Stockwatch: is this rally based on fantasy forecasts?

Rising share prices imply a V-shaped economic recovery, so our companies analyst reruns the numbers. 

A prime example of expectations for a V-shaped economic recovery is FTSE 100 constituent easyJet (LSE:EZJ).

Reflecting operational gearing, consensus 2020 net profit is projected to plunge from £349 million to £32 million in the year to end-September, on revenue down 13.3% to £5.5 billion.

Even the revenue forecast looks way-optimistic now that easyJet’s fleet is grounded until at least end-May.

Looking ahead to 2021, the numbers appear to presume a sudden unlocking of pent-up demand for summer holidays, then a return to normal business for a record £378 million net profit on £6.6 billion revenue.

Founder seeks a radical slimming down

While I haven’t agreed with the bouts of boat-rocking by founder and circa 30% shareholder, Sir Stelios Haji-Ioannou, his current broadside looks right – arguing that easyJet should slim its fleet initially by cancelling a £4.5 billion order for 107 Airbus, and steel for a “recovery” that involves testing routes, quite like a start-up, to find out what will be profitable.

Without knowing cash burn I have no idea as to his claim that the company may be on course to run out of cash by end-September, now that its fleet is grounded until at least end-May. But a return to anything remotely “normal” seems unlikely.  

• How ISA millionaires are behaving as Covid-19 harms investment growth

• Take control of your retirement planning with our award-winning, low-cost Self-Invested Personal Pension (SIPP)

Frequent flyers know air conditioning is a prime means to acquire respiratory illnesses at the best of times, and medics warn of Covid-19’s aerosol capability.

Maybe easyJet’s board will see sense to negotiate a deferral of orders, although Sir Stelios wants an outright cancellation and slimming down. I suspect he’s right in terms of weaker prospects for the travel industry, potentially for the next two years, instead of two months as some company analysts appear to reckon.

And yet enough investors agree with them, judging by easyJet’s 40% rally this week to 680p despite no guidance as to cash burn during lockdown.

In due respect, the end-September 2019 balance sheet had nearly £1.3 billion cash and on 6 April a £600 million “Covid Corporate Financing Facility” boosted total access (with an existing facility) to circa £2.3 billion reserves.

That easyJet notes it will consider “further liquidity and funding options” in the event of a prolonged grounding does hint at hefty cash burn.  

Source: TradingView Past performance is not a guide to future performance

Before all this kicked off, easyJet rated an Altman Z2 credit risk score of 1.3, indicating “not entirely safe from financial distress, caution should be taken”.

My study of the balance sheet (see below) suggests this related to easyJet’s overall liabilities so, as cash burns, the score must get riskier.

A sweetener for shareholders is no debt refinancing is said to be required until 2022, although I’d still beware lest any covenants deteriorate.

Stock market is jolted to a rose-tinted view

So easyJet illustrates how the latest share price rebound is based on some highly speculative assumptions about consumer behaviour normalising. But I do sense that many experienced investors are hunkered down, fearing the emergence from lockdown will be a slow process until reliable tests for Covid-19 are available, and ultimately a vaccine.

As to whether a market floor was established in late March: interestingly, a Credit Suisse analyst of the US stock market estimates that on the basis of revised forecasts last week, “forward PE multiples have already recovered their mid-February peak.” And that was before the last two days of stocks bounding on upwards.  

“All this rebound has effectively done is price in one set of poor earnings results and revert to what already looked in February, very expensive valuations.”

According to consensus forecasts for easyJet (though I am unsure of precise date), at around 650p, the stock trades on 7.5x the normalised earnings per share (EPS) projection of 87p for the year to September 2021, yielding 7.5% based on a 49p a share payout with 1.8x earnings cover. That looks pie in the sky to me.

The speculative buy case 

The flip side to such a cautionary assessment is the big-picture tactical view to buy hard-hit stocks with quality franchises – the Warren Buffett criterion meaning customer loyalty and strong market positions – which easyJet broadly meets. And though Buffett dislikes competition, in past months he has added to holdings of US airline stocks. 

At last November’s annual results, easyJet proclaimed itself: “The airline of choice with a record 96.1 million customers this year”, being at the forefront of carbon-neutral flying and also exploring electric planes.

Some extent of market rebound was also to be expected after stocks plunged over 30%, with short positions being closed out and near-term sentiment liable to twitch. It doesn’t reflect any change in underlying fundamentals, just a sense that if a quality company can survive then averaging into its stock will pay off longer-term.

Moreover, in fairness to easyJet, it rebounded to 650p also on 25 March, then dropped to a 475p low on 3 April, being down from over 1,500p in February. Re-testing a rally looks more like trying to establish a floor. 

But you have to assume “something different this time” about the Coviod-19 rebound. The history of bear markets linked to recessions shows them punctuated by rallies just like we’ve seen early this week. And with regard to airlines, Warren Buffett’s Berkshire Hathaway has dumped $314 million worth of shares in Delta Airlines and $74 million of Southwest Airlines, despite making bullish remarks about airlines as lately as February.

Raised costs and liabilities featured in the 2019 accounts

Before the current crisis, and in terms of easyJet’s quality of financial statements, it’s worth looking at last year’s numbers. Within an 8.3% rise in 2019 revenue, fuel costs rose 19.6%, airport costs by 11.9% and crew costs by 13.9% - which altogether flattened the EBITDA outcome, and, after a 143% hike in the depreciation charge, hit headline operating profit by 21.7%.

Who knows where oil prices may lie once this crisis is over, but they will probably remain volatile if demand destruction means production winds down, leading ultimately to a shortage.

So, the cost base looks to need cutting also, conceivably favouring Sir Stelios’s approach. Perhaps the board hoped it could overcome this with higher revenues, partly why it sought additional Airbus jets.

• Where to find dividend income from UK shares
• 11 UK stocks where experts think the dividend is safe
• A checklist for finding dividend shares in a crisis

The end-September balance sheet was good in parts, so why the cautionary credit score?

Within £2.9 billion net assets, goodwill/intangibles were a moderate £561 million and there was nearly £1.3 billion cash versus no short-term debt and £1.3 billion longer-term. With the income statement showing a net interest charge of £39 million - covered nearly 12x by operating profit - the balance sheet had even seemed “optimally” structured given low interest rates.  

Additionally, however, were £359 million lease liabilities and £397 million provided for “other liabilities and charges”, which helped push longer-term liabilities up to £2.5 billion alongside £2.7 billion current liabilities.

Total liabilities near £5.2 billion versus net assets around £3 billion looks the chief reason for a cautionary credit score which will now have worsened.

There’s an imbalance of £372 million trade receivables versus £1.1 billion trade payables, and current liabilities also include £1.1 billion “unearned revenue” that deserves a note of explanation.

Sir Stelios’ action might actually be helping the stock

Terminating a £4.5 billion contract – if at all possible – and battening down to test profitable routes with fewer aircraft, might be the most realistic way forward to survive and prosper.

Sir Stelios’ spokesman has referred to an “insolvency boundary” being pushed back from August to late-autumn, early winter, this despite 4,000 of a total 9,000 pilots and crew being furloughed during April and May, with the CEO declaring:

“Our current priority is to safeguard short-term liquidity in the event of a prolonged grounding of the fleet.”

If additional equity is required, then it could be vital to ensure Sir Stelios is on board; where previously he has balked at participating unless the Airbus contact is cancelled.

The situation is thus interesting to follow as a company re-inventing itself for the aftermath of Covid-19, but, for now, I see it as rather exemplifying a high-risk equity rally before fundamentals are known. With fresh money: Avoid.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.