Beware The Negative Spiral

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

While the world is fretting about a potential double dip recession in the US and loss of momentum in Europe even before austerity measures are kicking in, it should be clear to everyone the Australian economy will be battling its own little rough patch in the months ahead. Apart from an anticipated impact on government budgets and RBA interest rate policies, a significant loss in economic momentum also has the nasty habit of putting extra pressure on companies whose balance sheet is weak and vulnerable. This increases the risk for a nasty negative spiral, one that has in the past seen the likes of Clive Peeters disappearing from the stock market, while others such as Hastie Group ((HST)) survived, but at a significant loss for shareholders who where unaware or waited too long to exit.

In recent times investors have once again received multiple warnings that recessionary trading circumstances outside the mining and energy sectors can and will bring out worst case scenarios when profit growth remains absent and debt covenants come under threat for being breached. But it's not that companies who operate under more buoyant trading conditions are by default immune from such dangers. For example, infrastructure and mining services provider AJ Lucas ((AJL)) asked the ASX in late May for a temporary suspension of its shares while the company was negotiating a solution for its debt problems. At the time, it was estimated the suspension would only last up to six weeks. After six weeks, on the first of July, the board issued a statement it was investigating a significant capital raising, which would dilute shareholders in significant fashion.

It has been silent since, and we are now 12 weeks after the initial suspension and there is no sign of any such capital raising. Usually what happens under such circumstance is the bad news simply gets worse as staff grows ever so worried, suppliers are asking for extra guarantees and shorter payment arrangements (if not upfront), while fees from lending arrangements increase further and the company loses out on potential new contracts and revenues. In other words: things are only getting worse while no solution is being announced.

No wonder thus, analysts at JP Morgan declared on Monday the chances for the announced capital raising actually taking place are becoming more remote by the day and investors should brace themselves for asset sales instead. AJ Lucas is the largest supplier of drilling services to Australia's coal and coal seam gas industries as well as one of Australia's largest builders of long distance gas pipelines so there won't be a shortage of interested parties for the company's assets, but similar as to what happened with the recapitalisation of Hastie Group last year, investors who still own shares in the company must by now be really worried about what will remain of their original investment post the upcoming "solution", which to date remains the subject of market speculation and far from a certainty.

In the meantime, the ghost of Hastie Group is haunting shareholders in AJ Lucas. Hastie shares reached as high as $4.90 in December 2007. They had sunk as low as $1.00 when a recapitalisation had become unavoidable. Today the shares are one of many penny dreadfuls in the Australian share market with the price of the shares ranging in between 12c-16c. It's probably a fair assumption those shareholders who remained loyal throughout the company's battle for survival have now all but given up on regaining what went lost during the process of keeping Hastie out of the corporate graveyard.

Another company in need of more positive momentum is Nomad Building Solutions ((NOD)). Last month the company announced a renewal of its bank facilities with lender Westpac until late August 2012 but investors clearly remain uncomfortable with ongoing prospects for a negative spiral. The share price, which in late 2007 traded above $3 and which bounced back to above $1 in the post-March 2009 rally, now remains stuck around 10c. Major shareholder Citigroup has sold down its stake and RBS, one of few stockbrokers still covering the company recently abandoned ship, implicitly questioning whether Nomad can still be considered investment grade.

In their final report, RBS analysts stated: "We believe the order book has declined further over the last six months and is well below the run rate required to return to profitability. Earnings visibility remains very limited." The broker's final rating was Sell in combination with a 10c price target.

Last week, the $900m write down by major steel manufacturer BlueScope ((BSL)) attracted many headlines and post-the-event analysis. Two observations stand out, in my view. One is that without a substantial financial compensation from the federal government ahead of the proposed carbon tax the steel maker was considering going a lot further than closing down one blast furnace and sacking an estimated 600 workers. Two is that a final solution is far from reached at BlueScope. Market dynamics can still get worse and while debt covenants appear to be safe right now, there is a real and present danger this may not remain the case in the year ahead.

This easily explains why BlueScope's share price continues to weaken, from $2.20 in late February this year to below 90c this week. Talk to any stockbroker and they will tell you the underlying assets inside the company are probably worth about twice today's share price, but nobody wants to go near BlueScope until more certainty becomes visible about when the company might turn profitable again.

