Building a rock solid balance sheet

This piece was originally published in two Livewire pieces. Find them here and here.

Balance Sheet Strength – What is it and what to look for?

The great paradox of balance sheet strength is that businesses which have it, often don’t need it, whereas businesses that need it, often can’t get it.  

Obviously the strongest balance sheets are those with little or no net debt.  Better still, net cash. Think here Apple Inc (US$40b net cash) or in Australia, Technology One (A$84m net cash).  Businesses such as these with high ROIC and low capital needs can fund growth from internal sources without resorting to external debt.  Conversely, businesses with low ROIC and high capital intensity are often those with the weakest balance sheets.  Their returns on capital are insufficient to generate the free capital required to adequately fund their operations, hence the need to supplement with debt or new equity capital.

In assessing the balance sheet strength of any company, we like to focus on four key areas:

1. Serviceability.  Often expressed via leverage ratios such as net debt/EBITDA or net debt/equity.  The former is the more commonly used ratio although investors should always assess this ratio in the context of qualitative business factors such as revenue defensiveness, cyclicality and levels of recurring revenue.  The more defensive and recurring a company’s revenues, the higher the leverage ratio it can usually sustain and vice versa.  As a rule of thumb, a net debt/EBITDA ratio of less than 1.5x implies lower balance sheet risk.  A ratio of between 1.5-2.5x suggests some risk so be alert to funding crunches if circumstances change.  Lastly a ratio of greater than 2.5x indicates higher balance sheet risk such that debt levels should ideally be reduced. Some companies may point to undrawn debt facilities as evidence of balance sheet strength.  Be wary of this factor as a sign of balance sheet strength given, as we saw during the GFC, lenders can quickly pull such lines leaving companies in the lurch at the exact wrong point in cycle.
2. Stability.  This factor refers to the stability of the debt burden which can be impacted by foreign currency movements or changes in interest rate margins.  Borrowing money denominated in a different currency to that of the operating business is highly risky. Large unfavourable movements in exchange rates can cause debt to blowout.  A credit downgrading can also result in a material increase in the margin charged by lenders.  Look for evidence of hedging both FX and interest rate which can mitigate these risks.
3. Covenants and Tenor.  Lenders will place certain conditions on the debt (known as debt covenants).  For example, prescribed maximum debt/EBITDA ratios or debt/market capitalisation caps.  A breach of a covenant can trigger default requiring either early repayment, an increased interest margin levied or force a dilutive equity raising to correct the breach.  Each outcome will cause financial stress, sometimes resulting in permanent shareholder value destruction.  A company’s ability to service a debt repayment schedule is also important to assess (tenor of debt).  Obviously, longer dated repayment schedules and manageable debt amortisation rates will entail lower risk than short term borrowings and large bullet repayments.
4. Hard Asset Coverage. This factor attempts to assess the level of real or hard assets coverage for the debt (excluding intangible assets).  Lenders will often feel more comfortable lending to businesses that have substantial hard assets as opposed to those with high levels of unidentifiable intangibles (for example, large goodwill acquired via a rollup strategy).  For the same reason that it is cheaper and easier to borrow via a mortgage than an unsecured loan, a business with hard assets will provide lenders with more comfort during difficult times.

What stocks with Covid-19 headwinds are well positioned with balance sheet strength?

Using an analysis incorporating some of our four factors above there are two companies we would point to:

1. Auckland International Airport (AIA.ASX). In normal circumstances an airport, especially one with such a strong monopolistic position as AIA, would be considered very defensive and able to comfortably sustain an otherwise elevated level of debt.  Unfortunately, Covid-19 is not normal circumstances.  In the latest traffic update for April, AIA reported a 97% decline in traffic movements (in line with many other airports globally).  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 (NZ$8.5b of property, plant and equipment as at Dec 19).  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 (runways, terminals, etc), 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.
2. Reece (REH.ASX). Reece 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.  Since listing in 1954 and up until 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 (i.e. the maximum debt manageable) 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 (naturally hedged with Morsco USD earnings in addition to FX and interest rate hedging) 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 new construction such that directors thought it prudent to bolster the balance sheet with an A$800m equity raise early April.  With debt now halved and serviceability levels doubled, Reece is well placed to capitalise on the US opportunity, augmented by any opportunistic acquisitions of weakened competitors.

Author: Victor Gomes, Principal and Portfolio Manager