Life after lockdown: Survival of the fattest

The coronavirus will lead to business failures, market consolidation and entrench incumbents with strong balance sheets. Should policymakers react?

Perhaps no one could have predicted the exact time of the arrival of a global viral threat or that it would cause measures such as national lockdowns. Moreover, even in the midst of the pandemic it remains difficult to quantify the true human and economic cost of the virus. What is clear is that lockdowns will have an adverse impact on economic activity.

Earlier this month the Institute of Supply Management released the monthly Purchasing Managers’ Index (PMI), which saw the global PMI for March drop from 52 to about 47. For South Africa, this figure was 45.9, down from 47.6 at the end of 2019. Consumer expenditure makes up about 60% of South Africa’s GDP, which means that lockdown has practically brought the economy to a standstill. Globally, GDP growth rates will splutter and the aftermath of the pandemic will leave the world a different place.

Corporates are naturally concerned for the impact of the virus and global lockdowns on its supply chains, the health of employees, the ability to work from home and, most critical perhaps, if it has the resources available to survive the financial shock. Cash flow is the lifeblood of any organisation, big or small, and the ability to generate and access cash is of critical importance. As companies enter lockdown their ability to generate cash through operations are severely restricted.

Cash can come from a few sources, including debt and equity investment from shareholders. However, these two options may also be limited during these times:

On 9 March global markets experienced its worst fall since the 2008/9 financial crisis. The threat of the coronavirus and a severe drop in the oil price caused havoc with many bourses having paused trading on the day. “Black Monday”, as it was called, saw US stocks lose 8% of its value, the FTSE 100 dropped by 7.7% and the JSE lost about 12% of its value. While there has been some recovery, it is clear that approaching the equities market for capital at this stage may be unwise.

Debt is another source, but corporate debt in South Africa (much like individual and sovereign debt) is already relatively high. Moreover, the downgrading of the South African credit rating to sub-investment grade by Moody’s severely restricts the country’s access to debt and has seen a spike in the cost of debt. The South African 10-year government bond yield reached a maximum of 12.36% on 24 March compared with a low of 7.9% in 2018.

So, debt may do more harm than good during these times, even with the debt relief pledges made by banks and the reserve bank.

This leaves the use of reserves; accumulated profits that have been retained over multiple trading periods. In fact, we have seen this before during past recessions and crisis, where large, mature and cash-flush companies will gain further market share over its rivals with weaker balance sheets. I believe that this crisis will lead to further consolidation in the market.

According to the Economist, it costs less for Johnson & Johnson to insure its debt against default than it does for Canada. Apple, while not only having a perfect credit rating, has around $208 billion of cash reserves, which is not only more than most countries will be able to afford for stimulus packages, but also enables it to buy companies such as Boeing, Airbus and Tesla.

These ‘Alpha’ companies are primed to weather the storm, buy out its competitors and continue to invest for growth in life after the pandemic. I am reminded of an anecdote of Koos Bekker, who at the time of the tech bubble did not scale back Naspers’ efforts to increase its interest in technology companies, but rather stated: “Technology companies are cheap now!” (allow me to paraphrase – ed.).

Which brings me to two contrarian arguments on the cash reserves of South African companies that played out in 2017.

Position 1: Cash indicates an ‘investment strike’

A report funded by the South Africa Department of Trade and Industry and published by the University of Johannesburg’s Centre for Competition, Regulation and Economic Development in 2017 held that South African companies were accumulating reserves as opposed to investing it in the economy and, thus, stimulating economic growth.

The report noted that between 2005 and 2016, the cash reserves for the top 50 companies on the JSE increased from R242 billion to R1.4 trillion and that this was evidence of an ‘investment strike’. Moreover, the report stated that by retaining profits at these levels, companies were raising the barriers to entry in different industries and promoting concentration in the market into the hands of large conglomerates and incumbents.

While the report did concede that higher reserves were also caused by a lack of investment opportunities and internationalisation (where dual-listed South African companies deployed capital outside of South Africa), it called for policy intervention from government to stimulate domestic investment by these companies and to put an end to the ‘investment strike’.

Position 2: Cash hoarding is a myth

Soon after, Intellidex offered a different view. It published a research report, funded by Business Leadership South Africa (BLSA), which studied 85 mining and industrial companies in the Top 100 of the JSE. After adjusting for inflation, the report found that over a 10-year period, cash holdings for these companies increased by about 11% per year and that this increase was not as a result of ‘hoarding’ or an ‘investment strike’, but rather for two major reasons:

First, many of the large companies on the JSE operate at a global scale (some are even dual-listed), with significant operations outside of South Africa. So, the value of cash generated outside of South Africa is impacted by the exchange rate of the rand. Over the period of study, the strength of the rand against major currencies had weakened and, after adjusting for exchange rate fluctuations, the increase in cash holdings was actually 8.18% per year.

