One of the reasons the 2008 global financial crisis was so severe is that there had been a build up of too much debt around the world. This was particularly true in the financial sector, where banks had borrowed aggressively in the preceding decade.
Since then, the global financial sector has successfully reduced its debt levels. The same is not, however, true for governments and non-financial corporates. As the graph below shows, these sectors have significantly increased their debt, encouraged by a low interest rate environment.
“There is more debt today in the global system than there was at the time of the global financial crisis,” notes Johny Lambridis, head of equity at Prudential Investment Managers.
Data and analytics company GlobalData notes that this is a pattern across many countries. In China, most notably, the economy grew 586.9% between 1995 and 2017, but the total debt burden of the country expanded from 107.9% of GDP to 253.6% of GDP over the same period. Of the total outstanding debt in that country, 81.5% is private debt, mostly owed by corporates.
While debt at a country level is of growing concern to a number of economists, investors should also pay attention at a company level. As economist John Kenneth Galbraith notes:
“All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”
The two considerations
In this respect, Lambridis says it is particularly important to understand how corporate debt is structured. It is not like a personal mortgage, in which the borrower pays both interest and a portion of the capital every month.
Companies that have issued bonds only pay monthly interest on that debt. The total capital has to be repaid at the end of the term. This means that when analysing a company’s debt profile, you have to consider two things.
The first is its free cash flow, since that is effectively what is used to pay back the debt.
“A lot of companies report significant earnings, but those do not necessarily translate into cash flows,” says Lambridis. “Tongaat is the most poignant example of late. Historically, although that company had declared earnings, they weren’t generating cash.”
The second is to be aware of the repayment schedule.
“A lot of South African corporates haven’t spent enough time thinking about when their debt is due,” Lambridis argues. “Companies don’t go bankrupt because their liabilities exceed their assets. They go bankrupt because they don’t have enough cash in the bank when those liabilities become due.”
He believes it is important for investors to look at the local lessons that have already been learnt when it comes to debt. The first example is Edgars, which Bain delisted from the JSE in a private equity deal in 2007. At that point, Edgars did not need to carry much debt, but instead of paying for the acquisition with their own cash, Bain transferred the entire R26 billion purchase price onto the company’s balance sheet.
“Things didn’t turn out too well,” Lambridis notes. “The economy slowed materially after the global financial crisis and Edgars’s debt to equity rose steeply to 100% of its capital.
“Effectively its equity was worthless.”
In order to manage this, Edgars has twice converted debt to equity, meaning that its lenders have “taken the keys” to the business. Bain’s holding, meanwhile, has been wiped out.
Another example is Anheuser-Busch InBev (AB InBev), which took on too much debt at the wrong point in the cycle to finance acquisitions. With interest rates being so low after 2008, it was significantly cheaper for the company to issue debt than it would have been to use shares.
Between 2008 and 2016 AB InBev made three large acquisitions – Budweiser, Grupo Modelo and SABMiller – each financed through debt. Over this period its debt to capital ratio jumped from zero to 70%.
“The market initially rewarded AB InBev for its acquisitive strategy,” Lambridis says. “That is until we get to about 2018 and the market realises that since the acquisition of SABMiller, this company has not been able to de-lever, because all of its free cash flow is going to shareholders as dividends.”
Between November 2017 and January 2019, AB InBev’s share price fell by nearly 45% over concerns that it would struggle to pay back debt that was becoming due in the next few years.
“Management had no choice, they were in a corner, so they had to cut the dividend,” says Lambridis.
This decision allowed management to use some of the free cash flow to service debt, but the company’s dividend yield fell from over 4% in 2018 to around 2.2%.
“To some extent the share price has now stabilised, but there has been a large destruction in value,” Lambridis says.
The other side of the coin
There are numerous other examples of local companies that have run into debt problems, including Steinhoff, Aspen, Woolworths and a number of property stocks. These clearly highlight the risks. However, understanding debt also presents investors with opportunities.
“Companies that have a lot of leverage and are able to de-lever themselves can deliver astronomical returns,” says Lambridis. “We’ve seen this with Anglo American and Altron.”
The latter is particularly noteworthy because it built up a lot of debt quite quickly due to making a lot of acquisitions.
“The debt to capital approached very dangerous levels, and at one point there was more debt in the business than Altron’s market capitalisation,” says Lambridis.
However, the company was able to sell a number of its operating businesses, and reduce its debt. As a result, its share price has risen from R5.60 at the start of 2016 to over R25.