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 Estée Lauder Companies Inc. (NYSE:EL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Estée Lauder Companies’s Net Debt?
The chart below, which you can click on for greater detail, shows that Estée Lauder Companies had US$5.52b in debt in December 2022; about the same as the year before. However, it does have US$3.73b in cash offsetting this, leading to net debt of about US$1.79b.
How Strong Is Estée Lauder Companies’ Balance Sheet?
According to the last reported balance sheet, Estée Lauder Companies had liabilities of US$5.66b due within 12 months, and liabilities of US$8.36b due beyond 12 months. On the other hand, it had cash of US$3.73b and US$1.93b worth of receivables due within a year. So it has liabilities totalling US$8.35b more than its cash and near-term receivables, combined.
Given Estée Lauder Companies has a humongous market capitalization of US$84.4b, 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.
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). 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).
Estée Lauder Companies’s net debt is only 0.54 times its EBITDA. And its EBIT covers its interest expense a whopping 21.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Estée Lauder Companies’s saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Estée Lauder Companies’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Estée Lauder Companies recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Happily, Estée Lauder Companies’s impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its EBIT growth rate. All these things considered, it appears that Estée Lauder Companies can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start.