Two high profile commodity companies filed for bankruptcy last week. The first was St. Louis-based coal producer Peabody Energy (BTU). Peabody was the latest coal producer to file, following Arch Coal, Alpha Natural Resources, Patriot Coal, and Walter Energy. BTU quickly fell below $1 on the news. Just a few years ago, Peabody’s market capitalization exceeded $20 billion. On Wednesday, Houston offshore oil producer Energy XXI (EXXI) joined Peabody in bankruptcy court. Four years ago, EXXI was a $32 stock. On Thursday, the day after it announced its bankruptcy filing, it closed at 12 cents.
When the end comes, it comes quickly.
There are two reasons these companies fell from grace so precipitously. First, their revenues cratered as the prices of their primary products collapsed. Second, both companies are loaded to the gills with debt. Lots of debt. Specifically, Peabody has roughly $5.5 billion of debt outstanding, while Energy XXI has about $5 billion. Once revenues began to fall, and fall steeply, it was only a matter of time until BTU and EXXI crumbled under those onerous obligations.
I’m always dumbfounded by the buoyancy of troubled stocks like EXXI and BTU as they approach a bankruptcy filing. In recent weeks, both traded well above $1. Shockingly, Peabody was a $6.55 stock only one month ago. While retail and other investors were buying these dogs, the publicly traded debt of each company was plummeting, and rating agencies and credit analysts—who usually do a better job analyzing companies than stock analysts—were warning investors about impending doom.
Given these clear signals, why were BTU and EXXI (and countless troubled stocks before them) able to remain overvalued right up until the moment they went broke? And why did both companies willingly saddle themselves with killer debt loads to begin with?
The answer to the second question isn’t complicated: borrowing money is way too easy in the corporate world. That’s because facilitating debt deals is way too profitable for Wall Street. Ivy League-educated investment bankers are experts at convincing CEOs and company Boards to raise money via bond offerings.
The answer to the first question is a little more involved. Put simply, investors, as a group, overlook the dangers of debt on a company’s balance sheet. Two stocks outside of the commodity space illustrate this point. Both Twitter and Tesla have taken on billions in debt in recent years, and yet nobody seems to have noticed, or care. Despite the fact that Twitter is sitting on nearly $3.5 billion of cash, the company sold almost $2 billion of convertible debt in 2015. Last year, Twitter paid almost $100M in interest on those bonds. Tesla reported $2.6 billion of debt and $1.2 billion of cash on its year-end balance sheet, and paid $119M in interest in 2015. Meanwhile, GAAP losses at both companies in 2015 were enormous: Twitter lost $521M and Tesla lost $889M. While both reported much better ebitda amounts—Twitter’s was $558M, while Tesla lost “only” $294M—they both had large capital expenditures. Tesla spent $1.6 billion; Twitter, inexplicably, spent $347 million. If either company has an unexpected revenue slowdown or recall, they might deeply regret borrowing those billions.
Investors may underestimate the perils of high debt loads because our society itself does so. Homeowners are encouraged to take on mortgage debt. Most cars are bought with borrowed money. Student loan debt now exceeds $1.2 trillion. Outstanding debt on credit cards—which usually charge high, double-digit interest rates—is about $1 trillion. The Granddaddy of all borrowers, of course, is Uncle Sam. Our nation’s outstanding debt is approaching $19 trillion, up from about $10 trillion only eight years ago. Someday, possibly before I go to the giant credit bureau in the sky, folks worldwide might stop buying America’s short duration debt and our 10- and 30-year bonds at today’s all time low interest rates. That would be an economic disaster. As a country, we spend $600 billion/year servicing our national debt. If we were forced to pay much higher interest rates to borrow, that number could easily rise to $1 trillion or more, which would “crowd out” spending on defense, entitlement programs, and so-called discretionary items (government agencies, schools, infrastructure projects, NASA, etc). A severe recession and a lower standard of living would follow. Borrowers—and investors in stocks with excessive debt— beware