The COVID-19 crisis and country shutdowns is placing enormous pressure on the earnings, cash flows and balance sheets of many companies. We have provided a brief outline of some of the issues that we see across the major sectors, however given how fast the situation is changing, including government intervention, we expect our views to also change.
The shutdown will impact small businesses in particular. While SME gearing is low, the operating leverage caused by property rental and high wage costs will lead to losses and possibly send a number of SMEs bankrupt. The banks have security for the majority of SME loans, but will still take significant losses. Banks are highly leveraged with both financial and operational gearing, so a higher bad debt charge will impact profits.
Mortgage debts and corporate debts will increase but are less risky, as the low interest rates will cushion the impact on households in the short term and corporates are generally lowly geared relative to history. There will still be bad debt, but it should not be too high.
The government support package will allow some time before the bad debts ramp up, but SMEs are simply more vulnerable to the shutdown.
The banks themselves have more than twice as much capital as they had going into the GFC and less exposure to property and more exposure to mortgages, so they should get through without raising more capital.
Households are highly leveraged, so the shutdown will impact the ability to spend and lead to less spending in the future as households will need to repair their balance sheets.
Discretionary retailers will be significantly affected by shutdowns. For most discretionary retailers, sales are driven by shop visits. All retailers have a lot of operating leverage so a prolonged shutdown could lead to bankruptcy. Apparel retailers will be particularly impacted as winter stock is unlikely to be sold, and will have to be cleared at very low prices when they are able to re-open. Holding stock for the next year is costly as a lot of next year’s stock will already have been committed to.
Non-discretionary retailers, especially for home consumption, will do reasonably well.
Retailers that sell into cafés and restaurants will be negatively impacted, but few retailers are overly exposed to this sector.
In both the retail and bank sectors, the biggest risk is the shutdown goes on for longer.
While gaming is perceived to be relatively defensive and gaming revenue in Australia as a whole was still positive throughout the GFC, the impact from the COVID-19 has negatively impacted the gaming sector substantially — more than the broader market. While the consumer would ordinarily be expected to gamble less in a recession, the ability of the consumer to gamble at all has now become a real issue. Social distancing and the shutdown of pubs, clubs and casinos, as well as the suspension of most sports, has meant that many of these businesses are facing severe and unprecedented headwinds, which has, in turn, seen their share prices tank.
While these shutdowns are temporary, the duration is unknown, with many gaming companies most likely at the mercy of the bankers should the shutdown persist for a period greater than three months.
That said, within gaming, those that have diversified into online channels are seeing some offsetting benefit as patrons find alternative forms of entertainment while social distancing.
With the sell-off in equity markets, diversified financials have rightfully been sold off, as many of their business models are leveraged to funds under management. In addition to the negative mark-to-market, in these volatile times, these businesses also experience net fund outflows as investors shift assets away from risk assets. That said, the sector is very diverse, with some businesses 100% exposed to equity markets (one or multiple markets) while others have broader asset class exposures. Investors must look at these companies from a bottom up perspective to understand the degree of earnings risk resulting from the current equity market sell off and to identify opportunities that may arise from the broad sector sell off.
Of particular interest in this space are those that earn additional returns (sometimes material) on the spread between the cash rate and what they give investors.
With cash rates quickly approaching zero, these returns appear unsustainable, which could present additional risk to investors in an already fragile sector.
The saving grace for the sector is that many of these companies run net cash balances, and so have minimal balance sheet risk. Therefore, while there is substantial short-term pain, once markets return to normal (whenever and whatever that may look like), many of these companies will be in a position to move forward.
Generally, infrastructure stocks are perceived by investors as defensive, with toll roads, airports and gas pipelines considered relatively immune to an economic slowdown. That said, with COVID-19 completely changing the way individuals go about their day-to-day routine, changes to travel patterns has materially had a negative impact on most infrastructure stocks. With international bans and now state bans, airports are facing the reality of zero traffic for the next three months, if not longer.
Toll roads in countries that have already implemented lock down strategies are experiencing traffic volume falls of over 50%.
While it is logical and correct to argue that these are long-dated monopoly assets facing short-term operating headwinds, adding to the complexity is the fact that these companies are often highly geared.
