Here’s why NEXTDC (ASX: NXT) has a heavy debt burden
Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk that worries me … and every investor practices that I know worries “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Like many other companies NEXTDC Limited (ASX: NXT) uses debt. But does this debt worry shareholders?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
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What is NEXTDC’s debt?
The graph below, which you can click for more details, shows that NEXTDC was in debt of AU $ 781.3 million as of December 2020; about the same as the year before. However, it has A $ 715.9 million in cash offsetting this, leading to net debt of around A $ 65.4 million.
Is NEXTDC’s track record healthy?
According to the latest published balance sheet, NEXTDC had liabilities of AU $ 50.9 million due within 12 months and liabilities of AU $ 895.1 million due beyond 12 months. In compensation for these obligations, it had cash of A $ 715.9 million as well as receivables valued at A $ 35.5 million due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by AU $ 194.7 million.
Considering that NEXTDC has a market capitalization of AU $ 5.34 billion, it is hard to believe that these liabilities pose a significant threat. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet going forward. But in any case, NEXTDC has virtually no net debt, so it’s fair to say that it doesn’t have heavy debt!
We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
NEXTDC has a very low debt to EBITDA ratio of 0.58, so it is strange to see low interest coverage as last year’s EBIT was only 0.72 times interest expense. So one way or another, it’s clear that debt levels are not trivial. Unfortunately, NEXTDC’s EBIT actually fell 6.4% over the past year. If this earnings trend continues, its debt load will rise like the heart of a polar bear watching its only cub. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether NEXTDC can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, NEXTDC has spent a lot of money. While this may be the result of spending on growth, it makes debt much riskier.
Our point of view
While NEXTDC’s interest coverage makes us cautious about this, its track record of converting EBIT to free cash flow is no better. But on the bright side of life, its net debt to EBITDA lets us frolic more. Taking the above-mentioned factors together, we believe NEXTDC’s debt presents certain risks to the business. So while this leverage increases returns on equity, we wouldn’t really want to see it increase from here. Given our hesitation about the stock, it would be good to know if NEXTDC insiders have sold any stocks recently. You click here to see if any insiders have sold recently.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash growth stocks today.
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