Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. We can see that Navigator Holdings Ltd. (NYSE:NVGS) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 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 Navigator Holdings’s Debt?
As you can see below, at the end of September 2021, Navigator Holdings had US$1.01b of debt, up from US$850.8m a year ago. Click the image for more detail. However, it does have US$105.8m in cash offsetting this, leading to net debt of about US$902.5m.
How Strong Is Navigator Holdings’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Navigator Holdings had liabilities of US$188.9m due within 12 months and liabilities of US$881.4m due beyond that. On the other hand, it had cash of US$105.8m and US$60.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$904.3m.
When you consider that this deficiency exceeds the company’s US$743.3m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Navigator Holdings like a one-two punch to the gut. The debt burden here is substantial. Fortunately, Navigator Holdings grew its EBIT by 9.6% in the last year, slowly shrinking its debt relative to earnings. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Navigator Holdings can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Navigator Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
On the face of it, Navigator Holdings’s interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Once we consider all the factors above, together, it seems to us that Navigator Holdings’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start.
