MIE Holdings (HKG:1555) Takes On Some Risk With Its Use Of Debt
Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that MIE Holdings Corporation (HKG:1555) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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.
See our latest analysis for MIE Holdings
What Is MIE Holdings's Debt?
As you can see below, MIE Holdings had CN¥4.65b of debt at December 2018, down from CN¥7.12b a year prior. And it doesn't have much cash, so its net debt is about the same.
How Strong Is MIE Holdings's Balance Sheet?
We can see from the most recent balance sheet that MIE Holdings had liabilities of CN¥7.89b falling due within a year, and liabilities of CN¥2.04b due beyond that. Offsetting this, it had CN¥45.9m in cash and CN¥69.8m in receivables that were due within 12 months. So its liabilities total CN¥9.82b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥514.4m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, MIE Holdings 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.02 times and a disturbingly high net debt to EBITDA ratio of 14.3 hit our confidence in MIE Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that MIE Holdings achieved a positive EBIT of CN¥10m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is MIE Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, MIE Holdings actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Our View
To be frank both MIE Holdings's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider MIE Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Even though MIE Holdings lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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