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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Ultra Clean Holdings, Inc. (NASDAQ:UCTT) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Ultra Clean Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Ultra Clean Holdings had debt of US$338.1m, up from US$54.8m in one year. However, it also had US$168.1m in cash, and so its net debt is US$170.0m.
A Look At Ultra Clean Holdings's Liabilities
We can see from the most recent balance sheet that Ultra Clean Holdings had liabilities of US$155.0m falling due within a year, and liabilities of US$399.5m due beyond that. Offsetting these obligations, it had cash of US$168.1m as well as receivables valued at US$98.3m due within 12 months. So its liabilities total US$288.0m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$454.8m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Even though Ultra Clean Holdings's debt is only 2.2, its interest cover is really very low at 2.2. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Importantly, Ultra Clean Holdings's EBIT fell a jaw-dropping 56% in the last twelve months. 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 Ultra Clean Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ultra Clean Holdings produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
To be frank both Ultra Clean Holdings's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Ultra Clean Holdings stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Given our hesitation about the stock, it would be good to know if Ultra Clean Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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