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. Importantly, Comstock Resources, Inc. (NYSE:CRK) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Comstock Resources’s Debt?
The image below, which you can click on for greater detail, shows that at June 2021 Comstock Resources had debt of US$2.85b, up from US$2.50b in one year. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is Comstock Resources’ Balance Sheet?
The latest balance sheet data shows that Comstock Resources had liabilities of US$655.5m due within a year, and liabilities of US$2.99b falling due after that. Offsetting these obligations, it had cash of US$19.7m as well as receivables valued at US$186.0m due within 12 months. So it has liabilities totalling US$3.44b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$2.04b 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, Comstock Resources would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 Comstock Resources’s net debt to EBITDA ratio of 3.3, we think its super-low interest cover of 1.7 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Looking on the bright side, Comstock Resources boosted its EBIT by a silky 86% in the last year. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Comstock Resources can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Comstock Resources recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Comstock Resources’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, it seems to us that Comstock Resources’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.