Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 MagnaChip Semiconductor Corporation (NYSE:MX) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is MagnaChip Semiconductor's Net Debt?
The chart below, which you can click on for greater detail, shows that MagnaChip Semiconductor had US$303.6m in debt in June 2019; about the same as the year before. However, because it has a cash reserve of US$123.8m, its net debt is less, at about US$179.8m.
How Healthy Is MagnaChip Semiconductor's Balance Sheet?
We can see from the most recent balance sheet that MagnaChip Semiconductor had liabilities of US$158.3m falling due within a year, and liabilities of US$477.4m due beyond that. On the other hand, it had cash of US$123.8m and US$134.1m worth of receivables due within a year. So it has liabilities totalling US$377.9m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$363.6m, we think shareholders really should watch MagnaChip Semiconductor's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
While we wouldn't worry about MagnaChip Semiconductor's net debt to EBITDA ratio of 3.6, we think its super-low interest cover of 0.79 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, MagnaChip Semiconductor saw its EBIT tank 60% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 MagnaChip Semiconductor's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, MagnaChip Semiconductor burned a lot of cash. 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.
On the face of it, MagnaChip Semiconductor's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its level of total liabilities also fails to instill confidence. Taking into account all the aforementioned factors, it looks like MagnaChip Semiconductor has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Even though MagnaChip Semiconductor lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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