Short-term earnings are irrelevant
The global events that have occurred at rapid pace over the past few weeks have led to unprecedented government policy action from major economies, including the US, UK, China and Australia among others, aiming to prevent a significant peak in COVID-19 cases and avoiding a situation where hospital systems are completely overrun and unable to treat all patients. These policies will leave many businesses across a diverse range of industries experiencing a significant reduction in revenue, or in some extreme cases no revenue at all, potentially for the next 2-6 months. We believe it will be completely irrelevant for investors to focus on a company’s short term (6 months) earnings profile, in our view the next 6 months will be about a company’s liquidity and solvency profile or to put it bluntly ‘the ability of the company to survive’.
Company specific variables to consider for survival
Demand for Products and/or Services
We are witnessing huge fluctuations in demand across certain categories. Since 2016 NAOS have compiled a newsletter called CEO Insights that is shared with our investment community on a weekly basis. The newsletter contains a selection of comments made by Company CEO’s, these comments are helpful in providing ourselves and our investor base with a reliable look-through into individual sectors and the overall economy. During the past week, there have been a significant number of company updates which have allowed us to gain important insights into the current impact of COVID-19.
Starting with the beneficiaries, the most obvious seem to be the sellers of consumer staples, in particular supermarkets. Brad Banducci, CEO of Woolworths, recently commented that they “have recorded more sales in the last week than we would in the week before Christmas.” There have also been other beneficiaries, with Telstra CEO Andy Penn noting that they have seen an increase in “demand being seen in the enterprise market for upgraded capacity and mobile broadband in the consumer and small business market.” The demand for streaming services such as Netflix has increased to the point where Netflix have agreed with the European Union to reduce streaming quality to preserve network capacity. The shift to a nation working from home has also benefited JB Hi-Fi who said that they have seen increased demand for “technology products that enable remote working, learning and communication, and essential home appliances for food storage and preparation.”
A further flow on effect comes from the implications of a lower Australian dollar. The Australian dollar recently traded below parity with the New Zealand dollar for the first time since it was floated. When global growth is strong and the Australian dollar is low, it has typically buoyed demand for tourism and education. Obviously, this time around that won’t be the case, but consider the possible competitive benefits for our largest export, being iron ore, which is priced in US dollars and has suddenly become much cheaper for offshore customers to buy.
Unfortunately, however, it appears the businesses negatively affected will far outweigh the beneficiaries. The most obvious initial impact is on the airlines and the travel industries with Alan Joyce, CEO of Qantas commenting that “this is the worst crisis the travel industry has ever gone through.” Regional Express have cancelled all passenger air services with demand expected to “nosedive to around 80% from the 60% we are experiencing today.” The impact has obviously also been felt across the wider tourism market. To put into context how unprecedented the current events are Chris Nassetta, CEO of Hilton Hotels commented “Hilton has been around 100 years. We’ve never closed a hotel that wasn’t going to be demolished or rebuilt. The bulk of our hotels in the major cities are closing as we speak”.
In the retail space, Russell Zimmerman, Executive Director of the Australian Retailers Association noted that “early reports were that revenue across the board was down 30% for March compared to last year”. Given that retailers survive on small margins, it could mean that rent is not paid on time, and as a result we expect to see landlords come under pressure. We have since seen most of the large shopping centre trusts withdraw their earnings guidance. We are also witnessing the first stages of capital expenditure being reduced with two examples of this being Sydney Airport (ASX: SYD) and oOh!media Limited (ASX: OML) both announcing their planned spend would be significantly reduced, along with a number of Real Estate Trusts (REITs).
Recurring Revenue Base and Potential Variability
Over the past 12-18 months we have noticed a significant increase in the number of companies reporting ‘annual recurring’ revenue. The bulk of this has stemmed from newly created companies offering their products on Software as a Service (SaaS) business models, where their clients are charged a subscription fee. An example of this change has been the accounting software space, where Xero Limited (ASX: XRO) offers their accounting service entirely online, meaning easier integration with your accountant and easier compliance with any changes to taxation laws.
Following this significant shift in the revenue model, most of the industry now operates in this way, and we have seen numerous examples of companies adjusting their business model to a subscription-style offering. Not only does this benefit the customer, but also the company as they now have a more predictable revenue stream and they can become more fully integrated with their clients, who are then even more reluctant to switch providers. Pro Medicus Limited (ASX: PME) is another example of a company offering a very sticky subscription-style revenue stream. PME provide a tool for radiologists to view scanned images remotely with extremely high levels of quality. The contract with the hospital usually stipulates a minimum percentage of the total amount of scans each year to be viewed using their technology. The sales cycle is long, but if a client wanted to leave, the switching costs would be very high, and the company estimates the process would take close to two years. This business model should provide investors with a high degree of certainty relating to future revenue streams.
With the increasing popularity of ‘annual recurring’ revenue as a reporting metric comes a possible muddying of the waters in relation to the revenue which can be considered long- term recurring revenue, and the revenue that can easily disappear. It is in economic environments like the one we are currently experiencing that we find out how recurring the revenue really is. Another example of a company who offers a recurring revenue service to business customers is Nearmap Limited (ASX: NEA). Nearmap provides geo-spatial mapping solutions for their customers via images that can be viewed over the internet with a high degree of accuracy. In our view, a small business customer is much more likely to cancel this service than they would their accounting software, and hence what looked like a recurring annual fee, could turn out to be a significant fall in revenue.
Fixed Cost Leverage
Fixed cost leverage can be a benefit to a company on the upside, however it can equally be a cause for concern on the downside. Today, companies in industries facing challenges can simply not shed cost quickly enough. The notion of ‘getting very small very quick’ is all about survival. The profit margin reduction that is experienced on a slowing top line and a fixed cost base can be drastic.
