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.’ 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. As with many other companies MaxLinear, Inc. (NASDAQ:MXL) makes use of debt. But should shareholders be worried about its use of debt?
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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does MaxLinear Carry?
As you can see below, MaxLinear had US$246.5m of debt at June 2022, down from US$345.9m a year prior. However, it does have US$235.2m in cash offsetting this, leading to net debt of about US$11.2m.
How Healthy Is MaxLinear’s Balance Sheet?
According to the last reported balance sheet, MaxLinear had liabilities of US$316.1m due within 12 months, and liabilities of US$295.0m due beyond 12 months. Offsetting these obligations, it had cash of US$235.2m as well as receivables valued at US$137.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$238.8m.
Of course, MaxLinear has a market capitalization of US$2.67b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Carrying virtually no net debt, MaxLinear has a very light debt load indeed.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With debt at a measly 0.05 times EBITDA and EBIT covering interest a whopping 14.6 times, it’s clear that MaxLinear is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. Although MaxLinear made a loss at the EBIT level, last year, it was also good to see that it generated US$141m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if MaxLinear can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, MaxLinear actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
MaxLinear’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Zooming out, MaxLinear seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. There’s no doubt that we learn most about debt from the balance sheet.