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.' 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. Importantly, American Axle & Manufacturing Holdings, Inc. (NYSE:AXL) does carry debt. But the real question is whether this debt is making the company risky.
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does American Axle & Manufacturing Holdings Carry?
As you can see below, American Axle & Manufacturing Holdings had US$3.73b of debt at June 2019, down from US$3.91b a year prior. On the flip side, it has US$250.1m in cash leading to net debt of about US$3.48b.
How Strong Is American Axle & Manufacturing Holdings's Balance Sheet?
We can see from the most recent balance sheet that American Axle & Manufacturing Holdings had liabilities of US$1.27b falling due within a year, and liabilities of US$4.71b due beyond that. On the other hand, it had cash of US$250.1m and US$1.14b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.59b.
This deficit casts a shadow over the US$853.7m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, American Axle & Manufacturing Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about American Axle & Manufacturing Holdings's net debt to EBITDA ratio of 3.4, we think its super-low interest cover of 2.3 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, American Axle & Manufacturing Holdings saw its EBIT tank 36% 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 American Axle & Manufacturing Holdings 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, American Axle & Manufacturing Holdings recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, American Axle & Manufacturing Holdings's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. After considering the datapoints discussed, we think American Axle & Manufacturing Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given the risks around American Axle & Manufacturing Holdings's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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