Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. Importantly, FAT Brands Inc. (NASDAQ:FAT) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is FAT Brands’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 FAT Brands had US$34.0m of debt, an increase on US$17.5m, over one year. However, it does have US$690.0k in cash offsetting this, leading to net debt of about US$33.3m.
A Look At FAT Brands’s Liabilities
According to the last reported balance sheet, FAT Brands had liabilities of US$11.9m due within 12 months, and liabilities of US$43.3m due beyond 12 months. Offsetting these obligations, it had cash of US$690.0k as well as receivables valued at US$2.14m due within 12 months. So its liabilities total US$52.4m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s US$45.1m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
FAT Brands shareholders face the double whammy of a high net debt to EBITDA ratio (7.1), and fairly weak interest coverage, since EBIT is just 0.63 times the interest expense. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that FAT Brands actually grew its EBIT by a hefty 198%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since FAT Brands will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, FAT Brands created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
To be frank both FAT Brands’s net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, we think it’s fair to say that FAT Brands has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given our hesitation about the stock, it would be good to know if FAT Brands insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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