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 Materion Corporation (NYSE:MTRN) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Materion’s Net Debt?
The image below, which you can click on for greater detail, shows that Materion had debt of US$79.6m at the end of October 2021, a reduction from US$128.6m over a year. However, it does have US$18.0m in cash offsetting this, leading to net debt of about US$61.6m.
A Look At Materion’s Liabilities
We can see from the most recent balance sheet that Materion had liabilities of US$172.8m falling due within a year, and liabilities of US$312.5m due beyond that. Offsetting this, it had US$18.0m in cash and US$190.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$276.6m.
Since publicly traded Materion shares are worth a total of US$1.81b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Materion’s net debt is only 0.46 times its EBITDA. And its EBIT easily covers its interest expense, being 25.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Materion grew its EBIT by 133% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Materion can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Materion produced sturdy free cash flow equating to 50% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Materion’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Materion’s use of debt seems quite reasonable and we’re not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity.