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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Red Rock Resorts, Inc. (NASDAQ:RRR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Red Rock Resorts Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Red Rock Resorts had debt of US$3.00b, up from US$2.61b in one year. On the flip side, it has US$100.5m in cash leading to net debt of about US$2.90b.
How Strong Is Red Rock Resorts’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Red Rock Resorts had liabilities of US$297.3m due within 12 months and liabilities of US$3.01b due beyond that. Offsetting these obligations, it had cash of US$100.5m as well as receivables valued at US$53.4m due within 12 months. So it has liabilities totalling US$3.16b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$2.23b 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in Red Rock Resorts like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Investors should also be troubled by the fact that Red Rock Resorts saw its EBIT drop by 10% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Red Rock Resorts 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 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, Red Rock Resorts burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Red Rock Resorts’s net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. And even its level of total liabilities fails to inspire much confidence. Considering all the factors previously mentioned, we think that Red Rock Resorts really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. Given the risks around Red Rock Resorts’s use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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