There’s one concerning new risk that’s been introduced in response to the COVID-19 lockdowns that’s not been fully appreciated, Sebastian Evans, Chief Investment Officer at NAOS Asset Management told investors.
For as long as anyone can recall, businesses have operated under a simple assumption; if you provide goods or services, you should expect to be paid. If you're not, debt recovery actions can be pursued. But last month, the government issued a ‘temporary relief package’, which casts a cloud of doubt around this.
“It puts businesses in a bit more of a bind. Clearly, they want the best for their customers, but at the same time, they want their cash flow to run their own business,” said Evans.
This wire summarises some of the key topics covered by NAOS in their recent webinar, including a review of some of the beneficiaries and victims of the COVID-19 lockdowns, how societal trends could change for the long term, and some high-quality companies that have been impacted by the crisis.
Four key areas of impact
When understanding the impacts of COVID-19 on businesses, Evans broke down the impacts into four key areas – some more obvious than others.
Revenue reduction – this one is fairly easy to understand; if a business has no revenues, it’s going to have a hard time. Some businesses and industries will be hit hard on this front.
Cost structures – this is “a big one” according to Evans. For businesses with high levels of fixed costs (e.g. retail) the pain could be quite severe. Those with high levels of variable costs though could do better in shutdown. He cites the example of Experience Co (EXP), which despite having no revenues at the moment as all its business is shut down, should be able to massively reduce their cost base as most of their pilots and staff are casual, and grounded planes don’t need fuelling.
Long term demand – some long-term thematics may be disrupted by this crisis, while new ones may replace them. Many businesses are now asking themselves whether they really need all that expensive city office space and whether they could instead utilise Zoom for maintaining contact between employees. The big question is whether long-term consumer trends will be affected. Will people save more, spend less, and carry less debt? Will they take as many holidays? These remain unknown and will do for some time yet.
Funding – businesses will fund themselves through four main methods through this period. First, will be to draw on cash reserves – easiest and most preferable, for those that have the option. Second, many businesses have undrawn lines of credit that they can fall back on in times of need. The third option is to raise equity, which we’ve seen a lot of in recent weeks, with Cochlear, Oil Search, and QBE (among others) all undertaking raisings. If support from capital markets fail, the next option will be recapitalisation of businesses, potentially wiping out existing shareholders. Finally, if all four of these methods fail, insolvency will result.
While most of the focus has been on those businesses that have been badly affected, some have actually seen an uptick in demand for their services. This has been particularly obvious in the communications sector as businesses increasingly move towards working from home. No doubt for some, this change will be lasting. Robert Miller, Portfolio Manager, discussed three beneficiaries from the NAOS portfolio.
MNF Group (MNF) – MNF provides the underlying technology that allows online voice communication to work. Their customers include Microsoft, Google, Cisco, and China Mobile. They’ve reported an 80% increase in network usage in recent times, causing them to double the size of their network (again). “What would normally take 12 months, they're trying to do it in three weeks,” Evans said.
BSA Limited (BSA) – BSA is a beneficiary of the rollout and maintenance of the NBN. With employees increasingly working from home, suburban internet services are under high demand at the moment. That means more stress on the networks, and likely more maintenance as a result. With a net cash balance sheet and a workforce made up primarily of subcontractors, they’re well-positioned to weather any storms that do come their way.
Over the Wire (OTW) – OTW is a ‘one-stop-shop’ for IT and telco services, offering Data, Voice, Hosting, and security and IT support. With many companies brining forward spending in this area to allow working from home, they’re a clear beneficiary. Importantly, most of their revenue is recurring.
While communications businesses have held up well, some have not been so lucky. Tourism, lending, and marketing have all been hurt badly, as Miller outlines here.
Consolidated Operations Group (COG) – COG provides equipment finance for SMEs, or at least, they did. COG have ceased writing SME loans, which Miller says is “probably a good move in the market given there's likely to be delinquencies.” With the loan book now in runoff mode, they should receive $20 million of cash over the next two to three years. Their broking business continues to operate, and is reportedly seeing an uptick in enquiries.
Enero Group (EGG) – Marketing and PR services are a big cost for many businesses, and one that’s often seen as discretionary in times of crisis. However, Enero Group does have a strong, net cash balance sheet. Their customers are large multi-nationals like Aldi, Facebook, and Adobe. Additionally, their cost base is variable, allowing them to scale back in line with revenues.
People Infrastructure (PPE) – PPE provides workforce management services to hospitality, healthcare, IT businesses. Some of the businesses they service will have reduced hiring needs moving forward, while others, such as healthcare, may hold up well.
Experience Co (EXP) – It should come as no surprise that the company formerly known as Skydive The Beach has been suffering with tourism shut down. The company has expanded its business in recent years (hence the name change), but all its operations are in the travel and tourism business. While their businesses are facing a complete shutdown for an extended period, they have ample liquidity in the form of cash and undrawn debt to survive. They also have a highly variable cost base, allowing them to massively cut back on expenses while revenues are absent.
High quality businesses under fire
When markets sell off hard, everything gets hit, regardless of quality. Portfolio Manager, Ben Rundle, has been looking at some of these companies.
Fund managers – Pendal (PDL), Macquarie (MQG), and Magellan (MFG) have all seen share prices fall by between 35 and 40% in March. The base management fees these managers charge are recurring but based on funds under management. With FUM falling by double-digit percentages due to falling asset prices, these businesses could see revenues fall. Anecdotally, Rundle says funds are yet to see significant outflows. If this starts to pick up, particularly when combined with people accessing their superannuation, it could create a second wave of selling pressure.
Software providers – Many software companies are Software as a service (SAAS) businesses with ‘recurring’ revenue models. However, they’re yet to provide their models in a recession. “In times like these, we'll see how recurring their revenue is”, Rundle said. One of Australia’s biggest software companies, REA, could be seriously affected if listing volumes drop.
REITs – The impact on REITs should come as no surprise, given the high ownership of shopping centres and offices. The retail sector has been particularly hard hit, with many tenants having ceased trading with no intent (or ability) to pay rent during the closure period. Banks have so far stated their intention to allow the deferral of interest and principal, but the question then becomes; what is the longer-term impact on the landlord? Shopping Centres Australia’s (SCA) portfolio is underpinned by supermarkets, which have been among the better performers, but the share price is still off 25% as the rest of their tenants will likely suffer.
Education – IDP Education (IEL) is one that Rundle identifies as “a fantastic example of a quality business.” IDP handle English language testing for students entering Australia. With universities and even borders closed, demand for their services has evaporated. The company raised $225m from institutional investors two weeks ago, with a share purchase plan for retail investors to come.
Healthcare – private hospitals seem like the ultimate safe-haven asset, but even Ramsay Health Care (RHC) has suffered under the COVID-19 restrictions, which have resulted in the cancellation of elective surgeries. Many hospitals are half empty as beds have been cleared for COVID-19 patients, but have not been required. Pacific Smiles Group (PSQ) has seen its stock price down 40% as dental procedures have been put on hold.
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Thanks for posting your article Patrick I've been reading your work since February this year. Keep up the great work. Cheers
Thanks Jimmy, appreciate the support.