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Pandemic pain – oil, airline and leisure shares suffer

Two of our analysts look at the sectors and outlook of those companies hurting the most following the recent stock market slump.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

The COVID-19 pandemic has now touched on just about every corner of the economy. But some sectors have been hit harder than others, and this article looks at three – oil, airlines, and leisure.

This article isn’t personal advice. If you're not sure what’s right for your circumstances, please ask for advice.

Investing in individual companies isn’t right for everyone. They are higher-risk as your investment depends on a single company – if the company fails you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

What’s going on with oil?

Sophie Lund-Yates, Equity Analyst

Disagreements between Russia and Saudi Arabia sent oil prices tumbling in early March, as the countries started ramping up supply.

This has come at a time when the coronavirus outbreak has caused global demand to slump. If planes aren’t flying and no one’s driving to work, the world needs less oil.

All of that means since 6 March the oil price has fallen almost 25% to around $33. That follows a rise in recent days – at the end of March the price was as low as $23, as shown below.

This inevitably creates some serious challenges for the companies involved in oil.

Oil price over the last 6 months

Past performance is not a guide to future returns Source: Eikon, 7 April 2020

What does it mean for oil companies?

Cheap oil directly impacts the revenues of oil companies, and that will hurt some more than others. Smaller names in the sector face more risk in a downturn, and we have concerns about their future.

Lower revenues and profits are a problem for companies that are already struggling to generate healthy levels of cash. Cash is money in the bank companies can use to pay salaries, invest in growth and pay down debt.

Tullow Oil said recently it can break even on a free cash flow basis when the oil price is around $35. That means that at current prices it’s costing more money to extract the oil than it can be sold for.

Tullow was already facing cash flow problems, following disappointing discoveries and production issues at its key oil fields. Lower revenue will make that worse. Fellow small-cap oil company Premier Oil is also stretching its finances with an $871m asset buying spree. It’s facing serious pressure from one of its creditors to abandon these acquisitions and to boost cash flow instead.

The concern is warranted in our opinion.

Premier and Tullow struggled when the oil price crashed a few years ago, taking on lots of debt to get through the tough times. While debt has come down, their balance sheets are still laden with a lot of that borrowing, meaning this downturn makes them vulnerable.

Tullow has net debt of $2.8bn, while Premier Oil has $2bn – this means they have more debt (borrowing) than they do cash. Compared to each company’s respective profits, that’s more debt than we view as comfortable when profits and cash flow are being squeezed.

Unfortunately there isn’t too much left in the self-help toolkit for these groups. During 2016’s difficulties, Tullow resorted to emergency rights issues – issuing new shares to raise money – to help pay off the debt pile. In today’s volatile market, it might struggle to convince investors to part with their cash quite so freely.

In Tullow’s case production is well hedged over the next year or so – which should help it secure an above average price for its oil. That provides some breathing room, but it isn’t a long-term solution.

If the oil price stays low for a prolonged period, smaller oil companies could find themselves relying on asset sales to keep the lights on. And in that scenario finding buyers could be tough.

Whether or not prices will rebound to the levels needed for the ships to steady, or be properly lucrative, is another question. They might not get there for a while.

Is it all bad news?

Lower oil prices aren’t always a bad thing. It can mean lower input costs for lots of businesses, which in normal circumstances can be good news for the economy.

Bigger oil companies like BP or Shell are also in sturdier positions than the smaller players.

Of course lower oil prices will still hurt revenue, but these bigger operations generate a lot more cash, providing them with more of a cushion.

One thing to keep in mind though is as things progress, the oil majors might decide to put the brakes on dividends. Shell recently announced it’s sacrificing capital expenditure (spending to increase growth) in order to maintain the dividend, and has suspended its share buyback programme too. Without knowing how much longer current disruption has left to run, we can’t rule out a dividend cut, even from the big players.

Overall, all oil companies are exposed to swings in the oil price, and there could be further ups and downs yet to come. But some are in sturdier positions than others. These turbulent times are a reminder to have a look at the cash and debt positions of any oil companies you’re invested in, and this is especially true of the smaller ones.

As always past performance isn’t a guide to what might happen in the future, and all investments can fall as well as rise in value, so you could get back less than you invest.

