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.’ 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 Otter Tail Corporation (NASDAQ:OTTR) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Otter Tail’s Debt?
As you can see below, at the end of June 2021, Otter Tail had US$892.5m of debt, up from US$765.9m a year ago. Click the image for more detail. And it doesn’t have much cash, so its net debt is about the same.
A Look At Otter Tail’s Liabilities
Zooming in on the latest balance sheet data, we can see that Otter Tail had liabilities of US$483.5m due within 12 months and liabilities of US$1.27b due beyond that. On the other hand, it had cash of US$1.48m and US$163.4m worth of receivables due within a year. So it has liabilities totalling US$1.59b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of US$2.42b, so it does suggest shareholders should keep an eye on Otter Tail’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Otter Tail has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 5.0 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Importantly, Otter Tail grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. 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 Otter Tail can strengthen its balance sheet over time.
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. During the last three years, Otter Tail burned a lot of cash. 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.
Otter Tail’s conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. It’s also worth noting that Otter Tail is in the Electric Utilities industry, which is often considered to be quite defensive. We think that Otter Tail’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There’s no doubt that we learn most about debt from the balance sheet.