The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, NXP Semiconductors N.V. (NASDAQ:NXPI) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is NXP Semiconductors's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 NXP Semiconductors had US$8.54b of debt, an increase on US$5.34b, over one year. However, because it has a cash reserve of US$3.03b, its net debt is less, at about US$5.51b.
How Healthy Is NXP Semiconductors's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that NXP Semiconductors had liabilities of US$2.98b due within 12 months and liabilities of US$8.56b due beyond that. On the other hand, it had cash of US$3.03b and US$780.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.73b.
This deficit isn't so bad because NXP Semiconductors is worth a massive US$30.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
While NXP Semiconductors has a quite reasonable net debt to EBITDA multiple of 2.1, its interest cover seems weak, at 2.4. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Sadly, NXP Semiconductors's EBIT actually dropped 5.7% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 NXP Semiconductors'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, NXP Semiconductors actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
When it comes to the balance sheet, the standout positive for NXP Semiconductors was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. Looking at all this data makes us feel a little cautious about NXP Semiconductors'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 NXP Semiconductors 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.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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