A collaboration with Sextant Consulting analysing how companies can leverage retained earnings to stimulate growth post COVID-19. Here we consider a post COVID-19 environment and investigate which industries may be more susceptible to consolidation through the use of retained earnings, consider sustainable growth rates in the future and raise some key considerations for executives
Survival of the Strongest
Our previous paper investigated how much time cash reserves will buy you on average across sectors – essentially how a pre-existing cash war chest would help companies to handle the pain of the COVID-19 driven downturn. We modelled a few sensitivity scenarios indicating how OPEX reductions could assist in flattening the curve of cash burn rates, through a fast response on cost levers, before you have too many corporates on life support.
The previous article considered sector ability to handle pain and survive. This second article looks at sector ability potential to manage gain and to bounce forward. Results have been represented in averages per sector, summarised across 1 000+ major enterprises on key stock exchanges globally.
In looking at sectors most poised to gain (on average) we looked at two dimensions:
First, the likelihood of M&A activity through the use of retained earnings; and second,
Maintaining ongoing prosperity (continuing to achieve historic growth rates) by looking at sustainable growth rates.
Consideration of these factors was predicated on companies not going to the market to raise capital or debt to fund organic growth or acquisitions; and not seeking working capital funding to supplement cashflows to maintain previous / historic growth rates. First, regarding propensity for M&A, how could retained earnings help the strong overcome the weak, in the colloquial Darwinian sense?
Our Methodology
We decided to keep things relatively simple:
We ran two scenarios using the last publicly filed financial results:
What would the impact to Enterprise Value (EV) be of a decline of 25% in EBITDA and a corresponding 25% decline in the EBITDA multiple;
What would the EV impact be of a more severe decline of 50% in EBITDA and a 50% decline in the EBITDA multiple (essentially these two scenarios respectively represent the loss of one quarter of profits versus two quarters – depending on your optimism of how long the pandemic lasts)
We assessed which corporates could afford to acquire 51% (controlling) stakes in others in the same sector, by utilising 50% of their retained earnings. In other words, what buying power they had in theory by tapping into just half of their retained earnings (and not using debt or scrip)
We did this on an individual company basis and then rolled it up to industry groupings, so as to retain granularity at an individual entity (and avoid using blanket multiple values), while still gaining a global industry perspective.
Our Findings
This is what we observed from our modelling:
Median enterprise value drops by 42% and 74% under the two scenarios described. While no one can predict how quickly or dramatically TSRs may jump back post COVID (thus affecting EV), these drops are nonetheless startling (as depicted directly below)
The top five industries with the largest retained earnings which could be used to invest in future growth (organic or via acquisition) are Automotive, Natural Resources, Advertising & Media, Aerospace & Defence and Agriculture.
In contrast the five industries with the least retained earnings are Marine, Software, Commercial Cleaning & Suppliers, Construction and Diversified Consumer Services
Under Scenario 1, the industries most likely to experience acquisitions are Agriculture (14 listed companies in theory could be targeted), Chemicals (14), Natural Resources (13), Food and Industrial & Electronic Equipment
Under Scenario 2, the industries in the top five most likely to experience acquisitions are the same, but their ranking differs: Chemicals (22 companies in theory could be targeted), Agriculture (18), Natural Resources (16), Industrial & Electronic Equipment and Food (as in the figure opposite)
Unsurprisingly, some industries are more defensive in nature with much lower threats and opportunities for acquisitive behaviours, including Utilities, Telecommunication, Airlines and Marine Shipping. As an aside, US Airlines are on the nose for performance and investment (note Warren Buffet heading to the emergency exit on his investments[i]. Additionally, it is interesting to see US airlines requiring bailout support when they have followed aggressive share buybacks over the past decade and basically denuded their reserves. (“The biggest U.S. airlines spent 96% of free cash flow last decade on buying back their own shares.” [ii]
We also looked at the extent of pre-existing industry fragmentation (or consolidation) by applying the Pareto rule i.e. number of companies generating 80% of industry EBITDA; and we then highlighted (see figure below) two types of industries: (a) those with “natural” consolidation characteristics (i.e. with a significant number of companies at the ‘big end’ and also having a large number of potential relative-minnows at the other end, for acquisition); and (b) the strong vs. weak (i.e. already largely-consolidated industries but still with a reasonable number of acquisition potentials).
