Lockdown Protocol

We could be facing a near-total business shut down over the next few months. But this too shall pass. Cheer up. Think about it this way: If this virus gets out of hand and affects most of the world’s population in the next few weeks, we’re all ******. Then, investments really won’t be top of mind; food, health and safety will. That kind of apocalypse is a low-probability scenario. China has recovered. Hong Kong, Singapore and Taiwan have contained the outbreak. There is a blueprint.

In the more likely scenario where stocks will tank for another few months because we have a serious recession, we have 2 choices: If we need the cash right now to pay bills, we should cash out. Then Volatility is a real risk. If we’re invested for the long-haul (the next decade), we should stay invested – volatility is simply an emotional inconvenience. Even The Great Depression was followed by a six-year bull market in which the S&P 500 returned more than 300%. We can pick up some heavily discounted bargains along the way.

If this is a 2-month economic shock, then staying invested matters. It’s too hard for anybody to time the V-shaped or U-shaped recovery to perfection. Remember that stocks are forward-looking. If those scary COVID19 curves start flattening, the recovery can be fast and furious as well. History tells us that most (80-90%) or returns over a decade are made during a handful of up-days. If we miss those few days, we miss out on a majority of our returns. In the meantime, we need to make sure that our investments can survive the shock and come out of it ready to generate returns over the long-term. During this mayhem, they need to live to fight and another day. It’s all about the bridge to the other side now.

The Coronavirus disruption to life and business has already been reflected in stock prices, across the board. This has been the most fast and furious stock market correction in the history of markets. Airlines, Cruise Lines and Energy (the Saudi-Russia price war) stocks have been clobbered. Thankfully, we’ve never been interested in these sectors. We’ve invested in long-term growth themes that will change our civilization, arguably for the better. But even stocks in those growth vectors – like AI or 5G or Fintech or India – have been beaten down. There have been virtually no exceptions in this sell-off. Is it going to get worse? Possibly. As long-term investors, we can survive (and even ignore it) if we’re confident that our portfolio companies can withstand a short-term economic lockdown and come out of it ready to do business.

Stock prices don’t affect operating results like cash flow. It’s the other way around. Expectations of future cash flow affect stock prices. And for the past two weeks, Mr. Market thinks that virtually all companies will have severely depressed cash flows compared to his expectations in February. Looks like he expects a 2008-09 type of recession. Let’s assume Mr. Market is right. Let’s assume that business is severely depressed for the foreseeable future. Some companies cannot survive even a month of disrupted business. Others can take it on the chin and live to fight and another day. Some may hardly see a disruption (Spotify? Netflix?) in revenues.

We need a Liquidity Test.

I’m having flashbacks to be my days as a High Yield Analyst. I used to spend hours and days analyzing the “survivability” of a company through potentially trying times. The job was about Risk Management. This exercise we’ll be doing is also about Risk. It’s about figuring out if we really need to painfully amputate one of our portfolio companies if business dries up over the next 3-6 months.

In plain English, we need to estimate if our portfolio companies can pay their bills and keep the lights on. They will need cash to do that. There are 3 sources of cash:

1. Cash from Operations – from selling products and services.
2. Cash on the Balance Sheet
3. External Financing – issuing bonds, stocks or taking loans.

We would want all our companies to be able to survive on just cash from operations, especially when they are depressed. If a company can’t cover expenses with cash from operations, the next best alternative is to use some cash from the balance sheet to cover the deficit. We definitely wouldn’t want to be invested in the third category of companies – the ones that need to depend on external financing to survive a 6-month disruption.

Here’s what we’ll do: We’ll start with their performance over the last 12 months, and then stress those numbers to check survivability. We’ll shave off some percentage points of Revenue and then estimate how that trickles down to EBITDA less Maintenance Capital Expenditures. Let’s call this number Unlevered Cash Flow (UCF). We’ll want to check if a company’s UCF can cover its cost of debt or cash interest charges, with a comfortable Margin of Safety. This is classic Credit Analysis.

