Almost Daily Grant's
“Almost Daily” is the end-of-day delectation from Grant’s.
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Monday, September 16, 2019
Price gusher
The weekend drone attack on the Abqaiq processing plant in Saudi Arabia has sparked an international firestorm, with president Trump taking to Twitter to blame Iran and asserting the U.S. is “locked and loaded depending on verification.”
Whoever the culprit(s), their target is a crucial one to the world economy, as Abqaiq processes some 7 million barrels of oil per day (mbpd), equating to nearly 7% of the 101.2 million in global daily output according to the U.S. Energy Information Administration. The attacks hit their mark, as Saudi Arabia was forced to shut down 5.7 mbpd in output capacity, roughly half of the Kingdom’s daily production. Bloomberg notes that that gross supply loss marks the largest in history, topping the 5.6 mbpd in the Iranian Revolution of 1978 and 1979 and the 4.3 mbpd in the 1973 to 1974 Arab-Israeli War and oil embargo. The price of West Texas Intermediate crude jumped 14% to $62.5 a barrel this afternoon.
Hopes for a quick return to business as usual are dimming. “Damage to the Abqaiq facility is more severe than previously thought,” Amrita Sen, chief oil analyst at Energy Aspects Ltd., told Bloomberg this afternoon. “While we still believe up to 50% of the 5.7 million barrels a day of output that has been disrupted could return fairly swiftly, full resumption could be weeks or even months away.”
The supply disruption and price spike are welcome news for oil bulls, who have been forced to contend with a 20% drop in WTI crude in the 52 weeks ended Friday. In early July, fears of persistent oversupply led the Organization of the Petroleum Exporting Countries (OPEC) to extend the 1.2 mbpd in output cuts agreed to last December by an additional six months. In July, the International Energy Agency reported that global supply exceeded demand by 0.9 mbpd in the first six months of the year, predicting that 2020 will see “considerable oversupply because we are getting big growth from the United States and some other countries.”
In light of this weekend’s news, those concerns have moved to the back-burner. Saul Kavonic, head of equities research for oil and gas at Credit Suisse A.G., commented: “We have never seen a supply disruption and price response like this in the oil market. Political risk-premiums are now back on the oil-market agenda.”
The key question for oil investors: Are recent developments a one-off, or potentially a harbinger of a more sustained bullish regime? In a blog post Friday before the drone strike, resource investors Goehring and Rozencwajg LLC argued that the current backwardation term structure of oil, in which the spot price sits higher than futures (as opposed to contango, the opposite phenomenon), suggests that higher prices could be in the offing:
To understand why, consider that the future price of oil equals the current spot price plus the cost of capital and the storage cost less the ‘scarcity premium.’ This last term is the premium an oil trader is willing to pay to have crude delivered immediately. In a normal, well-supplied market, the scarcity premium is de minimis relative to the cost of capital and storage cost and the future price trades above the spot price resulting in contango.
However, when the physical market is very tight, the scarcity premium will overwhelm the cost of capital and storage and the spot price will actually trade higher than the far-dated futures contracts.
That dynamic has become more pronounced following this weekend’s events. As of this afternoon, front-month WTI and Brent crude trade roughly $10 a barrel above their respective September 2021 contracts, up from a $5 per barrel premium one week ago.
While an overseas supply shock is seizing headline space and investor attention, domestic developments could spur further upside in Texas tea. On Sept. 3, analysts at Raymond James wrote in a research report:
It now seems U.S. well productivity are tracking WAY below our model and this underperformance may reflect a significant inflection point in future global oil supply/demand balances. Specifically, over the past seven months, U.S. oil supply growth is tracking WAY below the same period last year (up less than 100,000 bpd this year vs. up nearly 600,000 bpd the same period last year).
Furthermore, for the past eight years, our model has typically predicted the highest U.S. supply growth on the street while actual production has generally come in even higher than our model. So far this year, however, U.S. oil supply growth has significantly undershot our model.
Reached by email this morning, Goehring and Rozencwajg co-founder Leigh Goehring expressed a similar belief:
Since January 1st, 2019, there has been no growth in U.S. shale oil production. Also, what is so interesting is that it looks like shale oil drilling productivity has come to a screeching halt as well. We have written extensively about how the productivity improvements in shale oil drilling have been much more a function of E&P companies “high-grading” their drilling acreage. . . i.e. they were drilling more and more tier one acreage, and less and less tier two acreage.
Although the problems in Saudi Arabia are getting all the attention today, real issues have already emerged with a vengeance in the U.S. shales. We have always said that the world oil industry is now completely dependent on just six counties in west Texas for production growth, and it now it looks like those six counties are developing large production problems.
Needless to say, continued strength in the oil market could yield many happy returns for energy investors. For a survey of potentially attractive opportunities in the sector, see the May 3 edition of Grant’s Interest Rate Observer.
Correction:
One letter, a world of difference: Friday’s edition of Almost Daily Grant’s stated that SmileDirectClub, Inc. generated $2.3 billion in adjusted Ebitda in the first six months of the year. The company instead posted $2.3 million in adjusted Ebitda over that period.
Recap Sept. 16
Stocks traded a bit lower, as the S&P 500 slipped back below the 3,000 mark, while Treasurys were well bid with the 10-year yield falling five basis points to 1.84%. Gold rallied back to the cusp of $1,500 an ounce, and the VIX remained below 15 for a forth straight session.
- Philip Grant
Friday, September 13, 2019
Everything burns
The S&P 500 has rallied by an impressive 20% year-to-date and sits at the cusp of all-time highs. Things are not so cut-and-dry in the land of the Unicorns.
Biotech company 10x Genomics, Inc. (TXG on the Nasdaq) debuted yesterday in style, with shares snapping higher by 35%. That performance is particularly impressive considering that the company was sued by publicly-traded research and diagnostics company Bio-Rad Laboratories, Inc. for patent infringement on Wednesday. Bio-Rad noted in a press release that this isn’t the first time it has taken 10x to court.
In November 2018, a Delaware jury found that 10X Genomics infringed patents licensed to Bio-Rad by the University of Chicago and awarded damages of $23.9M. In August 2019, the Delaware Court awarded Bio-Rad an additional $10.5 M in supplemental damages and interest and entered a permanent injunction against 10X Genomics.
In contrast, Mr. Market frowned on the IPO of orthodontics distributor SmileDirectClub, Inc. (SDC on the Nasdaq) yesterday, sending shares down by 28%. That drop, the worst first-day performance for a $500 million-plus IPO since at least 2000 according to Dealogic, is particularly vexing for shareholders given that SDC priced at $23 a share, above the indicated range of $19 to $22
One potential explanation for Mr. Market’s cold shoulder: SmileDirect posted a positive adjusted Ebitda of $2.3 million in the first six months of the year. As we know from this cycle, nothing scares growth investors like profitability.
That isn’t a problem for Uber Technologies, Inc., which sported a $6.5 billion operating loss on $6.3 billion in revenues for the first six months of the year. Public since May, triple-c-plus-rated Uber today priced a $1.2 billion (upsized from $750 million) in 7.5% notes due 2027 to help finance its acquisition of Dubai-based competitor Careem. A planned $1.7 billion convertible note offering is tentatively set for the first quarter of 2020.
While Uber receives a warm welcome from the junk bond market, the political arena has been less hospitable. Last week, the California legislature adopted Assembly Bill 5, which bars so-called gig-economy companies from classifying their workers as independent contractors and shifting health care, insurance and other benefits to those “contractors.” In response, Uber’s chief legal officer Tony West argued: “Drivers’ work is outside the usual course of Uber’s business, which is serving as a technology platform for several different types of digital marketplace.” If those arguments fail to catch on, Uber might be on the hook for $500 million in extra labor-related costs just from California, according to research from Barclays plc. Since coming public, UBER shares are down by 26%.
As recent IPO results have been thoroughly mixed, data-collection firm Palantir Technologies, Inc. has decided to change tack. Long rumored to be preparing an IPO of its own, Bloomberg reported last week that Palantir is instead “in talks to raise significant funding from private investors,” and will likely not come public for the next two to three years. Led by self-described socialist CEO Alex Karp, Palantir staffers have a taste for luxury. As noted in by The Wall Street Journal last November: “Palantir Entitlement Syndrome” has gained prominence as turn of phrase describing, among other things: “13-course tasting-menu lunches with lobster tail and sashimi at headquarters” and “‘artisanal bacon’ at the corporate breakfast bar.”
It’s full speed ahead for WeWork Cos., Inc. parent The We Company. In an updated S-1 filing today, We Co. announced a handful of governance changes to placate investors, including trimming the super-voting rights in the Class-C shares and removing family members of CEO Adam Neumann from the board of directors.
Nevertheless, things are trending in the wrong direction, as Reuters reports today that We’s updated projected valuation has fallen to as low as $10 billion. That’s down from a $47 billion valuation in a private funding round in January and a the $20 billion to $30 billion range reported just last week by Bloomberg. With $14.2 billion in total capital raised, We Co.’s private investors are, on balance, now well underwater.
The largest outside investor is facing particularly acute pain. At that reported $10 billion valuation, SoftBank’s Vision Fund, which has itself invested $10.7 billion for a 29% stake, would be sitting on mark-to-market losses of approximately $7.8 billion. Yet, SoftBank CEO Masa Son is apparently undaunted, as The Journal reports this afternoon that SoftBank will buy “at least $750 worth” of We Co. shares in the IPO.
Perhaps Masa might be fit for a cameo in the upcoming Joker movie?
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It’s not about the money, it’s about sending a message.
Recap Sept. 13
Thursday, September 12, 2019
The science of central banking
Investor eyes were trained towards Frankfurt
Investor eyes were trained towards Frankfurt
How now Kowtow
Recap Sept. 12
The science of central banking
Investor eyes were trained towards Frankfurt this morning as the European Central Bank sliced its benchmark deposit rate by 10 basis points to negative 50 basis points and announced €20 billion per month in fresh asset purchases.
In the accompanying statement, the ECB noted: “The Governing Council now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%.” Euro-area CPI rose 1% year-over-year in July, while inflation expectations, as measured by the five-year five-year inflation swap rate, sit at 1.3%.
While the ECB cuts rates further below zero in an effort to stoke inflation, the seventh-largest emerging market economy by GDP conducts its own monetary experiment. Today, the Turkish Central Bank levied a mammoth 325 basis point cut of its own, slashing the one-week repo rate to 16.5%. That follows a speech from President Recep Erdogan on Sunday in which he declared: “We are lowering and will lower interest rates to single digits in the shortest period. After [the benchmark rate] falls to single digits, inflation will also slow to single digits.”
Stimulating inflation and suppressing inflation. What can’t rate cuts do?
How now Kowtow
Yesterday, Hong Kong Stock Exchanges & Clearing Ltd. announced a surprise $39 billion bid for the London Stock Exchange Group plc. Apart from creating one of the world’s largest trading organizations, that combination would scuttle the LSE’s proposed $27 billion offer for financial data firm Refinitiv, Inc.
For Refinitiv, spun out from Thomson Reuters Corp. and acquired by The Blackstone Group, Inc. last year, losing out on the LSE’s offer would mark the latest turn in its recent saga with Chinese intervention. On Aug. 2, Refinitiv removed from its Eikon financial terminals a Reuters story detailing the efforts of Chinese Communist Party officials to incite counter-protests against demonstrators in Hong Kong. As noted by Reuters, “the Cyberspace Administration of China, or CAC, had said it would shut down the service unless it removed or blocked certain political stories.”
Those efforts were apparently insufficient to assuage the Chinese Communist Party’s displeasure, as Global Times editor Hu Xijin remarked on Twitter Sept. 2 that: “Reuters is engaged in politics on issue of Hong Kong. Its stories are [designed] to sabotage relations between HKSAR [Hong Kong Special Administrative Region] government and Beijing using journalism as a smoke screen.”
Other companies have stepped up their efforts to appease Beijing. In January 2018, Marriott International Corp. apologized to the Chinese government after referring to Hong Kong, Taiwan, Tibet and Macau as separate countries in an email questionnaire. As noted by The Washington Post, China had “temporarily requested Marriott shut down its six Chinese websites and apps as punishment,” a sanction which was lifted following an apology.
For its part, Wall Street needs no prodding to curry CCP favor. Yesterday, Bloomberg reported that J.P. Morgan Chase & Co., which is attempting to build out its China business, “has told some staff to ensure that they don’t refer to Hong Kong, Macau or self-governing Taiwan as separate countries.”
Some rhetorical flourishes go even further. On Wednesday, asset-management behemoth T. Rowe Price Group, Inc. recommended investors swap their U.S. equity holdings (rated underweight by the firm) and instead look to the Middle Kingdom. Thomas Poullaouec, head of Asia Pacific multi-asset solutions, told Bloomberg: “China is the one we have a preference [toward]. . . China is committed to manage this cycle in a very prudent way with policy measures.”
Discretion is the better part of valor.
Recap Sept. 12
A relatively weak 30-year auction, in tandem with a 2.4% year-over-year jump in “core” CPI (the hottest reading since September 2008) spelled more trouble for Treasury bulls, as the 10-year yield rose to 1.78%.
Stocks caught another bid, with the S&P 500 extending its gain for the week to 1.2% and pushing the broad index to within a few basis points of its July 26 high. WTI crude fell back to $55 a barrel, gold remained just under $1,500 an ounce, and the VIX finished near 14.
- Philip Grant
Wednesday, September 11, 2019
Flow rider
According to a recent report from Bank of America Merrill Lynch,
According to a recent report from Bank of America Merrill Lynch,
Recap Sept. 11
Flow rider
According to a recent report from Bank of America Merrill Lynch, collateralized loan obligations (CLOs) are, for the most part, in safe, unleveraged hands. Over the last five years, insurance companies held 24% of U.S. CLOs domiciled in the Cayman Islands (which include the bulk of the sector), followed by banks and mutual funds at 18% each, and pension funds at 11%.
Those hands had better be steady, as earnings growth in the companies that issue the leveraged loans (floating rate credits to speculative-grade borrowers) underying those CLOs is on the wane. On Monday, S&P’s LCD unit reported that among a sample of 202 corporate issuers, accounting for 18% of the S&P/LSTA Leveraged Loan Index, second quarter Ebitda rose an average of just 2% from a year ago and the weakest growth rate since the fourth quarter of 2016. That’s down from a 3% uptick in the first quarter and a range of 9% to 13% in growth in 2018.
As earnings growth slows, leveraged loan issuers find themselves on weaker footing. According to LCD, leverage for the average loan issuer rose to 5.6 turns of Ebitda in the second quarter, up from 5.26 turns in the first quarter. While that figure is not out of line with their trailing one-year average of 5.67 times leverage, LCD finds that issuers “operating at the extremes of credit tolerances” are on the upswing, with the percentage of issuers sporting a leverage ratio greater than 7 times jumping more than three percentage points to 18.3%.
More broadly, this provides a window into the ongoing private equity boom, as p.e. backed companies constitute 85% of the $1.2 trillion loan market. As the post-crisis economic expansion continues into a record 112th straight month, p.e. has paid ever higher prices and tacked on more debt, with Bain Capital’s 2019 Global Private Equity Report finding that the average LBO price rose to 10.9 times Ebitda last year, well above the 9.9 times seen in 2007, while leverage at p.e.-sponsored companies footed to 6 times Ebitda in 2018, compared to 4.9 times in 2007.
The S&P/LSTA Index has generated a 6.5% total return year-to-date, well below the 11.7% and 14.8% gains seen in the iBoxx USD Liquid High Yield and Investment Grade Indices. As loan performance lags, investors have headed for the exits, with a record 42 straight weeks of outflows for leveraged loan mutual funds and ETFs, according to data from Lipper. Total year-to-date outflows stand at $27.6 billion, according to J.P. Morgan, compared to $15 billion of inflows at this time last year.
Leverage can pinch, and sometimes it pinches the customers. Thus, in June 2018, hospital-based physician group Envision Healthcare Corp. was acquired by p.e. giant KKR & Co., Inc. for $9.5 billion in cash. The company has since generated a public outcry over its so-called surprise billing practices, i.e., charging much higher fees for out-of-network expenses than patients might normally expect.
In response to congressional scrutiny over surprise billing, KKR has rolled out an aggressive lobbying campaign aimed at members of Congress running for re-election in an effort to protect the company’s business model. In October 2018, KKR and Envision issued $5.45 billion in term loans, managing to saddle investors with fine print that those creditors may come to regret. Scott Josefsburg, an analyst at Covenant Review, wrote last fall:
This deal includes a radical change to the customary rules regarding the payment of dividends and other Restricted Payments. KKR is seeking to eliminate entirely any financial performance test for making Restricted Payments using the build-up basket [or the portion of accumulated profits which are available for dividends, etc.]. This may be one of the most drastic covenant changes we have seen in years.
Now KKR wants the ability to take out dividends and other distributions to equity whenever, regardless of the financial health of the portfolio company, so long as there has, at some point, been enough Consolidated Net Income.
The loan, priced at a 375 basis point spread over Libor (down from initial price talk of 400 basis points), has since fallen to just under 84 cents on the dollar from 99.75 at issuance, pushing the current all-in yield-to-maturity to 9.35%.
Recap Sept. 11
Tuesday, September 10, 2019
Flickering lights
Recap Sept. 10
Yesterday, California utility PG&E Corp. (PCG on the NYSE)
Yesterday, California utility PG&E Corp. (PCG on the NYSE)
Flickering lights
Yesterday, California utility PG&E Corp. (PCG on the NYSE) released its plan to emerge from Chapter 11. Particulars include a capped $18 billion wildfire liability fund used to compensate insurers and victims of the deadly 2017 and 2018 Northern California infernos, in tandem with fresh debt and equity issuance. The company entered bankruptcy on Jan. 29 and California governor Gavin Newsom has given PCG a June 30, 2020 deadline to emerge in order to participate in a $20 billion wildfire relief fund set up by the state.
The plan was met with some less-than enthusiastic responses from lawyers representing wildfire victims. Cecily Dumas told The Wall Street Journal: “We are not surprised that it is not an acceptable plan, but we are disappointed that it’s worse than expected.” Mike Danko dismissed the plan as: “Dead on arrival.” For his part, PCG CFO Jason Wells suggested the idea could be tweaked: “It’s a framework.”
As noted by Bloomberg, the insurers have argued that PCG owes them $18 billion, while lawyers for the victims have estimated that their own claims may exceed $40 billion. According to the company’s most recently filed form 10-Q, wildfire-related claims stood at $18.1 billion as of June 30, up from $14.2 billion three months prior. That number is expected to rise considerably, as CFO Wells stated in a Jan. 31 affidavit that potential liabilities could exceed $30 billion.
The wildfires have brought the problems with PG&E’s dated infrastructure into sharp and painful relief. On July 10, The Journal reported that company executives were aware of problems with transmission lines that were eventually responsible for 2018’s catastrophic Camp Fire, yet “repeatedly failed to perform the necessary upgrades.” In addition, in 2017 PCG found that its transmission towers were 68 years old on average (compared to a mean life expectancy of 65 years), with some as old as 108.
Meanwhile, the prospect of additional blaze-related liabilities looms large. Today, the San Francisco Chronicle reports that U.S. District Judge James Donato told PCG that he will likely allow a lawsuit against the company to proceed over the 2017 Tubbs wildfire in Santa Rosa. The Chronicle notes: “If PG&E is found responsible for the Tubbs Fire, the company’s bankruptcy would be billions of dollars more expensive than it would be otherwise.”
As PG&E attempts to restructure its liabilities, creditors and shareholders have presented competing proposals which underscore their distinct financial goals. A consortium of bondholders including Pacific Investment Management Co. and Elliott Management Corp. suggested a recapitalization, which would largely wipe out existing shareholders and transfer ownership to the creditors.
On Aug. 8, Bloomberg reported that Knighthead Capital Management and Abrams Capital Management (which own a combined 7.3% of shares outstanding) will put forth a plan featuring a $15 billion rights offering to help cover their forecast of PG&E’s liability shortfall, with the funds themselves chipping in $1.5 billion. With PCG’s market cap now at just $5.8 billion, a $15 billion rights offering would equate to issuance of up to 1.3 billion new shares vs. the 529 million shares currently outstanding.
As noted in an accompanying 13-D filing, some particularly optimistic assumptions underlie the plan: The shareholders pencil in $2.258 billion in 2021 net income. By comparison, fiscal 2017 saw a $1.65 billion bottom line for PCG, its highest figure in the past 15 years. The proposal also assumes that the utility sector maintains a 19 times price-to-earnings valuation. For context, the S&P Utilities Index has traded for an average of less than 17 times forward earnings over the last five years.
Forward price-to-earnings ratio for the S&P Utilities Index. Source: The Bloomberg
PCG shares have fallen by 43% since Feb. 22, when Grant’s produced a bearish analysis of the company. The piece noted that even prior to the disaster, PCG’s financials were on shaky ground, as $25.5 billion in operating cash flow from 2013 to 2018 was well short of the $31.9 billion in cumulative capital expenditures over that period, while the company paid some $4.4 billion in shareholder dividends from 2013 to 2017 using borrowed funds. Recent results have shown marked deterioration: Second quarter Ebitda fell to $1.06 billion, down from $1.41 billion a year ago, and revenues fell 7% to $3.9 billion over the same period.
While PCG’s liability woes could be dismissed as a company-specific outlier, Grant’s argued that investors might be well served by taking a broadly skeptical look at the utility industry as a whole:
For our part, we judge that the regulated-utility business model is vulnerable both financially and competitively. In the past 20 years, the S&P 500 utilities have covered capital expenditures out of operating cash flows in only seven years. And in only one of those seven, 2003, was free cash flow greater than common-dividend distributions. Utilities routinely spend more on property, plant and equipment than they generate in cash flow.
Then, too, accounting maneuvers represent another source of potential trouble. In 2017, PG&E amended the useful life of its energy-generating assets to up to 120 years, from a 100 year ceiling the year before. Grant’s noted the significance of that move:
Life-extension by the flick of a pen permits the classification of more current-period spending as growth capex, rather than maintenance spending. It’s only capex for growth that expands the rate base, therefore the income with which to service debt and pay dividends.
Utilities investors: What’s in your dividend?
Recap Sept. 10
Another sharp sell-off in Treasury bonds pushed the 10-year yield to 1.74%, erasing a chunk of recent gains that saw the 10-year fall to a three-plus-year low of 1.46% a week ago. The about-face in rates has coincided with a similar reversal in gold, which fell to $1,482 an ounce today from $1,553 last Wednesday. WTI crude slipped back to $57.50 a barrel, while the S&P 500 and the VIX both finished little changed.
- Philip Grant
Monday, September 9, 2019
Dueling banjos
From NBC4 New York:
From NBC4 New York:
T party
Today, hedge fund Elliott Management Corp. disclosed a $3.2 billion stake in AT&T, Inc. (T on the NYSE)
Today, hedge fund Elliott Management Corp. disclosed a $3.2 billion stake in AT&T, Inc. (T on the NYSE)
Recap Sept.9
Dueling banjos
From NBC4 New York:
A man damaged Wall Street's famous "Charging Bull" statue on Saturday by attacking it with a banjo, police said. Kevin Cevon Varlack, 42, of Dallas, was charged with criminal mischief, criminal possession of a weapon and disorderly conduct.
He was seen striking the bull with a banjo shortly after noon, police said. Photos showed the statue had cuts at the base of one of its horns.
Most hated bull market indeed.
T party
Today, hedge fund Elliott Management Corp. disclosed a $3.2 billion stake in AT&T, Inc. (T on the NYSE) and sent a letter to the company advocating for a series of actions to stir its moribund stock price. As noted by Elliott, T trades at roughly 10 times consensus 2019 EPS, far below its historical average of 12.4 times and the 18 times forward earnings valuation for the S&P 500. Over the last 10 years, T shares have returned 122% assuming reinvested dividends, compared to 229% for the S&P 500, and finished higher by 1.5% today.
Elliott argues that a $60 share price, approximately 65% upside from Friday’s closing price, is achievable through cost cuts, asset sales and a renewed focus on its core telecommunications business: “AT&T must undergo a strategic shift away from acquisitions and toward execution. Even aside from the questionable strategic value of its M&A, AT&T has spent far too much of the past decade in acquisition mode. Acquisitions require a significant allocation of time and resources – both capital and employee time – that AT&T has been unable to spare.”
AT&T’s efforts to diversify during this cycle included a pair of dubious mega-deals, the 2015 acquisition of DirecTV, Inc. for $67 billion followed by last year’s takeover of Time Warner, Inc. (now WarnerMedia) for $109 billion, at 19% and 39% premiums to their respective pre-announcement prices. Those deals have transformed AT&T’s income statement (wireless contributed only 39% of revenues in the second quarter), as well as the balance sheet. AT&T is now the world’s most encumbered nonfinancial company, with $194 billion in total debt.
Yet growth is seen wanting, as the Street pencils in $60.6 billion in adjusted EBITDA and $27 billion in free cash flow for 2020, compared to $63.8 billion and $29 billion, respectively, in the 12-months ended on June 30.
Analysts from Bloomberg Intelligence are skeptical that activist pressure will force wholesale changes at AT&T, writing that today’s letter “probably won’t prompt a change in company strategy. . . Elliott’s recommendation to spin off the DirecTV satellite business isn’t practical, in our view, as AT&T likely needs its free cash to help fund the dividend.”
Yet the company’s second-quarter results showcased Elliott’s concerns, as the DirecTV unit saw a 778,000 net subscriber loss for a meaty 8.7% year-over-year decline. In a July 24 research note, Craig Moffett of MoffettNathanson LLC suggests that WarnerMedia is a growing trouble spot: “just one year after the deal closed, events already seem to be taking over the company.” Noting the cool reception to the planned HBO Max streaming service at a hefty $17 a month, Moffett writes: “simply preserving revenues at HBO will only come at the expense of declining revenues at Turner cable networks and a truckload of lost licensing revenues at their TV studio.” The media unit reported $2.06 billion in adjusted Ebitda for the second quarter, short of the $2.22 billion consensus.
Elliott’s recommended strategy shift underscores the frailty of the growth-by-acquisition strategy. A bearish analysis of AT&T’s credit in the June 29, 2018 edition of Grant’s connected Ma Bell to a century-old study of large-scale corporate deal-making:
M&A is now—arguably, always has been—a leap in the dark. There’s no such book as The Art of Not Dealing but Rather Minding Your Own Business and Turning a Deaf Ear to the Fee-Slurping Promoters, though Arthur Stone Dewing’s The Financial Policy of Corporations, published in 1919, makes a good substitute. Dewing investigated the merger wave at the turn of the 20th century, the era today remembered as the age of the great trusts. Teddy Roosevelt’s trust-busting came later, but the market provided its own centrifugal powers of destruction.
Out of 29 such consolidations that Dewing studied, only four matched the projections of their promoters after 10 years of operations.
Since that publication date, triple-B-rated AT&T’s senior unsecured 4.3% bonds of 2042 have seen their spread over Treasurys narrow to 185 basis points from 240 and are currently priced at 105.75 cents on the dollar for a yield-to-worst of 3.92%.
Recap Sept.9
A flat showing for the S&P 500 featured some interesting price action under the surface, with the iShares S&P 500 Value ETF gaining nearly 1% while the iShares Edge MSCI USA Momentum Factor ETF lost almost 2%.
Treasury yields jumped higher in curve-steepening formation, with the two- and 10-year yields finishing at 1.59% and 1.63%, respectively. Gold and oil continued their recent divergence, with the former dropping back below $1,500 an ounce for the first time since Aug. 22 and the latter reaching $58 a barrel for the first time since the end of July. The VIX remained just above 15.
- Philip Grant
Friday, September 6, 2019
Vision zero
The office space company intent on “elevating the world’s consciousness” is set to downsize.
The office space company intent on “elevating the world’s consciousness” is set to downsize.
Recap Sept. 6
Vision zero
The office space company intent on “elevating the world’s consciousness” is set to downsize. Bloomberg reports today that ahead of its planned initial public offering, The We Company (née WeWork Cos., Inc.) is cutting its proposed IPO valuation to $20 to $30 billion from the $47 billion the company obtained in its last private funding round (Bloomberg suggests the number could be closer to the low end of the range).
In total, the Vision Fund has pumped $10.7 billion into We Co. (beginning in August 2017 at a $20 billion valuation) and owns a 29% stake. Needless to say, next week’s IPO roadshow will be critical. If We Co. is valued by the public markets at $22 billion, that would represent a $4.2 billion mark-to-market loss for SoftBank and its visionary CEO Masayoshi Son.
A valuation haircut would be a tough pill to swallow for Son and company. Bloomberg reports that Vision Fund employees are not paid out until profits have been realized, and face clawbacks of up to 20% and above for senior staff. With things currently looking grim, analysts at Bloomberg Intelligence proffer a suggestion: SoftBank “may consider injecting more capital into We Co. to gain majority control, which would enable the coworking leasing company to delay” the IPO in hopes of achieving a better price. We Co. posted a $900 million net loss in the first six months of the year, on $1.5 billion in revenues.
This comes at a bad time for SoftBank, which is in the midst of raising Vision Fund 2. While SoftBank has claimed to have already raised the $108 billion in commitments for the fund, The Wall Street Journal reported Aug. 7 that the pledges are based only on memorandums of understanding as opposed to firm commitments, while investors not named in the press release account for “the bulk” of outside funding. That figure could likewise include debt-like securities, further ‘stretching the definition of ‘capital.’”
Creative financing options abound. On Aug. 18, The Journal relayed that SoftBank was seeking to raise up to $20 billion from its own employees (including up to $15 billion from Son himself), a figure which the company itself might finance with “around 5% interest and in most cases requiring little money down.”
At the corporate level, Son likewise leverages SoftBank’s future to the success of the Unicorn-chasing Vision Fund and its portfolio of illiquid, largely money-losing technology startups. Last December, SoftBank had parted with staid but cash-generating positions like a 33.5% stake in domestic telecom subsidiary Softbank Corp. and sold a $4 billion stake in Yahoo! Japan Corp. to that telco unit in May. SoftBank’s full pivot towards tech will accelerate next year, as the company announced in early August that it will cease consolidating 85%-owned Sprint Corp. onto its financial statements, in anticipation of a successful merger with T Mobile U.S., Inc. (Almost Daily Grant’s, June 20).
At the same time, competition for attractive assets remains fierce. The Journal reported yesterday that p.e. firm Vista Equity Partners closed a new $16 billion technology fund.
For the quarter ended June 30, SoftBank reported ¥408.5 billion ($3.8 billion) in unrealized profits, as gains in Slack Technologies, Inc., OYO Hotels and Doordash, Inc. were partially offset by losses in Uber Technologies, Inc. That brings the Vision Fund’s pre-tax cumulative investment profits (which include realized and unrealized gains from investments) to $20.2 billion, from a total $71.4 billion acquisition cost basis. But the third quarter has not been kind to publicly-traded Uber and Slack, down 28% and 25%, respectively since July 1 (OYO and Doordash remain private), dealing the fund combined mark-to-market losses of approximately $3.6 billion from the pair.
As the Vision Fund portfolio shows signs of reversing its momentum, Son opts to turn once more to the yield-starved Japanese public. Today, SoftBank priced a ¥100 billion ($934 million) seven-year note at 1.38%, the second-highest coupon for a publicly traded corporate bond in Japan this year trailing only a six-year note from SoftBank at 1.64%, in April.
Of We Co.’s upcoming roadshow, an unnamed executive told Bloomberg: “fingers crossed.” The sequel is never as good as the original.
Recap Sept. 6
A weaker than expected non-farm payrolls reading might nudge the Fed towards easier policy, but financial markets mostly shrugged today with the S&P finishing flat, up 1.7% for the week and within 2% of its highs. Treasury yields likewise finished little changed, while gold extended yesterday’s losses to close near $1,500 and WTI crude rose back towards $57 a barrel. The VIX sank to near 15, its lowest since the end of July.
- Philip Grant
Thursday, September 5, 2019
Let's pretend
During an interview with Bloomberg radio yesterday,
During an interview with Bloomberg radio yesterday,
Fan depreciation day
The loan machine comes alive once more.
The loan machine comes alive once more.
Recap Sept. 5
Let's pretend
During an interview with Bloomberg radio yesterday, William Quigley, co-founder of the purportedly dollar-backed cryptocurrency tether, offered an existential perspective on his creation:
“Whether or not tether was backed by the dollar actually wouldn’t matter if everybody agreed to take tether and to value them at a dollar themselves.”
Unfortunately for tether fans, New York attorney general Letitia James appears to differ in that assessment. In April, the AG’s office accused the companies backing tether and the Bitfinex crypto exchange of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds,” then citing the wide-ranging Martin Act in a July filing to assert jurisdictional control over the companies in the state of New York. Two weeks ago, a state justice rejected the defendant’s request to dismiss the lawsuit, paving the way for a trial.
Fan depreciation day
The loan machine comes alive once more. The launch of a $4 billion refinancing term loan from Dell, Inc. today brings the weekly issuance of leveraged loans to $15.8 billion according to Bloomberg. That’s the busiest week for loan issuance since October of last year.
But while issuance remains healthy and defaults low (the ratio stood at 1.29% for August, well below the post-1997 average of 2.9%), the distressed ratio has spiked. According to S&P’s LCD unit, the percentage of loans in the S&P/LSTA Leveraged Loan Index trading below 80 cents on the dollar shot to 4.03% in August from 2.81% a month earlier. While that remains well short of the 12% sub-80 share in the winter of 2016, overall loan credit quality has deteriorated. Per LCD, the share of loans rated single-B and below rose to 48.41% in August, up from less than 35% in that 2016 winter of discontent. Then, too, the 2016 swoon could largely be attributed to the collapse in energy prices. By comparison, the latest move is broad-based.
Idiosyncratic pitfalls have also appeared. The Financial Times reports today that the Invesco-Oppenheimer Senior Floating Rate Fund saw its net-asset value sink to a three-plus year low, as a series of equity investments gone awry have hurt the fund’s performance. “I’m critical of it,” Brian Moriarty, analyst at Morningstar told the FT, “it’s not what investors signed up for.”
The recent uptick in distressed population (in tandem with the long slide in credit quality) and manager mission creep present a pair of risks to loan investors. An erosion in financial reporting, another. In a report today, Moody’s Investors Service declares: "The definition of Ebitda [earnings before interest, taxes, depreciation and amortization], a widely-used and fundamental measure for assessing a company’s profitability and credit profile, has been pushed to the edge in recent credit agreements.”
The analysts, led by senior covenant officer Enam Hoque, likewise note the prevalence of so-called add-backs, or credited cost savings that are projected to be achieved for three years into the future:
These long forecasts may turn out to be highly optimistic, leaving investors with little recourse as borrowers incur substantial debt, make extraordinary dividends, or sell material assets in the interim period.
According to Moody’s, 33% of deals through the first six months of the year had no limit at all on the amount of add-backs that management can credit itself. Of the remaining two-thirds, the average add-back is capped at 20% of an issuers’ Ebitda. That’s up from 15% in the first half of 2017.
The deterioration in financial reporting standards has been a long, slow one, highlighted by the rise of Ebitda in place of operating income, or Ebit, during the 1980s leveraged buyout boom. Of course, that opaque and ultimately investor-unfriendly change was not without its detractors. In June 2000, Moody’s released an analysis headlined: “10 Critical Failings of Ebitda as the Principal Determinant of Cash Flow.”
The ratings agency went on to assail Ebitda as excessively slack and easy to manipulate, terming the metric an often “misleading measure of liquidity” and asserting that “Ebitda can drift from the realm of reality.”
Evidently, what’s good for the goose isn’t always good for the gander. An analysis in the Aug. 18, 2000 edition of Grant’s, referencing that Moody’s report, offered this rule of thumb:
About a decade and a half ago, reader Michael Harkins noted that the very people who appeared to be most adamant about excluding depreciation from calculations of corporate cash flow were the ones who were divorcing their aging first wives.
Recap Sept. 5
Stocks ripped higher, with the S&P 500 extending to a near 2% gain for the week so far, while Treasurys were hammered with the two- and 10-year yields each rising 10 basis points to finish at 1.53% and 1.56%, respectively. Gold fell more than 2% to $1,519 an ounce, WTI crude held steady at $56 a barrel and the VIX fell to just over 16 from near 20 on Tuesday.
- Philip Grant
Tuesday, September 3, 2019
Devalue investor
The arrival of September brings $100 billion in additional tariffs on Chinese goods.
