Stock Analysis

Resideo Technologies (NYSE:REZI) Takes On Some Risk With Its Use Of Debt

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NYSE:REZI
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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, Resideo Technologies, Inc. (NYSE:REZI) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

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How Much Debt Does Resideo Technologies Carry?

The chart below, which you can click on for greater detail, shows that Resideo Technologies had US$1.16b in debt in December 2020; about the same as the year before. However, it does have US$517.0m in cash offsetting this, leading to net debt of about US$645.0m.

debt-equity-history-analysis
NYSE:REZI Debt to Equity History May 6th 2021

How Healthy Is Resideo Technologies' Balance Sheet?

According to the last reported balance sheet, Resideo Technologies had liabilities of US$1.54b due within 12 months, and liabilities of US$2.08b due beyond 12 months. On the other hand, it had cash of US$517.0m and US$863.0m worth of receivables due within a year. So it has liabilities totalling US$2.24b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Resideo Technologies has a market capitalization of US$4.16b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 1.5 and interest cover of 5.5 times, it seems to us that Resideo Technologies is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that Resideo Technologies's EBIT was down 50% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Looking at the most recent three years, Resideo Technologies recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Resideo Technologies's EBIT growth rate was disappointing. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Resideo Technologies stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example - Resideo Technologies has 4 warning signs we think you should be aware of.

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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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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