Here's Why Vallourec (EPA:VK) Has A Meaningful Debt Burden

By
Simply Wall St
Published
April 09, 2022
ENXTPA:VK
Source: Shutterstock

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Vallourec S.A. (EPA:VK) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

View our latest analysis for Vallourec

What Is Vallourec's Debt?

You can click the graphic below for the historical numbers, but it shows that Vallourec had €1.58b of debt in December 2021, down from €3.61b, one year before. However, it also had €619.0m in cash, and so its net debt is €958.0m.

debt-equity-history-analysis
ENXTPA:VK Debt to Equity History April 9th 2022

How Healthy Is Vallourec's Balance Sheet?

We can see from the most recent balance sheet that Vallourec had liabilities of €1.34b falling due within a year, and liabilities of €1.60b due beyond that. On the other hand, it had cash of €619.0m and €541.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €1.78b.

This deficit is considerable relative to its market capitalization of €2.65b, so it does suggest shareholders should keep an eye on Vallourec's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

While Vallourec has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 2.0. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. We also note that Vallourec improved its EBIT from a last year's loss to a positive €290m. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Vallourec can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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 the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Vallourec saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Vallourec's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Looking at the bigger picture, it seems clear to us that Vallourec's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Vallourec (2 make us uncomfortable!) that you should be aware of before investing here.

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.

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