Is AZEK (NYSE:AZEK) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that The AZEK Company Inc. (NYSE:AZEK) does have debt on its balance sheet. 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 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for AZEK

How Much Debt Does AZEK Carry?

As you can see below, AZEK had US$463.1m of debt at March 2021, down from US$1.24b a year prior. On the flip side, it has US$151.3m in cash leading to net debt of about US$311.8m.

A Look At AZEK's Liabilities

We can see from the most recent balance sheet that AZEK had liabilities of US$126.2m falling due within a year, and liabilities of US$514.8m due beyond that. On the other hand, it had cash of US$151.3m and US$128.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$361.2m.

Given AZEK has a market capitalization of US$6.88b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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 AZEK's debt to EBITDA ratio (3.0) suggests that it uses some debt, its interest cover is very weak, at 0.096, suggesting 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. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, AZEK saw its EBIT tank 95% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine AZEK'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, AZEK produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both AZEK's EBIT growth rate and its interest cover were discouraging. At least its conversion of EBIT to free cash flow gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that AZEK is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with AZEK .

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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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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