This week’s blog comes from EY’s UK&I Markets Leader, Lee Downham.
In this week’s blog, we’ll set out where we stand now, before exploring which parts of the economy could be most vulnerable to further operational, supply and demand-side shocks – both direct and indirect.
Whilst we hope the economic impact of the Covid-19 virus proves to be short, the early signs are it will be sharp, with wide ranging and unpredictable consequences. Our advice remains for companies to be clear in their purpose and to focus on reshaping their businesses to meet the challenge of increasing volatility – a persistent theme before this outbreak.
Where are we now?
Just over a month ago, I commented that 2020’s renewed capital market optimism wasn’t unqualified. Companies, markets and economies were contending with vulnerabilities that could create significant contrasts in fortunes, both between and within sectors.
In the last month, we’ve seen many of those vulnerabilities exposed and new fault lines emerge. The economic impact of Covid-19 virus has been characterised as a supply/demand shock, but its effects are much broader. It is fundamentally affecting companies’ ability to operate and plan. This isn’t like anything we’ve seen in the modern economic era, with borders closed and travel and activities restricted – and all on a global scale.
EY are tracking the impact of Covid-19 UK earnings through our continuing analysis of UK profit warnings. As of 13 March, we have recorded 24 confirmed profit warnings from UK quoted companies that cite Covid-19 – almost 90% of all profit warnings issued in the last three weeks. This only includes companies that have confirmed a material impact on their full-year earnings.
A similar number have issued what we’ve termed ‘holding statements’, because they are unable at this point to fully assess what is likely to be a significant impact on their full year results – in itself, a worrying signal.
Around 20% of UK profit warnings citing Covid-19 have come from the FTSE Travel & Leisure sector, which has been most exposed to travel restrictions and the consumer impact.
Initially a higher level of warnings came from industrial FTSE sectors. Assessing the impact of an initial supply chain disruption appears easier to quantify at an earlier stage than the more uncertain impact on consumer demand, where the picture may change dramatically depending on the spread of the virus and government action to limit travel and socialisation.
But, most of the warnings the last week have come from the consumer side of the economy and we expect the impact on earnings to escalate and number and profile of UK profit warnings to grow and change, as more consumer-facing companies quantify their earnings downgrades and we see further overspill into commodity and financial markets.
This is the crucial point we’re reaching now, where impacts begin to cascade and domino.
Mitigation and contagion
It is clear that the Treasury and the Bank of England want to present a united front to try and bolster business and consumer confidence by taking coordinated decisive action.”
Governments and central banks have moved to ameliorate and mitigate the economic impact of the virus through co-ordinated and extensive fiscal and monetary support. These measures should help companies by providing low-cost liquidity, lowering some business overheads and supporting demand in the wider economy.
Nevertheless, there are limits to the extent and reach of this support – especially in relation to deep supply and operational shocks, such as the complete closure of venues and borders. We are starting to see Covid-19 related ‘going concern’ risks, underlining the extensive support exposed businesses will need to trade through an extended crisis.
Moreover, significant market dislocations create domino effects. I don’t want to overplay the parallels. But what 2020 does have in common with 2008 is the speed and unpredictability of events and the potential for systemic contagion as market liquidity tightens.
The biggest contagion in evidence now is from the oil to debt markets. A global fall in demand has hit crude prices, which has exacerbated tensions in OPEC+, triggering a price war. Over 10% of the US high-yield debt market is linked into energy credits, according to The Financial Times, which has led to yields rising even further in debt markets that were already unnerved by the threat posed by Covid-19.
Right now, nobody can answer this question definitively. There are so many unknowns as we go to press in terms of how the virus will spread and how consumers, businesses, lenders and governments will react. Therefore, we think it helps to use this model to assess corporate resilience and work towards mitigation and planning.
What we’re assessing here is companies’ ability to operate and their revenue sensitivity against their ability to mitigate or absorb the financial impact of any demand/supply/operational shock. Covid-19 will disproportionally affect highly leveraged businesses and those with low cash-buffers without operational flexibility that are already facing tough trading conditions.
For instance, a manufacturer that relies on a vital component sourced from a quarantined area will have a high level of supply-chain vulnerability. But, if they can mitigate the impact by using alternative suppliers and have a significant cash balance, they could be in a strong position in the lower left quadrant.
Meanwhile, a peer, with a similar supply profile, but without the ability to flex its supply chain, will be more vulnerable to distress – especially if it is highly leveraged and lacks liquidity. They may well move into the ‘Risk Zone’ if disruption continues.
Where companies sit in these boxes could evolve very quickly as the impact of the virus increases. There is also a seasonal element to this picture. Airlines will feel even greater financial pain if travel is disrupted over the Easter peak. Moreover, as noted above, we are seeing the beginnings of a credit crunch.
The leveraged refinancing hump has been pushed out beyond 2021. But, as Bloomberg recently reported, hundreds of leveraged companies are due to refinance almost $100b of debt in the coming months. Even strong investment grade credits may find themselves facing liquidity issues, depending on their level of impact exposure.
Covid-19 has generated an exceptional list of challenges for most companies, encompassing supply, demand, operations, planning and liquidity, alongside high levels of uncertainty and an ongoing backdrop of existing volatility and weak demand. UK profit warnings were already running ahead of 2019’s exceptionally high numbers in January. EY ITEM Club previously expected historically low GDP growth of 1.2% in 2020, which has now been downgraded to 0.5%.
In helping companies to face this challenge, we have focused on a pragmatic approach based around four areas.
- Prioritising people safety and continuous engagement
Ensuring the safety and wellbeing of the employees in the workplace is essential. Where possible companies should be thinking about expanding flexible work arrangements and other policies that allow people to work remotely and safely. Companies also need to maintain dialogue across all stakeholders, including customers and suppliers.
- Focusing on business continuity
Most businesses will experience significant disruption to their supply chain and production commitments and shifts in demand. Companies need to put in place mechanisms to assess and monitor risks in their supply chain and adapt quickly.
- Focus on liquidity
Companies will need to look beyond their existing stress testing, given that the range of current scenarios are likely to be well beyond anything they have considered before. Boards will need to take a view on short and long-term risks and increase discipline and monitoring around cash. We are already seeing companies take radical action to preserve cash, including suspending dividends and postponing capital investment.The urgency to preserve cash increases as capital markets tighten – especially at the high-yield end, although the cost of capital is increasing for all. Companies should draw upon contingency funding and speak to lenders to extend facilities. But, they also need to be prepared for delays in accessing funding and for their usual avenues of capital to close. Boards should consider the attractiveness and long-term implications of any new and alternative forms of finance.
- Dynamic management
Companies need to think about the extent to which they reset their business to adapt to this new normal. There will a recovery and companies should be ready to adapt again to recalibrate and pick up revenues in the recovery.
- Prioritising people safety and continuous engagement
EY has a range of materials to help companies plan their response to COVID-19. You can find our dedicated website here – https://www.ey.com/en_gl/covid-19
EY’s budget analysis can be found here – https://www.ey.com/en_uk/news/2020/03/ey-item-club-budget-analysis
Edited by Kirsten Tompkins