With their “stable” income, this seemed like a good idea to amplify returns to equity investors under normal market conditions. To state the obvious, these are not normal market conditions. Many of these companies may need to turn to equity investors to shore up their balance sheet if the debt markets experience a GFC-like freeze.
We expect retail to perform poorly during this period as landlords will pull out all stops to keep vacancy in their centres down —think rent relief or escalated capital contributions as more tenants turnover. Assets with a higher discretionary composition will be hit harder, which will flow directly into rental income as well as ancillary income such as car parking and advertising fees. Asset valuations in the short-term probably will not be marked down to current discounts as seen in the listed securities as the listed operators have sufficient liquidity for the next 6-12 months to avoid distressed selling.
Office space will also be impacted especially if unemployment rises on the back of this.
Earnings in the short term should hold up well as rental contracts are long-dated and most of the larger corporate landlord’s tenants have better balance sheets to survive through this period. The question that also needs to be asked is whether a prolonged working-from-home environment will accelerate this digital trend, which can potentially result in lower demand for office space.
Industrial should hold up fine through this ordeal. The e-commerce trend will continue through this period.
We would expect general insurance to be somewhat defensive in this current environment, as it has during past economic downturns. Personal insurance (Motor, Home, CTP) has traditionally been seen as defensive as consumers continue to maintain protection over their key assets. Commercial Insurance is not quite as defensive as personal, because businesses can look to reduce premium costs via reducing the scope of their insurance. As businesses get shutdown, they would look to potentially cancel their policies, although property owners are unlikely to.
Typically, the claims environment is more weather related, but there are potential economic related events where we may see more arson (by the insured) and malingering/fraud to get bodily injury related claims via CTP and Workers Compensation. It will be possible to claim on COVID-19 under Workers Compensation if it can be shown the virus was contracted at work. However, with people being more at home and driving less under this unique COVID-19 situation, it is expected there will be fewer home and motor claims.
In addition, with COVID-19 being declared a biosecurity threat by the federal government under the Biosecurity Act 2015, virtually all Business Interruption (BI) policies written by Australian listed insurers, as part of packages, will mean that businesses cannot claim BI due to COVID-19.
This effectively rules out a potential major risk for general insurers under this current situation.
However, we should also bear in mind that while IAG is a pure general insurer, QBE and Suncorp have a somewhat different profile. QBE has about 20% of its business exposed to Lenders Mortgage Insurance in Australia, and Suncorp has about 15% exposure to its banking operations.
The building materials sector is likely to be significantly impacted by COVID-19. From a relative standpoint, the sectors which are most likely to be impacted are infrastructure, R&R, commercial and residential (admittedly hard to separate non-residential and residential). While there may be shutdowns of key infrastructure projects generally, we believe the governments are unlikely to abandon projects and activity levels should return to pre COVID-19 levels relatively quickly on existing projects.
There is obviously some risk around the pipeline of projects given greater levels of government indebtedness, but policy determinants should probably prevail.
Renovate and remodel also should remain relatively resilient in the context that some of the work is unavoidable and that the scale of capital required is generally smaller. It is hard to separate non-residential and residential sector given we believe both will be very hard hit. Coming out the other side of this our preferred exposure probably don’t differ greatly, but we would probably look to the quality of management and the different geographic exposures (probably prefer US over Australia given its more flexible economy and greater propensity to “snap back”).
Oil and gas
The oil and gas sector is facing unprecedented pressure from simultaneous events on both the supply and demand side. The economic slowdown from global governments curtailing activity in an attempt to slow the spread of COVID-19 will see oil use in air and land transport severely curbed, though the quantum of volume loss is difficult to determine given uncertainty around the duration of the slowdown in activity.
Supply has also been impacted to oil prices’ detriment, with OPEC and Russia unable to agree to additional supply cuts resulting in a price war between two of the world’s largest exporters. The result has seen oil prices fall precipitously, last week falling more than in 1991 during the first Gulf War. The rapid drop in oil prices led the market to sell off oil stocks — those with perceived balance sheet issues the most harshly treated.
If oil prices maintain sub-US$30/bbl levels over the remainder of 2020, OSH could face debt covenant issues on a portion of its overall debt, however, we believe that given ample liquidity via undrawn facilities, OSH will manage through this period through discussions with its lenders. More broadly, the rapid decline in the oil price will lead most, if not all, companies to rethink near-term growth plans; WPL’s Scarborough, STO Barossa and OSH’s Papua are examples of large scale LNG projects that will likely be delayed until oil finds a more stable footing.
