The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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 Costamare Inc. (NYSE:CMRE) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Costamare’s Net Debt?

As you can see below, at the end of December 2021, Costamare had US$2.46b of debt, up from US$1.46b a year ago. Click the image for more detail. On the flip side, it has US$276.0m in cash leading to net debt of about US$2.18b.

How Healthy Is Costamare’s Balance Sheet?

We can see from the most recent balance sheet that Costamare had liabilities of US$370.0m falling due within a year, and liabilities of US$2.31b due beyond that. On the other hand, it had cash of US$276.0m and US$32.3m worth of receivables due within a year. So it has liabilities totalling US$2.37b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company’s market capitalization of US$1.97b, we think shareholders really should watch Costamare’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Costamare has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 4.8 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Pleasingly, Costamare is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 121% gain in the last twelve months. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Costamare can strengthen its balance sheet over time.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Costamare created free cash flow amounting to 8.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Costamare’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Costamare’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. There’s no doubt that we learn most about debt from the balance sheet.