The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. Importantly, Penske Automotive Group, Inc. (NYSE:PAG) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is Penske Automotive Group’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Penske Automotive Group had US$6.01b of debt, an increase on US$5.76b, over one year. And it doesn’t have much cash, so its net debt is about the same.
A Look At Penske Automotive Group’s Liabilities
Zooming in on the latest balance sheet data, we can see that Penske Automotive Group had liabilities of US$5.17b due within 12 months and liabilities of US$5.53b due beyond that. Offsetting these obligations, it had cash of US$43.8m as well as receivables valued at US$944.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$9.71b.
This deficit casts a shadow over the US$3.58b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Penske Automotive Group would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 8.1, it’s fair to say Penske Automotive Group does have a significant amount of debt. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. More concerning, Penske Automotive Group saw its EBIT drop by 3.5% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill — a lot of effort for not much advancement. 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 Penske Automotive Group can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Penske Automotive Group recorded free cash flow of 48% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
To be frank both Penske Automotive Group’s net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to convert EBIT to free cash flow isn’t such a worry. Overall, it seems to us that Penske Automotive Group’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. Given the risks around Penske Automotive Group’s use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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