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. As with many other companies REV Group, Inc. (NYSE:REVG) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is REV Group's Debt?
The image below, which you can click on for greater detail, shows that REV Group had debt of US$342.2m at the end of October 2020, a reduction from US$380.2m over a year. However, because it has a cash reserve of US$11.4m, its net debt is less, at about US$330.8m.
How Strong Is REV Group's Balance Sheet?
The latest balance sheet data shows that REV Group had liabilities of US$447.3m due within a year, and liabilities of US$392.7m falling due after that. On the other hand, it had cash of US$11.4m and US$229.3m worth of receivables due within a year. So it has liabilities totalling US$599.3m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$543.2m, we think shareholders really should watch REV Group'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 0.22 times and a disturbingly high net debt to EBITDA ratio of 7.2 hit our confidence in REV Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, REV Group's EBIT was down 81% 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 REV Group can strengthen its balance sheet over time. 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. 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, REV Group recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
On the face of it, REV Group's interest cover 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. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. We think the chances that REV Group has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. Case in point: We've spotted 2 warning signs for REV Group you should be aware of, and 1 of them makes us a bit uncomfortable.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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