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 can see that Wheaton Precious Metals Corp. (TSE:WPM) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Wheaton Precious Metals’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Wheaton Precious Metals had US$1.10b of debt, an increase on US$956.5m, over one year. On the flip side, it has US$87.2m in cash leading to net debt of about US$1.01b.
How Strong Is Wheaton Precious Metals’s Balance Sheet?
We can see from the most recent balance sheet that Wheaton Precious Metals had liabilities of US$25.0m falling due within a year, and liabilities of US$1.10b due beyond that. On the other hand, it had cash of US$87.2m and US$1.45m worth of receivables due within a year. So its liabilities total US$1.04b more than the combination of its cash and short-term receivables.
Of course, Wheaton Precious Metals has a titanic market capitalization of US$12.0b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Even though Wheaton Precious Metals’s debt is only 2.1, its interest cover is really very low at 1.0. In large part that’s it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason — some assets are seen to be losing value. In any case, it’s safe to say the company has meaningful debt. Importantly, Wheaton Precious Metals’s EBIT fell a jaw-dropping 38% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Wheaton Precious Metals’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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Wheaton Precious Metals 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, Wheaton Precious Metals’s conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at staying on top of its total liabilities; that’s encouraging. Overall, it seems to us that Wheaton Precious Metals’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. 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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