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Debt might be the lifeblood of modern capitalism but it also causes heartache. Mispriced US mortgages caused the financial crisis. Excessive borrowing almost unravelled the eurozone. For private investors, it is essential to understand the debt sitting on company balance sheets.
British pubs are now creaking under the burden of heavy borrowing. Take Mitchells & Butlers, owner of chains including Toby Carvery and All Bar One. Net debt — borrowings minus cash — has reached an ugly £1.7bn including leases. Its shares are worth £800mn less.
This is casting gloom over other, more cheerful developments. Christmas parties and World Cup viewings are encouraging drinkers back into pubs. Sales have finally come back to pre-pandemic levels. Operating profits over the past year are a tenth higher than expected. Yet shares are close to record lows.
Whether the borrower is an individual, company or country, basic borrowing rules are the same. A lender agrees to hand over a sum of money for a fixed period, repaid at a certain rate of interest. Assets may be offered as security. If payments are missed, creditors can sue for ownership of those assets.
The main assets at the disposal of pub groups are properties. These account for £4bn of security backing M&B’s debt.
Lex is fascinated by the, ahem, latitude of debt metrics. The variety can make it difficult to compare one company with another precisely. But it can also reveal exactly which features a company is trying to highlight and those over which it hopes to draw a veil.
Think about the ways in which companies describe debt in comparison to profit. A typical business might cap its debt at three times the size of earnings before interest, tax, depreciation and amortisation (ebitda). That sounds sensible enough — and ebitda is a widely recognised way to measure profitability. But underneath this seemingly simple metric all sorts of spicy things can be going on.
Some companies like to adjust the numbers in flattering ways, adding back costs such as stock options and restructuring, for example, to make profitability appear more impressive. Net debt can be massaged down by excluding lease liabilities or by deducting readily saleable assets, such as commodities.
M&B’s debt is five times the size of its profits as measured by ebitda. This excessive level was achieved by the use of something called “whole business securitisation”. Financial whizzes cooked up the idea in the giddy pre-crisis days, packaging the value of pub properties and their incomes into long-term borrowing agreements.
On the plus side, M&B could borrow lots of money over a long period of time. M&B’s is not due to be paid off until 2036.
But the debt has been too heavy compared with profits. M&B’s leverage jumped from three times ebitda in 2003 to six times in 2006. Plus, some of the deals were struck before the era of low interest rates, tying pub companies to expensive debt. M&B’s average interest rate is 6 per cent. The agreements also contain clauses that make it almost impossible to refinance economically.
M&B has to find £200mn a year until 2023 to meet its debt payments. With total free cash flow of just £75mn expected over the next three years there is little money left to expand the business or hand back to shareholders.
This explains why M&B’s share price has tumbled down into the cellar and is likely to stay there. Lugging it back up to ground floor is going to be a struggle.
The lesson for equity investors is to be sceptical of highly leveraged companies, no matter how glib the assurances of management.
Unstable coins
Cryptocurrency remains lost in the wilderness, suffering from a heavy price crash and multiple scandals.
Undeterred, the UK is intent on becoming a hub for the crypto industry. Plans are afoot to introduce government oversight of stablecoins. The question Lex would like answered is how such a misnomer can be regulated without being entirely renamed. Faux fiat is one of the more polite suggestions we came up with. Investors who have lost money this year are likely to have a few unprintable alternatives.
First, a quick primer. Stablecoins are pegged to real world assets — usually US dollars. The idea is that this connection should stop prices from swinging around. That led some investors to dub them a safer digital asset than larger tokens such as bitcoin. The theory ran that stablecoins might be particularly useful to help people without access to bank accounts — including millions of people in emerging markets — to access financial services.
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But as is often the case with crypto, all was not as it seemed. In some cases, operators of the coins lacked the proper reserves required to back them. Some of the largest coins have traded well below the asset to which they were pegged — some by up to 40 per cent, according to JPMorgan research. In May, a popular stablecoin called Tether fell below its $1 peg following the collapse of another stablecoin called TerraUSD.
Strange that Circle, which operates the second-largest stablecoin called USD Coin, thought this might be a good time to go public. This week it came to its senses, terminating a $9bn deal with a company chaired by ex-Barclays chief executive Bob Diamond. Seeing as the value of USDC in circulation has contracted from more than $55bn in June to $43bn, that seems like a sensible decision.
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