Blowing in the September Winds: Debtors Face a Major Stress Test
Debt on a company’s balance sheet is like slow rot—it accumulates gradually, with often good intention, only to compound and erode financial stability if not managed well. It’s a liability no one really wants yet, in the normal course of doing business, is a foundational enabler of growth.
Debt, upon closer analysis, can provide valuable insights into a company's financial health and its ability to manage financial obligations. It’s an integral part of any stock analysis because investors use it to gauge future growth and manage risk exposure.
When it comes to borrowing money for working capital, debt refinancing or to maintain liquidity, no one does it better than the US. While rate hikes may sting more in Europe than in the US due to shorter terms and a penchant for variable rates, US companies are far from immune when it comes to managing debt responsibly.
Russell 2000 companies, given their higher proportion of smaller and more volatile firms, are particularly vulnerable to financial instability caused by higher-for-longer interest rates. Given their beaten down-market caps, and more fragile balance sheets, looming loan or bond defaults may be on the horizon, which means they may need emergency liquidity support or other financial help.
That’s not to say that larger caps don’t have their own share of headaches. Petco, like many growth-oriented companies highly dependent on discretionary consumer spending, has spent the year paying down high interest debt, in addition to what it calls, activating other “cost reduction initiatives”. Petco has shown consistent revenue growth in recent years, yet its stock price, since 2021, has endured a brutal descent, plummeting from a peak of $34.51 to $3.81 today.
The pet-products retailer has diligently implemented cost-cutting measures and is utilizing its cash flow to reduce debt. When interest costs surge to nearly 25% of free cash flow in Q2 2023 vs. two years ago, when in 2021 it accounted less than 5% of cash flow, the only way out, is to be patient and focus on “de-levering”.
That word came up infrequently during last quarter’s earnings calls, so did “floating rate debt” and “rolling recession impacts,” but that may change as Q3 reporting gets underway. Given the expectation of sustained high interest rates, and the puzzling ability of the US economy to withstand high debt, sticky inflation, and a robust labor market, “AI” the most frequently deployed word on Q2 calls is set to be upstaged by the harsh realities of cheap money.
Default rates are expected to continue to rise over the remainder of 2023, according to ratings firm Fitch, and end the year within a range of 4.0%-4.5%, due to refinancing challenges, constrained liquidity, tighter lending conditions, and the high cost of debt.
On the plus side, lower small-cap valuations could tempt buyers before year end potentially setting the stage for a rebound. In spite of the rate sensitive fall out, small caps still have a real chance to bust out of a rather lackluster year—that is, if they can survive the current environment.
—Harbor Access