Cartoon loser Wile E Coyote only started falling after he realised he had run off a precipice. European businesses are already experiencing that cruel awakening. The European Central Bank is expected to raise rates for the first time in more than a decade in July. A Lex data screening shows this trajectory could be awkward for companies such as Ocado and Just Eat Takeaway.
Ultra-loose monetary conditions have represented normality for years. During the pandemic they helped anxious companies to raise substantial sums. Much of this has been finding its way into shareholders’ pockets. Rising rates mean a bigger chunk of corporate cash will now go to creditors.
That will make highly indebted businesses much less attractive. Investors tend to fret when operating profits (ebit) cover interest charges by less than two times. Stagflation is the worst-case scenario. Even as central bankers jack up interest rates, earnings would fall. Both components of interest cover would be moving in the wrong direction.
Companies at the lower end of the credit spectrum already have volatile earnings and high interest costs. Our screening of S&P data on the largest non-financial UK and European equities found 39 out of 660 or 6 per cent currently have interest coverage below two times. Lossmaking meal delivery groups Delivery Hero and Just Eat Takeaway topped the list. Ocado, a UK-listed groceries delivery business, has a similar profile.
If interest costs increase by a half, the number of companies with thin cover would rise to 10 per cent. If interest costs double, that would push businesses in the danger zone to 16 per cent. Add in a recession where earnings collapsed by 25 per cent from the current consensus and the proportion would increase to 20 per cent. Big blue-chip names such as BT, Orange and Anheuser Busch would then have less than two times ebit cover.
In fairness, the food delivery companies would have no immediate liquidity problem, thanks to decent cash piles. Telecoms groups, meanwhile, boast steady, defensive cash flows. But expect investors to become increasingly picky about credit quality and dividend prospects as rates rise and earnings falter.
The Lex team is interested in hearing more from readers. Please tell us what you think of the outlook for interest cover in the comments section below.