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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies GSH Corporation Limited (SGX:BDX) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does GSH Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 GSH had S$511.0m of debt, an increase on S$450.6m, over one year. On the flip side, it has S$113.1m in cash leading to net debt of about S$397.9m.
How Healthy Is GSH’s Balance Sheet?
The latest balance sheet data shows that GSH had liabilities of S$313.2m due within a year, and liabilities of S$371.3m falling due after that. Offsetting this, it had S$113.1m in cash and S$94.5m in receivables that were due within 12 months. So it has liabilities totalling S$477.0m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s S$450.3m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
GSH shareholders face the double whammy of a high net debt to EBITDA ratio (7.8), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. The debt burden here is substantial. Looking on the bright side, GSH boosted its EBIT by a silky 69% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since GSH 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, GSH burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both GSH’s net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, it seems to us that GSH’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – GSH has 3 warning signs (and 1 which doesn’t sit too well with us) we think you should know about.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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