Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies frontdoor, inc. (NASDAQ:FTDR) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is frontdoor's Net Debt?
As you can see below, at the end of June 2019, frontdoor had US$1.01b of debt, up from US$2.00m a year ago. Click the image for more detail. However, because it has a cash reserve of US$425.0m, its net debt is less, at about US$584.0m.
How Strong Is frontdoor's Balance Sheet?
The latest balance sheet data shows that frontdoor had liabilities of US$396.0m due within a year, and liabilities of US$1.06b falling due after that. Offsetting these obligations, it had cash of US$425.0m as well as receivables valued at US$9.00m due within 12 months. So its liabilities total US$1.02b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since frontdoor has a market capitalization of US$4.19b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
frontdoor has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.0 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. frontdoor grew its EBIT by 7.9% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 frontdoor's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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 most recent three years, frontdoor recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
frontdoor's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And its EBIT growth rate is good too. All these things considered, it appears that frontdoor can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that frontdoor insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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