The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 The Middleby Corporation (NASDAQ:MIDD) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Middleby Carry?
As you can see below, Middleby had US$1.85b of debt at July 2021, down from US$2.46b a year prior. However, it also had US$395.6m in cash, and so its net debt is US$1.46b.
How Strong Is Middleby's Balance Sheet?
The latest balance sheet data shows that Middleby had liabilities of US$731.8m due within a year, and liabilities of US$2.57b falling due after that. Offsetting this, it had US$395.6m in cash and US$445.8m in receivables that were due within 12 months. So it has liabilities totalling US$2.46b more than its cash and near-term receivables, combined.
Middleby has a market capitalization of US$9.80b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 2.4, Middleby uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.1 times its interest expenses harmonizes with that theme. If Middleby can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Middleby recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Middleby's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And we also thought its EBIT growth rate was a positive. When we consider the range of factors above, it looks like Middleby is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Middleby that you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
What are the risks and opportunities for Middleby?
Trading at 18.5% below our estimate of its fair value
Earnings are forecast to grow 9.46% per year
Debt is not well covered by operating cash flow
Significant insider selling over the past 3 months
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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The Middleby Corporation designs, manufactures, markets, distributes, and services a range of foodservice, food processing, and residential kitchen equipment in the United States, Canada, Asia, Europe, the Middle East, and Latin America.
Fair value with questionable track record.