Survey of Bonds Sees Higher Risk in California : Los Angeles Consultants Focus on Nine Companies With Most Vulnerability

At first glance, Leisure Technology Inc. hardly looks like a firm in danger of falling on hard times. The Los Angeles-based developer and marketer of adult retirement communities reported record profits in its latest fiscal year. It owns high-quality properties and has a reputation for developing fine housing. The aging of the American population bodes well for its growth prospects.

But a closer look reveals signs of potential vulnerabilities, some analysts contend. Debt is high for a company its size. Earnings are cyclical, with projects generating an uneven stream of revenue and profit. Like other housing firms, earnings are prone to housing slumps or rising interest rates.

Such vulnerabilities make Leisure Technology one of nine California companies with bonds in most danger of default among 76 California companies that issue public debt, according to a survey conducted for The Times by Houlihan Lokey Howard & Zukin, a Los Angeles consulting firm that analyzes companies’ financial conditions.

Because of potential problems in paying interest on these high-yield “junk bonds,” the firms also have a higher risk of bankruptcy, particularly if the economy goes downhill, says Marko A. Budgyk, Houlihan Lokey’s manager of credit analysis and survey director.

And their collective troubles could result in California-based companies suffering a higher rate of bond defaults in a recession than the national average, Budgyk contends. “There’s a higher proportion of troubled debt issuers in California than in the rest of the nation,” Budgyk says.

Some Less Publicized

Five of the Bottom Nine are entertainment and health-care companies. The troubles of three--Cannon Group, New World Entertainment and Maxicare Health Plans--have been well publicized recently. Another entertainment firm, Fries Entertainment, a Los Angeles-based producer and distributor of television programming, has been hurt by intense competition and start-up costs for its home video and theatrical distribution operations. Nu-Med Inc., an Encino-based operator of general acute-care and psychiatric hospitals, has been losing money amid increased competition and higher health-care costs.

But the list also includes some companies, such as Leisure Technology and Angeles Corp., whose troubles have received far less publicity. Angeles, a Los Angeles-based investment management firm, has suffered losses due in part to slowdowns in demand for its real estate and energy limited partnerships.

Others whose troubles are less well known include Ducommun Inc., a City of Commerce-based firm providing manufacturing services to the aerospace industry. It continues to be burdened by high debt even after unloading some unprofitable divisions. The Bottom Nine also includes Erly Industries, a debt-laden Los Angeles-based firm (formerly called Early California Industries) trying to turn around its money-losing winery and rice operations.

To be sure, being on this list doesn’t mean these companies will default. Indeed, some could recover nicely or at least continue servicing their debt and avoid default. Angeles--which Budgyk considers by far the strongest of the Bottom Nine--has only about a 10% chance of default, and the next strongest, Leisure Technology, has a 10% to 50% chance, he estimates.

But when the average default rate on junk bonds today is only 2%, any probability of default over 10% is considered much riskier than normal, Budgyk says.

“Just because they are on this list doesn’t mean death is a foregone conclusion,” he notes. However, some on the list, such as Maxicare and Cannon, are virtually certain to default or undergo significant restructuring of their debt, he contends.

Several firms on the list--including Angeles, Fries Entertainment and Leisure Technology--take sharp exception to any suggestions that they are at high risk of default. They contend, correctly, that Houlihan Lokey’s mathematical analysis is only a starting point in bond risk analysis and doesn’t incorporate certain mitigating factors, such as cash available to service debt, that also can be analyzed.

“Any notion that Angeles might be likely to default on its debentures is ludicrous,” says Edward J. Hall, the company’s chief financial officer, contending that the firm’s cash flow is more than adequate to service its debt.

Similarly, Fries Entertainment’s chief financial officer, William T. Roland, notes that the firm has $8 million in cash and expects to add a credit line soon, more than adequate to handle $2 million in annual debt service.

Leisure Technology also contends that it has adequate cash and assets available to service its debt and that its bonds--issued as high-yield debt to begin with--are not yielding much more than they were when originally issued (meaning the marketplace is not too pessimistic on the company’s prospects).

Nevertheless, Budgyk predicts, about four or five of these Bottom Nine are likely to default or undergo significant restructuring. That forecast is based on what has happened to 24 firms, from a nationwide sample, that the firm identified in Fortune magazine in February, 1987, as the most default-prone.

Since then, 13 of those 24 have defaulted, with two more on the brink of default. Three more were acquired, staving off almost-certain default, Budgyk says.

Budgyk’s predictions already are off to a good start. His original list, compiled in early August, included 10 California companies. But one, Geothermal Resources, a San Mateo-based developer of geothermal energy, defaulted this past month.

And while some firms may take issue with their inclusion on the list, the market clearly treats their bonds as risky. Certain bonds of three of the firms--Cannon, Nu-Med and Erly Industries--are not rated at all by Standard & Poor’s, one of the leading bond rating agencies. The other six carry S&P; ratings ranging from CCC- for issues of New World Entertainment to CCC for certain issues of Maxicare and Ducommun to B- for Angeles and Fries Entertainment. All are below the minimal ratings that S&P; considers to be “investment grade.”

