Stock Analysis

Is MEG Energy (TSE:MEG) A Risky Investment?

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TSX:MEG
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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 MEG Energy Corp. (TSE:MEG) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

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What Is MEG Energy's Net Debt?

As you can see below, MEG Energy had CA$2.77b of debt at September 2021, down from CA$3.03b a year prior. However, because it has a cash reserve of CA$210.0m, its net debt is less, at about CA$2.56b.

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TSX:MEG Debt to Equity History February 19th 2022

A Look At MEG Energy's Liabilities

Zooming in on the latest balance sheet data, we can see that MEG Energy had liabilities of CA$584.0m due within 12 months and liabilities of CA$3.14b due beyond that. On the other hand, it had cash of CA$210.0m and CA$400.0m worth of receivables due within a year. So its liabilities total CA$3.11b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CA$4.82b, so it does suggest shareholders should keep an eye on MEG Energy's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While MEG Energy's debt to EBITDA ratio (3.9) suggests that it uses some debt, its interest cover is very weak, at 1.1, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. One redeeming factor for MEG Energy is that it turned last year's EBIT loss into a gain of CA$281m, over the last twelve months. 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 MEG Energy's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, MEG Energy actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

MEG Energy's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that MEG Energy is a somewhat risky investment as a result of its debt. 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. 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. For example, we've discovered 4 warning signs for MEG Energy (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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