Early Detection of Coverage
A first step in a preemptive approach to restructuring is to identify the coverage of financing obligations defined as dividends and debt service. Net Free Cash Flow is the primary internally generated cash flow source to cover these financing obligations. For further details and definitions see the Explanatory Notes at the end of this post. Coverage of these financing obligations (also abbreviated DDS coverage) is examined with (1) averages and actual (same-year) data in Chart 1 (2) compound annual growth rates in Chart 2, and (3) spatial centrality (in several frames featuring curves). This generic analysis employs actual data to fiscal year (FY) 2018 of a non-financial firm (KO) for which enough historical observations were available to construct extended charts.
Chart 1 below shows DDS coverage over fiscal years 1996-2018.
Average. DDS coverage is estimated by comparing the 10-year average of NFCF to the sum of debt service and dividends DDS in each of the fiscal years 1996-2018 (e.g. the average to FY 2018 is for FY 2009-FY 2018 inclusive). The data are as a percentage of revenues (i.e. NFCF/Revs and DDS/Revs). The arithmetic mean is shown for NFCF/Revs (labelled AM) along with the same year values labelled actual. (The geometric mean is not shown but does not appear to lead to different conclusions). DDS coverage appears to have been approximately adequate until FY 2013 per the averages (arithmetic and geometric); however, since FY 2014, the DDS/Revs figure has surpassed NFCF/Revs. As of FY 2018, DDS stood at a total of 39% of revenues (=18% for dividends/revenues and 21% for debt service/revenues). Actual (Same-Year). Now comparing the firm’s financing obligations to the NFCF/Revs values in the same year it appears that after rebounding in FY 2013, coverage began to fall short again by FY 2014.
Chart 2. CAGR. In terms of compound annual growth rates (10-year), FY 2014 also appears to have been a turning point in financing coverage. Revenue growth may have been an early warning indicator after peaking in FY 2011.
For additional reference, based on slightly longer period of 13 years of observations to FY 2018 (FY 2018-2006) the CAGR approximates negative 1% per year. The next section focuses on coverage from the standpoint of spatial centrality.
Spatial Centrality (Charts 3-9). In this section,financing coverage for each fiscal year of a total of six fiscal years is represented in each chart below as a fitted distribution of NFCF/Revenues. Results for FY 2013-FY 2018 are shown in the charts below, along with an interpretation of these charts. For example, in the chart labelled ‘fiscal year 2018’ (FY 2018), the underlying data for the distribution is for the 10 fiscal years from 2009 through 2018.
FY 2013-14. The frame on the left suggests hypothetically adequate coverage in FY 2013 (adequacy represented by green color-coding). The frame on the right is FY 2014 and shows a marked shift to a tendency towards inadequate coverage (represented by red color-coding). For further explanation, see the interpretation below.
Interpretation. Green and red color-coding between vertical lines signifies hypothetically adequate or inadequate coverage, respectively. The word ‘hypothetical’ is used because this type of format presents tendencies around a central estimate based on a theoretical model. Vertical Lines: Each curve features two vertical lines with a solid color in between them: (1) One of the vertical lines (V1) represents a spatial central estimate of the curve (where 50% of the space is located to the left and right of the vertical line); also abbreviated as ‘centrality’ and which tends to appear in the dense area of each curve. (2) A second vertical line (V2) represents the location of DDS/Revenues (i.e. the financing obligations) for the most recent fiscal year. This vertical line V2 can be anywhere around centrality V1: If V2 is to the left, the color coding is green, meaning hypothetically adequate. If V2 is to the right of V1, the color coding is red, suggesting hypothetically inadequate coverage.
FY 2015-2017. Compared to FY 2014, the next three framessuggest a slight worsening in 2015 (left), a stabilizing in FY 2016 (middle), followed by a further worsening in FY 2017 (right).
Fiscal Year 2018 (Most recent, below). By FY 2018, while the centrality is estimated at 13.8% of FY 2018 revenues, the DDS/Revs (financing obligations) total 39% of revenues and do not appear within the frame; therefore, a second ‘cutout’ frame is added (right) to show the DDS/Revs figure as a dot at 39% at the far right of the frame).
Shifts in Key Variables (Year-over-Year)
In addition to DDS coverage as discussed above, year-over-year (YoY) changes in the individual NFCF/Revs and Revenue growth variables can highlight if extra caution might be needed in debt and dividend decisions.
Chart 10. NFCF/Revs. The chart below shows YoY changes in the estimates of spatial centrality of NFCF/Revs (the figure 1 represents no change from the previous year). A simple trend line is added as a rough reference.
Chart 11. Revenue Growth. The CAGR figures for revenues based on rolling 10-year periods were shown in the CAGR chart (Chart 2) above, indicating a turning point after the peak of FY 2011. A chart of YoY revenue growth is shown next with a simple trend line.
As early as FY 2012, the significant change in revenues might have raised a red flag. The 10-year CAGR of revenues (FY 2018 to FY 2009) is nearly zero. The YoY revenue growth history since 2007 suggests a slight downtrend.
Tentative Conclusion: Early Detection. From the generic early warning analysis above, the firm could have begun taking a more cautious approach towards adding to its financing obligations as early as FY 2014; an even earlier signal occurred in FY 2012 with the significant drop in revenue growth from the previous fiscal year. This raises the question discussed next: Was the continued accumulation of financing obligations an oversight on the part of management?
Oversight or Intent? If decision-makers underwent a similar analysis and were aware of a deterioration in DDS coverage there may have been a conscious decision to add leverage after careful consideration of the trade-offs and risks. For example, one strategy might be to finance stock buybacks with low-interest debt to (A) maintain the stock price within a certain range, and (B) raise dividend growth rates on a smaller base of outstanding shares in hopes of a turnaround in revenues and improved cash flow. This may appear beneficial at least short-term if the share repurchases reduce net cash outflows such that reduced dividend payments exceed any additional debt service required from financing the repurchased shares. In the meantime, they may pursue strategies to raise revenues and cash flows.
However, if revenue and or cash flow growth do not materialize within a certain time-frame as determined by management, prompt action may be necessary before officially defaulting (e.g. ‘official’ here can mean default on payment or possibly certain covenant defaults as per loan agreements which would force their lenders to initiate a debt restructuring plan). The following is a cursory overview of possible preemptive actions: 1. Equity Infusion/New Equity Issuance. At the risk of diluting the stock and weakening the stock price, debt can be paid off and preferred stock retired (re: see the Addendum below whereby policy action can be instrumental; Grant 1996). Also, key investors and those with a stake in the company’s future may also step up by purchasing newly issued shares.
2. Debt Refinancing. Rather than waiting for the lenders to move, management seeks a change of banks/lenders (e.g. for a ‘take out’) or proactive negotiation with current lenders to stretch out debt service over a longer period. 3. Dividends. One strategy to reduce dividend payments via share repurchases was described in the previous section; if this is unsuccessful, an undesirable yet possibly unavoidable strategy is simply to cut or eliminate dividends. 4. M&A. An acquisition of, or strategic merger with, (ideally a much less indebted company) can raise revenues from the combined entity while affording the opportunity to eliminate cost redundancies. 5. Spin-offs. Cash can be raised by selling off poorly performing parts of the business to be better managed individually than as part of the big entity that it is dragging down; the proceeds of the sale can then be used to pay down (or pay off) debt.
Policy and Systemic Causal Factors
Firms may base some of their decisions on existing or new policies to be implemented (e.g. monetary policy and rate cuts). Lobbying by overextended firms for interventionist policies can play an important role, as well. Longer term, a major concern is the eventual ‘zombification’ of companies, financial institutions and economies as their dependence on one or more forms of state aid becomes endemic. A few examples are detailed next:
1.Monetary policy can be instrumental in reducing the cost of borrowing through lower policy rates, raising equity prices and in reducing the real value of debt through secular currency depreciation. For an historical example of an equity issuance replacing debt, see Grant (1996) on the “miracle cure” of the early 1990’s in which the Federal Reserve is described as a “helpmate” with low policy rates propping up stock prices and helping to reduce corporate-bond defaults and net corporate interest (pp. 244-245). The distortive and deceptive nature of this policy is noted; normally stock prices would be expected to reflect additional share issuance, but policy interventions can mask the market’s signal. Also, see the following section (Interest Rate Distortion) below regarding interest rate policy in recent years possibly contributing to a tendency towards overborrowing by firms.
2.Bailouts can take various forms, involving the purchase of company equity or debt, either by a government entity/agency or by central banks. These purchases (likely at inflated prices compared to the market) can have a distortive impact on yields because as securities are removed from the pool of available securities on the market, investors competing for, and bidding on, the remaining supply can lower yields below where they would settle in an undistorted market, sending the false signal of low-yield ‘safety’ and also pushing investors towards even higher-yielding and riskier investments. This phenomenon may be prevalent in high-yield debt markets (where the underlying debt issuers are highly leveraged firms); contradictorily, HY debt may cease to be high-yielding because policy has essentially severed the link between heavy debt loads and high-yield spreads.
3. Banking System leniency includes perpetual forbearance and perennial renewal of defaulted and non-performing loans without initiating any special servicing or restructuring arrangements. Working capital lines of credit that become unrepayable eventually stagnate on bank books as “permanent working capital lines of credit.” Problem loans also may be backstopped by government guarantees.
While at first banking system problems may fester quietly, they may eventually culminate in full-blown banking crises. (re: evergreening concept; see Kennedy (2015) Appendix 3 detailing the phenomenon of debt service and permanent non-amortizing debt in the banking system; also, Sigurjonsson, 2015 regarding systemic banking crises since 1970: 147 occurrences in 114 countries).
Monetary Policy Detail: Interest Rate Suppression? With early detection andpre-emptive action as summarized above, management may be able to stem or slow the growth of unsustainable debt accumulation. However, a system-wide issue remains that presents a challenge to limiting leverage: The absence of self-regulating market forces for the issuance of credit --until crisis hits. A more self-sustaining solution would be a long-term incremental adoption of flexible market rates of interest that naturally regulate the quantity of credit granted (i.e. natural interest rates): Interest rates should rise as a function of greater loan demand relative to the supply of credit; moreover, less creditworthy borrowers should be disincentivized from taking on too much debt through higher (not lower) interest rates that reflect higher risk.
Charts 12-13. 2008-2018 Period. A crucial question is whether monetary policy might be encouraging more borrowing than would otherwise be the case. The charts below show the year-over-year change in the yields for 90-day Treasuries (left) and 10-year U.S. Treasury bonds (right) from 2008 to 2018 (constant maturity).
During this period (2008-2018) central estimates (spatial) for the YoY change in the 90-day and 10-year yields are 0.95 and 0.93, respectively.
Charts 14-15. Comparison with 1963-2018 Rates. The estimates for the 2008-2018 period in the above Charts 12 and 13 appear to be substantially lower than those for the 55-year period from 1963 to 2018 shown in charts 14-15 below showing the distributions of the YoY change over 1963-2018 for the 90-day and 10-year bond yield. Their central estimates are 1.013 and 1.002, respectively, suggesting minimal change, particularly for the 10-year.
Since the Great Financial Crisis from 2008 to 2018, interest rate policy may have been somewhat more accommodative than the longer-term historical pattern suggests, both for short-term yields (90-day) and longer-term yields (10-year). Extended yield suppression, while intended to aid in the recovery, may have sowed the seeds of leverage for many firms, as a self-regulating rise of yields corresponding to increased borrowing was prevented from occurring.
1 Definition, NFCF. NFCF isthe primary source of payment for dividends and debt service DDS, defined as Free Cash Flow less acquisitions and is viewed as a more comprehensive measure for estimating debt service coverage than free cash flow. Further details are provided in the author’s Dividend Coverage Roundup reports and in Financial Distortion Dynamics (2018). NFCF is also referred to as equity income. For debt service coverage (DSC), the term primary source of repayment (PSOR) is used because of repayment of principal. DSC is considered an essential indicator of over-indebtedness in addition to debt on the balance sheet.
2. Dividends. It is recognized that dividends are not considered to be an obligation in the same sense as debt, however, for dividend-paying companies, it is assumed that there is a reasonable expectation of dividend payments (and in many cases, also dividend growth) that constitute an implicit sense of obligation.
3. Restructuring. Typically, restructuring refers to debt alone (i.e. debt restructuring). In this framework, the concept of restructuring covers both dividends and debt.
4. Models.The theoretical curves selected are generally the most commonly occurring highest-ranking fitted distributions for each variable. For example, for NFCF/Revs, from FY 2009-FY 2018 the highest-ranking fitted distribution occurred in 7/10 or 70% of the cases and was also ranked highest in five of the six most recent fiscal years (FY 2013 to FY 2018); in the one exception, its ranking was #2. The shortcomings of theoretical models have been noted in previous posts and should be emphasized.
The author may also hold positions in securities of companies, including through ETFs, that are covered herein. The discussion and any visuals may contain significant errors, are subject to revisions and are provided 'as is' solely for informational purposes, not for trading or investment advice. This preliminary analysis is exploratory; no claims are made as to the validity of data, assumptions, theoretical models and methodologies; results may be based on prior data that do not reflect the most current market events.
Barua, Akrur., Buckley Patricia., “Rising corporate debt: Should we worry?” Issues by the Numbers Deloitte Insights, April 2019
Board of Governors of the Federal Reserve System (US), Nonfinancial corporate business; debt securities and loans; liability, Level [TCMILBSNNCB], FRED, Federal Reserve Bank of St. Louis, July 15, 2019.
David, Javier E., “Investors aren't sweating US's massive corporate debt pile, but maybe they should,” Yahoo Finance, July 13, 2019.
Grant, James., The Trouble with Prosperity, Times Books, 1996.
Kennedy, Raoul., Interest Rate Analytics, 2015; and Financial Distortion Dynamics, 2018.
Sigurjonsson, Frosti., Monetary Reform: A Better Monetary System for Iceland. Reykjavik, Iceland, March 2015. (Report commissioned by the Prime Minister of Iceland, Ed. 1.0)