Warren Buffett famously said, ‘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. We can see that Mueller Water Products, Inc. (NYSE:MWA) does use debt in its business. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Mueller Water Products’s Net Debt?
As you can see below, Mueller Water Products had US$445.6m of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$125.6m in cash, and so its net debt is US$320.0m.
How Healthy Is Mueller Water Products’ Balance Sheet?
According to the last reported balance sheet, Mueller Water Products had liabilities of US$213.6m due within 12 months, and liabilities of US$585.2m due beyond 12 months. Offsetting this, it had US$125.6m in cash and US$205.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$468.2m.
This deficit isn’t so bad because Mueller Water Products is worth US$2.20b, and thus could probably raise enough capital to shore up 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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 1.7, Mueller Water Products uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.8 times its interest expenses harmonizes with that theme. Unfortunately, Mueller Water Products’s EBIT flopped 14% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Mueller Water Products can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Mueller Water Products’s free cash flow amounted to 42% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Mueller Water Products’s EBIT growth rate 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 is relatively strong. We think that Mueller Water Products’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt.