Consider Debt When Bottom-Fishing Retail

Every time I look at the group now, I hear the gravelly voice of Walter Schloss. "I don't like to lose money. I do not like debt." There is more pain ahead for this group, and those retail- and consumer-oriented companies with debt on the balance sheet will have a very difficult time surviving the downturn.

Consumer-sensitive companies with debt on the balance sheet could quickly see interest payment become a significant problem in maintaining profits. How much do sales have to decline for a company like Autozone (AZO - commentary - Cramer's Take) to have a problem. With annual interest payments of $ 140 million and lease payments of better than $60 million, one bad quarter could cause an enormous drop in earnings. It night not happen, but why take the chance?

Nordstrom's (JWN - commentary - Cramer's Take) just cut their estimates for the quarter by a larger-than-expected amount. With annual interest payments of $145 million and lease payments of $70 million, a prolonged slump could cause earnings to disappear. Again, it might not happen. But it could, which is why debt in retailers should be avoided. These are fixed costs that cannot be controlled and could easily turn earnings to losses in a bad environment.

Perhaps enough people will struggle with weight this holiday season that Weight Watchers (WTW - commentary - Cramer's Take) will easily cover the $85 million of interest payments and $24 million of rent payments. But they might not, and the large cost of debt will eat into earnings and could cause the share price to drop quickly.

Estimates for auto dealer Group One (GPI - commentary - Cramer's Take) are that the company will make about $40 million in net profits. If the auto business continues to decline at the current rate, the $30 million of interest payments have a huge impact on earnings per share. Why risk it?

We do not know how far the retail decline can or will go over the next several quarters. It depends heavily on housing prices and unemployment. Almost no one correctly predicted the steep decline in the economy, and I am not sure that I would give much weight to any forecast of when it is going to get better. I do know that if you are not spending all your cash flow in interest payments, you have a better chance of surviving the decline.

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At the time of publication, Melvin was long Charlotte Ruse, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.