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 Kellogg Company (NYSE:K) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Kellogg's Net Debt?
As you can see below, Kellogg had US$9.35b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$340.0m in cash offsetting this, leading to net debt of about US$9.01b.
A Look At Kellogg's Liabilities
According to the last reported balance sheet, Kellogg had liabilities of US$4.99b due within 12 months, and liabilities of US$10.5b due beyond 12 months. Offsetting this, it had US$340.0m in cash and US$1.64b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$13.5b.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$21.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). 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).
Kellogg's debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 6.6 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. Sadly, Kellogg's EBIT actually dropped 3.1% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Kellogg 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Kellogg recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While Kellogg's level of total liabilities makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But its not so bad at covering its interest expense with its EBIT. When we consider all the factors discussed, it seems to us that Kellogg is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Kellogg insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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