Here's Why NEXTDC (ASX:NXT) Has A Meaningful Debt Burden

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. As with many other companies NEXTDC Limited (ASX:NXT) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for NEXTDC

What Is NEXTDC's Debt?

The chart below, which you can click on for greater detail, shows that NEXTDC had AU$781.3m in debt in December 2020; about the same as the year before. However, it does have AU$715.9m in cash offsetting this, leading to net debt of about AU$65.4m.

How Healthy Is NEXTDC's Balance Sheet?

According to the last reported balance sheet, NEXTDC had liabilities of AU$50.9m due within 12 months, and liabilities of AU$895.1m due beyond 12 months. Offsetting these obligations, it had cash of AU$715.9m as well as receivables valued at AU$35.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$194.7m.

Given NEXTDC has a market capitalization of AU$5.34b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, NEXTDC has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

NEXTDC has a very low debt to EBITDA ratio of 0.58 so it is strange to see weak interest coverage, with last year's EBIT being only 0.72 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Sadly, NEXTDC's EBIT actually dropped 6.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 NEXTDC 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, NEXTDC burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While NEXTDC's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But on the brighter side of life, its net debt to EBITDA leaves us feeling more frolicsome. Taking the abovementioned factors together we do think NEXTDC's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Given our hesitation about the stock, it would be good to know if NEXTDC insiders have sold any shares recently. You click here to find out if insiders have sold recently.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

If you’re looking to trade NEXTDC, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.