QUALIPORT
Shares That Could Go Bust

By Maynard Paton (TMFMayn)
October 11, 2001

Carburton Street, London -- Independent Insurance, Cammell Laird, Independent Energy, Railtrack (LSE: RTK), Atlantic Telecom (LSE: ATN). All were stock market darlings at one time or another. And all eventually went bust.

The last year or two has been a wake-up call for most investors. As many shareholders have suddenly discovered, investing in a business is indeed an inherently risky proposition. Some companies will fail. Your shares can become worthless.

Unfortunately, there's no magic accounting formula to determine whether a company is heading for bankruptcy. However, there are certain danger signals that shareholders can look for.

For starters, investors should always review a company's working capital position. A business that has large amounts of operating cash flow being sucked into stocks and debtors is always a bad sign. This post highlights three good examples of the working capital danger, while this post-mortem of Independent Insurance and the Fool's Guide To Working Capital will also help in this respect.

Debt

However, while working capital problems may just herald a severe bout of trading trouble, it's debt that more often than not causes the terminal downfall of a business. There's nothing worse for shareholders than a company struggling to meet its borrowing obligations. But how can you tell if a company has too much debt?

As this feature describes, the best way to quickly check a company's debt level is the interest cover calculation. Divide the company's operating profit by its interest bill and if the result is a low, single digit figure, then some serious investment thought is needed. The lower the interest cover, the more chance the company will have an unwelcome visit from its lenders.

Indeed, given the harsh economic climate, there are plenty of companies presently struggling with their borrowings. Here are five familiar names that all have debt problems.

Dealing with debt

Company                        Share Price      Market Value
                                    (p)             (£m)

British Airways                   155.0             1,673
Corus                              44.5             1,389
Invensys                           50.3             1,759
Marconi                            17.0               473
Telewest                           38.5             1,106

British Airways (LSE: BAY), for obvious reasons, is having a tough time at the moment. BA's most recent annual results showed net debt of £6.2b and an interest charge of £297m. What BA's profits will be this year is anybody's guess. But given BA only made an operating profit of £380m last year, equating to a historic interest cover level of just 1.3, it's clear the company's going to struggle during the airline industry's turmoil.

Corus (LSE: CS.) is another perennial underperformer. The group's latest six-month numbers highlighted an operating loss of £200m, an interest bill of £50m, and net debt of £1.6b. Interest cover is currently below zero. And things are set to get worse(!). The steel manufacturer (yet again) took the interim opportunity to warn of weakening demand for its steel.

In comparison, Invensys (LSE: ISYS) is positively healthy. Following a profit warning in July, the engineering conglomerate will probably report a £280m operating profit for its current financial year. But with net debt of £3.2b and an interest bill of £227m for last year, the group's prospective interest cover could be around the wafer-thin 1.2 mark.

Telecom firm Marconi (LSE: MONI) is also in debt trouble. It's latest trading statement highlighted a first quarter operating loss of £227m and a second quarter breakeven performance. With net debt of around £3b expected by March next year, an annual interest bill of about £250m looks on the cards. Marconi is another company whose near-term profits won't fund its borrowing obligations.

And just like Marconi, Telewest (LSE: TWT) is also in the telecom quagmire. The group's recent half-year results highlighted an interim operating loss of £174m, an interim interest bill of £252m, and net debt of £4.8b. Telewest too could be handing out the corporate begging bowl soon.

Go for broke?

Of course, none of the above companies are 100% set for bankruptcy. Their respective managements are all busy selling off assets, firing employees or reviewing future financing options to help stave off further trouble. Indeed, for turnaround specialists, junk bond sleuths and pure stock market gamblers, the five companies could make for an attractive punt.

However, for those looking for the next WPP (LSE: WPP) or Next (LSE: NXT) turnaround (both companies narrowly escaped bankruptcy in the early nineties), be aware of  "survivorship bias". What happened to Parkfield, Rush & Tomkins, Coloroll, Lowndes Queensway and British & Commonwealth in 1990? At the time, they all had debt troubles too. But they went bust.

It's worth noting that, while the five companies highlighted may in fact survive, shareholders will not necessarily prosper from their "recoveries". Investors in debt-troubled businesses can suffer from an unsympathetic debt restructure or a dilutive rights issue. Eurotunnel (LSE: ETL) is a classic example in this regard, with the company having had its fair share of rescue financing packages in the past. Suffice to say, Eurotunnel shares have bobbed around the 60p mark for many years now, as interest payments continue to absorb all of the company's operating profit.

While the above company debt analysis may look a little superficial, prudent long-term investors don't need much more information to stay well away. The risks are just not worth it, especially when there are plenty of healthy companies valued on reasonable ratings available.

More: Just How Much Is "Too Much Debt"?