With bearish sentiment growing in the stock market, shifting to an intelligent defensive position is paramount in order to prepare for the next uptick. In many respects, equities should be a good buy: earnings multiples are low, gearing is low, interest rates are not especially high. The market is pricing in some significant weakness, and, of course, a two speed economy. The market is probably right. The question is: where is the market likely to be wrong? One way to determine that is to look at cash flows, which a Macquarie report has done. It shows that profit margins are quite weak, and that cash flows are slipping. The heavily indebted household sector is creaking and demand is weakening accordingly.
The aggregate gearing level for corporate Australia is at multi-year lows. This “comfort‟ level, however, masks the emerging pressures on debt coverage ratios due to weak cashflow generation for a select group of stocks. Even though many of these have low levels of debt, this may well still prove to be excessive, such is the current weakness in cashflows for some stocks.
The operating environment, particularly in domestic Australia, is deteriorating, with the Industrial sector (Market ex res, banks & LPTs) now forecasting the fourth consecutive year of -ve EPSg in FY11. Our analysis shows much of that slippage is due to weak EBITDA margins (indeed, for domestic stocks, EBITDA margins are forecast to contract). In turn, cashflows are also slipping.
While a strong EPSg recovery is forecast in FY12, this will be difficult to achieve unless the current tough operating environment changes materially.
Growth is at best sluggish; the RBA is maintaining a tightening bias; the consumer is experiencing large increases in “nondiscretionary” costs; companies are seeing rising costs across a broad spectrum; and the AUD appreciation is impacting export competitiveness.
In this environment, cashflows for some are under pressure. Critical will be where debt coverage (gross and/or net debt/EBITDA & interest cover) ratios fall to the point where action such as further capital raisings are required, thus diluting EPS (for many) again, leading to lower returns for shareholders.
Stocks already with poor debt coverage ratios resulting from cyclically weak cashflows and/or significant debt maturities due within 12 months include:
BSL, OST, ALZ, FXJ, SXL, SWM, NUF, LEI, QAN, TPI, AIO and ALL.
In many respects cash flow is a more reliable historical analytic than predictions of earnings growth or balance sheet metrics. This Macquarie analysis is a bit of a red flag. Australian corporates have weathered the GFC reasonably well (as did non-finance corporate America). But the suspicion is that this has delayed the effect — there will be a long period of weakness rather than a sudden collapse. American big corporates have got around the problem by globalising. They are bypassing America’s rapidly disappearing middle class. Australian corporates, with a few exceptions, are completely at sea in the globalisation race. The management skills and experience simply do not exist. They are confined to the domestic market and this Macquarie analysis suggests a long period of weakness, especially if housing continues to decline.