If you're looking for a quiet spot to contemplate the great mysteries of the day -- such as why the current stock market is so speculative -- you might take a seat at San Diego's new downtown baseball stadium, Debtco Park.
Debtco Park? Isn't it Petco Park? Well, officially it's Petco Park, but Debtco Park would be a more apt appellation, and not just because of the big debt the city took on to build it, or the debt you will put on your credit card because of much higher parking and ticket prices.
The San Diego specialty retailer that paid an unspecified amount of money to put its name on the new ballpark, Petco Animal Supplies, has been showing good results of late, but it faces a potential time bomb: far too much debt, particularly junk debt.
Generally, securities analysts get worried when a company's debt is 40 to 50 percent of its total capitalization. But Petco has a stunning $311.5 million of long-term debt, and $170 million of that is junk debt paying an interest rate above 10 percent. There is another $75 million that has been committed but not yet tapped. And Petco has barely any equity, or the value of stockholders' ownership. More than 95 percent of its capitalization is debt -- not only the junk debt, but also high-cost short-term debt with interest rates that float upward when rates in general go up.
Despite this baggage, Petco is one of San Diego's hottest stocks -- an example of what the overall stock market has been about for many months. Since March, stocks have made a very good and generally justifiable climb, because interest rates are so low and the economy is getting moderately better. Stocks are nowhere near where they peaked when the bear market started three years ago, but most of the time this year, stocks have been less overpriced than bonds.
Beginning next month, stocks enter a seasonally strong period. But in this post-March bull run, the smallest stocks have done the best, and the stocks of companies losing money have gone gangbusters. In short, it's a crapshoot market, but in the next few months, less speculative stocks could overtake the gamy ones.
That's why I'd like to focus on two red-hot but risky San Diego stocks: the debt-burdened Petco and loss-laden, historically pockmarked FemOne of Carlsbad, which just went public by sneaking through the back door and has a lousy financial record.
Petco is in an expansion race with Phoenix's PetsMart, also a retailer concentrating on pet supplies. Both stocks are Wall Street darlings; almost all analysts following Petco are bullish.
But PetsMart has its financial house in order. In the giddy 1990s, both companies piled up losses to expand across the nation. Indeed, Petco still has a large cumulative deficit. Petco also amassed a lot of low-quality debt. Now, PetsMart's annual revenues are $2.7 billion while Petco's are $1.5 billion, but PetsMart has only $173 million in debt.
Both stocks sell for more than 30 times most recent 12-month earnings. That's very high by historical standards and also high by current inflated standards. The Dow Jones Industrial Average, for example, sells for about 21 times recent 12-month earnings.
Where Petco went wrong, in my opinion, was in agreeing to a leveraged buyout three years ago. Leveraged buyouts, like tax-avoidance deals, have no economic reason for being, other than making a few insiders rich. The stock of a company is already trading. But the company piles up junk debt to buy out current shareholders at a premium, goes private, and then goes public again a couple of years later -- laden with all that debt. The buyout specialists and the company's top management make a bundle unloading their stock, but no economic purpose has been served, and the company emerges with a monkey (low-quality debt) on its back.
Petco did a buyout in 2000, taking on junk debt, and then went public again in February of last year at $19. Its stock has steadily climbed to above $30. It has soared more than 50 percent since July. "Because the company is performing so well, the bonds are trading at well above par," boasts a Petco financial executive.
Yes, for now. But listen to Petco's confession in its last annual report to the Securities and Exchange Commission, filed in March. "We have and will continue to have a substantial amount of debt," it warns. This debt pile "may limit the cash flow available for our operations and put us at a competitive disadvantage." The company must use "a substantial portion of our cash flow from operations to pay interest and principal on our debt."
Higher interest rates could force the annual debt-service bill to go up, laments the document. The debt load could inhibit the company's ability to get more financing and "heighten our vulnerability to downturns in business."
In my opinion, Petco would have been far better off attempting to retire its 1990s debt as it moderated its expansion spree and digested its prior rapid-fire acquisitions. The leveraged buyout only made the company more vulnerable to vicissitudes. Beware.
Then there's San Diego's hottest stock, FemOne of Carlsbad. It distributes nutrition, skin care, and cosmetics to women. For no apparent reason, its stock has zoomed from 15 cents early this month to around $1.45.
Instead of making a public offering for its stock, the company merged with a corporate shell that then changed its name to FemOne. The shell had planned to be a gold-prospecting company. It had no revenues, and its only employee, its chief executive -- a longtime diddler in mining stocks listed on the raucous Vancouver Stock Exchange -- only spent one-tenth of his time at the company. He had received his shares for one-tenth of a penny each.
In August, the company abandoned its gold-mining ambitions -- if there had ever been any -- and permitted FemOne's honchos, mainly Rancho Santa Fe's Raymond W. Grimm Jr., to gain control and thus get a public market for the stock without having to bare its soul in a prospectus.