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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Stericycle, Inc. (NASDAQ:SRCL) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Stericycle’s Debt?
As you can see below, Stericycle had US$1.51b of debt at December 2022, down from US$1.59b a year prior. However, because it has a cash reserve of US$56.0m, its net debt is less, at about US$1.45b.
How Strong Is Stericycle’s Balance Sheet?
According to the last reported balance sheet, Stericycle had liabilities of US$621.9m due within 12 months, and liabilities of US$2.29b due beyond 12 months. On the other hand, it had cash of US$56.0m and US$414.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.44b.
Stericycle has a market capitalization of US$4.51b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without 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.
While we wouldn’t worry about Stericycle’s net debt to EBITDA ratio of 3.9, we think its super-low interest cover of 1.8 times is a sign of high leverage. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Stericycle saw its EBIT tank 41% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Stericycle’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Stericycle actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
On the face of it, Stericycle’s interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Once we consider all the factors above, together, it seems to us that Stericycle’s debt is making it a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt.