A buddy of mine once got a bit of a shocker a few days before his wedding, when his soon-to-be bride confided that she owed $40,000 or so in unpaid student loans. Fortunately, it wasn't a deal-breaker and they are still happily married. But it took years to dig out from that deep financial hole.
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Many companies come with the same kind of baggage. General Electric (NYSE: GE), for instance, has some attractive assets, including $62 billion in cash and $50 billion in property and equipment. But then hidden a little lower on the balance sheet is a whopping $115 billion debt load. Even for a global giant, meeting the principal and interest payments on these loans is a heavy burden to bear.
That's not to say that debt is inherently bad. Just about every public company borrows money from time to time, including highly successful leaders such as Amazon.com (Nasdaq: AMZN). When used correctly, debt can be a powerful tool. And we are still in the era of cheap money. According to Moody's, the average corporate bond yield for creditworthy borrowers is around 4.2%, well below the historical average of 6.9%.
You can't really argue with the strategy of borrowing money at 4% and then deploying it into a growing enterprise boasting returns on invested capital (RoIC) of 10% or more.
Unfortunately, the math isn't always so clear-cut when the cold realities of business are involved. Acquisitions sometimes go awry. New ventures don't always pan out. Whatever the case, initial earnings projections often prove overly optimistic a few years down the line. In many cases, that leads to a write-down or impairment charge, an embarrassing acknowledgement of poorly spent money.
Even when the business is performing as expected, over-leveraged balance sheets can still be problematic. For starters, it means less flexibility for management to pursue growth opportunities. In fact, to protect their interests, many lenders insist on restrictive covenants that place limits on what borrowers can and can't do.
Then there's the obvious fact that every dollar spent on interest payments is one dollar fewer for dividend payments. That's true even when interest rates are stable. But in a rising rate environment (such as we're in now), every quarter-point increase can mean millions in additional annual financing charges.
This can be particularly concerning for businesses that must frequently tap the credit markets, such as real estate investment trusts (REITs) and midstream energy master limited partnerships (MLPs). In difficult markets, liquidity dries up and investors flee, causing share prices to plummet.
Let's Find Some Debt-Free High-Yielders
The U.S. Federal Reserve just released an eye-opening Financial Stability Report, sternly warning that excessive debt levels could be a ticking time bomb for some companies. At the very least, unhealthy balance sheets can scare away investors and weigh down a stock.
That was the motivation behind today's stock screen. I searched specifically for generous dividend payers that are completely unencumbered and debt-free. That's a rare trait -- and a soothing comfort for investors worried about the negative impact of future rate tightening.
After conducting secondary screens for earnings growth and overall dividend sustainability, here's what I found.
Be advised that the stocks in the table above haven't been fully vetted and shouldn't necessarily be considered portfolio recommendations. This screen is simply meant to uncover potential candidates that meet certain criteria.
By itself, a debt-free balance sheet doesn't tell us too much about the overall quality and profitability of a business. However, at a time when many are being dragged under by the weight of their debt, these companies have little to fear from rising rates and the freedom to divert a large portion of cash flows to dividend payments.
I approach valuation from the perspective of an acquirer eying a takeover target. Whenever a business is bought out, the new owner inherits assets such as real estate and equipment. But they are also responsible for liabilities and on the hook for any loans that must be repaid.
If a company with a $1 million market cap owes $200,000 in notes payable, then the Enterprise Value (the true cost of purchasing the business) would be $1.2 million. But the reverse is also true. If this same company has zero debt and $200,000 in cash sitting in the bank, then the cost for the rest of the business would be $800,000.
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A Closer Look At One Stock
Take PetMed Express (Nasdaq: PETS). The online pet pharmacy has a total market value of $487 million. But that includes a cash position of $87 million, which means the rest of the business is being valued at just $400 million, or about 10 times trailing annual operating cash flows of $40 million.
In other words, the stock is much cheaper on a cash-adjusted basis.
That wouldn't matter as much if sales were falling and the company were burning through its cash. But that's not the case. Average order values have increased to $87, from $85 a year ago, which helped drive revenues up 7% last quarter to $71 million. And thanks to corporate tax reform, net profits jumped 23% to $10.8 million, or $0.52 per share.
Those profits are supporting quarterly dividends of $0.27 per share, which means the company is paying out roughly half of its earnings. And those earnings are projected to climb nearly 10% annually over the next five years as the firm's lower online prices and convenient home delivery enable it to grab a larger slice of the $69 billion annual pet care market.
I'll be watching PETS as a possible candidate for my Daily Paycheck portfolio. But as with any official recommendation, my subscribers will be the first to hear about it.
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