Some companies have rather a lot of debt and this might be a problem

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We’ve heard a lot recently about how higher interest rates affect homeowners and not so much about how they affect the companies that pay their wages.

That may be because, top down, there’s not yet much to see. “Amend and extend” debt refinancings are so far keeping a lid on defaults and bankruptcies. (There’s a good summary from Tracy Alloway behind the Bloomberg paywall.) A top-down view is not much good, however, for identifying which highly-indebted companies looked comfortable in 2022 but are now hurtling towards a maturity wall.

On the back of Thursday’s surprise half-percentage-point raises from the Bank of England and Norges Bank, JPMorgan’s specialist sales team sent memo to clients identifying their favourite shorts based on refinancing risks.

First name on the list is Haleon, the UK-listed and £30bn-valued maker of toothpaste and over-the-counter drugs.

When GSK spun out Haleon in mid-2022 it banked a £7bn dividend while saddling the company £10.9bn of total gross debt, about £2.1bn of which matures by 2025. Even at the time this looked a bit punchy. When peers like Unilever, Reckitt and Nestlé were carrying net debt of between 2 and 2.5 times ebitda, Haleon’s burden of 4 times ebitda seemed extreme for what was in effect a start-up.

But the cost of servicing that debt was only 2.7 per cent or thereabouts, and Haleon’s plan was to bring leverage down towards a sector-average level by 2024. Since the company mostly sells generics to price-blind hypochondriacs — Centrum-branded vitamins, Panadol-branded paracetamol, etc — downturn risks appeared manageable.

Spin forward a year and with rates expectations where they are, Haleon’s most relevant refinancing cliff has been pushed out from £2.1bn by 2025 to £4.2bn by 2027. Here, from JPMorgan’s initiation note, is how the maturity profile breaks out:

The Haleon investment case has lots of moving parts, including exposure to Zantac litigation and the overhang of having Pfizer and GSK as unenthusiastic shareholders. Debt might overshadow them all. If 2023’s cold season doesn’t match the multi-viral tsunami of last winter and sales disappoint, can Haleon defend its credit rating (currently three notches above junk) without resorting to brand disposals?

JPMorgan isn’t confident. Here’s how its analyst Celine Pannuti sums up the investment case:

We are Underweight Haleon stock, reflecting our caution on the company’s earnings trajectory, the risks from high leverage and the overhang from stake disposal by minority shareholders. We concede Haleon’s pure-play position in the highly fragmented consumer health sector, an industry that we believe offers good growth prospects, strong margin potential and consolidation opportunities. Yet we see the company as overexposed to the less exciting parts of the market, and we worry that investments and culture changes needed to deliver on growth ambitions will dent already well-optimized operations. We are also concerned about the margin pressure in the face of standalone costs and cost inflation, while its high leverage adds risks amid an uncertain macro backdrop. We believe that Haleon’s valuation fails to reflect the unproven track record, margin downside risk, leverage and share sale overhang from its two major shareholders.

We derive our Dec-24 TP of £2.80, based on Haleon trading at a discount of 10% to key European peer Reckitt EV/EBITDA24E, given the share overhang and Zantac uncertainties.

Some other names on JPMorgan’s leverage hit list are:

• Target, the millennial-friendly US discount retail chain, whose near-term trading is exposed both to the fate of Joe Biden’s student loan forgiveness plan and to one of those culture war boycott things.

• Swedish banks — all of them — because of property exposure.

• Electrolux, which at 5.1 times net debt to ebitda has one of the highest leverage ratios in the industrials sector. There are no debt covenants to worry about and the refinancing need is more of a 2024 problem than an immediate one but, given the weak outlook for consumer spending and house moves, people probably won’t be buying many fridges, JPMorgan says.

• Affirm, a point-of-sale lender that has partnerships with Walmart and Amazon. Nasdaq-listed Affirm is overly reliant on disadvantaged consumers and as rates keep rising it’ll struggle to sell-off risk and price its loan book effectively, says JPMorgan.

• Rolls-Royce, which has been on the bank’s sell list since approximately forever. Shares are overvalued by 70 per cent given myriad uncertainties about jet engine demand and Rolls’ own attempts at reinvention, JPMorgan says. And while Rolls has taken some stress off is balance sheet since autumn 2020 by raising about £2bn in new equity and the same again from disposals, 77 per cent of its debt is expiring between 2025-2027, it says.

The above are JPMorgan’s calls, not ours. As always, DYOR.