Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. As with many other companies WESCO International, Inc. (NYSE:WCC) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is WESCO International’s Net Debt?
The chart below, which you can click on for greater detail, shows that WESCO International had US$5.37b in debt in September 2023; about the same as the year before. On the flip side, it has US$631.4m in cash leading to net debt of about US$4.73b.
How Healthy Is WESCO International’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that WESCO International had liabilities of US$3.65b due within 12 months and liabilities of US$6.63b due beyond that. On the other hand, it had cash of US$631.4m and US$4.25b worth of receivables due within a year. So it has liabilities totalling US$5.41b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$7.50b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
WESCO International has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 4.1 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Fortunately, WESCO International grew its EBIT by 8.6% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if WESCO International can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, WESCO International reported free cash flow worth 10% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, WESCO International’s level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making WESCO International stock 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.