Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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 NN, Inc. (NASDAQ:NNBR) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.
What Is NN's Net Debt?
As you can see below, NN had US$882.6m of debt, at September 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$24.4m in cash offsetting this, leading to net debt of about US$858.2m.
How Strong Is NN's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that NN had liabilities of US$156.0m due within 12 months and liabilities of US$1.04b due beyond that. Offsetting these obligations, it had cash of US$24.4m as well as receivables valued at US$143.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.03b.
The deficiency here weighs heavily on the US$409.3m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. After all, NN would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
NN shareholders face the double whammy of a high net debt to EBITDA ratio (8.2), and fairly weak interest coverage, since EBIT is just 0.28 times the interest expense. The debt burden here is substantial. Investors should also be troubled by the fact that NN saw its EBIT drop by 16% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine NN's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, NN saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both NN's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that NN is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. Given our concerns about NN's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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