Warren Buffett famously said, ‘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. Importantly, Stericycle, Inc. (NASDAQ:SRCL) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Stericycle Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Stericycle had US$2.82b of debt, an increase on US$2.65b, over one year. And it doesn’t have much cash, so its net debt is about the same.
A Look At Stericycle’s Liabilities
We can see from the most recent balance sheet that Stericycle had liabilities of US$784.2m falling due within a year, and liabilities of US$3.52b due beyond that. Offsetting this, it had US$34.5m in cash and US$613.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.66b.
This is a mountain of leverage relative to its market capitalization of US$3.95b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). 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).
Stericycle has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 2.7 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Even worse, Stericycle saw its EBIT tank 32% 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 Stericycle’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Stericycle recorded free cash flow of 45% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
We’d go so far as to say Stericycle’s EBIT growth rate was disappointing. Having said that, its ability to convert EBIT to free cash flow isn’t such a worry. Overall, it seems to us that Stericycle’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. While Stericycle didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.