After doing several of these analyses for the coal sector, a couple of questions came up. One was whether the original Altman Z-score model was the most adequate to use with mining companies. Another was curiosity regarding how Chesapeake Energy (CHK) and Encana (ECA) fared in this analysis. This article will seek to address both concerns. I'll analyze CHK and ECA, using both the original model and an alternate non-manufacturing Z-score.
Altman Z-Score, an Introduction
For those that didn't follow previous articles on this subject, I'll repeat this here. The Altman Z-score, as defined by Wikipedia, is:
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.
The Z-score is a linear combination of four or five common business ratios, weighted by coefficients. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).
The Z-score has 5 inputs:
T1 = Working Capital / Total Assets.
T2 = Retained Earnings / Total Assets.
T3 = Earnings Before Interest and Taxes / Total Assets.
T4 = Market Value of Equity / Book Value of Total Liabilities.
T5 = Sales / Total Assets.
Which then come together using the following formula:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
Alternate Altman Z-Score, for non-manufacturing companies
Given that the original Z-score can be biased in the case of capital-intensive non-manufacturing companies, such as mining companies, an alternate model was created. I will also present the results for Chesapeake and Encana using this alternate model, and indeed both in the natural gas sector and in the mining sector I will use just the alternate model going forward.
The main differences between the original model and the alternate are as follows:
- The alternate model does not include T5;
- In the alternate model, T4 = Book Value of Equity / Total Liabilities;
- The weights are different, with Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4 ;
- The interpretation of the results is done according to a different set of values (Z > 2.6 is safe; 1.1 < Z < 2.6 is the grey zone; Z < 1.1 is the distress zone).
Calculation for Chesapeake and Encana
The following data was sourced from Chesapeake's and Encana's reports:
With this data, we obtained the following results
The first thing we notice in the results, is that according to the original model both companies would fall in the deeply distressed zone (Z < 1.8, see Creditworthy.com), even though Encana (Z = 1.6) did substantially better than Chesapeake (Z = 0.69).
But more importantly, the alternate model seems quite a bit more discerning. Here, Encana still gets a much better score (alt Z = 2.43), which is enough to put it at the very top of the "grey" zone, and this at a time where natural gas' cycle is clearly unfavorable. As for Chesapeake, the alternate model still keeps it in the distressed zone (alt Z = 0.88).
Looking at the partials, it's easy to see why Encana does so much better. The difference comes essentially from T1 and T2.
T1 is working capital, with Chesapeake showing a deep gulf between its current assets and current liabilities. Remember, these are assets that are or can be turned to cash in the short term (< 1 year), and obligations that must be paid in cash in less than one year as well. Naturally the risk of insolvency is much, much higher if a company shows a deficit in these accounts.
T2 is retained earnings. Obviously showing an ability to produce consistent profits over time relates with a lower risk, and Encana is better there as well.
The obvious conclusion here is that Chesapeake is a much riskier prospect than Encana. No matter the speculative news around Chesapeake, any shareholder wanting to avoid insolvency risk would probably do well to avoid the stock altogether. I was actually surprised regarding the working capital deficit being so large - Chesapeake might have a lot of assets, but it's presently a company at the mercy of its financers.
In short, until new management comes in and changes Chesapeake's financing structure, it might be better to stand aside.