Some Very High Yields

Such low ratings means that all of these bonds are considered high-yield junk bonds. (Standard & Poor’s defines junk bonds as anything with ratings of BB or lower, while Moody’s cutoff is Ba.)

Their yields to maturity--which include regular interest payments as well as any gains from redeeming the bonds at face value when they mature--are running at least 14% to compensate for the risk. (Typical current yields for investment-grade bonds are less than 12%.) Some of the Bottom Nine carry yields to maturity above 30%, although many are unlikely to reach maturity because of their poor credit quality, and thus investors will never get to cash out the bonds at face value, Budgyk says.

“The market already perceives these bonds as troubled; there’s no news there,” said Joseph Bencivenga, senior bond analyst at the investment firm Drexel Burnham Lambert, when asked to comment on the Bottom Nine. Drexel pioneered the modern junk bond market and is its largest trader and marketer.

Almost all the bonds on the Bottom Nine list are small issues with low trading volume--another sign of the lack of investor interest in them.

But Houlihan Lokey’s survey attempted to go further than the ratings and actually select the riskiest of the risky. Bond rating agencies such as Standard & Poor’s and Moody’s typically are slow to adjust their ratings. So Houlihan Lokey’s determination of the Bottom Nine was based largely on ranking the California issuers against about 650 bond issuers nationwide, with firms compared to each other on such variables as stock market value, stock price volatility and debt.

The use of stock market values to aid in determining bond risks is a concept long used by Drexel. The level and volatility of a company’s stock, Houlihan Lokey’s Budgyk argues, foretells risk in its bonds, since stock investors are quick to react to a change in a firm’s fortunes. Companies with low stock market values and high stock price volatility, for example, tend to have riskier bonds, he says.

Instability in Earnings

That is because a low market value--the stock price multiplied by the number of shares outstanding--reflects a low net worth or shareholders equity. Such a company has a smaller cushion of assets to sell to pay interest on its bonds.

Further, high stock price volatility typically indicates widely fluctuating earnings. That is one reason utilities, with relatively stable earnings, have relatively stable stock prices. High earnings instability means the cash flows used to pay interest are subject to high uncertainty, Budgyk contends.

So bonds issued by a company with a low market value (low asset values) and high volatility (cyclical earnings) are inherently riskier, he argues. Such companies, if highly leveraged--that is, a high level of debt compared to their market value--may not be able to make bond interest payments if their earnings fall sharply for a sustained period.

“They can only take one punch from Mike Tyson and they’ll go under,” Budgyk says, drawing an analogy to opponents of the undefeated heavyweight boxing champion.

That is why companies issuing the safest bonds tend to be utilities, food companies and big consumer products concerns, with high asset levels and relatively stable earnings, Budgyk argues.

Just the opposite appears to be the case with Leisure Technology. Budgyk notes that the firm’s stock market value totals only about $40 million, making it among the smallest 8% of companies in Houlihan Lokey’s survey nationally.

Leverage Among Highest

The firm’s debt totals about $140 million, giving it a debt-to-market-value ratio of about 3 to 1. The ratio is even higher if the firm’s preferred stock is considered debt instead of equity, since preferred stock is similar to debt in that it carries regular dividend payments, Budgyk contends.

That puts Leisure Technology among the 5% of bond issuers with the highest leverage. And its stock price instability puts it among the 12% with the highest volatility.

So if Leisure Technology’s earnings ever head for a sharp fall, watch out for a bond default, Budgyk says.

However, Leisure Technology sharply disputes Houlihan Lokey’s assessment. John A. Kilduff, the firm’s executive vice president and chief financial officer, notes that it posted record earnings in both fiscal 1987 and 1988 and estimates that it will have more than adequate cash flow to service the debt.

And it is working to make its earnings more stable by acquiring additional properties, funded in part by proceeds from recent debt offerings, Kilduff says. Analysts and others had been concerned that there was a lot of time between completion of the company’s housing projects, thus creating some periods when revenues and earnings were not adequate to cover costs of developing new projects.

Kilduff added that Leisure Technology’s debt was originally issued as high-yield junk bonds, to compensate investors for the uncertainty of the housing industry. The recent yield to maturity of close to 16% on the firm’s senior notes is not far off from the initial 13.625% rate, and part of the difference can be attributed to the fact that the issue is very thinly traded, he says.

A similar story applies to Angeles, the investment management company. It is among the 8% most highly leveraged issuers nationally and among the smallest 4% in market value, Budgyk says.

A Rough Combination

Similarly, Nu-Med, the hospital operator, was rated in the lowest 6% in market value, the highest 1% in leverage and highest 2% in volatility. Erly, the winery and rice firm, was rated in the lowest 2% in market value, highest 1% in leverage and highest 3% in volatility.

“High leverage and small size (are) a rough combination,” Budgyk says. “The bigger you are, the more leverage you can handle.”

However, Angeles official Hall contends that the firm generated $10 million in cash in its latest fiscal year ended June 30, despite posting a $1.49-million loss. (The company had large non-cash charges such as depreciation.)

