Wednesday, 01 April 2020 13:04

Solvency and Debt in time of crisis

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This article was written by Hugh Dive - Atlas Funds Management and he has generously authorised its reproduction ..... Thanks Hugh!

 

Alongside the worldwide devastation as healthcare systems struggle to cope and deaths are well into the tens of thousands, the COVID-19 crisis is having a chilling impact on Australian corporates. Many companies are removing profit guidance given less than a month ago, cancelling dividends, raising debt, and in the last five days attempting to raise capital. Eleven years ago during the GFC many companies raised equity, often at deep discounts to their share price, as nervous bankers put pressure on management to shore up weakened balance sheets. In some situations, companies were forced to raise equity as their bankers were unable to refinance loans that had become due in a frozen credit market. 
 
In this week’s piece we are going to look at the various debt measures that we examine to assess a company’s solvency. These measures provide insight into whether management will be forced to raise equity during times of stress.

Gearing


Gearing is the most commonly discussed measure of a company’s debt. It indicates the degree to which a company’s business is supported by equity contributed by shareholders, as opposed to debt from banks and bondholders. Gearing is measured by dividing net debt by total equity (assets plus liabilities).  During times of buoyant business conditions, companies with a high level of gearing generally deliver higher returns to investors. However, when the tide turns, highly geared companies have a riskier financial structure and have an increased chance of going into administration or having to raise equity to retire debt.

Most companies on the ASX have a gearing ratio between 25% and 35%. However, the level of gearing needs to be assessed in the context of the industry in which the company operates.  Utilities such as Spark Infrastructure with regulated revenues can “safely” have a higher level of gearing than a highly cyclical stock such as Myer or Qantas. The latter two have more variable earnings and thus a variable ability to meet interest payments.

The key weakness in using gearing alone to measure a company’s solvency is that it assumes that the company’s assets can be realised for close to what they are valued on the balance sheet. The shortcomings of this approach are especially apparent for companies with a large proportion of intangible assets on their balance sheet, such as goodwill stemming from acquiring other businesses at prices above their net asset backing. In 2019 AMP’s gearing increased rapidly after the financial services company wrote down the asset value of its troubled wealth management and life divisions by $2.5 billion. Shortly after writing down the value of its assets, the highly geared AMP both cancelled its dividend and conducted a $650 million equity raising at a 16% discount to the share price at the time.

Companies such as Medibank PrivateJanus Henderson and A2Milk are in the fortunate position in 2020 of having no net debt on their balance sheet. As a result, each has a negative gearing ratio and is facing no anxious discussions with their bankers. By contrast AMP, Pact and OohMedia (which raised $167 million last week) all have high levels of gearing.
 

Short-Term Solvency


Short-term solvency ratios, such as the current ratio, are used to judge the ability of a company to meet their short-term obligations. The current ratio divides a company’s current assets by their current liabilities (i.e. liabilities due within the next 12 months). Firms can get into financial difficulties despite long term profitability or an impressive asset base if they can’t cover their near-term obligations. A current ratio of less than one would indicate that a company is likely to have trouble remaining solvent over the next year, as it has less than a dollar of assets quickly convertible into cash for every dollar they owe. A weakness in using this measure to assess the solvency of a company is that the current ratio does not account for the composition of current assets which include items such as inventory. For example, winemaker Treasury Wine reports a robust current ratio. However, a large proportion of current assets are inventories of wine which may be challenging to convert into cash at the stated value during times of distress (panic buying of wine notwithstanding).

A further limitation of the current ratio in assessing a company’s financial position is that some companies such the ASX, Coles and Transurban which have minimal inventories or receivables on their balance sheet. This occurs as they collection payment immediately from their customers, but pay their creditors 30 or 60 days after being invoiced. These companies will tend to report current ratios of close to 1. Alone, this figure would indicate that these companies may be in distress. Indeed Coles has a current ratio below 1, which far from being alarming is due to the nature of the grocery business. Suppliers such as Kellogg’s and Coke are paid on terms between 60 and 120 days after they deliver their goods which creates a large current payables balance, while the receivables balance is small when customers pay for their cornflakes or Diet Coke via direct debit. This favourable mismatch between getting paid and paying their suppliers allows Coles and Woolworths to report an alarming current ratio that is effectively a loan from their suppliers to fund the grocers’ working capital.
 

Interest Cover


A debt measure that we look at more closely than gearing is interest cover, as this measures cash flow strength rather than asset backing. Interest cover is calculated by dividing a company’s EBIT (earnings before interest and taxes) by their interest cost. The higher the multiple, the better. If a company has a low-interest cover ratio, this may indicate that the business might struggle to pay the interest bill on its debt.

Before the GFC, I had invested in a company that had significant asset backing held in the form of land and timber. Using gearing as a debt measure alone, Gunns appeared to be in a robust financial position. However, interest cover told a different story. The combination of a rising AUD (which cut demand for its woodchips) and weak economic conditions resulted in Gunns having trouble servicing their debts despite their asset backing, and the company ended up in administration.

