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. We can see that Andrew Peller Limited (TSE:ADW.A) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Andrew Peller Carry?
You can click the graphic below for the historical numbers, but it shows that Andrew Peller had CA$152.0m of debt in June 2019, down from CA$164.4m, one year before. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Andrew Peller's Balance Sheet?
The latest balance sheet data shows that Andrew Peller had liabilities of CA$98.7m due within a year, and liabilities of CA$147.6m falling due after that. Offsetting these obligations, it had cash of CA$77.0k as well as receivables valued at CA$33.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$213.0m.
While this might seem like a lot, it is not so bad since Andrew Peller has a market capitalization of CA$630.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Andrew Peller has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 4.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Andrew Peller saw its EBIT slide 5.2% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Andrew Peller'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Andrew Peller's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While Andrew Peller's EBIT growth rate makes us cautious about it, its track record of converting EBIT to free cash flow 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 Andrew Peller 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 Andrew Peller insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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