Is Vallourec (EPA:VK) Using Too Much Debt?

By
Simply Wall St
Published
January 07, 2022
ENXTPA:VK
Source: Shutterstock

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Vallourec S.A. (EPA:VK) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Vallourec

How Much Debt Does Vallourec Carry?

The image below, which you can click on for greater detail, shows that Vallourec had debt of €1.55b at the end of September 2021, a reduction from €3.69b over a year. However, it also had €552.0m in cash, and so its net debt is €993.0m.

debt-equity-history-analysis
ENXTPA:VK Debt to Equity History January 7th 2022

How Healthy Is Vallourec's Balance Sheet?

We can see from the most recent balance sheet that Vallourec had liabilities of €1.10b falling due within a year, and liabilities of €1.80b due beyond that. On the other hand, it had cash of €552.0m and €544.0m worth of receivables due within a year. So it has liabilities totalling €1.81b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of €2.13b, 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 2.5, its interest cover seems weak, at 1.0. 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. However, the silver lining was that Vallourec achieved a positive EBIT of €202m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Vallourec's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual 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

To be frank both Vallourec's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Overall, it seems to us that Vallourec's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example Vallourec has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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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