Rising interest rates and equity valuation from an earnings quality perspective

By Rachel Bradley
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

In mid-June, the Federal Reserve raised interest rates by 25 bps and signaled it was on track to raise rates twice more in 2018. With interest rates near zero for almost ten years, we believe that this gradual normalization to higher rates signals a long-term positive for the sustainable growth of the economy. The Fed is signaling its satisfaction with current inflation and unemployment trends and its confidence in the health of the broad economy. Fed chair Jerome Powell has stated that the economy has become sufficiently healthy such that the Fed can be more hands-off in stimulating economic activity.

During a normal expansion phase characterized by robust economic growth and rising equity prices, the Fed typically will push up interest rates (causing bond prices to fall). But in its most recent comments, the FOMC signaled it would likely allow inflation to hover above its official 2.0% target. Such a lenient (or dovish) stance on inflation is generally more favorable for continued growth as the Fed is in no hurry to increase the speed of its rate hikes. Even after the latest rate hike, the target nominal fed funds rate is 1.75%-2.00%, which is still a negative real rate once inflation is subtracted. The last time the fed funds rate was over 2.00% was in 2008.

One of the basic tenants of finance is the inverse relationship between interest rates and bond values. However, as the Federal Reserve continues on its path to normalize rates, we believe it’s worth exploring how interest rate changes can also affect equity valuations. The questions that seem to be on the collective investment community’s mind is, “What does this mean for me and my holdings? Are valuations peaking? Should I sell?” While it normally takes a year or more for changes in interest rates to be felt across the entire economy, the market often has a more immediate response.

To explore this in greater detail, we analyzed SeaWorld Entertainment, Inc. (SEAS) as an illustrative example of the potential impact of a future rate hike, given that it is heavily levered with a material proportion of variable-rate debt. We believe that the consensus forward EPS estimates for SeaWorld are likely overstated (and out of management’s control) as interest rates – and the firm’s interest expense – continue to rise, putting downward pressure on its valuation. Other companies with similar balance sheet exposure may be similarly at risk. Read on....

Unlike bond valuations, stock price movements are often difficult to predict and not uniform over an entire sector or industry. Rising rates typically do not have an immediate and direct impact to equity valuations, but rather a slower, ripple-like effect. Beyond increasing interest expenses, a departure from the abnormally-low government-supported rates may result in an increase in credit problems, delinquencies, and bankruptcies for highly-levered companies. This gradual rise in interest rates makes it both more expensive for companies to borrow money and often causes sell-side analysts to decrease their revenue estimates. When the cost of debt increases, these heavily-indebted companies may scale back their expansion plans or make cutbacks, suppressing earnings growth, cash flow, and valuations. Beyond these company-specific concerns, rising rates also can suppress stock prices by escalating the risk-free rate used in discounted cash flow (DCF) analysis.

SeaWorld Entertainment, a case study in high leverage and variable rate debt:

To demonstrate how a rising interest rate can impact financial results, we analyzed SeaWorld Entertainment, Inc. (SEAS). Beyond its high leverage, liberal use of floating-rate debt, and significant earnings quality issues, SEAS also has endured unfavorable news coverage, and activist investor Hill Path Capital has turned it into a battleground. While the high short interest (approximately 32%) makes this stock difficult to short for Gradient’s long/short hedge fund clients, the core analysis remains the same.

SEAS is an entertainment company that operates theme parks under the SeaWorld, Busch Gardens, Aquatica, Shamu and Sea Rescue brand names. Over the past eight years, SEAS received an extraordinary amount of bad press, namely from the documentary Blackfish. It described a pattern of “psychosis” among orcas in captivity, which the creators believe led to multiple deaths of SeaWorld employees who work with the orcas. As Blackfish gained traction with the public, SEAS started to experience a persistent decline in visitor traffic to its theme parks (particularly SeaWorld). The company responded by investing in aggressive marketing and “reputation campaigns,” but these led to only a temporary lift, and so the company is once again launching several new nationwide media campaigns in 2018. Gradient believes the ongoing level of investment in such media campaigns is likely greater than the company originally anticipated.

Amid these operational challenges, SeaWorld’s total equity persistently declined causing its liquidity and solvency metrics to deteriorate. However, since the first of the year, share price suddenly reversed and has increased nearly 60%. This valuation increase appears overdone – especially in light of our earnings quality concerns discussed next.

To assess the net interest rate risk, we examined the firm’s hedging activity to understand the true economic exposure. It uses derivative instruments (specifically interest rate swaps) to essentially turn a portion of its variable-rate debt into fixed-rate debt, thus lowering its net interest-rate risk. But even after considering the impact of these interest rate hedges, as of year-end 2017 it still appears that roughly 35% of SEAS’ total debt comprised variable-rate debt. We believe that this net exposure represents a material risk to its consensus earnings estimates. Furthermore, this issue appears to be specific to SEAS, with a much higher variable debt level than its closest publicly-traded peers.

To see how SEAS matched up against its peers, we examined three different debt metrics: debt-to-equity, debt-to-EBITDA and EBITDA (less CapEx)-to-interest expense. All three metrics show a deterioration in liquidity relative to peers over the last five years. The debt-to-equity metric has increased at a much faster rate than peers in recent periods and now carries the highest debt/equity levels in the peer group, approximately 5x higher than the peer median. Similarly, SEAS carries the highest debt-to-EBITDA ratio (more than double the peer median) and has the lowest EBITDA (less CapEx)-to-interest ratio in the group (which was below 1.0). Furthermore, if SEAS’s equity is not stated conservatively—for example, due to optimistic cash flow projections regarding intangible asset value or an impending write down of goodwill (SEAS had material impairments last year)—the firm’s “true” debt/equity ratio actually may be much higher. This analysis suggests that SEAS may bear a heightened risk of future debt downgrades or financial distress than its industry peers.

