Default risk (or insolvency) is the uncertainty surrounding a company’s ability to service its debt as and when it falls due. Prior to default, there is no way to discriminate unambiguously between companies that will default and those that will not. At best, we can only make probabilistic assessments of the likelihood of default. One way of assessing this is ‘distance to default*’(D2D).
Recent volatility played out on the ASX has signaled a sharp change in KPMG’s latest Distance to Default report scores for a range of sectors. Whilst the overall ASX D2D score has plateaued, for the first time we’ve seen 7 of the 11 sectors experience a decline in their score.Sectors that were traditionally strong performers. In addition, there remains almost 1 in 5 companies on the ASX with a D2D score that remains below 1 for three or more half year periods. We classify these companies as “Zombies”.
A 2 speed economy
Telecommunication Services recorded the largest deterioration in D2D score followed by Healthcare, Equipment and Services, and then Consumer durables. When examining the D2D scores in conjunction with key indicators of Revenue and EBITDA growth, Net Cash flows and Net Debt, the findings suggest that there’s a 2 speed economy in in each of the declining sectors. For example, almost half of the companies in the below sectors experienced negative operating cash flows and more than half had an increase in net debt.
This fact appears to have been missed from reporting season but it’s important none the less.
We see this change in D2D scores as a turning point in the default standing of many companies on the ASX and it should signal to credit managers the need for heightened awareness of default risk for those companies on watch or in workout or with extended trade terms.
The rise of Zombies
We continue to direct our focus towards the twilight zone i.e. – the Zombies of the ASX.
We define Zombies as companies that have held a D2D score of below one for more than 18 months. Our findings in our latest report indicate that almost 1 in 5 companies on the ASX remain stuck in the” zone”, representing close to $5bn in stranded capital waiting to be restructured and deployed towards more efficient uses.
Mining services and energy companies comprise almost 70 percent of Zombie companies and with the improved fortunes in the mining sector there are in number, less Zombie companies relative to our findings in the previous period. What we have seen however is a material increase in the number of IT and real estate and construction companies enter the Zombie zone.
For this reason we called out the construction sector which shows a slowdown in residential building is impacting the construction materials companies industry – those supplying building products for residential housing. We see this in the broader context of headwinds for the construction sector.
* D2D is a metric used to assess a company’s ‘distance-to default’. The metric takes into account financial information and market data. The closer to zero, the more likely a company is to default. In contrast, the further a company is from zero, the less likely it is to default. In our analysis, released every 6 months, we analyse the D2D score movements of ASX listed companies (following reporting season of full year and half year results) to draw insight as to corporate health across the Australian economy