David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. We note that Nine Energy Service, Inc. (NYSE:NINE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Nine Energy Service’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Nine Energy Service had debt of US$405.5m, up from US$113.7m in one year. However, it does have US$31.2m in cash offsetting this, leading to net debt of about US$374.3m.
How Healthy Is Nine Energy Service’s Balance Sheet?
The latest balance sheet data shows that Nine Energy Service had liabilities of US$93.6m due within a year, and liabilities of US$419.6m falling due after that. Offsetting these obligations, it had cash of US$31.2m as well as receivables valued at US$166.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$315.5m.
When you consider that this deficiency exceeds the company’s US$284.0m 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Nine Energy Service’s debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that Nine Energy Service actually grew its EBIT by a hefty 740%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Nine Energy Service’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Nine Energy Service reported free cash flow worth 12% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, Nine Energy Service’s level of total liabilities left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Once we consider all the factors above, together, it seems to us that Nine Energy Service’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Nine Energy Service insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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