Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. We note that Plexus Corp. (NASDAQ:PLXS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Plexus Carry?
You can click the graphic below for the historical numbers, but it shows that as of July 2022 Plexus had US$394.8m of debt, an increase on US$206.1m, over one year. However, it does have US$276.6m in cash offsetting this, leading to net debt of about US$118.2m.
How Healthy Is Plexus’ Balance Sheet?
The latest balance sheet data shows that Plexus had liabilities of US$1.86b due within a year, and liabilities of US$285.5m falling due after that. On the other hand, it had cash of US$276.6m and US$741.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.13b.
While this might seem like a lot, it is not so bad since Plexus has a market capitalization of US$2.57b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Plexus’s net debt is only 0.53 times its EBITDA. And its EBIT easily covers its interest expense, being 13.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Plexus’s EBIT dived 14%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Plexus can strengthen its balance sheet over time.
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. In the last three years, Plexus’s free cash flow amounted to 46% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Plexus’s EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Plexus is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.