Space-Communication (TLV:SCC) Use Of Debt Could Be Considered Risky

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 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. Importantly, Space-Communication Ltd. (TLV:SCC) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

View our latest analysis for Space-Communication

What Is Space-Communication's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Space-Communication had US$418.7m of debt in December 2020, down from US$452.2m, one year before. However, it also had US$120.4m in cash, and so its net debt is US$298.2m.

How Strong Is Space-Communication's Balance Sheet?

According to the last reported balance sheet, Space-Communication had liabilities of US$49.8m due within 12 months, and liabilities of US$441.6m due beyond 12 months. Offsetting this, it had US$120.4m in cash and US$32.1m in receivables that were due within 12 months. So its liabilities total US$338.9m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$38.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Space-Communication would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Space-Communication shareholders face the double whammy of a high net debt to EBITDA ratio (7.1), and fairly weak interest coverage, since EBIT is just 0.29 times the interest expense. The debt burden here is substantial. Worse, Space-Communication's EBIT was down 53% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Space-Communication's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Space-Communication actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Space-Communication's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Space-Communication has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Space-Communication (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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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