At current oil prices, most major supply participants are losing cash, or are requiring to either draw down on sovereign treasury reserves or put austerity measures in place to curb the fiscal bleeding.
Saudi Arabia and Russia are reported to require US$80/bbl and US$40/bbl oil prices to balance their budgets, while US shale producers require around US$45 – 55/bbl to continue to grow. Already, US shale appears to be feeling the economic impact, with reports of layoffs in Texas. In the absence of the COVID-19 pandemic, it’s likely some form of agreement between major exporters (US included) to return to a more economically disciplined supply approach, will be needed to see a sustained oil recovery.
Longer-term, we continue to believe the world requires higher oil prices to incentivise replacement supply from higher-cost conventional sources, such as ultra-deep water. The sell-off has created significant value in the energy space, with all stocks trading at heavy discounts to our assessed valuation, even valuations with no assumed growth. While we should expect continued near-term volatility given the ever-evolving pandemic and geopolitical relationships, there is significant upside when oil recovers.
Current events have created significant but quite diverse issues for the mining sector. Base metal prices are suffering on the weakened and uncertain global economic outlook, while bulk commodities, in particular steel-making inputs, iron ore and coking coal, have held up remarkably well. Chinese steel making rates held up well during the country’s strict quarantine period, while major suppliers faced weather-related challenges.
Chinese steel inventories did rise to unprecedented levels, but are now falling, indicating robust end-demand, providing further evidence that China is indeed returning to work.
While we do expect iron ore prices to gradually drift lower over 2020, we do expect BHP, RIO and FMG to continue to produce significant cash flow, further aided by a cost base helped lower through the fall in the AUD/USD. ILU is also a clear beneficiary of strong iron ore and FX, via its MAC royalty, which the company is looking to demerge.
Base metals declined initially on the expectation of weak near-term consumption from China, but while China looks to be recovering, the rest of the world is slowing rapidly and the overall demand outlook for copper, nickel and aluminium remains unclear. On top of this uncertainty, weakness in base metal prices has been further exacerbated by the significant strength in the USD. On the supply side, more newsflow is emerging from key metal producing regions of COVID impacting supply. While it’s unlikely to provide price support given uncertain demand, this could provide support once economic activity returns.
Fortunately, most of the sector has relatively low gearing and should be able to weather current events. Like the oil sector, the sell-off has seen substantial value emerge from the miners. Most current base metal prices are biting deep into cost curves, which should provide price support over the longer term.
Although healthcare is typically perceived as being a relatively defensive sector, the reality is that times of economic weakness do impact demand for healthcare services. This is typically a function of individuals choosing to defer doctor visits and elective procedures plus, for those with US exposure, the fact that healthcare insurance is tied to employment. As we saw in the GFC, rising unemployment resulted in demand weakness.
To date in the COVID-19 pandemic, we are seeing GP visitation decline as individuals are avoiding places with higher risk of transmission. This has had a flow-on effect to pathology and radiology volumes and will, in time, impact demand for sleep testing and elective surgeries, including cochlear implantation. Areas unaffected will be lifesaving medication and ventilator manufacturing.
In regards to the outlook, beyond a period of weaker demand associated with the current shutdown, the prospects for the different participants will vary according to their exposure to broad economic environment that results and their reliance on government funding. Certainly, government indebtedness will be higher in most, if not all countries, meaning healthcare budgets will be under greater pressure, potentially resulting in fee cuts or demand management.
In addition, should this crisis result in higher unemployment, US insurance coverage will be reduced and healthcare demand will be commensurately weaker.
In recent years, the sector has been priced for structural growth — this overlooked the economic sensitivity and exposure to government funding, which becomes problematic in times of stress.
This sector has traditionally suffered materially from occupancy issues during a heightened flu season, so COVID-19 will put operators under tremendous stress.
Balance sheets will be stressed if incoming residents numbers are reduced (which happens if centres are quarantined) compared to the amount of departing residents (higher mortality from COVID-19 in older cohorts according to World Health Organization reports).
