Here's Why AltaGas (TSE:ALA) Is Weighed Down By Its Debt Load

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. Importantly, AltaGas Ltd. (TSE:ALA) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for AltaGas

What Is AltaGas's Net Debt?

The image below, which you can click on for greater detail, shows that AltaGas had debt of CA$7.13b at the end of September 2020, a reduction from CA$7.73b over a year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is AltaGas's Balance Sheet?

According to the last reported balance sheet, AltaGas had liabilities of CA$2.12b due within 12 months, and liabilities of CA$9.89b due beyond 12 months. Offsetting this, it had CA$29.0m in cash and CA$848.0m in receivables that were due within 12 months. So it has liabilities totalling CA$11.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CA$5.02b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, AltaGas 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

AltaGas has a rather high debt to EBITDA ratio of 5.9 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that AltaGas grew its EBIT at 17% over the last 12 months, boosting its ability to handle its debt. 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 AltaGas'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, AltaGas saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both AltaGas's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Gas Utilities industry companies like AltaGas commonly do use debt without problems. We're quite clear that we consider AltaGas 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 5 warning signs for AltaGas (2 are a bit concerning!) 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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