For corporates, the next phase of the COVID-19 challenge is beginning. After a conversation dominated by the tragic human cost of the pandemic and, from a business perspective, liquidity and survival, the focus is shifting to how companies will come out of the crisis.
Will there be a “new normal” with respect to capital structure? And what’s the optimal way to manage both the challenges and opportunities presented by the post-lockdown world? At Standard Chartered, we’ve developed a framework to help corporates reassess their capital allocation.
Focus on the long term
First, we must start with the end in mind, meaning any new capital allocation structure needs to focus on the longer-term strategic objectives of the business. Yet with uncertainties remaining regarding the economic recovery, as well as concern about a second wave of the pandemic, financial agility remains paramount.
Second, getting to where any corporate needs to be will require an assessment of where they are now. Specifically, how has the sector evolved since the previous crisis and, indeed, since before the 2007-08 financial collapse? And are these changes sustainable?
To help answer these questions, we analysed capital allocation and indebtedness trends across large corporates1 over the past 15 years, and observed two key trends:
- For a variety of sectors, the relationship between shareholders and corporates – with respect to how returns are achieved and valued – has changed.
- Investor attitudes towards corporate debt levels have also evolved and now support an increase in leverage across the board.
Understand that both sector and stakeholder expectations have changed
With respect to shareholder returns, the sector differences are stark. They also clearly reflect how the market perceives – or is beginning to perceive – changes in the overall structure of some of these industries. For instance, Oil & Gas had the second-best average dividend returns over the past 15 years, after Utilities. Yet it suffers on a total-return basis due to the past decade’s underlying volatility and the emergence of environmental concerns.
Meanwhile, other sectors have been able to rely on steadily increasing stock market valuations to provide investor returns. Least surprisingly in this respect is the Tech sector, although the Non-Food Retail and the Fast-Moving Consumer Goods (FMCG – or “consumer products”) sectors also show strong value. Tech – as well as Aerospace & Defence and Hotel & Leisure – has offered incremental shareholder value via share buybacks.
15-year average shareholder return by sector2
Taking all three attributes together, FMCG comes out on top over the 15-year period. Meanwhile, Oil & Gas, Utilities and some other more established sectors remain reliant on cash dividends to maintain investor loyalty.
Why is this important for the capital structure? Because, in each case, the investor base has some clear expectations that will permeate the thinking of any corporate treasurer when allocating capital – particularly when it comes to debt.
Rising debt levels
Despite a widespread expectation that corporate debt levels would decline after the global financial crisis, they rose across all sectors. Average debt-to-EBITDA ratios of the S&P 1200 – the largest global companies – increased from 1.9x over a 15-year average, to 2.0x over a 10-year average and a 2.3x average for 2019.
While the rise is inexorable, it is not a uniform picture, with some sectors seeing a disproportionately larger increase than others (see below).
Highest average Net Debt to EBITDA increase (2004-2009 vs. 2014-2019 periods)
It is possible to conclude, therefore, that indebtedness has been increasing without any significant backlash from investors. And while there may be other factors underlying this tolerance, such as the low interest rate environment, it still marks a significant shift in investor attitudes.
Optimal capital allocation
What does this mean as we emerge from lockdown?
As the focus shifts from being reactive to the crisis to being more proactive – and even opportunistic – what should an optimal capital allocation structure look like for the medium and long term?
For most sectors, reinforcing balance sheet headroom, even if it is done to create a war-chest for potential M&A, will be critical and we see three possible routes to achieving this.
Route one involves “self-help” solutions. The second involves generating a more efficient use of capital. Route three requires a wholesale rethink of the long-term capital structure.
“Self-help” centres upon factors within direct control of the company – such as cost optimisation and reducing capital expenditure. This means protecting margins while postponing investment in future income streams. Added to this may be an increased emphasis on disposals, which means selling non-core assets to raise capital and pay down debt. Indeed, many Oil & Gas corporates have managed to reduce (or not increase) their debt levels by doing exactly this, although arguably this also forms part of a conscious effort to “right-size” the asset base to boost productivity.
The capital efficiencies route, meanwhile, relies on making the existing capital structure work more effectively, particularly with respect to working capital. Leaders in the FMCG sector, for instance, have been quick to embrace supply chain finance and other innovative mechanisms that enhance income flows and generate working capital efficiencies. Digitisation of transaction banking has helped improve cash flow forecasting. And while many see this as a chance to reduce debt, the more ambitious can utilise the enhanced cashflow to invest in top-line growth.
The third route involves the most change for a corporate and is often viewed as the last option. It involves a fundamental rethink of underlying indebtedness, including a bottom-up assessment of long-term liquidity needs, as well as the potential impact on their sector of regulatory, economic and societal changes. The assessment should include a detailed and informed analysis of working capital requirements, revenues, acquisitions, and disposals – all targeted to generate the preferred capital structure.
Such a review may point to a fundamentally higher indebtedness, though one adopted as part of a proactive growth strategy. It should certainly mean the removal of any legacy or emotionally driven target ratios that may now act less as a prudent benchmark and more as an albatross around the neck of a corporate treasurer.
A tailored approach in a recovering world
While the current pandemic is a once-in-a-generation event, it provides a clear measure of the required downside headroom for each industry. Of course, this may be a too-restrictive buffer on an ongoing basis. Yet for benchmarking purposes, it is worth revisiting pre-crisis policy with respect to working capital requirements for weathering such a storm.
Secondly, it is important to review how debt levels could impact the credit story of the business. Of course, credit rating agencies have a role here, although the story is usually more complex – as illustrated by the deteriorating credit quality of the S&P 500 without the expected adverse impact on borrowing costs3. Critical, here, will be a company’s long-term objectives, particularly with respect to growth – and its expectations regarding funding such growth.
Finally, we think it beneficial to widen the lens to assess situations with a similar underlying story. For example, do corporates in sectors such as Tech or Life Sciences – that have a higher portion of intrinsic value in future growth – retain higher levels of cash to allow greater balance sheet flexibility, or leverage-up to grow rapidly?
The above represents just part of the analysis companies should embark upon as we emerge from the crisis. It also shows that, far from there being one “new normal”, there are many – often highly dependent on the sector, but also on geography, and where the company sits on the lifecycle.
Given this, do you feel your capital structure and balance sheet is fit for the future?
1, 2 Based on an analysis of all corporates in S&P 1200 index above a market cap of US$10bn (~700 corporates) at year end 2019, excluding real estate and FIs