The coronavirus (2019-nCoV) and resulting illness (COVID-19) has spread rapidly within China and to neighboring countries. New cases are now emerging in other countries like Italy, Iran, Brazil, and the US. While efforts are being made to limit the spread of the virus, markets continue to sell off on the risk of pandemic. We are now seeing the first signs of the virus hit the global economy with diminishing demand in certain areas, supply chain interruption and earnings downgrades. This report addresses the industries and sectors where we are starting to see significant consequences from the virus to date.
Uncertainty surrounding the coronavirus is driving concerns within many industries and demand has suffered across sectors. At this point, companies are unable to quantify the full impact due to ambiguity around the duration of the virus, and how long it will take for demand to return once the virus is contained. Sectors with direct demand impacts are airlines and entertainment (including gaming, lodging, and cruise lines), automotive, homebuilders, retailers, and food and beverage. The energy sector is also affected, as lower economic activity and weaker demand weighs on commodity prices.
As quarantine measures and travel restrictions are extended, the coronavirus is negatively impacting air travel and those most affected are Chinese airlines (exhibit 1). On its recent earnings call, an aircraft lessor commented, "In China, right now, between 70% and 80% of the fleet is on the ground and liquidity has dropped significantly." The company also noted that the Chinese government is stepping in to help shore up liquidity for Chinese airlines. Bloomberg has reported that the Chinese government is considering direct cash infusions and arranging mergers among airline carriers to help the industry. While additional air travel geographies are affected (Singapore being the next most notable), we believe there may not be long-term negative impacts, provided the virus doesn't spread meaningfully around the globe.
Exhibit 1: China's passenger traffic of civil aviation, growth rate 2017-2020
Source: Data from the National Bureau of Statistics of China. As of January 2020.
Aircraft leasing companies, we believe, have the most potential exposure to financial issues. Still, in addition to lease and maintenance deposits, many lessors are protected through the Cape Town Convention (2006) which ensures the right of leasing companies to recover assets by asking for aircraft to be delisted from the national register when an airline is in default. With aircraft still in demand in other parts of the world, risks from the coronavirus to the aircraft lessors should be minimal, again, provided the virus is relatively contained in specific geographies.
The three major US domestic airline companies have halted flights to and from China through the end of March and end of April. However, Asia in general, and China, specifically, remain a small percentage of total traffic. US domestic air travel remains solid and the three major carriers appear to be in solid financial positions.
Currently, sectors within the entertainment industry that have greater exposure to the Asia Pacific region have been negatively affected by the virus. We contend that if the virus is not contained, other entertainment sectors would be affected including movie theaters, amusement parks, entertainment venues and music concerts.
- Gaming: The impact has generally been contained to companies with Macau operations. Macau casinos were shut down for two weeks, but have since reopened. While the reopening is positive for sentiment, demand will not materially return while travel bans in China remain in place. The casino resort business has high fixed costs so these properties will be significantly affected by the closures and ongoing travel bans. Macau operators believe there will be a lot of pent up demand once travel bans are lifted, but that is to be determined. We anticipate the coronavirus will have a significant impact on earnings, although the extent is uncertain.
- Lodging: US-based hotel companies have been growing in China, however, the overall exposure is relatively small. Negative effects from hotel closings and delays in building new hotels will be relatively modest if the virus is contained in the Asia Pacific region. If this becomes more widespread, e.g., into the US and Europe, the impact would be more significant.
- Cruise Lines: To date, virtually all recreation cruises have been cancelled in the Asia Pacific region as most ports are closed to cruise ships and tourists. One of the largest cruise lines announced last week the cancellation of all its Asia Pacific cruises through the third quarter of this year. Earnings will be affected from having to refund cancelled cruises, rebook trips on lower-margin cruises (Asia Pacific cruise are typically higher margin), and incur the cost of moving ships to different regions. If negative sentiment persists, demand for cruises outside the Asia Pacific region could decline, leading to a need for more marketing spend and promotion/discounting which would also impact earnings.
China is the largest global automotive market for light vehicles. The Chinese market has been on a downturn for the last couple of years with both US and European auto original equipment manufacturers (OEMs) negatively impacted. The coronavirus has provided a further headwind to the market. One of the largest local automakers in China reported a fall of 29% year-over-year in sales in January.
Another automotive company recently highlighted the near-term effects on its production and customer traffic in its dealerships. As an example, with only 34 of its 200+ dealerships open, February volume was at 15% of normal levels. Further, due to isolation restrictions in certain Chinese cities and provinces, the company delayed resumption of production post-Lunar New Year, but it is unclear if demand will continue to negatively affect production. Further, the virus potentially has negative effects on the auto supply chain, the extent of which are not entirely clear. As an example, a multinational automotive manufacturer halted production in South Korea due to issues sourcing component parts from China.
