Is Pegatron (TPE:4938) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Pegatron Corporation (TPE:4938) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Pegatron

What Is Pegatron's Debt?

As you can see below, at the end of September 2020, Pegatron had NT$158.7b of debt, up from NT$122.6b a year ago. Click the image for more detail. However, its balance sheet shows it holds NT$183.7b in cash, so it actually has NT$24.9b net cash.

How Strong Is Pegatron's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Pegatron had liabilities of NT$407.5b due within 12 months and liabilities of NT$36.1b due beyond that. Offsetting these obligations, it had cash of NT$183.7b as well as receivables valued at NT$203.0b due within 12 months. So its liabilities total NT$57.0b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Pegatron is worth NT$173.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Pegatron also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Pegatron has boosted its EBIT by 39%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Pegatron'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Pegatron has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Pegatron saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

Although Pegatron's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of NT$24.9b. And we liked the look of last year's 39% year-on-year EBIT growth. So we don't have any problem with Pegatron's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for Pegatron (of which 2 are a bit concerning!) you should know about.

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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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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