Emergent BioSolutions (NYSE:EBS) Takes On Some Risk With Its Use Of Debt

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. Importantly, Emergent BioSolutions Inc. (NYSE:EBS) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Emergent BioSolutions

How Much Debt Does Emergent BioSolutions Carry?

The image below, which you can click on for greater detail, shows that at June 2019 Emergent BioSolutions had debt of US$842.1m, up from US$13.5m in one year. However, it does have US$177.4m in cash offsetting this, leading to net debt of about US$664.7m.

NYSE:EBS Historical Debt, October 25th 2019
NYSE:EBS Historical Debt, October 25th 2019

How Strong Is Emergent BioSolutions’s Balance Sheet?

The latest balance sheet data shows that Emergent BioSolutions had liabilities of US$301.2m due within a year, and liabilities of US$1.03b falling due after that. Offsetting these obligations, it had cash of US$177.4m as well as receivables valued at US$218.1m due within 12 months. So its liabilities total US$936.9m more than the combination of its cash and short-term receivables.

Emergent BioSolutions has a market capitalization of US$2.79b, 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 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).

Weak interest cover of 0.68 times and a disturbingly high net debt to EBITDA ratio of 6.0 hit our confidence in Emergent BioSolutions like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Even worse, Emergent BioSolutions saw its EBIT tank 88% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Emergent BioSolutions 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 it’s worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Emergent BioSolutions recorded free cash flow of 45% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Emergent BioSolutions’s interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. We’re quite clear that we consider Emergent BioSolutions to be really rather risky, as a result of its balance sheet health. 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. Given our hesitation about the stock, it would be good to know if Emergent BioSolutions insiders have sold any shares recently. You click here to find out if insiders have sold recently.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Thank you for reading.