Here’s Why NewMarket (NYSE:NEU) Can Manage Its Debt Responsibly

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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies NewMarket Corporation (NYSE:NEU) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for NewMarket

How Much Debt Does NewMarket Carry?

As you can see below, at the end of September 2019, NewMarket had US$640.0m of debt, up from US$813 a year ago. Click the image for more detail. However, because it has a cash reserve of US$80.0m, its net debt is less, at about US$560.0m.

NYSE:NEU Historical Debt, January 17th 2020
NYSE:NEU Historical Debt, January 17th 2020

How Healthy Is NewMarket’s Balance Sheet?

The latest balance sheet data shows that NewMarket had liabilities of US$280.5m due within a year, and liabilities of US$861.2m falling due after that. Offsetting this, it had US$80.0m in cash and US$340.8m in receivables that were due within 12 months. So its liabilities total US$720.9m more than the combination of its cash and short-term receivables.

Since publicly traded NewMarket shares are worth a total of US$5.26b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

NewMarket has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 11.9 times over. So we’re pretty relaxed about its super-conservative use of debt. Also positive, NewMarket grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. There’s no doubt that we learn most about debt from the balance sheet. But it is NewMarket’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, NewMarket recorded free cash flow of 46% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that NewMarket’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Taking all this data into account, it seems to us that NewMarket takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Be aware that NewMarket is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant…

When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

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