies that satisfy this requirement. In Magic Formula Investing (MFI) alone there are dozens, even large-caps like Dolby (DLB) and Marvell (MRVL).
This does tend to limit your investing universe, however. In fact, an odd consequence of great business models is that management is often more willing to run aggressive balance sheets, given the stability of cash flows. Let's look briefly at such a case in MFI: DISH Network (DISH).
Taking a quick look at DISH's balance sheet, alarms might go off. The company has a negative book value, meaning total obligations are more than assets. Total debt is considerable at $8.5 billion, 185% of cash. Operating profits cover interest obligations at a tight 5 times over.
However, pay TV is undoubtedly a great business. Churn, the percentage of customers who leave the service in any given period of time, is extremely low, about 1.6%. There are tremendous barriers to entry, considering the costs of building a distribution network, getting FCC licenses, and acquiring content deals. Pricing has remained largely rational, given that only 7 companies control the pay TV market in the U.S., allowing for consistent (if small) price increases. Even in 2009, a horrible year for most businesses, DISH suffered no worse than flat revenue growth and a slight margin contraction.
Given this, we have reasonable assurance that DISH's cash flows are not going to fall off of a cliff anytime soon. The company generates over $1.3 billion in free cash flow annually, more than enough to cover debt maturities, buy back shares, and pursue growth opportunities. The initial concerns over the balance sheet become less, well, concerning.
On the other hand, let's look at an MFI example where debt is a major concern - home health and hospice services provider Gentiva (GTIV). Again, the cursory look at the balance sheet is disquieting - a massive $1.03 billion in total debt, just $98 million in cash, a very tight 1.9 coverage ratio, and annual free cash flow of only about $100 million dollars.
Initially, one might argue that Gentiva has the similar reliable business model that DISH has. Home health and hospice services are recession proof. Gentiva has been a reliable cash producer for many years. But thinking a little more about it, the argument breaks down. There are no barriers to entry - home health services are provided by hundreds of companies, from small non-profits to large public companies. And there is zero pricing power. Pricing is controlled by one entity - federal Medicare.
And therein lies the problem. Medicare has been cutting reimbursement rates to home health companies by significant levels - over 5% this year, another 2.3% next year, and is set for further cuts in other areas. New regulatory requirements, such as the "face-to-face" rule, have affected the willingness of doctors to refer to home care. Government budget tightening could lead to more pain on top of this. These are major business obstacles. Gentiva is suffering dramatic operating margin declines at the worse possible time. Their interest coverage ratios are now threatening debt covenants. It is times like these where the "b" word (bankruptcy) begins to creep into investor's minds.
When analyzing a prospective investment, always be mindful of financial health, but don't let debt scare you away from buying a great business at a reasonable price. Consider the predictability and stability of cash flows when deciding how much debt is too much for a particular business. This is one step in identifying the best Magic Formula stocks.
Disclosure: Steve owns no position in any stocks discussed in this article.