We don’t want to read too deeply into industry potential for acquisition activity: we are using averages; there are cross-border issues; the industry groups cover a range of subsectors that may not fit well together into rollups. Rather, please view this quick-and-dirty analysis as an encouragement to do a similar assessment (with retained earnings capacity being just one of several lenses) in your sectors and geographies, including of course unlisted companies.
Our first scenarios were about the prospects of M&A activity fuelled by retained earnings. Our second assessment looked at the sustainable growth rate ratio (essentially the rate at which EBITDA would need to be reinvested into the business to support growth, without adding further debt). While there are variants on the formula, we used the formula and definition provided by Investopedia[i] where SGR “is the maximum rate of growth that a company or social enterprise can sustain without having to finance growth with additional equity or debt”iii.
Put differently, it is the amount you could plough back into working capital to maintain historic performance; or use for further investment (as a retention) if a company does not distribute it. It is an important ratio to consider, given we may be in a capital constrained environment, for a least a while, where borrowings or capital raisings are not viable options. Arguably anything around or above a 10% SGR should be considered a strong result; but we found some unexpected results in the top 6 (see the diagram below), especially in Airlines, Freight and Logistics, and Consumer Goods & Services.
While a few of these sectors may be somewhat COVID-proofed (e.g. Defence, Medical, Health & Pharma), there were some other outliers which appear to have an unusually high dividend payout ratio in the latest period (more one-off returns of cash to shareholders) which influences the SGR ratio (e.g. Natural Resources). Here, we have to admit that there are a number of ‘outliers’ that we simply haven’t had time to unpack and do a deep dive on, company by company. There are, for example, a few big outliers in the airlines group; but some industries are being skewed by special dividends or bumper profit years which is causing this to appear as unsustainable growth (e.g. Resources) which we certainly do not believe is the case. Nonetheless, in the spirit of transparency, we are putting this out there to invite comments and suggestions as to why others think we are seeing this dynamic.
What to ask yourself
So, as a CEO, CFO or Board member, what are the front-of-mind questions you should be asking yourself?
Regarding cash flow and free cash flow (‘economic profit’):
Have you modelled cashflow scenarios showing relationships between the following four (4) variables:
Time – acting early vs later (best to worst case); revenue reduction (as we have explored); cost reduction measure (touched on this); and leverage – accessing loans (incl. as part of the government stimulus)
Do you know your sustainable growth ratio and what levels of organic growth / reinvestment you can likely support?
Do you have an informed and defendable view about your retained earnings policy? How much is this driven by a real and robust understanding about how much money you need to keep back for internal investment and external opportunities (and some unforeseen risks, presumably not quite of the COVID magnitude); versus how much is ‘safely’ left over afterwards for dividends? (see airline commentary above as a salutary lesson)
Regarding M&A and divestment opportunities (business portfolio adjustments):
Have you thoroughly assessed what types of acquisitions will make most sense – so you have a plan and deliberateness, rather than simply opportunistically tackling the infirm and weak?
What changes can you make to your portfolio to right size it, exit marginal or non-core businesses or ‘distractions’ and free up capital?
On bigger, longer-term strategic questions:
Once you have taken immediate steps to address revenue and OPEX pressures, what is the next phase of planning to returning to the “new normal”? What actions and decisions can you make now to begin to set the business up for success in future?
Do you have a roadmap for future resilience? What industry-structural, supply chain, culture and technology issues, has this pandemic highlighted within your business which need to be carefully reconsidered?
In conclusion
There’s nothing companies can do to make up for the lack of retained earnings going into this crisis, but using only that as a yardstick, there are promising signs in a number of sectors for companies which will be able to bounce forward once this is over: through acquisitions (inorganic growth) and / or higher reinvestment (organic) rates back into their business, without affecting indebtedness and gearing ratios.
We know this is an incredibly challenging time for all companies: large and small. We don’t wish to make light of the challenge. So, while this analysis is a broad-brush sweep across sectors, we are quite willingly to get more granular and specific. Company specific comparisons and using recent management reporting data, will provide far deeper insights. If you are interested in discussing this or would like a sounding board to discuss some of the questions raised, please contact us via email at Rhett@valueconsultingpartners.com.au and Dean at sextant_consult@optusnet.com.au
Comments