In the wake of COVID-19, both bulls and bears echoed the same cry - make sure your investments have strong balance sheets. But as Victor Gomes pointed out, “businesses which have , often don’t need it, whereas businesses that need it, often can’t get it.”
In the first part of this Collection, four leading Australian fund managers told us what they look for in a strong balance sheet. Now, they each share two stocks that meet those criteria, despite facing shorter term headwinds from COVID shutdowns.
Responses come from Paul Taylor, Fidelity International; Chris Stott, 1851 Capital; Joe Magyer, Lakehouse Capital; and Victor Gomes, Eiger Capital.
Look for a margin of safety
Paul Taylor, Fidelity International
In trying to assess which companies might fit these criteria it is important to address multiple questions. How long will restrictions last? Will restrictions change? Does the company have cash burn? How long can they burn cash with their balance sheet? In answering these questions, you may also want to factor in some margin of safety because in this environment things can change very quickly. Also, judgment is required as there is no absolute answer to any of these questions.
Ramsay Health Care (RHC) is a private hospital operator in Australia, UK, France, Malaysia, Indonesia and Hong Kong. Ramsay has been significantly impacted by COVID-19 restrictions as governments around the world have stopped or limited elective surgeries. State Governments in Australia have undertaken agreements with private hospital operators like Ramsay to provide critical care but on a not for profit basis. This means that Ramsay will be approximately cash break even for most of 2020. Ramsay just raised over $1bn last month to ensure the strength of their balance sheet. While Ramsay will probably not make any money this year, the quality of their assets, strength of their balance sheet, market position and importance of private hospitals to the health care system should mean that they not only survive to the other side of COVID-19 but thrive in the long term.
Tyro Payments (TYR) is a Fintech company and is one of Australia’s largest EFTPOS provider as well as an e-commerce payments software provider and Australian bank. Tyro has been significantly negatively impacted by COVID-19 as many of its small business customers of its EFTPOS services are CBD restaurants, cafes and retail outlets - which have either had to close or restrict trading due to COVID-19. Tyro should be around cash break-even this year, but its balance sheet is in a strong net cash position. While sales in cafes, restaurants and retail are weak for Tyro, their customers in medical areas and e-commerce are generally performing very well. In the medium to long term they would like to continue to gain share in EFTPOS, e-commerce software and lending to small business. I believe their strong product suite, very strong net cash balance sheet and good customer base will likely see them survive through COVID-19 and continue to gain share and thrive over the long term.
Raising capital to cut back on debt levels
Victor Gomes, Eiger Capital
Auckland International Airport (AIA) would be considered very defensive and able to comfortably sustain an otherwise elevated level of debt in normal circumstances, especially with such a strong monopolistic position. Unfortunately, COVID-19 is not normal circumstances. In the latest traffic update for April, AIA reported a 97% decline in traffic movements. It is likely to be some time before traffic movements at AIA return to pre COVID-19 levels. Nevertheless, one factor that AIA has in spades are hard assets. Not only is this asset unique and almost irreplaceable, it also includes about 1500ha of spare land. Along with the significant aeronautical assets of AIA, the surplus undeveloped land provides lenders with significant comfort that NZ$8.5b of hard assets can easily cover the NZ$2.2b of net debt. Such comfort is despite the current net debt/EBITDA ratio being very elevated. Even before the COVID-19 crisis this ratio was at 4x. There is also little doubt that in the current environment, AIA’s lenders will provide it some flexibility on their debt covenants including some deferment on the servicing of the debt. Nevertheless, to bolster their balance sheet the company has just raised NZ$1.2b of equity including a deferral of their dividend. This has put to bed any concerns about the balance sheet. All that remains now is to await the return of air travel… and it will return.
Reece (REH) is a plumbing supply distributor with businesses in Australia and now a growing footprint in the US. The company was founded 100 years ago and has a remarkable track record of profitable growth. Between 1954 and 2018 when it raised additional equity to purchase Morsco in the US, it had managed to turn A$10m of original shareholder equity into more than A$1b of retained earnings. This track record of excellent operational management gave them the confidence to back themselves and raise the minimum equity required to fund the purchase of Morsco in July 2018. The resulting debt level translated into net debt/EBITDA multiple of 3x, placing them at the top end of our risk range. Factors supporting the higher debt levels include stability and serviceability (interest cost covered 5x with EBIT). Given that plumbing services have been classified as essential services in both Australia and in the US, the initial impact from the COVID-19 pandemic lockdowns on their business was minimal. Nevertheless, there is some uncertainty in the outlook for construction such that directors thought it prudent to bolster the balance sheet with an A$800m equity raise early April. With debt now halved, Reece is well placed to capitalise on the US opportunity, augmented by any opportunistic acquisitions of weakened competitors.
Software companies well placed
Joe Magyer, Lakehouse Capital
PayPal (NSDQ:PYPL) is a prime example of a company with a balance sheet that’s built to survive. The business isn’t really facing headwinds -- growth is still robust and social distancing has actually pulled forward the adoption curve for e-commerce -- but the virtue of its strong balance sheet is becoming more obvious. The company was able to raise a few billion dollars on incredibly attractive terms including a slice at US$1 billion with a 3.25% yield due 2050. At a time when many smaller or weaker rivals are gasping for air, PayPal is borrowing money at near-sovereign rates with a maturity past when most of us will be retired. It’s good to be king.
One closer to home is Bravura Solutions (BVS). The Sydney-based enterprise software company, which focuses on wealth management and funds administration solutions, entered the crisis with $100 million in cash. Some professional services revenue will likely have been lost because of the crisis and it is possible some deals and projects might get delayed. However, the business is exceptionally well-placed to withstand any slippage given the fortress balance sheet and the fact that 78% of its revenue is recurring. Indeed, we would not be surprised if the business came out of this crisis competitively stronger given those advantages.
2 cashed-up small caps
Chris Stott, 1851 Capital
The Reject Shop (TRS) has been forgotten by many small-cap investors. It has a new management team with a turnaround strategy, and as at 31 December 2019, the company was well positioned with $51.3 million in net cash. In February, the company raised an additional $25 million, which brought total net cash balance to $76.3 million, or $2.00 per share. This figure does not adjust for working capital, which has historically increased in the second half of the financial year. The new management team is taking a “back to basics” product approach focused on selling everyday items at the lowest price. A similar strategy was successfully employed by the company 10 year ago and the share price peaked at over $18.00. The Reject Shop has had the luxury of keeping its stores open through the pandemic. In mid-March, the company announced it had achieved comparable sales of 36.1% on the back of the consumer hoarding activity. With a strong net cash balance and earnings at cyclical lows, we think the company is well positioned to execute on the new strategy and drive earnings growth over the medium to long term.
Uniti Group (UWL) is the owner of telecommunication assets within the fibre and wireless segments. It has assembled a strong management team and board with a proven track record from their time working at TPG Telecom and M2 Group. As at 31 March 2020, the company held $37.7 million in cash with all three of its business units performing above forecast. The company has been very acquisitive in recent years and has stated it will continue to pursue its growth agenda via a combination of organic growth and acquisitions. More recently, Uniti Group has been a beneficiary of the work from home trend which has driven elevated levels of domestic internet consumption. With an experienced management team, a strong balance sheet and effective strategy, the company is well-positioned over the longer term to be a key player in the telecommunications sector.
If you missed it...
What makes for a rock solid balance sheet? Chris, Paul, Victor, and Joe each share the key elements that they look for in this wire.
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Thanks Pat, another great wire
Thanks Pat, very informative, I have a few of shares youve mentioned and I'll ad a few more.
Thank you Patrick. Great series of articles Mohan