Moreover, SEAS’ trailing 12 months free cash flow has deteriorated significantly to the point that it is below 12-month interest expense in the last three quarters. We believe that a company whose free cash flow is inadequate to cover its interest expense carries an elevated risk of near-term liquidity issues. The current negative trends in SEAS’ cash-flow metrics add an additional layer of concern. It is Gradient’s belief that accrual-driven earnings (which are more discretionary in nature) are more likely to be indicative of less-conservative accounting choices than earnings driven by strong cash-flow generation (i.e., “Cash is King”). Consequently, we see elevated risk of near-term financial distress within the firm.

In light of the negative publicity and declining attendance described above, there appears to be further cause for concern as SEAS’ “Altman Z-Score” also indicates an elevated risk of financial distress. Developed by finance professor Edward Altman in 1968, it is an alternative metric that looks at debt levels (along with other items not related to interest rates) to assess financial risk. SEAS’ current value of -0.646 lies below the financial distress floor of 1.1 for non-manufacturers. (Note: For non-manufacturers, a Z-Score above 2.6 is considered to be within the “safe zone,” a score between 1.1 and 2.6 is considered to be in the “Zone of Ignorance,” indicating a greater level of caution, and a score below 1.1 indicates a high probability of financial distress and/or bankruptcy within two years.)

Other earnings quality issues:

Beyond SeaWorld’s declining attendance and financial distress signals, we have additional earnings quality concerns as well. Whenever a company utilizes derivative instruments, there is the potential to hide losses on the balance sheet rather than take the direct hit to earnings. When the fair value of derivatives declines, any gain or loss is split into two parts: effective and non-effective. The effective portion (meaning that the derivative was an offset to either gains/losses or cash flows) is recorded in equity and is thus added to accumulated other comprehensive income (AOCI). Conversely, the ineffective portion (gains/losses/cash flows in excess of SEAS’s underlying exposure) is recognized directly in earnings. For SEAS, these non-effective balance sheet losses totaled $5.8 million, or 10.1% of the consensus estimate of its next 12 months EPS. This decision to record losses as either equity or earnings represents an opportunity for some analysts to overestimate the true near-term economic earnings power of a firm.

To assess the likelihood of any near-term surprises, Gradient compared the company’s estimates and projections of near-term performance to analysts’ consensus estimates. In 2017, SEAS’ reported interest expense increased significantly; however, we believe even this substantial increase was understated as the company has significant derivative losses stored on its balance sheet. These losses likely will be unwound through the income statement eventually, thus further increasing interest expense and negatively impacting earnings.

Interestingly, the derivative losses discussed above don’t appear to account for any further rate increases. Current consensus estimates imply that 2018 interest expense will remain relatively flat from 2017. However, based upon the company’s own interest rate sensitivity analysis, higher rates would raise its 2018 interest expense substantially. Even if SEAS attempts to refinance its debt or convert a portion to fixed rate, it likely will have to pay higher interest rates to do so. This all points to a greater than expected interest expense in 2018 than the consensus estimate implies, even if SEAS’s net debt levels remain stable. We estimate that SEAS’ earnings profile may be negatively impacted by as much as $11.6 million, which represents about 34% of 2018 projected net income or 14% of 2018 projected free cash flow.

In addition to the financial risks inherent in a company adding more debt to its capital structure, we are concerned that SEAS may soon violate its debt covenant thresholds, putting the company at risk of a debt downgrade. This trend would represent a further earnings quality concern as highly-levered companies may be more motivated to make aggressive accounting choices in an attempt to avoid violating debt covenants. The significant decline in free cash flow further exacerbates this risk, in our view. Accordingly, we believe that SEAS’ earnings quality may continue to decline given the incentive to cosmetically enhance interest coverage and total net leverage ratios.

In summary:

While rising interest rates are beneficial for the long-term sustainable growth of the economy, it can negatively impact highly-levered companies with material variable-rate debt. On the other hand, there are certain companies that tend to thrive in a rising rate environment. For example, banks that provide variable-rate loans and financial and insurance companies that must hold large capital reserves all generate more income as rates rise. In addition, cyclical sectors like Industrial and Consumer, as well as sectors that benefit from commodity inflation like Materials and Energy, typically enjoy higher prices and/or increased sales volume – as long as they are not overly leveraged with variable-rate debt. Technology is also typically favored as an all-weather sector given its low financial leverage and its synergies throughout the broad economy as a driver of productivity.

Of note, almost half of the companies listed on major U.S. exchanges have variable-rate debt representing 75% or more of total debt. However, this represents the gross exposure to the firm, while the net exposure can be adjusted through hedging activities. We believe that it would be prudent for investors to consider these risks in connection with their investment decisions. Gradient’s analyst team examines this type of risk as part of its vetting process for long candidates, as well, including candidates for parent-company Sabrient Systems’ various equity portfolios, such as Sabrient’s Rising Rate portfolio that comprises growth-at-reasonable price (GARP) companies that Sabrient believes are well positioned to outperform in a rising interest-rate environment.