The arrival of September brings $100 billion in additional tariffs on Chinese goods.
Recap Sept. 3
Devalue investor
The arrival of September brings $100 billion in additional tariffs on Chinese goods. The U.S. negotiator-in-chief was back at it on Twitter this morning, promising that “when I win [reelection]. . . deal would get MUCH TOUGHER! In the meantime, China’s Supply Chain will crumble and businesses, jobs and money will be gone!” For his part, China’s ruler-for-life Xi Jinping stated in a speech today at the Central Party School in Beijing that his country faces “concentrated risks” and “must carry out a resolute struggle” against its adversaries.
The trade dispute appears to be taking a toll on the People’s Republic, as economists at Bloomberg, Oxford Economics and Bank of America Merrill Lynch each cut their respective 2020 real GDP growth forecasts to less than 6%. China reported 6.2% growth for the second quarter from a year ago, which was already its slowest pace since 1990. According to Louis Kuijs, chief Asia economist at Oxford Economics, “more policy easing is needed to convincingly stabilize economic growth.”
On that front, the Chinese Communist Party is hard at work. According to a report today from the South China Morning Post, the government’s Financial Stability and Development Committee promised “enhance[d] countercyclical measures in macroeconomic policies. . . to ensure sufficient liquidity and reasonable growth in credit.” Particulars, per the SCMP, included ordering financial institutions to issue local government spending bonds, as well as urging those local governments to “fully tap [their] investment potential.”
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Renminbi/dollar exchange rate, five-year chart. Source: The Bloomberg
The fulfillment of those government edicts may prove less than remunerative for China’s banks. Grace Wu, senior director at Fitch Ratings, said in an interview with Bloomberg television Friday that another burst of credit extension may lead to bigger problems: “What’s going to end up in the medium- and longer-term is you’re still going to have the margin pressure from the mispricing of risk. Ultimately, that’s going to have asset quality pressure down the road.”
The combination of a growth slowdown and hefty debt burden (China’s banking assets foot to $41 trillion as of June 30, representing nearly half of 2018 world GDP of $85.8 trillion) leaves China’s property sector especially vulnerable. According to an analysis from FinanceAsia, all Chinese developers who have reported first-half results have disclosed net gearing (debt-to-equity) ratios north of 50%, “typically seen as an indicator that a company is highly leveraged.”
The renminbi’s slide against the greenback is of particular concern for developer China Evergrande Group, which carries some $118 billion in net borrowings (six times consensus 2019 adjusted Ebitda) including some $18 billion in marketable dollar-denominated debt and which reported a 45% decline in earnings from its year-ago levels in the first half of the year. FinanceAsia notes that in the event of continued currency depreciation, the company “will have a tough time repaying their outstanding U.S. dollar loans.” Indeed, the company’s dollar-pay, senior secured 10.5% notes due 2024 which were issued at par in April fell to a fresh low of 91.6 on Friday according to Bloomberg, for a yield-to-worst of nearly 13%.
For Evergrande, which added some $20 billion to its debt stack in the first half of the year and which must contend with $53 billion in maturities over the next 10 months according to Bloomberg, corporate adventures (including nearly $4 billion in electric vehicle-related investments) have helped put the company into a deeper hole. Chuanyi Zhou, credit analyst at Singapore-based Lucror Analytics Pte. Ltd., writes: “Evergrande faces its biggest liquidity pressure in at least two years. It’s more difficult to borrow money, and they have a lot of debt to repay. The two kinds of pressure are squeezing them at the same time.”
The Evergrande story is far from over. An analysis in the June 2, 2017 edition of Grant’s put it this way:
We suspect that the company name will one day become proverbial, like “Bank of United States” or “Hindenburg.”
Recap Sept. 3
A dip below 50 in the August ISM Manufacturing PMI (its lowest since August 2016) helped the bears get the upper hand as the S&P 500 lost a bit less than 1%, while Treasurys rallied again with the 10-year yield falling below 1.47%. Gold rose above $1,550 intraday for the first time since April 2013, while WTI crude fell back below $54 a barrel and the VIX finished at 20.
- Philip Grant
Friday, August 30, 2019
Too much info
The Real Deal reports today
The Real Deal reports today
Pro AM
According to the Financial Times,
According to the Financial Times,
Recap Aug. 30
Too much info
The Real Deal reports today that some landlords are having second thoughts after viewing WeWork Cos., Inc.’s financials:
"There were certain things in that report I would rather not have seen," Rory Greenberg, who owns a WeWork building in Miami, told TRD reporter David Jeans. "Obviously, I'm sure a lot of it can be explained.”
Maybe these guys can help:
Pro AM
According to the Financial Times, Mexican President Andrés Manuel López Obrador (a.k.a. AMLO) is planning to allow foreign oil companies to participate in joint ventures with state-owned Petróleos Mexicanos and to resume auctions of deep water exploration blocks as early as next year. That news was good for a rally in Pemex bonds, as the dollar-pay, senior unsecured 6 3/4s of 2047 jumped one point to 94.5 cents, for a yield-to-worst of 7.21% and 569 basis point spread over Treasurys. That’s down from just above par as of March 23, 2018. The Mexican sovereign peso-denominated 30-year bond fetches a 7.5% yield, down from 7.8% in spring 2018.
Such a move would represent a major change in tack for the populist AMLO, who cancelled auctions after taking office on Dec. 1 of last year. The President’s populist and self-described “stubborn” governing style has already taken a toll, as longtime associate and finance minister Carlos Urzúa resigned via Twitter in July, citing policy disagreements with the administration. The Dos Bocas refinery project, for which AMLO rejected a trio of private bidders to award the project to Pemex (at a lower cost and faster timetable than the private companies were able to provide) supposedly loomed large in the decision.
For Pemex, problems abound. Since peaking at 3.4 million barrels per day (mbpd) in 2004 (coinciding with the high-water mark at the Cantarell field, once among the world’s largest), production has been on the wane, falling to 1.67 mbpd in July (AMLO claims that 1.8mbpd is attainable by December). Earlier this year, the deepwater Ku-Maloob-Zaap (KMZ) field, which accounted for roughly half of Pemex’s first-quarter output, saw its own decline after maintaining steady-state production for over 10 years. As deepwater fields tend to erode more quickly once a tipping point has been reached (Almost Daily Grant’s, May 2), that development is ominous indeed.
Dwindling production renders a $160 billion debt burden inclusive of pension liabilities (nearly seven times adjusted Ebitda through the 12-months ended June 30) increasingly daunting. On Feb. 15, AMLO announced a MXN 107 billion ($5.4 billion) bailout package, including tax relief and a direct recapitalization, but that wasn’t enough to mollify the rating agencies. On Jan. 29, S&P cut Pemex to triple-B-minus while, on June 6, Fitch Ratings sent Pemex into junk territory (the government announced a further $7 billion in tax rebates for Pemex in July). The company has lost money on an adjusted net income basis in each year since 2012 and has generated negative free cash flow in every year since at least 2009.
While AMLO remains upbeat on Pemex’s prospects, other government authorities express concern. In minutes from that Aug. 15 meeting, the Bank of Mexico discussed the sickly state-owned oil giant:
Most members agreed that Pemex’s situation is still a risk factor. They stated that [the company] has failed to reestablish confidence in its financial outlook due to doubts regarding the viability of increasing crude oil production.
Actions speak louder than words, and the central bank took steps at that meeting to batten down the hatches. At that Aug. 15 meeting, the Bank of Mexico undertook its first rate cut in five years (to 8% from 8.25%). That follows 3% year-over-year growth in nominal GDP for the second quarter, the lowest reading since 2013 and less than half of the average 6.8% seen over the last 10 years. The peso is down by 4.5% against the dollar in August, its worst monthly showing since last October, when AMLO surprised investors by cancelling a major airport project near Mexico City that was well underway.
The March 23, 2018 edition of Grant’s Interest Rate Observer featured an analysis of the symbiotic fortunes of Pemex and the Mexican government, concluding that the oil giant’s problems would soon become the government’s, and that creditors in each were not being adequately compensated for the substantial risks they bore. AMLO’s pivot back to allowing foreign investors could suggest that things are even worse than they appear.
Recap Aug. 30
Stocks drifted sideways to finish the week higher by a healthy 2.7% on the S&P 500, leaving the broad index near the upper end of its August range and within 3.5% of its high-water mark. The highest close for the Dollar Index since May 2017 helped pressure commodities, as WTI crude and gold finished at $55 a barrel and $1,523 an ounce, respectively, and Treasurys ended little changed with the two- and 10-year yields both settling near 1.5%. The VIX closed at 18.5.
- Philip Grant
Thursday, August 29, 2019
He said it
Meet the new boss
Same as the old boss.
Same as the old boss.
As the world turns
The recent bull stampede in rates,
The recent bull stampede in rates,
Recap Aug. 29
He said it
Uber Technologies, Inc. CEO Dara Khosrowshahi, on an interview with Bloomberg TV this afternoon:
“Uber is recession and trade-war proof.”
Meet the new boss
Same as the old boss. In remarks to the European Parliament today, incoming European Central Bank president Christine Lagarde made her stance on monetary policy crystal clear:
I don’t believe that the ECB has hit the effective lower bound on policy rates.
Lagarde went on to allow for the possibility that the negative-rate regime is damaging to euro-area banks, promising to “closely monitor whether adverse effects may emerge in the future.” Still, the former International Monetary Fund head has no qualms about this brave new financial world, stating:
All things considered, in the absence of unconventional monetary policy adopted by the ECB – including the introduction of negative rates – European citizens would be, overall, worse off.
That assertion is, of course, unprovable, but new research from a British academic finds that negative rates have led to a decrease in commercial bank lending. University of Bath finance professor Ru Xie explained:
If bank margins are compressed due to low long term yields, and if there is limited loan growth, then bank profits will fall accordingly. The decline in profits can erode bank capital bases and hitherto further limit credit growth, thus stifling any positive impact on domestic demand from negative interest rate policy.
Meanwhile, the central bank’s goal of stirring up inflation (the primary justification for negative rates) gets further and further away. The “five-year, five-year forward inflation swap”, the ECB’s preferred inflation gauge, is just 1.2% today, near the record low of 1.13% seen in June and far below the 2.1% average reading going back to 2004.
As the world turns
The recent bull stampede in rates, which has pushed the 30-year Treasury yield to less than 2% from 3.4% in November, has naturally spurred a wave of refinancings from mortgagers. The volume of applications has more than tripled since December, according to the Mortgage Bankers Association.
Banks are ramping up their infrastructure in response, as Bloomberg reports today that Wells Fargo & Co., the United States top mortgage lender, “has boosted staffing by about 10% this year and plans to keep hiring.” More broadly, the industry has added some 5,000 jobs since March, per the Bureau of Labor Statistics. As Bloomberg notes, “it’s a stark reversal from a year ago, when the Federal Reserve was hiking interest rates and banks were cutting thousands of jobs.”
Not just in staffing are lenders getting more aggressive. Last week The Wall Street Journal found that formerly strict mortgage lending standards in place through the post-crisis era “are starting to erode” as “home buyers with low credit scores or high debt levels as well as those lacking traditional employment are finding it easier to get credit.”
Those maneuvers are taking place during a time of elevated risk. A survey released yesterday by Realtor.com found that more than 36% of “active homebuyer” respondents believe that a recession will begin next year, up from less than 30% in March. Similarly, nearly 40% of wonks at the National Bureau of Economic Research polled by Realtor.com forecast a downturn in 2020.
Similarly, the August BofAML Fund Manager Survey finds that a net 34% of investors believe that a recession is likely within the next 12 months, the highest reading since October 2011. Then, too, data from Google Trends shows a substantial jump in the “recessions” term relative to “refinancing.”
Popularity over time. “Recession” in blue vs. “refinance” in red. Source: Google trends
Meanwhile, recent housing-related data have left something to be desired. Mortgage applications last week saw their biggest sequential decline since April, while pending home sales fell by 2.5% sequentially in July, far below the positive 0.3% consensus estimate.
Are mortgage lenders set to be caught offside by a cyclical turn?
Recap Aug. 29
Another strong rally in stocks extended the S&P 500’s advance to 2.7% so far this week, while weakness at the short end of the Treasury curve pushed the two-year yield to 1.52%, compared to 1.49% on the 10-year. WTI crude rallied to near $57 a barrel for its best close in more than two weeks, while gold retreated to $1,527 an ounce. The VIX fell back below 18.
- Philip Grant
Wednesday, August 28, 2019
Falling off the bike
How much does Uber Technologies, Inc. (UBER on the NYSE) really take for itself per ride? The company asserts that its take-rate stood at 18% in the six months ended June 30, down from 21% a year earlier. But an investigative report from auto-focused website Jalopnik finds a hefty 35% figure on a 14,756 fare-sample size (which Uber argues is statistically insignificant relative to the 15 million worldwide rides on the platform per day) examined by the publication.
The question is not academic. Uber classifies its drivers as “independent contractors” and thus provides no health insurance, while shifting responsibly for gas, tolls and vehicle wear-and-tear costs to those non-employees. In return, drivers have provided Uber with regular public relations headaches (recall the series of driver demonstrations surrounding the IPO, for instance) and high attrition rates, with a striking 2017 study conducted by The Information finding that just 4% of those who sign up to drive for Uber are still doing so one year later.
But if true, neither Jalopnik’s revelation nor increased scale from growth has helped to shore up a sieve-like corporate income statement. Second quarter revenues footed to $3.17 billion, up 14% year-over-year. Over the same period, adjusted Ebitda came in at a $656 million loss, more than double the $292 million shortfall seen in the three months ended June 30, 2018.
That red ink hasn’t dissuaded Wall Street from maintaining an upbeat stance, as 23 firms rate Uber shares “buy” with 11 “holds and a solitary “sell.” As the bull case does not hinge on profits, other considerations are front and center. Following second quarter results on Aug. 8, analysts at Needham Securities reiterated their “time acquisition thesis” as a primary basis for recommending the stock. Namely, that: “customers will increasingly leverage mobility platforms to re-acquire time in their lives.”
Such arguments may resonate with users who prefer the convenience of the app-based, standardized offering to the decentralized legacy taxi industry, but the rigid limits of Uber’s core business model have long been apparent to some. In a 2017 analysis published by the Transportation Law Journal, Hubert Horan of Horan Aviation Consulting (a speaker at the Grant’s fall conference on Oct. 23 – advt.) wrote:
Unfortunately, urban car-service op¬erators have never demonstrated significant scale economies, and Uber has not found any source of major margin improvements other than driver compensation cuts.
While investors in Uber and its peer Lyft, Inc. (LYFT on the Nasdaq) have fared poorly in their short public tenues, with shares down 28% and 46%, respectively, the IPO window for money-losing enterprises remains firmly ajar. Yesterday, home exercise equipment company Peloton Interactive, Inc. filed its form S-1, in preparation for listing. Peloton, which last August raised $500 million in a series-F funding round at an implied $4.15 billion valuation, is seeking an $8 billion or more public value at its debut, according to Bloomberg.
The S-1 filing contains no shortage of the messianic language regularly heard from Silicon Valley. CEO John Foley writes to would-be investors: “On the most basic level, Peloton sells happiness. But of course, we do so much more.” Indeed, the S-1 describes a corporate jack-of-all-trades: “a technology company, a media company, an interactive software company, a product design company, a social connection company, a [direct-to-consumer] retail company, an apparel company, and a logistics company.” Not mentioned: selling exercise bikes.
Despite offering pricey cycling machines that retail for $2,245 and generating strong sales growth (revenues doubled to $915 million in the 12 months ended June 30 from $435 million the fiscal year prior), Peloton’s net loss attributable to common shareholders rose nearly five-fold to $246 million from $48 million in fiscal 2018.
The last word goes to Kathleen Smith, co-founder of Renaissance Capital, who told CNBC on June 28: “Any private company that is not proceeding to go public in this market should have their head examined.”
Recap Aug. 28
Stocks caught a solid bid, with the S&P 500 rising back towards the middle of its three-week trading range, within less than 5% of its high-water mark reached on July 26. WTI crude rallied back near $56 a barrel and gold saw a small pullback to settle at $1,540 an ounce, while cryptos were slammed intraday with bitcoin falling below the $10,000 mark for the first time in four weeks.
A strong five-year auction helped the Treasury complex rally once more, as the 10-year yield remains near its all-time low of 1.37% while the 30-year long bond now yields 1.93%, well below the 2.12% effective Fed Funds rate.
- Philip Grant
Tuesday, August 27, 2019
The final frontier
It’s no breaking news that the Federal Reserve was charged with a defined mandate by Congress in 1977, namely: “to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.”
However, the passage of time has seen the monetary mandarins progressively grow their congressional remit. Former Fed chair Ben Bernanke roped financial asset prices into the equation in a memorable Washington Post opinion piece on Nov. 4, 2010:
For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
The ensuing years also brought an increasingly stretched definition of stable prices, as noted by Alex J. Pollock in the July 13, 2018 edition of Grant’s Interest Rate Observer: “The Federal Reserve Reform Act of 1977, for one, does not say ‘price stability.’ It does in particular not say ‘a stable rate of inflation.’ It says ‘stable prices.”
Nevertheless, “price stability” is now the term used to couch a persistent, but slow, erosion of purchasing power. The Fed explicitly picked a 2% annual inflation target (as measured by the Core Personal Consumption Expenditures Index) in 2012, and expanded on that four years later by introducing the concept of inflation symmetry. Chicago Fed president Charles Evans put it this way on July 12: “I really think it would be useful, it ought to be part of our policy, to be aiming for inflation a bit above 2% at this point, because we’ve been under-running for so long.” In April, Evans provided specific figures: “I would communicate comfort with core inflation rates of 2.5%, as long as there is no obvious upward momentum and the path back toward 2% can be well-managed.”
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Year-over-year Core Personal Consumption Expenditures Index in white, Fed Funds rate in orange, 20-year chart. Source: The Bloomberg
Beyond targeting asset prices and advocating for “symmetrical” growth in inflation, others look to rhetoric as a mechanism to more thoroughly tame market forces. In a Financial Times opinion piece last Wednesday, Minneapolis Fed president Neel Kashkari argued that the central bank can bring the entirety of the yield curve under heel (as opposed to the overnight Funds rate) through use of so-called forward guidance:
For example, the federal funds rate effectively hit zero in late 2008, but the rate on a 10-year treasury bond stood at 3.5% for much of 2009, in part because investors assumed rates would pick back up. If the Fed had made a firm commitment to keep overnight rates at zero for the next 10 years, the 10-year treasury rate would likely have been close to zero.
So the Fed can also influence long-term rates by giving guidance about the future path of their short-term equivalents. The firmer the Fed’s commitment, the more influence it can have.
The search for influence continues into new realms. On March 25, the San Francisco Fed published a paper studying how climate change could impact monetary policy, noting: “Some have advocated that central banks use their balance sheet to support the transition to a low-carbon economy, for example, by buying low-carbon corporate bonds (Olovsson 2018).” Author Glenn D. Rudebusch cautions, however: “Such ‘green’ quantitative easing is an option for some central banks but not for the Fed, which by law can only purchase government or government agency debt.” On July 23, Axios reported that the San Francisco Fed will host a conference on Nov. 8 to discuss the "implications for monetary and prudential policy of climate change and its consequences."
Those self-conferred expansions of the congressional mandate reached a new plane today, in the form of a Bloomberg Opinion piece from former Federal Reserve Bank of New York president Bill Dudley. Dudley (who is scheduled to debate editor James Grant at the Fall 2019 conference on Oct. 23 – advt.) suggests that the Fed resist Donald Trump’s demands for more policy accommodation to help weather the economic disruption which might follow a protracted trade spat:
There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy.
That spicy rhetoric engendered a reply from the Fed’s PR apparatus this afternoon, asserting that “political considerations play absolutely no role” in its policymaking. As for other considerations, the flacks were silent.
Recap Aug. 27
Stocks gave back early gains to finish a bit lower, while interest rates continued to collapse with the 10-year yield falling to 1.47%, now within reach of the all-time lows reached in the summer of 2016. Resources had a good day, with WTI crude rallying back to $55 a barrel and gold ripping to another post-2013 high at $1,543 an ounce. The VIX finished back above 20.
- Philip Grant
Monday, August 26, 2019
Fiat accompli
As the European Central Bank prepares for its policy meeting on Sept. 12,
As the European Central Bank prepares for its policy meeting on Sept. 12,
Recap Aug. 26
Fiat accompli
As the European Central Bank prepares for its policy meeting on Sept. 12, the course of action appears to be set: A lowering of the benchmark deposit rate from the current negative 40 basis points, as well as a resumption of the asset purchase program that was in place from 2015 to 2018. Carsten Brzeski, chief economist at ING Germany, predicts that an additional 20 basis point rate cut and €30 billion ($33 billion) per month in QE are in the offing.
Driving that likely decision, notes Bloomberg in citing the minutes from the ECBs July 24-25 meeting, are worries “that investors are losing faith in [the central bank's] ability to revive inflation.” Euro-area harmonized CPI rose just 1% year-over-year in July, the lowest reading since November 2016.
As European interest rates continue their descent into the sub-zero vortex, stretched local banks contemplate introducing negative deposit rates to the masses. Jaime Guardiola, CEO of Banco Sabadell SA, remarked that “with a change of paradigm like the one we’re experiencing, you could say that it could be contemplated.” Commerzbank AG CFO Stephan Engels expressed similar sentiments to reporters earlier in August: “If there’s a market trend of negative rates being passed on to clients, we will have to look at that. If we were swamped with deposits as a consequence, we’d have to examine very closely how to deal with that sensibly.”
The prospect of negative rates-for-all is generating some less-than enthusiastic feedback from German leadership. Jens Weidmann, the head of Germany’s central bank, took a skeptical view of further easing in an interview with the Frankfurter Allgemeine Sonntagszeitung: “The question is whether new measures are necessary based on our inflation outlook, particularly if side effects grow and effectiveness diminishes.” Finance minister Olaf Scholz agreed, stating that he “doesn’t think it’s a good idea to charge penalties for depositors in checking accounts,” while Bavarian Premier Markus Soeder told German newspaper Bild last week that he favors a ban on negative rates for deposits up to €100,000.
Then, too, the prospect of further QE faces its own legal challenges from Europe’s largest economy. At the end of July, Germany’s constituonal court held a hearing over whether the ECB asset-purchase program is legal, as the ECB is barred from direct “monetary” financing of governments. The Financial Times noted on July 30 that if the court rules in favor of the litigants, the “Bundesbank may decide it is preferable to obey German constitutional law rather than requests of the ECB.”
While legal and political risks present themselves, the Ph.D. economists soldier on. In an interview over the weekend with Spiegel Online, former ECB vice president Vítor Constâncio defended the policy actions seen this cycle, while providing his explanation for the emergence of widespread negative interest rates for the first time in 4,000 years of financial history:
All this is the result of a phenomenon that economists call secular stagnation: In the developed economies, there is a lack of aggregate demand – or, in other words, a surplus of savings over planned investment.
There are mainly demographic reasons for this: People are getting older and saving more. In addition, there has been a greater risk aversion among investors since the financial crisis. That's why they are all looking for safe investments.
The former central banker unsurprisingly took a rosy view of the current epoch of policymaking. Of the outgoing ECB president Constâncio remarked: “I think Mario Draghi can also be very satisfied with his time in office and his place in the history books.” On this last point, Grant’s agrees, though perhaps for different reasons.
Risk of a looming recession adds further complication to the calculus. This morning’s release of the German IFO Business Climate Index for August showed a fifth straight sequential decline to a seven-year low. Clemens Fuest, president of the IFO Institute, told Bloomberg that “the situation is becoming increasingly dire. The weakness which was focused on manufacturing is now spread to other sectors.” Germany’s economic output contracted by 0.1% sequentially in the second quarter, according to the Federal Statistical Office.
A darkening economic backdrop begs the question of a policy response if still-more negative rates and a resumption of QE are not enough. Philipp Hildebrand, vice chairman of asset management behemoth BlackRock, Inc. told Bloomberg on Aug. 15 that: “The next step needs to be more than just more of the same.” Hildebrand, the former head of the Swiss National Bank, suggested the ECB consider: “putting money directly in the pockets of consumers or corporates.” That follows a July 22 essay in the Financial Times from Hildebrand’s colleague, BlackRock chief investment officer Rick Rieder, advocating that the ECB “improve private sector growth prospects by expanding its quantitative easing program to include equity investments in European companies.”
Or, how about gift cards with which to buy BlackRock mutual funds?
Recap Aug. 26
Stocks jumped higher, with the S&P 500 rising more than 1% to erase the bulk of last week’s losses, while Treasurys largely held steady to consolidate Friday’s big gains with the two- and 10-year yields both settling just under 1.54%. WTI crude edged back below $54 a barrel, while gold ticked to $1,529 an ounce to extend its recent run. The VIX fell back towards 19.
- Philip Grant
Friday, August 23, 2019
Engineering major
3G Capital giveth, 3G Capital taketh away. Now follows an update on a trio of equities part owned and operated by the Brazilian p.e. giant, each the recipient of a bearish analysis in Grant’s.
This morning, S&P cut its outlook on triple-B-minus-rated Kraft Heinz Co. (KHC on the Nasdaq) to negative from stable, citing “continuing performance erosion and lack of clarity on the company’s outlook.” It’s the latest indignity for KHC, which has seen its share price tumble by 65% since a bearish analysis in the March 25, 2016 edition of Grant’s following a series of poor results and operational missteps. The company withdrew guidance on Aug. 9 after earlier taking a $15.4 billion noncash write-down associated with the erosion of key brand values.
CEO Bernardo Hees left the company at the end of June, replaced by fellow 3G board member Miguel Patricio, fresh from a 20-year career at 3G stablemate Anheuser-Busch InBev S.A./N.V. (ABI on the Brussels Stock Exchange and BUD on the NYSE). Thanks in large part to the October 2016 acquisition of fellow dishwater brewer SABMiller plc for $65 billion (equating to roughly 18 times the target company’s Ebitda) Anheuser-Busch cut its dividend by 50% last fall to help contend with an onerous 4.8-times leverage ratio, far above the three times leverage employed by fellow Baa1-rated Heineken N.V.
This year, BUD shares have enjoyed a 44% snapback, narrowing their loss since the Feb. 9, 2018 Grant’s bearish analysis to 8% (the S&P 500 is up 7% over that period). On July 25, the company reported better-than-expected second-quarter results, including 6.2% year-over-year “organic” revenue growth and a 9.4% jump in “normalized Ebitda.” However, those figures don’t square with reality. So-called normalized Ebitda rose to $5.86 billion from $5.69 billion (just a 2.9% uptick) while as-reported revenues declined to $13.96 billion from $13.99 billion.
But as Kraft-Heinz and Anheuser-Busch have both labored to ease their respective debt burdens, a third 3G entity, Restaurant Brands International, Inc. (QSR on the NYSE), has thrived. Year-to-date, shares are up a cool 46%, and sit higher by 24% since the initial bearish analysis in Grant’s on June 2, 2017 (the S&P 500 has gained 18% over that period). The company’s 5% second lien notes due 2025 have seen their spread over Treasurys fall to 252 basis points from 280 basis points at issuance in August 2017. That move makes a soothsayer of Pershing Square Capital Management CEO William Ackman, who proclaimed from the podium at the fall 2018 conference that Grant’s is “wrong on Restaurant Brands.”
The company has maintained steady profitability at its Tim Hortons unit, while well received roll-outs such as Burger King’s Impossible Whopper and Popeyes Louisiana Kitchen’s new chicken sandwich have likewise burnished the bull view. Analysts at Bloomberg Intelligence forecast mid-single digit revenue growth in 2019, on account of the company “improving operations, launching innovative new products and continuing its rapid unit expansion.”
QSR’s recent successes have bucked broader weakness. According to industry research firm TDn2K, comparable store sales across the restaurant industry posted a 1% year-over-year decline in July, while comparable traffic fell 4% over that period. The pullback is no outlier, as TDn2K finds that same-store traffic has remained negative in every month going back to at least December 2015.
The industry struggles cast a renewed light on the dynamic between asset-lite franchisors, who collect royalties from the store-level operators, and the franchisees who face that protracted decline in traffic and persistent wage inflation, along with ambitious remodeling requirements that entail heavy capital spending. That conflict was on full display in the rancorous negotiation between Tim Horton’s and the Great White North Franchisee Association documented in the June 16, 2017 edition of Grant’s. John Hamburger, president of the Franchise Times Corp., put it this way at the Grant’s 2018 spring conference:
You can’t have one side of the franchise contract get¬ting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
The strong run in Restaurant Brands has obscured the risks of a fraying franchisor/franchisee model, as evidenced by the continued struggles of Carrols Restaurant Group, Inc., (TAST on the Nasdaq) the largest franchisee of Burger King Restaurants. With QSR shares priced at 28 times forward adjusted earnings per share and a balance sheet carrying net debt of 5.3 times forward adjusted Ebitda, risks to the bull case continue to percolate.
QSR shares in white, TAST in orange; five-year chart. Source: The Bloomberg
Meanwhile, 3G has opted to take some chips off the table following Restaurant Brands’ bull run, selling 20 million shares earlier in August to pare their position in QSR to 36.7%, according to analysts at R.W. Baird. Insiders have followed suit, with CEO José Cil, co-chairman of the board Daniel Schwartz and Burger King executive vice president Alexandre Macedo, disposing of 127,000 shares, 1.04 million shares and 100,000 shares respectively, since March.
Recap Aug. 23
News of Chinese tariffs on additional U.S. goods put pressure on stocks early, while President Trump’s mid-day Twitter broadside against Fed chair “Powel” added fuel to the bearish fire.
By day’s end, the S&P 500 suffered a 3% swan-dive, leaving the broad average nearly 2% in the red for the week. Treasurys enjoyed another ferocious rally, with the 10-year yield falling below 1.53% to draw closer to its record low of 1.37% reached in the summer of 2016. WTI crude fell back below $54 a barrel, while gold reached a fresh five-year high at $1,526 an ounce. The VIX jumped to 21.
- Philip Grant
Thursday, August 22, 2019
Silver slugger
According to data from the U.S. Treasury Department
According to data from the U.S. Treasury Department
Boom goes the dynamite
A blip on the radar, or something more?
A blip on the radar, or something more?
Recap Aug. 22
Silver slugger
According to data from the U.S. Treasury Department released last Thursday, the federal budget deficit footed to $866.8 billion through the first 10 months of the fiscal year. That’s up 27% year-over-year, and already tops the full-year 2018 gap of $779 billion, the highest shortfall since 2012.
It’s like reaching 100 RBI with two months left in the season.
Boom goes the dynamite
A blip on the radar, or something more? Recent weeks have seen the formerly-red hot leveraged loan market retrench, as Bloomberg reports today that streaming service provider Vewd Software USA LLC pulled an offering, the fifth busted loan deal in the past week. Jeff Cohen, global head of leveraged finance capital markets at Credit Suisse AG., flagged the “widely divergent pricing outcomes” seen of late, predicting that “investors are likely to remain highly selective” in their allocations.
The post-crisis era has been a boon for leveraged loans, with total domestic supply outstanding exceeding domestic high yield bond supply for the first time last year. However, the sharp downward reversal in rates this year has cooled enthusiasm for the floating-rate securities vs. fixed-rate junk bonds. Year-to-date, the Bloomberg Barclays High Yield Index has generated a 10.4% total return and the iBoxx Investment Grade Index has jumped 16%, easily besting the 6.1% gain seen from the S&P/LSTA Leveraged Loan Index.
As loan performance has lagged, investors have continued to head for the exits, with data from Lipper showing $943 million in outflows across leveraged loan mutual funds and ETFs across the five business days ended Aug. 20. Overall, retail investors have pulled money for a record 39 straight weeks. Assets under management at U.S. loan funds likewise continue to slip, falling for a ninth straight month to $142 billion in July, down 23% from October 2018.
As momentum ebbs and some deals stall, others have come to market at less favorable terms than issuers would have liked. Bloomberg notes that B3/single-B-minus-rated Total Safety U.S., Inc. was forced to offer its six-year term loan at a relatively steep discount at 93 cents on the dollar (for a meaty 600 basis point spread over Libor), while other p.e. sponsored firms such as Whataburger Restaurants LLC and Teneo Holdings LLC strengthened covenants in the face of investor resistance. Apollo Management-owned CEC Holdings, Inc., which was featured in the July 12 edition of Grant’s Interest Rate Observer, was obliged to price a $760 million term loan due 2026 at 96, a 650 basis-point spread over Libor in order to refinance a loan maturing in 2021 at a 325 basis-point spread. That compared to price talk of 550 to 575 basis points above Libor and 99 cents on the dollar, according to S&P’s LCD unit.
Steve Miller, data analyst at Covenant Review, notes that “issuers are reaching for more aggressive terms than ever before and managers are vigorously pushing back against these proposals.”
Recent concessions aside, loan investors have largely continued to swallow less-than robust legal protections from issuers. On Aug. 13, Moody’s Investors Service reported that its in-house Covenant Quality Indicator reached a record-worst level in July. Moody’s noted that a higher-than usual ratio of Ba-rated paper (towards the upper end of speculative grade) helped entice investors to those cov-lite deals.
The erosion of creditor-friendly fine print presents one concern. The potential for systemic risks stemming from portfolio concentration, another. In an Aug. 9 report, Fitch Ratings estimated “that the banks most active in the leveraged loan market have direct loan and CLO exposures averaging 30% to 40% of capital.” Overall, the rating agency pegs leveraged loan exposure at 29% of tier-one capital among U.S. banks at year-end 2018, with European banks holding the equivalent of 27% and Japanese banks 16%.
Those loan- and CLO-happy financial institutions appear to be standing on increasingly shaky ground. S&P’s LCD unit noted on Tuesday that 34% of all domestic loans issued year-to-date have come to market with no “debt cushion” below in the capital structure. That compares to just over 25% in 2016 and below 20% in 2009. Leveraged loans are typically the senior-most portion of a borrower’s capital structure, i.e., when there is no debt below the loan and the company defaults, the loan stands to absorb all losses after the equity.
The key question: Where would a continued cooling in leveraged loans leave the private equity boom? According to data from Bain Capital, the average p.e. purchase price rose to 10.9 times Ebitda last year, well above the 9.9 times seen at the peak of the prior cycle in 2007. As p.e. has largely funded its acquisitions this cycle through an accommodative loan market, the prospect of attempted exits at elevated valuations in a less friendly environment could lead to unwelcome surprises for the industry and its lenders.
Recap Aug. 22
Stocks shook off early losses to leave the S&P 500 little changed for the day, as the broad index sits near the upper end of its two-week range and green by 17% year-to-date. Treasury yields ticked higher across the board, with both the two- and 10-year yields settling near 1.62% (the three-month vs. 10-year spread remains inverted by more than 35 basis points). WTI crude and gold settled at $55 a barrel and $1,499 an ounce, respectively, and the VIX rose 6% to 16.70.
Meanwhile, economic data continue to indicate trouble, as this morning’s reading of the Markit Manufacturing PMI for August fell below 50 (indicating contraction) for the first time since September 2009.
- Philip Grant
Tuesday, August 6, 2019
Bogey board
The latest dive in interest rates pushed the global stock of negative-yielding debt above $15 trillion for the first time yesterday. That represents 25% of all outstanding worldwide bonds according to data from Deutsche Bank A.G.
Needless to say, this development further complicates life for pension funds, which have been forced into increasingly “creative” measures to maintain rates of return sufficient to meet their obligations. According to the Wilshire Trust Universe Comparison Service and noted by The Wall Street Journal today, the median return for public pension funds exceeding $1 billion in assets was 6.79% for the fiscal year-ended June 30, lagging the projected median long-term return assumption of 7.25%.
A decade of rising asset prices hasn’t been enough for some. As reported by Connecticut’s Office of Fiscal Analysis on July 19, the State Employees Retirement System saw its funding level decrease to 38% as of June 30, 2018, down from 48% in 2011. On the corporate side of the ledger, the average plan was 88% funded as of June per consulting firm Milliman, Inc., down from 94% in September 2018.
How to close the gap? Low rates have their advantages. As noted by Barron’s on July 30, Baa2-rated Federal Express Corp. (FDX on the NYSE) tapped U.S. and European credit markets for $1 billion in 3.1%, 10-year notes and a pair of €500 million ($560 million), six- and 12-year notes yielding 0.45% and 1.3%, respectively, in order to make a voluntary pension contribution. Priced two weeks ago, all three issues are currently trading comfortably above par.
