(June 19): In the summer of 2015, I met Professor Ed Altman at a lecture in New York. He had founded the Altman Z-score in 1968, a popular formula for predicting bankruptcy.
Altman’s gentle manner belied a titanic drive. As a PhD student in 1965, he was struggling to find a thesis topic. His professor sent him a single word note with “bankruptcy” written on it. Academic studies on the causes of bankruptcy were then rare. Altman was inspired to create an index that would rate the default probability of corporations.
Raw data was hard to get in the pre-Internet era. He had to patiently read through thousands of pages of annual reports. This was long before Bloomberg and Edgar. Pen, paper and the slide rule were the main tools (not Excel). Altman was determined to collate the data.
Altman first published his Z-score formula 52 years ago. It is a combination of profitability, leverage, liquidity, solvency, and activity ratios. Its founder did not expect the metric to become the gold standard for bankruptcy analysis.
It has proved to be an excellent predictor of bankruptcy. Many high-profile bankruptcies have been identified by the metric, including Enron and WorldCom. The Altman Z-score marked out Hertz as a distressed company months before it filed for bankruptcy last month.
Though Altman’s Z-score was initially directed at American companies, it provides clues for Singapore’s volatile oil & gas sector.
Singapore has become the world’s largest maker of jack-up rigs. These are used to drill for oil in shallow ocean waters.
Singapore’s oil and gas sector has been on shaky ground since the oil collapse of 2014. The Covid-19 pandemic has worsened the situation.
The bear market for oil since 2014 has led rig builders to slash jobs and capacity. Some of the 42 listed oil and gas players have already gone belly up. Swiber Holdings, a prominent marine engineering company was placed under a court-supervised rescue plan in 2016. Swiber defaulted on coupon payment. A restructured Swiber is still struggling with an Altman Z-score deep in the danger zone. Ezra Holdings filed for bankruptcy in the following year.
Covid-19 has magnified the leverage issues of these companies. It has contracted their ability to service debt and worsened the working capital situation.
The recent oil rally has been kind to the oil and gas sector. It has risen 14% from their lows of March. But, we are not out of the woods.
The Altman Z-score has three zones. A Z-score of above 2.99 is the safe zone. Between 2.99 and 1.81 is the grey zone. Below 1.8 is the danger zone.
The Singapore oil and gas sector holds an average Z-score of 0.2, which is deep within the distress range. Admittedly, the Altman Z-score is backward looking. It does not capture the improved cash flow from a prospective oil rally.
The Altman Z-score seemed to be a prescient predictor of the distress in the oil and gas sector. Swiber’s descent into receivership was preceded by its fall into the Altman danger zone.
A vibrant oil recovery could improve the cash flow of the sector. Also, there have been severe cuts in capacity. That could be the seed of improved operating earnings.
However, investors may stay clear of the companies with the vulnerabilities that the Z-score reveals. The sector includes rig builders and marine engineers. Sembcorp Marine, Triyards and KS Energy are in the distress zone.
These firms have a high proportion of net working capital to assets. This lends itself to a dependence on short-term debt. Sembcorp Marine has a total debt of US$4.7 billion ($6.5 billion) and its Ebitda was barely sufficient to meet its interest payments in FY19.
It may be enticing to dabble in a sector that is at a 60% discount to its peak. But, the debt ratios of many Singapore oil & gas companies are alarming.
As the labour of a 79-year-old professor indicates, Singaporean investors should tread with caution.
Nirgunan Tiruchelvam is head of consumer sector equity at Tellimer (Exotix Capital)
