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MGE Energy (NASDAQ:MGEE) Takes On Some Risk With Its Use Of Debt
Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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, MGE Energy, Inc. (NASDAQ:MGEE) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for MGE Energy
What Is MGE Energy's Net Debt?
As you can see below, at the end of June 2019, MGE Energy had US$519.3m of debt, up from US$448.8m a year ago. Click the image for more detail. However, it does have US$69.9m in cash offsetting this, leading to net debt of about US$449.4m.
A Look At MGE Energy's Liabilities
We can see from the most recent balance sheet that MGE Energy had liabilities of US$128.2m falling due within a year, and liabilities of US$1.07b due beyond that. Offsetting this, it had US$69.9m in cash and US$64.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.06b.
While this might seem like a lot, it is not so bad since MGE Energy has a market capitalization of US$2.62b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
MGE Energy has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.6 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Sadly, MGE Energy's EBIT actually dropped 6.3% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since MGE Energy will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, MGE Energy recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
Our View
Mulling over MGE Energy's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its interest cover is not so bad. It's also worth noting that MGE Energy is in the Electric Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that MGE Energy's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of MGE Energy's earnings per share history for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
About NasdaqGS:MGEE
MGE Energy
Through its subsidiaries, operates as a public utility holding company in the United States.
Proven track record with adequate balance sheet and pays a dividend.
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