David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hewlett Packard Enterprise Company (NYSE:HPE) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, 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 Hewlett Packard Enterprise's Debt?
You can click the graphic below for the historical numbers, but it shows that Hewlett Packard Enterprise had US$12.6b of debt in April 2019, down from US$14.2b, one year before. However, because it has a cash reserve of US$3.59b, its net debt is less, at about US$9.00b.
How Healthy Is Hewlett Packard Enterprise's Balance Sheet?
The latest balance sheet data shows that Hewlett Packard Enterprise had liabilities of US$16.1b due within a year, and liabilities of US$16.8b falling due after that. Offsetting these obligations, it had cash of US$3.59b as well as receivables valued at US$4.93b due within 12 months. So its liabilities total US$24.4b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's huge US$19.6b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 1.7, Hewlett Packard Enterprise uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.9 times interest expense) certainly does not do anything to dispel this impression. Pleasingly, Hewlett Packard Enterprise is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 294% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hewlett Packard Enterprise 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Hewlett Packard Enterprise created free cash flow amounting to 4.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Hewlett Packard Enterprise's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Hewlett Packard Enterprise's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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