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How to spot a company in financial distress – part 3

Emma Rapaport  |  17 Apr 2020Text size  Decrease  Increase  |  
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The coronavirus has created an economic emergency. Stocks have fallen into a bear market; central banks across the world have taken unprecedented steps to maintain market efficiency; and companies are cutting staff.

Despite the heightened uncertainty and grim short-term outlook, Morningstar analysts view the broad sell-off as overstated and expect the pandemic to have minimal long-term implications on most companies’ outer-year earnings.

Admittedly though, companies must be strong enough and properly prepared to weather a near-term storm. And that means having cash in the bank, says Morningstar director of equity research Adam Fleck.

"Next to economic moats, cash reigns supreme when cash flows and liquidity dry up and balance sheet strength becomes key in determining the state in which companies might come out the other end," Fleck says.


How to spot a company in financial distress – part 1

How to spot a company in financial distress – part 2

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Investors may want to take advantage of the market sell-off, but how can they isolate those companies best equipped to ride out the uncertainty?

We’ve compiled a list of stocks the analysts believe have “fortress balance sheets”—a term coined by JPMorgan Chase boss Jamie Dimon. Specifically, analysts provided stocks from their respective sectors that have sturdy financial foundations—balance sheets that can withstand financial shocks—and that are undervalued according to our metrics.

Analysts also gave an assessment of balance sheet strength for every undervalued name under coverage. "Strong" indicates little risk, "Weak" points to elevated liquidity concerns, while "High Risk" suggests a stretched balance sheet and flags our estimated probability of an equity raising, or worse, of greater than 25 per cent.

Morningstar Premium subscribers can access the full list here.

10 undervalued stocks with fortress balance sheets

10 stocks

Star and moat ratings as at 17 April 2020. Balance sheet health analysis as at 7 April 2020. Source: Morningstar Australia and New Zealand Best Stock Ideas April 2020

Let's take a closer look at three stocks on the list, one from each of the three categories—Strong, Weak and High Risk—and the assessment of Morningstar analysts. 

Strong: Crown Resorts CWN

While we are maintaining our fair value estimates for all three casino companies under our coverage, the coronavirus-induced situation is changing by the day. It culminated in the federal government's latest decision to shut down most nonessential public venues, including casinos, from March 23. Immediate earnings impact is dire, as evaporating revenue is compounded by large fixed cost structures which take time to rationalise. Attempts to dimension the financial hit are futile, given the uncertainty on how long it will take for COVID-19 to be contained and when normality may subsequently return.

Amidst this chaos, adjusting our near-term earnings for the three casino companies is akin to nailing Jell-O to a tree. Our immediate focus is on balance sheet. Crown's (CWN) net debt/trailing normalised EBITDA is 0.5, likely enough to weather the current storm and help Crown realise our fair value estimate longer term. Elimination of near-term dividends and a complete halt to all nonessential operating and capital expenditures will be necessary. Management of all three companies are frantically devising these measures and more announcements are likely. Survival in the near-term is now the first and foremost concern.

Crown Resorts ended December 2019 with gross debt of $872 million and available cash of $501 million, resulting in net debt of $371 million. This equates to net debt/trailing 12 month normalised EBITDA of 0.5, It had committed underdrawn bank facilities of $201 million as at the end of December 2019 but over half of it matures in fiscal 2020 and the rest in fiscal 2021. The next maturity is not until fiscal 2026. On our estimates, Crown would have to suffer an EBITDA loss of close to $300 million in the second half of fiscal 2020 (versus $383 million in positive earnings a year ago) for fiscal 2020 net/debt/EBITDA to reach the 5.0 covenant limit.

- Brian Han, senior equity analyst (24 March 2020)

Weak: Qantas Airways QAN

The near-term outlook for Qantas (QAN) is bleak, and we expect negative operating leverage to result in an aftertax loss of $86 million in fiscal 2020. The firm is effectively grounding 150 aircraft and virtually all of its wide-body fleet. Qantas is halting the majority of domestic capacity and suspending practically all international flights until at least the end of May 2020. On a full-year basis, we estimate a capacity reduction of 26 per cent in fiscal 2020 across the airline. However, we anticipate this stifled demand will prove short-lived. We continue to forecast a U-shaped impact on demand from COVID-19, similar to the impact experienced during SARS in 2002, and expect a return to capacity growth from fiscal 2021.

