The Reserve Bank of Australia (RBA) announced this month that it would keep the official cash rate at 1.5 per cent for the twenty-first consecutive month. This extended period of low interest rates has benefitted companies in several ways and been a key driver in company decision making around capital allocation. Put simply, we feel the extended period of low and falling rates has resulted in boards and management taking on more financial risk.
Perpetual has observed over this time:
Lower interest costs driving improved company profits;
Funding acquisitions through debt. The cheaper cost of debt has been a key driver in acquisitions being earnings per share accretive;
The use of free cash flow to return capital to shareholders through on-market share buy-backs or increased dividend payout ratios, rather than paying down debt; and
In some cases, borrowing to fund dividends.
At the same time, companies that have maintained a conservative balance sheet and used the falling cost of debt to reduce leverage in their business have not, in some cases, been rewarded by the market with a higher stock price, or higher P/E ratio, to reflect the strength of their balance sheet.
This low interest rate environment is due to change and when it does, the tailwind bolstering companies will become a headwind. It will be those companies with conservative balance sheets that will end up the biggest winners.
The interest rate headwinds
There are several indicators pointing to oncoming headwinds caused by a rising rate environment.
Firstly, the Australian Bank Bill Swap Rate (BBSW) has blown out over the last two months with similar moves being observed in other key global reference rates such as the three-month London Interbank Offered Rate (LIBOR). The Australian BBSW has likely moved higher on expectations of a tightening rate environment in combination with tightening liquidity as demand exceeds supply.
The BBSW is generally a function of the RBA cash rate. Interest rates paid by most Australian companies are derived from the BBSW, with a margin over this rate typically factoring in company-specific risk. With the significant moves higher in the BBSW, variable interest costs are set to increase in the coming months for Australian companies.
Similarly, America’s official interest rate increased this month – the second hike this year – lifting its key policy rate from 1.75 per cent to two per cent which indicates that global interest rates are rising.\
The extent to which these headwinds will impact Australian companies will depend on their debt structures. For companies that have high levels of debt and pay out a significant portion of their free cash flow as dividends, this headwind is likely to become material, such that it may affect the sustainability of the dividend which would likely have a negative flow-on effect on their share price. The increased cost of debt will also have a direct impact on earnings and cash flow which will have a secondary impact on management behaviour regarding capital allocation.
In most cases, the higher costs of debt will, over the long term, result in lower dividend payout ratios and will impact the drivers of earnings per share growth such as share buy-backs and debt-funded acquisitions.
Company indebtedness is rising
A comparison of the leverage and funding costs for stocks on the S&P/ASX 200, excluding Financials, Resources and Property stocks, in FY14 versus FY17 reveals that companies have been taking advantage of low interest rates.
During this period, the aggregated leverage of these stocks increased from 1.6x net debt over EBITDA (earnings before interest, depreciation and amortisation) to 1.8x. In other words, companies are taking on more debt, increasing the period of time it would take them to pay it down.
Despite the rise of indebtedness of companies, the average cost of debt (the effective interest rate paid) for these companies has fallen from 6.5 to 4.8 per cent. This shows that companies are using low interest rates to justify an increase in borrowing but are spending less on paying interest.
Amcor (ASX: AMC) is an example of a company that has used the low interest rate tailwind, adding over $US1 billion of net debt since FY14 yet net finance costs have gone down by $6 million. Its average cost of debt has fallen from 6.4 to 4.6 per cent but leverage increased from 2.1x to 2.9x over this period.
However, companies like Amcor will be sensitive to headwinds caused by higher interest rates. If we assume that Amcor’s debt level stays flat at the FY17 level of US$4.05 billion and the average cost of debt increases from 4.6 to 5.6 per cent, Amcor’s finance cost would increase by $40 million, representing a four per cent profit before tax headwind. This would have an impact on the dividends it could pay out to shareholders.
Are investors ready for the headwinds to come?
Conversations with sell-side analysts reveal that the market is underestimating the material impact that rising interest rates will have on company earnings and the way boards and management will allocate capital.
For investors and their advisers, strong consideration should be given to companies that are highly leveraged, pay out a substantial portion of their cash in dividends or are heavily reliant on debt to fund acquisitions.
It will be worthwhile factoring in the impacts of higher interest rates to highly geared companies, such as increased funding costs resulting in downgrades to EPS and the headwinds for these companies to “manufacture” EPS growth through debt-funded acquisitions and buy-backs.
Anthony Aboud is an Australian equities portfolio manager for Perpetual Investments.