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 Freeport-McMoRan Inc. (NYSE:FCX) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Freeport-McMoRan’s Debt?
The image below, which you can click on for greater detail, shows that Freeport-McMoRan had debt of US$9.50b at the end of June 2023, a reduction from US$11.1b over a year. However, it does have US$6.68b in cash offsetting this, leading to net debt of about US$2.81b.
A Look At Freeport-McMoRan’s Liabilities
Zooming in on the latest balance sheet data, we can see that Freeport-McMoRan had liabilities of US$4.79b due within 12 months and liabilities of US$20.1b due beyond that. Offsetting these obligations, it had cash of US$6.68b as well as receivables valued at US$1.09b due within 12 months. So its liabilities total US$17.1b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Freeport-McMoRan has a huge market capitalization of US$57.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
Freeport-McMoRan has a low net debt to EBITDA ratio of only 0.36. And its EBIT easily covers its interest expense, being 12.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Freeport-McMoRan’s load is not too heavy, because its EBIT was down 40% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Freeport-McMoRan’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Freeport-McMoRan’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
We feel some trepidation about Freeport-McMoRan’s difficulty EBIT growth rate, but we’ve got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Freeport-McMoRan’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. There’s no doubt that we learn most about debt from the balance sheet.