A buoyant stock market offers its own potential workaround. In September 2017, Boeing Co. (BA on the NYSE) partially plugged a $20 billion pension shortfall with a $3.5 billion infusion of its own shares, including those which it had accumulated through open-market share repurchases. That move adds a sort of unconventional, embedded leverage unseen on the balance sheet (the 25% drop in BA shares from March puts this problem into some relief).
But with the bond market offering microscopic yields (at best) and the S&P 500 trading at a substantial premium to its five-year average on price-to-earnings basis (Almost Daily Grant’s, July 30), pension funds look primarily to the private markets to make up the shortfall. According to analytics firm eVestment, private equity accounted for 27% of U.S. and U.K. pension fund allocations in 2018, up from 25% a year prior. In Japan, corporate pension funds allocated a record 21.3% of assets to so-called alternative investments in March according to J.P. Morgan Asset Management, up from 12.8% in 2014.
The problem: As the bull market goes on and private equity proliferates, value is increasingly hard to come by. According to data from Bain Capital, the average p.e. purchase price footed to 10.9 times Ebitda last year, just below 2017’s record of 11 times and (un)comfortably higher than the 9.9 times seen at the peak of the prior cycle in 2007. Fancier prices are accompanied by a higher debt burden, as p.e. deals in 2018 carried an average net debt equal to just over six times Ebitda, compared to 4.9 times in 2007.
Daniel Rasmussen, founder and portfolio manager of Verdad Advisors, L.P., noted in the April 5 issue of Grant’s Interest Rate Observer that even those price and leverage figures are flattering:
By the way, that is on pro forma adjusted Ebitda numbers, which probably overstates Ebitda by about 15%. So, you’re probably in reality looking at a 13 or 14 times purchase price with seven or eight turns of net debt to Ebitda on a GAAP basis.
Considering the risks involved in paying up and levering up, recent performance from the industry has been wanting. While p.e. generated 14.4% in net annual returns from 1990 to 2010 (easily topping the 8.1% for the S&P 500), industry returns lagged both the S&P 500 and Russell 2000 indices from 2012 to spring 2018.
Of course, those five-plus years of underperformance have come during the longest U.S. expansion on record (barring a hindsight-aided declaration by the National Bureau of Economic Research). With global yield curves and purchasing manager indices alike suggesting the risk of an economic downturn, Rasmussen ventured in that April 5 Grant’s that p.e.’s past resilience through turbulent periods may not apply this time:
I think the question is not how did private equity do historically during times of recession, but how did companies that traded at those multiples and with those amounts of leverage do. And, the answer is: Companies with seven or eight turns of net debt go bankrupt at very disproportionately high rates when there is a recession.
Attention underfunded, benchmark-lagging and financially repressed pension fund managers: Thank-you notes can be directed to the offices of the Bank of Japan, European Central Bank and the Federal Reserve.
Recap Aug. 6
Stocks enjoyed a solid rebound after days of persistent selling (and, indeed, just for the record, persistent buying), with the S&P 500 rising nearly 1.5% and closing near session highs. Treasurys mostly took a pause from their relentless recent descent, though the 30-year yield edged lower to 2.24%, not far above the 2.13% effective funds rate. Gold and oil continued to diverge, with the former climbing to $1,486 per ounce while WTI crude fell to a six week low under $54 a barrel, and the VIX retreated to 20, down 19% on the day.
- Philip Grant
Monday, August 5, 2019
Shine a light
The public debut of The We Company, parent of co-working outfit WeWork Cos., Inc. draws closer. Over the weekend, Reuters reported that J.P. Morgan Chase & Co. has secured “the pole position” to lead the offering. That follows a July 23 report from The Wall Street Journal that the IPO could come as soon as September, earlier than had been widely expected. Per The Journal, that expedited timeline accompanies a sense of urgency: “One reason for the September launch target is executives at WeWork are worried that the good times won’t last, with the U.S. stock market trading near records.”
The stakes are high. According to a Bloomberg dispatch today, WeWork is set to raise up to $6 billion in a two-part debt offering, but that deal comes with a caveat: “banks will have to make good on their commitments only if at least $3 billion is raised” in the IPO. The company was most recently valued at $47 billion in a private fundraising round led by SoftBank Group Corp.
With that backdrop in mind, let’s take a stroll through WeWork’s most recently published audited financial results (Ernst & Young LLP did the honors) recently obtained by Grant’s. Despite the company’s imminent public debut, accessing the data is not easy. The documents are only available online, and printing is disabled. Each page is stamped “confidential,” with the recipient’s name, along with the date and time of publication. Unlike most web-based financial statements such as those domiciled on sec.gov, searching for specific terms is disabled.
Now, to the figures. In the quarter ended March 31, revenues footed to $728 million, more than doubling year-over-year from $342 million in first quarter 2018. Similarly, total WeWork memberships rose to 371,000 in the fourth quarter, compared to 174,000 at year-end 2017.
Unfortunately, increased scale has yet to provide any relief to the torrent of red ink. So-called community operating expenses (“exclusive of depreciation and amortization”) rose at a similar clip, doubling to $581.5 million in the first quarter from $288 million, while WeWork’s operating loss jumped to $637 million from $296 million year-over-year. Sales and marketing expense rose to $151 million, or 21% of revenues, from $63 million (19% of revenues) in the year ago period.
Meanwhile, community-adjusted Ebitda (or, adjusted adjusted adjusted Ebitda), WeWork’s signature metric, rose to $169.5 million in the first quarter from $95 million year-over-year. That gain failed to keep pace with the jump in revenues, as the “margin” declined to 27% from 29.2%.
While the financials provide little fodder for optimism, the company looks for other ways to impress investors. On July 30, CNBC reported WeWork was in talks to acquire startup SpaceIQ, which sells software to aid the efficient use of office space, a move which “could help WeWork convince Wall Street that it’s at least somewhat of a technology company.”
The bond market seems to need some persuasion. Single-B-plus-rated WeWork’s senior unsecured 7 7/8 notes due 2025 last changed hands at 96.5 cents, for a 8.66% yield-to-worst and 712 basis point spread to Treasurys. That’s well above the 491 basis points at issuance. By comparison, the Bloomberg Barclays High Yield Index has seen its option-adjusted spread widen by just 63 basis points over that period, to 397 basis points at Friday’s close.
Meanwhile, CEO Adam Neumann is ringing the register. On Thursday, The Real Deal reported that Neumann “is putting a property that he owns as a personal investment in Greenwich Village up for sale on the open market. . . The 11-story building at 88 University is place is almost fully leased to WeWork and is about to come to market with an asking price north of $110 million.” That follows the July 18 bulletin from The Wall Street Journal that the WeWork boss has already cashed out more than $700 million from the company, news that Neumann’s associates downplayed by noting that “Neumann’s borrowings against some of his WeWork shares indicate that he is bullish on the company’s long-term prospects.”
Recap Aug. 5
An overnight devaluation of the Chinese Renminbi pushed the exchange rate to more than seven per dollar for the first time since 2008 and spurred another sharp selloff, as the S&P 500 sank 3% for its worst one-day showing of the year. The broad index saw its year-to-date gains whittled to 13.5%, and sits 6% below its July 26 highs.
Treasurys ripped in near lockstep with yields declining 11 or 12 basis points across the curve and the 10-year falling to 1.72%, 35 basis points above its record close in July 2016. WTI crude fell back below $55 a barrel, while gold rose to $1,463 an ounce, its best close since May 2013. The VIX finished above 24 and has nearly doubled in the last five sessions.
- Philip Grant
Friday, August 2, 2019
I hate when that happens
From Nine News Australia:
From Nine News Australia:
Climate change field trip
From the New York Post on Wednesday:
From the New York Post on Wednesday:
See that my grave is kept clean
This roll-up is not exactly on a roll.
This roll-up is not exactly on a roll.
Recap Aug. 2
I hate when that happens
From Nine News Australia:
The 73-year-old's body was donated to science, with her family believing her remains would be used to study the effects of Alzheimer's Disease. Instead her body was sold to the US Army for explosives testing.
Maybe the Army can return the body for medical testing after it’s finished blowing it up.
Climate change field trip
From the New York Post on Wednesday:
The billionaire creators of Google have invited a who’s who of A-list names— including former President Barack Obama, Prince Harry, Leonardo DiCaprio and Katy Perry — to the Sicilian seaside for a mega-party they’ve dubbed Google Camp.
The three-day event will focus on fighting climate change – thought it’s unknown how much time the attendees will spend discussing their own effect on the environment, such as the scores of private jets they arrived in and the mega yachts many have been staying on.
Missed the party? National Geographic and The Wall Street Journal have just the thing: “The Future of Everything: Exploring Global Innovation by Private Jet.” The offer includes:
Gain unique perspectives on advances in science and technology—from brain science to climate change—with insights from National Geographic experts and Wall Street Journal reporters and editors.
The 24 day expedition starts at $92,725 per person for double-occupancy accommodations.
See that my grave is kept clean
This roll-up is not exactly on a roll. Yesterday, memorialization company (among other things) Matthews International Corp. (MATW on the Nasdaq) reported third quarter results. Management pulled no punches in the press release: “Consistent with the updated expectations that we provided last quarter, our third quarter continued to be challenging.” The particulars included an 8% year-over-year decline in sales to $379 million, 15% drop in adjusted Ebitda and 40% plunge in diluted earnings per share. Unfavorable currency fluctuations, asset sales and a higher tax rate contributed to those declines, but investors have still been unimpressed. Since a bearish analysis in the Oct. 7 edition of Grant’s, MATW shares are down 33%.
Founded in 1850, Matthews is a one member of a quasi-duopoly, sharing approximately 80% of the burial products market with Hillenbrand, Inc.’s Batesville unit. Then, too, valuation appears undemanding, with enterprise value of $1.9 billion eight times consensus adjusted Ebitda for the 12-months ending Sept. 30. The problem: Cash-strapped Americans have increasingly turned towards cremation, which costs as little as $800, compared to $7,000 for a non-high-end casket and burial. Last year, cremation accounted for slightly more than half of domestic market share, up from one-third in 2005.
As the legacy business shrinks, Matthews has diversified. The company now operates three distinct business lines. Memorialization (funeral-related services) is its legacy business, contributing 42% of revenues and roughly half of adjusted Ebitda in the third quarter. Then there’s the packaging, marketing and advertising unit SGK, which chipped in 48% of sales and 40% of adjusted Ebitda. Industrial technologies accounts for the rest.
Since 2012, Matthews has bought at least nine other companies, paying some $990 million (that compares to its current market cap of $1 billion) and has adjusted reported earnings with a slurry of one-time, acquisition-related expenses. The SEC took exception to MATW’s accounting treatment, asking the company in Feb. 2018 to “quantify the impact acquisitions had on revenues,” and then challenging: “Please explain how you concluded that these expenses are not normal, recurring, cash operating expenses necessary to operate your business.”
The company has taken more than $200 million in acquisition-related costs over that period. The magnitude of MATW’s income statement nip-and-tucks are on display in the most recent period, as adjusted third quarter EPS came in at 90 cents, nearly double the 46 cents per share “diluted” figure.
There’s also the matter of free cash flow. From that Oct. 5 Grant’s:
A glance at page 21 of the third-quarter-earnings presentation shows that free cash flow spurted to $120.7 million in 2017 from $92.6 million in 2015, or by 30.4%. But that is the Matthews version of FCF, which the company redefines as EBITDA less capex, interest and taxes; no adjustment is made for changes in working capital, i.e., for the investments Matthews must make to remain a going concern. On the more rigorous and customary calculation, FCF would have grown to $104.4 million from $92.8 million over the same three years, a rise of only 12.4%.
Not that a large cohort of shareholders would complain, or even notice. Passive investing giants BlackRock, Inc., the Vanguard Group, Inc. and State Street Corp. hold a combined 28.8% of shares outstanding. Despite its poor recent performance, Matthews belongs to an impressive cross-section of indices, including the Nasdaq Broad Dividend Achievers Index (its dividend yield is 2.6%), the S&P 1500 Positive Momentum Tilt Total Return Index, and the S&P Small Cap 600 Pure Value Index.
That Oct. 5 analysis noted that the raft of purchases has helped obscure the company’s true operating results, as Matthews management does not provide a breakout of revenues from acquisitions. Indeed, colleague Evan Lorenz noted that “adjustments to non-GAAP earnings are opaque and aggressive. . . management offers little explanation as to what acquisition-related expenses pertain too or why these charges persist as long as they do.” Then, too, double-B-rated Matthews has added substantial borrowings to aid its corporate shopping spree; net debt stands at $938 million, four times consensus adjusted Ebitda. The senior unsecured 5 1/4 notes due in 2025 last changed hands at 98.5 cents on the dollar, for a yield-to-worst of 5.53% (the spread to Treasurys has widened to 386 basis points from 295 at issuance).
Questionable accounting, passive ownership and debt-financed growth. Matthews has a bit of something for everyone.
Recap Aug. 2
Stocks fell for a fifth straight day, with the S&P 500 wrapping up the week down a meaty 3%. Treasurys likewise continue to augur trouble, with the 10-year yield dropping to 1.85%, within 50 basis points of its all-time low and more than 20 basis points below the three-month bill yield. Energy rebounded with WTI crude rising back above $55 a barrel, and gold finished slightly lower. The VIX settled above 18.
- Philip Grant
Thursday, August 1, 2019
Heart of darkness
Yesterday, a pair of senators, one from each party, introduced a bill designed to weaken the U.S. dollar by levying a tax on foreign investments. The Democrat, Sen. Tammy Baldwin (D-WI) explained: “Today, foreign investors have driven up the American dollar, helping Wall Street profit but holding back stronger economic growth. We need reforms that create a competitive American dollar and an even playing field for manufacturers, farmers and workers.” That follows a July 26 report from CNBC that President Trump held a meeting to devise ways to drive the greenback lower.
As currency wars return to the forefront, with the U.S. and Europe (among others) expressly seeking to devalue, crypto-currencies continue their 2019 revival. Year-to-date, bitcoin is up 175%, while ethereum has gained 61% and litecoin 226% (all in dollar terms), despite the highest close in more than two years yesterday in the U.S. Dollar Index.
The decentralized nature of cryptos offers a lifeline to those under the thumb of autocratic regimes, and consternation for those enforcing U.S. sanctions and other applications of international law. Coindesk reported on Tuesday that “Chinese importers in Russia are buying up to $30 million a day of [the purportedly dollar-backed crypto] tether from Moscow’s over-the-counter trading desks,” to avert domestic capital controls. In Iran, which is being squeezed by punishing economic sanctions from the U.S., the theocratic government turned tail and announced that bitcoin mining will be permitted as of Monday, per Mehr News.
More broadly, the bull case for crypto was articulated by Real Vision CEO and co-founder Raoul Pal, on a July 29 podcast with Stephen Livera:
I know all these macro guys, they’re all in it. They get it. They get the optionality. They may be complete believers, part believers. . . if it’s a 1% chance of being right and the upside is 100 times from here, you’d do this all day.
So, if it’s worth $80 trillion, let’s say you have a 10% probability, that’s $8 trillion. It’s currently worth $200 billion. So, even if there’s a 1% chance of it working. . . it’s ludicrously underpriced if any of these probabilities play out.
Bitcoin’s already substantial year-to-date gain brings potential headaches to the investor flock. On July 26, Bloomberg reported that the Internal Revenue Service “is warning more than 10,000 holders of crypto-currency that they may be subject to penalties for skirting taxes on their investments.” The agency, which in 2014 declared cryptos to be property for tax purposes, Bloomberg reported, “served a summons against digital currency exchange Coinbase, seeking details about customers who traded digital currencies from 2013 to 2015.”
While the taxman is on the lookout for his due, other government players look to crash the crypto party. Recall that in April, New York Attorney General Letitia James accused the Bitfinex Exchange (which shares ownership of the purportedly dollar-backed tether crypto) of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds” (Almost Daily Grant’s, May 31). Progress in remedying the shortfall has been slow in coming. Bitfinex, which borrowed $700 million from Tether through a line of credit in early 2019, announced on July 1 that it has repaid $100 million “in fiat wired to Tether’s bank account.”
Tether has seen its total supply of coins outstanding double to $4 billion in four months, while trading volumes over the past 24 hours foot to $15.8 billion, larger than any other crypto including bitcoin at $15.2 billion.
Meanwhile, the AG’s office continues to ramp up the pressure, invoking the dreaded Martin Act (which bestows upon the AG broad power to investigate securities fraud) in a June 8 filing in response to Bitfinex’s argument that its business has “nothing to do with New York investors.” The AG countered with evidence suggesting that Bitfinex had allowed New Yorkers to log into its website as recently as December 2018. The filing also notes that Phil Potter, Bitfinex’s former CEO, “resided and conducted his work from New York” between 2014 and his resignation in 2018. For more on Potter, the curious case of Bitfinex and Tether and the wider connection to the crypto phenomenon, see the June 29, 2018 edition of Grant’s.
This just in; a pair of bulletins from Coindesk this afternoon:
Crypto derivatives platform FTX has perhaps the most speculative and oddly-named futures index fund on the market: SHIT-PERP, or the Shitcoin Index Perpetual Futures.
Adult industry-oriented blockchain project SpankChain has launched a crypto-currency payments platform.
QT progress report
Parting is such sweet sorrow. The Fed’s portfolio of securities held outright registered at $3.594 trillion, down $23 billion from a week ago and $31 billion below the trailing four-week average.
This represents the final episode of the QT run-off initiated on Oct. 1, 2017. Over that 22 month stretch, the Fed’s total balance sheet assets fell by 15.2%, for an 8.6% simple annualized pace.
Recap Aug. 1
A mid-day Trump tweet announcing 10% tariffs on an additional $300 billion of Chinese goods spurred some afternoon chaos, as stocks took another dive to extend the S&P 500’s loss for the week to nearly 2.5%. Treasurys enjoyed a ferocious rally, with the two-year yield dropping to 1.75% and the 10-year settling at 1.9%, just over 50 basis points above its all-time low. Energy was hammered with WTI falling below $55 a barrel, while gold rallied to $1,443 an ounce. The VIX rose to 18, extending its gain for the week to near 50%.
- Philip Grant
Wednesday, July 31, 2019
Triple threat
Fed chair Jerome Powell accomplished
Fed chair Jerome Powell accomplished
General hospital
This morning, General Electric Corp. (GE on the NYSE)
This morning, General Electric Corp. (GE on the NYSE)
Recap July 31
Triple threat
Fed chair Jerome Powell accomplished the seemingly impossible today: he cut rates, announced the early end of balance sheet run-off AND disappointed markets.
General hospital
This morning, General Electric Corp. (GE on the NYSE) reported second quarter results, including $28.8 billion in revenues and 17 cents in earnings per share, down 4% and 6% year-over-year but north of the expected $28.7 billion and 12 cents, respectively. CEO Larry Culp termed the updated outlook “a sign of progress, a sign of stability here.” But those figures were aided by a lower than expected tax rate, and the aviation division saw orders fall 10% from a year ago thanks in part to the Boeing 737 Max saga.
Some analysts were less than impressed, with Stephen Tusa of J.P. Morgan Chase & Co. declaring that “the quarter was a miss operationally, with the combined power/renewable segments worse. . . and a material miss at aviation, the key value driver.” Gordon Haskett Research Advisors’ John Inch summarized the quarter as “a modest step back [relative to] expectations.” Mr. Market agreed, as GE common stock finished slightly lower. Since November 2007, GE shares are down 75%, compared to a 93% rise in the S&P 500 over that period.
It’s been a long, steep fall from grace for America’s former preeminent industrial concern. As early as the Sept. 14, 1990 issue and many times thereafter, Grant’s expressed a bearish view on then-CEO Jack Welch’s commercial pride and joy. That judgement was long flummoxed by GE’s routine one cent quarterly earnings “beats,” a soaring share price and a pristine triple-A credit rating. Following GE’s dramatic near-demise (and subsequent government rescue) during the 2008-era crucible, Grant’s issued the postmortem in the Sept. 18, 2009 edition:
Some day, financial historians will try to make sense of it all: the mere existence of a $100 billion GE commercial paper program (the number today seems incredible); the ideal of “shareholder value” carried to the point of alleged institutionalized fraud; an industrial company recreating itself as a highly and precariously leveraged financial institution with nary a peep of protest from the stockholders; the close brush with insolvency of a company still bearing the imprimatur, triple-A.
Finally, the historians of the future will scratch their heads to understand why Jack Welch and Alan Greenspan, icons of the late 20th century, put so much stock in an idealized “stability” that can only appear to exist in a dynamic world but can never be present in fact.
The company’s well-ventilated post-crisis struggles culminated with the Oct. 30 slashing of its dividend to a mere penny, while credit default swaps reached as high as 268 basis points on Nov. 23. In the Nov. 16, 2018 issue, Grant’s returned to the scene of now triple-B-minus-rated GE in search of value. While the company’s “mind-numbing” complexity, the run-off of its insurance operations and various contingent liabilities argued for a “wide berth” to GE common, the 5% series D perpetual preferred, then trading at 80 cents on the dollar for a 16.2% yield-to-call, offered a compelling risk vs. reward proposition in the sharp analytical judgement of colleague Fabiano Santin.
While the stock has managed only a halting recovery, those preferreds have since flourished, rising to 96 as of yesterday for a yield-to-call of 7.3%.
With that strong price run and generous yield, what might a series D preferred holder do now? A follow-up in the May 3 edition laid out the calculus:
Take a profit and pay the short-term capital-gains tax (which, for an afflicted New York resident, would total 53.5%)? Or stick with CEO Culp and his GE renovation plan, finally paying the long-term capital-gains rate (36.5% for the same overburdened New Yorker)?
With respect to tax advice, both Fabiano Santin, who performed the superb security analysis, and your editor agree that it is better not to live in New York. Fortunately, the self-directed readers of Grant’s have likely already made up their minds on this sensitive point.
Recap July 31
Stocks took a tumble with the S&P 500 finishing red by more than 1%, but well off its worst levels of the day. The Treasury curve saw notable flattening, with the two-year yield rising two basis points and the long bond dropping five, and gold lost more than 1% to settle at $1,416 an ounce. The VIX jumped to more than 16 and is up 33% so far this week.
Earlier today, the July Chicago PMI collapsed to 44.4, its worst reading since Dec. 2015.
- Philip Grant
Tuesday, July 30, 2019
Golden years
From the New York Post:
From the New York Post:
Pay now, grow later
As of last Friday, 44% of the S&P 500 had reported earnings
As of last Friday, 44% of the S&P 500 had reported earnings
More where that came from
It’s a done deal.
It’s a done deal.
Recap July 30
Golden years
From the New York Post:
Former swimsuit model Elizabeth Hoad, 49, went on live television Tuesday in the UK to wed her 6-year-old golden retriever, Logan.
Hoad wore a modest knee-length, long-sleeved white dress and an oversized white rose fascinator. Logan sported a tuxedo tailored for dogs — naturally. They even had wedding bands — her a ring and the handsome pooch a dog-sized bracelet.
After Hoad said, “I do,” officiant Hammond waited briefly for Logan’s response before taking his lack of protest as a “yes.”
No pre-pup needed.
Pay now, grow later
As of last Friday, 44% of the S&P 500 had reported earnings with 77% of those index components reporting a better than expected bottom line, according to Factset. That compares to a 70% “beat rate” across the post-crisis era, but this latest period hasn’t exactly been a high hurdle to climb. Factset reports that the S&P’s overall blended (combining those that have reported and the estimates of those yet to do so) earnings are down 2.6% year-over-year, the second straight such decline.
While Wall Street is taking it easy on corporate America this quarter, things are looking a bit more challenging in the future. Following an expected third quarter decline of 1.9% year-over-year, analysts are penciling in gains of 4.9%, 9.2% and 12.6% in the fourth quarter, first quarter 2020 and second quarter 2020, respectively. Meanwhile, those expected future earnings come at a premium: The S&P 500 currently sports a forward P/E ratio of 17.1, compared to a five-year average of 16.5 and a 10-year average of 14.8.
More where that came from
It’s a done deal. Interest rate futures are pricing 100% odds of a rate cut at tomorrow’s meeting of the Federal Open Market Committee. A trio of Fed emeriti have also weighed in, with Alan Greenspan, Janet Yellen and Bill Dudley all recently arguing for a 25 basis point cut to the funds rate.
The Fed’s presumptive cut will merely help the U.S. begin to “catch up” to the rest of the world. As noted by Bianco Research last Tuesday, almost 95% of developed market sovereign debt around the world is quoted at yields below the 2.40% Fed funds rate, up from 40% in 2015. According to Deutsche Bank, roughly 25% of all worldwide bonds trade at nominal yields below zero, including some corporate issues rated as low as single-B (well into junk territory), per BofA Merrill Lynch. As a reminder, negative nominal yields of even long-dated sovereign bonds are unheard of in 4,000 years of financial history prior to this cycle.
Overseas influence is palpable. On a July 18 television appearance, Fed vice chair Richard Clarida noted that the domestic price of money “can diverge to some extent from global rates but there’s a limit to how far that process can go, because of integrated capital markets.” Last week’s suggestion by ECB president Mario Draghi of further rate cuts from the current negative 40 basis point deposit rate further exacerbates the discrepancy. Wall Street Journal economics columnist Greg Ip sums up that line of thinking today: “A big part [of tomorrow’s rate decision] will have already been made – in Frankfurt.” Domestic rates markets are likewise pointing lower, with the 10-year yield of 2.06% comfortably below Fed Funds.
Bloomberg Businessweek captures the current zeitgeist.
Some observers believe there is much more room for rates to fall, even toward the yield-free levels seen across the globe. Writing in the Financial Times on Thursday, Bob Michele, global head of fixed income at J.P. Morgan Asset Management, lays out the bull case, citing the flood of foreign capital seeking positive nominal yields, along with the imminent end of the QT balance-sheet runoff program and the risks of a global economic slowdown aggravated by ongoing trade tensions. To avoid that outcome, Michele suggests large fiscal stimulus or monetary easing aggressive enough to steepen the yield curve and stoke reflation. Otherwise, “anything short of that risks the 10-year Treasury remaining on the well-worn path, forged by Japan and Germany, to zero.”
But while U.S. creditors ride the wave of price appreciation, Uncle Sam’s seawall of red ink continues to grow. This morning, the Treasury department announced updated marketable borrowing estimates for the third quarter, increased to $443 billion from $159 billion in April. That change is mostly attributable to the prospective lifting of the debt ceiling and accompanying rise in the Treasury’s cash balance, but the upcoming supply deluge might give UST bulls pause. Mark Cabana, head of U.S. short rates strategy at Bank of America Corp. summed it up: “It’s going to get hot and heavy in coming weeks and the market needs to be prepared for that.”
Recap July 30
Stocks fell slightly for a second day, continuing the pullback from Friday’s high-water mark close, while Treasury yields ticked a bit lower across the curve. WTI crude finished above $58 a barrel for the first time in two weeks and gold rose to $1,431 an ounce. The VIX caught another bid, settling near 14 to sit higher by 13% so far this week.
- Philip Grant
Monday, July 29, 2019
You can't do that to our pledges!
Buyer beware
The London Stock Exchange Group plc. today confirmed reports
The London Stock Exchange Group plc. today confirmed reports
Auditing Potemkin village
Recap July 29
You can't do that to our pledges!
This morning, timeshare vacation rental company Diamond Resorts International, Inc. announced it has obtained preliminary injunctions against five companies “accused of defrauding Diamond Resorts customers by falsely claiming to be associated with Diamond and then charging fees to unlawfully ‘rent’ Diamond vacation points on their behalf.” The company was purchased by Apollo Management in June 2016.
For more on Diamond’s business practices, see the Dec. 11, 2015 edition of Grant’s.
Buyer beware
The London Stock Exchange Group plc. today confirmed reports that it was in talks to buy financial data company Refinitiv, Inc. for $27 billion, including the assumption of debt.
The Blackstone Group, Inc.’s investment in Refinitiv, which was partially spun out from Thomson Reuters last year, is playing out quite nicely for the p.e. giant, with Bloomberg reporting today that the carrying value of the financial data business has nearly doubled in just 10 months.
While Blackstone is sitting pretty, the historical track record might give the LSE pause. Near the peak of the last cycle in November 2006, Blackstone acquired Equity Office Properties, then the largest publicly-traded owner and manager of office buildings in the U.S. Blackstone soon thereafter flipped portions of EOP’s portfolio, including seven buildings in New York to Macklowe Properties. Needless to say, that didn’t work out too well for Macklowe with the Great Recession looming: all seven were later seized by creditors, plus four of Macklowe’s non-Blackstone buildings.
Auditing Potemkin village
Whack-a-mole continues in the Middle Kingdom. Over the weekend, three separate state-owned Chinese banks announced an agreement to each buy “at least” 17% of Bank of Jinzhou Co., Ltd. (416 on the Hong Kong exchange). The bank, which has RMB 748 billion ($112 billion) of assets as of June 30, 2018, has seen its shares suspended since April, made the sale at a roughly 40% discount to its last closing price, per Bloomberg. The deals were completed with “support and guidance of the local government and financial supervising authorities,” according to a statement from the Bank of Jinzhou.
The trouble at Bank of Jinzhou (predicted by China expert Carl Walter on the July 5 Grant’s Current Yield podcast) follows the takeover of Baoshang Bank Co., Ltd. and represents the latest evidence that something is not right in the world’s second-largest economy. China’s reported GDP growth rate in the second quarter fell to its lowest since at least 1990, while June industrial profits dropped 3.1% year-over-year, a figure which analysts at Bloomberg Intelligence suggest “may understate the magnitude of the deterioration.”
Problems reach beyond a shaky banking system and weak macro data. Reuters reported Friday that China Construction Bank Corp. has agreed to cough up RMB 2 trillion ($291 billion) worth of “comprehensive financial support” for the Hunan province over the next five years. The region, located in the central part of the country, has seen its financial condition deteriorate to the point where the city of Leiyang “did not have enough money to pay its civil servants” in May, according to local media. As noted by prof. Christopher Balding on Twitter, the bailout represents slightly more than half of the region’s GDP.
While growth wanes and signs of trouble continue to appear across the financial system, China’s capital markets got a boost with last week’s debut of the Star Market, a science and tech-focused stock exchange styled after the Nasdaq. But as reported today by Yicai Global, China’s Securities Regulatory Commission on July 26 suspended 43 IPOs and refinancings (including some on the Star Market) while it investigates allegations that auditor Ruihua Certified Public Accountants falsified company information.
The regulators accuse Ruihua-audited chemical maker Kangde Xin Composite Material Group Co,. Ltd. of inflating profits by RMB 11.9 billion from January 2015 to December 2018. During that period, the company reported RMB 14.6 billion in adjusted gross profit and RMB 6.2 billion in net income. Ruihua, China’s second-largest auditor, inspecting the books of almost one-third of publicly-traded companies.
It takes a village.
Recap July 29
A sleepy summer session saw stocks wilt lower, while Treasurys caught a modest bid. Gold rebounded to $1,426 per ounce, and WTI crude settled at $57 a barrel. The VIX finished green but remained below 13.
- Philip Grant
Friday, July 26, 2019
What does he know about safety?
Financing secured
Easy come easy go
From the Rio Times:
From the Rio Times:
For whom the bell tolls
This afternoon, T-Mobile U.S., Inc won approval
This afternoon, T-Mobile U.S., Inc won approval
Recap July 26
What does he know about safety?
Capt. Chelsey Sullenberger, on Twitter:
Tesla announced the launch of so-called “full self-driving” features that are largely unregulated as soon as this year. This should concern everyone who will share the same streets as a driver or pedestrian.
Financing secured
SoftBank Group Corp.’s Vision Fund 2 is off and running, as the company announced commitments from a who’s who of investors, including Apple, Inc., Microsoft Corp. and Kazakhstan’s sovereign-wealth fund.
The only problem, per The Wall Street Journal:
Some of the companies named in SoftBank’s news release said talks were at an early stage. An official at one said it hadn’t given SoftBank an amount it was ready to invest and said it had to sign the memorandum of understanding so it could get a close look at the fund’s term sheet.
Easy come easy go
From the Rio Times:
In a heist, straight from a movie plot, a Brazilian gang drove onto the runway of a São Paulo airport well disguised as Federal Police and left with 123 million Brazilian Reais (US$ 32 Million) in gold.
The thieves managed to gain access to Cumbica airport Thursday, July 25th, in two trucks identical to those driven by the Federal Police; featuring exact copies of the lights, stencils, and logos of the law enforcement agency.
As Brazilian bandits covet the yellow metal, the stewards of monetary policy take a more relaxed approach. This morning, the European Central Bank announced it will not renew a 1999 agreement with its constituent national central banks that had limited sales of the money of kings.
For whom the bell tolls
This afternoon, T-Mobile U.S., Inc won approval from the Justice Department for its $26.5 billion acquisition of Sprint Corp., marking another step on the long-running regulatory odyssey. The next step for the pair: a lawsuit from a coalition of state attorneys general.
As the domestic wireless industry remains in limbo, an industry juggernaut continues to transform. On Wednesday, AT&T, Inc. (T on the NYSE) reported second quarter results, featuring $44.96 billion in revenues and $15.04 billion in adjusted Ebitda, compared to consensus estimates of $44.74 billion and $15.07 billion, respectively. The company also reiterated its full-year earnings growth forecast and CEO Randall Stephenson suggested a stock buyback might be in the cards.
On the bearish side of the ledger, the video unit, saw a hefty 946,000 net subscriber loss, far worse than the expected 586,000 loss. AT&T also lost 154,000 monthly wireless customers, worse than the 40,000 consensus retrenchment. Thanks to mega-deals including $67 billion for DirecTV, Inc. in 2014 and $110 billion for Time Warner, Inc. in 2018, Baa2/triple-B-rated AT&T carried some $223 billion in net debt as of June 30, inclusive of pension liabilities, accounting leases and working capital deficit; that’s down from just under $250 billion last fall.
That still-fearsome debt load and subscriber trends going in the wrong direction are causes for concern to Craig Moffett, co-founder and one-half eponym of telecom research firm MoffettNathanson, LLC (which rates T shares “neutral”):
Despite a business that looks, on the surface, to be almost monotonously stable – neither revenue nor EBITDA is either growing or shrinking much – AT&T’s business is in constant flux. It’s hard to imagine that this stability will last…
But, financially at least, AT&T is delivering on its stated priority: debt reduction above all else.
Yet the quarter was enough to strengthen the conviction of some T bulls. Jeff Middleswart, president at research firm Behind the Numbers, LLC, tells Grant’s today that the company’s relatively undemanding valuation (enterprise value stands at just over seven times consensus 2019 Ebitda) and sturdy cash flows allow for room to maneuver:
2019 free cash flow will be $28 billion, that was helped by securitizing Warner receivables for $2 billion. That won’t recur. So make the starting point $26 billion. Eliminate $30 billion in debt this year – that’s $1 billion in higher cash flow via reduced interest in 2020. Reduce capex by $2 billion as projects are completed in 2019; free cash flow goes to $29 billion before other revenue growth (decay) and cost savings. In 2021, we expect $31 billion.
The dividend is $15 billion, the coverage there is improving and is an attractive 6% yield. There is basically another $15 billion to play with to retire more debt and grow future cash flow via lower interest expense or retire stock and reduce the $15 billion total dividend payment. There is no pressure to repay debt as rapidly as 2019 either. The goal is probably another $20 billion paid down over 3 to 4 years – the cash to do that is definitely there.
Middleswart concludes:
To me, the margin of safety is increasing. There are warts here, there is no doubt. But, I’m looking at a $150,000 sports car that someone knocked the mirror off driving it out of the show-room that is marked down to $56,000 and I have to take on the repair bill to replace the mirror.
The bulls and bears have had their say. For more on the telecom-cum-entertainment behemoth, see the Jan. 25 edition of Grant’s.
Recap July 26
Another blistering rally left the S&P 500 higher by nearly 2% for the week and 21% year-to-date, as the bulls can seemingly do no wrong at the moment. Gold managed to eke out a modest gain and WTI crude held at $56 a barrel, and Treasury yields inched lower. The VIX closed just above 12, its lowest weekly finish since April.
- Philip Grant
Thursday, July 25, 2019
Keep digging
Today, the European Central Bank held a stand-pat meeting,
Today, the European Central Bank held a stand-pat meeting,
Yellow light
As we close out month 121 of the longest economic expansion on record,
As we close out month 121 of the longest economic expansion on record,
QT Progress report
Recap July 25
Keep digging
Today, the European Central Bank held a stand-pat meeting, keeping the benchmark deposit rate at negative 40 basis points. However, ECB president Mario Draghi indicated that rate cuts and a resumption of asset purchases are on tap for September. In the accompanying presser, the outgoing ECB chief captured the mood of central bank-levitated markets, stating that: “it’s difficult to be too gloomy today,” while the outlook “is getting worse and worse.” The German 10-year yield traded as low as negative 42 basis points, briefly crossing below the 40 basis point deposit rate.
While sovereign debt holders continue to rack up mark-to-market gains, not everyone is enamored with the prospect of still-more negative interest rates. “We already have a devastating interest rate situation today, the end of which is unforeseeable,” Peter Schneider, who represents banks in the south-eastern German state of Baden-Württemburg, told Bloomberg yesterday. “If the ECB aggravates this course, that would hit not only the entire financial sector hard, but especially savers.”
Meanwhile, policymakers down under attempt to quantify the practical limits of negative policy rates. In a paper written to New Zealand finance minister Grant Robertson in January and recently released to the public, staffers in the Treasury Department concluded: “The Reserve Bank expect rates could only fall at most 35 basis points below zero before risking the hoarding of physical cash.”
Today, the global stock of negative-yielding debt rose to $13.74 trillion, a new record.
Yellow light
As we close out month 121 of the longest economic expansion on record, let’s take a look at the state of U.S. corporate credit. Year to date, investment-grade bonds have generated a whopping 12.3% total return, while high-yield has returned 10.6%. Leveraged loans have lagged far behind, with the LSTA Index gaining just 3.3% so far this year.
That standout performance from investment-grade comes as fears of an economic slowdown percolate, while the Fed’s dovish turn has raised the relative value proposition for fixed rate IG and high-yield bonds over floating-rate loans. U.S. leveraged loan funds saw a $446 million outflow for the week ended July 17 according to Lipper, extending the streak of withdrawals to 35 straight weeks.
As loan demand cools, yields for the most creditworthy portion of collateralized loan obligations (which purchase and securitize leveraged loans; see the Sept. 7, 2018 edition of Grant’s for more) continue to climb. According to S&P’s LCD unit, spreads of triple-A CLO tranches reached a post-crisis low of 93 basis points above Libor in March, from 130 basis points in February 2017. Since then, they have reversed higher, with the index rising to 109 basis points in May, while some recent issues have come in well above that. Oaktree Capital Management L.P.’s CLO 3 triple-A tranche priced at 128 basis points above Libor on July 17, and Pikes Peak CLO 4 saw its triple-A slice set at 137 basis points over Libor on July 12.
While high yield has enjoyed a gangbusters 2019, investors have retained some reticence, as a Bloomberg story from July 18 notes that buyers are prioritizing “large, liquid issues as the economy slows. That defensive posture has led to oversubscribed offerings from higher-rated and well-known borrowers.” Sure enough, the triple-C-rated cohort of the high-yield index has lagged the group, logging a year-to-date gain of 7.6%. Despite that quasi-defensive posture on the part of investors, high-yield remains “extremely overvalued,” according to an analysis yesterday from Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC.
In an investor letter circulated today, Greenlight Capital founder and president David Einhorn concurs, revealing that his fund has taken a short position against U.S. corporate credit:
Over the past few years, corporate debt has expanded dramatically, while covenant packages and other bondholder protections have weakened considerably.
Rating agencies have been complacent and allowed debt to Ebitda and debt to equity ratios to deteriorate without a corresponding reduction in credit ratings. Meanwhile, we are a decade into an economic recovery and there are signs the economy may be slowing.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.618 trillion this week, down $5.5 billion sequentially and $14.5 billion below the trailing four-week average. Mortgage-backed securities accounted for all of the weekly decline and about two thirds of the run-off compared to the trailing four-week figure.
Since the Oct. 1, 2017 beginning of QT, total balance sheet assets are down by 14.6%, for a simple annualized pace of 8.3%.
Recap July 25
Stocks lost ground, with the S&P 500 falling 50 basis points to narrow its gains for the week to less than 1% with one session remaining. The VIX popped back toward 14 and gold extended its recent pullback to sink to $1,415 an ounce while WTI crude held at $56 a barrel.
Treasurys came under notable pressure, with the 10-year yield rising back to 2.08%. This afternoon’s seven-year auction priced well higher than the when-issued, marking the third straight poor auction following similar softness from two- and five-year note offerings earlier this week.
- Philip Grant
Tuesday, July 23, 2019
Chapter two: The next chapter
SoftBank Group Corp. (9984 on the Tokyo Stock Exchange), is set to launch a sequel to its $103 billion Vision Fund (the world’s largest venture capital pool), according to a Bloomberg report today. Saudi Arabia’s Public Investment Fund is likely to kick in a similar sum to the $45 billion it contributed last time. That prospective fundraising success follows a heady period for the Vision Fund, which reported a 62% mark-to-market return through June.
For SoftBank CEO Masayoshi Son, the debut of Vision Fund 2 represents another step in his long game of technological investment. Son told Barron’s over the weekend that he sees his investments playing out over a 300 year horizon, explaining:
There were many long dynasties in Asia. We’re creating an ecosystem that can last for a long time. That’s what I’m interested in. The industrial revolution started a few hundred years ago, and still is an important part of modern life. The information revolution will last for the next few hundred years. We’re looking at the long horizon to design the architecture of our ecosystem to last, not just for my life.
A series of IPO “graduations” is further good news for the first Vision Fund, with portfolio companies such as Uber Technologies, Inc. and Slack Technologies, Inc. making their public debuts recently, while WeWork Cos., Inc. is working towards coming public later this year. Son even floated a public offering for the Vision Fund itself in May.
More bullish news comes in the form of reports that the 84% SoftBank-owned Sprint Corp. will soon see its merger with T-Mobile U.S., Inc. approved by the Justice Department, a step towards removing a major potential overhang as Sprint would have potentially needed to undergo debt restructuring without that deal.
SoftBank bulls point to Son’s golden touch (he bought a 29% stake in Alibaba in 1996 for $20 million; that position is now worth $134 billion). Chris Lane, analyst at Bernstein Research, told Barron’s that: “Masa is probably better at this than anyone, in most cases getting in early enough that the investments will ultimately prove to be value-creating.”
Barron’s, too, takes a bullish stance: “Investing in SoftBank Group offers a radically discounted bet on the future. The stock is cheap. Crazy cheap.” On a sum-of-the-parts basis, the investment weekly deems SoftBank shares to be undervalued by 30% to 50%.
Grant’s sees things differently, deeming SoftBank “the epitome of the cycle,” in the Dec. 15, 2017 issue. That imputed discount reflects carrying values (frequently driven higher by the Vision Fund itself) for illiquid, largely money-losing technology startups, not all of which will turn out as happily for the bulls as Alibaba. Then, too, the company has been selling cash-generating but slow growth assets like a 33.5% stake in domestic telecom subsidiary Softbank Corp. and selling a $4 billion stake in Yahoo! Japan Corp. to that telco unit, to continue its shopping spree. SoftBank announced another $3 billion investment in WeWork in January and a €900 million ($1 billion) in Germany’s Wirecard A.G., a hotly contested name among shorts, three months later.
Leverage looms larger in the SoftBank story than might be expected. The company, which carries some $40 billion in net debt, reported $10 billion in consolidated operating income in the fiscal year ended March 31 with $6.5 billion of that sum attributable to the domestic telco group. But said telco unit’s free cash flow (i.e. funds available to shareholders) footed to just $2.6 billion. The subsidiary, SoftBank’s most important on a cash flow basis, features net leverage of 5.2 times Ebitda and a premium valuation featuring enterprise value of 6.9 times forward Ebitda, above the 6.1 times and 4.9 times Ebitda for peers NTT DoCoMo, Inc. and KDDI Corp., the number one and two players in Japan, respectively (SoftBank Corp. is third).
A follow-up in the May 17 edition of Grant’s concluded: “Thus, absent a path to solid profitability for its numerous unicorns, SoftBank is leveraged to the goodwill of the capital markets.” Since that original salvo, SoftBank shares are up by 20%, while the dollar-denominated 6% perpetual notes have declined to 96 from 99.
The show goes on.
Recap July 23
A strong bid in equities pushed the S&P 500 back above 3,000 at the close, up nearly 20% year-to-date. Treasury yields moved higher across the board following a relatively weak two-year auction this afternoon, while energy finished green and gold lost a bit less than 1% to settle at $1,417 an ounce. The VIX was pummeled for a second straight day to fall to near 12.5.
- Philip Grant
Monday, July 22, 2019
Technical analysis
From the Daily Beast:
From the Daily Beast:
Hello Neumann
With the stock market near all-time highs and money losing IPOs seemingly coming to market daily,
With the stock market near all-time highs and money losing IPOs seemingly coming to market daily,
Modern monetary medicine
Let the bloodletting commence.
Let the bloodletting commence.
Recap July 22
Technical analysis
From the Daily Beast:
Canadian police held a somber press conference this weekend to deliver details on a double homicide, but viewers tuning in on Facebook Live were left baffled: The police officer speaking about the slaying was shown with cat ears and whiskers.
The Royal Canadian Mounted Police in British Columbia later explained that an “automatic setting” on Facebook Live had accidentally been switched on. . . After re-recording the entire press conference minus the “cat filter,” Sgt. Janelle Shoihet apologized for the “technical difficulties” viewers experienced the first time around.
Hello Neumann
With the stock market near all-time highs and money losing IPOs seemingly coming to market daily, it’s the deals that don’t happen which are sometimes more notable.
The Real Deal notes today that brokerage Rudin Management Co. spooked some landlords with stark language describing co-working giant WeWork Cos., Inc. In an offering document for 110 Wall Street, which is fully leased to WeWork, Rudin cautioned would-be buyers: “Given the single-tenant nature of 110 Wall Street, the outcomes of the asset are binary.” The management company has since pulled the property off the market, choosing to retain ownership. Signed in 2013, the WeWork lease runs for 22 more years.
As WeWork (which sports a $47 billion valuation and lost $1.9 billion last year on $1.8 billion in revenue) prepares for a potential IPO later this year, CEO Adam Neumann eyes the exit. On Thursday, The Wall Street Journal reported that Neumann “has cashed out more than $700 million from the company.” While that move might suggest limited confidence in his business’s future, Neumann’s camp counters: “his borrowings against some of his WeWork shares indicate that he is bullish on the company’s long-term prospects.”
Nothing like margin debt for building confidence.
Modern monetary medicine
Let the bloodletting commence. A headline in today’s Financial Times: “[Jerome] Powell seeks a cure for the disease of low inflation.” As James Politi writes, the Fed chair has “warned Congress that downbeat prices could lead to an ‘unhealthy dynamic’ of lower interest rates and less room to act in a downturn.”
The source of Powell’s angst: The core (excluding food and energy) personal consumption expenditures (PCE) deflator, the Fed’s preferred indicator, rose 1.6% year-over-year in May, below the central bank’s “price stability” goal of a 2% rise. Of course, it’s all relative. The core Consumer Price Index has registered at or above 2% for 15 straight months, while headline CPI has compounded at a 3.1% rate since the Fed’s chartering in 1913.
But as Powell et.al fret over an insufficient pace of purchasing power erosion, one scholar questions the very premise of the Fed’s definition of “price stability.” Alex J. Pollock, distinguished senior fellow at the R Street Institute in Washington, reviewed pertinent materials, including the 1977 Federal Reserve Reform Act and the 1978 Humphrey-Hawkins legislation (which established the Fed’s dual mandate) to determine the provenance of that 2% inflation target within the context of “price stability.” His findings, documented in the July 13, 2018 edition of Grant’s, are summarized below:
The Federal Reserve Reform Act of 1977, for one, does not say “price stability,” as Pollock notes: “It does in particular not say ‘a stable rate of inflation.’ It says, ‘stable prices.’ Does the term ‘stable prices’ mean perpetual inflation? What did Congress mean by ‘stable prices’ when it put that term into law?”
Humphrey-Hawkins, enacted the next year in response to the abomination of double-digit inflation with accompanying high rates of joblessness, foreign-exchange tumult, fiscal disarray, etc., committed the government to promote, among other blessings, “full employment, production, and real income, balanced growth, adequate productivity growth, proper attention to national priorities, and reasonable price stability.”
The law established goals for unemployment (3% or less among individuals aged 20 and up) and inflation (not more than 3%) by the fifth anniversary of the first economic report required by the act, i.e., by 1984. That was just for openers. By 1988, the 10th anniversary of the act, the government was to have achieved “a rate of inflation of zero per annum.”
Of course, things turned out differently. In 1988, 10 years after the passage of Humphrey-Hawkins, the CPI rose by 4.4%. In Congressional testimony that year, Fed chair Allan Greenspan made no mention of that zero-inflation goal. Eight years later came a formative exchange between Greenspan and future Fed chair Janet Yellen, recounted by the New York Times in 2013:
[Greenspan] saw a chance for the first time in decades to drive annual inflation all the way down to zero, achieving the price stability he had long regarded as the central bank’s primary mission.
But Janet L. Yellen, then a relatively new and little-known Fed governor, talked Mr. Greenspan to a standstill that day, arguing that a little inflation was a good thing.
So, 41 years after the Humphrey-Hawkins act, how do we read the Fed shoehorning a 2% target into reasonable price stability? “A kind of smokescreen, a convenient legislative excuse for the Fed to do what it would have done anyway,” Grant’s wrote last year.
Recap July 22
Stocks floated higher, with the S&P 500 extending its year-to-date advance to 19%. Energy prices rallied with WTI rising back above $56 a barrel, while gold held at $1,425 an ounce. Treasurys caught a modest bid, with the 10-year yield falling below 2.05%, and the VIX closed at session lows near 13.5.
- Philip Grant
Friday, July 19, 2019
What we have here is a failure to communicate
Following yesterday’s remarks from New York Fed president John Williams,
Following yesterday’s remarks from New York Fed president John Williams,
Talking his book
BlackRock, Inc. (BLK on the NYSE) reported second quarter results this morning,
BlackRock, Inc. (BLK on the NYSE) reported second quarter results this morning,
Recap July 19
What we have here is a failure to communicate
Following yesterday’s remarks from New York Fed president John Williams, who moved markets by suggesting a more-dovish FOMC than had been widely expected, the New York Fed press office walked his statements back:
This was an academic speech on 20 years of research. It was not about potential policy actions at the upcoming FOMC meeting.
That pronouncement was news to Bloomberg, which listed yesterday’s event: “Williams speaks on Monetary Policy.” Interest rate futures were similarly taken aback, with Bianco Research noting that the odds of a 50 basis point rate cut on July 31 fell below 20% this afternoon after jumping to 70% yesterday from 34%.
Anyway, the Fed now enters its quiet period ahead of the FOMC’s July 31 rate decision. That well-earned breather follows at least 12 speeches from at least eight Fed presidents over the past week, plus Wednesday’s release of the Beige Book.
Money talks – but this?
Talking his book
BlackRock, Inc. (BLK on the NYSE) reported second quarter results this morning, continuing the financial behemoth’s impressive asset collection. Fixed income inflows were characterized as “blockbuster” by Bloomberg, jumping to $110 billion from $26.4 billion year-over-year. That pushed total inflows to a record $151 billion and assets under management to $6.8 trillion from $6.3 trillion a year ago. Although revenues of $3.5 billion and net income of $1 billion represented year-over-year declines of 2% and 7%, respectively, BLK shares finished little changed and sit higher by 21% year-to-date. Since a bearish analysis in the Sept. 30, 2016 edition of Grant’s, BLK is up 31%, compared to 37% for the S&P 500.
Needless to say, the breakneck growth in indexation and ETF have been a boon to New York-based BlackRock, the world’s largest asset manager. The problem: How much is left to conquer? According to a June 28 research note from J.P. Morgan strategist Dubravko Lakos-Bujas, 60% of U.S. equity assets are already parked in passive management vehicles, with quantitative funds controlling another 20%.
But as demonstrated by the contraction in revenues and earnings despite AUM growth, fee compression looms large, as BlackRock’s operating margin slipped to 36.3% from 39.9% a year ago. Kyle Sanders, analyst at Edward Jones, commented: “The fee rate continues to tick down and that’s something that they’re going to have to outrun. You just have to grow faster, and for the most part they’re able to do that.” Kevin Duffy, principal at Bearing Asset Management and longtime BlackRock bear, points out the erosion in iShares’ profitability in the following chart:
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iShares quarterly revenue as a percentage of prior quarter AUM. Source: Bearing Asset Management.
Management commentary likewise suggests that compression is a sore subject. On June 13, managing director and head of Latin America Armando Senra told the press that BlackRock is fighting the low-cost migration: “There’s too much emphasis purely on cost. We don’t talk enough about quality. That’s not to say we’re not going to be competitive – we have to be competitive, this is a competitive industry – but I would move away from just a low-cost conversation.”
BLK’s cost conversation is indeed taking place at a whisper. On April 8, Bloomberg reported that the company cut fees on its corporate bond ETF. “But rather than shout about the move, the discount was announced without fanfare – in a footnote on page 94 of a revised filing last month.” Other players have been less reticent. On Tuesday, Fidelity announced the creation of four equity index funds charging five basis points, undercutting the Vanguard Group which charges six to 19 basis points on similar offerings.
How might BlackRock weather a bear market alongside ongoing fee compression? Just under 65% of the company’s total assets under management are invested in index funds or iShares ETFs. At the same time, base management fees accounted for 84% of BLK revenues for the first six months of the year. An interruption to the ongoing asset price levitation would spell trouble for BLK.
As for his reaction to that yet-unseen day, CEO Larry Fink may have provided a preview this morning. Appearing on CNBC, the BlackRock boss called for the European Central Bank to further ramp its policy accommodation: “If the ECB is really going to try to re-stimulate the economy in Europe, they are going to have to buy equities.”
Recap July 19
Stocks came under pressure, with the S&P 500 finishing the week with a 1.1% decline. While Treasury yields rose with the short end underperforming as expectations of a 50 basis point rate cut largely evaporated. This afternoon’s news that Iran seized a British oil tanker in the Straight of Hormuz spurred a bounce in oil prices with WTI rising above $56 a barrel, while gold pulled back more than 1% to finish at $1,425 an ounce. The VIX finished at 14.25, the high of the day.
- Philip Grant
Thursday, July 18, 2019
Fake cruise
From Motor1.com:
From Motor1.com:
He said he said she said
Three's a crowd
Business is booming for a titan of private equity.
Business is booming for a titan of private equity.
QT Progress report
Recap July 18
Fake cruise
From Motor1.com:
The Civil Police of Santa Catarina, Brazil closed a clandestine factory in the city of Itajaí alleged to be building replica Ferrari and Lamborghini models. Police discovered eight replicas in the workshop, part of a counterfeiting scheme denounced by the two Italian automakers.
The copies were sold for between 180,000 and 250,000 Brazilian Reals ($47,774 and $66,353 at current exchange rates). The shop used old car parts and other poor-quality materials, and the vehicles were made to order.
“In one of the vehicles, they were installing the engine of an [Chevrolet] Omega,” said delegate Angelo Fragelli, who was responsible for the operation, in an interview with Folha de São Paulo newspaper.
He said he said she said
On Tuesday, Chicago Fed president Charles Evans weighed in on the direction of the funds rate:
There is an argument that if I think that it takes 50 basis points before the end of the year to get inflation up, then something right away would make that happen sooner.
This afternoon, New York Fed president John Williams concurred, declaring the (unobservable) “neutral rate of interest” to be just 0.5% and advocating “swift action” to “keep interest rates lower for longer.”
Esther George of the Kansas City Fed sees things differently, telling reporters today:
When I look at the current settings for monetary policy, my own outlook suggests we will continue to see growth in the economy around or slightly above the trend rate of growth, we see an unemployment rate at a 50-year low and continued job gains as recently as the most recent employment numbers.
Across all of these parameters, inflation has remained low and stable. So for me that suggests we are in a good range in terms of thinking about monetary policy.
All three are voting members of the Federal Open Market Committee, which is scheduled to reach its next interest rate decision on July 31. George’s stand-pat inclination aside, interest rate futures price 100% odds of a cut, with traders expecting the Fed will lop either 25 or 50 basis points from the funds rate.
Three's a crowd
Business is booming for a titan of private equity. This morning, The Blackstone Group, Inc. announced that year-to-date capital inflows have reached $88 billion, putting the firm on pace to blow past a prior $100 billion fundraising target for 2019. Total assets under management rose by 24% year-over-year to $511 billion, including $150 billion in cash.
It’s been a charmed cycle to be sure for Blackstone, the subject of numerous bullish Grant’s analyses beginning in the Oct. 7, 2011 issue (BX shares have since generated a 480% total return assuming dividend reinvestment, compared to 203% for the S&P 500).
As Stephen Schwarzman’s powerhouse builds its war chest, the rest of the p.e. industry scrambles to keep up. According to Preqin’s Second Quarter Update, total fundraising across the industry stood at $109 billion, little changed year-over-year, but with just 244 funds reaching a final close, down from 399 in the second quarter of 2018.
The narrowing band of successful fundraisers isn’t dissuading new entrants, as the number of p.e. funds coming to market reached 3,951 in June, up 5% from January and a whopping 72% above the Jan. 2018 figure. At the same time, total targeted funds stood at $981 billion, little changed from January and up 32% from Jan. 2018. Notes Preqin, “this represents two years’ supply at 2018 fundraising levels, showing how crowded the fundraising market is.”
Other market mainstays eye their own entrance into the fray. On June 23, The Wall Street Journal reported that indexing giant the Vanguard Group “is evaluating partnerships to make a mix of private-equity funds available to Vanguard clients.”
As new entrants pile in, a political threat to the p.e. machine steps forward. Today, Senator Elizabeth Warren (D-MA) issued a broadside in the form of various proposals, including restrictions against so-called sale leasebacks, an end to the extraction of “transaction fees” from target companies and limitations on leverage that can be used to finance transactions. Warren commented:
For far too long, Washington has looked the other way while private equity firms take over companies, load them with debt, strip them of their wealth, and walk away scot-free — leaving workers, consumers, and whole communities to pick up the pieces.
Presidential hopeful Warren currently stands at 21% odds of winning the Democratic nomination on political betting site PredicIt, just behind Joe Biden and Kamala Harris at 23% and 22%, respectively. For in-depth analyses of other risks to the private equity boom, see the July 12 and Aug. 10, 2018 editions of Grant’s Interest Rate Observer.
QT Progress report
The Fed’s portfolio of securities held outright came in at $3.62 trillion, down $7 billion from a week ago and $18.4 billion below its trailing four-week average. Mortgage-backed securities accounted for about 80% of the sequential drop, while the decline from the four-week average was largely split between Treasurys and MBS.
Since the Oct. 1, 2017 introduction of QT, total balance sheet assets are down by 14.5%, for a simple annualized pace of 8.3%.
Recap July 18
Stocks rose a bit, with the S&P 500 narrowing its weekly loss to 0.6% with one session left. Treasurys saw bull steepening action as the short end caught a strong bid while the long bond finished slightly in the red, while gold and WTI crude continued to diverge, jumping to $1,445 an ounce and slumping to $55.5 a barrel, respectively. The VIX finished at 13.5.
- Philip Grant
Wednesday, July 17, 2019
The Wire
Yesterday, California governor Gavin Newsom signed Assembly Bill 1054,
Yesterday, California governor Gavin Newsom signed Assembly Bill 1054,
Recap July 17
The Wire
Yesterday, California governor Gavin Newsom signed Assembly Bill 1054, establishing a $21.5 billion wildfire relief fund and setting a June 30, 2020 deadline for fallen utility PG&E Corp. (PCG on the NYSE) to emerge from bankruptcy in order to participate. PG&E, which was found liable for a series of 2017 and 2018 blazes including the Camp Fire (which killed 85 people and destroyed the town of Paradise), entered Chapter 11 on Jan. 29. Investors have kept their hopes up for a swift return to business as usual, as the company still commands a $9.8 billion market cap.
There is reason for that optimism. The new legislation will allow utilities to choose between accessing designated liquidity and insurance funds which allow for fire cost coverage. While PG&E cannot participate in the scheme until it emerges from bankruptcy, analysts at Bloomberg Intelligence note today that PG&E shareholders “would face significantly less downside” if the company can achieve various safety certifications and make the necessary payments to buy in to the insurance fund post-bankruptcy.
As noted by The Mercury News yesterday, “as much as some legislators may have wanted to roundly punish bad actors among California’s electricity providers, they were mindful that even a slap on the wrist to utilities could have the unintended impact of a punch in the nose to consumers.”
But will PG&E investors avoid the proverbial knuckle sandwich? In its most recent 10-Q filing on March 31, the company disclosed $14.2 billion in existing wildfire-related liabilities. In testimony concurrent with the filing, CFO Jason Wells estimated that figure could end up topping $30 billion.
The clock is ticking for future liabilities, as claims from any new wildfire damages would take precedence over existing liabilities. A study released Sunday by the journal Earth’s Future finds that: “During 1972–2018, California experienced a five-fold increase in annual burned area, mainly due to more than an eight-fold increase in summer forest-fire extent.”
Media scrutiny continues apace. Last Wednesday, The Wall Street Journal reported that company executives were aware of problems with transmission lines that were eventually responsible for the Camp Fire, yet “repeatedly failed to perform the necessary upgrades.” In addition, PCG estimated in 2017 that its transmission towers were 68 years old on average (already above the mean life expectancy of 65 years), with some as old as 108.
The company is no stranger to bad press surrounding environmental disaster and big payouts. In 1996, PG&E was forced to pay $333 million to settle claims it dumped more than 350 gallons of chemically-poisoned water into ponds near Hinkley, Calif., an episode memorialized in the 2000 film Erin Brockovich.
It might be harder to shake the wildfire legacy costs than the bulls reckon. In a bearish analysis of PG&E in the Feb. 22 edition of Grant’s, Angelo Thalassinos, the deputy managing editor at Reorg Research, Inc., noted that the Camp Fire may act as a millstone around PCG for years to come.
The thing that jumps out at me, and the distinction here from other mega cases, is the damages and liabilities from the wildfires. It most harkens back to old Chapter 11 cases that had asbestos liabilities. . . . There is potential for continuing damages from that respect throughout the bankruptcy case and even post-emergence.
In the five months since our report, PCG shares have treaded water, lagging the 8.3% total return from the S&P 500 Utilities Index over that period. But the company’s debt has fared well, with the senior unsecured 6.05% notes of 2034 rallying to 111 cents on the dollar (from 93 in February), for a 283 basis point pickup over Treasurys.
That performance disparity seemingly reflects the unfolding political situation. On Friday, The Journal reported that creditors led by Elliott Management Corp. petitioned California lawmakers for bondholder-friendly tweaks to the bill, including allowing PG&E to issue debt to pay future wildfire claims but not existing liabilities, such as from the Camp Fire. As noted by the WSJ: “Legislators ultimately sided with bondholders on the issue.”
Victory in court for that Elliott-led bondholder group would likewise spell trouble for shareholders. Creditors have proposed injecting up to $18 billion into PCG, in return for control of the company. A court hearing at which Elliott et al. will present their arguments is scheduled for July 23.
With PCG continuing to sport a substantial market cap, investors may be underestimating the risks. That Feb. 22 Grant’s analysis broke down the pertinent numbers, concluding:
To the equity holders, it’s a daunting figure. Wildfire claims of just $10 billion (around a third of the CFO’s estimate) would impair the equity— assuming that PG&E’s asset base is not overstated through overly long depreciation schedules.
Even prior to the recent disaster, PCG’s shareholder economics looked less than compelling. From 2013 to 2018, the company generated $25.5 billion in operating cash flow, well shy of the $31.9 billion in capital expenditures over that period. In his Jan. 31 affidavit, CFO Wells forecast that cash from operations will lag capex by an additional $1.6 billion per year in 2019 and 2020. Even after suspending its dividend in December 2017, post-2013 disbursements to shareholders foot to $4.4 billion, a sum which PCG borrowed to pay.
The utility increased operating earnings to $3 billion in 2017 from $2.3 billion in 2008, while capital employed jumped to $62 billion in 2018 from $30 billion in 2008. James S. Chanos, founder and managing partner of Kynikos Associates L.P. and a PG&E bear, noted to Grant’s in February:
It’s a 2% return on incremental capital. That is below their cost of capital. They are liquidating. The utility is in effect liquidating before your eyes before any wildfire liability.
Recap July 17
Stocks came under pressure, with the S&P 500 finishing at session lows to extend its losses for the week to 1% so far. Treasurys caught a sharp bid, with the 10-year yield dropping back below 2.05%. Energy and metals prices saw a notable divergence, with WTI crude falling below $57 a barrel to extend its slide while gold rose to $1,425 an ounce, its best close since May 2013.
After the bell, Netflix, Inc. surprised the Street by disclosing just over 2 million in net paid subscriber additions for the second quarter, far below the 5 million expected. NFLX shares lost 11% in early reaction.
Tuesday, July 16, 2019
Float upstream
Yesterday, China reported that second quarter GDP growth came in at 6.2% year-over-year according to the National Bureau of Statistics, the slowest pace of output expansion on record going back to 1992. That follows Thursday’s revelation that exports to the U.S. fell by 7.8% from a year ago in June, with overall exports dipping by 1.3% year-over-year.
Of course, the slowdown in China’s self-reported growth rate comes as the Trump trade war shows no signs of cooling off. This afternoon, the U.S. president commented that negotiations “have a long way to go,” and suggested he could levy tariffs on an additional $325 billion of goods. Donald Straszheim, head of China research at Evercore ISI, summed it up: “Trade progress has been in reverse. The two sides are further apart now than in Nov-Dec 2018.”
At the corporate level, rising commercial tensions with the U.S. has caused all sorts of problems. Spencer Fung, CEO of supply-chain manager Li & Fung Ltd. (which manufactures consumer goods in the mainland for multinational corporations like Walmart, Inc. and Nike, Inc.), described the state of China’s factories as: “urgent and desperate. . . Nobody’s investing, nobody’s buying. The trade war is causing people to stop investment because they don’t know where to put the money.”
With reported growth on the wane and local supply chains in disarray, the Chinese Communist Party may need to go back to the well for more stimulus. Elliot Clarke, senior economist at Westpac Banking Corp., wrote:
Over the past year, Chinese authorities have sought to accelerate the economy by increasing credit availability and lowering its cost. Consequently growth in credit has, however, been slow in coming.
Small and medium private firms won’t be able to access capital markets anytime soon, and more work needs to be done before the quality of lending by shadow banking agents can be relied upon. Hence, improved access to credit for small and medium-sized enterprise will have to rely on the banks. Further easing by authorities is therefore a necessity, as are broader liquidity measures to reduce the overall cost of credit.
The problem: As China has relied on debt-fueled fixed asset investment to generate growth, banking assets have ballooned to $39 trillion, compared to a combined $27 trillion for the U.S. and Japan (the world’s largest and third-largest economies, respectively). The consequences of that credit expansion were on full display in May, as the failure of Baoshang Bank, a rounding error in terms of assets, led to the temporary seizing up of China’s repo markets.
The powers that be are looking to prevent wider trouble. On Friday, the National Development and Reform Commission rolled out new rules preventing property developers from taking out foreign currency debt unless used to refinance existing borrowings set to mature in less than one year. In addition, developers have to disclose both the size of the offering and use of proceeds in advance.
While property developers remain on the CCP’s radar, one local government-financing vehicle (LGFV) is reconsidering its options. On Thursday, Bloomberg reported that Tianjin Binhai New Area Construction & Investment Group Co., Ltd. shelved plans to sell a three-year dollar bond. The pulled deal, per Bloomberg, “signals growing investor angst over credit stress in Tianjin, home to several high-profile distressed cases from local state-bonds come due this year.” Tianjin-based LGFVs face a record RMB 114 billion ($16.5 billion) in maturities in 2019.
As China’s economy cools and both public and private entities work to keep their heads above water, tough choices lie ahead. At the spring 2019 Grant’s conference, Russell Napier, independent strategist and founder of the Electronic Research Interchange, predicted that the CCP, which maintains a quasi-peg to the dollar and is a de facto importer of U.S. monetary policy, will eventually seek a cheaper renminbi by allowing the currency to float freely (potentially leading to a 30% to 40% decline in the currency against the greenback, per his estimation).
The choice for Xi Jinping and friends is between a stable exchange rate and reflating the economy. With the producer price index flat year-over-year and M2 money supply growth at a virtual 20-year low, “it is not a good time to have lower cash flow when your debt-to-GDP ratio is at excessively high levels,” notes Napier. The decline in FX reserves to $3.11 trillion from $4 trillion five years ago “indicates that the glory days of undervaluation are over.”
Recap July 16
Stocks took a modest dip as volumes remain muted. The most notable move came from energy, as WTI crude fell nearly 3% to $58 a barrel after signs of easing tension between the U.S. and Iran. Treasury yields ticked higher, and the VIX remained below 13.
- Philip Grant
Monday, July 15, 2019
Get your shinebox
A friend checks in from the Long Island Expressway:
A friend checks in from the Long Island Expressway:
Swamp things
A trio of corporate situations unfolding in Washington, D.C.
A trio of corporate situations unfolding in Washington, D.C.
Recap July 15
Get your shinebox
A friend checks in from the Long Island Expressway:
Our mobile correspondent writes:
The 21st century stock tip from the shoeshine boy is the bus wrapped in an ad touting Sharespost, where anyone can “access the new private market.”
Swamp things
A trio of corporate situations unfolding in Washington, D.C. may have important ramifications for their respective investors. A quick update on each follows:
On Friday, the U.S. Court of Federal Claims dismissed a lawsuit from Oracle Corp. asserting that the Defense Department’s $10 billion Joint Enterprise Defense Infrastructure (JEDI) procurement contract was structured to unfairly favor Amazon.com, Inc.’s Web Services unit. Judge Eric Bruggink ruled that the award has not been marred by “organizational conflicts of interest,” as alleged by Oracle, and that the litigant failed by its own admission to meet the JEDI requirements in the first place.
That decision seemingly clears the way for Amazon and Microsoft, Inc. to vie for the winner-take-all contract, one that has been beset by claims of cronyism related to three former DoD employees with close ties to AWS (Almost Daily Grant’s, April 18).
For AWS, which leveraged a $600 million CIA contract in 2013 to gain commercial deals and represents a critical part of the Amazon success story (the unit chipped in 62% of consolidated operating income in the most recent quarter), the JEDI award would be the proverbial cherry on top. But obstacles remain, as the DoD inspector general and FBI public corruption unit continue a joint investigation of conflicts of interest claims.
Meanwhile, Senator Marco Rubio (R-FL) sent a letter Thursday to national security advisor John Bolton criticizing the single award structure as “contrary to industry best practices, statutory preferences, and the Administration’s Cloud Smart guidelines” and asked for a delay to the award to “ensure a fair and open process.”
Perhaps most importantly, the CIA announced in April it will shift toward a multi-cloud strategy by 2021 as opposed to continuing to exclusively rely on AWS. Of course, Amazon is fighting to protect its turf, signing a $294 million lease for its “HQ2” in Crystal City, VA, up the street from the CIA headquarters in Langley.
Next, the ongoing merger saga involving Sprint Corp. and T-Mobile U.S., Inc. The corporate suitors continue to negotiate the spin-off of wireless assets to Dish Network Corp. in their efforts to secure approval from the Department of Justice (which is forthcoming “any day,” according to Bloomberg). On Thursday, The Wall Street Journal reported that the negotiations are “dragging” and will likely extend beyond the July 29 deadline. Hang-ups include: potential restrictions on Dish flipping the spectrum assets acquired by the pair and limitations on data traffic that Dish can send through the T-Mobile network, per The Journal.
While negotiations continue apace, a coalition of more than a dozen state attorneys general who are suing to halt the merger prepare their next move. On Friday, the Capitol Forum reported that the DoJ delay will allow the group of 14 attorneys general to potentially “request that the Oct. 7 start of the trial be delayed.” Hopes for a timely deal consummation following DoJ approval are up in the air: “If it’s up to the states, a decision in the federal case wouldn’t come for some time.”