As interest rates have trended downwards over the past decade, it has become easier for companies to pay their declining interest bills, so in general, the interest cover ratio for corporate Australia has increased. Across the ASX companies such as JB Hi-Fi, Goodman Group, Wesfarmers and RIO Tinto all have an interest cover of greater than ten times. At the other end of the spectrum Nufarm, Viva Energy, Boral and Vocus all finished 2020 with interest cover ratios less than three times, which is likely to result in some worried discussions with their bankers. Nufarm has since sold its South American crop protection business with the proceeds going to pay down debt.  
 

Tenor of Debt


A very harsh lesson learned on debt during the GFC was not on the absolute size of the debts owed by a company, but the time to maturity – known as the tenor of the debt. The management of many ASX-listed companies sought to reduce their interest costs by borrowing on the short-term market and refinancing these debts as they came due. While this created a mismatch between owning long-dated assets that were refinanced yearly, it was done under the assumption that credit markets would always be open to finance debt cheaply. This strategy worked well until global credit markets seized up in 2008 and a range of companies such as RAMS and Centro struggled to refinance debts as they came due.

When looking at a company’s solvency during times of market stress, one of the critical items to look at is the spread of a when a company’s debt is due. If the company’s debt is not due for many years, management teams may not be forced by their bankers into conducting dilutive capital raisings during a period of difficult economic times. In the ASX over the next year Seven West Media, Downer and Southern Cross Media all have significant levels of debt to refinance, which may prove challenging in the current environment.

After the GFC many of the larger ASX-listed companies have sought to limit refinancing risks by issuing long-dated bonds in the USA and Europe. Toll road companyTransurban does carry a large amount of debt, but as you can see from the table below, the maturities of these debts are spread over the twenty years with an average debt to maturity of 8.4 years.

Similarly, at the smaller end of the market, the supermarket landlord SCA Property has minimal debt due over the next three years after issuing long-dated bonds in the USA. While COVID-19 is disrupting SCA Property’s business in March 2020, this spread of debt maturities positions this property trust better to ride out the current storm.


 

Covenants


Covenants refer to restrictions placed by lenders on a borrower’s activities and are contained in the terms and conditions in loan documents. These are either affirmative covenants that ask the borrower to do certain things such as pay interest and principal, or negative covenants requiring the borrower not to take on more debt above a certain level – for example; gearing must stay below 60% or an interest cover above three times. For investors, covenants can be difficult to monitor since, while companies reveal the maturity, currency and interest rate of their debts in the back of the annual report, disclosure on debt covenants is generally relatively weak.

Debt covenants were something that received little attention before the GFC when a covenant linked to Babcock & Brown’s market capitalisation triggered the collapse of the company. In June 2008, Babcock & Brown’s share price fell such that the company’s market capitalisation fell below $2.5 billion, and this triggered a covenant on the company’s debt that allowed its lenders to call in the loan.  After this experience, very few borrowers will include a market capitalisation covenant in their debt, as this leaves the company vulnerable to an attack by short-sellers. More recently in 2019 when Blue Sky Alternatives breached covenants, bondholders called in the receivers to protect their loan.

In 2020 amid the COVID-19 crisis, debt covenants are once again in the minds of investors, particularly in the hard-hit media and listed property sector. In the media sector, a fall in TV advertising revenue of 10% is likely to trigger Seven West Media’s debt covenant of 4 times EV/EBITDA (enterprise value divided by earnings before interest, depreciation and tax).

In listed property, the embattled shopping centre trusts have more breathing room, as they entered 2020 with a lower level of debt. The key covenants for Scentre are gearing (less than 65%) and interest cover (higher than 1.5 times). For the gearing covenant to be breached, the independent valuation of Scentre’s assets would have to fall by 60% from December 2019; for the interest cover to be breached, earnings would have to fall by 60% assuming no change to Scentre’s cost of debt.
 

Hedging


In the context of debt, hedging refers to the addition of derivatives to limit the impact of movements in either interest rates or the currency in which the debt is denominated. Many Australian companies borrow in Euros, US dollars and yen – both to take advantage of the lower interest rates in these markets, but more importantly to borrow money for a longer-term.  In 2020 the Australian dollar has fallen 12% against both the Euro and the US Dollar.

Companies that have significant un-hedged debt – such as building materials company Boral – will see their interest costs increase, especially if the company does not have enough foreign earnings to service their debt. This situation occurred in 2010 for Boral and required a dilutive $490 million to keep the company within their debt covenants. In December 2019 Boral’s debt was A$2.8 billion, but currency movements over the past 90 days have added $340 million to the struggling building materials company’s debt pile.

Our take

The upcoming year  will be tough for Australia’s companies as the sudden step change in demand is very different to the falls in 1987,1991,2000 or 2008/09. While demand for goods and services fell during these previous times of stress, some companies are now facing a government mandated shut-down in their businesses.

On a more positive note businesses are also likely to find more sympathetic bankers in 2020 than they faced in previous recessions, as well as massive government support. During the GFC,  the banks themselves were not well placed to help businesses, as issues with the global banking sector were at the heart of the crisis. The banks were de-levering their own balance sheets, while struggling to explain collapsed credit markets and the problems created by complex financial instruments to hostile politicians. Given that the shutdowns from COVID-19 are a temporary state of affairs and in light of the massive fiscal stimulus, we would expect the banks to give many struggling firms a degree of leeway over the next year.

 

 

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