What Not To Buy: Low Interest Cover

It's not losses that kills a business, it's the inability to pay its obligations. Many companies have high levels of debt but as long as there's plenty of cash coming in to pay it the bank's happy. The easy way to check this is to calculate a firm's interest cover.

Here's one definition of  gross interest cover:

Gross Interest Cover = Operating Profit + interest receivable
                                     ----------------------------------------------------                                        Interest payable

A cover of only two would mean that interest payments take half of all operating profits and leaves a company in a weak position to weather a downturn.

Run for cover

I ran a filter on the Hemscott database to find shares with the lowest interest cover and high debt but still with a high market value compared to net assets. I looked for:

•         cover < 1

•         price to book value (PBV) >2

•         net gearing > 100%

•         market cap (value) > £25m (to ignore microcaps)

The only hit was London Town (LSE: LTW) , which owns over 200 pubs in the UK. Its main income is profit from drink sales to its tenants, the rest is rent. It's listed on AIM with a capitalisation of £47m.

When I found this share I got pretty excited at its inclusion in What Not To Buy. It ticks more of my bad boy boxes than any share I can remember:

• Unsustainable interest cover of 0.55 (gross), 0.53 (net)
• Very high gearing of 462% (net)
• Trades at 118% premium to its net asset value even though it is more or less a property company
• Chief Executive resigned in December with immediate effect after only nine months in job
• Issued 4m shares on the cheap (85p, a 49% discount to the share price before announcement) to fund an acquisition
• Very tightly held -- 1.7% free float
• Losses for last five years
• No forecasts
• No trading update for six months, since the interims, despite leading pub chains reporting downturns

The figures are taken from the most recent interims, since the company expanded hugely in 2006, the last year we have figures for.

When a company has issued shares at a 49% discount (5% to 20% would be the normal range) it makes me suspicious that the issue price better reflects the true value of the company than the market price.

I'm baffled at the price of these shares, especially given the sector outlook. Regent Inns warned that "the smoking ban, introduced in Wales in early April 2007 and England in July 2007, is having a greater impact during the colder and darker winter months." Many chains are reporting a drop in alcohol sales, which will hit tenanted operations like London Town worst, since they won't benefit from increased food sales being seen. 

Here's the WNTB table to date. Cost is the best quote from an online broker.

Buy date	Company	Cost p	Now p	Gain/ (Loss) %
March	Griffin Group (LSE: GFF)	2.5	1	(60)
April	British Airways (LSE: BAY)	507	243	(52)
May	Patientline [LSE: PTL]	4	0.42	(90)
June	Coffee Republic [LSE: CFE]	3.37	2.025	(40)
July	Manganese Bronze (LSE: MNGS)	864	471	(45)
August	Victoria Oil & Gas [LSE: VOG]	37.9	19.875	(48)
November	Northern Rock [LSE: NRK]	150	Delisted *	(??)
December	iShares China 25 [LSE: FXC]	7765	6275	(19)
February	Netstore [LSE: NES]	23.7	20	(16)
March	London Town [LSE: LTW]	170

Warning: this is not a portfolio of companies to short sell. Luck, speculation and my being plain wrong may send values up sharply.

* The Government will announce shareholder compensation (if any) for the recently nationalised Northern Rock. It is likely to be a small amount.