Finally, the price-gouging saga involving TransDigm Group, Inc. continues to develop. In February, an audit from the DoD inspector general found that the company charged “excess profits” on 46 out of 47 selected spare parts, including markups of as high as 4,451%.
The company agreed to pay back the $16.1 million in “excess profits” identified in the report, but that hasn’t prevented bipartisan pushback against the TDG business model. On June 14, senior officials at the DoD issued a memo directing staff to “require the submission of uncertified cost or pricing data to support prices proposed by TransDigm and its subsidiaries.”
On Friday, Sen. Charles Grassley (R-IA) wrote a letter lamenting the DoD’s inability to ascertain pricing information from its contractors and suggesting new amendments those loopholes, while Rep. Ro Khanna (D-CA), who has proposed similar legislation, commented in June: “It’s more than evident that TransDigm can’t be trusted, so singling them out is warranted.”
As noted by the Federal News Network, current law allows vendors to refuse to provide price data for individual transactions below $2 million, a statute of which TDG was all too aware. According to a report from the House Oversight Committee, TransDigm “coached” employees to maintain prices below that threshold and avoid providing cost documentation whenever possible. Fat markups appear to be a crucial feature for TransDigm, which has long pursued a roll-up business model and which carries net debt in excess of six times consensus 2019 Ebitda.
Recap July 15
Stocks recouped an early dip to finish unchanged on the S&P 500, as Citigroup, Inc. helped usher in second quarter earnings season with a similarly flat finish. Treasurys were bid across the curve as the 10-year yield dropped below 2.09%. Oil and gold both traded a bit lower, and the VIX remained below 13.
- Philip Grant
Friday, July 12, 2019
Bears on vacation
From June 29 at the Omni Hotel Mount Washington,
From June 29 at the Omni Hotel Mount Washington,
Bond-splainin'
From Bloomberg Opinion today:
From Bloomberg Opinion today:
Merger, she wrote
A pair of notable deal-related
A pair of notable deal-related
Stag party
A whiff of stagflation in the heavy summer air?
A whiff of stagflation in the heavy summer air?
Recap July 12
Bears on vacation
From June 29 at the Omni Hotel Mount Washington, via the Associated Press:
Rather than taking in the historical sights (the resort famously served as the venue for the 1944 Bretton Woods monetary agreement), the furry visitor was merely “in search of a trash can.”
Bond-splainin'
From Bloomberg Opinion today:
With some $13 trillion of bonds worldwide yielding less than zero percent, it would be easy to characterize fixed-income assets as nothing more than a giant bubble waiting to burst. Those who agree probably haven’t heard of the concept of a “Giffen good.”
Goodbye Ph.D. standard, hello B.S. standard?
Merger, she wrote
A pair of notable deal-related developments today. This morning, industrial manufacturer Hillenbrand, Inc. announced the acquisition of Milacron Holdings Corp. at a 34% premium. Seemingly recalling that high price tag deals often destroy value, Mr. Market marked down Hillenbrand shares by 13%.
This afternoon, global beer powerhouse Anheuser-Busch InBev S.A./N.V. (BUD on the NYSE; see the Grant’s Interest Rate Observer issue dated Feb. 23, 2018) announced it will not go forward with its previously announced plans to IPO its Asia Pacific subsidiary, citing “market conditions.” The listing of that unit would have raised up to $9.8 billion, according to The Wall Street Journal, providing highly-leveraged InBev with some much needed cash.
However, Bloomberg reported early this morning that the company’s proxies “had difficulty finding enough demand to price [the offering] within the current range.” That’s quite a change from less than two days ago, as Bloomberg had relayed Wednesday that the order book “was at least 1.5 times covered as of Wednesday afternoon.” BUD shares, which had rallied 43% year to date, fell 3% on the day.
Stag party
A whiff of stagflation in the heavy summer air? This morning’s release of the June producer price index showed a 2.3% year-over-year rise in the core (ex-food and energy) reading, topping the 2.1% expected. That follows a 2.1% year-over-year rise in core CPI yesterday, above the 2% consensus and representing the 16th straight month in which that metric rose by 2% or more.
Those figures have done little to assuage fears within the Fed of an insufficient inflationary pace (the Fed’s preferred gauge, the core personal consumption expenditures index, rose 1.6% year-over-year in June). “I am nervous about inflation,” declared Chicago Fed president Charles Evans (meaning not enough of it). Jerome Powell told Congress Wednesday that “there is a risk that weak inflation will be even more persistent than we currently anticipate.” Recently, both St. Louis Fed president Jim Bullard and Minneapolis Fed president Neel Kashkari advocated for “insurance” rate cuts.
While the monetary mandarins fret over inflation half of the mandate, growth worries loom large. The New York Fed’s recession indicator model rose to 32.9% in June, up from 28% in May and the highest since 2008. That gauge rose above 30% prior to the recessions in 1991, 2000 and 2008 (a glance at the 50-year trend shows few false positives). Then, too, the yield curve has remained inverted since late May with the three-month yield outpacing that of the 10-year note (itself one of the more reliable recession harbingers), while both the June Chicago Purchasing Managers’ Index and ISM Manufacturing Index’s new-order components fell to their lowest levels since December 2015. As of July 8, the Atlanta Fed’s GDPNow tracker implies that output grew at an annualized 1.4% clip for the second quarter, down from 3.1% in the first quarter.
That evident growth slowdown may be the ace in the hole for bond investors. In Hoisington Management’s second quarter letter, the stalwart bond bulls reiterate their longstanding (and so far correct) hypothesis that debt saturation will constrain growth and keep yields moving still lower:
With the current global experience of more than two decades of subnormal economic growth in the face of extreme over-indebtedness, numerous cases of sustained historically low levels of real yields have come into focus and the following analysis indicates this recent pattern is likely to persist. If debt levels as percentage of total output continue higher, then investors will likely face even lower future real yields.
But, for Treasury bulls, it’s not just the persistent rise in measured consumer and producer price indices which should be cause for concern. Yesterday’s auction of $16 billion in 30-year bonds priced at 2.66%, more than two basis points above its when-issued level at auction time. Glen Capelo, head of rates at Academy Securities, told Bloomberg that the results were eye-opening: “This is as close to a fail as we’ve seen in at least a decade.” Capelo, who has been trading Treasurys since 1986, observed the unusual backdrop that accompanied the auction: “This is the first time in my lifetime the Fed is actually trying to create inflation.”
One auction does not a trend make, but there are other worrying signs. As noted in the below chart by Bianco Research today, relative bidding interest at two, five, seven and 10-year U.S. Treasury note auctions continues a protracted decline seen throughout this cycle:
At least we’re making it up in volume.
Recap July 12
One of the lowest volume days of the year was fertile ground for the bulls, as the S&P 500 rose to another fresh high and its first ever close above 3,000. Treasurys also caught a bid, with the 10-year yield falling two basis points to 2.11%, and gold jumped to $1,414 an ounce. The VIX fell below 12.5.
- Philip Grant
Thursday, July 11, 2019
We're gonna need a bigger boat
Mexican finance minister Carlos Urzúa resigned
Mexican finance minister Carlos Urzúa resigned
QT progress report
Recap July 11
We're gonna need a bigger boat
Mexican finance minister Carlos Urzúa resigned via Twitter on Tuesday, citing “many disagreements over economic policy” within the presidential administration of Andrés Manuel López Obrador (AMLO). Alberto Ramos, chief Latin America Economist at Goldman Sachs Group, Inc., called the departure of Urzúa (who served as AMLO’s finance secretary when he was mayor of Mexico City) “an unexpected and negative development.” Mr. Market agreed, as the peso fell by 2% against the dollar in reaction. For his part, AMLO took things in stride, telling reporters yesterday that “you have to get used to the changes and there could even be other resignations.”
A major factor in Urzúa’s departure, according to The Wall Street Journal: The $8 billion refinery project in AMLO’s hometown region of Tabasco recently awarded to state-owned oil company Petróleos Mexicanos (Pemex). The oil giant is faced with a punishing $160 billion debt load inclusive of pension liabilities (nearly six times last year’s earnings before interest, taxes, depreciation and amortization), ten straight years of cash burn to the tune of $72 billion in total and steep production declines. Pemex produced 1.68 million barrels per day in June, down from a 3.4 mbpd high water mark in 2004 (Almost Daily Grant’s, May 2). Management is targeting 1.83 mbpd in output by year-end.
The rating agencies have taken notice. On June 6, Fitch Ratings cut Pemex to junk, while Moody’s could follow suit (analyst Dirk Willer of Citigroup, Inc. dubs a cut “pretty well set). In April, AMLO’s government offered $5.6 billion in tax rebates and capital injections to shore up Pemex’s finances, while in June the company signed an $8 billion syndicated loan from a consortium of banks, partly used to refinance existing obligations. AMLO celebrated that development, telling reporters: “The banks don’t act without information, they don’t take a decision like this because they like the government. They know that Pemex is in very good health.”
But there’s going to need to be more where that came from. In a June 14 report, analysts at Morgan Stanley attempted to quantify the ongoing budget gap:
Under a scenario of $60 a barrel oil and $15 billion in capex [with] production stabilizing at 1.65mbpd, the annual net Pemex funding would need to come out at around $14 billion, or $23 billion gross. These are challenging funding needs to meet, even with help from the sovereign.
While Pemex bonds suggest some discomfort with the situation (the senior unsecured 6 3/4 bonds due 2047 trade at 88 cents on the dollar for a 571 basis point pickup over Treasurys, down from 97 cents in March 2018), investor concern over the enterprise is more evident in credit default swaps, as the Pemex 5 year CDS trade at a record 252 basis point premium to Mexico sovereign CDS.
The co-dependent nature of Pemex and the government is evidenced by the fact that the oil giant contributed nearly 20% of government revenues last year. Analysts at Bloomberg Intelligence predicted yesterday that “creditors may link the abrupt resignation of [Urzúa] to the weakened financial condition of Pemex, which could drive spread convergence between Pemex and its sovereign parent.”
An analysis of the relationship between Pemex and the Mexican government in the March 23, 2018 edition of Grant’s Interest Rate Observer noted the potential for a costly Pemex bailout that would potentially imperil the sovereign profile: “It would do the national credit profile no good if 15 percentage points of Pemex debt came to alight on the Mexican debt-to-GDP ratio.” A follow-up analysis on Nov. 16, 2018 reiterated the journalistic verdict: “bearish – emphatically.”
QT progress report
The Fed’s portfolio of securities held outright registered at $3.63 trillion this week, unchanged sequentially and down $14.8 billion from two weeks ago, with Treasurys accounting for all of that run-off. Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 14.3%, for a simple annualized pace of 8.3%.
Recap July 11
Stocks edged a bit higher, as the S&P 500 sits slightly above unchanged for the week. But while the equity markets cruised sideways, Treasurys had a lively day as a hotter than expected June inflation (the 16th straight year-over-year rise of 2% or greater in core CPI) and weak long bond auction this afternoon pushed interest rates sharply higher across the board. That move left the 10-year yield within two basis points of crossing back above the three-month yield, nearing the first “un-inversion” since late May.
WTI crude and gold finished at $60 a barrel and $1,406 an ounce respectively, and the VIX settled just below 13.
This morning, industrial supplier and economic bellwether Fastenal Co. reported weaker than expected results and noted a slowdown in activity, in another sign of slowing industrial production.
- Philip Grant
Tuesday, July 9, 2019
Detergent needed
Canada’s housing market continues to bifurcate. In Toronto, June sales rose a snappy 10.4% from a year ago while prices ticked higher by 3% year-over-year. Tight supply helped: “Because we saw virtually no change in the number of new listings, market conditions tightened, and price growth picked up, especially for more higher density home types, which, on average, are less expensive than traditional detached homes,” noted Jason Mercer, chief market analyst at the Toronto Real Estate Board.
In Vancouver, sales fell 14.4% from a year ago and sit 34.7% below the 10-year average. The Multiple Listing Services composite benchmark price dropped 9.6% year-over-year, while total inventory for sale jumped 25.3% from a year ago. Vancouver-based realtor and analyst Steve Saretsky notes in his June market report:
With some developers reluctantly cutting prices this begins to raise questions about appraisal values moving forward. If prices continue to drop it will create problems for existing pre-sale buyers who are relying on bank appraisal values to match what they paid at the pre-sale centers a year or two earlier.
In many respects, the peak of Canada’s post-2009 "housing miracle" exceeds the U.S. version from the pre-2009 bubble. Demographia’s Housing Market Affordability Survey for 2017 found that Vancouver and Toronto ranked 291st and 273rd out of 293 world housing markets, sporting a median home price of 12.6 times and 7.9 times median household income, respectively. That compares to an 11.5 times median price to income in Los Angeles (then the most unaffordable market in the world) and 7.0 times in New York in 2007. According to the Organization for Economic Co-operation and Development, Canadian household debt reached 181% of disposable income at year-end 2017, compared to 144% for the U.S. in 2007. In 2017, 35% of the Toronto Stock Exchange’s market capitalization came from the financials, insurance and real estate sector, compared to 21% of the S&P 500 in 2007.
While Vancouver has gone into deep freeze and nationwide price growth has abated, with the Teranet-National Bank House Price Index rising 0.7% year-over-year in May (the lowest since fall 2009), the housing machine rolls on. Housing starts amounted to 246,000 in June, far above the expected 209,000 and within 7,000 units of the most active month in the last 10 years. That recent acceleration in housing starts comes on the heels of an uptick in output, as GDP growth in March and April logged 0.5% and 0.3% respectively, the best sequential two-month period since the end of 2017.
***
Widespread money laundering appears to be the wildcard in the equation, with a British Columbia-based panel pegging the flow of illegal funds in the Canadian housing market at C$5.3 billion ($4 billion) in 2018. The panel estimates that Vancouver home values are inflated by 5% through dirty money.
Likewise, a March analysis by Transparency International Canada found that between 2008 and 2018 more than 50,000 properties in the Toronto area were purchased by anonymous, privately owned corporations, representing nearly 4% of all residential transactions during that period. The practice is especially prevalent at the high end: “if a home was purchased for C$7-10 million, there is a 54% chance it is owned through a company.” That is significant because 49% of unregulated, private mortgages (which are not subject to anti money-laundering regulations) were taken out by corporate entities over the last 10 years, compared to just 3% for individual borrowers.
Today, Sam Cooper of the Global News reports that Robert Kroeker, vice-president of corporate compliance at the British Colombia Lottery Corp., resigned after the local regulator began investigating claims he told staff to “ease up” on anti-money laundering protocols at local casinos. The problem is likewise reflected in a broader lack of enforcement. According to Statistics Canada, just 316 money laundering convictions were logged between 2000 and 2016, while the United Kingdom snagged 1,435 such convictions in 2017 alone per The Wall Street Journal.
Might the Toronto supply shortage, and relative resilience of its local housing market, be at least partially attributable to the practice? Comeau told the Financial Post that “Ontario is notorious for being a money-laundering front.”
Short seller Marc Cohodes, who has expressed bearish views on at least one Canadian non-bank lender, tells Grant’s today that a lack of political will lies at the heart of the money-laundering problem:
The motto seems to be: Look the other way, everything’s fine.
They don’t want to take on the problem. Everyone wants to enjoy the status quo. The finance minister, Bill Morneau, is determined to protect the banks from the consequences of their behavior. Until real adults take over, this situation won’t improve.
Recap July 9
Stocks rebounded from early lows as the S&P 500 eked out a green finish, while Treasury yields rose a bit with the 10-year finishing at 2.06%. WTI crude oil and gold likewise enjoyed modest gains, finishing at $58 a barrel and $1,397 an ounce, respectively, and the VIX held at 14.
- Philip Grant
Monday, July 8, 2019
Hong Kong rumbles
Massive protests
Massive protests
Prosperity gospel
On Saturday, Turkish President Recep Erdogan announced he fired
On Saturday, Turkish President Recep Erdogan announced he fired
Recap July 8
Hong Kong rumbles
Massive protests in Hong Kong against a heavy-handed extradition law have grabbed the headlines, but other developments in China’s “special administrative region” deserve a close eye. On Wednesday and Thursday, the one-month Hong Kong interbank offered rate (Hibor) jumped a combined 50 basis points to nearly 3%, the highest since October 2008 and up from less than 1% as recently as February. That was followed by a similarly violent fall today back to 2.69%.
That spasm in funding costs comes ahead of the projected $9.8 billion IPO of Anheuser-Busch InBev S.A./N.V.’s Asian unit, set for debut on July 19, which can temporarily constrain liquidity as investors allocate funds to the new offerings. Indeed, Carie Li, an economist at OCBC Wing Hang Bank, told Reuters that the timing of InBev’s offering is likely influencing the Hibor move: “We haven’t seen such a large IPO for a while, and it is happening during the [June and July] dividend season when liquidity is usually tight.”
Regardless of the cause, the sharp Hibor move could prove easier for some to swallow than others. Hayman Capital Management L.P. managing partner Kyle Bass noted on Twitter Wednesday evening that corporate loans in Hong Kong “reset against Hibor monthly.” The Hong Kong money market is likewise very sensitive to short-term flows. If locals and expats lose faith in the special administrative region and take their dollars elsewhere, it could pose a problem for the city’s highly-leveraged housing market.
For more on the state of play in Hong Kong and an analysis of a speculative but potentially asymmetric investment opportunity, see the May 31 edition of Grant’s Interest Rate Observer.
Prosperity gospel
On Saturday, Turkish President Recep Erdogan announced he fired central bank president Murat Cetinkaya, one year prior to the scheduled end of his four year term in 2020.
The catalyst for that move: Cetinkaya’s refusal to cut interest rates from the current 24% benchmark rate on account of intense inflationary pressures (CPI rose 15.8% year-over-year in June, the 23rd straight double-digit reading). Indeed, Turkish newspaper Hurriyet quoted Erdogan explaining the rationale: “We told him repeatedly in economy meetings that he should cut rates. We told him that the rate cut would help inflation to fall. He didn’t do what was necessary.”
Rabobank strategist Piotr Matys commented: “By abruptly dismissing Cetinkaya, Erdogan reminded everyone who is in charge of monetary policy.” This is not the first time that sort of message has been sent. In July 2018 Erdogan named son-in-law Berat Albayrak as minister of Finance and Treasury. Albayrak traveled to New York in April to meet with investors, one of whom shared a harsh review with the Financial Times:
Another investor, who was among a small number of people who held additional private meetings with Mr. Albayrak, said that the encounter was “disastrous”, describing it as “one of the worst performances from a finance minister I have seen.”
But Erdogan’s attempts to tighten his grip have been met with increasing opposition from the political class and voters alike. Today, former deputy prime minister Ali Babacan, who served as economy minister from 2002 to 2007 and was a founding member of Erdogan’s AKP party, announced his resignation from the group on account of “deep differences” over the party’s direction. On June 23, AKP was defeated in the Istanbul mayoral election by opposition candidate Ekrem Imamoglu, a significant rebuke from Erdogan’s hometown (he was Istanbul mayor prior to being elected president).
While Erdogan attempts to keep the electorate and Mr. Market in line after taking action, Donald Trump watches enviously. On Monday, the U.S. president took to Twitter to liken the Fed to “a stubborn child” that “doesn’t know what it’s doing” following a stand-pat meeting in late June. Yet the market reaction to the change in Turkey may give Trump pause: In response to Saturday’s news, the lira fell 2% against the dollar to 5.74 per greenback today, while the yield on Turkey’s 10-year dollar-pay notes jumped 24 basis points to 7.26% and the Borsa Istanbul 100 Index fell nearly 1%.
Meanwhile, a New York Fed press release trumpeting the end of its listening tour included some language that might appeal to Trump’s (and Erdogan’s) sensibilities. John Williams, president of the New York Fed, struck an ambitious tone in an accompanying Twitter post: “We talk about monetary policy and interest rates and things, but really the Fed has a broader mandate for shared prosperity.”
Recap July 8
Fallout from Friday’s much stronger than expected jobs report has been limited, as interest rate futures continue to price 100% odds of a rate cut at the next Fed meeting on July 31. Stocks edged lower for a second straight session today, while the 10-year yield ticked higher to 2.05%, gold finished at $1,392 an ounce and WTI crude settled just above $57 a barrel. The VIX rose to near 14.
- Philip Grant
Wednesday, July 3, 2019
Justice league
Two down, one to go?
Two down, one to go?
Car man
Auto executive Lee Iacocca,
Auto executive Lee Iacocca,
Three musketeers
Yesterday was a busy one for the future of central banking,
Yesterday was a busy one for the future of central banking,
Recap July 3
Justice league
Two down, one to go? Bloomberg reports this afternoon that the Department of Justice is close to green lighting T-Mobile U.S., Inc.’s (TMUS on the Nasdaq) all-stock acquisition of Sprint Corp. (S on the NYSE). In response, Sprint stock rose slightly to $6.98, narrowing the discount to the TMUS-implied offer price to 11%. However, that gap was just 7% on June 19.
DoJ approval would leave the coalition of more than 10 state attorneys general as the final major roadblock to the deal, one which appears to still be in question based on the size of the discount. The merger appears necessary to ensure Sprint’s continued viability (Almost Daily Grant’s, March 29) and avoid a big hit to SoftBank Group Corp., which owns 85% of Sprint shares.
Car man
Auto executive Lee Iacocca, president of Ford Motor Co. and longtime CEO of Chrysler Corp., died yesterday at the age of 94. Among many other accomplishments, Iacocca was instrumental in developing and bringing to market the fabled Ford Mustang, which debuted at the 1964 World’s Fair in New York at a list price of $2,338 according to Hemming’s Daily.
Beyond their status in American culture, the cars have fared pretty well as a store of value. In January, the very first Ford Pilot Plant/Pre-production 1965 Mustang hardtop was sold at auction for $192,500. That’s a compound annual growth rate of 8.19% over 56 years.
Three musketeers
Yesterday was a busy one for the future of central banking, as a pair of names were nominated for posts at the Federal Reserve and as one for president of the European Central Bank. Let’s take a quick look at the candidates.
Christopher Waller, head of research at the St. Louis Fed, is well versed on the theory and practice of modern central banking. In a 2015 paper titled “Stabilization Policy at the Zero-Lower Bound”, Waller suggested with co-writer Paola Boel that monetary stimulus might be better targeted at private enterprise: “Our model suggests that it can be optimal for the central bank to buy private debt claims instead of government debt.”
More recently, Waller told Bloomberg Radio on June 25 that he wasn’t on board with the Fed’s policy tightening (nine hikes from December 2015 to December 2018): “We didn’t see any overheating in the economy coming, so the question was: why are we raising rates?”
The second nominee, Judy Shelton, is cut from a different cloth. Currently the U.S executive director for the European Bank for Reconstruction and Development and an informal Trump advisor, Shelton “has already faced criticism for some of her unconventional views on monetary policy” according to Bloomberg. In a May 31 interview with the Financial Times, she dared question the premise of modern central banking:
How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market supply determined rate? The Fed is not omniscient. They don’t know what the right rate should be. How could anyone?
If the success of capitalism depends on someone being smart enough to know what the rate should be on everything. . . we’re doomed. We might as well resurrect Gosplan.
Needless to say, those ideas don’t sit well with some prominent figures. In response to that interview, former Harvard University president Larry Summers, himself a candidate for the Fed chair in 2014, attacked Shelton’s candidacy as “dangerous” (Almost Daily Grant’s, May 31).
But the biggest news by far from central bank land was the nomination of current International Monetary Fund head Christine Lagarde as president of the European Central Bank. Lagarde was greeted by another powerful rally in local sovereign bond prices, with French and Italian 10-year yields dropping five and 26 basis points to minus 11 basis points and 1.58%, respectively. Seema Shah, global investment strategist at Principal Global Advisors, told the FT that it’s safe to expect more of the same: “Markets are unfamiliar with her academic monetary leanings. Yet, going by her previous support of [outgoing president Mario] Draghi’s decisions to introduce innovative monetary policies, they’re making the safe assumption that she’s in the dovish camp.”
As with IMF predecessor Dominique Strauss-Kahn, the law has occasionally proved a thorn in Lagarde’s side. In December 2016, a French court found Lagarde guilty of “negligence by a person in position of public authority” over €404 million ($457 million) in taxpayer funds given by the then-French finance minister to businessman Bernard Tapie in 2008.
They couldn’t make it stick: Facing up to a year in prison, Lagarde was given no punishment, while the IMF said it retained “full confidence” in its boss. Lagarde declined to appeal, stating: “There’s a point in time when one has to just stop, turn the page and move on and continue to work with those who have put their trust in me.” Summers likewise weighed in, describing the verdict as “a sorry day for French justice.”
Recap July 3
The bull party rages into the fourth of July, as the S&P 500 pushed higher once more to extend its year-to-date gains to nearly 20%. At the same time, interest rates continued to dart lower with the 10-year yield falling to 1.95%, and economic indicators continue to wobble with the ISM non-manufacturing index matching its lowest reading since October 2016.
WTI crude rose back above $57 a barrel, while gold cruised sideways at $1,419 an ounce after notable recent volatility. The VIX dropped to 12.57, its lowest since February.
- Philip Grant
Tuesday, July 2, 2019
Real deal
On Friday, online luxury consignment retailer The RealReal, Inc. (REAL on the Nasdaq)
On Friday, online luxury consignment retailer The RealReal, Inc. (REAL on the Nasdaq)
Recap July 2
Real deal
On Friday, online luxury consignment retailer The RealReal, Inc. (REAL on the Nasdaq) made its public debut in style, jumping 45% from its IPO price of $20 a share. Valued at $1 billion in a Series H funding round in March, San Francisco-based RealReal, which was founded in 2011 by Julie Wainwright, former CEO of Pets.com (which famously liquidated nine months after its February 2000 IPO), now commands a $2.1 billion price tag.
RealReal’s experience caps off a bountiful second quarter for U.S. IPOs, which included 62 debuts raising $25 billion according to Renaissance Capital, LLC. That’s the second-best showing in terms of proceeds since 2000. As per tradition, early investors got the worm, with the average IPO return for the quarter clocking in at 30%. Poor showings from ride-share unicorns Uber Technologies, Inc. and Lyft, Inc. were decidedly in the minority, with surges from the likes of Beyond Meat, Inc., Chewy, Inc. and Slack Technologies, Inc. (up 500%, 50% and 40%, respectively) more representative of current zeitgeist. More big names are on the way, with WeWork Cos. Inc., Peloton, Inc. and Postmates, Inc. having filed relevant paperwork with the Securities and Exchange Commission.
Unprofitability is no obstacle. Jay R. Ritter, the Joe B. Cordell Eminent Scholar Chair at the Warrington College of Business at the University of Florida, finds that the percentage of IPOs with negative earnings per share surpassed 80% in 2018, joining 2000 as the only period in which that dubious threshold has been reached in the last 28 years. That ratio has topped 60% only eight times since 1990, but in each year since 2013.
IPO fever is making its way abroad. Today, Anheuser-Busch InBev S.A./N.V.’s Asian unit began taking orders for an offering on the Hong Kong Stock Exchange that could raise upwards of $9.8 billion, according to The Wall Street Journal. That compares to a projected $7 billion haul per the WSJ in early May and would top the $8.7 billion debut of Kraft Foods, Inc. in 2001 for the world’s largest food and beverage IPO. Also today, Bloomberg reports that the Kingdom of Saudi Arabia “is restarting preparations” for a potential IPO for the Saudi Arabian Oil Company (Aramco). The Saudis are shooting for a $2 trillion mark from Mr. Market.
The latest boom in public offerings is no cause for concern according to Barron’s, which notes in the June 28 edition that the median age of tech companies stood at 12 last year, compared to four in 1999. Barron’s concludes:
The resurgence of IPOs is no flash in the pan, no signal of a bubble re-inflated. Instead, it reflects a shift in the way that investors and entrepreneurs approach company creation, the rich supply of mature companies that have yet to come public, and investors’ insatiable hunger for growth stories.
Comparisons with the Y2K epoch aside, the current IPO frenzy can be traced back to that seemingly all-encompassing modern phenomenon: Radical monetary policy around the globe. The April 5 edition of Grant’s Interest Rate Observer featured an analysis of the forces at work:
A little-known fact about unicorns is that they feed on interest rates. They like low, little rates – the tinier, the better. It’s a preference that they share with the humans of private equity and the bulls of Wall Street.
The risk-incentivizing strategies concocted by central banks have amplified the simple financial calculus of those forecasting future performance:
The lower the interest rate you pick to discount future cash flows to the present, the fatter those cash flows appear. And in the absence of past or present positive cash flow, such projections take center state.
Skipping down to the bottom line, we judge that loss-making unicorns are queuing up to go public for no better reason than it’s now or never.
Indeed, issuers are striking while the iron is hot. Kathleen Smith, co-founder of Renaissance Capital, told CNBC Friday: “Any private company that is not proceeding to go public in this market should have their head examined. The market is wide open, and it’s not always going to be.”
A curious divergence: One might assume that the IPO wave has spurred another leg higher in Silicon Valley housing as tech employees cash out their newfound riches, but that’s not the case. An analysis today from Kate Seabaugh, senior manager at John Burns Real Estate Consulting, finds that a nationwide slowdown in residential housing markets has hit the Northern California tech epicenter particularly hard. San Jose, San Francisco and Seattle saw net resale deceleration (meaning the change in year-over-year price growth this year compared to last) in home prices of 26%, 15% and 13% respectively, in May. For instance, San Jose went from a 20% percent year-over-year price gain in May 2018 to a 6% drop this year. That’s the worst three showings out of the 33 metro areas tracked by the firm.
Recap July 2
Stocks cruised higher, with the S&P 500 notching another record close to extend its year-to-date gain to 19%, while rates continued to dive with the 10-year yield falling below 1.98%, the lowest since the November 2016 elections. Gold jumped 2% to $1,413 an ounce to erase yesterday’s losses, while energy was hammered following the OPEC meeting with WTI crude falling 5% to $56 a barrel. The VIX closed below 13 for the first time since May 3.
- Philip Grant
Monday, July 1, 2019
Expansion team
Today, the post-2009 streak of economic growth rolls into a record 121st month,
Today, the post-2009 streak of economic growth rolls into a record 121st month,
Color me repressed
Over the weekend, Agustín Carstens,
Over the weekend, Agustín Carstens,
Recap July 1
Expansion team
Today, the post-2009 streak of economic growth rolls into a record 121st month, barring a hindsight-aided recession call from the National Bureau of Economic Research.
Writing in Bloomberg today, economist Gary Shilling contends that the NBER may indeed determine that the expansion will soon, or has already, come to a close. Shilling cites the pair of large downward revisions to the March and April readings of non-farm payroll figures compiled by the Bureau of Labor Statistics. That was followed by a feeble net gain of 75,000 jobs in May (the consensus estimate was for 175,000 new jobs).
Shilling notes that “an analysis of post-World War II data reveals that employment often slides from diminishing gains to substantial declines within a few months of the onset of recessions.” The June payroll figures are set for release on Friday.
Key manufacturing data points have also turned south, with the Institute for Supply Management’s new orders index for June falling to its lowest since December 2015. On Friday, the Chicago Purchasing Managers’ Index for June likewise matched its worst reading since December 2015.
The downshift in employment growth and macro data is matched by a likely retrenchment in corporate profits. As noted by FactSet on Friday, second quarter earnings among S&P 500 companies are expected to decline by 2.6% year-over-year, which would mark the second straight quarterly earnings decline. FactSet likewise notes that 87 members of the S&P 500 issued negative guidance for the quarter (meaning below the mean analyst estimate), the highest since first quarter of 2016 and an average of 74 guidance cuts from S&P 500 components over the last five years.
Color me repressed
Over the weekend, Agustín Carstens, general manager of the Bank for International Settlements, offered words of caution to reporters following the release of the bank’s annual report.
We would stress that it is important to preserve some room for maneuver for more serious downturns. Monetary policy should be considered more as a backstop rather than as a spearhead of a strategy to induce higher sustainable growth.
Carstens likewise wondered about diminishing returns from additional easing:
How much more stimulus will you get if rates are reduced by another 25 basis points? That will produce [less] bang for your buck.
While the BIS urges caution, it’s full steam ahead for the European Central Bank. Yesterday, The Wall Street Journal reported that ECB president Mario Draghi, whose term ends on Oct. 31, is set to defy his lame-duck status with “some of the boldest policy moves of his eight-year term. . . potentially binding the hands of his successor for years.” A return to corporate and sovereign bond buying (with a potential uptick in the ownership limit to 50% of a given issue from 33%) and additional rate cuts from the current negative 40 basis point deposit rate are on the table per the WSJ. The outgoing central banker faces little resistance, as “key critics on his rate-setting committee have gone quiet as the race to lead the ECB approaches its climax.”
The bond market has received the memo, as German and French sovereign 10-year yields fell this morning to record lows of negative 36 and negative 5 basis points, respectively (vs. year-over-year CPI growth of 1.6% and 1.2% in June).
Meanwhile, the powers-that-be look to put the clamps down on European savers sticking their cash under the mattress. Earlier today, Dutch finance minister Wopke Hoekstra said in an interview with Radio 1 Journaal that the government will seek to lower the threshold for illegal cash payments to €3,000 from the current €10,000, as well as to remove the €500 note from circulation. “It will genuinely help to tackle organized crime and money laundering,” Hoekstra said.
Recap July 1
Risk appetite reigned, as an announced “trade truce” from this weekend’s G-20 meeting in Osaka helped the S&P 500 reach a fresh record close, while WTI crude edged back to $59 a barrel. By the same token, Treasury yields rose across the curve, gold got smacked by 2% to finish at $1,384 an ounce, and the VIX fell to 14, its lowest close in nearly two months.
- Philip Grant
Friday, June 28, 2019
Fill 'er up
Oil prices continue their recovery from last fall’s swoon, with WTI crude fetching $58 a barrel, up from $42 a barrel on Christmas Eve. The coming days will bring a pair of potentially crucial catalysts, with a scheduled Donald Trump-Xi Jinping meeting at the G-20 in Osaka dictating the course of the Sino/American trade spat and global oil demand, followed by Monday’s gathering of the Organization of the Petroleum Exporting Countries in Vienna, which will help set the worldwide supply agenda.
Stateside, the fallout from the shale revolution continues. The Department of Energy pegs total domestic output at 12.1 million barrels per day (mbpd) as of June 21, up 11% year-over-year and just off the record high 12.4mbpd reached at the end of May. “If U.S. production continues to grow this year,” Callum MacPherson, head of commodities at Investec plc, told Bloomberg, “OPEC may find itself in the impossible position of having to make even further cuts to balance the market when it meets later in the year.”
The sharp growth in U.S. production hasn’t necessarily been kind to those doing the pumping. Fracking giant Pioneer Natural Resources Co. (PXD on the NYSE) typifies the current environment. The company recently changed strategic course, backing off from ambitious production goals, replacing the CEO and undertaking expansive cost cutting. Newly reinstated CEO Scott Sheffield (who had retired in 2016) told The Wall Street Journal on Monday that a painful transition is underway: “We lost the growth investors. Now we’ve got to attract a whole other set.” For more on Pioneer, see the May 3 edition of Grant’s Interest Rate Observer.
Investors have indeed been migrating elsewhere. As noted by Bloomberg this morning, oil and gas companies account for just over 5% of the S&P 500. That compares to nearly 11% in 2014.
On Wednesday, the Federal Reserve Bank of Dallas released its quarterly energy survey for the eleventh district, covering Texas, southern New Mexico and northern Louisiana. The results were less than encouraging: “We are experiencing very tough, and unpredictable, business conditions.” One respondent from the exploration and production subsector commented. “I operate with the expectation that my revenue will be lower each month than the prior month.” Another remarked: “Nobody’s generating free cash flow.” An oilfield service provider commented: “Customer activity is being reduced daily, which compounds the worsening business environment.” Analysts at Simmons Energy surmised in a note Wednesday that the dark industry mood “persists today” despite a 10% uptick in WTI over the past two weeks.
In need of higher oil prices, there is reason to believe the U.S. producers’ wish may be granted. The Energy Information Agency cut its forecast for domestic full-year production to 12.32mbpd in its June productivity report, down 140,000bpd from last month’s estimate. The agency reported 8,283 drilled but uncompleted wells, down 77 from May and the lowest reading since March 2018. Baker Hughes, a GE company, reported two weeks ago that active rigs in the all-important Permian Basin (the largest shale field in the U.S.) fell to 441, also the lowest count since March 2018.
