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.' 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 Playa Hotels & Resorts N.V. (NASDAQ:PLYA) does use debt in its business. But should shareholders be worried about its use of debt?
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. 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. 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.
What Is Playa Hotels & Resorts's Net Debt?
The chart below, which you can click on for greater detail, shows that Playa Hotels & Resorts had US$1.02b in debt in June 2019; about the same as the year before. However, it does have US$104.5m in cash offsetting this, leading to net debt of about US$914.7m.
A Look At Playa Hotels & Resorts's Liabilities
We can see from the most recent balance sheet that Playa Hotels & Resorts had liabilities of US$130.6m falling due within a year, and liabilities of US$1.19b due beyond that. Offsetting these obligations, it had cash of US$104.5m as well as receivables valued at US$65.6m due within 12 months. So its liabilities total US$1.15b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of US$994.3m, we think shareholders really should watch Playa Hotels & Resorts's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). 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).
Playa Hotels & Resorts shareholders face the double whammy of a high net debt to EBITDA ratio (5.6), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. The debt burden here is substantial. Another concern for investors might be that Playa Hotels & Resorts's EBIT fell 15% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Playa Hotels & Resorts's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Playa Hotels & Resorts recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
To be frank both Playa Hotels & Resorts's conversion of EBIT to free cash flow and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. And furthermore, its EBIT growth rate also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Playa Hotels & Resorts has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Playa Hotels & Resorts's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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