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.’ 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. Importantly, Hawaiian Electric Industries, Inc. (NYSE:HE) does carry debt. But should shareholders be worried about its use of debt?
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, 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Hawaiian Electric Industries’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2021 Hawaiian Electric Industries had debt of US$2.43b, up from US$2.33b in one year. On the flip side, it has US$278.0m in cash leading to net debt of about US$2.15b.
How Healthy Is Hawaiian Electric Industries’ Balance Sheet?
We can see from the most recent balance sheet that Hawaiian Electric Industries had liabilities of US$400.3m falling due within a year, and liabilities of US$12.6b due beyond that. Offsetting these obligations, it had cash of US$278.0m as well as receivables valued at US$5.49b due within 12 months. So its liabilities total US$7.23b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$4.79b 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, Hawaiian Electric Industries would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Hawaiian Electric Industries has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 3.9 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. The good news is that Hawaiian Electric Industries improved its EBIT by 6.6% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Hawaiian Electric Industries’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Hawaiian Electric Industries created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
We’d go so far as to say Hawaiian Electric Industries’s level of total liabilities was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It’s also worth noting that Hawaiian Electric Industries is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that Hawaiian Electric Industries’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt.
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