Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Scientific Games Corporation (NASDAQ:SGMS) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Scientific Games Carry?
The chart below, which you can click on for greater detail, shows that Scientific Games had US$8.86b in debt in June 2019; about the same as the year before. On the flip side, it has US$369.0m in cash leading to net debt of about US$8.50b.
How Strong Is Scientific Games's Balance Sheet?
The latest balance sheet data shows that Scientific Games had liabilities of US$733.0m due within a year, and liabilities of US$9.32b falling due after that. Offsetting these obligations, it had cash of US$369.0m as well as receivables valued at US$850.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.83b.
The deficiency here weighs heavily on the US$1.91b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Scientific Games would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Scientific Games shareholders face the double whammy of a high net debt to EBITDA ratio (8.0), and fairly weak interest coverage, since EBIT is just 0.93 times the interest expense. The debt burden here is substantial. However, one redeeming factor is that Scientific Games grew its EBIT at 17% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Scientific Games'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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Scientific Games recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Scientific Games's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Scientific Games's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given the risks around Scientific Games's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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