Is Hongkong and Shanghai Hotels (HKG:45) Using Too Much Debt?

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.' 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 can see that The Hongkong and Shanghai Hotels, Limited (HKG:45) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. 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, 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 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 Hongkong and Shanghai Hotels

What Is Hongkong and Shanghai Hotels's Net Debt?

As you can see below, at the end of June 2020, Hongkong and Shanghai Hotels had HK$8.89b of debt, up from HK$7.23b a year ago. Click the image for more detail. On the flip side, it has HK$581.0m in cash leading to net debt of about HK$8.31b.

How Healthy Is Hongkong and Shanghai Hotels's Balance Sheet?

The latest balance sheet data shows that Hongkong and Shanghai Hotels had liabilities of HK$2.67b due within a year, and liabilities of HK$11.5b falling due after that. Offsetting this, it had HK$581.0m in cash and HK$267.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$13.3b.

Given this deficit is actually higher than the company's market capitalization of HK$11.5b, we think shareholders really should watch Hongkong and Shanghai Hotels's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

Weak interest cover of 0.75 times and a disturbingly high net debt to EBITDA ratio of 13.5 hit our confidence in Hongkong and Shanghai Hotels like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Hongkong and Shanghai Hotels's EBIT was down 89% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Hongkong and Shanghai Hotels 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Hongkong and Shanghai Hotels recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Hongkong and Shanghai Hotels's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Hongkong and Shanghai Hotels's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Even though Hongkong and Shanghai Hotels lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.

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