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. Importantly, Hostess Brands, Inc. (NASDAQ:TWNK) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Hostess Brands's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Hostess Brands had US$1.11b of debt, an increase on US$971.5m, over one year. On the flip side, it has US$173.0m in cash leading to net debt of about US$938.5m.
How Strong Is Hostess Brands' Balance Sheet?
The latest balance sheet data shows that Hostess Brands had liabilities of US$189.5m due within a year, and liabilities of US$1.55b falling due after that. Offsetting this, it had US$173.0m in cash and US$125.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.45b.
This deficit is considerable relative to its market capitalization of US$1.95b, so it does suggest shareholders should keep an eye on Hostess Brands' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Hostess Brands has a debt to EBITDA ratio of 4.3 and its EBIT covered its interest expense 4.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, one redeeming factor is that Hostess Brands grew its EBIT at 17% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hostess Brands can strengthen its balance sheet over time. 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 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 most recent three years, Hostess Brands recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Hostess Brands's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Hostess Brands's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Hostess Brands (including 1 which is potentially serious) .
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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