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.’ 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. As with many other companies Archrock, Inc. (NYSE:AROC) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Archrock’s Debt?
The image below, which you can click on for greater detail, shows that Archrock had debt of US$1.70b at the end of December 2020, a reduction from US$1.84b over a year. Net debt is about the same, since the it doesn’t have much cash.
A Look At Archrock’s Liabilities
We can see from the most recent balance sheet that Archrock had liabilities of US$111.7m falling due within a year, and liabilities of US$1.73b due beyond that. Offsetting these obligations, it had cash of US$1.10m as well as receivables valued at US$104.4m due within 12 months. So it has liabilities totalling US$1.74b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of US$1.40b, we think shareholders really should watch Archrock’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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
While we wouldn’t worry about Archrock’s net debt to EBITDA ratio of 4.3, we think its super-low interest cover of 1.9 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Notably, Archrock’s EBIT was pretty flat over the last year, which isn’t ideal given the debt load. 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 Archrock can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Archrock basically broke even on a free cash flow basis. Some might say that’s a concern, when it comes considering how easily it would be for it to down debt.
To be frank both Archrock’s level of total liabilities and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We’re quite clear that we consider Archrock to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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.