Second, cash cannot be looked at in isolation, but should be seen in relation to total assets. The ratio of cash to total assets during the study period varied between 6.4% and 10.2%. This does not offer evidence of the hoarding of cash, but rather that the value of cash increased since the value of total assets had increased (or, put differently, the companies grew and so did cash holdings).

Position 3: Just ask Mr Price

While both arguments are compelling, I am inclined to side with Position 2 in that the higher cash reserves held by companies were simply ‘business as usual’ and a sign of the times.

For example, an analysis of CFO comments in the annual reports of JSE-listed companies will show that many companies accumulated cash for replacement investment. Further to this, about 75% of capital expenditure during the period of the Intellidex report was for new and expansion capital.

When we specifically consider mining companies, the return on equity (ROE) of these companies have regularly been lower than the interest rates that could be earned on cash savings. In this sense, it makes better sense for a company to invest in cash than in actual mining activities.

And then there is simply the low economic growth that the country has experienced: When GDP growth declines, cash holdings increase for companies to strengthen their balance sheets and account for uncertainty.

An example of this is Mr Price. Near the end of 2019, iol.co.za published an article: “Strong cash balance helps Mr Price’s share price”. In the article, the company refers to its strong balance sheet and cash holdings that allowed Mr Price to maintain its dividend policy despite weaker profits.

It is simply unreasonable to expect companies to invest in projects that are unlikely to yield satisfying returns and leave a very thin cushion on the seat for bumpy roads in the future.

A final position

But what these arguments really presuppose are the responsibilities of companies and governments. What exactly is the role of companies in the market? Is it to ensure its own survival (thus accumulating cash) or to stimulate economic growth at all costs?

During the pandemic we have seen many companies shift to a more socialist stance, offering free products, expertise and financial aid to its employees and other virus-related efforts. Is this perhaps the dawn of a new social contract? Perhaps.

But more specifically to our discussion, if companies decide to pursue stimulus over being conservative (retaining cash for rainy days), what responsibility then do governments have to support businesses that now have no further cash holdings? It is likely that had government policy been used in 2017 to force South African companies to spend cash holdings (and end the ‘investment strike’) fewer companies would have been able to weather the current storm. This could support the view for lower government involvement in business and the protection of the free market.

That being said, government intervention during the pandemic has not only been welcomed by many, but in most cases has been expected. Similar to 2008/9, governments have moved to act to protect the free market, but in many countries the interventions for the coronavirus have been radical. Putting a freeze on the free market by way of lockdown is counter to the political and economic ideologies of many countries who acted nonetheless.

What is clear is that the impact of the coronavirus will lead to business failures and those companies with the fattest cash holdings will be more likely to survive. This means that markets will become more concentrated and the position of incumbents more entrenched. The business world will look different after the pandemic and it will most likely fall on governments to regulate the new ‘Alphas’ to ensure better competition. If it should do so and how this should be achieved remains to be seen.

We find ourselves in one of the most uncertain periods of human history. It is blurring the lines between business, government and society. Policymakers, business and society are confronted with an unprecedented trade-off between life, death and economic growth. What is required is ‘big government’ and ‘business with a heart’ to fight it. If these roles will remain after the pandemic is unclear, but I do feel that business and governments in the post-pandemic world to be very different from what we know.

The dim flicker of a new social contract is on the horizon.

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Sources:

CCRED. 2017. Companies hoarding R1.4-trillion in cash. CCRED article. 4 August 2017. Online [Available]: https://www.competition.org.za/seminars/2017/8/4/companies-hoarding-r14-trillion-in-cash

Economist.com. 2020. The pandemic shock will make big, powerful firms even mightier. The Economist article. 26 March 2020. Online [Available]: https://www.economist.com/business/2020/03/26/the-pandemic-shock-will-make-big-powerful-firms-even-mightier

 Machokoto, M., Areneke, G. & Maherlbrahim, B. 2020. Rising corporate dent and value relevance of supply-side factors in South Africa. Journal of Business Research, 109(March): 26-37.

Tambo, O. & Theobold, S. 2017. The myth of corporate cash hoarding. Intellidex research report. September 2017. Online [Available]: https://www.intellidex.co.za/wp-content/uploads/2017/09/The-Myth-of-Corporate-Cash-Hoarding-Final-Report.pdf