Away from the U.S., the upcoming OPEC meeting shines a light on swing producer Saudi Arabia and questions about its true capabilities. Back in April, the $12 billion bond offering of state-owned Saudi Arabian Oil Company (Aramco) included something of a revelation concerning the Ghawar oil field, one of the world’s largest with a 2017 EIA output estimate of 5.8mbpd. A recent blog post from resource investors Leigh Goehring and Adam Rozencwajg of Goehring and Rozencwajg Associates LLC explains:
While the Aramco bond prospectus does not list historical production by field, it does disclose both the so-called “Maximum Sustained Capacity” and the remaining reserves for the major fields. Ghawar’s maximum sustained capacity is 3.8 mbpd. Last year, Aramco produced at 85% of its sustained capacity, suggesting that Ghawar pumped approximately 3.3mbpd, down nearly 35% from its peak of 5mbpd in 2005.
Reached by Grant’s today, Goehring emphasized that the Ghawar output decline is permanent, rendering Saudi’s prodigious fall 2018 (in which the Kingdom produced 10.7mbpd, 11.1mbpd and 10.7mbpd across October, November and December) ancient history:
Ghawar is 60 % depleted and will continue to decline. Saudi will probably never get production over 10.5mbpd ever again.
Goehring likewise forecasts that ex-U.S., non-OPEC supply growth will turn negative by the fourth quarter, while noting that key domestic Eagle Ford and Bakken fields are both “nearing peak production and will soon start to decline.” With OPEC production on the wane (to 30.3mbpd as of May 31 from more than 33mpbd in November), Goehring concludes:
The oil market is going to significantly tighten in the second half of 2019.
Recap June 28
Stocks caught a solid bid, narrowing the week’s losses to 0.3% on the S&P 500 and leaving the broad index higher by more than 17% year-to-date through the second quarter, its best first half performance since 1997. Treasury yields and the VIX finished little changed, while energy prices came under pressure following an announcement from the European Union that it is preparing a workaround to navigate Iranian sanctions.
On the data front, another key metric indicates a slowdown, as the May Chicago purchasing managers index fell into contraction territory at 49.7 (above 50 indicates expansion), well below the 53.7 consensus and matching its weakest reading since December 2015.
- Philip Grant
Thursday, June 27, 2019
Powerfinger
Time for a survey of recent happenings in leveraged loans.
Time for a survey of recent happenings in leveraged loans.
QT progress report
Recap June 27
Powerfinger
Time for a survey of recent happenings in leveraged loans. “Aren’t all loans leveraged?” one might ask. This cohort comprises secured, floating-rate loans made by speculative borrowers, typically to fund private equity buyouts and frequently packaged into CLOs (collateralized loan obligations). Faring relatively well in the global financial crisis, leveraged loans have since become the apple of Wall Street’s eye.
Despite a relatively soft recent performance (the S&P/LSTA Loan Index sports a 52 week total return of 3.8%, well behind the 7.1% gain for the Bloomberg Barclays High Yield Index over the past year), the current cycle has been a boon to the asset class. The domestic quantity of loans outstanding has reached $1.2 trillion according to S&P’s LCD unit, more than doubling since 2012 and exceeding the supply of high-yield bonds last May for the first time ever.
While the Fed’s expected rate cuts have diminished the relative demand for floating-rate securities, sources of new supply remain plentiful. Private equity activity, which accounts for a hefty chunk of loan issuance, remains particularly robust. The Financial Times, citing data from Preqin, reports today that p.e. is sitting on a record $2.44 trillion cash pile. “Deal volume in private equity has been very good. A number of transactions have kept the machine going,” Simona Maellare, global head of financial sponsors at UBS Group A.G., tells the FT. “Deals can be financed, competition for assets is vivid, everyone has a lot of money.”
Yet various observers have viewed the breakneck growth in loans with alarm: “It'll be ugly for those companies if the economy slows down and they can't carry the debt. . . then the usual carnage goes on," Brian Moynihan, CEO of Bank of America Corp. said in a June 4 speech at the Economic Club of New York. Minutes from the May 1 Fed meeting flagged the recent growth in leveraged loans, noting that “heightened leverage and associated debt burdens could render the business sector more sensitive to economic downturns than would otherwise be the case.” Congress held a hearing on leveraged loan risks earlier this month, fulfilling the prophecy of the July 13, 2018 Grant’s leveraged loan analysis headlined “Tomorrow’s debt hearings.”
One point of concern is the erosion (or disappearance) of loan covenants, the fine print that holds the corporate borrower to a standard of behavior. LCD reckons that the proportion of loans considered covenant-light, meaning that traditional investor protections have been largely removed, remained at a record 79% in May, up from about 20% in 2007. That potentially exposes creditors to higher loss levels in the event of trouble. A report today from Moody’s Investors Service expresses alarm at the growing ability of borrowers nearing or even in default to nevertheless hive off assets – including cash – beyond the reach of creditors:
An increasing number of loan provisions require only that there be no event of default, granting the borrower access to carve-outs while in default (a default is a breach that matures into an event of default if not cured or waived within time limits; an event of default permits lenders to exercise remedies). Some loans go further, dispensing with conditionality altogether and allowing borrowers access to certain carve-outs even if an event of default exists.
As the private equity, leveraged loan and CLO trains chug along, one familiar name enthusiastically hops aboard. Last Thursday, LCD reported that Deutsche Bank A.G. (DBK in Frankfurt and DB in New York) “is planning to follow the lead of a number of U.S. banks and invest in the senior-most CLO tranches as a way to better manage excess liquidity and boost profitability.” Bloomberg notes today that Deutsche Bank is tapping cash for the endeavor that would otherwise be parked at the ECB and subject to the negative 40 basis point deposit rate.
But as Deutsche buys CLO tranches for its own account, its investment banking division has been burned by the securities which comprise a CLO. Yesterday, the FT reported that the beleaguered bank is facing large losses on a pair of loans after investors balked at the original terms, forcing DB to unload the loans at a discount and absorb the difference.
More broadly, leverage across the group continues to rise, with the share of p.e. deals leveraged more than seven times Ebitda reaching nearly 40% last year according to Loan Pricing Corp. That's from less than 20% in 2015. Then, too, there is a question about earnings quality. LCD finds that almost 56% of M&A loans featured issuer-friendly adjustments to Ebitda as of the second quarter of 2018, up from 34% in 2015; such adjustments can add 40% or more to reported earnings.
At the same time, fundamentals are on shakier ground, as year-to-date downgrades from Moody’s have totaled 156, above the 132 seen at this time last year. Upgrades, likewise, have fallen to 47 year-to-date from 54 in 2018.
An analysis in the Sept. 7, 2018 edition of Grant’s began with a universal fact of investing life, one that applies to the bourgeoning leveraged loan/CLO machine:
On Wall Street, success begets failure. Take a good idea, emulate it and embellish it, drive it into the ground like a tomato stake. Voilà: It’s a bad idea.
QT progress report
The Fed’s portfolio of securities held outright fell to $3.645 trillion, down $16 billion from a week ago and $22 billion from the trailing four-week average with mortgage-backed securities providing the sequential decline.
Commenced on Oct. 1, 2017, the QT program has seen the Fed shrink total balance sheet assets by 13.7%, at a simple annualized rate of 8.3%.
Recap June 27
Some risk aversion was visible, as the S&P 500 edged lower to remain in the red by nearly 1% for the week so far, while Treasurys caught another bid with the 10-year yield falling back to 2.01%. Both gold and oil lost some modest ground, and the VIX held just below 16.
- Philip Grant
Tuesday, June 25, 2019
Dance of the living dead
Globally, the stock of negative-yielding debt crossed a record $13 trillion on Thursday, according to data from Bloomberg. That represents 26% of global sovereign debt supply and 15.3% of nominal worldwide GDP for 2018. Stateside, the 10-year Treasury yield remains below 2%, down from 3.25% in November.
In a New York Times opinion piece last Sunday, Ruchir Sharma, chief global strategist at Morgan Stanley, discussed the fallout from the incredible shrinking interest rates. Citing a report from the Bank for International Settlements, which found that 12% of publicly listed companies around the world can be described as zombie firms (meaning they don’t earn sufficient profits with which to cover their interest payments), Sharma concluded that simple policy miscalculations are on display:
Once the crisis hit, governments erected barriers to protect domestic companies. Central banks aggressively printed money to restore high growth. Instead, growth came back in a sluggish new form, as easy money propped up inefficient companies and gave big companies favorable access to cheap credit, encouraging them to grow even bigger.
Other academic studies lend credence to Sharma’s, and the BIS’s claims. On January 22, the National Bureau of Economic Research released a paper examining the effects of low interest rates on economic dynamism. Incumbents will like what they see:
A reduction in long-term interest rates tends to make market structure less competitive within an industry. The reason is that while both the leader and follower within an industry increase their investment in response to a reduction in interest rates, the increase in investment is always stronger for the leader. As a result, the gap between the leader and follower increases as interest rates decline, making an industry less competitive and more concentrated.
When interest rates are already low, this negative effect of lower industry competition tends to lower growth and overwhelms the traditional positive effect of lower rates on growth.
In January 2017, the Organisation for Economic Co-operation and Development released Working Paper No. 1372, which reached a similar conclusion:
Evidence of a decline in productivity-enhancing reallocation is particularly significant in light of rising productivity dispersion, which would ordinarily imply stronger incentives for productive firms to aggressively expand and drive out less productive firms.
Instead, the productivity gap between frontier and laggard firms has risen, even while the forces bringing dynamic adjustment are waning. This tension is a red flag that something is wrong with productivity, but also points to a potential deterioration of the exit margin [meaning fewer firms are going to corporate heaven].
E-Z money likewise helps bring the dead back to life. As noted by Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, during the Spring 2014 Grant’s Conference, the 2008-2009 default cycle was anomalously brief: “We actually had the situation where the default rate went from a record level to below average the very next year. I would submit that is physically impossible, but it did actually happen.”
Needless to say, the march lower in interest rates will help this encumbered group continue to walk the earth. As compiled by Ben Breitholtz, data scientist at Arbor Research & Trading, LLC and noted in the March 8 edition of Grant’s, the proportion of zombie companies (defined here as those whose operating income fails to cover interest expense for three straight years) in the S&P 1500 Index rose to 13.6% at the end of January. That’s up from 12.4% year-over-year and compared to less than 6% of that broad cohort in 1990. During that period, the yield on 10-year Treasury Inflation Protected Securities declined to less than 1% from more than 14%.
Breitholtz also spotted a key threshold for this undead cohort, telling Grant’s in March: “We noticed that the closer the 10-year real yield gets to 1%, there is a hypersensitivity for a lot of these overleveraged companies.” With the 10-year real yield now sitting below 20 basis points, the corporate undead continue to roam.
Recap June 25
Stocks took a dive with the S&P 500 falling 1% as commentary from the Fed’s Powell and Bullard didn’t suit Mr. Market. However, dovish expectations remain firmly ingrained, as interest rate futures price more than 50 basis points of rate cuts by September (up from 38 basis points last Tuesday) and the two-year yield remains at 1.74%, down 10 basis points from a week ago. Treasurys mostly rallied again (with the exception of that two-year) and gold inched higher to $1,422 an ounce, extending its winning streak to six straight sessions.
- Philip Grant
Monday, June 24, 2019
Gig inequality
The New Republic,
The New Republic,
Trump friends China
Whack-a-mole in the Middle Kingdom.
Whack-a-mole in the Middle Kingdom.
Recap June 24
Gig inequality
The New Republic, self-described as “a champion for equality in all its guises,” posted a job listing today for an “inequality editor.” The successful candidate will have to settle for 29.5 hours a week, 30 hours being the threshold for full-time status under the Affordable Care Act; the position “does not include benefits.”
Next up: Self-awareness editor.
Trump friends China
Whack-a-mole in the Middle Kingdom. Following the state-led takeover of small Mongolian lender China Baoshang Bank Co. in early June, evidence of stress in the Chinese economy and banking system, especially among smaller institutions, is multiplying. Bloomberg reports today that overnight pledged repurchased rates rose to 8% and seven-day pledged repo rates 18.3% today for nonbank institutions, compared to just 0.99% and 2.77%, respectively, for banks. Those elevated borrowing costs are not well timed, as Enodo Economics reports that nonbank borrowings through bond repurchases jumped to a net RMB 74.7 trillion ($11.2 trillion) in the first quarter, representing 84% of 2018 nominal GDP and up 50% year-over-year.
The wide-rippling effects of Baoshang’s failure are remarkable, considering that the lender had RMB 418 billion worth of assets on its balance sheet at year end 2016 (the most recent year in which the bank filed an annual report), barely a rounding error compared to the RMB 275.8 trillion in total Chinese banking assets as of March 31.
Earlier today, the Bank of Beijing announced it has infused RMB 2.5 billion ($364 million) into troubled conglomerate CITIC Guoan Group Co., Ltd., after Guoan failed to make debt payments by last Thursday’s deadline, according to Reuters. That follows an RMB 3 billion default by Guoan in April. The cash crunch at Guoan looks to be severe, as Asian real-estate website Mingtiandi, citing local media, reported on June 16 that the company’s long-term rental subsidiary “has been accused by landlords of not paying rent on the apartments that it leases to tenants.”
Last week, property developer China Evergrande Group announced an additional equity investment RMB 13.2 billion in Shengjing Bank Co., Ltd. (2066 on the Hong Kong exchange), doubling its ownership stake to 36%. The move is “a head scratcher” according to Jacky Wong of The Wall Street Journal: “There are no obvious synergies, and the investment returns have been lousy for Evergrande.”
Conventional synergies may be lacking, but Evergrande’s move makes more sense as a bailout. Though the RMB 6 per share deal price represents a 37% premium to Shengjing’s June 5 closing price, that figure still represents new issuance at a 38.3% discount to the bank’s book value. One anonymity-seeking China bear views the decision to issue stock at that markdown as a potentially crucial strategy shift: “In all other cases, we have seen Rube Goldberg-like efforts (perpetual preferreds, etc.) to avoid doing exactly this. Stay tuned to see if this becomes a precedent.”
On June 13, the Bank of East Asia Ltd. disclosed a “material decrease” in first half profits. The culprit: “significant post-tax impairment losses” of roughly HKD$3 billion ($390 million) on a HKD$6.2 billion loan portfolio. The Bank cited “worsening market conditions, which have impacted the commercial property sector in non-tier one cities in mainland China.”
Signs of a slowdown in China’s property market continue to accumulate. On Wednesday, Caixin reported that class-A office vacancies in tech-centric Shenzhen rose to more than 23% for the first half of 2019, a decade high.
Meanwhile, a pair of key indicators covering economic and financial health remain near their lows of this cycle. Fixed asset investment, which played a starring role in the debt fueled investment boom and accounts for nearly half of Chinese GDP, grew by 5.6% in May, down from a 10-year average of 16.7%. M2 money supply growth, the end result of money printing from the People’s Bank of China, is also on the wane, rising 8.5% year-over-year in May. That compares to a 10-year average of 14%.
Will China be able to avoid a debt-driven accident? In a note today, Anne Stevenson-Yang, co-founder of J. Capital Research, writes that with China’s economy on the ropes, an unlikely figure could be set to (unwittingly) ride to the rescue:
Trump’s preoccupation with the stock market is currently China’s best bulwark against financial disaster. As Trump bullies the Fed into a more dovish stance, the additional U.S. dollar liquidity and associated asset appreciation improve China’s visible balance of payments, push down U.S. dollar borrowing rates, and make Chinese assets look more attractive to foreign investors.
Hot money is more likely to come into China to take advantage of its higher money-market rates, while capital flight becomes less attractive. All of these things give China more time to tread water, paper over defaults, and invest more in infrastructure to buck up GDP numbers.
Stevenson-Yang draws a parallel between China’s current situation with the predicament faced by another Asian power following the bursting of its own real estate bubble:
China has already entered its “Japanese phase,” when its financial resources are being marshalled exclusively for the avoidance of crisis.
An easier Fed will buy time, but the fact remains: Chinese economy is overleveraged, and, as the Baoshang situation demonstrates, extraordinarily sensitive to disturbance.
Recap June 24
Stocks reversed early gains to edge a bit lower, the second straight modest selloff after the S&P 500 made a new high on Thursday. Treasurys caught a bid with the 10-year yield dropping four basis points to 2.01%, while gold continued its torrid run, rising to $1,420 an ounce for the first time since 2013. The VIX settled just above 15.
- Philip Grant
Friday, June 21, 2019
Tricky Dix
Let’s hit redial. The Sept. 21 edition of Grant’s Interest Rate Observer featured a bullish analysis of Dixons Carphone plc (DC/ on the London Stock Exchange), reckoning it was a cheap stock. It has since gotten cheaper, falling 36% while the FTSE All-Share Index has lost 2% over the same period. An analytical update follows.
Born of the 2014 merger between electronics retailer Dixons Retail Group Ltd. and mobile phone vendor Carphone Warehouse Group plc, the combined entity has run into all manner of misfortune: Adverse change in consumer behavior compounded by lamentable strategic decisions from the prior management team, while the chaos associated with Brexit has added an external stumbling-block.
Yesterday, Dixons disclosed a nasty surprise, as pretax profits for the fiscal year ended April 27 fell to £298 million ($378 million) from £400 million year-over-year. Company guidance for fiscal 2020 calls for pre-tax profits of £210 million (as well as £80 million in one-time charges), well below the Street consensus of £295 million. The Carphone mobile unit was the culprit, with “more pain” in the form of a “significant loss” in store for the coming year, according to CEO Alex Baldock (the former Shop Direct plc boss who took over in April 2018). The company took a £557 million non-cash write down for the year, primarily attributed to that sickly mobile division.
Those mobile troubles can be attributed to changing consumer tastes that have laid bare the problems in that unit’s business model. Customers get the phone upfront (Dixons pays for the handset), connected to one of the U.K.’s big 3 wireless providers, and pay for it, along with network charges, over the duration of the contract. In other words, cash goes out the door in bulk, then comes back gradually. What’s more, Dixons is contractually obligated to deliver certain volumes to the network carriers on the pain of hefty cash penalties for any shortfall.
But with customers increasingly opting for monthly contracts rather than locking up lengthy and expensive (read: higher margin) post-pay phone contracts, Dixons is stuck under unfavorable fixed-cost contracts with the network providers, while the capital-intensive nature of the business adds another layer of negative operating leverage. There is a light at the end of the tunnel however. As noted by Baldock on the conference call, much of that legacy burden will be lifted during fiscal 2021 as contracts expire.
While the mobile division’s woes are front and center, electronics retail is Dixons’ bread and butter, representing more than 80% of company sales. As the U.K. mobile division suffered a 4% year-over-year decline in revenues, so-called electricals ground out 1% positive comps with management forecasting further sales and profit growth in 2020. Market share is on the upswing, a “crucial” factor according to James Armstrong, senior analyst at The Analyst Research LLP, as growing share lends itself to “buying scale and central efficiencies.” On the cost front, low-hanging fruit still exists to be plucked: For instance, the two businesses continue to run separate operating systems five years after the merger.
Following the latest leg-down, Dixons shares are priced for imperfection, with a £1.55 billion enterprise value representing just over three times consensus fiscal 2020 EBITDA. The balance sheet is presentable, with £265 million in net debt and mobile contract accounts receivable of £800 million (of which management expects to realize some £500 million, per commentary on the conference call). By comparison, domestic pure-play electronics retailer Best Buy Co., Inc.’s enterprise value stands at 7.3 times forward EBITDA, and net debt of $2.5 billion compares to an expected $2.8 billion in consensus 2020 EBITDA.
One Dixons investor is taking the recent pain in stride, telling Grant’s yesterday that while the post-earnings selloff was justified, the odds are good that this year is the trough: “No real change in view for me, I think there is more than 100% upside here.” Our nameless source added to his position in the selloff.
Dixons management is at least sampling their own cooking. Today, eight separate directors reported stock purchases on the open market, led by CEO Baldock who acquired 150,000 shares at £1.1372. Early (meaning wrong) on our fall 2018 pick-to-click verdict, Grant’s remains bullish.
Recap June 21
Stocks fluttered a bit lower, as the quadruple witching options expiration didn’t yield much in the way of trading fireworks, though the VIX jumped late in the day to finish above 15.
The Treasury curve saw notable steepening, as the 30-year yield finished at 2.59% after briefly trading below 2.48% yesterday morning, while energy and gold extended their recent rally to leave WTI crude and the Money of Kings at $57.50 a barrel and $1,400 an ounce, respectively.
Nice lookin’ chart: Gold since 1920. Source: The Bloomberg
- Philip Grant
Thursday, June 20, 2019
Chickens counted
Another step forward for the never-ending merger saga.
Another step forward for the never-ending merger saga.
QT progress report
Recap June 20
Chickens counted
Another step forward for the never-ending merger saga. On Tuesday, Bloomberg reported that Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq) were making progress in asset sale negotiations with Dish Network Corp. (DISH), as the pair continues to seek regulatory approval for their $26.5 billion, all-stock deal announced in spring 2018. “Dish could announce a deal as soon as this week,” for the Boost Mobile prepaid brand and wireless spectrum that the pair agreed to divest in order to garner approval from the Federal Communications Commission on May 20, though talks could still fall through.
T-Mobile is indeed hedging its bets. Yesterday, Reuters relayed that Goldman Sachs Group, Inc., which is advising T-Mobile, is soliciting other bids for those assets. Reuters describes T-Mobile as “hopeful it would reach an agreement with the Justice Department by early next week.”
Resolution could come as soon as tomorrow, according to a tweet from Fox Business reporter Charles Gasparino this morning. CNBC’s David Faber pegs the odds of approval at 90%, with a divestiture of Boost and spectrum assets serving as a lynchpin for the green light.
While regulatory approval would be a huge step forward, the hopeful suitors wouldn’t be out of the woods just yet. On June 11, a group of 10 state attorneys general filed suit to block the deal, with New York AG Letitia James asserting that the combo would “cause irreparable harm to mobile subscribers nationwide.” Late this afternoon, the Capitol Forum reports that "several" additional attorneys general, including from Massachusets, intend to join the suit.
For single-B-rated Sprint, burdened by an onerous debt load and stagnant operating results, its easy to understand the urgency to consummate the deal. In early 2016, Sprint’s senior unsecured 6 7/8 notes of 2028 fell to 57 cents on the dollar and its credit default swaps implied 80% odds of a default as investors came to doubt the company’s standalone viability. A completed merger would likewise be manna for SoftBank Group Corp. (9984 on the Tokyo Stock Exchange), which holds an 84.5% equity stake in Sprint currently worth $25.6 billion.
The logic from T-Mobile’s perspective is less clear. In a note over the weekend, boutique research firm MoffettNathanson, LLC addressed this issue, writing:
What does it say about T-Mobile’s standalone prospects that they seem so hell-bent on getting a deal done… at seemingly ANY price?
Let’s try to remember why T-Mobile wanted the Sprint merger in the first place. Leave aside all the nonsense about scale and heft and competitive equilibrium. What the deal really boiled down to was two things: spectrum and industry structure. One might then reasonably ask: why would T-Mobile or Deutsche Telekom ever agree to a remedy that forfeits both benefits in order to get the deal done?
The analysis takes a dim view of the rumored Dish deal that may clear the way for regulatory approval:
We’re not sure why that deal is sensible for anyone involved. Dish, remember, already has more spectrum than they know what to do with; what they lack is money and ground facilities, and the deal described on Friday wouldn’t deliver either one. Instead, it would make both problems worse. And while Boost would help provide a baseline revenue stream in return for an upfront purchase price, the fit between Boost and Dish is, at best, superficial.
Back to T-Mobile. At what point does T-Mobile, and/or its parent company Deutsche Telekom, walk away? Hey, we tried. We turned over every stone. But we just couldn’t make it work.
At the end of the day, a bad deal is worse than no deal at all. Truth be told, there have been nagging questions about whether T-Mobile would be better off without the deal under any circumstances. Certainly, the exchange ratio never made any sense to us. And, absent a deal, T-Mobile would seemingly be in a good position to poach an awful lot of Sprint’s subscribers… without having to pay for them.
The idea of T-Mobile voluntarily selling assets to Dish would have been risible just months ago. On Oct. 25, TMUS sent a letter to the FCC asserting that Dish “intends to continue to warehouse spectrum with no benefit to customers.” As noted by Mike Dano of industry website FierceWireless, Dish has been one of the staunchest opponents of a TMUS/S tie up, arguing in an FCC petition last August that the merger would: “lead to excessive concentration in other relevant markets, and likely increase prices for consumers.”
One investor familiar with the situation tells Grant’s today that even with DOJ approval and an agreement on divestitures, Sprint and T-Mobile will have their hands full getting the deal past the state AGs:
So the solution is to give Dish additional spectrum and then position Dish with: less subs than stand-alone Sprint (and only prepaid); less or no corporate-owned stores than stand-alone Sprint; a more levered balance sheet than stand-alone Sprint (Sprint has SoftBank behind it too, whether Sprint wants to admit it or not); less spectrum than stand-alone Sprint; and no history operating a wireless business (so a start-up) vs. Sprint being an operating company?
Oh, and Dish won’t actually own its network, no matter how strong an MVNO [mobile virtual network operator] it gets. This remedy is a joke anyway you cut it. States will see this and will refile the complaint.
I’ve heard the argument that the judge will heap deference on DOJ/FCC. But that’s just not how the law works – the Clayton [Antitrust] Act is the Clayton Act, and the proposed fixes won’t change the presumption of harm. In the eyes of the law, the deal is illegal, and the parties will have their day in court to show the fix and efficiencies rebut the presumption.
Yet as far as Mr. Market is concerned, it’s a done deal: Sprint currently trades just 6% below the all-stock deal price implied by T-Mobile shares, while the senior unsecured 6 7/8 notes of 2028 last changed hands at 107 cents on the dollar for a 404 basis point spread over Treasurys.
QT progress report
The Fed’s portfolio of securities held outright fell to $3.661 trillion this week, down $6.5 billion sequentially and $11 billion from the trailing four-week average, with mortgage-backed securities holdings providing all of this week’s change.
Since the fall 2017 start of QT, total balance sheet assets are down by 13.7%, an 8.2% simple annualized pace.
Recap June 20
The tide continues to rise, as another impressive rally in stocks pushed the S&P 500 to a fresh closing high above 2,950, up 18% year-to-date. The gaudy gains were not limited to equities, as Treasury yields continued their eye-watering dive with the 10-year falling as low as 1.98% this morning from 2.5% as recently as May. Energy prices caught a strong bid after President Trump offered more bellicose commentary towards Iran on Twitter, with WTI crude jumping 6% to near $57 a barrel, and gold continued its hot streak with a 3% rise to $1,387 per ounce, its best finish since March 2014.
One potentially bearish trading indicator was a strong rebound in the VIX, which reversed an early dip below 14 to finish at 14.75, up 3% on the day.
So-called quadruple witching options expiration tomorrow could yield some early volatility.
- Philip Grant
Wednesday, June 19, 2019
Wax on wax off
Cognitive dissonance reigns supreme, as the stock market sits near an all-time high, credit spreads remain tight and the post-crisis economic recovery looks to match a record-long 120th month in June. Yet investors continue to pour their capital into perceived safer assets, sending Treasury yields diving and pushing the global supply of negative-yielding debt securities to a record $12.5 trillion. Signs of the times is the subject, beginning with a pair of anecdotes reported by Bloomberg this morning.
In South Africa, state-owned utility Eskom Holdings SOC Ltd. struggles to service its $30 billion debt load through internal cash flow generation. That hasn’t stopped its dollar-pay bonds due 2028 from returning 22.3% year-to-date as investors anticipate a helping hand from the double-B-rated South African government. That assistance better be forthcoming, according Citadel Holdings Ltd. portfolio manager Mike van der Westhuizen, who notes: “Without government support Eskom is dead in the water.”
This morning, triple-C-rated Greek lender Piraeus Bank S.A. finalized terms for €400 million ($448 million) of tier-two notes with a 9.75% coupon, as an order book exceeding €850 million helped the issue price more than 50 basis points tighter than the underwriters had expected. Sohail Malik, co-CIO and portfolio manager at Roxbury Asset Management, told Bloomberg that “Piraeus has timed this well,” capitalizing on a global “bid frenzy” for subordinated bank debt.
Risk appetite likewise continues to percolate in the U.S., as the Bloomberg Barclays High Yield Index trades at an option adjusted spread of 398 basis points over Treasurys, well below the 512 basis point average pickup going back to March 1994. More broadly, the Bloomberg Barclays U.S. Corporate Bond Index has generated a total return of 8.43% less than halfway through 2019, better than any full year since 2012. Some watchers expect more of the same, with analysts at BofA Securities writing today that psychological factors could help extend the rally:
There is only one large, reliable, source of yield for fixed income investors, which is the global corporate bond market. Should U.S. interest rate volatility recede, as U.S.-China trade related uncertainties are lifted, we expect significant foreign demand for U.S. corporate bonds to supplement near record inflows to investment grade bond funds and ETFs, leading to significantly tighter credit spreads and flatter spread curves.
A trade deal would accelerate this, but we believe this scenario would play out even without, as fixed income investors are unable to stay underweight indefinitely and - due to Fed rate cuts - the cost of staying underweight becomes prohibitive.
While the fear of missing out looms large in the minds of investors, key indicators show signs of deterioration. According to J.P. Morgan Securities, LLC, an analysis of more than 500 speculative-grade non-financial and non-utility borrowers showed a 4.3% year-over-year EBITDA decline in the first quarter (the first such contraction since 2016). Average EBITDA now covers interest expense 4.56 times on average, down from 4.78 times a year ago.
That downtick in corporate health flagged by J.P. Morgan is confirmed by a pair of metrics from Moody’s Investors Service. On June 10, the ratings agency raised its 12 month global default forecast to 2.4%, well below the post-1983 average of 4.1% but nearly double the 1.3% 12-month default guesstimate issued a month ago. Two days later, Moody’s reported that its Liquidity Stress Indicator rose to 4.5% in May, likewise comfortably below its 6.3% long-term average but at its highest level since April 2017.
Curiously, according to the BofAML June Fund Manager Survey, respondents raised their average cash balance to 5.6% from 4.6% in March, April and May, representing the biggest jump in dry powder since the 2011 European sovereign debt crisis. In addition, long U.S. Treasurys took the number one spot for the most crowded trade identified by investors for the first time ever.
Meanwhile, lower rates at the short end are a stone-cold lock according to interest rate futures, which now price 100% odds of a July rate cut following this afternoon’s stand-pat decision from the FOMC.
Recap June 19
The Fed didn’t cut rates, but price action suggested they may as well have. Most notable was another panic bid in short term Treasurys, as the two-year yield dived lower by 11 basis points to 1.74%, down from 2.39% two months ago. Stocks enjoyed a late lift, with the S&P 500 drawing closer to its April 30 peak, and gold continued its hot streak by pushing to $1,360 an ounce, its highest since July 2016. The VIX reversed early gains, falling 5% to 14.3.
- Philip Grant
Tuesday, June 18, 2019
So much winning
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.”
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.”
Recap June 18
So much winning
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.” Thus declared economist Eugen von Böhm Bawerk, according to Richard Sylla and Sidney Homer’s classic tome A History of Interest Rates. By that logic, Europe is the domain of superhumans, as the overnight deposit rate has resided below zero since June 2014 and at negative 40 basis points since March 2016.
The M.D. overseeing Europe’s monetary affairs has his own version of the Hippocratic Oath. Speaking at the ECB’s annual forum at the resort town of Sintra, Portugal today, ECB president Mario Draghi made waves by suggesting the central bank will impose still lower interest rates:
Further cuts in policy interest rates and mitigating measures to contain any side effects remain part of our tools. . . Negative rates have proven to be a very important tool in the euro area.
In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.
The implications are clear. Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics, told Bloomberg: “Draghi is going to finish his tenure [set to end on Oct. 31] with a cut. The door is now open and I don’t see how they can not walk through it.” Mike Riddell, fund manager at Allianz Global Investors, noted: “The ECB has just handed the bond bulls an ammunition dump.”
Five years and counting into the negative rate era, the ECB’s increasingly radical policies designed to hot up inflation simply haven’t worked. Eurozone CPI rose just 1.2% year-over-year in May, the lowest figure in over a year. Likewise, the “five year, five year inflation swap rate,” Draghi’s preferred metric for the future inflation expectations that the central bank is so eager to manipulate, fell to a record low 1.14% on Friday, since rebounding to 1.23% but still well below the five-year average of 1.48%, let alone the ECB’s now-symmetrical, “close to 2%” bogey.
While inflation stubbornly refuses to follow the playbook, the bond market has been more easily cowed. Following Draghi’s remarks today, the French 10-year yield temporarily broke below zero for the first time ever, while Sweden (which resides outside of the eurozone currency bloc but is an E.U. member state) also saw its 10-year borrowing costs make their first ever foray into negative territory.
More broadly, the worldwide sum of negative-yielding debt instruments rose to $11.8 trillion as of yesterday, up from less than $6 trillion as recently as last fall and within range of the record $12.2 trillion seen in July 2016 (when the 10-year Treasury yielded less than 1.4%, compared to 2.06% today). Never in the 4,000 years of human history, per Sylla, were negative rates seen in substantial size prior to this cycle. The upside-down policy rate extends to the less-creditworthy members of the E.U., as Baa3/triple-B-rated Italy and B1/double-B-minus-rated Greece saw their 10-year yields fall to 2.12% and 2.51%, respectively, not far above the split-rated (triple-A at Moody’s, double-A-plus at S&P) United States.
Bloomberg’s global negative rate index by market capitalization since January 2010
The peculiar state of affairs has not seemed to help the Old Continent’s frail banking system, which lags far behind global peers in terms of profitability and valuation (Almost Daily Grant’s, May 28). As the banks list, one of the shakiest institutions continues to search for answers. Bloomberg reports today that Deutsche Bank A.G. (which has seen shares fall 84% in the last nine years to less than 21% of its year-end 2018 book value) CEO Christian Sewing is set to “purge” a number of top executives and is also “zeroing in on another round of deep trading cuts that may result in the shuttering of the U.S. equities” division.
Others take a different tack. Speaking on a conference panel this morning, Cornelius Riese, co-CEO of Frankfurt-based DZ Bank A.G. (Germany’s second-largest by assets), observed that negative rates indeed “have a huge impact on banks.” Riese ventured to offer some gentle criticism of Draghi & Co.’s grand policy experiment: “Maybe at the end of the story, in three to five years, we will notice it was a historical mistake.”
Not everyone was so circumspect. This morning, Donald Trump took to Twitter to complain:
Mario Draghi just announced more stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA. They have been getting away with this for years, along with China and others.
Sad!
Recap June 18
News that Trump will meet with China’s Xi Jinping at the G-20 meeting next week helped spur another bull move, as the S&P 500 jumped 1% to close within 100 basis points of its April 30 highs. Energy prices ripped with WTI crude closing above $54 for the first time since late May, while gold moved to a new 52-week high above $1,346 an ounce. Treasurys rallied with strength in the long end pushing the curve flatter, and the VIX finished just above 15.
- Philip Grant
Monday, June 17, 2019
That was then
How the turntables have turned.
How the turntables have turned.
Everyone's a critic
A shocker this morning:
A shocker this morning:
Recap June 17
That was then
How the turntables have turned. Over the weekend, the New York Post reported that Goldman Sachs Group, Inc. CEO David Solomon has been invited to perform at European house music festival Tomorrowland later this summer, a gig which “will take DJ D-Sol’s career to a new level, according to insiders.” Solomon/DJ D-Sol already saw a recent single reach as high as number four on the Billboard Dance music charts earlier this year.
It’s a new era for Goldman, long a Wall Street investment partnership led by co-chairman John Whitehead, a Navy veteran who saw action at the invasions of Normandy and Iwo Jima before joining the firm in 1947. A 2015 Financial Times obituary of Whitehead cited a telling exchange early in his Wall Street career:
As Whitehead relates in Money and Power, How Goldman Sachs Came to Rule the World, that did not mean the partners tolerated any compromise in formality. Arriving at the office in a seersucker suit in a humid New York summer, he was accosted by Walter Sachs, scion of the firm’s co-founder and asked: “Young man, do you work at Goldman Sachs?” He confirmed that he did, only for Sachs to reply: “In that case, I would suggest that you go home right now and change out of your pajamas.”
