Weighing the Balance Sheet
It was 1999, wireless telecom stocks were the rage, and Nextel Communications' (NXTL ) shares rose an outrageous 336%. No one seemed to care that the company's balance sheet carried $10 billion in long-term debt, since its income statement showed soaring revenues. But when the bubble burst, investors realized Nextel might have trouble paying its creditors. Today, Nextel trades at $6.29, down 88% from its yearend 1999 price of $51.56.
Nextel's downfall--and that of countless others--highlights the need for investors to scrutinize balance sheets. That's the way to tell which companies are truly growing internally and which are using debt, or leverage, to goose their performance. In the post-bubble economy, the distinction between these types of companies is crucial. Overly leveraged companies can face financial distress, even bankruptcy, if they can't generate sufficient cash flow to service their debt.
Many companies levered up their balance sheets in the late '90s. After all, interest rates were falling and lenders were willing. Some companies used the debt to ramp up production, build vast communications networks, or gobble up other companies. When the bust came, inventory piled up on warehouse shelves, networks went dark, and the acquisitions didn't deliver the expected growth. With a trickle of revenue, the distressed borrowers had to service a mountain of debt.
Those companies with little debt and excess cash can profit from these situations. "A strong balance sheet not only allows you to endure an economic downturn but to be very opportunistic and buy things from distressed sellers," says Mark Donovan, chief equity strategist at fund company Boston Partners Asset Management. "Look at what a Berkshire Hathaway (BRK.A ) can do in this environment." The insurer has $5 billion in cash on its balance sheet. So when debt-ridden Williams Cos. recently needed to raise cash, it sold a gas pipeline to Berkshire at a very reasonable price. Asks Donovan: "Who else could Williams call?"
To find companies with strong balance sheets, BusinessWeek screened Morningstar's Principia Pro stock database, which contains financial statement data on more than 7,000 companies. The database is not a lie detector, so it won't help uncover the next Enron. Yet assuming a company's financial statements are accurate, it helps separate the strong balance sheets from the weak.
We first looked for companies with long-term debt of less than $5 billion. Long-term debt, basically obligations that come due in more than a year, is not all bad. Many solid companies have some long-term debt, which can include leases on factories or offices. What's important is that the ratio of the long-term debt to all of the capital--common stock, preferred stock, and debt--invested in the company is as low as possible. So we limited the debt-capital ratio to a maximum of 15%.
We then looked at short-term debt, which is due within a year and also is recorded on the balance sheet. Companies often use short-term debt to manage their cash flows, such as to fill in the gap between the time they build products and receive payment. Analysts often compare short-term assets like cash and receivables to short-term debt. That's called the "current ratio." When the ratio is greater than one, it means there are more assets than liabilities coming due. For added protection, we screened for a current ratio of at least 1.5.
One problem with the balance sheet is that it's a financial snapshot, taken quarterly. You also have to look at the cash-flow statement, which gives you an idea of what's going in and out during the year. Here, the key is free cash flow--how much cash is left after expenses, debt service, capital expenditures, and dividends. High free cash flow confirms the strength of the balance sheet. So we screened for 12-month free cash flow exceeding $100 million.
We also applied a valuation criterion to the screen. Here we took operating cash flow, a broader measure than free cash flow because it doesn't take out capital expenditures or dividends. For the screen, we set a maximum for the ratio of 18--that's slightly higher than the 16.2 average for the Standard & Poor's 500-stock index. We added return on assets, a measure that connects the balance sheet to the income statement by dividing net income by assets. ROA looks at how efficiently a company is using its capital. We asked for a ROA exceeding 5% for the past 12 months--a low hurdle, but we've just come through an economic slump.
Only 17 U.S. companies passed this screen. The largest was Dell Computer (DELL ), which has $1.3 billion in long-term debt and $3.8 billion in cash. Despite the tech blues, Dell is still gaining market share against its competitors and has generated $3.7 billion in free cash flow in the past 12 months. Such a company can easily survive the downturn, but given Dell's 17.3 price-cash flow ratio, it's rich at today's prices.
You can find better values if you buy smaller companies. With a low 4.9 p-c ratio, Dycom Industries (DY ) is a construction company that lays cable for the beleaguered telecom industry. Yet its balance sheet is solid: only $16.3 million in long-term debt and a strong current ratio of 3.6. With $148 million in cash and $108 million in free cash flow, it should be able to weather the slump.
The screen also pulled up semiconductor maker AVX (AVX ). It's the largest holding of value hound Martin Whitman, portfolio manager of Third Avenue Value Fund. The company has $686.6 million in cash and only $35.5 million in long-term debt. "How can it get in trouble with that kind of cushion?" asks Whitman. Whitman likes companies with such cushions because it gives them financial flexibility. "We don't want our companies forced into the capital markets when it's the least attractive time to do so," he says.
Companies in certain industries can bear more debt than others. Traditional utilities--not the unregulated kind--have steady cash flows with which to pay their debts. So although electric company Consolidated Edison (ED ) has $2.3 billion in short-term debt and a 0.9 current ratio, that's not necessarily a red flag. The same is true for many banks and credit-card companies. Their entire business depends on borrowing and lending, so they are debt-heavy by nature. What's more important when analyzing them is the quality of the loans they're making. If a bank has many borrowers defaulting, steer clear.
Some companies with strong balance sheets can still be risky. Whitman, for instance, won't touch tobacco or asbestos-related companies, regardless of their financials. "Their litigation liability is more significant than their debt levels," he says. While such off-balance sheet risks are unscreenable, finding the on-balance sheet ones can help you avoid the next Nextel.
By Lewis Braham