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. We can see that Pinnacle West Capital Corporation (NYSE:PNW) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
How Much Debt Does Pinnacle West Capital Carry?
As you can see below, at the end of September 2021, Pinnacle West Capital had US$7.04b of debt, up from US$6.37b a year ago. Click the image for more detail. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is Pinnacle West Capital’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Pinnacle West Capital had liabilities of US$1.65b due within 12 months and liabilities of US$13.7b due beyond that. On the other hand, it had cash of US$25.7m and US$595.4m worth of receivables due within a year. So its liabilities total US$14.7b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$7.47b 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. At the end of the day, Pinnacle West Capital would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Pinnacle West Capital has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 3.6 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. The good news is that Pinnacle West Capital improved its EBIT by 8.2% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Pinnacle West Capital can strengthen its balance sheet over time.
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. During the last three years, Pinnacle West Capital burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
On the face of it, Pinnacle West Capital’s conversion of EBIT to free cash flow 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 Pinnacle West Capital is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that Pinnacle West Capital’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.