Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies CK Hutchison Holdings Limited (HKG:1) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does CK Hutchison Holdings Carry?
The chart below, which you can click on for greater detail, shows that CK Hutchison Holdings had HK$345.1b in debt in June 2019; about the same as the year before. However, it does have HK$123.3b in cash offsetting this, leading to net debt of about HK$221.8b.
How Healthy Is CK Hutchison Holdings’s Balance Sheet?
According to the last reported balance sheet, CK Hutchison Holdings had liabilities of HK$233.4b due within 12 months, and liabilities of HK$475.2b due beyond 12 months. On the other hand, it had cash of HK$123.3b and HK$39.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$545.7b.
The deficiency here weighs heavily on the HK$266.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet.” So we definitely think shareholders need to watch this one closely. At the end of the day, CK Hutchison Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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.
CK Hutchison Holdings’s debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 3.9 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Looking on the bright side, CK Hutchison Holdings boosted its EBIT by a silky 38% in the last year. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CK Hutchison Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, CK Hutchison Holdings recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Neither CK Hutchison Holdings’s ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that CK Hutchison Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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