Halloween's around the corner but trick or treaters in scary costumes isn't what shareholders of Chemring should be afraid of...
Recent reports show that the pre-tax profit for Chemring was only two thirds of what it was originally expected to be and that their underlying operating profit forecast was cut down to £16m from about £33m. Since the start of the Iraq war in March 2003, Chemring has experienced rises to their share price until March 2011 but then this has fallen significantly by approximately 80% since then. Analysts are also suggesting that the warnings about their expected profits would also contribute to the decrease in share prices. From the graph below you can see the sudden drop in the share price between the 26th and 27th of October.
A cause for these negative effects on the profits was that there have been delays to their contracts. A contract with the Middle East worth about £100m had to be delayed until next year and Chemring was hoping that this contract would compensate for their other issues.
What is the main problem for Chemring though?! Why are they facing these issues? The answer is simple...the company had taken on more debt than they can handle. Modigliani and Miller (1963) suggested that a company should take on debt but only as much as you can! The theory is that this would increase the company's value in the future. I believe Chemring did try to follow this theory to a certain extent because a large amount of their debt was due to high borrowings between 2007 and 2012. The money went towards the acquirement of 11 other businesses so technically, in the long run this should benefit the company, but I believe they took on more debt than they should have although it was for a good investment.
Although high levels of gearing would decrease the overall cost of finance, it is not always possible with high levels of risk. A company with high levels of gearing have high debt so the financial distress costs associated with this becomes higher as well. I believe that this is the issue Chemring is currently facing because their net debt is between £155m and £165m with their interest costs for 2015 are expected to be about £15m.
High gearing levels are also risky for the shareholders which would explain the sudden drop in the price. Chief Executive Michael Flowers stated that the company has restructuring plans in place but it is a slower process than expected due to the high levels of debt in the company. A large amount of time has been contributed towards managing this debt and the opportunity cost has been the operational movement and growth opportunities to the group. Chemring has a plan to raise £90m through a rights issue next year and all the money from this would go towards the debt and the capital structure of the company.
Despite all the problems they are currently facing, Chemring remains optimistic about the fact that they will recover in 2016. It would be a slow recovery but due to the ongoing international political situations in the Middle East (they would need more robust defence and security measures) the company claims that they would have higher returns.
If a company takes on a large amount of debt, the business would require high returns. The issue for Chemring is that they have high debts but they are not generating the returns needed right now. Another important factor that they should have considered is what a reasonable amount of debt would be for them. It depends on various factors such as the type of economic conditions as well as the time period - I believe that what's acceptable in one era may not be acceptable in the other.
What do you think? Let me know in the comments below!
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