We continue to expect Qantas' balance sheet to weather the storm. Qantas' debt book has no covenants, and we do not expect the firm will be forced to raise equity despite the significant drop in near-term earnings. The firm has around $1.9 billion in cash and another AUD 1 billion in undrawn debt facilities, which we expect to be utilised.

The airline is focused on preserving cash, cutting expenditure where possible. The majority of staff will be stood down through May 2020, with employees taking leave with or without pay depending on their available entitlements. Executive management and the board will take no pay for the remainder of fiscal 2020, joining measures already undertaken by the CEO and chairman. Although we anticipate the bulk of capital expenditure earmarked for fiscal 2020 has already been spent, the firm intends to delay other nonessential and nonoperational capital expenditure, such as airport lounges and new aircraft payments. The firm has already cancelled its $150 million buyback and is now delaying paying of $201 million in first-half dividends until September 1 2020.

- Gareth James, senior equity analyst (20 March 2020)

High risk: Myer Holdings MYR

We have cut our fair value estimate on no-moat Myer (MYR) and raised our uncertainty rating to very high from high. Our fair value hinges on our expectation that Myer remains solvent, viable, and avoids a dilutionary equity raising. There are various moving parts, but we expect a sustainable solution to a severe drop in sales and profits largely depends on successful negotiations between Myer, its banking syndicate, and its landlords. We contend, both the banks, but perhaps more so the landlords, would prefer Myer to remain in business than collapse. The wage piece of the puzzle has been falling into place with the Australian government’s $130 billion JobKeeper package, which we expect to essentially underwrite Myer’s wage bill for the next six months.

Myer’s balance sheet has been at the top of its shareholders minds, even before the current economic crisis. Absolute gearing levels, measured as debt/equity, are relatively low. At January 2020, Myer was in a net cash position but has been operating close to one of its debt covenants, the fixed charges cover ratio, or FCCR.

Before the crisis escalated in March 2020, many of Myer’s operating metrics were improving, including a widening of the gap to its FCCR covenant. Then came the recent slump in consumer confidence and foot traffic to malls, followed by the temporary shutdown of the entire Myer store network from March 30, 2020. These developments have prompted us to slash our near-term earnings estimates. For the nine months to the end of calendar year 2020, we expect an annualised decline in sales of 40 per cent versus our previous estimates.

In fiscal 2020, we cut our EPS forecast by 20 per cent to AUD 3 cents, and we now expect Myer to report an underlying loss of 9 cents per share in fiscal 2021—down from an estimated profit of 5 cents per share previously. From fiscal 2022 we forecast earnings to gradually recover to previrus levels in line with the overall Australian economy.

Under the circumstances described base case, we estimate Myer would breach its FCCR covenant in fiscal 2021. We anticipate Myer either refinances its debts on amended terms or received waivers from the lenders prior to a looking breach. Another option is for the landlords to reduce rents enough for Myer to meet its FCCR covenant. Rental expenses lower the dominator of the ratio, and the landlords could decide to reduce rents and take a short-term hit to maintain a large tenant with a profitable underlying business model for the years to come after the current economic downturn.

We already factor into our base case an average rent reduction of 20 per cent over the next three years. But if landlords were to cut rents by a further $63 million, equating to a total rent reduction of about 60 per cent in fiscal 2021, we estimate the FCCR should meet the debt covenant that year. Another, but no uncertain possibility to meet our base case is the government stepping in with a rescue package for commercial tenants.

Other scenarios are plausible and can't be discounted by us through. These include: (1) a dilutive equity issuance, raising $200 million at 10 cents per share would reduce our valuation; (2) corporate activity, significant shareholder, Premier Investments, has a relatively strong balance sheet. Premier could make a successful bid for Myer below our fair value estimate (3) Myer is unable to refinance its debt maturing in February 2021 or raise enough equity to meet its obligations and enters administration. On March 30, 2020, Myer advised there were no immediate risks to its covenants.

- Johannes Faul, director of equity research (2 April 2020) 

Prem Icon Access Morningstar's latest Best Stock Ideas list, together with an assessment of each company's balance sheet risk here.


is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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