Debt is More Than A Number

Finding out the backstory is always worth your while

There’s nothing like a banking crisis to put the focus on debt. And that’s for very good reason: When the Federal Reserve squeezes the economy, weakness is exposed and the most heavily levered companies and individuals frequently crack.

 As investors, avoiding the most exposed companies now will very likely make the difference between whether bear market losses will prove temporary, or long lasting and potentially unrecoverable. But identifying the truly vulnerable borrowers isn’t as simple as screening for a specific ratio or number.

 Take a well-worn metric like the debt/asset ratio, which is simply a company’s total debt divided by its total assets. All else equal, a low ratio would be better. But there’s a lot more to consider.

 Companies financing assets with a 40 to 50 year lifespan like pipelines or electricity powerlines, for example, can afford to borrow a relatively high amount against them. In contrast, companies operating in markets where products have lifecycles of a year or less like personal computers can afford to take on much less debt without piling on the risks.

There’s not even a one size fits all debt/assets ratio for companies operating in the same industry. Let’s look at the utility sector, a group I’ve focused on as an investor and an advisor since the mid-1980s.

Utilities hold debt on three different levels: Parent/holding company, subsidiary and project level.

At one extreme is MDU Resources (NYSE: MDU), which has no parent level debt and everything at the operating level. At the other are larger entities that own multiple utilities through a parent holding company. They own debt at both the holding company and subsidiary level. A good example would be Dominion Energy (NYSE: D), which as of the end of 2022 held roughly $17.3 billion in holding company debt of a total of $41.9 billion.

Dominion as a larger company has considerably more overall debt than MDU, as well as more debt relative to assets. Nonetheless, the two companies hold roughly the same investment grade credit ratings. The reason: Dominion’s revenue and cash flow is 100 percent from regulated utilities and contracted assets, whereas MDU runs a large construction materials and services business it’s in process of spinning off.

Dominion can afford to hold more debt than MDU because its overall cash flow is far more reliable and tied to long-life assets. When MDU completes the spinoff of its Knife River construction materials business and resolves the fate of its services operations it will be a pure utility/contracted assets business. And it will therefore be able to afford a higher debt/assets ratio than it can now as a more diversified company.

Subsidiary level debt such as MDU has is, however, currently advantaged to holding company borrowing in a big way. That relates to tax treatment.

Before President Trump's tax reform, holding company and operating company debt were treated the same for tax purposes. Corporations were allowed to deduct the full amount of interest expense against taxable earnings. After the change in the law, utilities are still allowed to deduct the full amount of interest expense on debt held at the subsidiary level. The amount at the holding company level, however, is now capped.

Conversely, holding company debt still holds one huge advantage for utilities that own more than one regulated subsidiary. If operations turn sour at one unit, the utility can ring fence the damage, even maintaining dividends while they repair it.

When Entergy Corp (NYSE: ETR) was hit by Hurricane Katrina in 2005, it was able to put its New Orleans unit into bankruptcy without cutting its quarterly dividend of 54 cents per share. Some years later, Southern Company (NYSE: SO) was able to take a $6 billion loss for a failed carbon capture project at its Mississippi Power unit. Meanwhile, it continued to raise its dividend and fund construction of the Vogtle nuclear plant, which is on the brink of entering service later this year.

Because of the interest expense deductibility issue, credit raters and investors value companies with a greater weighting of operating company debt more highly. And in fact, utility operating level debt now often commands a premium price to holding company debt, even for the same company. WEC Group's (NYSE: WEC) 6.2 percent bonds of April 2033 (holding company level), for example, yield 5.33 percent to maturity while its May 2033 Wisconsin Electric Power bonds yield just 4.54 percent to maturity.

From a long-term standpoint, it’s a safe bet that the advantage holding company utilities have of being able to ring-fence operations will prove its value again. But with holding company debt clearly more expensive than operating level borrowings, it obviously makes sense to hold less of it.

At this point, utilities with heavy levels of parent/holding company level debt like Dominion Energy have focused on cutting it. The company is currently in the middle of a top-to-bottom strategic review that’s likely to end with sales of non-utility assets. And I anticipate proceeds will go overwhelmingly for that purpose.

The holding company level is also where Dominion has more than 54 percent of its variable rate debt. And with short-term interest rates twice what they were 18 months ago, reduction of floating rate borrowings has become a top priority for management, as it is for other utilities. 

In my view, the best way to gauge balance sheet risk for utilities in 2023 is to examine their exposure to rising interest rates. In the case of operating level debt, the cost is generally passed on in customer rates. That carries its own set of challenges, since higher costs make it more difficult for regulators to allow capital spending that drives earnings and dividend growth.

The additional cost of variable rate debt at the holding company level, however, must be borne by shareholders. Equally important is maturing debt. What comes due this year will almost surely have to be refinanced at a higher interest rate. That means increased interest expense for companies. And the more borrowings that come due, the greater the hit to earnings.

Dominion has parent level/holding company maturities for 2023 of $1 billion, all at floating rates. Consequently, the utility has already absorbed at least most of the cost of having to refinance. The $2.45 billion coming due next year is also floating rate, leaving just $399 million of 3.496 percent coupon bonds from which to absorb a higher cost for refinancing. And even that shouldn’t be too severe, as the company still has moderately priced longer-term debt, for example at the holding company March 2033 bonds yielding only about 5 percent to maturity.

Dominion still faces challenges from adapting to changes in Virginia regulation, as well as from attempting to control the cost of building a 2.6 gigawatt offshore wind farm. And the outcome of the strategic review is highly uncertain. But its actual balance sheet risk is considerably less than its relatively high debt/assets ratio would otherwise indicate.

My Conrad’s Utility Investor Utility Report Card uses a five-point Quality Grade system. One of them is balance sheet, which is based on a range of criteria including cost of debt, variable rate debt exposure, debt maturing in the next two years, holding company debt and so on.

Dominion currently has 37 percent of debt at the holding company level, the highest in the utility sector. Eversource (NYSE: ES) in second at 36 percent is also at far less risk than it appears, as the pending sale of its direct offshore wind project interests will cut it down to size in the next 12 to 18 months.

Southern Company at 32 percent will see huge balance sheet improvement when the two new nuclear reactors start up at the Vogtle site in Georgia. The first of them has now achieved initial criticality and appears to be on track to at last start up early this summer, with the second early next year. And Exelon Corp (NYSE: EXC) at 32 percent now garners 100 percent of revenue from owning regulated utilities.

At the lowest end of the holding company debt range is NextEra Energy (NYSE: NEE) at just 6 percent. That’s despite its NextEra Resources unit being the largest non-regulated owner and operator of solar and wind power in the US. And it’s another strength for this extraordinary company.

But the main point here is that gauging balance sheet risk of utilities—or any other company—is always more complex than it appears. Relying on a single number can be misleading, especially if it’s obtained from a mass screening service.

Don’t get me wrong. Less is definitely better. But what really matters where the debt is concerned is how well companies are able to control its cost. Taking the time to find out a little more backstory will always be worth your time.