Is Otter Tail (NASDAQ:OTTR) A Risky Investment?

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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. We can see that Otter Tail Corporation (NASDAQ:OTTR) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 step when considering a company’s debt levels is to consider its cash and debt together.

View our latest analysis for Otter Tail

How Much Debt Does Otter Tail Carry?

The chart below, which you can click on for greater detail, shows that Otter Tail had US$633.8m in debt in March 2019; about the same as the year before. And it doesn’t have much cash, so its net debt is about the same.

NasdaqGS:OTTR Historical Debt, July 16th 2019
NasdaqGS:OTTR Historical Debt, July 16th 2019

How Strong Is Otter Tail’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Otter Tail had liabilities of US$200.7m due within 12 months and liabilities of US$1.16b due beyond that. On the other hand, it had cash of US$891.0k and US$140.9m worth of receivables due within a year. So its liabilities total US$1.22b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Otter Tail has a market capitalization of US$2.07b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. Because it carries more debt than cash, we think it’s worth watching Otter Tail’s balance sheet over time.

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.

Otter Tail’s debt is only 3.14 times its EBITDA, and its EBIT cover its interest expense 4.09 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. More concerning, Otter Tail saw its EBIT drop by 3.0% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill — a lot of effort for not much advancement. 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 Otter Tail’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Otter Tail’s free cash flow amounted to 21% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Otter Tail’s net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at (not) growing its EBIT. We should also note that Electric Utilities industry companies like Otter Tail commonly do use debt without problems. Taking the abovementioned factors together we do think Otter Tail’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. 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 Otter Tail’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.