Stock Analysis

Here's Why 7-Eleven Malaysia Holdings Berhad (KLSE:SEM) Has A Meaningful Debt Burden

KLSE:SEM
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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. We can see that 7-Eleven Malaysia Holdings Berhad (KLSE:SEM) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for 7-Eleven Malaysia Holdings Berhad

What Is 7-Eleven Malaysia Holdings Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 7-Eleven Malaysia Holdings Berhad had RM506.5m of debt, an increase on RM138.7m, over one year. However, it also had RM175.9m in cash, and so its net debt is RM330.7m.

debt-equity-history-analysis
KLSE:SEM Debt to Equity History January 7th 2021

How Strong Is 7-Eleven Malaysia Holdings Berhad's Balance Sheet?

According to the last reported balance sheet, 7-Eleven Malaysia Holdings Berhad had liabilities of RM852.2m due within 12 months, and liabilities of RM899.4m due beyond 12 months. Offsetting this, it had RM175.9m in cash and RM54.9m in receivables that were due within 12 months. So it has liabilities totalling RM1.52b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of RM1.50b, we think shareholders really should watch 7-Eleven Malaysia Holdings Berhad's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Even though 7-Eleven Malaysia Holdings Berhad's debt is only 1.8, its interest cover is really very low at 2.3. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. 7-Eleven Malaysia Holdings Berhad grew its EBIT by 2.2% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if 7-Eleven Malaysia Holdings Berhad 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 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, 7-Eleven Malaysia Holdings Berhad 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

7-Eleven Malaysia Holdings Berhad's interest cover and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that 7-Eleven Malaysia Holdings Berhad's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 7-Eleven Malaysia Holdings Berhad (including 1 which shouldn't be ignored) .

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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