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, Meggitt PLC (LON:MGGT) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Meggitt Carry?
You can click the graphic below for the historical numbers, but it shows that Meggitt had UK£1.13b of debt in June 2019, down from UK£1.23b, one year before. On the flip side, it has UK£116.4m in cash leading to net debt of about UK£1.02b.
How Strong Is Meggitt's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Meggitt had liabilities of UK£694.9m due within 12 months and liabilities of UK£1.68b due beyond that. Offsetting these obligations, it had cash of UK£116.4m as well as receivables valued at UK£459.4m due within 12 months. So it has liabilities totalling UK£1.80b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Meggitt has a market capitalization of UK£4.61b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt to EBITDA of 2.9 Meggitt has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.1 times its interest expense, and its net debt to EBITDA, was quite high, at 2.9. Unfortunately, Meggitt's EBIT flopped 19% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Meggitt can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Meggitt recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Meggitt's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to convert EBIT to free cash flow isn't too shabby at all. When we consider all the factors discussed, it seems to us that Meggitt is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Meggitt insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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