We would expect that most auto companies with exposure to China will be similarly impacted. JPM equity research noted that seven provinces that reported over 900 infected cases represented 34% of China's car production. The net impact has led to 1Q20 Chinese auto sales down 17-30% with the low end likely factoring in some recovery in March.
Bloomberg reported on February 20 that the Chinese government was considering extending its subsidies for electric car purchases beyond 2020 to assist the industry with the impact from the virus. This extension would be beneficial for electric car makers.
Car rental companies in China will be affected by the travel bans currently in place. However, they could benefit from higher demand for private transportation later on as people are likely to be cautious with using public transportation. The largest car rental company in China said recently in a conference call that it expects its revenue to fall by 20% year-over-year during the first quarter. To help boost its liquidity, the company plans to accelerate its car disposals during the quarter.
The Chinese homebuilding industry is likely to be temporarily affected by the virus as buyers postpone their purchases due to travel restrictions and investment cautiousness. The industry and its major players should be able to withstand this period of uncertainty as they have recently improved their liquidity profiles given their expectations for slower sales. One of the largest developers is offering discounts of up to 25% in some of its projects, including price guarantees. However, it is likely that some small players with weak liquidity profiles might experience some distress. The China Real Estate Chamber of Commerce cautioned that developers have a cash buffer of only three months and is calling for government action.
Retailers/Food & Beverage
Given quarantine measures were implemented during Chinese New Year, the peak of consumption, both revenue and margins will be affected in retail and global food and beverage companies. However, the effect continues to evolve as the geographic extent and duration of the disease remains widely unknown. While companies make mention of the likely effect the virus will have on operations, they have given limited visibility into quantification of the impact.
Oil producers are being pressured by rapidly softening commodity prices due to weaker demand for jet fuel and other petroleum products. Chinese imports of crude oil are down 3 million barrels/day, as refineries cut production runs. To date, OPEC and Russia have not coordinated additional production cuts to offset the reduced demand, although, OPEC is scheduled to meet March 5/6. Weakening demand for liquefied natural gas (LNG) in China is also weighing on natural gas markets globally. Some Chinese buyers are seeking to implement force majeure provisions that allow them to reject LNG cargoes. Upstream energy companies are reducing capital spending and production guidance in an effort to operate within cash flow. But concerns about market oversupply and weak commodity prices are putting significant pressure on their debt and equity securities.
Snags in the Supply Chain
The sectors that could see the most supply chain problems in the near term are consumer products, food and beverage, retail, technology, and basic industrials.
The coronavirus epidemic is materially impacting the Chinese manufacturing base integral to a number of consumer products companies' supply chains. Following the Chinese New Year holiday, companies have seen a delay in workers returning to work due to travel restrictions. Once able to travel, workers are subject to a two-week quarantine before they can return to work, causing delays in production thus far in the first quarter.
Companies have also noted lower productivity once workers are back on site (reported at 40-50% of normal levels) as new work requirements are forcing them to take precautionary measures with their attire and take mandatory temperature readings throughout the day. Further, with constrained labor, there is increasing competition for workers with concerns that companies producing lower-margin goods may lose workers to those producing higher-margin products. This is also affecting companies with production in other Southeast Asian countries as they often source materials from within China and are reliant on Chinese laborers and truck drivers further up the supply chain. The disruption goes beyond the factory as the labor shortage and reduced productivity is also causing delays at ports. Products companies anticipate shipping delays and higher costs through the first quarter.
However, most companies have been reluctant to comment on the anticipated drag on first quarter results. All are indicating the effects should be limited to the first half of the year with no full-year impact. The longer production delays linger, however, the less likely that is to remain true.
Food and Beverage
Global food and beverage companies are seeing demand decline as manufacturing supply chains and distribution networks are constraining inventories, while quarantine restrictions are also affecting traffic and related demand at supermarkets and restaurants. Some companies are indicating potential offsets to the negative demand as consumers utilize e-commerce and restock on staple food items and cleaning products, although depleted inventory levels likely moderate this offset. Agriculture players are still working through African swine fever issues, while the coronavirus affects their ability to move livestock and places constraints on animal feed supplies. In general, China represents low-to-mid single digit percentage of global food and beverage companies consolidated revenues, and thus far, companies are guiding for the virus effect to be temporary, offset by a rebound due to pent up demand, and are largely affirming current fiscal year guidance.
