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 Huazhu Group Limited (NASDAQ:HTHT) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Huazhu Group Carry?
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. On the flip side, it has CN¥8.72b in cash leading to net debt of about CN¥2.25b.
How Healthy Is Huazhu Group’s Balance Sheet?
We can see from the most recent balance sheet that Huazhu Group had liabilities of CN¥9.18b falling due within a year, and liabilities of CN¥41.9b due beyond that. Offsetting these obligations, it had cash of CN¥8.72b as well as receivables valued at CN¥876.0m due within 12 months. So it has liabilities totalling CN¥41.5b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Huazhu Group is worth a massive CN¥115.6b, and thus could probably raise enough capital to shore up 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. 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 Huazhu Group can strengthen its balance sheet over time.
Over 12 months, Huazhu Group made a loss at the EBIT level, and saw its revenue drop to CN¥11b, which is a fall of 3.0%. That’s not what we would hope to see.
Importantly, Huazhu Group had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CN¥984m. 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. However, it doesn’t help that it burned through CN¥844m of cash over the last year. So suffice it to say we do consider the stock to be risky. The balance sheet is clearly the area to focus on when you are analysing debt.