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. 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 The Middleby Corporation (NASDAQ:MIDD) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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 Middleby’s Net Debt?
The chart below, which you can click on for greater detail, shows that Middleby had US$1.99b in debt in September 2019; about the same as the year before. On the flip side, it has US$87.2m in cash leading to net debt of about US$1.90b.
How Healthy Is Middleby’s Balance Sheet?
According to the last reported balance sheet, Middleby had liabilities of US$585.2m due within 12 months, and liabilities of US$2.49b due beyond 12 months. On the other hand, it had cash of US$87.2m and US$437.0m worth of receivables due within a year. So its liabilities total US$2.55b more than the combination of its cash and short-term receivables.
Middleby has a market capitalization of US$6.29b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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).
Middleby has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 6.5 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. One way Middleby could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. 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 Middleby 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. During the last three years, Middleby produced sturdy free cash flow equating to 59% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Both Middleby’s ability to to grow its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Middleby is managing its debt quite well. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we’ve spotted with Middleby .
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 firstname.lastname@example.org. 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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