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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Callon Petroleum Company (NYSE:CPE) does use debt in its business. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Callon Petroleum’s Net Debt?
The image below, which you can click on for greater detail, shows that Callon Petroleum had debt of US$2.90b at the end of March 2021, a reduction from US$3.25b over a year. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is Callon Petroleum’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Callon Petroleum had liabilities of US$672.0m due within 12 months and liabilities of US$3.04b due beyond that. On the other hand, it had cash of US$24.4m and US$179.1m worth of receivables due within a year. So its liabilities total US$3.51b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$1.78b 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, Callon Petroleum would probably need a major re-capitalization if its creditors were to demand repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Callon Petroleum’s ability to maintain a healthy balance sheet going forward.
In the last year Callon Petroleum wasn’t profitable at an EBIT level, but managed to grow its revenue by 36%, to US$1.1b. With any luck the company will be able to grow its way to profitability.
Caveat Emptor
Despite the top line growth, Callon Petroleum still had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable US$286m at the EBIT level. When we look at that alongside the significant liabilities, we’re not particularly confident about the company. We’d want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through US$49m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.