The AES Corporation: Another Utility With Leverage On An Unsustainable Path

Summary

• Normally utility companies are seen as a safe and reliable source of dividend income, such as The AES Corporation, but the analysis of their finances should still not be skipped.
• Whilst debt-funded growth can be an excellent way to grow, their leverage still has to be taking a sustainable path as it cannot increase indefinitely.
• Since the end of 2013, their total free cash flow has been negative and thus their dividend has been funded through debt.
• During this same period of time, their leverage has increased and thus is now very high, although thankfully their liquidity is still adequate.
• After considering all the factors analyzed, I believe that a neutral rating is appropriate, but this was only a marginal decision and would have been bearish without their adequate liquidity.

Introduction

Traditionally utility companies such as The AES Corporation (NYSE:AES) are considered safe and reliable sources for dividend income, however, it can be risky for investors to simply jump to this conclusion without analyzing their finances. This is especially relevant given their often heavy reliance on debt and the fact that interest rates are almost certainly not going any lower. Whilst I have nothing against using debt to fund growth, it does not matter what type of company, their leverage cannot continue increasing indefinitely.

Cash Flows & Debt

Thankfully the graphs largely speak for themselves, with the first three graphs included below summarizing their cash flows and debt from the last quarter and previous seven years.

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Their historical cash flow was primarily provided for general context and to frame the subsequent analysis. Throughout the last seven years, it can be seen that their free cash flow has varied with only one year being very slightly positive and unfortunately has also been declining in the most recent years, with the economic downturn in the first quarter of 2020 only weighing it down further year on year. Since it stems from relatively high capital expenditure, the extent that this is problematic will depend on their overall financial position and whether these investments are producing sufficient returns.

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Following their previously discussed scarcity of free cash flow, their negative dividend coverage should not be surprising, despite always being easily covered by adjusted earnings. Since the beginning of 2013 their dividend payments have totaled $1.947b, which clearly exceeds their total free cash flow of negative $4.27b during this same time period. Since dividends are ultimately paid with free cash flow cash not adjusted earnings, this indicates that the entirety of their dividend payments have been funded through debt, which at best is highly questionable if it could be sustainable in the long-term. In order for this to be the case, their earnings would have to increase sufficiently to offset the additional debt used to fund both the negative free cash flow and dividend payments.

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It would normally be expected to see their net debt increasing significantly given the previous discussion, however, this has not transpired with their net debt at the end of the first quarter of 2020 being only 2.56% higher than at the end of 2013. This has primarily eventuated due to $3.457b of divestitures net of acquisitions during this same period of time. Given the turmoil that was recently striking global financial markets, it is positive to see that they retain a relatively decent cash balance, which as subsequently discussed, helps support their liquidity.

Financial Position

Whether this path of funding dividend payments through debt appears sustainable will depend upon its impact on their financial position. The two graphs included below summarizes their financial position from the last quarter and previous three to seven years.

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It unfortunately becomes apparent upon reviewing these financial metrics that their leverage has been continuously increasing since the end of 2013. Whilst their net debt-to-operating cash flow and interest coverage have varied but not deteriorated materially, the same cannot be said for their net debt-to-EBITDA and gearing ratio. If this was simply due to a one-off event over a short length of time, it could be argued that it is no reason for concern; however, this is a clear and strong trend emerging across seven years. The trend is in fact so noticeable that 2018 was the only year where these two important metrics saw a sequential year-on-year improvement albeit to a very small extent.

This continuously increasing leverage has resulted in their net debt-to-EBITDA increasing to 6.54 and this cannot be blamed upon the coronavirus, as it was already 6.19 at the end of 2019. Their other financial metrics also paint a similar picture, and unfortunately, this is noticeably above the level that is can be considered safe, even for an organization with economically resilient earnings. Since their interest coverage has remained broadly flat and their leverage is not yet at crisis levels despite being very high, this may not pose a risk to their dividend in the short-term, but they still require a change within the medium-term.

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Thankfully their liquidity appears decent and adequate, as evidenced by their aforementioned relatively sizeable cash balance and current ratio of 1.03. This partly counteracts the risk posed by their very high leverage and will help them remain a going concern. Since they are a fairly large company providing critical infrastructure across several countries, it would be difficult to imagine them being completely unable to access adequate liquidity to remain a going concern, especially with the recent supportive central bank monetary policy. Although they could still be forced to reduce their dividend within the medium-term if their leverage does not cease increasing, as the support from debt markets will always have an endpoint.

Conclusion

Whilst their very high and historically increasing leverage may not pose too significant of a threat to their dividend in the short-term, it obviously cannot continue in this manner indefinitely. Although investors can debate exactly when their leverage would become too burdensome, it does not alter the fact that without changes this will eventuate one day. Considering the recent economic conditions are hardly going to help their situation, I would argue that this day is approaching within the next few years and thus I believe a neutral rating is appropriate. This decision was only marginal and if it were not for their adequate liquidity, my rating would have been bearish.

Notes: Unless specified otherwise, all figures in this article were taken from The AES Corporation's SEC filings and Quarterly Reports, all calculated figures were performed by the author.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.