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.