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Clues are emerging to what could be one of the biggest trends in 2018. The rate on the 10-year Treasury has jumped 15% since early September and is causing an investor exodus from one segment of the market.
The selloff could get worse as rates rise further and a wave of debt threatens these companies' already precarious financial health.
In fact, as investors anxiously wait for tax reform, one proposal could actually cause taxes on this segment of the market to increase.
It's all lining up to be a harsh wake-up from years of debt-fueled growth and is certain to create winners and losers.
The Next Debt Crisis Threatens An Entire Segment Of The Market
High-yield bonds saw 1% of their value wiped out in the first half of November. That may not sound like much, but it's on pace for the worst month since January 2016.
Investor fears of rising rates and weak earnings for some sectors have caused an exodus out of highly leveraged companies. High-yield bonds in the telecom sector have lost 3.3% so far this month and investors pulled more than $2 billion from high-yield ETFs in just the second week of the month.
Corporate debt at U.S. non-financial companies topped $6 trillion in the second quarter, a 40% increase from $4.3 trillion just in the last five years.
The selloff in high-yield bonds may just be the beginning as the potential for higher rates threaten balance sheets for highly leveraged companies.
Tax reform, or any government stimulus, will mean a surge in government deficits and the need for more borrowing. Besides the upward pressure this would have on rates, economic growth from the measures would also act to drive long-term rates higher.
There's also a wave of corporate debt maturities coming in 2018. More than $95 billion in high-yield debt is maturing next year and $1 trillion over the next five years, compared to approximately $47 billion in high-yield maturities this year.
That increase in supply through refinancing could act to further increase rates for high-yield corporate borrowers, driving interest expenses higher and decreasing profitability.
Yet another catalyst against highly leveraged companies may be coming in the proposed tax reform. The proposal by the House of Representatives seeks to limit how much interest a company can deduct from its earnings to 30% of EBITDA, potentially increasing tax rates for highly leveraged companies even as overall corporate rates come down.
3 Losers And 2 Winners From The Next Debt Crisis
If the selloff in high-yield debt continues, one of the biggest themes in 2018 could be weakness for highly leveraged companies, especially smaller firms with weaker access to capital.
Weight Watchers International (NYSE: WTW) has $1.9 billion in long-term debt and negative $1.1 billion in shareholder equity. Despite an upside-down balance sheet, shares have surged 268% this year and trade for 2.4 times sales.
The company has done well over the last year on Oprah Winfrey's sponsorship, but beyond that there isn't a competitive advantage that separates it from others in the weight management space. Consumers are fickle and the industry is highly competitive, both of which could weigh on margins. Sales of $1.37 billion are expected over the next four quarters, a growth of 8% over trailing sales. However, that still puts shares at 2.2 times sales, a premium of 22% over the industry average.
Cogent Communications Holdings (NASDAQ: CCOI) has $560 million in debt against negative $80 million in shareholder equity. Shares have increased 12% so far this year and trade for 4.3 times sales, more than three times the industry average of 1.4 times sales.
Management has been guiding to 10% - 20% in long-term annual sales growth, well above the 9% annualized growth booked over the last three years. Other measures like data traffic growth have also come in lower than long-term targets. Against increasing competition for net-centric clients, the company may eventually need to bring growth targets down and that could result in a big hit to investor sentiment. Sales are expected 9% higher next year to $520 million, putting the shares at 4.1 times revenue.
Wingstop (NASDAQ: WING) shares have jumped 40% this year despite a balance sheet showing $137 million in debt and negative $58 million in shareholder equity. Shares trade for 11.4 times sales -- more than four-times the industry average of 2.8.
Management has done well growing sales and managing costs. The operating margin has increased to 34.4% over the last year, but the company may have trouble driving growth without sacrificing profitability moving forward. The operating margin may have peaked considering competitors in the industry, 22% margin at Yum Brands and 29% at Restaurant Brands International.
Nearly 85% of the company's total assets are represented by Goodwill and Intangible Assets on the balance sheet, compared to 13% at Yum Brands. This is a red flag for me and I would not rule out an asset impairment in the future. Sales are expected 11% higher to $113 million over the next four quarters but that still puts the current share price at 10 times revenue.
Cirrus Logic (NASDAQ: CRUS) shares have fallen 8.4% this year despite a solid balance sheet with no debt and $1.2 billion in shareholder equity. Shares trade for 2.3 times sales, half the industry average of 4.6-times sales.
Cirrus is a leader in voice-control technology, one of the most promising industries in the market. The company still has over $80 million left in its share repurchase plan and $200 million in balance sheet cash. Sales are expected to grow 6.4% over the next year, placing the current price at just 2.1 times revenue.
Maximus Inc (NYSE: MMS) holds just $16 million in long-term debt against $886 million in shareholder equity. Shares trade for 1.7 times sales for a discount of 26% on the industry average of 2.3 times sales.
Maximus provides business process management to health and human services agencies in the United States and abroad. As of September, it reported a $5.7 billion backlog in projects, which represents more than two years' worth of revenue. Revenue in the first quarter could surprise to the upside on disaster relief services following the hurricanes in the United States.
Sales are expected relatively flat at $2.5 billion for growth of 2.3% over the next year but the company has beaten earnings expectations in seven of the last eight quarters.
Risks To Consider: The market may continue to reward shares of highly leveraged companies if the economy continues to grow and rates stay lower than expected.
Action To Take: Position in companies with solid balance sheets as the market punishes highly leveraged firms on higher tax rates and valuations.
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