The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Hubbell Incorporated (NYSE:HUBB) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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.
What Is Hubbell's Debt?
The image below, which you can click on for greater detail, shows that Hubbell had debt of US$1.81b at the end of March 2019, a reduction from US$2.08b over a year. However, it does have US$214.8m in cash offsetting this, leading to net debt of about US$1.59b.
How Strong Is Hubbell's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hubbell had liabilities of US$847.9m due within 12 months and liabilities of US$2.30b due beyond that. Offsetting these obligations, it had cash of US$214.8m as well as receivables valued at US$716.2m due within 12 months. So it has liabilities totalling US$2.22b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Hubbell has a market capitalization of US$6.86b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Hubbell's net debt of 2.2 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.2 times interest expense) certainly does not do anything to dispel this impression. Hubbell grew its EBIT by 9.6% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Hubbell 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Hubbell produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Hubbell's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its interest cover was a positive. Looking at all the aforementioned factors together, it strikes us that Hubbell can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Hubbell insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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