Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Royal Caribbean Cruises Ltd. (NYSE:RCL) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Royal Caribbean Cruises's Net Debt?
As you can see below, at the end of June 2019, Royal Caribbean Cruises had US$10.7b of debt, up from US$8.57b a year ago. Click the image for more detail. On the flip side, it has US$235.0m in cash leading to net debt of about US$10.5b.
How Strong Is Royal Caribbean Cruises's Balance Sheet?
The latest balance sheet data shows that Royal Caribbean Cruises had liabilities of US$7.59b due within a year, and liabilities of US$10.1b falling due after that. Offsetting these obligations, it had cash of US$235.0m as well as receivables valued at US$340.9m due within 12 months. So it has liabilities totalling US$17.1b more than its cash and near-term receivables, combined.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$23.9b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Royal Caribbean Cruises has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 5.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Royal Caribbean Cruises could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 16%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Royal Caribbean Cruises's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Royal Caribbean Cruises produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Royal Caribbean Cruises's EBIT growth rate was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about Royal Caribbean Cruises's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We'd be motivated to research the stock further if we found out that Royal Caribbean Cruises insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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