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.’ 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. We can see that Insulet Corporation (NASDAQ:PODD) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Insulet Carry?
As you can see below, Insulet had US$1.42b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$685.4m in cash, and so its net debt is US$735.0m.
How Healthy Is Insulet’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Insulet had liabilities of US$451.4m due within 12 months and liabilities of US$1.41b due beyond that. On the other hand, it had cash of US$685.4m and US$270.3m worth of receivables due within a year. So it has liabilities totalling US$904.5m more than its cash and near-term receivables, combined.
Of course, Insulet has a titanic market capitalization of US$13.8b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
With net debt to EBITDA of 4.7 Insulet has a fairly noticeable amount of debt. But the high interest coverage of 8.9 suggests it can easily service that debt. Shareholders should be aware that Insulet’s EBIT was down 32% 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 Insulet’s ability to maintain a healthy balance sheet going forward.
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. Over the last three years, Insulet saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
To be frank both Insulet’s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. It’s also worth noting that Insulet is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Insulet stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage.