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 note that Callon Petroleum Company (NYSE:CPE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Callon Petroleum's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Callon Petroleum had US$3.19b of debt, an increase on US$1.19b, over one year. Net debt is about the same, since the it doesn't have much cash.
A Look At Callon Petroleum's Liabilities
Zooming in on the latest balance sheet data, we can see that Callon Petroleum had liabilities of US$417.4m due within 12 months and liabilities of US$3.32b due beyond that. Offsetting these obligations, it had cash of US$10.5m as well as receivables valued at US$112.5m due within 12 months. So its liabilities total US$3.61b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$402.7m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Callon Petroleum would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Callon Petroleum's debt is 4.9 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, Callon Petroleum's EBIT was down 32% 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. There's no doubt that we learn most about debt from the balance sheet. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. During the last three years, Callon Petroleum burned a lot of cash. 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.
On the face of it, Callon Petroleum'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. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that Callon Petroleum is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. Case in point: We've spotted 2 warning signs for Callon Petroleum you should be aware of, and 1 of them can't be ignored.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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Callon Petroleum Company, an independent oil and natural gas company, focuses on the acquisition, exploration, and development of oil and natural gas properties in Permian Basin in West Texas.
Undervalued with acceptable track record.