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. Importantly, UGI Corporation (NYSE:UGI) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is UGI’s Debt?
The image below, which you can click on for greater detail, shows that at December 2021 UGI had debt of US$7.12b, up from US$6.60b in one year. However, it does have US$334.0m in cash offsetting this, leading to net debt of about US$6.78b.
How Strong Is UGI’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that UGI had liabilities of US$2.58b due within 12 months and liabilities of US$8.86b due beyond that. Offsetting this, it had US$334.0m in cash and US$1.68b in receivables that were due within 12 months. So its liabilities total US$9.42b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s US$7.54b 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.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
UGI has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 6.0 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. It is well worth noting that UGI’s EBIT shot up like bamboo after rain, gaining 53% in the last twelve months. That’ll make it easier to manage its debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine UGI’s ability to maintain a healthy balance sheet going forward.
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. In the last three years, UGI’s free cash flow amounted to 23% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Neither UGI’s ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Gas Utilities industry companies like UGI commonly do use debt without problems. Taking the abovementioned factors together we do think UGI’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt.