Is Deluxe (NYSE:DLX) A Risky Investment?

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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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. Importantly, Deluxe Corporation (NYSE:DLX) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 Deluxe

How Much Debt Does Deluxe Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2019 Deluxe had US$946.0m of debt, an increase on US$742.5m, over one year. However, it also had US$61.5m in cash, and so its net debt is US$884.5m.

NYSE:DLX Historical Debt, July 10th 2019
NYSE:DLX Historical Debt, July 10th 2019

How Healthy Is Deluxe’s Balance Sheet?

The latest balance sheet data shows that Deluxe had liabilities of US$356.4m due within a year, and liabilities of US$1.07b falling due after that. Offsetting this, it had US$61.5m in cash and US$190.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.17b.

This deficit is considerable relative to its market capitalization of US$1.78b, so it does suggest shareholders should keep an eye on Deluxe’s use of debt. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Either way, since Deluxe does have more debt than cash, it’s worth keeping an eye on its balance sheet.

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

We’d say that Deluxe’s moderate net debt to EBITDA ratio ( being 1.97), indicates prudence when it comes to debt. And its commanding EBIT of 11.5 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, Deluxe’s EBIT flopped 11% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Deluxe can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Deluxe produced sturdy free cash flow equating to 72% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Deluxe’s ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about Deluxe’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you’re interested in Deluxe, you may well want to click here to check an interactive graph of its earnings per share history.

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.

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 editorial-team@simplywallst.com. 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.