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 Landec Corporation (NASDAQ:LNDC) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Landec's Debt?
As you can see below, at the end of May 2019, Landec had US$149.5m of debt, up from US$72.9m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Landec's Balance Sheet?
We can see from the most recent balance sheet that Landec had liabilities of US$137.1m falling due within a year, and liabilities of US$111.9m due beyond that. On the other hand, it had cash of US$1.08m and US$71.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$176.3m.
Landec has a market capitalization of US$346.0m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 2.1 times and a disturbingly high net debt to EBITDA ratio of 6.9 hit our confidence in Landec like a one-two punch to the gut. The debt burden here is substantial. Worse, Landec's EBIT was down 62% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Landec 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Landec burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Landec's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Taking into account all the aforementioned factors, it looks like Landec has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given the risks around Landec's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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