Ultra Clean Holdings (NASDAQ:UCTT) Takes On Some Risk With Its Use Of Debt

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’. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Ultra Clean Holdings, Inc. (NASDAQ:UCTT) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Ultra Clean Holdings

What Is Ultra Clean Holdings’s Debt?

The image below, which you can click on for greater detail, shows that at September 2019 Ultra Clean Holdings had debt of US$313.2m, up from US$374 in one year. However, it does have US$158.7m in cash offsetting this, leading to net debt of about US$154.5m.

NasdaqGS:UCTT Historical Debt, January 22nd 2020
NasdaqGS:UCTT Historical Debt, January 22nd 2020

How Healthy Is Ultra Clean Holdings’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ultra Clean Holdings had liabilities of US$162.6m due within 12 months and liabilities of US$373.5m due beyond that. Offsetting these obligations, it had cash of US$158.7m as well as receivables valued at US$110.4m due within 12 months. So its liabilities total US$267.1m more than the combination of its cash and short-term receivables.

Ultra Clean Holdings has a market capitalization of US$1.01b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Ultra Clean Holdings has a quite reasonable net debt to EBITDA multiple of 1.7, its interest cover seems weak, at 2.0. This does suggest the company is paying fairly high interest rates. In any case, it’s safe to say the company has meaningful debt. Importantly, Ultra Clean Holdings’s EBIT fell a jaw-dropping 32% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Ultra Clean Holdings can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Ultra Clean Holdings recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both Ultra Clean Holdings’s EBIT growth rate and its interest cover were discouraging. But its not so bad at converting EBIT to free cash flow. Taking the abovementioned factors together we do think Ultra Clean Holdings’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – Ultra Clean Holdings has 3 warning signs (and 1 which is potentially serious) we think you should know about.

At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.

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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