Stock Analysis

Callon Petroleum (NYSE:CPE) Has No Shortage Of Debt

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NYSE:CPE
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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Callon Petroleum Company (NYSE:CPE) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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.

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What Is Callon Petroleum's Debt?

You can click the graphic below for the historical numbers, but it shows that Callon Petroleum had US$2.81b of debt in September 2021, down from US$3.19b, one year before. And it doesn't have much cash, so its net debt is about the same.

debt-equity-history-analysis
NYSE:CPE Debt to Equity History January 5th 2022

How Healthy Is Callon Petroleum's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Callon Petroleum had liabilities of US$828.4m due within 12 months and liabilities of US$2.93b due beyond that. On the other hand, it had cash of US$3.70m and US$216.1m worth of receivables due within a year. So it has liabilities totalling US$3.53b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's US$3.41b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 6.2 hit our confidence in Callon Petroleum like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Callon Petroleum's EBIT was down 44% 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 future earnings, more than anything, that will determine Callon Petroleum'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Callon Petroleum burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Callon Petroleum's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. We think the chances that Callon Petroleum has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Callon Petroleum that you should be aware of.

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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