How to prepare for a flood of capital raisings
With much of the global economy effectively shutting down over the next few months, many - or even most - companies are going to need an infusion of cash. Already investors are applying their own version of social distancing, keeping well away from stocks that are going to need the most.
The worst part is that this can become a self-fulfilling prophecy. At its January high of $14.44, Webjet had a market capitalisation of about $2bn, so the $250m it's apparently hunting for would have meant dilution of about 15%. At a likely steep discount to the last traded $3.76, though, a capital raising now might mean handing over half the company to the new equity.
• Many companies will need capital
• Watch out for debt covenants
• Think now about your cash levels
The people who have the cash get to call the shots; they will have many capital raisings to choose from, so they can afford to be greedy with the terms.
So how can you tell if a company is safe? And how can you tell how much fresh capital it might need?
The first step is to make a conservative estimate of how much revenue a company is going to make over the next year. For Woolworths you might fairly reckon it'll be about the same as last year; but for retailers or those in the travel or entertainment business, it's probably worth assuming zero revenue to begin with.
Now check the company's running costs. These should be broken out on the profit and loss account, but they might be split into several categories. We're looking for any cash costs that come between a company's gross profit and its profit before tax. Exclude depreciation and amortisation since these aren't cash costs.
From this basic figure, you might make some adjustments to strip out variable costs which the company might not have to pay if it doesn't earn any revenue. Many companies will be able to trim their wage bill by eliminating bonuses, but redundancies will involve significant one-off costs.
Some will also be able to reduce marketing (particularly if they have little hope of earning any revenue). Research and development expenditure could also be trimmed in extreme circumstances, but this should be considered a last resort; the companies that do best on the other side of this will be the ones that can keep investing in their products. Most companies would be better off raising capital rather than cutting off investment in future products.
A big problem here for many companies - notably retailers - is their rent bill. Some may be able to get out of their leases, or get some relief from landlords, but it's probably best to start by assuming that all the rent remains.
You'll probably need to add a bit to the interest bill, since the net debt position will be worse than last year.
Setting all this against the expected revenue will move many companies in the most exposed industries into a loss, in which case there will be no tax to pay for this year. However, companies will typically be paying tax quarterly or monthly based on last year's profit, so without relief there may also be some additional tax to pay.
There are a number of additional drains on cash, though, starting with capital expenditure. This is the line on the cash flow statement called 'Purchase of property, plant and equipment'. Technically speaking this is discretionary spending. But as with the servicing on your car, there's only so much you can delay without the whole thing falling apart - even if the machines aren't running. Think about the nature of a company's business and its growth plans, and estimate how much of the capital expenditure is necessary - assuming something similar to the depreciation charge might be a reasonable estimate for most companies, since this is the charge for annual wear and tear.
For technology companies, in particular, you should also look at the 'Purchase of intangible assets' in the cash flow statement, to see what technology costs are being capitalised. Look at the note referenced on the cash flow statement and find the 'additions' to 'capitalised development'. Again, most companies would be better off raising capital than cutting back too much on this.
Adding up the running costs and the capital expenditure (including any capitalised development costs) - and deducting any revenue a company might still receive - should give you a figure for how much cash the company will need for expenses over the next 12 months.
The other major drag on cash for many companies is working capital. This comprises the short-term assets and liabilities a company needs to keep running, and it has three main components - inventory, receivables and payables. Inventory is the stuff on the shelves waiting to be sold, receivables are the payments you're due but have not yet received and payables are the bills you've incurred but not yet paid.
The crisis has hit so suddenly that few companies will have had much opportunity to run down their inventory, so we'll assume that remains.
What will disappear for many companies are the receivables and payables - at least those related to sales. The main component of these will be 'trade receivables' and 'trade payables, but may also include things like GST. If a company doesn't split it out, then it's best to assume that all payables are 'trade payables' and, if sales wind down, will have to be paid and not replaced.
The problems occur when the trade payables exceed the trade receivables, so that a sudden sharp reduction of sales will suck in cash. This 'negative working capital' position is often the case with businesses that have large companies as suppliers and consumers as customers, such as the many retail, travel and entertainment businesses currently at risk of lengthy shut-downs due to coronavirus. Ironically, it's especially the case with the most efficiently run companies, which would have been considered high quality as they gushed cash while they expanded.
At 31 December, for example, Lovisa had receivables of $7.1m and payables of $22.5m, leaving a gap of $15.4m that it will need to find from somewhere. JB Hi-Fi had receivables of $387m and 'trade and other payables' of $1,025m. Flight Centre and Webjet, which were both suspended earlier in the week, had gaps of $683m and $178m respectively.
You can find a list of stocks in the ASX 200 with payables greater than receivables at the bottom of the article.
The next step is to work out what all this will mean for overall indebtedness.
The numbers for this are also on the balance sheet. You need to pull out cash and short-term investments from the current assets at the top, and then short-term and long-term borrowings from further down (under current and non-current liabilities respectively).
The only short-term investments you should be interested in are those that can be turned quickly into cash to repay debt. So term deposits and money-market instruments are probably fine, but it's probably wise to knock a bit off any listed equity investments in case they need to be sold in a hurry.
The borrowings are split between those due within one year (the current, or short-term) and those due after a year (non-current or long-term). While the short-term borrowings are the more immediate concern, the long-term debt affects a company's ability to raise further capital and can turn quickly into current debt if covenants are breached (see below).
With this in mind, a company's net debt figure is its total borrowings less net cash (and perhaps liquid investments depending on how generous you feel).
Onto this net debt figure, you can add any working capital gap and your operational and capital expenditure requirements for the year. If that's negative - as it's likely to be for most companies at the moment - then fresh capital will likely be needed.
The first port of call may be an 'unused line of credit' or, 'available headroom in a borrowing facility', but these come with conditions attached, known as covenants. Companies tend to be tight-lipped about the precise details, but covenants will typically specify that the overall net debt and/or interest bill must stay below certain levels of profits, cash flow, or even market capitalisation. So just when you need the money most - when profits dry up and your share price is tumbling - a line of credit can disappear.
So, in the first instance most companies will need to raise enough new capital to cover their operating and essential capital expenditures over the next 12 months, plus any working capital gap. If covenants are breached on existing debt, though, then bankers are likely to take the opportunity to force companies to raise further equity to increase their comfort levels.
In the absence of profits and cash flow bankers will be looking elsewhere for comfort. That means assets, and preferably high-quality property assets. So companies with these might be allowed more leeway.
After estimating how much fresh capital a company will need, the next step is to compare it to the market value, subject to a suitable discount to encourage investors to prefer the opportunity to the many others available. So, if you think a company will need $500m and that it will need to raise it at a 50% discount to its current market value of $1bn, then it will need to offer one new share for every share currently on issue - a 'one-for-one' capital raising. If you think the discount might only be 25%, then it would be a 'two-for-three'.
If you want to avoid dilution, then you will need to participate (if you're permitted to by the terms of the raising). So the final step in your preparation is to run down all the stocks in your portfolio and work out how much new equity they will need - and how much cash you'll need to participate.
James Carlisle is an analyst at Intelligent Investor. To access more ASX share research, start a 15-day free trial.