Should you Expect Credit Events by Corporate Australia?

“Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” – Sir John Templeton

At the backdrop of ‘evolving risks’ to the global economy, the credit rating agencies are paying close attention to the underlying debt of the industries that are hit hard by the repercussions of the coronavirus outbreak.

It is important to note that credit rating agencies were at the heart of the Global Financial Crisis in 2008, thereby it might be the case that rating agencies are monitoring the situation closely this time in an effort to prevent reputational damages.

But it has already started in Australia…

Late in February, S&P Global Ratings had downgraded the outlook for Australian airline business – Virgin Australia Holdings Limited (ASX:VAH).

In a research note, S&P credit analysts note that a confluence of adversities like Covid-19, softer economic season and a prolonged bushfire season. They expect debt-to-EBITDA of the business to exceed 6x for the period ending 30 June 2020.

While the ratings were maintained at B+ and B for long-term issuer profile and issue rating on company debt respectively, its outlook was downgraded to negative from stable. Analysts note that the downgraded outlook reflects the challenging industry conditions, which are likely to impact firm’s earnings propensity.

In its results release for the first-half, the Company expects to take a hit between $50-75 million in the second half, owing to coronavirus disruptions.

And, the spillovers could be far reaching...

An outbreak like coronavirus, which is hitting the real economy in the first place, could result in material adversities in the event of extended stalled economic activities. The level of uncertainties posed by the outbreak is at a paramount level – it is making the world panic at large, such that, supermarkets are rationing the supply of necessities.

Other than demand-side damages, the supply chain shocks in an extremely globalised world, like we have today, could prove to be detrimental for global companies. China has been a manufacturing hub for global companies, and it has been a major supplier of goods – be it a toy, wine bottles, apparels, rare earth elements, magnesium, natural graphite etc.

If Chinese supply were to be curtailed across a range of goods, it is likely that a widespread cost-pull inflation could follow, thus, raising further concerns for central bankers that are trying to improve liquidity by lowering interest rates in the face of a pandemic.

It is, indeed, highly favourable for the whole world that China returns back to work as a stalled Chinese economy means productivity loss, supply chain disruptions, and consequently, lower earnings by workers – thus a lower household demand in China.

However, the outbreak in China has been stabilising and the government has urged the citizens to return back to work, but the shortage of workers remains a concern.

At the same time, the rest of the world has started to face circumstances similar to China, including mass infections and a rapidly spreading disease. Should the economic activity be stalled in other jurisdictions, the repercussions point to weaker economic growth in many countries, and consequently, a weaker global economic growth.

Including, hotels, entertainment & gaming…

As tourists are cancelling travel plans, the brunt would be felt faced by businesses in the hotel, entertainment and gaming industry as well. Australia’s climate makes it an attractive place for travelling as when most of part of the world experiences winter, the Australian beaches are filled with tourist to soak heat.

However, the damage to businesses could be limited to smaller ones as such businesses are exposed to a greater risk of stress due to relatively less-diverse revenue streams. Cinema businesses are also exposed to the risk of lower revenues as panic amongst the citizens is likely to weigh on entertainment habits.

Luxury/high-end retailers…

When tourism is booming in a country, it provides a fair level of tailwinds to luxury retailers. Since tourism has taken a hit in the place, the consequences for the luxury retailers could be damaging.

Retailers have been running under stress across the globe, owing to increased competition from online channels, thereby suppressing margins as retailers try to match the level of prices offered by discount-online retailers.

Domestically, the rising wage bills across the retail sector, coupled with slow wage growth, depleting consumer confidence, and changes in consumer preferences – has led to many retailers closing business, bankruptcies, administration etc.

And, the present coronavirus situation has added more woes to the luxury/high-end retailers, who are more exposed to the spending by tourists.

And discretionary spending.

Australian consumer confidence has been sluggish, and after interest rate cuts and personal tax cuts – it had started to show signs of pick-up. However, the coronavirus outbreak has resulted in panic amongst the households, which is likely to delay spending decisions on discretionary goods.

Therefore, a pick-up in the discretionary spending should be pushed out further as the consumers are increasingly getting worried about staples and necessities for the time being, which may mean that potential discretionary spend could be delayed.

Small business lenders to feel the rage!

Assuming that the coronavirus repercussions are muted by the start of Q2 (i.e. April), the damages could be limited to companies that are operating small businesses as such business models are less resilient in generating sustainable cash flows.

However,

If coronavirus repercussions were to continue into Q2, the material damages could be felt by the medium and large businesses. It also depends upon the business of the company as the China-dependent businesses are likely to face more damaging consequences on cashflows.

Triggering a credit event would require a business to default on its debt. Therefore, the companies with debt maturities in the near-term and potential adversities to the cashflows of such businesses should be looked carefully.

Poor financial results due to revenue loss are likely to alter debt covenants, bank loan covenant for business across the board, especially for small businesses, which are generally funded by bank loan facilities and growing new-age lenders.

A fiscal response in this space c0ould be need of the hour when the signs are more visible in the broader economy, just like the government’ $2 billion Australian Business Securitisation Fund (ABSF) that was established in April 2019 for SME sector. China being the epicentre of the coronavirus has already taken fiscal measures such as subsidies, rent reduction, taxation in a bid to restore confidence and stimulate the economy.

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