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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Conduent Incorporated (NYSE:CNDT) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
How Much Debt Does Conduent Carry?
As you can see below, Conduent had US$1.40b of debt at September 2019, down from US$1.58b a year prior. However, because it has a cash reserve of US$228.0m, its net debt is less, at about US$1.18b.
How Strong Is Conduent's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Conduent had liabilities of US$1.12b due within 12 months and liabilities of US$1.98b due beyond that. Offsetting these obligations, it had cash of US$228.0m as well as receivables valued at US$1.01b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.87b.
Given this deficit is actually higher than the company's market capitalization of US$1.56b, we think shareholders really should watch Conduent's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Conduent has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 0.76. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Importantly, Conduent's EBIT fell a jaw-dropping 70% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Conduent 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 we always check how much of that EBIT is translated into free cash flow. During the last two years, Conduent 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.
On the face of it, Conduent's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its net debt to EBITDA is not so bad. After considering the datapoints discussed, we think Conduent has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Even though Conduent lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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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