The airlines – the clock is ticking

Sophie Lund-Yates, Equity Analyst

The airlines have been among the hardest hit by the COVID-19 pandemic. Governments have imposed wide ranging travel restrictions and airlines have been forced to ground the vast majority of their fleets.

Airlines and the market

Past performance is not a guide to future returns Source: Refinitiv, 3 April. Please note Ryanair isn’t listed on the UK stock market.

This means airlines will generate very little revenue for as long as these restrictions are in place. Absent a sudden post-quarantine rush to go on holiday, demand for flights might also be slow to recover.

However, while cash isn’t coming through the door in large quantities, it is going out. Some costs can be scaled back when the fleet isn’t in the air, fuel being the most obvious. But other demands on cash will be much harder to flex in the next few months. Unionised staff will likely have contracts that make rapid redundancies expensive and leased planes still need to be paid for, for example. Government support could help here, but doesn’t fundamentally solve the problem.

This means earnings are likely going to take an ugly hit. How big depends on the duration of the restrictions and management’s ability to keep costs as low as possible.

The two main questions are: how much cash do the airlines have on hand? And how quickly are they going to burn through it?

We know how much cash the airlines have, and we also have a good idea what sort of credit they have access to. IAG has €7.35bn in cash and €1.9bn in available credit. easyJet has around £2.3bn after using its credit facilities. Ryanair has €3.8bn in cash, but has not disclosed what credit lines it has to draw on, if any.

However, it’s much harder to figure out how quickly they’ll go through the cash they have. We can get a sense of where the groups are starting from by looking at prior years, but this is of limited value because management will be cutting every cost they can. Management surely knows what their weekly cash burn is, and it’s frustrating that investors haven’t been told.

What’s next for the airlines?

It doesn’t look to us like any of these companies are in imminent danger of going bust, but it’s hard to say with certainty and they’re all definitely on the clock. If the shutdown continues long enough, then without much in the way of revenue the airlines will eventually go under.

In the long run the airlines are likely to change – especially if they get government help. Firstly, they’ll probably take on more debt in the short term, and it will take several years to get the balance sheets back into decent shape. Either that or investors will have to stump up more cash to put them back on their feet.

The chancellor has ruled out an industry wide bailout, but bespoke deals might still be on the table. While it’s risky to speculate about what these potential deals would mean, we don’t think they’re likely to be favourable for equity investors.

Brave investors might be rewarded if the shutdown is short lived and the planes can get back in the sky, but losses could be total in an adverse scenario.

Ultimately, remember all investments can rise and fall in value so you could get back less than you invest.

Leisure in lock down

Emilie Stevens, Equity Analyst

The leisure sector is home to an array of different businesses, from eating and drinking out, to gambling and hotels. But there’s a common theme running through – in the main they rely on us leaving the house to spend our money.

Coronavirus-induced lockdowns both in the UK and globally are therefore a big problem. Only businesses serving essential purposes remain open – meaning many leisure companies are facing low or zero revenue.

The extent of the damage on the sector will depend on how long the disruption lasts, and how well businesses are built to weather it.

No two businesses are the same, but there are a few common factors we think investors should consider.

Flexible cost base

With revenue low or close to zero in many scenarios, preserving cash that’s already within the business is key. To give themselves the best chance of weathering the storm, cutting costs is essential, and we’re seeing more and more companies announce cuts and changes to spending plans.

While costs like building or equipment leases, or financing costs, are relatively fixed, other business costs are more flexible. As the pandemic has progressed we’ve seen more companies scrapping or pausing non-essential spending like capital expenditure, marketing and shareholder returns.

It’s worth noting that staff and business rates are significant costs in the leisure sector and these are two areas the government have stepped up to help with – covering a significant chunk of the wage bill and implementing a yearlong rates holiday.

In response to having to close its doors, Whitbread, the owner of Premier Inn, has been bold in cutting costs. A dividend is off the table, refurbishments are on hold, as is marketing and non-essential training. Furloughed staff numbers will be significant too. Whitbread welcomed the business rates holiday, which will save them around £125m this year.

While slashing costs will help make businesses more resilient during the eye of the storm, having lower fixed costs in the first place is better.

