Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. As with many other companies Woodside Petroleum Ltd (ASX:WPL) 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 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Woodside Petroleum's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Woodside Petroleum had debt of US$5.52b, up from US$4.11b in one year. However, because it has a cash reserve of US$3.10b, its net debt is less, at about US$2.43b.
How Healthy Is Woodside Petroleum's Balance Sheet?
According to the last reported balance sheet, Woodside Petroleum had liabilities of US$1.04b due within 12 months, and liabilities of US$10.6b due beyond 12 months. On the other hand, it had cash of US$3.10b and US$325.0m worth of receivables due within a year. So its liabilities total US$8.19b more than the combination of its cash and short-term receivables.
Woodside Petroleum has a very large market capitalization of US$19.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Woodside Petroleum has a low net debt to EBITDA ratio of only 0.71. And its EBIT covers its interest expense a whopping 16.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Woodside Petroleum grew its EBIT by 9.2% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Woodside 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, 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. Over the most recent three years, Woodside Petroleum recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Woodside Petroleum's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Woodside Petroleum is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Woodside Petroleum insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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