With increased focus on forward-looking areas of scope, we believe there will be limited value in presenting a COVID-19 adjusted earnings before interest, tax, depreciation and amortization (EBITDA) in the majority of cases. Forecast results, particularly for FY21, will be more critical than ever. We consider the focus of due diligence should be on the shape of the recovery and forecast cash flows.
We believe that for businesses adversely affected by COVID-19 there is limited value in presenting FY20 adjusted revenue, and earnings as if COVID-19 had not occurred. Any such numbers would be somewhat arbitrary.
The discounted future cash flows of target businesses are fundamental for valuation purposes. EBITDA was only ever a proxy for this. Therefore, in times of material disruption, this proxy diminishes in relevance.
Not all sectors will be affected by COVID-19 in equal measure. In addition, COVID-19 may have accelerated the shift toward a more digital business model. This may have required increased levels of investment/capex but with sustainable efficiency/business model gains and upsides post COVID-19.
In the majority of cases, FY20 is likely to be too distorted a baseline from which to propose add backs. This may also apply to FY21 depending on the duration and extent of the pandemic.
However, it will be important to explain the impact of COVID-19 on the business across all touch points, the levers available and remedial measures taken. This will highlight the relative resilience of the business model and the quality of the management team.
With an increased focus on forward-looking areas of scope, particularly the achievability of the FY21 budget, the key areas of scope will include:
If the FY21 forecast EBITDA is the baseline for assessing earnings, the following areas will be a key focus of due diligence work, which will need to be more commercially focused:
Additional debt-like or cash-like items relating to COVID-19 could include customer / supplier / employee claims, litigation, onerous contracts, one-time re-start up costs, CLBILs / CCFF, catch-up holiday pay above normal levels, VAT / corporate tax deferrals, catch-up rent payments, capex catch-up amounts, deferred bonus / pay awards, treatment of pension deficits / contributions withheld, and leases (if modified).
FY20 cash flows could be distorted reflecting the impact of emergency measures taken by management to preserve cash.
Increased focus on 26 week rolling short term cashflow forecasts.
Forecast cash flows will need to take account of the unwinding of each of these measures.
Average normalised working capital (NWC) should be calculated for the same period used for baseline EBITDA. Benchmark NWC, therefore, may move away from an adjusted LTM to synchronise with a normal level of earnings i.e. FY21.
Forecast NWC is likely to be derived from first principles i.e. underlying days payable outstanding (DPO), days sales outstanding (DSO) and days inventory outstanding (DIO) plus other working capital receivables and payables in the “New reality” (what is the new normal level of inventory holding and bad debt provisioning required in a likely recession).
For forecast NWC, it will be key to assess assumed DSO / DPO / DIO against pre-COVID metrics but also taking into account possible supply chain / customer changes. It will also be important to understand what is in the opening balance sheet and how that might unwind / convert to cash i.e. are there agreed extended payment terms to clear legacy balances?