Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Concho Resources Inc. (NYSE:CXO) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Concho Resources's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Concho Resources had US$4.49b of debt, an increase on US$2.37b, over one year. Net debt is about the same, since the it doesn't have much cash.
A Look At Concho Resources's Liabilities
Zooming in on the latest balance sheet data, we can see that Concho Resources had liabilities of US$1.40b due within 12 months and liabilities of US$6.12b due beyond that. Offsetting this, it had US$24.0m in cash and US$761.0m in receivables that were due within 12 months. So its liabilities total US$6.73b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Concho Resources has a huge market capitalization of US$14.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Given net debt is only 1.4 times EBITDA, it is initially surprising to see that Concho Resources's EBIT has low interest coverage of 2.2 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, Concho Resources grew its EBIT by 78% over the last twelve months, and that growth will make it easier to handle its debt. 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 Concho Resources 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, 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. During the last three years, Concho Resources burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Concho Resources's conversion of EBIT to free cash flow and interest cover 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 Concho Resources's debt poses some risks to the business. 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 Concho Resources 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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