Turnaround and restructuring: The health of SA companies

Fresh off a report on the health of the restructuring, rescue and turnaround profession, Deloitte recently released a report looking at the health of some of the biggest companies in South Africa as it relates to the likelihood that they will face financial distress in the future.

We have seen some of the country’s biggest companies being placed into business rescue following their distress. Further, we have seen the problems that State-Owned Enterprises are currently facing. What can we expect in terms of rescues going forward?

The DSI
The Deloitte Stability Index (DSI) measures the extent to which a company is financially stable based on a granular model that converts leading indicators into a composite score.

The Deloitte Stability Index tracks six leading indicators:

Trading/Operational Triggers

• Trading performance: Change in Revenue over time;
• Debt Management: ability to manage debt over time;

Balance sheet Distress Triggers

• Share price volatility: market segment;
• Financial leverage: ability to repay debt from profits

Cash crisis triggers

• Interest cover: ability to service debt;
• Probability of default: extent of overall creditworthiness.

Deloitte takes a four step approach to arrive at a DSI score:

• Ratio analysis. The six ratios opposite are calculated for each listed company in the dataset for the defined time periods;
• Scoring. Each ratio is assigned a score based on boundaries that have been set;
• Aggregation. The six ratios are aggregated to form an overall score out of 100, where 100 is the lowest level of stability;
• Categorisation. We assign each company a sector classification based on Deloitte’s industry taxonomy, and banking relationships are derived from AFS.

The Deloitte reports points out that the following themes were prevalent in 2021

• Credit taps were open at the height of the crisis: Total debt increased by c.R250bn in the first wave of Covid 19 as lenders rushed to the aid of their clients, preventing a credit crunch this drove down the DSI in 2020;
• Covid-19 has had a polarising impact on the JSE: The gap between the top and bottom 20 performers widened during Covid 19, creating “winners” and “losers” along sector
• The “winners” repaid Covid 19 loans in H1 2021:  The improvement in the overall DSI score in H1 2021 was driven by companies who took the opportunity to repay Covid 19 loans.
• But trading remains muted: The metrics that track trading remained low in H1 2021. For many, liquidity runway is rapidly disappearing: difficult decisions must be made.

High and lows
The headline grabbing rally in JSE stocks has been fuelled by global factors such as a booming commodities market and optimism around a global recovery this is reflected in the H1’21 uptick in the DSI. But this rally seems to belie local fundamentals where fragile business and consumer confidence has kept trading performance weak in 2021.

The gap between the best and worst performers widened during the Covid-19 Pandemic for the JSE: mining, metals and chemical companies benefited from the commodity price boom, keeping the average top 20 score trending near 100, whereas the Covid vulnerable real estate and hospitality sectors drove the bottom 20 score ever lower.

High performing sectors:

• banking and capital markets;
• insurance;
• investment management;
• life sciences;
• telecoms, media and entertainment.

Low performing sectors:

• automotive;
• healthcare;
• industrial products and construction;
• real estate;
• transportation, hospitality and services.

The report points out that South Africa’s ailing healthcare sector, and the real estate and hospitality sectors are particularly vulnerable to Covid-19 lockdowns. The workout of lender exposures to these Covid vulnerable sectors hinges on an accelerated vaccine rollout programme and, for hospitality, continued lobbying of key tourist markets such as the UK to ensure SA remains off red lists ahead of the critical December period.

The rise of black swan events
The report points out that precedent from advanced economies shows that a successful vaccine rollout is key to eliminating draconian lockdown measures. However, SA’s rollout has been slow despite being open to all adults.

The report adds that South African companies were just coming to grips with the impact of the Covid-19 pandemic when the July 2021 riots hit. The events of the past year have shown that black swan events will continue to increase in frequency. How management teams respond will become a critical determinant of survival.

The end of the road?
The report points out that the banking sector has taken up the mantle of supporting South Africa’s economy through the pandemic so far. But as commercial enterprises, banks’ capacity to fulfil a sovereign role is limited.

“67% of respondents to the 2021 Deloitte Restructuring Survey believe financial institutions handled the fallout from the Covid-19 pandemic well, compared to 8% for government” – Deloitte.

As we continue to see volatility in banks’ profits and shareholder returns, we expect to see less support towards distressed clients, particularly where there is no clear turnaround plan.

The report adds that it may be the end of the road for restructuring options such as ‘amend & extend’, especially given the more stringent capital requirements for distressed positions tough decisions will need to be made by all stakeholders.

Without further lender support, many ‘zombie’ companies that are unable to articulate a coherent turnaround strategy will face insolvency, either via business rescue or directly into liquidation.

However, business rescue is only a means to an end, not the end itself – Deloitte

The report points out that recent case law places increasing pressure on BRPs to deliver a plan in shorter timeframes and stakeholder impatience with the business rescue framework is increasing.

With these factors at play, we believe that accelerated M&A will become the standard exit route out of business rescue.

A new beginning
The report adds that banks have capital to deploy and the cost of not putting it to work is increasing. Companies with a clearly articulated investment case supported by robust forecasts should be able to secure funding on favourable terms.

So where should BRPs focus their attention? Most of their attention should be focused on the poor performing companies as they need to try and survive the storms that are associated with the further waves of the Pandemic and their lockdowns. There will also be major opportunities for these companies to take advantage of strong demand post Covid-19; therefore, these companies need to align their strategies accordingly.

Attention must also be paid to the high performing companies. While there is significant demand now, there is a bit of downside risk that demand will tail of significantly – and possibly sharply – post Covid. These companies should align their strategies accordingly.