Retailers are being affected by the virus, both on manufacturing of the product and the raw materials sourced from China, as the supply chain disruptions constrain operations and the movement of goods. As a potential mitigating factor, a number of companies moved their manufacturing facilities due to recent trade wars and the rising cost of doing business in China. To a lesser extent, global retailers are also being negatively impacted by store closings and traffic declines due to quarantine measures in an effort to contain the virus. Much like food and beverage sales, e-commerce channels are a mitigating factor, but also constrained by inventory levels.
Several hardware, electronics manufacturing services (EMS), and semiconductor companies have publicly reduced first quarter guidance related to the coronavirus. The technology supply chain in China supports multiple end-markets, but tends to have higher concentration in smartphones, game consoles, optical modules, notebooks, NAND and DRAM memory, and televisions. EMS companies in the region will likely be negatively affected by both employee and part shortages. General transportation restrictions are also hampering the flow of parts and finished parts. In late January/early February, numerous management teams openly discussed the difficulties of estimating the impact from the coronavirus, as workers had just started to return from the Chinese New Year; multiple management teams spoke of operating at reduced workforce levels (30%-50%). The coronavirus will negatively affect near-term operating performance for several technology companies, but we do not believe it changes the long-term secular growth story fueling numerous technology firms. It should also be noted, that several semiconductor and sensor manufacturers support the automobile industry. Lower Chinese automotive production will negatively impact several semiconductor and sensor manufacturers. As of late February, a few CEOs were publicly stating factory operations in China were getting closer to normal production.
China is a big consumer and producer of various base metal and bulk commodities. Copper smelting production has been impacted as sulfuric acid (a byproduct of the process) inventories are reaching full storage capacity given the inability to transport it offsite. In addition, copper smelters are having issues getting copper concentrate transported to the smelters. Logistical and personnel constraints, as well as a lack of local bauxite supply, have hit alumina production, which has driven up pricing and put pressure on aluminum smelter margins. For steel, inventories have spiked as logistical bottlenecks have prevented the load-out of steel products from mills. This has resulted in some production curtailments with a knock-on effect of weakness in iron ore demand. In terms of end demand, logistics and worker availability have constrained commodity users, which has reduced demand for metals commodities meaningfully.
The story for chemicals is similar to metals/mining with China owning a large portion of production and demand across several chemical chains. Logistical issues and staffing shortages have resulted in rising inventories, which are likely to impact production rates across various chemical chains. On the demand side, curtailed economic activity and downstream chemical production delays have negatively impacted demand. For ethylene/polyethylene specifically, inventories are bloated as production did not stop over the Lunar New Year. The weaker downstream demand from logistical constraints and reduced labor availability is likely to have negative implications for global polyethylene prices. The Hubei province contains a material proportion of China's phosphate production, which has been curtailed and driven upside to phosphate pricing.
The effect the virus is having on paper/forest products is a bit more challenging to determine. Companies have mentioned that end customers are having some problems delivering finished goods to supermarkets. In terms of pulp demand, logistical disruptions are occurring, but structural consumption could benefit due to demand related to sanitary measures.
The virus expanding to other countries would be more of a first derivative impact on broad basic industrials through a further weakening of the macro environment and associated impact on demand. The concentration of production and consumption related to the basic industries in China is much higher than the likes of most other geographies around the world.
The manufacturing and automotive sector will be impacted, however it might not be as significant given the globalization of their supply chains as regions are often sourced by local production facilities.
Currently, we do not anticipate that the coronavirus will have a material impact on the (re)insurance industry outside of China. The number of deaths from the virus remains concentrated in China where global (re)insurance penetration is low. Even for the Chinese insurers, a UBS study indicated that the financial impact from elevated mortality claims in a downside scenario would be fairly limited for the Chinese insurers and well contained within 2020 earnings. The Chinese government has also committed to support insurance companies with medical claims from the virus (but not mortality claims). For the global reinsurers, life and health (L&H) premiums derived from the Asia region are a relatively small proportion of overall revenue ranging from around 4% for SCOR on the low end to roughly 22% for RGA on the high end. China represents only a portion of these premiums. If the situation worsens and the number of mortalities from the coronavirus increases outside of China, particularly in regions where global reinsurance penetration is higher, then we would expect a more meaningful financial impact to the broader insurance industry. For property and casualty (P&C) insurers, business interruption claims are likely to be limited, as most policies exclude shutdowns caused by infectious diseases.
We remain mindful of the risks of pandemic, balanced against indications that the virus will be contained and economic effects transitory. For the most part, we are seeing companies taking the appropriate measures to mitigate the risk that the virus poses to demand, supply chain and earnings. We urge patience and, most importantly, a level-headed approach given the uncertainties that remain.
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