Understanding value during COVID-19

COVID-19 has had far reaching economic impacts across numerous industries. As we move through the first earnings season since the beginning of the pandemic, it is important for companies and investors to understand and assess the true impact it has had on earnings, and ultimately value.

In March companies were forced to react quickly to the implementation of lockdowns across Australia and the globe. Some businesses responded quickly, such as retailers closing stores and shifting sales online and breweries pivoting to produce hand sanitiser. Other industries have not fared so well with COVID-19 significantly impacting the business models of tourism and hospitality operators. Webjet and Flight Centre were forced to conduct deeply discounted capital raisings to survive. Virgin was not so lucky, collapsing into voluntary administration in April.

Impact on M&A transactions

COVID-19 is also causing issues on the M&A transaction front, with sellers unprepared and unaware of the impact it has on earnings and valuations. In a number of recent transactions, we are noticing a trend of savvy or unaware sellers presenting one-off items (such as JobKeeper and various payroll tax concessions) as part of normalised earnings, thus distorting value and leading to awkward price renegotiations during due diligence.

For the April and May period, c.3.5 million Australians were recipients of the JobKeeper subsidiary, with over 920,000 organisations approved to receive the payments.[1] In the June quarter alone, c.$50 billion of government subsidiaries flowed into business, predominately via JobKeeper and cash flow payments from the ATO.[2]

Reporting earnings distorted by COVID-19 impacts, both adverse and auspicious, makes it difficult for investors, potential acquirers and even business owners/shareholders to accurately assess value. Hugh Dive, Senior Portfolio Manager at Atlas Funds Management, notes cash flows from the government were a “significant” feature of the August results season, albeit one that was not highlighted by companies when presenting their results.[3]

Key items and trends impacting earnings

Government subsidies such as JobKeeper, cash flow boosts and payroll tax concessions

In a number of recent transactions, we have seen businesses receive these subsidies despite no drop off in revenue, inflating reported earnings. This is not isolated to transactions, with a number of companies materially benefitting from these subsidies including:

  • Adairs received $11.3 million in wage subsidies from JobKeeper and the New Zealand equivalent scheme during the program’s first three months and is on track to receive more over coming periods. After cancelling its interim dividend in March to preserve cash, it lifted its final dividend by 37.5% to $18.6 million.[4]
  • Furniture retailer, Nick Scali, received $3.9 million under JobKeeper and the New Zealand scheme and an additional $2.3 million rent relief from 85% of its landlords. Nick Scali increased its dividend by 12.5% to 22.5c and its share price hit a record high.[5]

Other cash flow benefits 

Cash flow benefits such as rent deferrals, staff pay reductions, postponed or cancelled capex and loan deferrals are also impacting earnings. Despite these short-term cash benefits, businesses may need to repay these deferrals in the future, further distorting earnings. Premier Investments has publically stated it will emerge from the coronavirus pandemic in stronger shape thanks to millions of dollars in wage subsidies, refusal to pay rents while stores were closed (and intention to not repay any deferred rent), and soaring online sales growth.[6]

Unsustainable short term demand spikes

Some industries will be forever changed by the pandemic, so it is important for investors and potential acquirers to understand the sustainability of any sales boosts during COVID-19. We have seen a shift in consumer spending to online with Kogan and JB Hi-Fi all experiencing a significant increase in sales through their online sales channel.

Material effect of lockdowns and reduced demand

Consideration needs to be made on how to assess underlying performance in industries materially impacted by COVID-19, with certain businesses including an EBITDAC metric (where C is for COVID-19).

Seasonality impacts

We are yet to see a full year impact of COVID-19, but industries heavily impacted by seasonality factors such as Christmas (e.g. retail, hospitality and tourism) may need to revise budgets. Additionally, in recent months there have been strong distortionary retail and automotive sales, driven by superannuation withdrawals, the stimulatory impact of JobKeeper and the inability of consumers to spend on overseas holidays.

Adverse supply chain impacts 

Due to lockdowns in overseas countries where manufacturing facilities are located, some supply chains have been adversely impacted. In some instances companies’ margins have been impacted as companies have been forced to pay for premium airfreight to offset production delays.

Transactions and valuation assessments are beginning to change

COVID-19 and the financial impact it is having may change the very nature of transactions and valuation assessments. We are beginning to see:

  • More earn-outs proposed by acquirers to protect against any lingering effects of COVID-19, whilst providing sellers with the opportunity to benefit from the ‘new normal’ if successful.
  • An increase in special situations and distress driven deals, with current market conditions providing significant opportunities to purchase distressed assets. However, acquirers need to develop a thorough understanding of the transaction risks and potential upside value (such as a turnaround plan) in order to benefit.
  • Less focus on historical business information, with increased focus on up to date and forward-looking information, including budget forecasts and order books.
  • Focus on understanding the ‘new normal’ for a company, including any shift in business and customer behaviour which could have a lasting impact on business (both positive and negative). Additionally, understanding if the nature of working capital changed for the business as a result of the pandemic.
  • Increased focus on the customer base of businesses and how at risk certain customers are in the industries most impacted by COVID-19.

Whether preparing a business for sale or assessing an acquisition, it is now more important than ever to understand underlying earnings. As COVID-19 continues to impact businesses, using metrics such as EBITDAC will assist quantifying its impact (positive or negative), whilst having a continual understanding of the true maintainable earnings of the business.

Businesses need to be careful including one-off government subsidies (for example) as part of normalised earnings as this may create a false sense that the business is in better financial health than it actually is. Continually assessing the ‘new normal’, and constantly updating budgets and forecasts is essential to understanding the true value and position of a business during such unprecedented times.

[1] https://treasury.gov.au/sites/default/files/2020-07/jobkeeper-review-executive-summary.pdf

[2] https://www.afr.com/policy/economy/the-surprise-good-news-behind-the-ugly-recession-numbers-20200902-p55rng

[3] https://www.afr.com/wealth/personal-finance/lessons-from-reporting-season-20200831-p55qze

[4] https://www.afr.com/politics/federal/jobkeeper-becomes-dividendkeeper-20200810-p55kc0

[5] https://www.afr.com/chanticleer/what-we-learnt-welcome-to-profit-season-s-brave-new-world-20200807-p55jj7

[6] https://www.afr.com/companies/retail/lew-s-premier-expects-record-profits-despite-covid-20200813-p55l8n