Sasol’s assets nosedive in value, but what about a rights issue?

Sasol released a trading statement today that used the word “impairment” many times. That isn’t usually good news for shareholders, but Sasol was up over 4% regardless. Let’s unpack how that might be possible.

What is an impairment?

An impairment is an accounting entry that recognises a drop in the value of an asset. Auditors place a lot of focus on this to ensure that assets in a company are not overstated. In practice, it’s not as simple as it sounds. Many accounting frauds relate to assets that either don’t exist entirely or should’ve been impaired and weren’t.

Impairments, or “write-downs” occur when a company destroys shareholder value. The company either overpaid for its assets or operating conditions have deteriorated to the point where the assets aren’t even worth their book value anymore.

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It’s important to remember that a decrease in the value of an asset doesn’t change the fact that a company might still owe money on that asset. If your house loses value, you still owe the bank the purchase price.

Sasol’s impairments are enormous

Sasol’s impairments for 2020 financial year will be R112bn. That’s staggering. Sasol’s market cap (company value) is only R100bn, so Sasol is writing down its assets by more than the entire company is worth.

Of the R112bn impairment, the Base Chemicals division accounted for over R71bn. That’s the Lake Charles project, a pet hate of long-suffering Sasol shareholders who were there before the March share price crash.

The reason for this company value (share price x number of shares in issue) vs. impairment relationship is that the share price already plummeted to reflect the problems at Sasol. The accounting is just playing catch-up, as companies only report earnings every six months.

This is a perfect example of why you must be cautious of using book value (accounting value of assets minus liabilities) in assessing what a company might be worth. It’s only appropriate in specific industries where the accounting rules force companies to recognize the balance sheet values at a fair market value (e.g. banking and property).

It’s also a great example of why a share price can increase despite bad news coming out. It all depends on what the expectation was vs. the reality.

Look beyond net profit

Sasol will report a substantial net loss this year, but the real story is in the operating profit line.

The closest proxy we have for operating profit in this announcement is Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA). EBITDA strips out the impact of debt and different depreciation policies for assets. It’s a purer view of earnings and makes it easier to compare companies.

Sasol’s EBITDA will drop between 17% and 37%. However, it will still come to a substantial positive number (between R30bn and R39.5bn). This demonstrates that Sasol is still a profitable business at its core, despite the drop in the oil price (which is the reason for the decrease in EBITDA). As the oil price recovers further, so will Sasol’s EBITDA.

Unfortunately, Sasol has a lot of debt. That’s why things go badly wrong below the EBITDA line, causing the company to swing into a net loss.

The only words that matter right now: rights issue

The trading statement was silent on Sasol’s cash flow position and whether the company will need to go ahead with the rights issue that it warned about a few months ago.

City Lodge is a terrific example of how shareholders can be wiped out by a rights issue, forced to put in more money to retain any kind of value in the company. Avoiding such a situation is all that Sasol shareholders care about currently.

With the partial recovery in the oil price and some asset sales already executed by Sasol to reduce debt, the great hope is that Sasol will get through this mess without having to tap into shareholders for more money. If that happens, the current gains in the share price will be sustained.

I’m still holding my Sasol shares, up 238% since I bought in the crisis. Timing the market isn’t usually that important, but in times of volatility it definitely matters.

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