Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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, Lendlease Group (ASX:LLC) does carry debt. But the real question is whether this debt is making the company risky.
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.
What Is Lendlease Group’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Lendlease Group had AU$2.72b of debt, an increase on AU$2.36b, over one year. On the flip side, it has AU$1.38b in cash leading to net debt of about AU$1.34b.
A Look At Lendlease Group’s Liabilities
We can see from the most recent balance sheet that Lendlease Group had liabilities of AU$6.29b falling due within a year, and liabilities of AU$4.53b due beyond that. Offsetting this, it had AU$1.38b in cash and AU$2.06b in receivables that were due within 12 months. So its liabilities total AU$7.38b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of AU$10.1b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Lendlease Group shareholders face the double whammy of a high net debt to EBITDA ratio (5.1), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. This means we’d consider it to have a heavy debt load. Worse, Lendlease Group’s EBIT was down 78% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Lendlease Group’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Lendlease Group recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
On the face of it, Lendlease Group’s interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Lendlease Group has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. Given our concerns about Lendlease Group’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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