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Magic Diligence
Magic Diligence

5 Magic Formula Stocks With High Debt Burdens

October 06, 2011 | About:

Due to its technique of using enterprise value in lieu of market capitalization, Joel Greenblatt's Magic Formula Investing (MFI) strategy generally does a good job of weeding out firms with poor balance sheets. However, occassionally there are stocks with high debt burdens that do slip through the screen, although it generally takes a very cheap stock price to make up for the debt penalty that enterprise value applies. High debt burdens cause several issues. In extreme cases (one of which exists below), debt can create a situation where the solvency of the company can be at risk when interest payments or debt maturities cannot be met, or when financial ratios exceed covenants on the debt.

More often, however, large debt obligations limit the ways in which a company can generate returns for shareholders. Interest payments reduce the amount of cash that can be invested in growing the business, or in rewarding shareholders through dividend hikes and share repurchases. These firms are often required to retain more of their free cash flow to meet maturity obligations and leverage requirements. Meanwhile, less burdened competitors can take advantage by being more aggressive on pricing, or by investing more aggressively through R&D or marketing. Clearly, having a poor balance sheet limits an investment's attractiveness in many ways.

Below are 5 current Magic Formula stocks that have total debt burdens of 2 or more times the cash listed on the balance sheet:

Vonage (NYSE:VG)

Total cash: $63 million

Total debt: $126 million

Free cash flow run rate: ~$95 million

Interest coverage (ttm): 2.7

Business trends: modestly negative

Vonage, the well-known voice-over-IP telephony pioneer, might surprise many to be a Magic Formula stock. On an operating and cash flow basis, the firm has actually been quite profitable for over 2 years running. Vonage's legacy debt had poor terms, but it was refinanced at the end of last year. The 2.7 interest coverage ratio looks worrisome, but after refinancing, Vonage's coverage has improved to over 5 times in the last 2 quarters. Additionally, robust free cash flows, minimal near-term maturities, a fair amount of cash on the balance sheet, and modest declines in revenue (low single digits) put the firm on a financially safe footing.

Deluxe (NYSE:DLX)

Total cash: $18 million

Total debt: $753 million

Free cash flow run rate: ~$225 million

Interest coverage (ttm): 6.4

Business trends: modestly negative

Deluxe is one of the largest check printing firms in the nation. As most would assume, checks are becoming an endangered payment method, with volume falling about 4% annually over the past decade. Recent cost cutting and an attempt to diversify into Internet services are not a long-term solution to a secularly declining core business. The firm has been able to kick the can down the road with a recent refinancing, so near-term maturities are not a huge concern. However, over the long-term a prospective investor has to assume this company can successfully turn around declining business trends. If they cannot, the already frozen dividend may be at risk and debt maturities could become a problem down the road.

Lender Processing Services (LPS)

Total cash: $22 million

Total debt: $1.23 billion

Free cash flow run rate: ~$360 million

Interest coverage (ttm): 7.5

Business trends: increasingly negative

Lender Processing Services offers technology and outsourced services to the mortgage lending industry, covering pretty much the entire process from origination through foreclosure. This is a business facing all sorts of issues right now, from a cooling default market to pressure over improper practices during the mortgage bust of 2007-09. LPS has little cash on the balance sheet and nearly $70 million in interest to cover per year. Fortunately, a recent refinancing has pushed back maturities to 2016 and beyond. Interest coverage tightened to 5.4 last quarter, a trend I see continuing. This is another company where less-than-stellar financial health puts a noose on shareholder friendly activities such as share repurchases and dividend hikes.

Gannett (NYSE:GCI)

Total cash: $165 million

Total debt: $2.02 billion

Free cash flow run rate: ~$700 million

Interest coverage (ttm): 5.3

Business trends: modestly negative

Gannett is one of the largest publishers in the world, owning USA Today and thousands of smaller publications in the U.S. and U.K., as well as a number of TV stations. The move to Internet consumption of news has hurt Gannett badly, with revenues down 31% from 2006, straining a firm that has historically carried a lot of debt. Maturities are running in the $300-500 million a year range for the next several years, with interest obligations around $180 million a year. That is a tight ceiling on about $700 million in free cash flows, which have been falling in the mid-single digit percentage range for several years. While Gannett's balance sheet looks much better than it did 5 years ago (when the firm had over $5 billion in debt!), this is still a company not out of the woods as far as financial health goes. I was surprised to see the dividend recently hiked - I'm not so sure this was a good idea.

Gentiva Health (GTIV)

Total cash: $98 million

Total debt: $1.03 billion

Free cash flow run rate: ~$100 million

Interest coverage (ttm): 1.9

Business trends: negative

Gentiva is a home health and hospice services provider which is nearly 90% dependent on Medicare reimbursements for revenue. Home health is a business under fire. Medicare has reduced reimbursement rates by 5% this year, with a similar cut slated for next year. New regulations have caused some doctors to avoid referral to home care to avoid burdensome paperwork. And this week, a Senate report blasted providers (including Gentiva) for gaming the rules to earn more revenue. Under these dark clouds, it isn't good that Gentiva can cover its interest obligations barely 2 times over and has a total debt burden that is 10 times its market capitalization! The company is nearly breaking covenants on its loans as is, so there are very near-term health concerns here. Gentiva is one of the only Magic Formula stocks I would categorize as being in "critical condition" as far as financial health is concerned.

Steve owns no position in any stocks discussed in this article.

About the author:

Magic Diligence
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now pre-order his book Invest Like a Guru on Amazon.

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