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. Importantly, CenturyLink, Inc. (NYSE:CTL) does carry debt. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is CenturyLink’s Net Debt?
As you can see below, CenturyLink had US$35.5b of debt at March 2019, down from US$37.4b a year prior. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is CenturyLink’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that CenturyLink had liabilities of US$5.37b due within 12 months and liabilities of US$45.9b due beyond that. On the other hand, it had cash of US$441.0m and US$2.47b worth of receivables due within a year. So it has liabilities totalling US$48.3b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$12.4b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, CenturyLink would probably need a major re-capitalization if its creditors were to demand repayment. Since CenturyLink does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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.
While we wouldn’t blink an eye at CenturyLink’s net debt to EBITDA ratio of 3.83, we think its super-low interest cover of 1.90 times is a bad sign. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that CenturyLink grew its EBIT a smooth 63% over the last twelve months. 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 CenturyLink 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, CenturyLink produced sturdy free cash flow equating to 64% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
To be frank both CenturyLink’s interest cover and its track record of staying on top of its total liabilities 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. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making CenturyLink stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.