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 Teradata Corporation (NYSE:TDC) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Teradata’s Debt?
The chart below, which you can click on for greater detail, shows that Teradata had US$499.0m in debt in June 2020; about the same as the year before. However, it also had US$494.0m in cash, and so its net debt is US$5.00m.
A Look At Teradata’s Liabilities
Zooming in on the latest balance sheet data, we can see that Teradata had liabilities of US$893.0m due within 12 months and liabilities of US$863.0m due beyond that. On the other hand, it had cash of US$494.0m and US$351.0m worth of receivables due within a year. So its liabilities total US$911.0m more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Teradata is worth US$2.43b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Carrying virtually no net debt, Teradata has a very light debt load indeed.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Teradata’s debt of just 0.036 times EBITDA is clearly modest. But EBIT was only 0.85 times the interest expense last year, which shows that the debt has negatively impacted the business, by constraining its options (and restricting its free cash flow). Shareholders should be aware that Teradata’s EBIT was down 65% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Teradata 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Teradata actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
We feel some trepidation about Teradata’s difficulty EBIT growth rate, but we’ve got positives to focus on, too. For example, its conversion of EBIT to free cash flow and net debt to EBITDA give us some confidence in its ability to manage its debt. We think that Teradata’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. 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. Case in point: We’ve spotted 3 warning signs for Teradata you should be aware of, and 2 of them make us uncomfortable.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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