I was watching a financial call in show last week. The financial “expert” examined stock after stock. Many he dismissed because of the company’s debt load. It didn’t matter why they were carrying the debt, how recent the debt, or what kind of debt it was, his opinion was that all debt was bad.
What a load of hooey.
One of the companies he was talking about was an ice company I own shares in. Yes, the company was carrying debt. Why? Because they just acquired a competitor.
Having spent most of my working life in new business development, I’ve looked at quite a few acquisitions. When companies acquire other companies, they have two choices for financing, they can borrow or they can issue equity.
The former is the preferred choice. It’s easier. It doesn’t dilute ownership (affecting management stock options). It’s short term. If the acquisition is expected to cover its costs in one or two years, debt is used (if available).
The type of debt also matters. The more conservative the lender, the more likely the acquisition is sound (companies often have to sell lenders on why they need the money).
If the major purchase is new equipment and the lender is the equipment supplier, this usually means that either the supplier has little doubts about repayment or they feel that the asset is worth at least the debt offered (this doesn’t always hold true if the purchaser is a dominant player).
If the lender is a high brow, conservative bank, then again the bank fully expects to be paid back. The bank can be choosy about clients so their participation is reassuring to investors. If the lender however specializes in high risk ventures (the interest rate offered will be a glaring signal) then I, as an investor, would be nervous.
I don’t expect the company to start paying back the principal less than a year after acquisition. Acquiring a company is expensive that first year. There are legal fees, severance payouts for redundant employees, system conversion costs, etc. These one time charges will either gobble up the profits from the acquired company or require more debt (this debt should be factored into the acquisition calculation).
However, if there is not enough available debt (the purchase is too large or the company is already leveraged to the hilt), then the company will look at offering new shares. If the management is unsure about payback, again shares will be issued. Both situations make me as an investor nervous. It doesn’t mean I won’t invest but I will do more research before I do.
So no, not all debt is bad. In case of acquisitions, I actually prefer that the company borrow.