Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that The Southern Company (NYSE:SO) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Southern's Debt?
The image below, which you can click on for greater detail, shows that Southern had debt of US$44.2b at the end of June 2019, a reduction from US$49.7b over a year. On the flip side, it has US$1.38b in cash leading to net debt of about US$42.8b.
How Healthy Is Southern's Balance Sheet?
According to the last reported balance sheet, Southern had liabilities of US$11.0b due within 12 months, and liabilities of US$72.4b due beyond 12 months. Offsetting these obligations, it had cash of US$1.38b as well as receivables valued at US$3.37b due within 12 months. So its liabilities total US$78.7b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's massive market capitalization of US$62.6b, we think shareholders really should watch Southern's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
With a net debt to EBITDA ratio of 5.1, it's fair to say Southern does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. On a slightly more positive note, Southern grew its EBIT at 14% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Southern can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Southern saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Southern's net debt to EBITDA 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 at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Southern is in the Electric Utilities industry, which is often considered to be quite defensive. We're quite clear that we consider Southern 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. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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