As for the musically-inclined who don’t care for techno, alternatives abound. As noted by Jim Bianco this morning on Twitter, Fed governor Richard Clarida released an album in 2016 on Apple Music. Relevant track titles include “Gone too far,” “Take too long,” “Just can’t wait” and others.
Everyone's a critic
A shocker this morning: Patrick Drahi, founder and president of the board of telecom giant Altice N.V. as well as chairman of Altice U.S.A, Inc., announced he will acquire Sotheby’s, Inc. (BID on the NYSE) for $3.7 billion in cash. Drahi, worth some $9.3 billion according to Forbes, will take 275-year old Sotheby’s private through his appropriately named BidFair USA, LLC entity, ending the company’s 31-year run on the New York Stock Exchange.
The $57 per share deal price represents a 61% premium to Friday’s close and is 56.3% above Sotheby’s volume weighted average price over the past 30 days. BID shares had not exactly been a hot commodity of late, falling 25% from the Grant’s bearish analysis on September 7, 2018 to Friday, compared to a 10% loss from the Russell 2000 Index. Following today’s announcement, BID shares now sit higher by 19% over the past nine months and change.
For already junk-rated (Ba2 at Moody’s and double-B-minus at S&P) Sotheby’s, today’s news is seemingly a best-case outcome for management and shareholders, if not the short interest. Wendy Battleson and Giulia Costantini, co-founders of Art Strategy Partners and themselves former outspoken bears (Grant’s, April 19), have this comment:
Taking Sotheby's private was the only smart move for the company. Sotheby's requirements for complete transparency as a public company and quarterly disclosures of guarantee risk and the sizing of their art finance book were cumbersome when compared to their main competitor Christie's. Auction houses like confidentiality even within their own operations and being public simply doesn't allow that.
Sotheby’s, Inc. one-year price chart. Source: The Bloomberg
For Drahi, a self-described “longtime client and lifetime admirer of the company,” BID’s cachet looms large, as he describes Sotheby’s in the press release as “one of the most elegant and aspirational brands in the world.” Consistent with Altice’s highly leveraged business model (net debt stands at 6.8 times consensus 2019 adjusted EBITDA), Drahi will fund the deal through financing from BNP Paribas S.A., as well as by selling a portion of his stake in Altice U.S.A., Inc.
Is that move a sign of the times? A number of corporate bellwethers have recently opted to monetize existing stakes instead of raising fresh capital. On May 30, the Financial Times reported that SoftBank Group Corp.’s Vision Fund will take out $4 billion in loans, collateralized by its stakes in Uber Technologies, Inc., Guardant Health, Inc. and Slack Technologies, Inc., after encountering difficulty in raising money for a Vision Fund sequel.
The FT notes that “by borrowing against the value of publicly traded shares, SoftBank can return capital to investors in the fund while bypassing ‘lock-up’ periods that can prevent shareholders from selling stakes in newly-listed businesses.” That follows an $8 billion margin loan in April 2018 taken out by SoftBank collateralized by its stake in Alibaba Group Holding Ltd. (BABA on the NYSE). Last Thursday, The Wall Street Journal reported that Alibaba filed confidential paperwork with the Hong Kong Stock Exchange ahead of a second listing, a move which could raise upwards of an additional $20 billion per media reports.
Alternatively, some companies pursue highly dilutive offerings to scrounge cash. On Thursday, single-B-plus-rated Hertz Global Holdings, Inc. announced a rights offering of up to $750 million, a move which will help the company meet $1.5 billion in debt maturities set for 2020 and 2021 but would dilute existing shareholders by 69% if the entire allotment were exercised.
Recap June 17
Stocks gave back early gains as the S&P 500 finished just above unchanged, up 15% year-to-date and 2% below its April 30 high-water mark. WTI crude and gold both ticked lower, finishing at $52 a barrel and $1,339 an ounce, respectively, and rates mostly ticked higher. The Fed commences its two-day policy meeting tomorrow, with interest rate futures currently implying 17% odds of a rate cut on Wednesday.
- Philip Grant
Thursday, June 13, 2019
Liquidity shortage
Recovery room
Yesterday, the U.S. Treasury reported that Uncle Sam’s
Yesterday, the U.S. Treasury reported that Uncle Sam’s
QT Progress report
Recap June 13
Liquidity shortage
From Bloomberg:
The London Metal Exchange is toughening its stance on alcohol consumption with new rules that will prohibit floor traders from drinking during the workday, according to people familiar with the matter.
Maybe they could take the party to a WeWork office?
Recovery room
Yesterday, the U.S. Treasury reported that Uncle Sam’s May deficit totaled a record $208 billion, bringing the 2019 year-to-date (the fiscal year begins on Oct. 1) shortfall to $739 billion. For context, full-year 2018 and 2017 saw gaps of $779 billion and $666 billion, respectively.
The explosion in government deficits during this extended epoch of economic growth is unusual. Typically, the government ledger improves during expansions, as revenues increase and the need for emergency spending diminishes. Thanks in large part to the Trump administration’s 2017 Tax Cuts and Jobs Act, that playbook is out the window. Instead, the White House’s own Office of Management and Budget pegs this year’s deficit at 5.1% of GDP.
The flowing red ink is set to continue, if estimates from the Congressional Budget Office are on the beam. The CBO pencils in deficits averaging 4.3% of GDP each year through 2029. That compares to a 50 year average deficit of 2.9% and 2.4% as recently as 2015.
Those persistent deficits will accelerate the pileup of Treasurys, as the CBO estimates that debt held by the public will jump an additional $12.7 trillion to $28.5 trillion by year-end 2029, equal to 92% of projected GDP from 78% currently and 66% in 2011.
There’s more where that came from. The Wall Street Journal reports today that “political support for taming deficits has melted away.” The electorate is increasingly comfortable with persistent shortfalls, as a January survey from Pew Research found that 48% of respondents favored prioritizing deficit reduction, down from 72% in 2013. Then, too, former IMF economist Olivier Blanchard argued at the American Economic Association in January that as government borrowing costs have generally lagged nominal GDP in the past 75 years, debt can essentially pay for itself as long as the economy keeps growing.
Indeed, as the post-crisis economic expansion rolls into its 120th consecutive month, tying the March 1991 to March 2001 period for the longest on record, The Journal concludes that the U.S. “is on course to test just how much it can borrow.”
That complacency is understandable, considering the bond market’s forgiving stance. Since 2002, federal debt held by the public has more than quadrupled, to $16.2 trillion. Yet, as the government’s books deteriorate, interest rates march lower, with the 10-year yield now at 2.13%, compared to 4.9% 17 years ago.
An interruption of the now decade long economic expansion would accelerate those fiscal shortfalls. Over the past 50 years, recessions have spurred deficit growth equating to 4% of GDP, on average. As widely noted, the yield curve suggests that something nasty may be in the offing (Almost Daily Grant’s, June 6).
Other indicators are likewise concerning. On Monday, The Dodge Momentum Index, a leading indicator for nonresidential construction, fell 9.2% year-over-year in May, with the commercial component down 16% from a year ago. Similarly, the Architecture Billings Index, which leads nonresidential construction activity by nine to 12 months, slipped into contraction in March for the first time since 2017. After a modest rebound in April (the most recent reading), American Institute of Architects chief economist Kermit Baker commented: “In contrast to 2018, conditions throughout the construction sector recently have become more unsettled.”
As the prospect of recession hovers and investors pile into the obligations of an ever-more spendthrift government, might an inflection point be approaching? The Feb. 9, 2018 edition of Grant’s Interest Rate Observer detailed the psychological shift between current conditions (underscored by the famous line reputedly offered by Dick Cheney: “Reagan proved that deficits don’t matter”) and the fallout of the 1946 to 1981 bond bear market, in which the 30-year Treasury was quoted at 14% in 1984, offering an inconceivable inflation-adjusted yield of nine percentage points:
In a bear market, new supply is perceived to be bearish, or at least not bullish (another tautology freighted with trading wisdom). Supply is thought to be bearish not, perhaps, because the supply of bonds is greater than the demand for bonds at prevailing yields and prices (though that is certainly true), but because the very thought of fixed-income securities has become repellent.
That attitude, and its opposite, are years in gestation.“The bond crop never fails” was how disgusted fixed-income investors expressed the free-floating hatred (or love-hatred, as the opportunities for reinvestment of coupon income were forever improving) of an asset class that had disappointed so many for so long.
From which it would follow that the Cheney/Reagan deficit doctrine is due for cyclical revision.
QT Progress report
No change this week, as the Fed’s portfolio of securities held outright remained at $3.668 trillion, down $9.2 billion from the trailing four-week average. Since the fall 2017 commencement of QT, total balance sheet assets are down by 13.7%, an 8.3% simple annualized pace.
Recap June 13
Stocks finished little changed, leaving the S&P 500 marginally higher so far this week, while resources caught a bid with WTI crude bouncing over $52 a barrel and gold reclaiming a 52-week high at $1,341 an ounce. Another strong day for Treasurys saw the curve steepen as the short end outperformed, and the VIX remained stuck, finishing near 16 for a seventh straight session.
- Philip Grant
Tuesday, June 11, 2019
Inspector Gadget
Will the taxpayer say no más? Last week, four Democrats on the House Committee on Oversight and Reform wrote a letter to the Department of Defense Inspector General asking for a broader investigation into TransDigm Group, Inc. (TDG on the NYSE). TransDigm, which provides aerospace equipment to public and private entities including the DoD, has long been under scrutiny for its aggressive pricing. Only recently has the extent of these practices been laid bare.
A preliminary Inspector General examination from 2015 to 2017 of government contracts for 47 spare parts found that TransDigm earned “excess profits” on all but one, totaling $16.1 million of the $26.2 million total audited value. Markups ranged as high as 4,451% on some equipment. The four Democrats write:
Because you identified so many overcharges in just the small sample of contracts you examined, we believe it is highly likely that TransDigm is receiving additional excess profits that have not yet been identified.
The interest is bipartisan. On May 15, Senate Committee on Finance Chairman Chuck Grassley (R., Iowa) wrote a letter to Secretary of Defense Patrick Shanahan featuring some withering criticism of TransDigm’s business practices:
The pattern of price-gouging by TransDigm and its subsidiaries has gone unimpeded for decades. It has amassed exclusive rights to sell these spare parts to the Pentagon. In fact, the Defense Department accounted for 34% of its sales in 2017. TransDigm exploited its business model and took advantage of its sole-source position to leverage higher prices.
Monopolies invite government regulation. If that’s the road TransDigm wants to continue following, I’m here to deliver a message. The jig is up on this cozy relationship. The buck stops here.
The rising heat from Congress seems to be making an impact, as the company announced on May 24 that it would reimburse the government for $16 million. That decision followed May 15 testimony from Assistant Secretary of Defense for Acquisition Kevin Fahey that TransDigm was “gouging the taxpayers with their sickening business practices.” A TransDigm spokeswoman told the Washington Post that the “decision to voluntarily issue refunds was a demonstration of good faith and a reflection of the importance of our DoD customers.”
If so, TDG would be turning over a new leaf, according to the Capitol Forum, which reported in 2017 that the company conducted quarterly training sessions “on how best to navigate the [government] procurement process to maximize price increases. . . seminars taught subsidiary leadership to deny the government’s requests for cost and pricing information.”
Needless to say, TransDigm’s business model has been a successful one, as the company boasts an income statement that is the envy of the industry: TDG’s trailing 12-month EBITDA margins stand at a princely 48%, triple the peer group average as compiled by Bloomberg and nearly double the next highest, HEICO Corp. (HEI on the NYSE), which was identified as a world class operator by John Hughes of Quantum Capital Management, LLC at the Grant’s Spring Conference in April.
Might the rampant overcharging suggested by the Inspector General explain TransDigm’s remarkable profitability? Mr. Market gives the company its due, as TDG shares command a fancy valuation of 28 times 2019 EPS, with the company’s $40 billion enterprise value standing at 17.5 times 2019 consensus EBITDA. As noted by J.P. Morgan Securities, LLC analyst Seth Seifman, who has a “sell” rating on TransDigm, the bipartisan congressional outrage might not translate into much, in the short term at least:
TDG has a successful business model based partially on aggressive pricing and no one has alleged that the company broke the law; therefore, we have little doubt that TransDigm will remain as aggressive as ever in pushing price until Congress and/or DoD change the rules.
Not just in hiking prices does B1-rated TransDigm distinguish itself. Thanks in large part to no fewer than 22 acquisitions since 2012 (headlined by a $4 billion cash deal announced last October for Esterline Technologies Corp., at a 41% premium), TDG is highly leveraged, carrying a net debt load of 6.5 times consensus 2019 EBITDA. That compares to an average debt to EBITDA ratio of 5.2 for the average B-rated company within Moody’s Investor Service coverage universe, per an October report from the ratings agency.
Management has further tipped the capital structure scales, issuing a $22-per-share special cash dividend in September 2017 as well as a $24-per-share dividend in 2016, for a total disbursement of $2.6 billion. For context, the company generated $2.3 billion in free cash flow across 2016, 2017 and 2018 (TransDigm’s fiscal year ends on Sept. 30).
With a hefty debt burden built on a foundation of perhaps unsustainable profitability levels, TransDigm creditors have no shortage of reasons to lie awake at night. The compensation on offer? The first lien 6 1/4 notes due 2026 currently trade at 105 cents on the dollar, for a 5.14% yield-to-worst and a 323 basis point pickup over Treasurys. A government crackdown or simple interruption in TransDigm’s growth-by-acquisition model would potentially reverberate: That debt issue is the third largest in the iShares iBoxx High Yield ETF (HYG on NYSE Arca), accounting for 51 basis points of the fund’s total assets.
As for TDG stock, a 76% levitation over the past two years has chased the bears, as short interest currently stands at 5%, down from near 13% in spring 2017. As the shorts cover, TransDigm management hits the bid. Year-to-date, corporate insiders have sold 137,205 shares, cashing out some $61 million. CEO Kevin M. Stein owns just 8,300 shares for a current market value of $3.8 million. Stein took home $29 million in total compensation last year.
Recap June 11
Status quo today, as stocks gave back strong early gains to finish unchanged, while oil and gold also cruised sideways and long rates likewise held steady. The two-year yield rose to 1.93%, up from a post-2017 low of 1.83% last Monday, and the VIX closed near 16 for a fifth straight session.
- Philip Grant
Monday, June 10, 2019
Alberta king
A rebound north of the border? Toronto-area real estate saw a relatively brisk showing in May, as total transactions jumped 18.9% to 9,989, not so far below the 10-year average of 10,300, while the average sales price rose 3.8% year-over-year to C$839,000 ($629,000), within range of the C$862,000 seen in May 2017 near the peak of the market. Nationwide, GDP expanded by 0.5% sequentially in March (the most recent reading), matching the strongest growth rate since 2016. The labor market remains red hot, as the unemployment rate for May fell to 5.4%, down from 5.7% in April and the lowest on record dating back to 1976.
The stronger data have the attention of Bank of Canada governor Stephen Poloz, who told BNN Bloomberg on May 17 that he maintains a hawkish bias: “The natural tendency is for interest rates to still go up a bit.” The market seems to feel differently. On Friday, the Canadian 30-year yield closed at 1.72%, (below the current BoC 1.75% overnight rate), while interest rate futures suggest 30% odds of a rate cut by October, with no chance of a hike.
Despite the improvement in Toronto, it’s safe to say that the sun has set on Canada’s long-running housing boom. Nationwide, price growth has abated, with the Teranet-National Bank House Price Index rising just 1.2% in April, the worst reading since 2009 and well below the 2% year-over-year rise in April CPI. By comparison, April 2018 and 2017 saw year-over-year gains of 5.6% and 13.2%, respectively.
As housing cools, the leveraged Canadian consumer shows signs of strain. Canadian household borrowings rose to a record 179% of disposable income at year-end 2018, well above the 144% U.S. peak in 2007. That burden looks to be taking a toll. On Monday, the Office of the Superintendent of Bankruptcy reported that nationwide consumer insolvencies footed to 11,785 in April, down slightly from the eight-year high of 11,963 logged in March but up 9.3% year-over-year. The annual home renovation poll conducted by the Canadian Imperial Bank of Commerce (CIBC) finds that respondents plan to spend an average C$10,200 on home repairs this year, down from C$11,000 last year and C$11,800 in 2017.
A downshift in activity likewise crimped recent results from some of Canada’s largest banks. In the most recent quarter, the Royal Bank of Canada reported a 2.4% year-over-year rise in earnings from its domestic unit, the slowest growth rate in five years. Toronto-Dominion Bank’s Canadian unit saw a 1% year-over-year uptick in net income, while CIBC generated $570 million in earnings from its personal and small business banking unit, down 2.4% from a year ago. The slow- or no-growth domestic environment casts shade on some premium valuations: RBC shares currently trade at two times book value, TD Bank at 1.31 times and CIBC at 1.35 times book. By comparison, the U.S. KBW Bank Index currently trades at 1.15 times book.
CIBC, which is particularly exposed to the local housing market (see the Feb. 9, 2018 edition of Grant’s Interest Rate Observer), seems to have been caught off guard by the recent sea change. On the May 22 conference call, executive vice president Christina Kramer explained:
And that’s due to the market turning out different than we had anticipated, impacting us more than our peers due to our strategic focus. In the large urban markets, [the] pullback in activity has been more pronounced and more prolonged than we assumed.
But that shift in conditions isn’t cause for concern to the CIBC c-suite. CFO Kevin Glass remarked on the call that “there’s nothing on the horizon that would give us any indication that economic conditions are about to change significantly that would give rise to significant loan losses.” As noted by Fitch Ratings, the average impaired loan ratio for Canada’s Big Six ticked to 53 basis points in the second quarter, up from 48 basis points year-over-year but still comparable to the net 47 basis points seen among U.S. banks in the first quarter (the most recent data available), according to the St. Louis Fed. For context, the prior U.S. credit cycle culminated with a 312 basis point loan loss ratio in the first quarter of 2010.
Signs of more acute distress are evident away from the largest banks. ATB Financial, an institution owned by the Province of Alberta, reported credit metrics for its fiscal year ended March 31 that could be described as shocking. Namely, ATB’s provision for loan losses jumped to C$338 million, more than triple the C$105 million logged in 2018. That increase in bad debt led directly to a 50% drop in net income, as the pre-provision bottom line rose 12% from a year ago.
Seth Daniels, founding partner at JKD Capital Management, tells Grant’s today that ATB’s plight is instructive:
ATB Financial arguably provides the most accurate glimpse into credit quality in Alberta and can be considered another major domino to fall in the Canadian credit cycle. ATB’s impaired loans and provisions for bad debt stand in stark relief to its publicly traded financial counterparts, and potentially point to a larger problem--the systemic under provisioning for bad loans while actual impaired loans are building, thereby artificially inflating earnings and capital ratios.
Recap June 10
Stocks continued their rampage, with the S&P 500 catching another solid bid to extend its five day winning streak to more than 5% and close to within 2% of its April 30 highs. Key commodities took a breather, with WTI crude and gold each falling about 1% as the Money of Kings saw its eight-session winning streak snapped, and interest rates jumped higher with the 10-year yield rising six basis points to 2.15%. The VIX held near 16, remaining relatively sturdy during this bull move.
- Philip Grant
Friday, June 7, 2019
Step Brothers 2
Alternative lodging by the Bay
Alternative lodging by the Bay
Right place wrong time
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex)
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex)
Recap June 7
Step Brothers 2
Alternative lodging by the Bay from real estate blog Curbed San Francisco:
How much does it cost for bare minimum accommodations in San Francisco—i.e., a bed and a roof?
In the Tenderloin, that’ll be $60 per night, or $1,200 per month. That’s what the Southern California-based startup Podshare charges for one of its “pods” at the company’s first San Francisco locale.
According to the company, “A pod is a hand-built, high-end bunk bed complete with your own flat screen TV and night light.”
Renting with Podshare buys access to the bed and the communal spaces in the building in what’s essentially a hostel-like setup—complete with a dearth of privacy thanks to the wide open, multi-pod layout of rooms Podshare offers.
Behold the sharing economy.
Right place wrong time
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex) into junk territory (to double-B-plus from triple-B-minus) one day after cutting its rating of Mexican sovereign debt to triple-B from triple-B-plus. “This assessment,” said Fitch, "reflects the very high level of transfers to the government at the expense of underinvestment in the company’s business.” A recent $5.5 billion bailout package wasn’t enough to move the needle.
For Pemex, a vicious cycle of long-term decay is at hand: “the company continues to severely underinvest in its upstream business, which could lead to further production and reserves decline.”
The symbiotic relationship was on full display last month, when President Andrés Manuel López Obrador, or AMLO, announced that Pemex would be tasked with building a mega-refinery in his home state of Tabasco at an expected cost of $8 billion, with a targeted completion date of 2022. That’s better than anything the private sector could muster, as a trio of bidders provided cost and completion estimates ranging from $10 billion to $12 billion and 2023 to 2025.
Those heady ambitions run headlong into unpleasant facts. Pemex, which has an outstanding debt stock of $106 billion along with $54 billion in pension liabilities (combining for six times 2018 adjusted EBITDA of $28 billion), faces a protracted decline in reserves and production, as first quarter output slumped to 1.66 million barrels per day (mbpd), down 12% year-over-year and less than half of the 2004 peak of 3.4mbpd. That erosion is evident on the financial statements, as $87.5 billion in 2018 revenue is little changed from an $85.3 billion top line in 2005. Over that period, external debt less cash has jumped to $102 billion from $39 billion.
Perhaps most concerningly, the deepwater Ku-Maloob-Zaap (KMZ) oil field, which now represents more than half of Pemex’s production and has remained rock steady (the larger Cantarell field saw production peak in 2004) in recent years, saw output slide 4% in the first quarter. Though that’s far less than the 12% aggregate decline, John Padilla, partner and managing director at energy consulting firm IPD Latin America, told Grant’s last year that any drop at KMZ is ominous indeed:
They [Pemex] have managed it infinitely better [at KMZ] than what they did at Cantarell. If there is one glorious thing that they’ve been able to do to date, [it] is that they’ve been able to manage KMZ’s production well, but any field that you use secondary, tertiary recovery tech-niques . . . you squeeze it faster and there is less of it at the end. That pro¬duction will fall, and when it falls, it is going to fall very significantly.
Since a bearish analysis in the March 23, 2018 edition of Grant’s Interest Rate Observer, Pemex’s senior unsecured dollar-pay bonds due 2047 have fallen to 88 cents from 99 cents, pushing the spread over Treasurys to 572 basis points from 477 basis points. There may be more pain to come, potentially necessitating drastic measures from the Mexican government that may, in turn, augur further pain in the sovereign. Padilla summed it up: “Pemex, in any private sector context, would absolutely be considered bankrupt.”
Recap June 7
A softer than expected reading of April nonfarm payrolls did nothing to dampen raging animal spirits, as stocks enjoyed another strong rally to leave the S&P 500 higher by a meaty 4.5% for the week. A weaker dollar helped stoke a strong bounce in energy, with WTI crude rising to $54 a barrel, while gold edged to a new 52-week high at $1,341 an ounce, extending its winning streak to eight. Despite the bullish action, the VIX reversed early losses to finish near 16.
Interest rates continue to collapse, as the two- and 10-year yields finished the day at 1.85% and 2.08%, respectively, down from 2.97% and 3.24% in early November. The 10-year remains 20 basis points below the three-month bill yield.
- Philip Grant
Thursday, June 6, 2019
Grand central
Following today’s press conference at the European Central Bank, Mario Draghi struck a contented tone, assessing a “very low” probability of recession and “no probability” of deflation, while citing risks such as “protectionism, geopolitics [and] emerging markets,” which are outside of Frankfurt’s purview.
However, that sanguine outlook doesn’t mean that hawkish, or even neutral policy is called for. In his statement, Draghi said that the ECB “is determined to act in the case of adverse contingencies.”
More specifically, he told reporters that some members of the ECB governing council discussed both cutting interest rates from the current negative 40 basis point deposit rate, as well as restarting the QE program (which has already boosted balance sheet holdings to 40% of 2018 eurozone GDP, compared to 18% of 2018 U.S. GDP for the Fed). Indeed, the ECB “has considerable headroom” to restart QE, in Draghi’s judgement.
That rosy assessment, in tandem with the suggestion of still-easier money, didn’t spark Mr. Market’s interest, as the Stoxx 600 Index gave back a near 1% gain at midday to finish in the red. More broadly, Europe’s banks have floundered despite (or, perhaps because of) the ECB’s exertions. The Stoxx 600 Banks Index trades at a feeble 0.54 times book value and generated a 6.91% return on equity over the past 12 months, compared to the KBW Bank Index’s 1.2 times book and 11.7% trailing-12 month ROE.
While negative rates and indiscriminate asset purchases haven’t helped Europe’s banks, the ECB is considering tweaks to ease the burden of negative rates. Thus, today’s statement referenced “mitigating measures” that may be used to offset “possible side effects on bank-based intermediation” resulting from the policy prescriptions of Draghi et al, such as a tiering system for deposit rates.
Rather than ease back on the negative-rate throttle, the ECB suggests other remedies. On May 15, executive board member Benoit Coeuré argued that negative rates are costing banks €8 billion ($9 billion) annually, “really peanuts.” Europe has too many banks and needs industry consolidation, per Coeuré.
Stateside, central bankers indulge in their own sympathetic self-analysis. Earlier this week, the Federal Reserve conducted a confab in Chicago to culminate their nationwide “listening tour,” at which chairman Jerome Powell assured listeners that he “will act as appropriate to sustain the expansion,” as well as approvingly assessing past QE and ZIRP programs: “These policies provided meaningful support for demand.”
Tinkering was also on the agenda, as attendees debated the utility of the so-called dot plot predictions, along with the concepts of implementing nominal GDP and “average inflation” (meaning that periods of below-2% price growth should be offset by symmetrically higher ones) targeting. The Fed plans on announcing new policy goals next year.
But after all that listening, new concepts aren’t likely to be implemented soon. Fed vice chairman Richard Clarida told CNBC on Tuesday that “we are going to have a high hurdle for any major change to the [existing] framework.”
Instead, the Fed has more prosaic, and immediate concerns. Namely, the future course of interest rates. Interest rate futures now point to 98% odds of a rate cut by year end, pricing in a 1.74% funds rate compared to the current 2.38%. Two months ago, those figures were 54% and 2.23%, respectively.
There is good reason for the market’s increasingly dovish expectations. As noted by Bianco Research, LLC, the inversion of the 10-year Treasury yield below that of the three-month bill for at least 10 straight days is a reliable indicator of trouble, occurring eight times in the past 50 years and followed on each occasion by recession, 311 days later on average. Today, with the 10-year closing at 2.11% and the three-month at 2.30%, marks the 10th straight day of inversion. Jim Bianco, president and eponym of Bianco Research, writes this morning that the implications are clear:
The Fed is too tight. The longer an inversion lasts, the more damage it does to the economy. Once an inversion hits 10 consecutive days, history shows it continues for weeks, if not months. The Fed understands this. Will they heed the yield curve’s warning?
QT progress report
The Fed’s portfolio of securities held outright fell to $3.668 trillion, down $5 billion from last week’s reading and $18 billion from the trailing four-week average. As is usually the case on the first week of the month, Treasury securities accounted for the change in holdings. Since the Oct. 1, 2017 start of QT, total balance sheet assets are down by 13.6%, an 8.4% simple annualized rate.
Recap June 6
The bulls have retaken control of the proceedings, as another strong day for stocks left the S&P 500 3.3% higher for the week and back within 3.5% of its April 30 high water mark. Energy prices finally caught a bounce with WTI crude popping back over $53 a barrel, while gold managed a seventh straight green finish, advancing to $1,333 an ounce and closing within 50 basis points of a 52-week high. The Treasury curve flattened a bit after pronounced recent widening, and the VIX fell below 16.
- Philip Grant
Wednesday, June 5, 2019
The world is yours
Received in the Grant’s inbox today,
Received in the Grant’s inbox today,
The blind side
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers
Lobby horse
The Department of Defense’s forthcoming $10 billion cloud computing award,
The Department of Defense’s forthcoming $10 billion cloud computing award,
Recap June 5
The world is yours
Received in the Grant’s inbox today, via investor Paul Isaac:
Coming soon: The first blockchain-accelerated early payment default.
The blind side
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers has formed a new venture capital fund, Rx3 Partners with Byron Roth, chairman and CEO of Roth Capital Partners.
Rodgers, who threw 25 touchdowns and just two interceptions in 2018 but whose Packers failed to make the playoffs for a second straight year, commented: “With Rx3, I saw the opportunity to create an investment platform that brings together a group of like-minded influential investors and their respective networks with the backing of institutional resources.”
In other words: motion right, end-around, play-action fake on two.
Lobby horse
The Department of Defense’s forthcoming $10 billion cloud computing award, known as JEDI, has been mired in controversy and allegations of misconduct involving Amazon.com, Inc.’s web services division (AWS). Does a potential scandal involving AWS and Uncle Sam present a risk to the continuation of Amazon’s unparalleled success?
On May 24, Amazon competitor Oracle Corp. which vied for the JEDI contract and was eliminated from contention (AWS and Microsoft Corp. are the remaining bidders), filed an updated complaint with the U.S. Court of Federal Claims alleging that the procurement process for JEDI has been rife with conflicts of interest.
Oracle alleges that at least two employees, Deap Ubhi and Anthony DeMartino, improperly influenced the process to favor AWS at the expense of other competitors, as detailed by Almost Daily Grant’s on April 18. On March 4, the Federal News Network reported that the DoD Inspector General and FBI’s Public Corruption Unit have opened a joint investigation into the JEDI procurement process.
The updated court filing contains no shortage of explosive allegations:
The Department of Defense deviated from its procurement policy and did not require Ubhi, [redacted] or DeMartino (and many others) to complete conflict of interest forms and sign nondisclosure agreements prior to JEDI involvement. Consequently, several DoD officials with clear financial interests in AWS participated in JEDI in violation of applicable laws and regulations.
Mere sour grapes from a losing contestant? In its filing, Oracle cites correspondence on the Slack messaging platform suggesting that Ubhi (who worked at AWS from 2014 to 2016 before joining the Pentagon, and then returned to AWS in November 2017) pressed senior DoD official Jane Rathbun to favor a single-award approach, which is widely believed to favor AWS:
In one message, Ubhi reports “we just won this conversation’ because ‘Jane R. is now moved to our side and is supportive of a single provider.” Ubhi later advised the Defense Digital Service team to “check your email, and see Jane coming to the light”. . . In subsequent messages, Ubhi noted it “puts multi vs. single to bed once and for all hopefully (at least from a technical standpoint.”
Ubhi later indicated to [DDS general counsel Sharon] Woods that he was not worried about the “single vs. double” awardee approach and “if there are people in the building (Pentagon) that (he) need(s) to go see and school, or ally, let’s do that too.”
Beyond lobbying DoD officials to structure JEDI as a winner-take-all, Oracle claims that Ubhi used his position to accumulate intelligence about competitors cloud capabilities, while preparing for his return to Amazon:
In mid-September 2017 (during his employment discussions with AWS), Ubhi helped set up the Google Drive to act as DoD’s “repository for *everything*” JEDI related. Ubhi and the DDS team subsequently convinced all DoD JEDI participants “to data dump” everything into the Google folder.
Ubhi managed untold amounts of nonpublic and acquisition sensitive JEDI-related information based on his access to the JEDI Google drive. At some point prior to rejoining AWS, Ubhi synced the Google Team Drives to his laptop.
Amazon will have a hard time distancing itself from Ubhi’s conduct, if Oracle’s allegations are accurate:
AWS knew of Ubhi’s central JEDI role as AWS courted Ubhi to rejoin AWS. AWS also knew that Ubhi had not recused himself as legally required. Still neither Ubhi nor AWS notified DoD of the employment negotiations.
On October 2, 2017, Ubhi emailed AWS advising that he is “running point on all [JEDI] industry touch points.”
Apart from the criminal investigation into JEDI, Congress has taken a dim view of the winner-take-all approach to the massive contract. In its 2020 budget released on May 20, the House Appropriations Committee stated that due to concerns about committing to a single provider for a 10-year term:
The Committee directs that no funds may be obligated or expended to migrate data and applications to the JEDI cloud until the Chief Information Officer of the Department of Defense provides a report to the Congressional Defense Committees on how the Department plans to eventually transition to a multi-cloud environment, as described in its January 2019 Cloud Initiative Report to Congress.
That follows an early April decision from the C.I.A. to shift to a multi-cloud strategy by 2021, after signing a $600 million contract with AWS in 2013.
No matter what happens with the government investigation, the competition is collectively taking aim at AWS. Today, Microsoft and Oracle announced an agreement to connect cloud computing units by linking their respective data centers, as well as letting users log into either company with a single user name.
As for Amazon, a $10 billion award over 10 years doesn’t stand out as critical, considering the company reported $242 billion in revenue and $11.4 billion in net income over the 12 months ended March 31. But a loss of government confidence in AWS (which generated $2.2 billion of net income in the first quarter, up 57% year-over-year and representing two thirds of the consolidated total) could be significant. As a D.C.-based observer told ADG in April: “The AWS story, as sold to enterprise customers and the Street, is built upon the [C.I.A] reference case and the cash that has come in from that deal.”
Recap June 5
A second straight rally in stocks pushed the S&P 500 higher by 2.7% this week, while short-dated Treasurys partially reversed yesterday’s pullback with the two-year yield finishing at 1.84%, down from 2.22% just two weeks ago. Energy was once again hammered, with Brent crude falling below $60 a barrel this morning for the first time since January, while gold continues to diverge, finishing at $1,330 an ounce for a near-four month high. The VIX closed at 16, its lowest in two weeks.
- Philip Grant
Tuesday, June 4, 2019
Minority report
Many unhappy returns.
Many unhappy returns.
Today's debt hearings
An analysis of the leveraged loan market
An analysis of the leveraged loan market
Recap June 4
Minority report
Many unhappy returns. Thirty years ago, British ambassador Sir Alan Donald cabled home his classified report on the bloody goings-on in Tiananmen Square: “Students linked arms but were mown down. Armored personnel carriers then ran over the bodies time and time again to make, ‘pie’, and remains collected by bulldozer, incinerated and then hosed down drains. . .”
Unsurprisingly, the Xi Jinping-led government has little interest in commemorating the event, or in allowing others to pause and remember. Domestic social media platforms have “barred users from changing their profile photos and other information,” Bloomberg says, while financial data company Refinitiv has blocked all Tiananmen-related stories from its Eikon terminals, after the Cyberspace Administration of China “threatened to suspend the company’s service,” according to Reuters.
While Refinitiv may suffer a reputational knock in the West for this evident kowtow, its social credit score looks poised for an upgrade.
If only the recent trouble in China’s banking system could be so easily suppressed. Following the government’s takeover of distressed Baoshang Bank Co., the People’s Bank of China tried to calm the situation by assuring investors that no further such interventions were in the cards: “Everyone,” says a message on the PBOC website: “please don’t worry. At present we don’t have this plan.” But Bloomberg reports today that a pair of smaller institutions, Guilin Bank Co., Ltd. and Jincheng Bank Co., Ltd., have delayed plans to sell RMB 1 billion ($140 million) in tier-2 bond sales following the Baoshang news.
Over the weekend, Bank of Jinzhou, which holds $113 billion and $53 billion of assets and deposits, respectively, saw its auditor Ernst & Young Hua Ming LLP resign due to “indications that some loans to institutional customers weren’t used in ways consistent with the purposes stated in documents,” per Bloomberg. In response, the bank’s 5.5% dollar-pay perpetual bonds fell below 65 from 81 a week ago, for a 19.2% yield-to-call.
In a report on May 28, Anne Stevenson-Yang, co-founder of J Capital Research explains that the emergence of systemic balance-sheet risk is inevitable in China’s command economy:
What regulators fail to see, or at least to admit, is that there is fundamentally a contradiction between clean banks and targeted growth. The growth can be achieved only by heroic additions of credit, which has been growing at about 2.5 times the rate of GDP, itself clearly exaggerated.
Stevenson-Yang points out the contradiction between healthy reported metrics and the abrupt seizure of Baoshang and apparent stress at small and medium-size lenders:
One of the more unusual aspects of the Baoshang drama is that it’s been reported – not only that, but high-level authorities have publicly expressed concerns that there may be bank runs and financial institutions that ‘disappear.’ This is peculiar for an economy that claims to be growing at 6.5%, have average non-performing loan rates under 1.5% and that has buoyant construction and property markets.
