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. We can see that Rite Aid Corporation (NYSE:RAD) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Rite Aid’s Net Debt?
The chart below, which you can click on for greater detail, shows that Rite Aid had US$3.06b in debt in February 2021; about the same as the year before. However, it also had US$160.9m in cash, and so its net debt is US$2.90b.
How Healthy Is Rite Aid’s Balance Sheet?
According to the last reported balance sheet, Rite Aid had liabilities of US$2.60b due within 12 months, and liabilities of US$6.12b due beyond 12 months. Offsetting these obligations, it had cash of US$160.9m as well as receivables valued at US$1.46b due within 12 months. So it has liabilities totalling US$7.10b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$1.14b 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, Rite Aid 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). 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).
Weak interest cover of 0.65 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Rite Aid like a one-two punch to the gut. The debt burden here is substantial. Worse, Rite Aid’s EBIT was down 36% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. 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 Rite Aid 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Rite Aid saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
To be frank both Rite Aid’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. Considering everything we’ve mentioned above, it’s fair to say that Rite Aid is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we’d probably stay away from this particular stock. There’s no doubt that we learn most about debt from the balance sheet.