April saw a recovery in the property market as new cases of COVID-19 (CV-19) slowed rapidly in Australia and the state governments, towards the end of the month announced some relaxations to the social distancing rules and the path to reopening the economy. Government programs such as the Code of Conduct for Commercial Tenancies have provided landlords with a mechanism for sharing the impact of falling sales by deferring rents, very different to the fear prevalent in March that rental income would go to zero.
The Atlas High Income Property Fund gained +13.1% reversing a proportion of March’s losses. Over the month, several holdings in the portfolio gave trading updates that indicated that their businesses were trading in-line with expectations given in February, with their tenants facing minimal impacts from CV-19 or in the case of supermarkets, chemists and liquor stores had seen increased turnover.
Unlike companies such as the banks, property trusts cannot retain earnings for a rainy day and have to distribute profits each year. The Fund has a strong focus on non-discretionary retail, and we expect that the June distributions from the underlying holdings will be ahead of meagre market expectations, especially as the economy emerges from the lock-down.
Human beings have consistently congregated in public places for shopping, dining and work since the Agora was built in Athens during the Fifth Century BC, it is hard to make the case that CV-19 permanently changes this pattern of human behaviour.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.
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 Private, Janus 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 company Transurban 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 of 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.
Australians have panicked and hoarded groceries. Coles has reported 20-30% grocery volumes above their peak Christmas periods. Hugh Dive from Atlas Funds Man…
Australians have panicked and hoarded groceries. Coles has reported 20-30% grocery volumes above their peak Christmas periods. Hugh Dive from Atlas Funds Management review the impacts to Coles’ profit and looks at whether it’s a buy in this current market.
During the months of February and August, the majority of Australian listed companies reveal their profit results and most guide as to how they expect their businesses to perform in the upcoming year. Today marks the end of the February 2020 company reporting season and companies have until the end of the day to release their financial results for the past six months, or they will be suspended on Monday from trading on the ASX.
In this piece we are going to run through the key themes that have emerged over February, a volatile month where greed reigned over the first two weeks, to be replaced by fears over the impact of the novel coronavirus COVID-19 in the last two weeks.
Australian consumer doing better than expected
Going into the February reporting season we were concerned that company results would reflect a dramatic pull-back in retail sales due to bushfires, consumer preferences to reduce debt rather than spend, and the emergence of COVID-19.The financial results for large listed property trusts such as Scentre group give a good insight into consumer spending. Scentre’s portfolio of 42 shopping centres accounts for 8% of Australian retail sales and is a good indicator as to the health of the consumer. Sales were up +2% with weakness in department stores being offset by sales growth in food, personal services, supermarket, and even fashion. Elsewhere in retail, JB Hi-Fi saw sales grow +4% as consumers opened their wallets to buy phones, gaming consoles, and Fitbits. Coles and Woolworths both showed approximately 3% sales growth in supermarkets and liquor.
Beating and missing guidance
Going into reporting season, the market develops a sense for the profit that a company is expected to earn, either through explicit guidance by management (generally within a range) or by the average or consensus forecast of the sell side analysts. Beating guidance usually sees a company’s stock rise sharply, whereas missing sees it fall. In February, on UBS’ numbers 1/3 of the companies that have reported beat expectations, 1/3 were in-line, with 1/3 disappointing. This should be considered a good outcome as normally the percentage of companies that beat guidance is much lower than 33%.
Looking at the large cap (ASX 100) companies that beat expectations AGL Energy, Charter Hall Group, Coca-Cola Amatil, Commonwealth Bank of Australia, JB Hi-Fi, Lendlease and Qantas were well received by the market. On the negative side of the ledger, companies that reported a profit number below expectations were Cochlear, Downer EDI, Mirvac, Tabcorp, Treasury Wine Estates and Whitehaven Coal.
Shorts Getting Burned
Traditionally, most of the market attempts to own stocks that will report a good result and increase their dividends. Some fund managers, however, try to capitalise on bad profit results by short selling the shares of companies in the expectation that the company’s share price will fall.
Due to the extreme variance in share price performance over the month, in many cases short-sellers would have gone from tearing their hair out after the short-sold company result mid-month, to toasting their good fortune at the end of the month. Provided the short seller kept their nerve and did not close out the position as the stock rallied on the day of the results.
The two largest short positions – Domino’s Pizza and AMP – would have been painful for those shorting these stocks as their prices have rallied strongly post result, though AMP gave up these gains on general market fears towards the end of February. Domino’s Pizza delivered a result that was around market expectations, with sales in Japan and Germany offsetting weakness in Australia. AMP entered the reporting season with very low expectations to say the least, with questions about the company’s vertically integrated business model being able to survive in a post-Hayne report world. Despite suspending the dividend, losing 440 financial advisers, and taking $2.5 billion of impairments, AMP rallied on the view that after selling some assets such as insurance, the company’s remaining banking and wealth management businesses can absorb further remediation provisions.
Give me my money back!
