The biggest risk investors face this earnings season lurks just below the surface

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The third quarter earnings season now drawing to a close saw S&P 500 companies generate overall earnings per share growth of over 27% and sales growth of over 15%, numbers that suggest a strong recovery from pandemic lows of 2020.

But the high growth rates, emerging from what was for many companies a very weak base, mask underlying problems that do not bode well for the future. An analysis of the underlying strength of companies in an economically sensitive industry – travel and leisure – highlights the trend.

This sector, which has borrowed heavily to survive the worst of the pandemic, is expected to experience a sharp increase in demand for flights and hotel rooms during the summer after the launch of the vaccination program in the spring. But that expectation has been dashed by the highly transmissible delta variant of the coronavirus which has reduced cases, hospitalizations and deaths to levels seen in winter and discouraged people from leaving their homes.

“The biggest public travel and leisure companies are still on a knife-edge,” said James Gellert, CEO of RapidRatings, a company that assesses the finances of private and public companies.

“For these companies, much of the pain has been going on for over a year now, largely because of empty properties, unsold tickets, lingering confusion around lockdowns and quarantine policies, and a optimism which has not yet fully responded to reality. ”

It’s not just the travel industry that is suffering. Many industries are grappling with inflationary pressures, supply chain issues, border closures and quarantine measures, including autos and retail, both of which have seen big changes in market conditions. liquidity and current liabilities from 2019 to the end of 2020.

“People need to carefully monitor all of the industries and the companies that make them up, to see if the ‘new’ liquidity gained over the last 4 to 5 quarters can support companies or just support them a little longer,” Gellert said. .

See now: Hopes of a business travel boost fade for U.S. airlines as September bump fails to materialize

Deep dive

RapidRatings analyzes a company’s financial data and assigns it a Financial Health Score, or FHR, and a Baseline Health Score, or CHS. The first is a measure of the probability of default in the short term and the second assesses the effectiveness of a business over a two to three year perspective.

“The biggest public travel and leisure companies are still on the cutting edge. For these companies, much of the pain has been going on for over a year now, largely due to empty properties, unsold tickets, lingering confusion around lockdowns and quarantine policies, and optimism. which has not yet fully responded to reality.


– James Gellert, RapidRatings

Both produce a number on a scale of 1 to 100, which is grouped into categories based on risk, to help a potential business partner, supplier, or counterparty determine a company’s performance over time. Only financial data is analyzed, not stock prices or other market data that would include investor sentiment.

As the graph below illustrates, a sample of companies in the travel and leisure industry mostly had strong FHRs at the end of 2019, before the onset of the pandemic. Southwest Airlines Co. LUV,
-2.11%
led the field with an FHR of 91, but which fell sharply to 48 at the end of the second quarter, placing him in the “medium risk” category of RapidRatings.

Likewise, the DAL of Delta Air Lines Inc.,
-1.73%
FHR fell from 87 at the end of 2019 to 25 at the end of the second quarter, placing it firmly in the “high risk” category. Booking Holdings Inc. BKNG online travel site,
-0.17%
FHR fell to 53 from 86. Las Vegas Sands Corp. LVS,
+ 0.55%
fell to 24 at the end of the second quarter from 86 at the end of 2019.

Source: RapidRatings


Baseline health scores didn’t get any better. Southwest fell from 84 to 18, placing it in the “very poor” category; Delta from 86 to 23, the “poor” category; Reservations from 81 to 31; and Las Vegas Sands at 20 to 83, all low scores that imply high risk in the medium to long term. Only Marriott International Inc. MAR,
-2.51%
was spared a poor baseline health score, dropping to 53 from 78 at the end of 2019, to stay in RadidRatings’ “average” category.

Source: RapidRatings


“While the holiday season could give many of these businesses a boost in revenue, the hangover will be even more nasty next year if rough fundamentals don’t show signs of improving beyond the next quarter. “said Gellert.

Money is king

The deterioration in numbers comes after public and private companies were forced to borrow more, lengthen maturities and do whatever was necessary to secure short-term liquidity at the height of lockdowns and movement restrictions. in 2020.

The airline industry, hammered when travel stopped last spring, demanded a government bailout to increase liquidity, which came with onerous terms. Some airlines have issued bonds backed by their own frequent flyer programs because ground flights have made them spend money.

The cruise industry was further hampered, when the Centers for Disease Control and Prevention imposed closures for more than a year, and as companies fought with the state of Florida over their policies to require COVID-19 vaccinations for crew and passengers.

Carnival Corp. CCL,
-2.00%,
which had the lowest FHR score among the companies in the sample, said that by the end of 2021, almost 22 months after the COVID-19 outbreak was declared a pandemic, its goal was to bring 65% of its worldwide cruising capacity back online. .

Source: RapidRatings


At Booking.com, survival meant a multitude of actions ranging from raising $ 4.1 billion in new debt, negotiating amendments to its revolving credit facility, restructuring the business, participating government assistance programs, including wage support programs, suspension of share buybacks and non-essential travel, reduction in marketing spending. and sell investments, according to its 2020 annual report, published in February.

“Easy and cheap access to capital has provided an incredible band-aid to strong and weak companies,” Gellert said. “The big question is whether these companies can improve after pandemic trauma with this money or if it will run out before they return to health and when they will have to pay the piper for increased borrowing and maturities.” debt futures that they may or may not be able to meet.

Forget the basics

One factor that makes the difference is the amount of cash that businesses raised in 2020, which is now helping them overcome the current difficulties. For example, Delta and Carnival raised funds while adding leverage, which now gives them more resilience than Las Vegas Sands.

All three experienced sharp declines in revenue, declining profitability or declining losses and higher leverage. But Las Vegas Sands saw the biggest drop in FHR “in part because, unlike others, the increase in debt has not come with the resilience created by more liquidity.” The other two saved time with their money, ”Gellert said.

For investors, the market performance of many travel-related stocks seems very disconnected from RapidRatings data. Many have more than doubled from their pandemic lows, even as fundamentals show companies are struggling.

Delta shares, for example, climbed about 125% from their closing low of $ 19.19 on May 15, 2020. Deutsche Bank analyst Michael Linenberg recently initiated a “buyout” catalyst call “on action in anticipation of increased travel demand, saying Delta was one of them. “highest quality names in the industry”.

See also: More than a quarter of Nasdaq-100 stocks are in bear markets, and Wall Street sees buying opportunity

So far, investor confidence appears to be based on what people believe will happen, rather than what the realities of the airline’s quarterly results and balance sheet have shown.

Delta announced a return to net profitability in the second quarter. Its net income of $ 652 million was the first profit since the pre-pandemic fourth quarter of 2019. But that profit resulted from the inclusion of $ 1.5 billion in benefits related to government payroll support programs; excluding this benefit, Delta recorded an adjusted net loss of $ 678 million.

The total adjusted net loss for the first half of 2021 was $ 2.94 billion, barely better than the loss of $ 3.14 billion suffered in the first half of 2020, while payments on debt and lease obligations – Funding during these periods increased by over 80% to reach $ 3.1. billion.

And yet, the stock has more than doubled, even though the debt-to-assets ratio has reached the highest levels since Delta’s last exit from bankruptcy in April 2007.

FactSet, MarketWatch


As the chart above shows, the share price and the debt ratio tend to move in opposite directions.


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