Stock Analysis

These 4 Measures Indicate That Deluxe (NYSE:DLX) Is Using Debt Extensively

NYSE:DLX
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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.' 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, Deluxe Corporation (NYSE:DLX) does carry debt. But should shareholders be worried about its use of debt?

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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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt 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 September 2021 Deluxe had US$1.78b of debt, an increase on US$1.05b, over one year. However, because it has a cash reserve of US$121.1m, its net debt is less, at about US$1.66b.

debt-equity-history-analysis
NYSE:DLX Debt to Equity History December 2nd 2021

How Healthy Is Deluxe's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Deluxe had liabilities of US$540.9m due within 12 months and liabilities of US$1.91b due beyond that. Offsetting these obligations, it had cash of US$121.1m as well as receivables valued at US$217.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.11b.

Given this deficit is actually higher than the company's market capitalization of US$1.44b, we think shareholders really should watch Deluxe's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

With a net debt to EBITDA ratio of 5.3, it's fair to say Deluxe does have a significant amount of debt. However, its interest coverage of 5.5 is reasonably strong, which is a good sign. Unfortunately, Deluxe'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 Deluxe 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Deluxe recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Deluxe's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Deluxe's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Deluxe (1 shouldn't be ignored) 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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Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.

About NYSE:DLX

Deluxe

Provides technology-enabled solutions to small and medium-sized businesses, and financial institutions in the United States and Canada.

Very undervalued with proven track record and pays a dividend.

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