Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Deere & Company (NYSE:DE) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Deere’s Net Debt?
The chart below, which you can click on for greater detail, shows that Deere had US$46.0b in debt in January 2021; about the same as the year before. However, because it has a cash reserve of US$6.65b, its net debt is less, at about US$39.4b.
How Healthy Is Deere’s Balance Sheet?
According to the last reported balance sheet, Deere had liabilities of US$22.3b due within 12 months, and liabilities of US$39.1b due beyond 12 months. Offsetting this, it had US$6.65b in cash and US$6.33b in receivables that were due within 12 months. So its liabilities total US$48.4b more than the combination of its cash and short-term receivables.
Deere has a very large market capitalization of US$120.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without 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.
Strangely Deere has a sky high EBITDA ratio of 6.1, implying high debt, but a strong interest coverage of 18.5. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. We note that Deere grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Deere’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Deere recorded free cash flow of 37% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Deere’s net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Deere is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.