Can ESG help you spot an impending bankruptcy?

Environmental, social and governance factors are no doubt important considerations when analysing a business. But I expect that many would say that when it comes to a business going bankrupt, that’s all down to the cold, hard numbers. While that may be true, independent of the financial health of a business you can certainly spot red flags that may indicate a business is headed for ruin. Most likely, these warning signs will appear in analysis of the ‘G’ in ‘ESG’: governance.

Over the weekend, Weatherford, the international oil and gas services company, announced that it intends to file for Chapter 11 bankruptcy restructuring. The business had to accept that its debt was unsustainable given its weak financial position. Analysis of the financials could have told you this (Weatherford is painfully free cash flow negative), but management had embarked on a grand turnaround scheme that involved asset sales as part of a road to continued solvency. However, even if we believed that the financial position of the company could have been saved, the company has some glaring red governance flags that meant we wouldn’t invest.

Strong governance hasn’t been a highlight for Weatherford. Its past is littered with examples of poor controls, such as charges for violating trade sanctions and also for corruption. It settled with the SEC for material weaknesses in its tax accounting. The company has also re-domesticated itself a few times, moving its domicile from the US to Bermuda, then to Switzerland, and most recently Ireland.

But there are other governance concerns. At the same time as being under extreme financial pressure, the company continually missed its own guidance and Wall Street’s expectations. With demanding turnaround targets that the business was already missing, and looming insolvency, there’s a very strong incentive to manipulate and obscure earnings. And while I am categorically not suggesting that management are cooking the books, disclosure has been progressively reduced. Weatherford’s product lines (at a very broad level) are only disclosed as percentages of sales, while earnings are only disclosed by Western and Eastern Hemisphere! This is as broad as it gets, and makes it impossible to analyse the profitability of the company’s operations. Disclosure used to be better, and this direction of travel is a serious warning sign.

There’s more. A planned joint venture with Schlumberger was abandoned unexpectedly after management U-turned on it and, at least to my eyes, was abandoned for a poorer outcome. Assets are also being sold, but at the nadir of profitability. Weatherford’s land drilling rigs were agreed to be sold just as day rates are rising – the business participated on the way down as day rates collapsed, but captured little of the upside as they rose. And despite management’s ambitious turnaround plan, they remain net sellers of their own stock, a concerning development.

So while the company fell into restructuring due to its financial woes, its significant governance failings certainly didn’t help. The fixed income team at Kames researched Weatherford in August last year and chose not to invest. These warning signs from an ESG perspective only solidified the team’s view that the business was unsustainable in its current form – and analysing whether it could become sustainable was increasingly difficult thanks to decisions made by management.

The ‘G’ in ESG helped confirm that the business was not on an upward trajectory and that bankruptcy was a very real possibility. Here at Kames we encapsulate ESG in our investment research process and this example demonstrates how we endeavour to minimise the potential for credit rating migration, volatility and default.

About the author

David McFadyen is an investment manager in the Fixed Income team. David specialises in high yield bonds and is the support manager for our global high yield bond funds. David joined us from BlackRock in 2015. He initially worked in our client management and investment writing teams before joining the Fixed Income team. He has an honours degree in Business Management from the University of Glasgow. He is a CFA charterholder and has 5 years’ industry experience. *As at 11 May 2019.

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Tick tock goes the Klöck

Climate change and general concern for the environment, they’re an ever-increasingly important issue for society, so why would it be any different for investors? It isn’t. This is something we’ve been watching for a long time; our ethical franchise will have been running for 30 years next year, so it’s something deeply engrained in our processes.

Lately, plastics and the pollution they cause have faced increasing scrutiny and regulation. This backlash has a fundamental impact on companies in the high yield universe. Take the metal can specialist, Crown Holdings. They suggest that the aluminium can is the world’s most recycled beverage container… and actually it is estimated that 75% of all aluminium ever produced is still in use today. Crown believe that a 1% shift from plastic bottles to metal cans for soft drinks alone could increase demand by billions of cans. This could be an impressive tailwind for positions that produce metal cans – companies like Ball Corp, Crown and Ardagh.

But for every winner, there’s a loser. Klöckner Pentaplast is one of the world’s largest producers of plastic films. This company makes the rigid plastics that cover your food, wraps around batteries, surround gift cards and the packs that your painkillers come in. As such, Klöckner is highly exposed to plastic packaging regulation (and backlash). While regulation isn’t the only problem that this company faces, it certainly hasn’t helped. Operating performance has been deteriorating, with limited revenue growth, falling earnings and negative free cash flow. To its credit, Klöckner has been trying to use more sustainable raw materials, focusing on recycled plastic. But so has everyone else, and the cost of recycled PET has been rising in response – compounding the problem.

Something else that’s interesting about Klöckner Pentaplast is how it has structured its debt. The company has issued a type of bond known as a Toggle PIK. These allow the company to pay interest in cash (like normal) or to elect to ‘pay in kind’ (this means adding more debt to its existing debt!). This toggle option means the company isn’t forced to pay cash away when it can’t afford to. But this extra debt means that the company is becoming increasingly indebted – even as it struggles to pay its existing obligations! This risk means that PIK bonds often come with large coupons, and can be an excellent investment when the business is doing well. This is where stock selection is so important.

We decided not to participate in the Klöckner bond when it was first issued at par (i.e. 100) this time last year. I reviewed the company when the bond was trading in the 50s last month, having lost almost half of its value. We chose to pass again, as the firm’s fundamentals had continued to deteriorate. This week, Klöckner announced it would elect to pay its interest in PIK. Today, the bonds are priced at 35. I can hear the Klöck ticking…

Meanwhile, our can makers in the portfolio continue to hold in very well amidst the recent market volatility. These are fundamentally strong businesses that may also benefit from a helpful regulatory tailwind.

About the author

David McFadyen is an investment analyst in the Fixed Income team, focusing on high yield bonds. David joined us from BlackRock in 2015 and held various roles across distribution including investment writing and client management before joining the Fixed Income team in 2018. He has an honours degree in Business Management from the University of Glasgow. He is a CFA charterholder and has 4 years’ industry experience (as at 30 November 2018).

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