This is due to the refundable accommodation deposit (RAD), which can result in high negative operating cash flow in the short term if the incoming/departing resident ratio becomes skewed. The most recent government support package was welcomed, but only equated to ~$460/bed or ~1% of staffing cost. Either more material support packages will need to come through or the sector will need to undertake equity raisings.
The media sector will be hit hard by advertising but should benefit from subscription services. Advertising is too easy a cost to cut for corporates not to use it as a profit and cash preservation lever. TV viewership will be up whilst radio and outdoor will be down as people lock down at home. But the bigger issue is what your advertising customers do: 30-40% declines feel like a reasonable starting assumption.
News (SMH, WSJ) and entertainment subscription services (Stan) will benefit.
Longer term the consolidation of the media sector will be accelerated by this pressure (either my mergers or players closing) but it still feels too early to be focusing on such potential positives given the operational gearing in traditional media.
Online marketplaces will be hit hard in the short term as housing, jobs and cars are all likely to see huge volume impacts. Jobs are likely to be first in and should be first out of the downturn, whilst houses and cars are likely to see a shallower trough but a slower recovery. All the Australian listed online players have strong balance sheets and high margins to eat into, but if the impact on activity spanned more than six months even they would be under balance sheet pressure.
The telco sector should be relatively unaffected. Demand for data will increase for home and mobile users. Corporate customers are also more likely to be increasing rather than cutting bandwidth.
This is unlikely to result in earnings upside, as we have already seen operators offer extra data and bill relief, but the downside is limited.
Other things to watch out for in the sector are lower overseas roaming revenues and lower wholesale pricing from the NBN (which will help buffer the telcos from higher data costs from the increased usage on home broadband). And what relief might telcos (especially Telstra) be asked to provide to customers who struggle to pay?
Airlines are the most affected companies in the market with huge capital bases and massive operating leverage. Difficult to forecast at the best of times, it is now a matter of estimating how long they can survive with operations on hold. Reactions so far to park planes, stand down staff and run down leave liabilities have been decisive and will give them the best chance to survive. On the other side of this crisis we will be talking about what fuel hedging was put in place at these low oil prices and how the competitive landscape might be changed by this event.
For now, we are just watching to see who can survive until travel is safe again.
Agriculture should be relatively resilient given demand for soft commodities is unlikely to be materially impacted. In this context we would prefer to be exposed via inputs rather than outputs given the outputs will be exposed to the normal seasonal volatility. That said, there are potential unforeseen risks around supply chains for both inputs and outputs, which create some uncertainty. Relatively speaking, this should be less than other sectors of the economy.
Packaging should be relatively resilient if exposed to consumer packaging. Any exposure to industrial packaging is likely to be more volatile given its greater exposure to industrial production and economic growth. In a perverse twist we would not be surprised to see some of the sustainability issues which have been prevalent over the last few years move into the background as the focus shifts squarely to cost.
Producers of staple proteins will act defensively in this period as overall demand remains constant. However, those with businesses that have a sizeable channel exposure to the restaurant sector may experience a short term earnings impact as the orderbook evaporates. Most of the larger players do have enough balance sheet flexibility to ride out this for 6 – 12 months.
How deep and how long are the relevant questions being asked within Nikko AM, as the past month has seen a dramatic turn in the global economy as COVID-19 has spread rapidly outside of China. Many Western governments have initiated restrictions on travel and social interactions that are unprecedented given most are countries on a deep recession trajectory.
Governments, central banks and other government agencies are working together to provide enormous levels of stimulus to stabilise and protect the economy, people and businesses while the shutdown is enacted, with the aim of slowing down and hopefully eradicating the transmission of COVID-19. The Australian stimulus now totals some A$189b or c10% of GDP, which we believe is required given unemployment may double from here.
The unprecedented speed of this correction and changing economic landscape due to government intervention is making assessment of sustainable valuation difficult. However, this provides opportunities within different sectors and stocks as the selloff has been often indiscriminate.
Like other large market corrections, it is always difficult to pick the bottom and thus rotating slowly into some of the beaten down value names funded by reducing and exiting the outperformers is an approach that we have found has worked well in these type of markets.
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Insightful commentary. Will be interested to see a bit more of how you think! PZ
great insight into the market sectors