Stock Analysis

Is Resideo Technologies (NYSE:REZI) Using Too Much Debt?

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NYSE:REZI
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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Resideo Technologies, Inc. (NYSE:REZI) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

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What Is Resideo Technologies's Debt?

As you can see below, Resideo Technologies had US$1.19b of debt at July 2021, down from US$1.43b a year prior. On the flip side, it has US$579.0m in cash leading to net debt of about US$615.0m.

debt-equity-history-analysis
NYSE:REZI Debt to Equity History August 20th 2021

How Strong Is Resideo Technologies' Balance Sheet?

The latest balance sheet data shows that Resideo Technologies had liabilities of US$1.51b due within a year, and liabilities of US$2.10b falling due after that. Offsetting this, it had US$579.0m in cash and US$895.0m in receivables that were due within 12 months. So it has liabilities totalling US$2.14b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Resideo Technologies is worth US$4.10b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Resideo Technologies has a low net debt to EBITDA ratio of only 0.91. And its EBIT covers its interest expense a whopping 11.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. While Resideo Technologies doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Resideo Technologies'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Resideo Technologies's free cash flow amounted to 20% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Resideo Technologies's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Resideo Technologies's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Resideo Technologies has 3 warning signs we think you should be aware of.

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.

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What are the risks and opportunities for Resideo Technologies?

Resideo Technologies, Inc. develops, manufactures, and sells comfort, residential thermal, and security solutions to the commercial and residential end markets in the United States, Europe, and internationally.

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Rewards

  • Trading at 41% below our estimate of its fair value

  • Earnings are forecast to grow 11.03% per year

  • Earnings have grown 45% per year over the past 5 years

Risks

  • Debt is not well covered by operating cash flow

  • Large one-off items impacting financial results

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