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.’ 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. As with many other companies SM Energy Company (NYSE:SM) makes use of debt. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is SM Energy’s Net Debt?
The image below, which you can click on for greater detail, shows that SM Energy had debt of US$2.08b at the end of September 2021, a reduction from US$2.35b over a year. Net debt is about the same, since the it doesn’t have much cash.
How Strong Is SM Energy’s Balance Sheet?
According to the last reported balance sheet, SM Energy had liabilities of US$1.10b due within 12 months, and liabilities of US$2.32b due beyond 12 months. Offsetting these obligations, it had cash of US$29.8m as well as receivables valued at US$272.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.12b.
This deficit is considerable relative to its market capitalization of US$4.22b, so it does suggest shareholders should keep an eye on SM Energy’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine SM Energy’s ability to maintain a healthy balance sheet going forward.
Over 12 months, SM Energy reported revenue of US$2.0b, which is a gain of 65%, although it did not report any earnings before interest and tax. Shareholders probably have their fingers crossed that it can grow its way to profits.
While we can certainly appreciate SM Energy’s revenue growth, its earnings before interest and tax (EBIT) loss is not ideal. Its EBIT loss was a whopping US$437m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of US$554m into a profit. In the meantime, we consider the stock very risky. The balance sheet is clearly the area to focus on when you are analysing debt.