Another company that is currently operating in between a rock and a hard place is Macquarie Group ((MQG)). Not that Macquarie is under similar threat as the companies mentioned above, but similar to BlueScope, Macquarie's share price is now well below the price stockbroking analysts believe would be achieved by selling all individual assets on the open market place. This makes Macquarie vulnerable for corporate predators, in particular because market speculation has it staff shareholders may well accept a reasonable offer given the steep decline in the share price over the past two years or so.

It seems but a faint memory today, but only a few years ago Macquarie shares seemed destined to become Australia's first $100 stock. The shares rallied to $57.40 in the post-March 2009 rally but have since derated significantly to $23-something. Most stockbrokers would have predicted $26-27 would be the absolute bottom as that's where their calculated Net Asset Value (NAV) lies. Alas, for Macquarie, equity markets worldwide don't seem conducive for IPOs and/or capital raisings. Mergers and acquisitions have slowed down significantly as well.

Macquarie does have a few options available to rapidly improve market sentiment. The most obvious one is to reduce staff numbers. Macquarie's operational leverage to staff reductions remains amongst the highest in the share market. On UBS's calculations, for every 1% the company reduces its total staff compensation to revenue ratio (from 50%) this adds an estimated $77m to the group's pretax profit and 6% to earnings per share. Right now the market is anticipating no EPS growth for Macquarie in the year until March 2012. There's wideheld belief that if the board shows it does care about shareholders' interests, the shares will be pushed higher in response. But for a talent driven organisation as is Macquarie, it is a tough decision to make.

Note that the board's expansion strategy in North-America appears to have been ill-timed and some staff reductions over there seem but logical. But even in Australia, market rumour has it the group has been quietly directing unspecified staff numbers out the door.

The board at Macquarie does have additional options available. Market speculation has it MQG's 22% stake in Macquarie Airports ((MAP)) will be put up for sale once MAp's special dividend has been received later this year. In addition, Macquarie still owns shares in listed infrastructure trusts including DUET Group ((DUE)) and Macquarie Atlas Road ((MQA)). Investors might want to check their portfolio on any Macquarie ownerships because these shares are likely to trade at a discount for the time being, even without Macquarie pulling the trigger.

Macquarie shares are seen offering an unusually high dividend yield of close to 8% (unfranked), but analysts at UBS suggested this week investors better not take any dividends for granted this year. This because the exceptionally low share price makes it far more attractive for Macquarie to use available funds for a share buyback than redistribution in the forms of unfranked dividends, argues UBS. Just as to where the Macquarie share price would be without the current harsh discount remains anyone's guess, but none of the stockbrokers in the FNArena universe has a price target lower than $30.

Another company struggling with too much debt is international project consultant Coffey ((COF)). At last week's results presentation, company management acknowledged this matter had their full attention, which is a positive, but Coffey management also refused to rule out any capital raisings, which could be a big minus for the short to medium term. Coffey shares have fallen from above $1 in March to around 50c this week. As the consensus price target sits at 60c this suggests significant upside potential, but a sudden capital raising can change all that with one simple announcement to the ASX.

Investors should also keep a close watch on Southern Cross Media ((SXL)) and on The Reject Shop ((TRS)) where further deterioration in operations can easily trigger the attention of their respective lenders. Media analysts at Citi recently reviewed the sector and concluded there are more candidates among media companies whose debt covenants might come under threat if, as is now anticipated, revenues will remain under negative pressure throughout FY12. Apart from Southern Cross Media, Citi believes APN News & Media ((APN)), Fairfax ((FXJ)) and Ten Network ((TEN)) should be considered "in danger" too.

In general, current global anxiety has more to do with governments running into problems because of debt, and not so much about companies which are today in a far healthier state than back in 2007-2008. Many an analyst has made the extra effort recently by reiterating the general observation that banks and REITs in Australia today are far less vulnerable to any credit or funding shocks than was the case throughout GFC Part I. While this is undoubtedly the case, this does not remove the fact that certain companies are in danger of a perpetually negative spiral. Even if corporate survival is not always at stake, the news might still turn out negative for existing shareholders. The above list is almost guaranteed to be incomplete.

(This story was originally written on Monday, 15th August, 2011. It was sent in the form of an email to subscribers on the day).

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