Corporate interest rates thwarting competitiveness – really?

Commentary: Assume a manufacturing company:

• that has what one might conventionally consider an ‘optimal’ or ‘reasonably balanced’ debt:equity ratio of 40% debt and 60% equity;
• whose borrowing cost averages in ‘normal times’ 5%, and averages 7.5% in ‘abnormal times’;
• with revenues on product sales of $10 million;
• with gross margins, in ‘normal times’, of 30%
• with overheads in ‘normal times’, including depreciation, of 20% of revenues; and,
• a capital structure comprised of interest bearing debt of $2 million and equity of $3 million (40%/60%).

The following table shows the effect of an interest rate increase of 2.5% on that hypothetical company’s profitability.

	Normal Times	Abnormal Times – interest rate change only	Abnormal Times with 20% revenue decline but same cost structure
Revenue	10.0	10.0	8.0
Gross margin (30%)	3.0	3.0	2.4
Overheads	2.0	2.0	1.6
Pre-tax, pre-interest earnings	1.0	1.0	0.8
Interest expense on $2.0 million debt
@5% (normal times)	0.1
@7.5% (abnormal times)		0.15	0.15
Pre-tax profit	0.9	0.85	0.65

  In essence, for an optimally financed company that does not suffer in ‘abnormal times’ from a decline in revenue, but experiences a 50% increase in its interest rates, that company should be able to ‘weather the interest rate storm’ without much difficulty. However, superimpose:

• revenue declines;
• gross margin declines and overhead cost % increases as a function of revenues;
• perhaps most importantly, an over-levered financial position – that is a balance sheet that has far more debt than it has equity,

and the company’s circumstances can change in a radical negative way very quickly. For example, if our hypothetical company saw its sales decline by 20% and it had a capital structure of 20% equity and 80% debt (in the example, $1 million equity and $4 million debt) the results, as set out in the following table, would be quite different.  

	Normal Times	Abnormal Times with 20% revenue under revised scenario
Revenue	10.0	8.0
Gross margin (30% dropping to 25%)	3.0	2.0
Overheads (20% increasing to 25%)	2.0	2.0
Pre-tax, pre-interest earnings	1.0	0.0
Interest expense on $2.0 million debt
@5% (normal times)	0.2
@7.5% (abnormal times)		0.3
Pre-tax profit	0.8	(0.3)

  In essence, a suggestion that Italian (or any other country’s) companies competitiveness is materially impacted by a 2.5% increase in interest rates may be quite correct (the referenced article at one point suggested Italian interest rates have increased by 2%). However, this typically would only be the case where a company either suffered a drop in revenue, a drop in gross margins, an increase in operating costs, or a combination of those things in circumstances where it had over-levered its balance sheet in good (or better) economic times. Like individuals and countries, companies are vulnerable when they carry too much debt against their equity positions. Topical Reference: Analysis: Crisis stifles Italian firms’ competitiveness drive, from Reuters, Lisa Jucca, August 5, 2012 – reading time 4 minutes, thinking time longer. North America >> United States: President Obama in January 2009 and now Why Read: To test the contemporaneous views I expressed four years ago, to observe similarities and differences then and now, and to determine if you agree with my current views. Commentary then: On January 26, 2009 newly inaugurated President Obama announced plans for the U.S. to achieve energy independence. Among other things, Obama then said (my summary comments):

1. We (the U.S. government) have inherited a deepening economic crisis and the need for urgent action. In the last few days Microsoft, Intel, United Airlines, Home Depot, Sprint Nextel and Caterpillar have announced they each are cutting thousands of jobs.
2. No single issue is as fundamental to our (the U.S.’s) future as energy. America’s dependence on oil is one of the most serious threats that our nation has faced.
3. Urgent dangers to our (the U.S.’s) national and economic security are compounded by the long-term threat of climate change which, if left unchecked, could result in violent conflict, terrible storms, shrinking coastlines, and irreversible catastrophe.
4. America is at a crossroads. It will be the policy of my administration to reverse our dependence on foreign oil while building a new energy economy that will create millions of jobs.
5. We must take bold action to create a new American energy economy that creates millions of jobs for our people. The American Recovery and Reinvestment Plan before Congress will put 460,000 Americans to work with clean energy investments and double the capacity to generate alternative energy over the next three years.
6. My administration will work on a bipartisan basis in Washington and with industry partners across the country to forge a comprehensive approach that makes our economy stronger and our nation more secure.
7. We will fully take into account the unique challenges facing the American auto industry and the taxpayer dollars that now support it.
8. We will make it clear to the world that America is ready to lead. To protect our climate and our collective security, we must call together a truly global coalition. I’ve made it clear that we will act, but so too must the world. That’s how we will deny leverage to dictators and dollars to terrorists, and that’s how we will ensure that nations like China and India are doing their part, just as we are now willing to do ours.
9. We can create new industries and revive old ones, we can open new factories and power new farms, we can lower costs and revive our economy. We can do that and we must do that (emphasis added).

