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. We can see that Welbilt, Inc. (NYSE:WBT) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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.
How Much Debt Does Welbilt Carry?
The chart below, which you can click on for greater detail, shows that Welbilt had US$1.45b in debt in June 2019; about the same as the year before. However, it also had US$90.0m in cash, and so its net debt is US$1.36b.
How Healthy Is Welbilt's Balance Sheet?
The latest balance sheet data shows that Welbilt had liabilities of US$320.8m due within a year, and liabilities of US$1.65b falling due after that. Offsetting these obligations, it had cash of US$90.0m as well as receivables valued at US$216.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.67b.
This is a mountain of leverage relative to its market capitalization of US$2.39b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
While we wouldn't worry about Welbilt's net debt to EBITDA ratio of 4.8, we think its super-low interest cover of 2.3 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. More concerning, Welbilt saw its EBIT drop by 4.0% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off 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 Welbilt'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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Welbilt saw substantial negative free cash flow, in total. 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.
We'd go so far as to say Welbilt's conversion of EBIT to free cash flow was disappointing. But at least its EBIT growth rate is not so bad. Overall, it seems to us that Welbilt'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 Welbilt'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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