Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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. We can see that Martin Marietta Materials, Inc. (NYSE:MLM) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Martin Marietta Materials’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Martin Marietta Materials had US$2.92b of debt, an increase on US$3.2k, over one year. Net debt is about the same, since the it doesn’t have much cash.
A Look At Martin Marietta Materials’s Liabilities
We can see from the most recent balance sheet that Martin Marietta Materials had liabilities of US$689.0m falling due within a year, and liabilities of US$4.23b due beyond that. Offsetting these obligations, it had cash of US$49.1m as well as receivables valued at US$763.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.11b.
While this might seem like a lot, it is not so bad since Martin Marietta Materials has a huge market capitalization of US$17.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without 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.
Martin Marietta Materials has net debt worth 2.4 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 6.8 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. One way Martin Marietta Materials could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Martin Marietta Materials’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Martin Marietta Materials recorded free cash flow of 42% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Martin Marietta Materials’s EBIT growth rate was a real positive on this analysis, as was its interest cover. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Martin Marietta Materials is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 2 warning signs for Martin Marietta Materials which any shareholder or potential investor should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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