David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 note that Public Service Enterprise Group Incorporated (NYSE:PEG) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Public Service Enterprise Group
How Much Debt Does Public Service Enterprise Group Carry?
The image below, which you can click on for greater detail, shows that at September 2019 Public Service Enterprise Group had debt of US$15.9b, up from US$14.8b in one year. And it doesn’t have much cash, so its net debt is about the same.
A Look At Public Service Enterprise Group’s Liabilities
According to the last reported balance sheet, Public Service Enterprise Group had liabilities of US$4.07b due within 12 months, and liabilities of US$27.8b due beyond 12 months. On the other hand, it had cash of US$120.0m and US$1.35b worth of receivables due within a year. So its liabilities total US$30.4b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s huge US$29.5b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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.
Public Service Enterprise Group’s debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 5.2 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. One way Public Service Enterprise Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Public Service Enterprise Group 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Public Service Enterprise Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
We’d go so far as to say Public Service Enterprise Group’s conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Integrated Utilities industry companies like Public Service Enterprise Group commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Public Service Enterprise Group’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Like risks, for instance. Every company has them, and we’ve spotted 3 warning signs for Public Service Enterprise Group (of which 1 doesn’t sit too well with us!) you should know about.
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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