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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Antero Midstream Corporation (NYSE:AM) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Antero Midstream's Debt?
As you can see below, Antero Midstream had US$3.10b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.
How Strong Is Antero Midstream's Balance Sheet?
We can see from the most recent balance sheet that Antero Midstream had liabilities of US$118.7m falling due within a year, and liabilities of US$3.10b due beyond that. Offsetting these obligations, it had cash of US$678.0k as well as receivables valued at US$86.9m due within 12 months. So its liabilities total US$3.13b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$4.55b, so it does suggest shareholders should keep an eye on Antero Midstream's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.
Antero Midstream's debt is 4.2 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Given the debt load, it's hardly ideal that Antero Midstream's EBIT was pretty flat over the last twelve months. 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 Antero Midstream 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Antero Midstream generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Neither Antero Midstream's ability handle its debt, based on its EBITDA, nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that Antero Midstream's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 instance, we've identified 3 warning signs for Antero Midstream (1 doesn't sit too well with us) you should be aware of.
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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