Adding more debt — VietEcon

A week and a half ago (see post here), I wrote about two things that I was certain would happen post-COVID-19.

The first is that the move to online, while it may be temporary, will give companies a lot more data about their customers. Big companies will very likely be able to take advantage of that. Data mining to figure out how better to sell/extract money from people.

The second is that companies will probably be more cautious, at least in the short term. Most companies have been optimizing everything they can: supply chains, working capital, capital structure. As part of that, they really worked hard to make sure that there was very little slack in each area. Well, now we could use some of that slack!

I bet that, like after the great depression, companies and people will save more and not overextend themselves. For companies, this will likely mean less debt and more equity. So what could this mean for companies in Vietnam.

Source: company data, Vietecon.com, Vietstock.com.vn

Back to basics: Return on equity depends on numerous things, but they can be broken down into three: margins, turnover (sales/assets) and leverage (assets/equity). I believe that COVID-19 will return leverage.

So let’s see what would happen if companies de-levered their balance sheets.

I ran these numbers back in October, so they reflect 2H2019 figures. Back then in Vietnam, the average was 48% for turnover, and 2.4x assets/equity. Net margin was 16%. [Because these are simple averages, you can’t actually multiply them to get the return on equity (that only works for individual stocks).]

Source: Company data, Vietecon.com, Vietstock.com.vn, Yahoo Finance, Bloomberg

These are different than the what we see in the S&P 500. Vietnam has much lower leverage, but significantly higher asset turnover and almost double margins. That may be because the market is less developed and so investors are less willing to favor companies with high leverage.

Now, what will happen if companies have to de-lever even more? Well, it’s pretty simple: returns would fall. I did two different scenarios.

Everyone takes a 25% cut in leverage, meaning that assets/equity falls 25%. This is based on the view that everyone will face difficulties accessing debt markets, that everyone will have a general inclination to use less debt in the capital structure. The impact is straightforward: a 25% cut in leverage results in a decline in return on equity by the same 25%.
The other way is to say that companies with high leverage will not be able to maintain it. In order to see what that would mean, I made a few assumptions. I choose 1.5x as a target leverage ratio and said everyone above that will want to lower leverage, everyone below that will do nothing. And the higher you are above 1.5x, the more you lower your leverage. I assumed that companies will try to lower any leverage above 1.5 by half. So 2.5x leverage becomes 2.0x (1.5 + 1.0/2). Of course I am guessing at these figures, but it gives us an idea of the impact.

Looking at the chart (above right), you can see that some companies will not have to lower their leverage much in scenario 2: returns for VNM, VRE and TCH are all mostly unchanged. VHM, MSN and NVL will all see a decline of more than 400bps! That’s a lot.

VHM and VHL are real estate companies, where high debt levels are seen as a normal course of business. However, that’s not actually true in all markets. Take Growthpoint, the largest commercial landlord in South Africa. It has assets worth ZAR142bn ($7.5bn), and has equity of ZAR83.9bn ($4.46bn) for a leverage ratio of 1.7x. VHM is at 3.6x, while NVL is at 3.4x.

It is going to be interesting if and how quickly companies de-lever. The problem is that it is hard to de-lever without profits and growth. So while companies may want to de-lever (and may have to), we could see leverage grow in the near term.