Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Albemarle Corporation (NYSE:ALB) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Albemarle’s Net Debt?
The image below, which you can click on for greater detail, shows that Albemarle had debt of US$1.99b at the end of June 2021, a reduction from US$3.48b over a year. However, because it has a cash reserve of US$823.6m, its net debt is less, at about US$1.16b.
How Strong Is Albemarle’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Albemarle had liabilities of US$984.9m due within 12 months and liabilities of US$3.45b due beyond that. Offsetting this, it had US$823.6m in cash and US$513.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.09b.
Of course, Albemarle has a titanic market capitalization of US$27.0b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Albemarle has net debt of just 1.4 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.6 times the interest expense over the last year. But the bad news is that Albemarle has seen its EBIT plunge 12% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Albemarle’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Albemarle recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
Albemarle’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. When we consider all the factors discussed, it seems to us that Albemarle is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here.