Leverage - A Double Edged Sword

Leverage is a word often heard of these days, especially with the sub-prime credit crisis in full swing affecting everything from major US banks to far flung Japanese banks. Apparently, the amount of debt which investment banks take on is enough to cause a ripple effect and add to the major headaches experienced by reputable financial institutions, who have had to write down amounts of CDO and debt-related instruments to the tune of billions of USD. All these problems actually stemmed from debt, or leverage as it is known. There have been countless articles written on the ongoing sub-prime debacle, and George Soros has even written a book about it; so I will not delve further into this issue. Instead, let's examine the effects of leverage on companies and how it can make or break them.

As readers may know, many companies (public and private) grow by taking on debt into their Balance Sheets. The reason for taking on debt is to use the money to grow the business and to earn a return on investment which is HIGHER than the interest rate charged on the debt. In effect, you are using money to build more money. Of course, one may argue that there are businesses out there which employ purely equity or cash flows from operations to grow organically and expand, but these "great" businesses are few and far between. Warren Buffett has personally identified the "great" business of See's Candy, which I will elaborate on in a subsequent post; but he admits that companies can also be "good" yet take on substantial leverage in order to grow the business. He is referring to companies which gear up to either grow the business through asset acquisitions, construction of new plants to increase production capacity, or to grow the business organically through vertical or horizontal integration.

Leverage itself is NOT a bad thing, as long as one is mindful of the potential risks and pitfalls involved. It's a little like medication - enough of it is good for you and will cure your ailments and even make you healthier in some cases, but too big a dose may cause permanent harm and the effects may be irreversible. There are examples of companies listed on SGX which have taken on more bank loans and issued debt securities (e.g. notes or debentures) in order to grow their business. Recent examples include Olam in order to scale up the business through acquisitions, and also several China companies which have issued convertible debt to fund asset enhancements. Growth at a reasonable price (GARP) is a concept which is taught in some value investing books, and states that growth can come as a result of a debt being carried at a certain price (i.e. interest rate); provided the debt is cheap and the growth can be justified. In cases where growth is not sufficient to justify the debt taken, then the debt should be avoided and the company should seek alternative sources of financing (e.g. equity financing).

The situation becomes more problematic and dire when companies take on excessive debt over and above what would be required to grow the business. Firstly, this is a sign that operating cash flows are insufficient to grow and sustain the business, which results in a vicious cycle of borrowing to grow (this gives the investor the illusion that a company is growing, while its current ratio falls below one). Second, finance costs may become prohibitively high and eat away at gross margin, leaving the net margin in tatters. Thus, a company with a decent gross margin may still be left with little profit after accounting for financing costs. Of course, one has to be careful in assessing what is the "right" amount of debt for a company to take on, as this can be industry specific (some industries are highly capital intensive) and there may also be a short-term reason for taking on additional debt which justifies bumping up the leverage ratio. In short, there is no hard and fast rule for "sufficient or excessive leverage" as one must look at companies on a case-by-case basis.

Looking at my current portfolio of companies, Ezra, Swiber and Pacific Andes/China Fishery take on substantial amount of debt to grow their businesses, in the process fortifying their balance sheets with more fixed assets. For Ezra and Swiber, they have been able to "avoid" taking on excessive debt by using sale-and-leaseback, a form of vessel financing. However, for CFG and PAH, their issuance of senior notes and convertible bonds has added to their gearing substantially, and this represents a risk for the company should growth stagnate and their finance costs balloon above their ability to generate operating cash flows. Hence, this is one of the risks I take on as a shareholder. Seeing how Management have a good track record of growing the company despite having high leverage the last 10 years, I continue to be confident that their additional debt can be used effectively to grow the business and generate high ROE/ROI. Only one of my companies, Boustead, is sitting on a substantial pool of cash (S$150 Million) which it can deploy for acquisitive opportunities during a bear market and crisis. This is also one of the advantages of having cash instead of debt, the opportunity costs of NOT being able to take advantage of good deals during bad times.

To close off this topic (which I am sure should invite a considerable number of comments), I will talk about a company called OSIM and how they used a leveraged buyout scheme to purchase a company in USA called Brookstone back in 2005. Before the acquisition, OSIM was flushed with cash from their strong sales of their products; however after the acquisition they ended up in a net debt position which they are still trying to clear after 3 years. Unfortunately, the debt which they took up did not help to grow their bottom line to the extent that they were hoping for, and the result is that the debt is becoming a burden as they have to pay for high finance costs while suffering from declining sales and an erosion of their competitive edge. Their last corporate action was raising money through an issue of warrants to subscribe for shares at 30 cents, as a direct equity raising was not feasible. It remains to be seen whether the company can pull itself out of the doldrums and justify that the gearing they took up was indeed worthwhile.