Intercontinental Hotels Group provides a good example of this. While it’s certainly not immune to the current troubles - the group said recently hotel demand was the “lowest ever” - it’s also not your average hotel chain.

Despite having a portfolio of over 5,000 hotels across the globe, with brands from Holiday Inn to the more luxurious Six Senses, the group only owns around 25 of them.

Instead IHG licences a brand to the hotel owner in return for a percentage of their hotel earnings. This model will help protect IHG initially as it’s not on the hook for hotel running costs. But if an extended crisis forces franchisees out of business that poses a much bigger challenge, though it’s too soon to call what will happen.

IHG ownership model

Business model Number of hotels
Franchised 4,870
Managed 1,007
Owned 26

IHG's ownership structure

Source: IHGplc.com, Annual Report 2019

Ability to keep earning

Coronavirus has seen sports events cancelled globally and retail shops closed in response to government lock downs – posing some big problem for bookies.

William Hill thinks the loss of sports revenue could knock off around £100m in cash profits, plus an extra £23-30m per month for retail store closures – nearly half of original expected profits this year. GVC makes the corona impact to be a £100m hit to cash profits per month. Both are before taking into account cash savings measures.

With such a hit to earnings, cost cutting to preserve what cash they have is key. GVC recently reported it has enough cash to cover its costs at the moment and William Hill has access to cash too – but we’ve yet to hear a more detailed update from them.

Both also have access to credit from banks, but it comes with an agreement to keep net debt as a proportion of cash profits in check – this will prove trickier in the current environment and could get uncomfortably close to the limit.

It’s still too early to tell, but there might be some glimmers of hope, with earnings proving more resilient than expected. When the £2 maximum bet was introduced in shops, many moved to the counter to up their wager. And in the current disruption we could see gamblers switch to gaming and online casinos. Meanwhile there are some sports like Irish horseracing carrying on behind closed doors.

Some have also touted the rise of e-sports betting. In the same place where you went to bet on Liverpool to (finally) win the league, you can now bet on professional gamers. Whether that’s League of Legends or virtual Formula 1 is up to you.

While these sound like good opportunities in theory, it’s again too early to determine their impact to earnings. For now, bookies remain in hot water with ‘how long’ remaining the key question. The longer the disruption the bigger the dent.

Debt the deal breaker

When times are good and money is flowing in, borrowing might be no bad thing. Done well and within reasonable limits, it might allow a company to expand more quickly and grow the value of the business – acquisitions could be one example.

However, when the music stops and there’s a sudden drop in demand, debts still need to be serviced and that can prove a problem. ‘How soon’ will depend on the level of how much debt the company has and how hard earnings are hit.

Unfortunately, Cineworld amidst the current pandemic acts as something of a cautionary tale.

Having acquired the US cinema chain Regal in 2018, it’s the second largest cinema group in the world, with nearly 10,000 screens. But at a cost of $3.6bn (or $5.8bn if you include Regal’s debts), the deal pushed Cineworld’s net debt from around $378m before the deal to $3.7bn after – where it’s stayed. With a $2bn acquisition of the Canadian chain Cineplex due to complete this year, debt’s set to rise further.

This means Cineworld went into the pandemic with net debt nearly four times cash profits and interest cover (the amount cash profits cover financing expenses) of two times.

With the pandemic seeing some cinemas closed due to lockdown, and blockbusters like the new James Bond film postponed, with others released for home viewing early – near term earnings look shaky.

Cineworld’s own worst case scenario is a loss of three months of revenue from closures, meaning the group could get dangerously close to breaching borrowing agreements. Cineworld went on to say if the worst case scenario were to occur, it had “significant doubt” over its ability to keep trading.

What should investors keep in mind?

Until we’ve come out the other side of the pandemic, which looks some way off for now, the leisure industry will continue to take a hit. It’ll be a bumpy ride but there are steps you can take to give yourself the best chance of avoiding the potholes.

  • Costs – think about a company’s ability to cut them, are many of them fixed or can they slim down to a skeleton service for now?
  • Earnings – how big is the hit caused by coronavirus, are there ways for the company to keep earning?
  • Debt – take extra caution when looking at companies who carry debt, with earnings lower, it could quickly become unmanageable.

Hargreaves Lansdown's Non-Executive Chair is also a Non-Executive Director of Whitbread.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.


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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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