Investing in companies that will emerge stronger after COVID-19
By Thomas Chua on The Capital
Since COVID-19 caused countries to go into shutdown, we have seen the conversation amongst investors shift abruptly from a company’s growth prospects to “How long can they survive without revenue coming in?”
Many businesses have closed amidst this crisis. At the height of the pessimism during March 2020, many investors were shocked to discover the high cash burn-rate of many F&B companies. With no revenue, many restaurants and entertainment companies had to furlough, retrench employees in an attempt to preserve cash. Cash flow is the lifeblood of any company, and this crisis has placed many companies on the verge of going into insolvency.
We have no certainty as to when this pandemic will end, and predicting the end of the outbreak is beyond our control. That being said, investors looking to invest in industries caught directly in this crisis would have to ask this important question: are they able to raise capital?
How much can the company borrow? — Debt to EBITDA ratio
We can use the Debt to EBITDA ratio to estimate how much capital a company can raise. EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It is an estimate of the amount of cash inflow from business operations that the company could use to repay debt.
For simplicity purposes, a Debt to EBITDA ratio of 3 tells us that it would take 3 years for the company to repay its debt. Naturally, the lower the ratio, the better it is.
Generally, an investment-grade company would have a Debt to EBITDA ratio below 3. A ratio between 4 to 5 represents an elevated risk for rating agencies and creditors. Anything above 5 indicates significant financial difficulties and the strong likelihood that the company will be unable to borrow additional funds.
Debt to EBITDARisk Level< 3Low Risk3 to 5Elevated Risk> 5Unlikely to be able to borrow further Debt to EBITA and Corresponding Risk Level
A company with a Debt to EBITDA ratio of 1, could easily double or triple the amount of debt by borrowing from the capital markets before it will hit the threshold of 3. Compared to a company with a ratio of 5, they are unlikely to be able to raise debt to tie through this crisis.
Using Starbucks (SBUX) as an example, the 5 years average EBITDA is approximately $5.8 billion. With its long-term debt at $11.1 billion, it gives SBUX a comfortable ratio of 1.9. Given this, SBUX could likely borrow an additional $6.3 billion before it hits the Debt to EBITDA ratio of 3.
Note: To adopt a more conservative approach, we could use Earnings before Interest, Tax, Depreciation, Amortization, and Rent (EBITDAR) if the company has lease agreements in place. Likewise, we will add the total operating lease to the debt figures as the company still have to pay for its rent during the shutdown. However, given today’s unique circumstances, we have seen many restaurants such as The Cheesecake Factory getting away with paying rent.
SBUX has also iterated in their latest conference call on 28 Apr 2020 that they remain committed to a leverage cap of 3 times rent-adjusted EBITDA.
How much more interest expense can they bear? — Interest Coverage Ratio
We would also need to look at the Interest Coverage Ratio. This measures the company’s ability to meet its interest obligations. A ratio for 8 indicates that the company is able to meet its interest payments 8 times over.
For this, we refer to the guidance provided by the rating agencies. Generally, anything above 3.5 would be considered safe. And anything below 1.5 would be considered extremely risky.
A company with an interest coverage ratio of 20 times would have greater capacity to incur interest expense. Compared to a company with a ratio of 1.5, creditors would be very concerned about their ability to pay their interest obligations.
Continuing with the SBUX example, on average they made $4 billion in operating profits per year and incurred $300 million of interest expense in 2019. Giving them a cushy interest coverage ratio of 13.3x.
This means that they are able to pay their interest expense 13.3 times over, putting them in a comfortable position to raise additional capital.
Also, SBUX would be able to bear an additional interest expense of $200 million before their interest coverage ratio drop to 8x (which is still super cushy). Even if SBUX were to raise debt at 5%, it is able to borrow up to $4 billion dollars ($200 million divided by 5%).
At the height of the uncertainty, CEO Kevin Johnson stated that SBUX has a strong balance sheet. If required, the company has the ability to borrow an additional $3 billion very quickly. This is on top of the $2.5 billion in cash SBUX has in its bank. Thus, allaying fears that the company may face insolvency issues due to the shutdown.
In determining a company’s ability to raise capital, we will need to examine the debt to EBITDA ratio and the interest coverage ratio together. This will give us a rough idea of how much the company can borrow and at what interest rates.
Is the capital raised sufficient?
Lastly, we will need to determine if the capital raised is sufficient to last the company through this difficult moment. Sometimes the company will provide the burn-rate (e.g. how much cash each store burns per month) during earnings call and from there we can have a rough idea.
Otherwise, we can simply estimate the amount of cash required for the business to stay afloat. In this estimation, we can assume that the company will cut all non-essential expenses such as marketing, expansion plans, etc. The cost of goods sold will be reduced significantly due to the shutdown. We will also not include non-cash expenses such as depreciation, amortization, and stock-based compensation.
In the case of SBUX, the company has stated that it is burning $125 million of cash per week. The company expects the burn rate to decline as they open more stores from next week onwards. Given their capital of up to $6 billion, they are able to survive for 44 months, or 3.7 years in the worst-case scenario.
This puts SBUX in a comfortable position to go through this crisis. In fact, it will likely come out stronger as the company has the strength to expand into prime locations as weaker F&B establishment collapse during this crisis.
The company has also seen increasing traction in customers becoming Starbucks members and adopting digital payments. Customers who are members are more likely to be returning customers, as they enjoy the reward program Starbucks offer.
During the shutdown, 90-day active Starbucks Rewards members, increased to 19.4 million in the US, up 15% from a year ago. The membership card value has seen an increase from $1.2 billion to $1.4 billion. Effectively, the customers are providing a free loan to Starbucks.
To sum it up, COVID-19 is a black swan event and since then, many companies have raised capital by either borrowing or issuing shares. And as shareholders, we are the lowest in the pecking order when it comes to capital protection. To avoid severe dilution or total capital loss, I would prefer companies with a strong balance sheet, and the capability to raise cash in the debt market at favorable rates if necessary.
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