MARKET COMMENT
The Debt-to-Equity Flop

By David Kuo (TMFDragon)
August 19, 2002

Debt-to-equity is a term that seems to crop up with increasing regularity these days. The likes of Marconi (LSE: MONI), Telewest (LSE: TW) and NTL (Nasdaq: NLI) are in discussions with their lenders on how they propose to repay their debts. Debt is money borrowed that must be paid back at a set time. That debt can take the form of bonds, debentures and other types of loans and it carries an interest charge. Companies that borrow money must ensure that they can meet the interest payments when these fall due. They must also make sure that they can repay the principal when the due date arrives.

In addition lenders can set out financial conditions, known as covenants, in their debt agreements. If these are broken then the lender has the right to insist that the debt is repaid early. Lenders are normally ranked, meaning some will be paid before others if the company is wound up. However, all lenders are ranked before shareholders so if a company does go bust it is rare for shareholders to get much money back.

Lenders are not especially interested in the growth potential of a business. They are concerned with is whether the company has assets against which the loans can be secured. They are also interested in the cash that a business is able to generate. They want to know if a company can meet its interest payments and in so doing generate income for the lender. As failure to repay the loans or a breach of the covenants could result in the lender taking possession of those assets companies that require additional working capital are often cautious about taking on too much debt. However, at the same time, shareholders can be reticent when it comes to stumping up additional working capital through more equity financing.

Marconi, Telewest and NTL are three companies that decided to go down the route of debt financing to fund their growth plans. Those plans have now been found wanting. There is little chance that their outstanding debts will be repaid when the day of reckoning arrives. These three companies took on debt in the belief that revenues would continue to grow. In the case of Telewest and NTL growth has come through but at a lower level than expected and total level of debt was too excessive. Marconi, on the other hand, has seen its business shrink significantly.

Negotiations are presently under way that include plans to swap outstanding loans for shares in the business. In most cases the number of new shares issued dwarfs the number of shares held by existing shareholders. As a result existing shareholders could be left with very little, if anything, once the debt restructuring is finalised. The precise details will depend on just how much value the lenders are prepared to place on the business itself.

There are many lessons from the debacles at Marconi, Telewest and NTL. But perhaps the one important lesson is to pay particular attention to the level of debts by analysing the details in the notes to their accounts. Shareholders tend to look at a business through rose-tinted glasses but it is worth stressing that debt is inherently bad. Additionally high levels of debt are very bad and can be a terminal drain on business' resources.