For the first time in a few years capital management was not the dominant feature of the recent reporting season, with most companies struggling to increase dividends over what was paid in February 2019. Twelve months ago, many companies loosened their purse strings in moves that appear designed both to reward shareholders and to get franking credits into the hands of their shareholders before the expected Labor victory that would have devalued these tax credits. Across the ASX, the dividend payout ratio (dividend per share dividend by earnings per share) decreased. This was due to boards conserving cash for growth, and also to the uncertain impact of COVID-19 over the coming year. While the big miners BHP and RIO paid healthy dividends, many in the market expected large special dividends to be paid based on high iron ore prices over 2019. Given that the iron ore price is likely to be heavily impacted by a slowdown in China, this is a prudent move by the large miners.
Best and worst results
Over the month the best results were delivered by Charter Hall, JB Hi-Fi, Coca-Cola and QBE Insurance Charter Hall benefited from a large amount of property transactions (some between their own funds – not a good sign) and grew funds under management to $39 billion. Coke beat guidance by improving sales in Australia and Indonesia, which was contrary to the market view that carbonated soft drinks were in a terminal decline. JB Hi-Fi had a solid result with sales growth up +4%, which contrasts sharply with rival Harvey Norman. The latter saw sales increase by just +1.6%, indicating that JB Hi-Fi is winning market share. Additionally, JB’s management gave guidance for 6-8% profit growth for 2020, which was very well received.
On the negative side of the ledger WiseTech, Altium, Treasury Wine and Reliance all reported profit results that were significantly below market expectations. The common themes amongst this group were popular stocks trading on high PE multiples delivering profit results below expectations, combined with bearish management commentary for the coming year. The market is very unforgiving to high PE stocks that don’t deliver. Atlas were concerned about CSL going into reporting season as this was a company with high expectations for profit growth. After growing earnings by 11% and upgrading full year profit guidance, the biotherapy company briefly became Australia’s largest company by market capitalisation in February, before the title was snatched back by Commonwealth Bank.
Looking ahead: guidance surprisingly upbeat
Around 30% of large cap companies upgraded profit guidance for 2020, something that surprised Atlas. Especially noteworthy was the broad range of companies upgrading which included LPTs, cyclicals, defensives and resources. While the novel coronavirus was mentioned often in management outlook commentary, only a few companies such as WiseTech, Crown and Vicinity have downgraded future earnings based on 4 to 8 weeks of travel restrictions. This leads one to suspect that COVID-19 might in some cases be used as a fig leaf to cover other issues in these companies, especially when the management teams from companies operating in the same industry don’t use the virus as a reason for flagging sales and profits.
Managing the portfolio in a “crisis”
The pattern of the COVID-19-induced sell off that we have seen in February 2020 is very broad based and different to selling that I observed in the market falls on the ASX in 2007 and 2008 during the GFC, and on the Toronto Stock Exchange during the tech wreck. The GFC and tech wreck saw selling more heavily weighted towards those companies actually exposed to the negative event. This reflects the greater influence of index funds and ETFs on global markets in 2020.
When an index fund receives a redemption (which dramatically increase during market sell-offs), the manager simply liquidates a portfolio of stocks in proportion to their index weight. This results in the entire market being sold down in a roughly uniform percentage, even companies whose earnings are likely to face a minimal impact from COVID-19. We see that February’s broad-based sell-off in the market reflects the greater influence of index funds and ETFs on global markets in 2020, as index funds comprised a smaller percentage of assets under management 20 and twelve years ago.
Looking through the portfolio, Atlas are adding to positions in companies whose share prices have fallen despite offering investors defensive earnings that are likely to provide consistent dividends through a variety of market conditions. Additionally, the decline in the AUD, which hit an 11-year low overnight to 0.65, will give a boost to offshore earnings from companies with foreign operations.
Our Take
As fund managers are neither virologists nor epidemiologists, I can’t say when the current novel coronavirus will be contained. However as a long term investor who has seen a few unpleasant crises in the market I believe in the words of Abraham Lincoln that “this too will pass” and that consumers are still likely to shop for food, drive on toll roads, consume packaged food and medicine, get medical tests done, as well as bet and play the lotteries. Owning companies that provide goods and services such as these are likely to provide investors with a stream of dividends despite the inevitable times of sturm und drang that occur on the share market.
The Atlas High Income Property Fund gained by 3.6% during January. While this was an above-average return, a portion of these gains was a recovery after some curious price activity on the last day of 2019. Here the entire market was sold down by close to -2% in a thinly traded four-hour session. In hindsight, this appears to have been an offshore index fund reducing its weight to Australian securities, with these losses recovered in the first week of January.
The key news over the month was a large fall in the Commonwealth Government 10-year bond yield that fell to 1%, as the negative impacts of both bushfires and the Coronavirus on the Australian economy have raised the probability of further rates cuts by the RBA.
The falling official cash rate has seen the major banks cut their benchmark 180-day term deposit rates fall to 1.25%. While this looks grim for savers, the situation is likely to get worse with six-month interest rate futures at 0.65% which points towards further cuts.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.
