If you are not familiar with Altman's Z2-Score, please read my previous article "Evaluating Bankruptcy Risk In The Energy Sector Using Altman's Z2-Score." In that article, I included background information on Altman's Z2-Score, my reasoning for using Altman's Z2-Score, Z2-Scores for 20 oil and gas E&P companies, and the risks associated with Altman's Z2-Score. Without the information provided in my previous article, the data provided in this article will provide little value.
After completing the research provided in my previous article, I decided to calculate Z2-Scores for oil and gas equipment and services companies, expecting to find widespread distress. However, much to my surprise, none of the companies in my sample set have Z2-Scores below 1.1. In fact, 14/18 companies in this sample set had Z2-Scores above 2.6. If you recall from my previous article, a Z2-Score below 1.1 indicates high bankruptcy risk, a score above 2.6 indicates low bankruptcy risk and a Z2-Score between 1.1 and 2.6 is considered a gray area with moderate bankruptcy risk, but not a definite sign of financial stress. Below I have included my results and reasons for the variations in Z2-Scores between the equipment and services industry and the E&P industry.
In this article, I used the general use form of Altman's Z-Score. However, it can be argued Altman's original Z-Score could be used to value several of the companies profiled in this article because they are mainly manufacturing firms. I decided to use Altman's Z2-Score because while some of the companies profiled are manufacturers, most of the companies profiled are mainly service providers or have substantial services divisions in their firms. Ultimately, I concluded using Altman's Z-Score on a non-manufacturing company could be more damaging than using Altman's Z2-Score on a manufacturing company.
The table below contains Altman's Z2-Scores for Halliburton Co. (NYSE:HAL), Chart Industries, Inc. (NASDAQ:GTLS), Dril-Quip, Inc. (NYSE:DRQ), Matrix Service Co (NASDAQ:MTRX), Bristow Group, Inc. (NYSE:BRS), Schlumberger Limited (NYSE:SLB), Weatherford International plc (NYSE:WFT), Superior Energy Services, Inc. (NYSE:SPN), National Oilwell Varco, Inc. (NYSE:NOV), TETRA Technologies, Inc. (NYSE:TTI), Cameron International Corporation (NYSE:CAM), CARBO Ceramics Inc. (NYSE:CRR), Baker Hughes Incorporated (NYSE:BHI), Core Laboratories NV (NYSE:CLB), Flotek Industries Inc. (NYSE:FTK), Oil States International Inc. (NYSE:OIS), Helix Energy Solutions Group, Inc. (NYSE:HLX), and Tidewater Inc. (NYSE:TDW). (The companies listed below had market caps between $100MM and $100,000MM as of Jan. 29, 2015. Altman's Z2-Scores were computed using Q3 2015 financial statements.)
Source: Created by author.
If you recall, 50% of the oil and gas E&P companies screened in my previous article had Z2-Scores below 1.1. Surprisingly, 0/18 of the equipment and services companies screened have Z2-Scores below 1.1. Additionally, only 4/18 companies profiled in this article have Z2-Scores below 2.6.
Bond Prices Vs. Altman's Z2-Score
The table below shows a comparison between the Z2-Scores and bond prices of the equipment and services companies discussed previously. Essentially, I wanted to compare market-based bankruptcy risk (bond prices) to mathematics-based bankruptcy risk (Altman's Z2-Score). In my previous article, I avoided talking about debt to equity as a measure of distress because the D/E ratio a company can sustain, and remain healthy, varies greatly among industries. However, because the Z2-Scores for equipment and services companies were so high, relative to the E&Ps, I wanted to add more components to my analysis in order to discern whether or not the Z2-Score was exhibiting type 1 error.
Additionally, I included D/E and two-year stock performance to help us understand why the Z2-Scores computed for equipment and services companies are so high when compared to the Z2-Scores calculated for the E&P companies profiled in my previous article. (Bond prices and YTMs were based on Jan. 27, 2016, and closing prices were provided by FINRA. Two-year stock performance was based on prices between Jan. 27, 2014, and Jan. 27, 2016, rounded to the nearest 5%.)
Source: Created by author.
(Prices for private debt issues was not available for 8/18 of the companies profiled, which limits our ability to gauge the correlation between Altman's Z2-Scores and bond prices. I assume the risk-free rate is equal to the yield on U.S. treasuries.)
Generally speaking, debt trading at 70% of par or debt with yields 700+ basis points above the risk-free rate is considered distressed debt. Debt with a longer maturity will show distress in the form of YTM because longer-term debt has more interest rate sensitivity than short-term debt. Debt with a shorter maturity will show distress in the form of a discount to par. Most of the companies profiled in this article have debt with long maturities, which leads me to believe YTM is the best choice for gauging distress. Surprisingly, none of the public market debt issues for companies with Z2-Scores above 2.6 have yields 700 basis points over the risk-free rate.
Furthermore, the three companies with Z2-Scores below 2.6, and public debt issues, have debt with yields 700+ basis points above the risk-free rate. Based on the correlation between bond prices and Altman's Z2-Score, it appears Altman's Z2-Score is not showing false positives. Furthermore, If you take a look at the D/E column you will notice most of the companies profiled have a relatively low D/E ratio when compared to E&P companies.
Lastly, it is important to note the stock prices of most of the companies listed have collapsed over the past two years. Even CRR stock, which essentially has no debt, has fallen by an egregious 85% over the last two years. So, while Z2-Scores and bond prices are both indicating relatively low bankruptcy risk, it does not mean the companies are undervalued. It is definitely possible for the stocks of the companies profiled to continue to fall and not recover, even if they are perfectly solvent.
Why Do Equipment and Services Companies Have High Z2-Scores?
1. Leverage. Most of the companies profiled have healthy balance sheets and avoided incurring large amounts of debt relative to their equity. In fact, 4/18 of the companies profiled have debt below 10% of equity. Furthermore, only 2/18 of the companies profiled have a D/E ratio above 100%. Ultimately, Altman's Z2-Score attempts to measure bankruptcy risk, and companies with low leverage are able to weather periods of contraction better than companies with high leverage.
2. Profitability. 12/18 of the companies profiled had positive EBIT in the third quarter of 2015. It is important to note services companies have long-term contracts, which will begin to roll off in 2016, as these contracts roll off profitability will begin to decline. Alternatively, many of the equipment manufacturers profiled have order books that will begin to roll off in 2016, as oil and gas producers continue to cut back capital spending.
3. Impairment. I believe many equipment and services companies have not written down the value of their assets to reflect the current price environment. Generally speaking, companies tend to wait as long as possible before impairing their assets. If, in fact, equipment and services companies have failed to write down their assets, Altman's Z2-Score would be artificially higher.
Before starting my research, I believed the equipment and services industry was faring just as poorly as the oil and gas E&P industry. However, based on the Altman's Z2-Score, it appears the equipment and services industry is not dealing with the same level of bankruptcy risk as the rest of the energy sector. Furthermore, bond prices are not indicating a high level of bankruptcy risk in the equipment and services industry, at least not in the companies profiled in this article. It is possible I was being overly bearish on the equipment and services industry because of my own cognitive biases.
That said, just because a company has low bankruptcy risk, it does not necessarily mean the company's stock price will benefit. If a company's future expected cash flows fall, the stock will also fall without regard to credit risk. Lastly, the purpose of this article is not to provide a list of companies I believe will or won't go bankrupt, but rather provide investors another tool that can be used when evaluating investment decisions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.