Stock Analysis

Does Callon Petroleum (NYSE:CPE) Have A Healthy Balance Sheet?

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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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. 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 is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

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How Much Debt Does Callon Petroleum Carry?

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.

debt-equity-history-analysis
NYSE:CPE Debt to Equity History February 24th 2021

How Strong Is Callon Petroleum's Balance Sheet?

The latest balance sheet data shows that Callon Petroleum had liabilities of US$417.4m due within a year, and liabilities of US$3.32b falling due after 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 outweigh the sum of its cash and (near-term) receivables by US$3.61b.

The deficiency here weighs heavily on the US$981.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Callon Petroleum would probably need a major re-capitalization if its creditors were to demand repayment.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Callon Petroleum's debt is 4.9 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. 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'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Callon Petroleum 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.

Our View

To be frank both Callon Petroleum's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. It looks to us like Callon Petroleum carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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. Case in point: We've spotted 1 warning sign for Callon Petroleum you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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What are the risks and opportunities for Callon Petroleum?

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.

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Rewards

  • Trading at 42.2% below our estimate of its fair value

  • Became profitable this year

Risks

  • Earnings are forecast to decline by an average of 11.5% per year for the next 3 years

  • High level of non-cash earnings

  • Has a high level of debt

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