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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Huazhu Group Limited (NASDAQ:HTHT) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Huazhu Group’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Huazhu Group had CN¥11.0b of debt in March 2021, down from CN¥13.6b, one year before. However, because it has a cash reserve of CN¥8.72b, its net debt is less, at about CN¥2.25b.
A Look At Huazhu Group’s Liabilities
Zooming in on the latest balance sheet data, we can see that Huazhu Group had liabilities of CN¥9.18b due within 12 months and liabilities of CN¥41.9b due beyond that. On the other hand, it had cash of CN¥8.72b and CN¥876.0m worth of receivables due within a year. So its liabilities total CN¥41.5b more than the combination of its cash and short-term receivables.
Huazhu Group has a very large market capitalization of CN¥110.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Huazhu Group’s ability to maintain a healthy balance sheet going forward.
In the last year Huazhu Group had a loss before interest and tax, and actually shrunk its revenue by 3.0%, to CN¥11b. We would much prefer see growth.
Importantly, Huazhu Group had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost CN¥984m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled CN¥844m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be risky. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it.