The rapid changes in economic conditions are such that the reductions in revenues are occurring at such a rapid pace that many fixed cost businesses will simply not be able to adjust accordingly to the new landscape and losses will occur very quickly. The make-up of a cost base will vary drastically from industry to industry, however those with a high percentage of staff costs are likely to have a higher degree of flexibility in terms of ability to reduce the cost base quickly, as are those companies which have a significant portion of their cost base geared towards growth initiatives as these initiatives can be quickly wound back.
All companies are likely to have a degree of costs which are fixed regardless of circumstances – rent, utilities, insurance, audit, utilities, etc, but those companies that can scale their cost base up and down with growth are going to stand a better chance of survival.
Balance Sheet Flexibility
A sound balance sheet has always been a core pillar of the NAOS investment process. Never has it been so important to judge a business on the cold hard facts of their balance sheet. In our view it will become binary, many companies will not survive this period, whilst companies that do survive will be those with enough existing liquidity and reserves to simply outlast the unknown duration of these unique circumstances and capitalise upon the opportunities on the other side.
When considering which existing balance sheets might survive this crisis, the following available pockets of liquidity to draw upon will be key:
- Cash – is king, it is times like these when we are most reminded of this. The more the better.
- Drawn Debt – whilst banks are likely to be lenient on covenants for a period, this cannot last forever. Given the already low interest rate environment, many companies were already highly geared. With many industries now seeing a significant/entire loss of revenue, the ability to service existing debt has become significantly more difficult. Debt levels have become an amplified problem without an immediate solution as equity markets generally are not yet willing to fund emergency capital raisings. Keep in mind that at their February 1H FY20 presentation, Webjet Limited (ASX: WEB) described their borrowings levels as conservative.
- Lease Obligations – whilst we would hope that landlords are providing flexibility, lease obligations will be one of the cash outflows that are hardest to structurally or cyclically reduce.
- Undrawn Debt – having a (relatively) substantial amount of incremental debt headroom available under existing facilities will be crucial for many companies going forward. Mindful of the above mentioned comments on drawn debt, any liquidity can be good liquidity. Obtaining a new debt facility and/or raising equity will be a lot more challenging, if not impossible until market conditions begin to improve.
- Assets – hard assets such as plant, property & equipment, possibly even account receivables, will become a valuable source of survival. If/when the banks are considering funding again, they will be looking for the highest quality security; hard assets. Furthermore, hard assets may end up being a valuable source of capital if they are sold, even at depressed prices, to ensure business survival. Event Hospitality and Entertainment (ASX: EVT) is an example of a company with a high-quality property portfolio, including some of the most premium land in Sydney’s CBD. This likely provides a level of flexibility to the company and its lenders.
- Dividends – the reduction/cancellation in dividends is already being seen across the market. As an example, Flight Centre Travel Group Limited (ASX: FLT) have cancelled their interim $40m dividend, a responsible move given the revenue reduction they are facing. Whilst shareholders lose out in the short term, it is a responsible and effective measure to protect cash balances. If the company can survive, the long- term benefit of not paying an interim or final dividend is multitudes greater.
We cannot say when a recovery will occur, but we do believe that a recovery will eventuate at some time in the future. Our focus at NAOS will always be on the stock specific opportunities that are presenting themselves to us at any given time.
To highlight an example of the movements we have seen within our portfolio, Enero Group Limited (ASX: EGG) has seen its share price fall by approximately 60% from its CY20 high. NAOS sold a circa 10% stake in the company just 6 months ago to several larger institutional investors. The business now has a market capitalisation of just $74 million or an enterprise value of just $60 million taking into account their net cash position of $14 million. This is a business that generated free cash flow after all capital requirements of $8.20 million for 1H FY20, which equates to a free cash flow yield of circa 25% on an annualised basis. Even if the revenue base was to fall by 50% and EBITDA margins from 16% to 10%, then the EV/EBITDA ratio would still only be around 4 times. Clearly public relations spend will be reduced significantly in the short-term, but in our view, B2B PR will remain and Enero has a client base that includes some of the largest technology businesses in the world, such as Facebook and Adobe. As such, we believe it may soon be an ideal time for us to start to acquire some of the shares we sold at much higher levels.
There are many examples similar to Enero both within and outside of our portfolios. To try and remain rational in such extraordinary times I believe it is important to keep a simple and relevant framework. Investors must ask themselves that if a company’s share price is down by anywhere between 25%-60% does this represent a fair reflection of the long-term value of that business? For share prices to remain at such levels over the long term either the earnings of the business would need to fall permanently by 25-60%, or the valuation multiple would need to fall by the same amount. As I mentioned earlier, no one knows how the earnings of a business will rise or fall over the short to medium term. Regarding valuations, it is somewhat easier to take a view, we believe interest rates will remain at record lows for the foreseeable future, which in theory should be positive for equity valuations over the long- term. If the wider market can start to see a base in a company’s earnings profile, there is potential for a significant re-rate based on valuation differentials, especially for high quality and self-funding businesses.
The NAOS Asset Management team and I will continue to communicate on the developments we are seeing within the current portfolios as well as the actions we are taking to ensure we are ideally positioned for a post COVID-19 world.
NAOS directors, staff, family and friends are amongst the largest investors within the three LICs and will remain aligned with all shareholders.
This is an extract from our letter to investors. View the letter in full
A webinar will be held on the 8th of April at 11:00 am (AEST), all are welcome to join as we provide a brief presentation and Q&A session. The event details and registration can be found on our website.
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Sebastian Evans is the Managing Director and Chief Investment Officer of NAOS Asset Management Limited. Sebastian is the major shareholder of Naos and has worked in the firm for over 13 years. Sebastian has a Bachelors Degree in Commerce Majoring...