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Canadian Utilities (TSE:CU) Has A Somewhat Strained Balance Sheet To Put It Lightly

Why that's a problem

avatar by Editor
November 12, 2019
0
Canadian Utilities (TSE:CU) Has A Somewhat Strained Balance Sheet To Put It Lightly

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. 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 Canadian Utilities Limited (TSE:CU) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Canadian Utilities’s Net Debt?
As you can see below, Canadian Utilities had CA$9.03b of debt at September 2019, down from CA$10.2b a year prior. However, because it has a cash reserve of CA$978.0m, its net debt is less, at about CA$8.05b.

TSX:CU Historical Debt, November 12th 2019

A Look At Canadian Utilities’s Liabilities
Zooming in on the latest balance sheet data, we can see that Canadian Utilities had liabilities of CA$2.26b due within 12 months and liabilities of CA$12.4b due beyond that. Offsetting these obligations, it had cash of CA$978.0m as well as receivables valued at CA$532.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$13.1b.

When you consider that this deficiency exceeds the company’s CA$10.5b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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.

Canadian Utilities’s debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. On a lighter note, we note that Canadian Utilities grew its EBIT by 23% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 Canadian Utilities can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Canadian Utilities reported free cash flow worth 6.4% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View
On the face of it, Canadian Utilities’s interest cover 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 at least it’s pretty decent at growing its EBIT; that’s encouraging. It’s also worth noting that Canadian Utilities is in the Integrated Utilities industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Canadian Utilities’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given our hesitation about the stock, it would be good to know if Canadian Utilities insiders have sold any shares recently.

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