May 10, 2020
The common theme of posts for the past two months is that things are not going back to normal anytime soon. Of course the markets are telling a different story, up about 30% off the bottom set on March 23rd, but that is probably a ‘bounce’ provided by government intervention.
It is important to recognize that the market is not ‘wrong’. It is a fools game to try to outsmart the market, but also foolish to assume that participants in the market have a solid understanding of the fundamental underpinnings of the market.
In today’s world of finance, the direction is set by momentum traders and the excess capital floating around in the financial system. This excess capital can be seen by looking at money supply (M2 is the US measure of money supply including cash and easily convertible money sources such as money market funds). Here is the growth in M2 since the crisis began. It is a MASSIVE change). This capital is deployed (risk on) or taken away (risk off) depending on many different factors. Since the Federal Reserve stepped in to support markets, participants have been proceeding with ‘risk-on’ strategies.
So the government has used it’s infinite ability to tax in the future (that’s the people’s money) to send cheques to some of the worst run businesses and most financially insecure individuals in the nation (in many nations, but this post is focused on the US). The result is that asset markets are leaping back from the brink of disaster.
But what does this mean for businesses? There is certainly a chorus of pundits (some who know a LOT about markets) that think the market is way ahead of itself. What gives?
During the pandemic many businesses are shut down, some are operating at reduced capacity and some are succeeding magnificently at satisfying the needs of consumers and businesses.
Take for example a restaurant. Shut down for 6-8 weeks now, restaurants still must pay rent, but their staff has been laid off, their food costs are zero and perhaps they are making money with takeout or selling groceries, prepared meals or something of that nature. It is too early to tell, but many of them will simply not be making enough to sustain their businesses. Let’s look at a simplified financial statement for a major Canadian restaurant chain (Cara Operations, who run Swiss Chalet, Milestones, Montana’s, East Side Marios, Kelseys and other restaurants). It is worth noting that this is a very well run company. They have low debt, great brand recognition and generally successful restaurants. Here is the data from their latest annual report (very much simplified):
Note that their earnings, after all their bills are paid are just 4% of sales. $44 million of 1.25 billion dollars in sales. Of their sales, during good times, they spend 96% of their revenue on things like rent, food, salaries, marketing and other boring stuff like interest on their debt and taxes.
In a simplified view, if sales were to drop by just 4% and all remained the same, they would be losing money. Of course not all will remain the same. They will have lower revenue, lower employee costs, lower marketing budgets and so forth, but the fixed costs like leases (52% of their revenue goes to leases) still need to be paid, and interest on debt remains the same. If a restaurant is heavily indebted, and many are, the percentage of expenses for debt payments becomes a heavy burden.
What happens when everything re-opens? Restaurants may be only able to seat 50% of the people they did before COVID-19 arrived. Perhaps diners will spread themselves over longer periods, but 50% of revenue on the same cost base, even 80% on the same cost base means that many restaurants will not be able to survive.
In an article over the weekend, Bloomberg News quoted one analyst’s review of Sweden’s restaurant activity and it was bad. Sweden with some of the least restrictive policies in the world are seeing a 70% drop in sales at restaurants. Another proprietor from Spain was probably representative of the typical small restaurant owner. “For me to turn a profit, I have to have the bar full at lunch and dinner,” he said. “In such a small place, it’s impossible to open.”
This analysis will be similar for many service businesses. Airlines that have 20-50% declines in passengers, movie theaters that have 20% perhaps 50% declines in clientele will have a significant negative effect on profitability for some time. This will be made worse if companies are forced to borrow for short term payroll and lease payments, those interest payments will reduce profit margins for many quarters into the future and make some businesses unprofitable.
There will be many winners too. Companies that deliver services without significant human intervention may continue to do well as long as consumers are fearful of public spaces. Netflix and Amazon are well known names that are benefiting, however such companies may subside in some ways as other vendors open and supply chains are rearranged.
In all, the idea that ‘this time’ profits of companies will only decline by a few percentage points is bordering on the ridiculous. During the 2008-2009 crisis, GDP barely even budged between Q4 2007 and Q3 2009 before it started back on an upward trend. The services component of GDP never even turned negative! Meanwhile the stock market lost more than 50% of its value.
This time, different as it is, will see GDP in the current quarter, drop significantly. Perhaps by as much as 12% and unemployment, already at 14.7%, could hit 20%.
The scale of that collapse is epic and normal is not in the cards.