I have little doubt that Obama is a sincere man who in many respects has lost the ‘game of music chairs’. He spoke about creation of 460,000 jobs. The U.S. has lost approximately 4,000,000 manufacturing jobs since December 31, 2000. Manufacturing jobs tend to create products of enduring value, unlike service jobs which typically do not. Obama spoke about altering the U.S. automotive industry as if the Queen Mary (for those of you who don’t know, a luxury liner of a length that would take at least 50 miles to turn 180 degrees) in a period of time that will be meaningful. He did not mention:

• the cumulative U.S. National Debt burden;
• the cumulative U.S. trade deficits;
• that the U.S. is increasingly dependent on its trading partners;
• that the U.S.’s developing country trading partners have different ideologies and economic strategies than does the U.S.; or,
• the reduction in U.S. consumer confidence and spending in recent months and the resultant U.S. reduced tax revenues.

The speech he made was one he had to make. Stay tuned for the results of his and his government’s efforts. My guess is that he is a man who has come into office with the best of intentions to face an inherited set of circumstances that will prove overwhelming. Too bad he wasn’t elected in 2000 – and I say this as a Canadian who if I was American would have a clear predilection to vote Republican. If I am correct that we are headed into years, not months, of worst economic times before things improve. I hope that the U.S. population and the world will not fault Obama. Make no mistake, the problems he has to deal with are legacy problems. They should be attributed by history to those who created them, including in my view the Clinton and George W. Bush administrations, and not least Alan Greenspan. Commentary now: Quickly review what newly elected President Obama said in January 2009 he would work to accomplish, and what has been accomplished to date. Broadly:

• progress has been made on some of the things he itemized in his January 26, 2009 speech. These include (1) some progress toward less U.S. dependence on energy, and (2) subsidization and post stabilization of the U.S. auto industry, at least for the time being;
• depending on whether one has Republican or Democratic leanings, one could argue that Washington is more polarized now than it was in January 2009 due to bad behavior on the part of one political party or the other. My truth is that members of both parties are dealing with highly complex problems from very different perspectives, and senior elected representative in both parties probably go to bed every night hoping the U.S. economy will revert to its former self, but not really knowing how that can be accomplished – all with a sinking feeling that ‘bad things might happen on their watch’;
• with respect to the climate, that is a very long term proposition, and hardly one that President Obama can be held responsible for; and,
• with respect to global coalition, the U.S. continues to be a very important player, but one whose position weakens as each month its economy ‘muddles along’ without a clear route to meaningful economic recovery.

Brief Country Risk Commentaries prompted by world headlines South America >> Ecuador: Ecuador to introduce constructive mining reforms Ecuador’s Natural Resources Minister has said Ecuador’s President will have a new bill to amend Ecuador’s mining law in front of him for review within a few weeks. That bill apparently will include two reforms:

• the first will delay a ‘windfall tax’ until miners recover their investments; and,
• the second will set a ceiling on mining royalties.

Such changes to Ecuador’s mining law, should they in the end become law, ought to be seen as positive. That said, a law made today can be changed tomorrow. Topical Reference: Ecuador says mining reform will pave way for contracts, from Mining Weekly, from Reuters, August 2, 2012 – reading time 2 minutes; and Ecuador vows mining reforms will pave way for major contracts, from Mineweb, from Reuters, August 3, 2012 – reading time 3 minutes. Important Snippets From Today’s Commentaries Snippet #1: Like individuals and countries, companies are vulnerable when they carry too much debt against their equity positions. Snippet #2: With respect to global coalition, the U.S. continues to be a very important player, but one whose position weakens as each month its economy ‘muddles along’ without a clear route to meaningful economic recovery.