Stock Analysis

We Think American States Water (NYSE:AWR) Is Taking Some Risk With Its Debt

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NYSE:AWR
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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that American States Water Company (NYSE:AWR) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

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How Much Debt Does American States Water Carry?

As you can see below, at the end of September 2020, American States Water had US$532.7m of debt, up from US$475.8m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

debt-equity-history-analysis
NYSE:AWR Debt to Equity History December 15th 2020

A Look At American States Water's Liabilities

According to the last reported balance sheet, American States Water had liabilities of US$113.5m due within 12 months, and liabilities of US$979.1m due beyond 12 months. Offsetting these obligations, it had cash of US$8.13m as well as receivables valued at US$99.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$985.2m.

American States Water has a market capitalization of US$2.82b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

American States Water's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 6.0 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably American States Water's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if American States Water can strengthen its balance sheet over time. 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 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, American States Water recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

American States Water's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. It's also worth noting that American States Water is in the Water Utilities industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that American States Water is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that American States Water is showing 1 warning sign in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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What are the risks and opportunities for American States Water?

American States Water Company, through its subsidiaries, provides water and electric services to residential, commercial, industrial, and other customers in the United States.

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Rewards

  • Earnings are forecast to grow 8.77% per year

Risks

  • Debt is not well covered by operating cash flow

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