Stock Analysis

Is Allegion (NYSE:ALLE) Using Too Much Debt?

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NYSE:ALLE
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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Allegion plc (NYSE:ALLE) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

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What Is Allegion's Net Debt?

As you can see below, at the end of June 2022, Allegion had US$2.03b of debt, up from US$1.43b a year ago. Click the image for more detail. However, because it has a cash reserve of US$919.6m, its net debt is less, at about US$1.11b.

debt-equity-history-analysis
NYSE:ALLE Debt to Equity History September 8th 2022

How Healthy Is Allegion's Balance Sheet?

According to the last reported balance sheet, Allegion had liabilities of US$610.4m due within 12 months, and liabilities of US$2.26b due beyond 12 months. On the other hand, it had cash of US$919.6m and US$333.3m worth of receivables due within a year. So it has liabilities totalling US$1.62b more than its cash and near-term receivables, combined.

Of course, Allegion has a market capitalization of US$8.61b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 1.8, Allegion uses debt artfully but responsibly. And the alluring interest cover (EBIT of 10.0 times interest expense) certainly does not do anything to dispel this impression. Unfortunately, Allegion's EBIT flopped 11% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Allegion can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Allegion produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Allegion's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its EBIT growth rate has the opposite effect. All these things considered, it appears that Allegion can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Allegion (of which 1 is significant!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

What are the risks and opportunities for Allegion?

Allegion plc manufactures and sells mechanical and electronic security products and solutions worldwide.

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Rewards

  • Earnings are forecast to grow 10.73% per year

Risks

  • Debt is not well covered by operating cash flow

  • Significant insider selling over the past 3 months

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