We Think SJM Holdings (HKG:880) Is Taking Some Risk With Its 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.' 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 note that SJM Holdings Limited (HKG:880) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for SJM Holdings

What Is SJM Holdings's Debt?

The chart below, which you can click on for greater detail, shows that SJM Holdings had HK$15.5b in debt in June 2020; about the same as the year before. However, it does have HK$7.36b in cash offsetting this, leading to net debt of about HK$8.09b.

How Strong Is SJM Holdings's Balance Sheet?

The latest balance sheet data shows that SJM Holdings had liabilities of HK$10.8b due within a year, and liabilities of HK$14.1b falling due after that. Offsetting this, it had HK$7.36b in cash and HK$695.5m in receivables that were due within 12 months. So it has liabilities totalling HK$16.8b more than its cash and near-term receivables, combined.

SJM Holdings has a market capitalization of HK$52.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Strangely SJM Holdings has a sky high EBITDA ratio of 10.1, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that SJM Holdings's EBIT was down 97% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if SJM Holdings 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 last three years, SJM Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, SJM Holdings'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 covering its interest expense with its EBIT; that's encouraging. Overall, it seems to us that SJM Holdings'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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with SJM Holdings (including 2 which is make us uncomfortable) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.
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