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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Realogy Holdings Corp. (NYSE:RLGY) makes use of debt. But is this debt a concern to shareholders?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 Realogy Holdings's Debt?
The chart below, which you can click on for greater detail, shows that Realogy Holdings had US$3.94b in debt in June 2019; about the same as the year before. On the flip side, it has US$270.0m in cash leading to net debt of about US$3.67b.
How Strong Is Realogy Holdings's Balance Sheet?
We can see from the most recent balance sheet that Realogy Holdings had liabilities of US$1.28b falling due within a year, and liabilities of US$4.42b due beyond that. Offsetting this, it had US$270.0m in cash and US$475.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.96b.
The deficiency here weighs heavily on the US$1.07b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt After all, Realogy Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Realogy Holdings like a one-two punch to the gut. The debt burden here is substantial. Worse, Realogy Holdings's EBIT was down 22% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Realogy Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Realogy Holdings recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
On the face of it, Realogy Holdings's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Realogy Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given our concerns about Realogy Holdings's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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