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. Importantly, Pool Corporation (NASDAQ:POOL) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Pool Carry?
As you can see below, at the end of June 2022, Pool had US$1.60b of debt, up from US$435.2m a year ago. Click the image for more detail. On the flip side, it has US$116.3m in cash leading to net debt of about US$1.48b.
How Healthy Is Pool’s Balance Sheet?
The latest balance sheet data shows that Pool had liabilities of US$891.0m due within a year, and liabilities of US$1.84b falling due after that. On the other hand, it had cash of US$116.3m and US$756.6m worth of receivables due within a year. So its liabilities total US$1.86b more than the combination of its cash and short-term receivables.
Given Pool has a humongous market capitalization of US$14.1b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
Pool’s net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 58.1 times the size. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that Pool has boosted its EBIT by 47%, thus reducing the spectre of future debt repayments. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Pool’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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Pool recorded free cash flow of 41% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Pool’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! When we consider the range of factors above, it looks like Pool is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders.
