Thursday, March 22, 2012

A Treasure Hunt In Reverse

How to track down ALL the leverage on a balance sheet

When investing in either the stock of a leveraged company or a junk bond, it is important to understand how much leverage that company has.  Some leverage is very easy to find: you look on the balance sheet and there is a number labelled "long term debt."  Unfortunately, there are other forms of leverage that are not as clearly labelled, although it is disclosed by SEC filers if you know where to look.  As part of your reular due diligence, you should always tally up all the forms of leverage and ensure that the issuer in which you are about to invest has as solid a balance sheet as first appearances suggest.  As an aid to my readers, I will walk through a specific example and illustrate how to find all of an issuer's leverage.

The issuer I will use as an example is Federal Signal Corporation (ticker FSS).  FSS is a provider of goods and services primarily to municipalities and the company has seen some challenging times in the last few years.  As municipal budgets came under pressure and the economy slowed, operating results declined and the company saw its leverage increase as it came under pressure.  More recently, FSS completed a refinancing in February 2012 that included a $215MM term loan (fully funded) and a $100MM five year revolving line of credit (probably not yet completely drawn down).  So at first glance, this company appears to have $215MM in debt outstanding.  With 2011 full year EBITDA of approximately $50MM, FSS would be leveraged 4.3X if we assume that the revolving credit facility is entirely undrawn.  This is a modestly high level, but manageable if they can execute on their business plan and get a bit of a tailwind from an uptick in the economy and municipal spending.

Unfortunately, the funded debt balance is not the end of FSS' total leverage.  Note 8 of the company's annual report on for 10K (available here ) shows the details of FSS' pension and post-retirement benefit plans for some of its employees.  The US plans have an accumulated benefit obligation of $154.5MM but assets of only $97MM.  Since the company is ultimately on the hook for the difference, we will add the gap ($57.5MM) to the total leverage calculation for FSS.  Similarly, the company's non-US pension and post-retirement obligation was $57.1MM but the plan only had assets of $47.9MM.  We will add this gap ($9.2MM) to FSS' leverage.  Adding the underfunded pension obligations to the funded debt gives us total obligations of 215 + 57.5 + 9.2 = $281.7MM.  Based on this figure and its $50MM 2011 EBITDA performance, FSS is leveraged 5.6X.  This is materially higher than the 4.3X that just the funded debt would have suggested.

But wait, there is more!  FSS does not own most of its facilities and in fact has even entered into a sale-leaseback of some of its properties.  A sale-leaseback is a way to raise cash at the time of the transaction by paying higher rents over time.  Sale-leaseback transactions are effectively secured debt.  In total, the 10K indicates that FSS spent $11MM on rents in 2011.  As a rule of thumb, rents can be multiplied by 8 times to produce a rough estimate of the amount of debt a company would have incurred to finance these assets rather than renting them.  Adding in the lease equivalent debt of 8 X $11MM gives us an additional leverage amount of $88MM.  Lease equivalent debt plus the unfunded pension obligations and funded debt outstanding gives us total leverage of 281.7 + 88 = $369.7MM.  With 2011 EBITDA of $50MM, FSS shows total leverage of 369.7/50 = 7.4X.  This is almost double the leverage level shown only by looking at the funded debt from the term loan.  At this level of leverage, most issuers do not have much financial flexibility and they will likely struggle to fund interest and maintenance capital expenditures.  The minimum interest rate on FSS' new term loan is 12% (LIBOR plus 10% with a 2% floor on LIBOR).  With $215MM outstanding, the interest bill alone on just this loan is $25.8MM.  If FSS spends the $20MM it is permitted under the terms of the term loan on capital expenditures, there is almost nothing left to pay down debt or otherwise improve the balance sheet.  Clearly, FSS does not have a lot of room to maneuver and unless the business starts generating more earnings soon the company will likely be under financial stress.

All of the above assumes that FSS has not drawn any of its $100MM revolving credit facility.  If that facility were fully drawn, FSS would show total leverage of 9.4X EBITDA.  That level of leverage would suggest that the company would be in dire straits if the business did not rebough quickly.

So what lesson should we draw from this exercise?  Simply, make sure you thoroughly comb through an issuer's financial statements, including the notes to the financial statements which is where lots of leverage can be buried.  Leveraged companies can have significant leverage that is not apparent at first glance, and investors who look only at the funded debt shown on an issuer's balance sheet can be mislead as to the company's financial status.  In the case of FSS, the total leverage amost doubled when we compared the final amount to the funded debt on their balance sheet.  Caveat emptor is the name of the game and the more due diligence you do the better off you will be as an investor.

As always, be careful, do not take my ramblings as investment advice, consult your advisors and do your own due diligence.  You can lose money on this stuff so be careful.


  1. I am wondering with declining; revenue, shareholder equity, growing losses, and hidden debt is FSS a short candidate?

  2. Interesting thought, HiGuy. I am generally more of a long-biased investor, but will happily go short where I see an obvious opportunity. In the case of FSS, I was actually looking closely at the company as a candidate to go long and was looking to see how shaky the balance sheet is (the better the balance sheet, the greater your margin of error with a leveraged company). The 4Q2011 report showed the highest book/bill ratio in many quarters and revenue momentum seems to be picking up. As FSS is sensitive to municipal revenues and spending, if you believe the economy is making a recovery then it would be natural for municipal revenues to rise via increased sales tax collections, building permits, etc. Leveraged company equities have the greatest return potential when things turn around because the equity is generally so eavily discounted against the trouble these companies often find themselves in.

    I would be hesitant to short this one. The shaky balance sheet gives me pause as a long investment, but if the fourth quarter momentum is sustained this company could show vastly improved operating results in a short period of time given its balance sheet leverage and operating leverage. There are investors who make a habit of collecting low dollar priced stocks. You know that some will go bust and some will remain low dollar priced stocks, but a percentage will show operating improvement and in those cases the stock price generally increases by many times.