Jazz Pharmaceuticals (NASDAQ:JAZZ) takes some risk with its reliance on debt
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Jazz Pharmaceuticals plc (NASDAQ:JAZZ) is in debt. But does this debt worry shareholders?
What risk does debt carry?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for companies 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.
Check out our latest analysis for Jazz Pharmaceuticals
How much debt does Jazz Pharmaceuticals have?
The image below, which you can click on for more details, shows that as of March 2022, Jazz Pharmaceuticals had $6.02 billion in debt, up from $2.10 billion in one year. On the other hand, it has $490.8 million in cash, resulting in a net debt of around $5.53 billion.
How strong is Jazz Pharmaceuticals’ balance sheet?
According to the last published balance sheet, Jazz Pharmaceuticals had liabilities of $737.4 million due within 12 months and liabilities of $7.42 billion due beyond 12 months. As compensation for these obligations, it had cash of US$490.8 million and receivables valued at US$572.4 million due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of US$7.10 billion.
This is a mountain of leverage compared to its market capitalization of US$8.93 billion. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While we’re not concerned about Jazz Pharmaceuticals’ net debt to EBITDA ratio of 4.4, we believe its extremely low interest coverage of 1.9x is a sign of high leverage. It appears that the company is incurring significant depreciation and amortization costs, so perhaps its debt load is heavier than it appears at first glance, since EBITDA is undoubtedly a generous measure benefits. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. Worse still, Jazz Pharmaceuticals has seen its EBIT drop 21% in the past 12 months. If profits continue like this in the long term, there is an unimaginable chance of repaying this debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Jazz Pharmaceuticals’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Jazz Pharmaceuticals has generated free cash flow of a very strong 94% of its EBIT, more than expected. This puts him in a very strong position to repay his debt.
Our point of view
At first glance, Jazz Pharmaceuticals’ interest coverage left us hesitant about the stock, and its EBIT growth rate was no more appealing than the single empty restaurant on the busiest night of the year. But on the bright side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. Once we consider all of the above factors together, it seems to us that Jazz Pharmaceuticals’ debt makes it a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example, Jazz Pharmaceuticals has 2 warning signs (and 1 which is potentially serious) that we think you should know about.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.