Intelligent Monitoring Group and Paragon Care offer substantial growth potential, but their rising debt makes fundamental analysis essential.

Investors are always hunting for growth. But as interest rates rise, the share market becomes less willing to pay high prices for that growth.

That is why investors need to look outside the obvious opportunities and consider companies trading under the radar.

Two ASX companies currently pursuing ambitious growth strategies are Intelligent Monitoring Group (ASX: IMB) and Paragon Care (ASX: PGC). Both offer considerable potential, but both are carrying substantial financial and operational risk.

In simple terms, these companies are leveraging up to pursue growth. If their strategies work, the returns could be significant. If they stumble, debt can quickly turn an operational problem into a serious problem for shareholders.

When debt-funded growth works

Using debt to fund growth is a high risk strategy. Many companies have attempted it, but relatively few have executed it successfully.

Northern Star Resources and Evolution Mining are two prominent successes. Both gold producers used debt to acquire assets, increase production and generate strong returns for shareholders.

Macquarie Technology Group is another example. The company invested heavily in data centres without raising equity for an extended period. Much of that investment was funded by debt, and the strategy has paid off handsomely.

But corporate history is also filled with examples of companies that took on too much debt. Kathmandu, now KMD Brands, came under intense financial pressure. Larger companies including Lendlease and Rio Tinto have also endured periods when excessive debt resulted in painful and highly dilutive capital raisings.

Debt amplifies outcomes. It can magnify shareholder returns when a strategy succeeds, but it can also magnify the damage when something goes wrong.

Intelligent Monitoring Group goes global

Intelligent Monitoring Group is a particularly fascinating growth story.

The company transformed itself through the acquisition of ADT’s Australian operations, initially funded with relatively expensive debt. Management subsequently grew the business and refinanced that debt, making the acquisition a success despite a sometimes uneven journey.

IMB is led by Dennis Hambling, whom we regard as a very capable operator.

The company has previously shifted its emphasis between residential and corporate security customers. Residential customers provide volume, while corporate customers can deliver higher margins.

This changing emphasis reflects one of the realities of operating with debt. Debt creates discipline and sharpens strategic decisions, but it also places considerable pressure on management to deliver.

IMB is now proposing to acquire ADT’s UK residential business for approximately $346 million. This follows two New Zealand acquisitions worth about $40 million each.

The company is rapidly becoming an international security monitoring business.

IMB has a market capitalisation of approximately $250 million and existing debt of around $80 million. It also has a $450 million debt facility earmarked for the proposed UK acquisition.

That creates substantial potential, but also substantial risk.

The strategic argument centres on scale. Security monitoring involves a significant technology and operating platform. The more customers that can be serviced through that platform, the lower the unit cost can potentially become.

But with gross profit margins around 30%, IMB does not have an enormous margin for error. Successfully integrating the UK operation will be critical.

It is an ambitious strategy and definitely one to watch. See our full research on IMB

Paragon Care’s enormous operating leverage

Paragon Care is a wholesale distributor of medical technology products.

Brokers have been supporting the company since the share price was around 30 cents, and the stock appears inexpensive on a single-digit price-to-earnings multiple.

However, its debt is currently greater than its market capitalisation.

Paragon Care has approximately $280 million of debt compared with a market capitalisation of about $220 million. That is where we start to become nervous.

The group handles enormous transaction volumes, but converts only a relatively small proportion of those flows into cash.

Last year, Paragon Care reported receipts of approximately $4.1 billion but generated operating cash flow of only $29 million. The encouraging detail was that operating cash flow reached approximately $50 million in the second half, recovering strongly from a weak first half.

This highlights both the opportunity and the risk.

Small improvements in margins, working capital and cash conversion could make a very large difference to earnings and debt reduction. But when margins are thin and debt is high, relatively small operational disappointments can also have an outsized impact.

Paragon Care reported operating earnings, or EBITDA, of about $97 million in its latest result, although this figure included a number of adjustments.

Management expects its net debt-to-EBITDA ratio to decline from around three times to approximately 2.5 times. Achieving that target will depend on continued earnings growth and strong cash conversion.

If the second-half improvement continues, EBITDA could potentially reach about $113 million. On that basis, Paragon Care would be trading on a cash flow multiple of less than four times.

That is very cheap, but it is cheap for a reason.

Debt can mean danger

Intelligent Monitoring Group and Paragon Care both demonstrate why debt-funded growth can be so attractive.

IMB is attempting to create a global security monitoring business with the scale to lower its unit costs. Paragon Care has enormous revenue flows and the potential to generate substantially more cash from relatively small operational improvements.

If these strategies work, shareholders could be rewarded.

But neither opportunity should be assessed on valuation alone. Investors need to examine the balance sheet, debt covenants, interest costs, cash conversion, margins and management’s ability to execute.

There are potentially big opportunities here, but debt can mean danger.

That is the purpose of fundamental analysis. We cannot eliminate investment risk, but we can understand where it lies before putting our money on the line. Access our full small cap growth stocks here.