Its cash position of about $13.6 million “is more than enough to provide for debt service and pay obligations when due,” Hall says, noting that the firm’s annual debt-service costs are about $4.2 million. Houlihan Lokey’s analysis also fails to take into account the value of the relationships that Angeles has with its individual investor clients, Hall says.

A Nu-Med official said he would have no comment on the survey until he could study its analysis. Erly officials did not return telephone calls asking for comment.

Houlihan Lokey says about 15% of California issuers studied fall into its list of the 10% least credit-worthy bond issuers nationwide. These include companies whose bonds were originally issued as junk, as well as so-called fallen angels that were originally considered investment-grade but have subsequently been downgraded into junk.

So while the default rate on junk bonds in a recession could reach 5% nationally--up from about 2% currently--with California bonds it could be more like 6%, Budgyk says.

Of course, no one knows for sure just what the default rate might be, in part because most junk bonds have been issued in the past five years or so. Thus, the junk bond market has never really seen a full-blown recession.

Also, even with higher risk, junk bonds as a group--if held in a diversified portfolio--are still good investments because their higher yields more than compensate for the higher default risk, Budgyk says.

Why the higher risk in California? A higher proportion of the state’s bond issuers are in entertainment and health care, Budgyk says. Entertainment firms, for example, are particularly risky for issuing debt, because their earnings are highly cyclical and they have high leverage, he argues.

Low Price on Debentures

“I’d hate to be a debt holder in an entertainment company and depend on the fortunes of the next movie to determine if I get my interest payment,” says William H. Gross, managing director of Pacific Investment Management Co., a Newport Beach manager of fixed-income portfolios for pension funds.

Such risks are evident with bonds issued by such troubled entertainment concerns as Cannon Group and New World Entertainment. Los Angeles-based Cannon, once a darling of Wall Street, took on high debts to nearly double the number of films it made. But those films largely were disappointments at the box office, leading to a string of losses and a management shake-up under which its major European investor took control. Its 12.875% subordinated debentures recently traded at about $46.50 for each $100 in face value. A company official refused to comment on the Houlihan Lokey survey.

New World Entertainment, the once cash-rich Los Angeles-based producer of low-budget exploitation films and TV series, has suffered losses due to the poor showing of recently released films, high overhead and TV production costs, and interest payments on its heavy debt load.

The firm is trying to sell the comic book publishing unit of its Marvel Entertainment Group to bring in badly needed cash. It also recently completed a debt restructuring under which it exchanged some of debt for new notes and repurchased additional bonds, lowering its debt to about $200 million from $285 million. A company official said the moves have improved the firm’s prospects, but Houlihan Lokey’s Budgyk said the firm’s leverage still remains very high.

Such risks also are evident with Maxicare. The once fast-growing firm, the nation’s largest publicly held health maintenance organization, suffered from indigestion thanks to its ambitious expansion of recent years, which loaded it with debt during a period of soaring medical costs. The loss-plagued company recently underwent a management shake-up amid speculation that it may file for reorganization under Chapter 11 of the U.S. Bankruptcy Code. Its 11.75% notes recently traded at about $33.75 for each $100 of face value.

Another firm burdened with debt is Ducommun, which recently sold three electronics distribution divisions to downsize itself and change its focus. But the move merely left it with a smaller business base to support a high amount of debt, says Tom Schiller, rating officer at Standard & Poor’s.

Ducommun Chief Executive Norman A. Barkeley said he “didn’t agree” that his firm’s bonds are risky, although he refused to elaborate. The firm’s 7.75% convertible subordinated debentures recently traded at $54.00 for each $100 of face value.

RISKIEST CALIFORNIA JUNK BONDS

Company Issue S&P; rating Angeles Corp. 12.5% sub deb due 1995 B- Cannon Group 12.875% sub deb due 2001 NR Ducommun 7.75% conv sub deb due 2011 CCC Erly Industries 12.50% sub deb due 1993 NR Fries Entertainment 7.50% conv sub deb due 2006 B- Leisure Technology 13.625% note due 1996 CCC+ Maxicare 11.75% note due 1996 CCC New World Entertain. 11.00% note due 1995 CCC- Nu-Med 13.75% sub deb due 1995 NR

Recent bond Market value Debt to Company bid price (in millions) market value* Angeles Corp. 83.00 28 2.1 Cannon Group 46.50 43 13.9 Ducommun 54.00 8 8.1 Erly Industries 92.00 15 9.0 Fries Entertainment 39.00 10 3.1 Leisure Technology 89.00 45 3.0 Maxicare 33.75 19 25.8 New World Entertain. 28.50 28 7.2 Nu-Med 58.00 36 9.0

*Market value measures share price multiplied by number of outstanding shares. Debt to market value measures a firm’s leverage. The higher the ratio, the higher the leverage, and generally the higher the risk.

NR--not rated

sub deb--subordinated debenture

conv sub deb--convertible subordinated debenture

Data as of Sept. 1, except for Erly Industries, which is current as of Aug. 1

Source: Houlihan Lokey Howard & Zukin