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 can see that Tenneco Inc. (NYSE:TEN) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Tenneco's Debt?
The image below, which you can click on for greater detail, shows that Tenneco had debt of US$5.33b at the end of December 2020, a reduction from US$5.55b over a year. However, because it has a cash reserve of US$798.0m, its net debt is less, at about US$4.53b.
How Strong Is Tenneco's Balance Sheet?
The latest balance sheet data shows that Tenneco had liabilities of US$4.69b due within a year, and liabilities of US$6.91b falling due after that. On the other hand, it had cash of US$798.0m and US$2.53b worth of receivables due within a year. So its liabilities total US$8.27b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$910.0m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Tenneco would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Weak interest cover of 0.84 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Tenneco like a one-two punch to the gut. The debt burden here is substantial. Even worse, Tenneco saw its EBIT tank 59% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Tenneco 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 we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Tenneco actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Tenneco's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that Tenneco is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. Given our concerns about Tenneco's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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.
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