A common outcome emerging from earnings announcements this year has been losses arising from write-downs.  Within the US, impairment charges for the first half of 2020 have exceeded $260 bn which is almost 30% higher than the entire amount recorded in 2019.  Moreover, it is on track to exceed the highest for the past 20 years which was in 2008 during the GFC.  Within Australia, there has been a steady stream of companies recording impairments charges across a wide range of industries ranging from energy to construction.  Senior executives will blithely argue that such charges are non-cash and are accounting adjustments driven by the auditors. In other words, there is no impact upon the value of the business.

Lenders to such companies would beg to differ.

A brief explanation about impairment charges. ‘Aggregate future cash flows’ is the commonly accepted tool used to value an asset. Hence, if such cash flows of an asset or independent group of assets (cash-generating unit – CGU) is less than the value on the books, companies are required to write down the book value, i.e. record an impairment charge.  

Asset write-downs have several implications.

Firstly, they indicate that the outlook for an operating unit of a business (CGU) is less rosy than what the company had originally believed.  Clearly, that is the reason behind write-downs in the energy sector such as Woodside Petroleum’s massive $4bn write-down and Quanta’s $1.4 bn write-down.

Secondly, a write-down impacts upon the leverage ratio of a company.  For companies that have a high leverage ratio, an asset write-down has significant consequences.  Companies that breach such covenants or at risk of breaching them will be seeking to bolster their capital. While debt refinancing would be the common sense approach, that avenue may be restricted if banks take a pessimistic view of further exposure. Especially so if the write-downs are pervasive within the industry.

A poster boy for this is the US shale industry.  It is predicted that this industry is facing almost $300bn in asset impairment charges.  Low oil prices, a sharp reduction in demand, capital constraints and high leverage are the primary factors which analysts are predicting to cause such a magnitude of write-downs.  The high leverage will likely lead to a chain reaction of bankruptcies, restructuring and consolidation of the industry.  If such a scenario eventuates, there will be a domino effect impacting along the oil and gas value chain.

An alternative pursued is the disposal of assets or business carve outs. Within this activity may lie some hidden gems for your business.

If you have been looking at scenarios for your business, write-downs would be a lagging though useful trigger for evolution of a particular outlook. It is a reflection of the changing environment and there may be opportunities and risks to your business model.  In particular, there could be a domino effect along the value chain which reaches your operations.

At this point, it would be useful to do a straightforward SWOT analysis. Breaking down your business model into its core components, namely:

• Value proposition
• Financial drivers
• Resource and infrastructure
• Marketing and customer interactions.

Then assessing each of these into the SWOT quadrant.  However, a tweak to the standard SWOT analysis, which is usually an inward-looking exercise, is to integrate the external environment into your consideration.  By this, I am referring to the write-downs as a potential external weakness which may be either a threat or an opportunity to your corresponding strength and weakness.  For example, write-downs could be a sign of a higher credit risk which means you would need to strengthen your risk management practices to guard against losses. 

Alternatively, the write-down can be seen as an opportunity if such a company is required to dispose of assets which play to your strengths.  Hence, an acquisition at potentially depressed prices could accelerate your growth and importantly, strengthen your market position.

In summary, it is always worthwhile to look beyond the immediate impact of losses within one sector and estimate what may be domino effects rippling across the value chain.  Lying within such activities could be some attractive opportunities for your business to take advantage of in order to leapfrog market leadership.