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.’ 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 note that OGE Energy Corp. (NYSE:OGE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 OGE Energy’s Debt?
The image below, which you can click on for greater detail, shows that at March 2021 OGE Energy had debt of US$4.73b, up from US$3.57b in one year. Net debt is about the same, since the it doesn’t have much cash.
How Healthy Is OGE Energy’s Balance Sheet?
We can see from the most recent balance sheet that OGE Energy had liabilities of US$1.84b falling due within a year, and liabilities of US$6.35b due beyond that. Offsetting these obligations, it had cash of US$1.10m as well as receivables valued at US$205.8m due within 12 months. So it has liabilities totalling US$7.98b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$6.85b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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 5.3, it’s fair to say OGE Energy does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.2 times, suggesting it can responsibly service its obligations. Given the debt load, it’s hardly ideal that OGE Energy’s EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine OGE Energy’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, OGE Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both OGE Energy’s net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It’s also worth noting that OGE Energy is in the Electric Utilities industry, which is often considered to be quite defensive. We’re quite clear that we consider OGE Energy 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it.