The Portfolio Stress Test

Here’s what I’ll do to all companies in the Portfolio:

1. Mark down revenue (last 12 months) by 20%, 30%, 40%.
2. Identify Fixed Cost vs. Variable Cost split. Fixed costs don’t decrease with lower sales. Variable costs do.
3. Estimate a stressed EBITDA.  
4. Subtract Maintenance Capital Expenditure Charges.
5. Estimate UCF.
6. Estimate Cash Interest Charges.
7. What remains after I deduct Cash Interest from UCF is our Margin of Safety (MOS).
8. If a company has little to no MOS, I will check if there is more than enough cash (a year’s worth of revenue) to cover cost of debt. Not ideal, but in these circumstances, maybe it will suffice.

If a company doesn’t pass #8, I’ll sell, even if it’s at a significant loss. I just don’t want to hang on to hope of a bailout or a bridge loan.

Let’s put some numbers to this.

Is Ford “built tough”?

I was concerned about Ford. Its business is bound to take a hit. Can it survive?

Revenue: 

In 2019, Revenue was about $156 billion.

If we stress that by 20%, we get $125 billion.

But in 2009, the last terrible year, Ford’s sales were down to $116 billion. That’s about 25% below 2019 levels. We’ll go with that.

Fixed Costs vs. Variable Cost: 

I will count about 40% of its Cost of Goods Sold (COGS) as Fixed. Usually, COGS is mostly variable. But building cars is a highly capital-intensive process – companies like Ford bake in a lot of fixed cost within COGS. The rest of the Fixed Costs are part of their Capital Expenditure line (see below). So, their total COGS was about $135 billion in 2019. 40% of that is $56 billion. And then we add their Selling, General & Admin costs, which are all considered to be Fixed. That’s about $11 billion. Ford Credit Interest Costs are assumed to be Variable. That’s about $9.5 billion.

So:

Fixed Costs = $67 billion.

Variable Costs = $78 billion

Stressed Scenario Variable Cost (at same margin): $58 billion

Stressed EBITDA: 

Stressed Revenue minus Fixed Costs minus Stressed Variable Costs plus Depreciation.

$116bn - $67bn - $58bn + $10bn = $1 billion

Unlevered Cash Flow: 

UCF is EBITDA minus Maintenance Capital Expenditure. That’s $1bn – $3.5bn = Negative $2.5 billion. I’ve assumed about 50% of their total Capital Expenditures – about $7 billion in 2019 – as Maintenance. The rest of their Capital Expenditure is Growth Capex – for things like launching new product lines like their Mach E.

Cash Interest Charges: 

About $1 billion.

Margin of Safety: 

Negative $3.5 billion.

So far, it looks terrible. If Ford were to have a 2008-09 type of demand shock, it looks like cash from operations won’t cover the bills. But there is hope. The next step is to see if they have enough cash on the balance sheet to cover this deficit. Turns out, they do.

Cash on the Balance Sheet: 

As of December 31^st, 2019, they had about $17.5 billion of cash on the balance sheet. That covers about 5 years of the type of deficit we just calculated.

Long story short, Ford won’t need outside help to survive a 2008-09 style depression. But it’s not an ideal situation because just cash flow from operations won’t suffice.

Next Steps

We’ll do this type for a test for all our Portfolio companies. We’ll hold on to companies that can comfortably pay their bills with just cash flow from operations. We will need to make tough decisions on companies that need to draw on their balance sheet. And we will get rid of companies that will need to depend on external finance to survive this depression.

Our rankings will be:

1. Safe – cash flow from operations can comfortably cover all expenses.
2. Stressed – cash flow operations cannot cover all expenses but there is more than enough cash on the balance sheet.
3. Unsafe – cash flow from operations cannot

Ford, for example, will be labeled as stressed. We will send out the full analysis tomorrow.

Many Happy Returns. It’s hard to imagine that now but this too shall pass.