Beware the living dead

Zombie companies are multiplying on the JSE.

Call them zombie companies, the living dead of the corporate sector. Companies whose costs or prices have rendered them uneconomic, which prey on the capital of investors just to keep the doors open. With plummeting commodity prices and rapidly rising input costs, the JSE is sporting a growing number of them.

We look at some among the ghoulish gang and ask a chilling question: can it ever make sense to invest in a company that cannot make money in the current environment? The answer, sometimes, is yes, but only for those companies who can come back to life before they’ve sucked investors completely dry. Drawing the line between companies that will ravage your portfolio and those that will rise from the dead is critical for any would-be investment zombie slayer. Here we look at a few in increasing order of sickliness.

Just a year ago, Sasol was in rude health. Gas prices were low and oil prices were high, the perfect scenario for a company that specialises in converting the one into the other. The firm was preparing a massive capital investment in Louisiana to open a gas-to-liquids plant that would have transformed it into a global major. Its existing operations were pumping profits.

Then an economic apocalypse hit. Oil prices fell from $114/barrel to under $50. The Sasol board quickly announced a cash conservation strategy, focusing on survival and shelving the Louisiana plans. That helped to arrest a share price collapse that took 38% off its value in two months, though the share price has not recovered from that low.

The strategy ensured that Sasol didn’t slip into the red – in fact profits stayed about steady – but the investment case for Sasol had the life sucked out of it. Until there is some sign of oil price appreciation, Sasol is unlikely to find much shareholder support. Unfortunately, oil prices have remained stubbornly low, bouncing just under $50. Coming to Sasol’s aid, however, has been the weak rand.

With revenue in hard currency and a substantial slice of costs in rand, it translates into a more profitable business.

Sasol has slashed costs in response to the low oil prices, helping to protect profits while top line revenue has slumped some 10%. That is a great credit to its management team, but until the growth scenario improves, Sasol’s share price is not going to recover.

Sasol provides important lessons for our zombie strategy. For one thing, it often doesn’t matter if management is brilliant – market conditions can be beyond anyone’s control. The more than halving of the oil price tripped Sasol up, despite its responsiveness. Clearly, a strong recovery in oil prices is needed before Sasol will regain previous full health. That scenario is difficult to foresee in current economic conditions; if you could see an oil price increase coming, a punt directly on oil may be more sensible. Sasol’s portfolio of chemicals, coal and other products offers some diversification to lessen risk, though, plus rand hedge properties. If you are bullish about oil, then it may be a good way to position for upside, without getting too absorbed. At its current price:earnings ratio of about 9.7, its not demanding for the lack of growth on offer. So you won’t be too badly off getting this zombie into your portfolio.

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Our second zombie provides another lesson: leverage. High cost companies can quickly demise when prices fall, but they can be a bonanza when prices rise. Think of it this way: a low cost company is profitable when prices are low, and more profitable when prices are high. A high cost company loses money when prices are low but makes it when they are high. It is the second type that can stage the biggest turnaround. An already profitable company can become more profitable, but a high cost company will shoot the lights out from a profit growth perspective.

Lonmin is a high cost platinum miner. Its share price has been decimated, falling from over R112/share in 2011 to just R3.40 now while the platinum price has fallen from $1800 to $915. That shows leverage in action: the share price moves as a multiple of the prices the company can get. At current prices the company is losing money at the operating level, adding it the ranks of the walking dead.

In response it has been doing what it can to reduce costs, putting high cost shafts onto care and maintenance and cutting all capex. It expects to be able to produce at R10 800/ounce, which will place it in the top half of producers, up from the bottom quartile in 2011.

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With the rand sharply weaker it should be able be profitable now at an operating level, though ballooning debt levels will absorb a lot of debt service costs. And therein lies another lesson on zombie companies: the walking dead keep their doors open by burning cash. When they run out of cash resources they either have to borrow or raise capital from shareholders. Lonmin’s owners have been braced for a rights issue which has kept the dampener on the share price.

While Lonmin is a higher cost producer than Anglo Platinum or Impala Platinum, all three are cutting production. Lonmin will cut 100 000 ounces from its 730 000 production target. Naturally the firms will cut their higher cost production first, usually the deepest level and most geologically difficult shafts.

As the industry cuts back supply, prices should rise, which makes the lower cost output more profitable. That is the standard economics for the platinum industry, though it has yet to make a difference – the platinum price has stayed on its downward trajectory.

Eventually, though, reduced supply has to work to push prices back up. The question is whether the current Lonmin share price justifies the risks on when that day will come. In effect, buying the share is like buying an option on a recovery – you’re not buying it for the current economics. In its last good year – 2011 – Lonmin earned over R10/share in profits. The current share price is a third of that year’s earnings. So while Lonmin is clearly in dog territory, it is well-priced for it. Our bottom line: if it does end up doing a rights issue, the price will fall on the announcement making a great entry point. Buy it if that happens.

Just to make the point that it’s not only resource companies that wind up in the zombie army, diversified electronics producer and supplier Ellies has wound up on the front line. It made a bottom line loss of R327 million in the year to April, pretty close to its market cap of R397 million. The share price is in the morgue at 64c, sharply off a mid-2013 high of 949c.

It got into this mess thanks to some bad strategic choices that heavily exposed the company to certain opportunities that didn’t come off.

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But ultimately it shows a clear hallmark of zombieconomics: a high cost base and little control over prices. When planned for opportunities didn’t come through, particularly the digital terrestrial television rollout, Ellies was saddled with costs it could not avoid. The result was blood across the income statement.

Over the last year it has conducted equity capital raising twice just to keep the coffin lid open and its bankers out of the liquidation court. It is busy with a major restructuring that will cleave the business into separately listed units, reducing risk. It is trying to get a grip on its various business units to improve the cost scenarios in each of them, but it is a huge task and the risks are big. There are plenty of valuable bits in the business that it may do well to sell to generate value for shareholders, but soon there’d be nothing left. This is one that’s best left to roam into the wilderness.

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Just as a lesson to show how bad a zombie can be for your health, consider Evraz, now in business rescue with shareholders having been gouged of everything. The business is up for sale but there’s unlikely to be anything left for shareholders after settling creditors. It was suspended in April, flat lining at 165c, having traded at R94 in 2011.

The death knell for Evraz has been cheap Chinese steel imports flooding the SA market, rendering its steelworks sub economic. While the declining fortunes of the business have been in evidence for some time, management convinced shareholders to stay the course while it tried to reduce costs. Unfortunately, it couldn’t get it right, with cash becoming ever tighter until it had no choice but business rescue. Shareholders may feel some succour that 85% of the shares were held by its parent which will be feeling the most pain. For the rest of us it’s a stark lesson of how zombieconomics can crush the life out of your portfolio.

 Watch Orin Tambo of Intellidex speak on the four zombie companies profiled: 


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