Very cheap now — but what lies ahead?

The Covid-19 pandemic has injected a lot of uncertainty into the world of investment.

For those with the stomach to nibble at the market there should be a focus on cheap, quality businesses that are well capitalised with minimal debt on the balance sheets and with traditionally good cash flows.

A business such as restaurant and fast-food franchiser Famous Brands might have been considered too expensive in the past. So how do you make the decision to invest in the current environment? And does the fall of more than 70% in the share price in the year to date discount enough bad news to warrant an investment?

If forecasting a company’s earnings was difficult in the past, it is almost impossible now. It is hard to estimate the impact of Covid-19 on a company like Famous Brands, which is heavily reliant on consumers’ disposable spending.

Though the company does have a foreign component, it’s still predominantly a local firm, with R382m of its R405m operating profit (using the first half of the 2020 financial year) coming from its SA brands and manufacturing and logistics business.

Its recent update gives some guidance on what shareholders can expect when results are released towards the end of May. The results are for the year ended February 29 2020, so the guidance can still be relied on. But the challenges that have arisen since the most recent update will have a heavy impact on the current financial year, ending February 2021.

The recent trading update (released on March 12) already painted a grim picture, referring to “subdued consumer sentiment and constrained discretionary spend” as well as the effect of low inflation and power outages. The share was trading at about R45 then, a far cry from about R80 a year earlier.

The company released a subsequent announcement on March 23, but this update is also now outdated, as President Cyril Ramaphosa has since instituted a countrywide lockdown. This means that revenue has now completely stopped.

The share price has since fallen even further, and at the time of writing was at R25.

On most valuation metrics — using historical numbers — the company looks as cheap as chips (excuse the pun). But there is a huge question mark about the valuation, as there will be a period when some of its operations will earn nothing.

What will be especially hard hit is the 2,800-strong franchise network (some company owned), which has already been under pressure from load-shedding and slowing consumer disposable income.

To weather the coming storm it is an imperative for it to have a sound balance sheet. According to its most recent interim results Famous Brands had a net debt-to-equity ratio of 165%, meaning that the company is going into trying times fairly highly geared (largely due to its acquisition 2016 of UKbased GBK).

In the past Famous Brands has generated sufficient cash flow to cover its finance cost commitments. But the present uncertainty makes it important to watch what guidance management gives regarding its debt management as well as what the impact is likely to be on its franchisees.

With equity markets falling so dramatically during March, it’s tempting to argue that investors could just close their eyes and buy any share or sector, as long as they have a longterm view.

Famous Brands falls into this category, as it “optically” looks cheap — though investors must be aware that there are a lot of unknowns management will need to address.