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Penn National Gaming (NASDAQ:PENN) Takes On Some Risk With Its Use Of Debt

Editorial Staff by Editorial Staff
August 22, 2021
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Penn National Gaming (NASDAQ:PENN) Takes On Some Risk With Its Use Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Penn National Gaming, Inc. (NASDAQ:PENN) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 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. 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 Penn National Gaming’s Net Debt?

The image below, which you can click on for greater detail, shows that Penn National Gaming had debt of US$2.38b at the end of March 2021, a reduction from US$3.12b over a year. However, it does have US$2.06b in cash offsetting this, leading to net debt of about US$313.1m.

debt-equity-history-analysis
NasdaqGS:PENN Debt to Equity History August 18th 2021

How Strong Is Penn National Gaming’s Balance Sheet?

We can see from the most recent balance sheet that Penn National Gaming had liabilities of US$947.3m falling due within a year, and liabilities of US$11.2b due beyond that. Offsetting these obligations, it had cash of US$2.06b as well as receivables valued at US$137.5m due within 12 months. So its liabilities total US$9.93b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of US$10.3b, so it does suggest shareholders should keep an eye on Penn National Gaming’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Penn National Gaming has a very low debt to EBITDA ratio of 0.25 so it is strange to see weak interest coverage, with last year’s EBIT being only 1.7 times the interest expense. So one way or the other, it’s clear the debt levels are not trivial. Notably, Penn National Gaming’s EBIT launched higher than Elon Musk, gaining a whopping 270% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Penn National Gaming can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Penn National Gaming recorded free cash flow of 40% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.

Our View

We feel some trepidation about Penn National Gaming’s difficulty interest cover, but we’ve got positives to focus on, too. To wit both its EBIT growth rate and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Penn National Gaming is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. 

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