Today's debt hearings
An analysis of the leveraged loan market (“Tomorrow’s debt hearings”) in the July 13, 2018 edition of Grant’s Interest Rate Observer predicted that a cyclical crack-up would lead to unwanted (for industry practitioners) attention from Washington. Sure enough, the House Committee on Financial Services conducted a hearing today titled: “Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending.”
That July 2018 examination identified the erosion of creditor protection via widespread cov-lite documentation, deteriorating credit quality and aggressive earnings additions or cost-savings assumptions from issuers, called add-backs that can artificially inflate projected results. As noted by S&P’s LCD unit in a report last year, loans related to mergers and acquisitions are particularly susceptible to such add-backs of late, with a record 22% of M&A related-loans featuring add-backs greater than 50% of EBITDA in the first half of 2018, double the pre-2008 high.
Despite a suddenly-wobbly stock market, the M&A train keeps rolling. According to data from Bloomberg, more than $40 billion in corporate transactions were logged yesterday, the second-busiest deal day of the year.
Credit quality continues to wane. As noted by investment fund Driehaus Capital Management, LLC’s Twitter account this morning, the proportion of loans rated double-B (the high end of junk territory) now foot to less than 30%, down from 50% at the beginning of 2008. Single-B-rated issuers now comprise nearly 30% of loans, up from less than 10% in early ‘08.
Those red flags haven’t yielded much pain yet, as the S&P/LSTA Leveraged Loans Index has returned a solid 5.5% year-to-date, while LCD reported yesterday that the May default rate registered a skinny 0.93%, well below its historical average of 2.93%. But some investors aren’t waiting around: According to Bloomberg, the Invesco Senior Loan ETF saw its largest funds outflow on record yesterday.
Recap June 4
Remarks from Fed chairman Jerome Powell that the FOMC “will act as appropriate to sustain the expansion” helped spur a steep rally in stocks, as the S&P 500 gained 2% and the tech-heavy NYSE FANG+ Index enjoyed a 4% rebound. But Treasury yields also jumped across the curve after a sharp recent rally, perhaps suggesting that today’s action was more of a bounce off recent moves than a sea-change in investor perception.
Elsewhere, energy prices managed a feeble bounce of their own with WTI crude rising less than 1% to $53.50 a barrel, while gold finished unchanged. The VIX fell by 10% to settle near 17.
- Philip Grant
Monday, June 3, 2019
Bar none
Per USA Today:
A rat-infested pop-up bar is opening up in San Francisco later this month.
Guests who dare to venture to the Rat Bar will be served the bar's ‘signature cocktail,’ the ‘Ama-RAT-to Sour.’ It's billed as a traditional amaretto sour with a ‘rat's tail’ as garnish. Then, Rat Bar crawlers will have a half-hour to play with their newfound rodent buddies.
A rat rescue non-profit called the Ratical Rodent Rescue will be providing the rats. Just in case an attendee falls in love with a newfound rodent drinking buddy, the organization has rats up for adoption.
Tickets cost about $50 a head.
Typical San Francisco pricing. The New York City subway system provides a similar experience for just $2.75.
Dots plotted
Change is afoot. Across venture capital, high-end real estate and the retail sector of the stock market, investor behavior has seen a notable shift recently. A trio of sightings:
The Wall Street Journal reports today that SoftBank Group Corp. (9984 on the Tokyo Stock Exchange) has been “met with a chilly reception” in efforts to raise capital for a sequel to the $100 billion Vision Fund.
Contributing factors, per the Journal, include the fact that the larger investment firms generally have the capability to invest in start-ups directly and are thus reluctant to pay an additional round of fees, as well as concerns over the Vision Funds’ “lack of transparency.” Cantor Fitzgerald, L.P., tasked with raising funds for the project, approached would-be investors for commitments of as little as $50 million, a move which “tends to be a last resort for firms raising big investment pools. . . in part because of the cost of servicing multiple accounts.” Cantor scrapped the strategy “after [SoftBank] objected.”
Not just for SoftBank (termed “the epitome of the cycle in the Dec. 15, 2017 edition of Grant’s Interest Rate Observer) does the environment appear less hospitable. Last week, The Real Deal reported that Secured Capital Partners LLC., which owns a 157-acre land parcel in Beverly Hills, filed for Chapter 11 bankruptcy protection in Los Angeles federal court. Secured Capital listed the property for a record-breaking $1 billion last summer. Finding no takers, the list price was dropped to $650 million in February.
In its bankruptcy filing, Secured Capital listed $50 million to $100 million in liabilities, and assets of between $500 million to $1 billion (that was revised from less than $500,000 initially, an apparent typo). Ronald Richards, the fund’s lawyer, asserted in the filing that “the property will be sold or refinanced utilizing the best value the market or lending environment will bear.” The inability of this asset-rich, cash-poor borrower to extend terms on its debts may be a new development in this cycle.
While the winds seem to be shifting in the V.C. and real estate realms, a key corridor of the economy has fallen into deep freeze, if the stock market is any guide. Thus, independent retail analyst Mitch Nolen notes on Twitter today that apparel retailers have logged a brutal recent stretch, with each of the 24 clothing store stocks he tracks falling last month, with all but three absorbing double-digit declines in May.
More broadly, trouble in the apparel sector has spared neither the established players nor high-flying newcomers. Last week, industry mainstays Gap, Inc. and Abercrombie & Fitch Co. shares plunged 10% and 27%, respectively, after reporting weaker than expected sales in the most recent quarters. At the luxury end of the spectrum, Canada Goose Holdings, Inc. absorbed a 27% selloff last Wednesday after missing revenue expectations for the first time since its 2015 IPO. Since ripping higher by 450% from March 2017 to November of last year, GOOS shares have since lost more than 50%.
Recap June 3
News that the Federal Trade Commission is investigating Facebook, Inc. and Amazon.com, Inc. while the Department of Justice is probing Google parent Alphabet, Inc. as well as Apple, Inc. for potential antitrust violations was not well received, as the Nasdaq 100 Index lost 2% while the NYSE FANG+ Index shed 4%. On the bright side, the damage was localized, as the S&P 500 managed to finish just 25 basis points below unchanged.
Treasurys continued their head-spinning rally, as language from the Fed’s Jim Bullard suggesting a rate cut might be imminent helped push the two-year yield lower by eight basis points to 1.84%, while the 10-year yield dropped five basis points to 2.07%. Energy continued its losing streak with WTI crude falling below $53 a barrel for the first time since January, while gold jumped to a three month high near $1,325 per ounce.
- Philip Grant
Friday, May 31, 2019
Hail Mary
Sports business publication VenuesNow reported yesterday:
Social Finance, Inc., the private lender known as SoFi that specializes in refinancing student loans, has acquired naming rights for the $5.2 billion NFL stadium under construction in Inglewood, Calif., according to multiple sources.
Terms are believed to be in the range of $20 million a year over 20 years, sources said.
Buying naming rights, like erecting skyscrapers, is a bull-time endeavor.
Some corporate namesakes at the end of the 1990-2000 economic expansion:
Enron Field in Houston, CMGI Field in Foxboro, Mass., PSINet Stadium in Baltimore, Adelphia Coliseum in Nashville, Trans World Dome in St. Louis, MCI Center in Washington, D.C.
And more recently:
Chesapeake Energy Arena in Oklahoma City, American Airlines Arena in Miami, American Airlines Center in Dallas, Wachovia Center in Philadelphia, Citi Field in New York.
Ominous historical comparisons aside, it’s a pretty good day for V.C.-owned SoFi, which managed to close a $500 million funding round led by private-equity firm Silver Lake Partners at a $4.3 billion valuation, according to TechCrunch. That brings SoFi’s total funding to $2.3 billion, including a $1 billion round in fall 2015 led by SoftBank Group Corp.
This is what happens Larry
In an interview with the Financial Times today, Trump’s economic advisor and potential Fed nominee Judy Shelton offered some eye-catching remarks about the discretionary, “Ph.D. standard” of monetary policy that is currently in force:
How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market supply determined rate? The Fed is not omniscient. They don’t know what the right rate should be. How could anyone?
In response, Lawrence Summers took to Twitter to attack:
Judy Shelton does what I would not have thought possible. She falls well below [Herman] Cain or [Stephen] Moore as a potential @federalreserve governor. Hers would be a dangerous appointment.
Another feather in her cap.
Trading sardines?
What selloff? The recent eruption in risk aversion hasn’t dented the digital HODLers, as cryptocurrencies have enjoyed a sterling start to 2019. At a current price of $8,500, bitcoin sits higher by 123% year-to-date, and touched $9,000 yesterday for the first time since spring 2018.
Michael Novogratz, founder and CEO of crypto investment fund Galaxy Digital Holdings, Ltd. told listeners on a conference call yesterday that he expects things to simmer down in the short term, forecasting a range of $7,000 to $10,000 for bitcoin, but “if I’m wrong on that, I think I’m wrong to the upside.”
To Novogratz, the latest rally is evidence of broader adoption of the digital ducats: “We have gone from, you know, crypto as an experiment, is it real? Is it tulips? To crypto is going to be a substantial part of the financial and consumer infrastructure of the world.”
But as Bloomberg reports today, bitcoin has thus far struggled to expand much beyond a trading sardine. Data from research firm Chainalysis, Inc. find that 1.3% of bitcoin transactions took place through merchants in the first four months of the year, little changed from 2017 and 2018. Kim Grauer, senior economist at Chainalysis, commented to Bloomberg: “Bitcoin economic activity continues to be dominated by exchange trading. This suggests bitcoin’s top use case remains speculative, and the mainstream use of bitcoin for everyday purchases is not yet a reality.”
There are also questions about the utility of the blockchain technology that underpins the cryptos (see, for instance, the Grant’s Current Yield podcast on Jan. 22, 2018 with Kai Stinchcombe). More recently, German central bank president Jens Weidmann told Bloomberg Wednesday that a trial project using blockchain to transfer and settle cash and securities was found lacking in terms of both costs and speed when compared to traditional methods: “The blockchain solutions did not fare better in [any] way . . . despite numerous tests in blockchain-based prototypes, a real breakthrough in application is missing so far.”
The rally in bitcoin comes as a familiar force in the background ramps up activity once more. Tether, the purportedly dollar-for-dollar-backed crypto which is widely used by crypto exchanges as a workaround for know-your-customer and anti money-laundering laws, has issued more than $1 billion in fresh supply over the last seven weeks, bringing tether outstanding to $3.1 billion as of yesterday from less than $2.1 billion on April 7.
While that $3.1 billion puts tether as the ninth-highest crypto by market cap, trading volume over the past 24 hours foots to $27.7 billion, according to Coinmarketcap.com. That nearly matches the $27 billion in 24 hour trading volume for bitcoin, which sports a market cap of $149 billion.
On April 25, New York Attorney General Letitia James accused the Bitfinex exchange (which shares ownership with Tether) of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled client and corporate funds.” Bitfinex covered Tether’s lost greenbacks with an I.O.U. Then, after that bit of prestidigitation, crypto investors supposedly sent a fresh $1 billion to purchase more tether.
The episode recalls the late 2017 explosion in tether supply, to $4.6 billion on Dec. 22 from $800 million eighteen days earlier, as bitcoin was racing to its all-time high near $20,000. A month later, Bloomberg reported that the CFTC issued subpoenas to Bitfinex and Tether on Dec. 6, 2017. By early February, bitcoin fell to $6,200.
This afternoon, Bitfinex announced on Twitter:
Due to the outage of one of our network providers we temporarily paused deposits and withdrawals. Funds are safe in cold storage. Situation should be restored ASAP. Apologies for the inconvenience.
Recap May 31
Another ugly day saw stocks slammed to the tune of 1.3% on the S&P 500, extending the post April 30 selloff to 6.5% and narrowing the year-to-date gains to just under 10% for the broad index.
Action elsewhere might have been even more bearish, as Treasurys caught another panic-type bid with the 10-year yield dropping to 2.13%, down nearly 20 basis points for the week and 21 basis points below the three-month bill yield. Interest rate futures now imply 51% odds of a rate cut at the July Fed meeting.
Energy was once again hammered, with WTI crude extending its two-day loss to nearly 10% to fall below $54 a barrel, while gold rose more than 1% to finish above $1,300 an ounce for the first time since mid-April.
- Philip Grant
Thursday, May 30, 2019
With a side of fries
Yesterday, the Department of Energy
Yesterday, the Department of Energy
Down in the bottom
Credit-centric consumer business models are in focus today,
Credit-centric consumer business models are in focus today,
QT Progress report
Recap May 30
With a side of fries
Yesterday, the Department of Energy announced the approval of gas exports from the Freeport LNG Terminal on Quintana Island, Texas. In the press release, under secretary of energy Mark Menezes laid it on thick:
Increasing export capacity from the Freeport LNG project is critical to spreading freedom gas throughout the world.
With the U.S. in another year of record-setting natural gas production, I am pleased that the Department of Energy is doing what it can to promote an efficient regulatory system that allows for molecules of U.S. freedom to be exported around the world.
Cleaner burning than tyranny gas.
Down in the bottom
Credit-centric consumer business models are in focus today, with a review of a pair of past picks-to-not-click: Signet Jewelers Ltd. (SIG on the NYSE) and Aaron’s, Inc. (AAN on the NYSE), which are featured in the issues of Grant's Interest Rate Observer dated June 3, 2016 and June 30, 2017, respectively. Since those publications, the duo’s fortunes have gone their seperate ways, with SIG shares slumping by 79% while AAN has thrived, jumping 41%. Yet the pair have more in common than the divergent price action might suggest.
Signet, the baubles retailer, has since been beset by slumping sales and P.R. woes, while the company’s highly anticipated efforts to sell its credit portfolio left the bulls wanting. In May 2017, Signet managed to unload $1 billion in prime loans at par and divested its subprime book at 72 cents on the dollar one year later. That 2016 bearish verdict from Grant’s hinged on the contention that the company’s "recency" accounting methodology flattered its underlying business metrics and credit performance. In July 2017, 55-year old CEO Mark Light resigned citing health reasons, following the departure of COO Bryan Morgan on account of “violations of company policy unrelated to financial matters.”
Aaron’s, founded in 1955, is the largest “rent-to-own” retailer in the United States. Thus, generally credit-constrained customers pay monthly rates for the use of home furnishings for a given lease term, and, if current on their payments at the end of that period, own the product outright. Customers also have the option of returning the item or purchasing it at the full list price during the lease term.
As Aaron’s brick-and-mortar business gradually shrinks under the competitive pressures partially supplied by Amazon.com, Inc., the company’s Progressive Leasing unit, a subprime lender to third-party merchants, picks up the slack. Progressive’s leasing volume (a.k.a. new sales financed by rent-to-own) jumped 14.5% year-over-year to $394 million in the first quarter, accounting for virtually all of Aaron’s consolidated 5.9% first quarter revenue growth to $1.02 billion. Locations are either company-owned or franchised, with the former increasingly prevalent. As of the first quarter, Aaron’s systemwide store count registered at 1,530, down from 1,864 at year-end 2016. Franchise locations have declined to 369 from 699 during that period.
What’s not to like? Profitability has grown while the store count shrinks. First quarter results featured $1.08 in adjusted earnings per share, well above the highest analyst estimate of $0.96. AAN has generated positive free cash flow in every year since 2015, and trades at a reasonable 14.5 times consensus 2019 earnings. The corporate balance sheet (in contrast to that of the composite Aaron’s client) is pristine, with net debt of just under $700 million compared to $430 million in trailing 12-month EBITDA, and The Street is bulled up, with eight “buy” ratings and one “hold” among the nine analysts tracked by Bloomberg.
Now for the bear case. Aaron’s has bought out 152 franchise locations in 2017 and 2018, along with two more in the first quarter. As noted in that June 2017 analysis of AAN, those repurchase transactions flatter the company’s cash flow statement. Deputy editor Evan Lorenz explained:
The cost of acquiring franchisee stores shows up in cash flows from investing activities under ‘acquisition of businesses and contracts, net of cash acquired’. The purchase price of a franchisee’s store includes that seller’s floor inventory. Normally the cost of acquiring retail stock is a charge to cash flow. Not so when you buy a store lock, stock and barrel.
So when Aaron’s leases a couch or a TV which it hauls out from the storeroom of a former franchisee, the cash-flow metrics look better than they really are. Still and all, the store net-work is declining.
In May 2017, Signet Jewelers announced the formation of a seven-year partnership with Progressive, “to provide a lease-purchase payment program to Signet customers who do not qualify for Signet’s credit programs.” The press release further spells things out, explaining that “Progressive leasing will assume any financial risk from leasing the merchandise.”
Signs of a downshift in Aaron’s credit quality are visible. According to the most recent form 10-Q, the proportion of the credit portfolio to consumers with a FICO score of 600 or below stood at 4.1% as of March 31, double the 2% figure from a year ago. At the same time, the percentage of loans to those with a FICO score of 700 or greater declined to 16.9% from 21% year-over-year. Recall that Fair Isaac Corp., changed the methodology it uses to calculate FICO scores “to boost the number of approvals for credit cards, personal loans and other debt,” according to The Wall Street Journal.
Analysts are expecting a major increase in profitability. While revenue is projected to decline to $3.3 billion in 2020 from $3.7 billion in the twelve months ended March 31, adjusted net income will rise to $295 million in 2020 from $226 million over the past 12 months if estimates are on point, indicating more than 300 basis points of margin expansion. But while the sell-side is expecting big things, Aaron’s management has been hitting the bid. Since March 21, seven corporate insiders have sold a combined 184,220 shares, cashing out some $9.7 million.
The Signet and Aaron’s pair continue to exhibit a type of corporate symmetry. As the market continues to punish Signet, which has unloaded its subprime credit exposure, Aaron’s has been rewarded for doubling down on the same.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.67 trillion, down by $8.8 billion from a week ago with mortgage-backed securities supplying the change. Since the commencement of QT, total balance sheet assets are down by 13.4%, for a simple annualized pace of 8.3%.
Also this afternoon, the New York Fed formally announced plans to reinvest the proceeds from maturing mortgage-backed securities and agency debt into Treasurys beginning in October.
Recap May 30
Stocks finished little changed, with the S&P 500 managing to eke out a green finish after back-to-back selloffs to start this holiday-shortened week. The broad average remains higher by 11% year-to-date.
Price action elsewhere remained ominous. Another sharp rally in Treasurys pushed the 10-year yield below 2.22%, now 16 basis points below the three-month bill to leave the curve inverted for a sixth straight day. Energy prices were hammered, with WTI crude falling back below $57 a barrel. The Dollar Index remained at the cusp of its 52-week high.
- Philip Grant
Tuesday, May 28, 2019
ETF phone home
Time to batten down the hatches? The Wall Street Journal reports today that the recent uptick in stock-market volatility has spurred a search for safety. Risk-mitigation, “low-vol” strategies have seen an inflow of $10 billion year-to-date, taking assets to a record $77 billion, according to data from Morningstar, Inc.
Two ETFs, the Invesco S&P 500 Low Volatility ETF (SPLV on the NYSE Arca) along with BlackRock, Inc.’s iShares MSCI Min Vol USA ETF (USMV on the CBOE’s BZX Exchange) have alone raked in $6.4 billion. Impressive recent performance at least partially explains the pair’s popularity: SPLV has gained 15.3% over the past 52 weeks, while USMV has rallied by 14%. That compares to a less-than 5% gain for the S&P 500.
Kevin Duffy, co-founder and principal at Bearing Asset Management LLC, argues to Grant’s today that such vehicles may not necessarily act as effective hedges in times of trouble, noting that the top five holdings of the iShares Min Vol ETF (Visa, Inc., Waste Management, Inc., McDonalds Corp., PepsiCo., Inc. and The Coca-Cola Co.) each carry a forward P/E ratio of more than 21 times. That compares to a 16.5 times consensus 2019 price-to-earnings ratio for the S&P 500. The fund manager asks:
Even if these businesses weather the next recession, will their valuations hold up in a bear market? Other than Visa (analysts expect 11% revenue growth next year), these companies sport mediocre growth prospects (4% at WM, PEP and KO; 2% at MCD).
More broadly, the relentless growth in the ETF industry and indexation strategies continues. ETFs pulled in $311 billion in fresh capital last year, the second-most on record following a $471 billion inflow in 2017, according to the Investment Company Institute Fact Book for 2019. The number of ETFs rose to 2,057 as of Dec. 31, nearly triple the 743 available in 2008. The ICI likewise finds that index equity mutual funds accounted for 29% of total equity mutual fund assets as of year-end, up from 14% in 2008.
But, as noted in investment firm Horizon Kinetics, LLC’s first quarter market commentary, the secular growth of indexation and ETF strategies comes during a period of historic market calm:
There is a certain price volatility that people accept with stock investing, an accepted tradeoff for the higher expected return. That volatility has been measured, and is based on 92 years of data, starting from 1926.
It is expressed as the standard deviation of share price changes, and this figure is 19.8%, meaning that in a given year, stock prices have tended (meaning roughly two-thirds of the time) to vary by as much as 20% points above and below the long-term average return. So if the expected average return is 10%, one should expect a return as high as 30% or a loss as much as 10% in most years.
The current standard deviation of the Vanguard S&P 500 ETF (VOO) over the past 3 years is 10.7%; over the last 10 years, it’s 12.7%. For the Vanguard Total International Stock ETF, the 3- and 10-year standard deviations are 10.5% and 15.9%. Both are way below the long-term figure.
In other words, the migration toward indexation seen this cycle has coincided with a historically-anomalous low-vol era. Of course, that relationship presents a potential corollary: A reversal of this trend could see volatility return with a vengeance.
How might an active manager contend with this sea change toward indexation? Perhaps by venturing outside the lines. Speaking at the Grant’s 2016 fall conference, Steven Bregman, president and co-founder of Horizon Kinetics, offered this council: “If you’re willing to take a bit of illiquidity risk – in those securities that have been discarded by the indexes – your degrees of freedom and optionality expand tremendously.”
Recap May 28
Stocks came under late pressure after a sideways start to the day, with the S&P 500 finishing at session lows, down 0.8% with traditionally defensive groups health care, utilities and consumer staples losing 1.4%, 1.6% and 1.8%, respectively. Treasurys likewise rallied sharply, with the 10-year yield falling to 2.27%, well below the 2.35% three-month bill as well as the 2.39% effective Fed Funds rate. The VIX rose 10% to 17.50.
- Philip Grant
Friday, May 24, 2019
Bouncy-bouncy
This is no joke.
This is no joke.
Damage control
Big doings in the Middle Kingdom.
Big doings in the Middle Kingdom.
House of cards
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s
Dem bones
Yesterday, French retailer Rallye S.A.,
Yesterday, French retailer Rallye S.A.,
Recap May 24
Bouncy-bouncy
This is no joke. Tech-focused website The Next Web reported yesterday on mobility startup Cangoroo, which offers users access to pogo-sticks as they travel around Stockholm and Malmö, Sweden. CEO Adam Mikkelsen assured the skeptical publication:
It is a real venture. . . with the pogo stick, the way we’ve branded it is as a product you can actually use for last-mile transportation. A lot of people in Sweden had pogo sticks as children, so we see them using them as adults.
Bullish for the orthopedic profession, at least.
Damage control
Big doings in the Middle Kingdom. Reuters reports:
China’s financial regulators said on Friday the country’s banking and insurance regulator will take control of Inner Mongolia-based Baoshang Bank Co., Ltd. due to the serious credit risks it poses, in a rare takeover of a domestic lender.
Baoshang had a total of 156.5 billion yuan ($22.68 billion) of outstanding loans by the end of 2016, a 65% jump from the end of 2014, according to the bank’s last filing on its assets and liabilities on its website. Its non-performing loan ratio was at 1.68% as of December 2016.
The bank, which has not published an annual report since 2016, carries a double-A-plus rating from local agency Dagong Global Credit Rating Co., though Dagong cut its outlook on Baoshang to negative last year. This is the first state takeover of a Chinese bank since at least the 1990s.
The Wall Street Journal, citing local media, notes today that Baoshang was linked to missing financier Xiao Jianhua, who was apparently abducted upon returning to the Chinese mainland from Hong Kong in early 2017.
House of cards
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s right wing government is beginning to teeter, with “talk of impeachment” beginning to surface just five months into his four year presidential term. Bloomberg reports that “the situation has become so tense that, earlier this month, a senior player at the heart of Brazil’s political wranglings had a nervous breakdown during an interview.”
Trouble in the Bolsonaro administration is beginning to show up in the polls. According to a May 21 XP Investments/Ipespe survey, more Brazilians disapprove than approve of Bolsonaro for the first time, while 36% of respondents say the government “is bad or terrible.” That’s up from 31% one month ago.
Those ominous signs haven’t dimmed hopes for successful pension reform, a crucial issue for Brazil. Yesterday, economy minister Paulo Guedes predicted at a São Paolo event that “in 60 days there will be a favorable surprise in the Senate.” Reuters however reports that sources in Brazil’s congress “say the government remains well short of the 308 votes required in the lower house to even take it up to the Senate.”
For his part, Marcelo Ramos, chairman of the congressional committee on pension reform, had some sharp words for the president, telling Reuters on Wednesday: “Bolsonaro despises democracy. We have to isolate his anti-democratic attitude and lack of respect for institutions, so this does not paralyze the country.”
The stakes are high. In an interview with Veja magazine published today, Guedes said: “If we don’t make the reforms, Brazil will go down in flames. There will be chaos in the public sector, both in the federal government as well as the states and municipalities.”
The economy minster also detailed his back-up plan in the event of legislative failure: “I will take a plane and go live abroad. I am already old enough to retire.”
Dem bones
Yesterday, French retailer Rallye S.A., parent company of supermarket chain Casino Guichard-Perrachon (a.k.a. Groupe Casino, CO on the Euronext Paris Exchange) entered a court-led creditor protection program, as the distressed conglomerate looks to avoid bankruptcy.
The collection of companies, each headed by majority shareholder and CEO Jean-Charles Naouri, have an interconnected structure, as the Financial Times notes a 41% decline in Casino stock since March “hurt Rallye because the parent company has used it as collateral to secure credit lines at banks.”
Nauri, who told the FT in October that those selling short his company do so “at their risk and peril,” has received unwanted attention before. In December 2015, research firm Muddy Waters initiated a short position in Casino shares, asserting that the company’s opaque, highly leveraged capital structure presented risks well beyond market expectations.
The episode is instructive beyond the specific travails of Casino and its related entities. The Jan. 15, 2016 edition of Grant’s Interest Rate Observer featured a look at European hybrid securities, which, as an anonymity-seeking, London-based correspondent noted, act as something of an investment panacea:
For ratings and regulatory purposes, a hybrid is neither exactly debt nor exactly equity. It answers the needs of leveraged issuers and yield-starved investors alike. It offers incremental returns relative to senior bonds in the same capital structure. Plainly, there must be something wrong with it.
Here, as in other areas of financial innovation, we are dealing with an arbitrage; of credit-rating methodologies, of tax rules and, yes, of investor sophistication.
The analysis identified a pair of picks-to-not click among these hybrid contraptions, including the Groupe Casino’s perpetual 4.875% note, then priced at 88 cents on the euro for a 9.5% yield-to-call. The securities, which saw the coupon reset in January to a floating rate of 357 basis points over the mid-swap benchmark, have since declined to 61 cents on the euro for a 16.6% yield-to-call.
Recap May 24
Stocks finished slightly higher after giving back bigger early gains, leaving the S&P 500 in the red by just over 1% for the week. Treasurys finished little changed, as the three-month vs. 10-year spread remained inverted for a second day, while oil bounced with WTI crude finishing near $59 a barrel. The VIX settled at 16.
- Philip Grant
Thursday, May 23, 2019
He said it
Sports talk radio mainstay and overall renaissance man Mike Francesa
Sports talk radio mainstay and overall renaissance man Mike Francesa
Fake schmooze
Today, Facebook, Inc. (FB on the Nasdaq) said
Today, Facebook, Inc. (FB on the Nasdaq) said
Yield yodel
QT Progress report
Recap May 23
He said it
Sports talk radio mainstay and overall renaissance man Mike Francesa weighed in on the stock market this morning on Twitter:
The market is quickly becoming less about finding good businesses and more about managing the day’s headlines.
Fake schmooze
Today, Facebook, Inc. (FB on the Nasdaq) said it removed 2.19 billion bogus accounts from its platform in the first quarter, more than double the 1.2 billion faux-users the company booted in the fourth quarter of 2018.
Those combined figures might represent 45% of the global population, as reckoned by the U.S. Census population clock, but Facebook reassured investors today: “Because we remove these accounts so quickly, they are never considered active and we don’t count them as monthly active users.” Instead, the company reckons that only 5% of its reported 2.38 billion monthly active user accounts are fake.
Yield yodel
Junk has been the place to be for credit investors, as the Bloomberg Barclays High Yield Index has delivered an 8.3% total return year-to-date, topping the 7.1% gain in the iBoxx Liquid Investment Grade Index and outpacing the 5.7% generated by the S&P/LSTA Leveraged Loan Index. Even after a recent pullback in prices, the ICE BAML High Yield option-adjusted spread sits at just 403 basis points over Treasurys, well below the 552 basis point average going back to 1997.
What’s driving the superior performance in high-yield? The prospect of an easier Fed is one key contributor, helping increase the perceived value of fixed-rate junk bonds as opposed to floating-rate loans. Relatively robust economic growth (GDP growth has averaged an annualized 3.3% over the last four quarters) has likewise helped, as has a buoyant stock market. Meanwhile, defaults have remained low, with Fitch Ratings forecasting that May’s trailing 12-month high-yield default rate will settle at 2%. That compares to 4.7% in calendar 2016 and 14% in 2009, per Fitch.
Some investors expect the good times to continue. Vivek Bommi, senior portfolio manager at Neuberger Berman, told Bloomberg over the weekend that the junk bond market “is very attractive, given that the fundamentals are still very good and corporate credit quality is still good.” Bommi notes that the post-crisis boom in leveraged loan issuance has shifted risks away from high-yield: “In the last 10 years, a lot of the more aggressive issuance that may have gone into the high-yield market has gone into other markets like private credit or loans.”
But with the economic expansion set to match the post-World War II record of 110 months in June and the stock market still less than 5% below its closing high-water mark, some concerning signs have emerged. Economic growth looks set to slow, as the Atlanta Fed’s GDPNow tracker indicates second quarter output growth at just 1.2%, revised down from 1.6% on May 14. Retail sales for April fell by 0.2% on a sequential basis, vs. expectations of a 0.2% gain. Resource prices likewise look to be rolling over, with the Goldman Sachs Commodity Index down 5% over the last month.
Broad cracks in credit are also appearing. On Monday, the Financial Times published an analysis showing that non-performing loans among the 10 largest commercial lenders in the U.S. jumped by 20% sequentially in the first quarter, snapping a streak of improvement in that metric dating back to 2016. Brian Foran, a bank analyst at Autonomous Research, tells the FT that unlike three years ago, when plunging oil prices pushed a number of energy-related borrowers into distress, the recent uptick is broad-based: “There hasn’t been a clear theme.”
Meanwhile, rich valuations leave little room for error. Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, writes in S&P Global’s LCD publication that his fair value estimate of the ICE BAML option adjusted spread is 648 basis points, far above the 405 currently on offer. “That qualifies as an extreme overvaluation even if one interprets the Fed’s more recent retreat from its strongly stated intention to tighten rates as an effective reinstitution of quantitative easing.” Reached by Grant’s this afternoon, Fridson added that even supposing a new round of QE, high-yield is overvalued by more than 100 basis points by his analysis.
With high-yield priced for perfection, where might a yield-starved investor turn? The March 22 edition of Grant’s Interest Rate Observer offers a survey of income-producing securities that may offer an attractive substitute for junk bonds.
QT Progress report
The Fed’s portfolio of securities held outright ticked to $3.681 trillion, down $5 billion from a week ago. Mortgage-backed securities accounted for the change, as Treasury holdings remained flat at $2.11 trillion.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 13.4%, at a simple annualized pace of 8.3%.
Recap May 23
Risk aversion reigned supreme as stocks fell and Treasury yields darted lower, with the 10-year yield falling seven basis points to 2.32%, well below the Fed Funds Rate and once again inverted against the three-month bill.
Energy prices were hammered, with WTI crude falling 5% to less than $59 a barrel for its worst session of the year and the S&P 500 energy sector extending its two-day drop to nearly 5%, following a surprise build in yesterday’s weekly inventory report from the DoE. The VIX jumped 15% to finish just below 17.
- Philip Grant
Wednesday, May 22, 2019
In the shop
The auto industry caught a break last week, as the Trump administration announced that planned tariffs would be placed on six month delay. Global industry trade group The Alliance of Automobile Manufacturers expressed relief, commenting that “at the end of the day, you can have tariffs or investment, but you can’t have both.”
The removal of additional taxation (for now at least) is some welcome good news for an industry that has entered something of a rough patch. April U.S. auto sales footed to a seasonally adjusted annual pace of 16.4 million vehicles, down from a comparable 17.2 million pace a year ago.
Stateside, pricing remains strong both in the primary and secondary market. Kelly Blue Book pegs the average transaction price for a new auto at $36,843 in April, up 2% year-over-year. Likewise, the J.D. Power Valuation Services’ Used Vehicle Price Index rose by 1.7% year-over-year last month, with strength in the wholesale market pushing the price of used units (up to eight years old) higher by 1.4%, “the best April performance on record.” At the same time, dealers are increasingly holding the line, as incentive spending fell 6.8% year-over-year in April according to J.D. Power. That’s the tenth consecutive decrease after 54 straight months of rising incentives.
But as pricing continues to strengthen and sales remain in the upper end of the cyclical range, trends in credit augur trouble. According to data from the New York Fed, serious (meaning 90 days or more) auto loan and lease delinquencies rose to 4.69% in the first quarter, up from less than 3.5% in 2016 and just 58 basis points below the post-crisis peak of 5.27% in 2010.
As the cycle has progressed, the auto loan market has grown significantly. Thus, the New York Fed reports that first quarter auto loan and lease balances rose 4% year-over-year to $1.28 trillio, leaving that figure 65% above its first quarter 2009 level. But, as pointed out by financial blogger Wolf Richter, the number of auto-loan accounts has risen by only 34% over the same period, suggesting that “much of the increase in the auto-loan balances is the ballooning amount financed with each new loan and longer loan terms.”
Daniel Ruiz, founder of automotive research firm Blinders Off, LLC, expects that the uptick in bad auto debt will have a broader impact. Ruiz tells Grant’s by email that as the auto market is dependent on trade-in values on financed vehicles, used prices are the lynchpin to sales:
The real risk is not in the length of the loan, but rather the amount of time that it takes for the value of the asset to meet or exceed the principal balance owed on the loan. Used vehicle values have been relatively strong so far this year but not strong enough to offset the increased loan lengths and interest rates of three years past.
Aside from the risk of significant loan losses for lenders with high exposure to subprime auto loans, increased default rates will also increase wholesale volume at auctions.
Indeed, despite the strong recent pricing environment, J.D. Power notes that secondary supply is on the upswing, as auction volumes through the first four months of the year are up by 6.5% from 2018.
As for the broader health of the market, Ruiz utilizes a bespoke indicator he dubs “time-to-equity,” meaning the interval until a vehicle’s trade-in value exceeds the principal balance outstanding on a given auto loan, as a key indicator:
To sum it all up, increased wholesale volume from subprime auto loan defaults will impact used-vehicle retail inventory levels. If that happens, time-to-equity will spike, slowing new-vehicle sales further and causing an even larger increase in subprime auto loan delinquencies.
In essence, longer loan terms and higher interest rates will lead to increased time to equity going forward even if used-vehicle values remain strong. If/when used-vehicle values fall, the situation will get worse until time to equity falls sometime in the future due to shorter loan terms, lower interest rates and or a rebound in used-vehicle values; exactly what happened after our last recession.
The automakers themselves are tightening their belts. Yesterday, Ford Motor Co. announced it will cut 7,000 white-collar jobs, roughly 10% of its global salaried workforce as part of a companywide “redesign.” As noted by Bloomberg today, that brings the total number of announced global job cuts among U.S. vehicle manufacturers to 38,000 employees over the last six months.
Recap May 22
Stocks fluttered a bit lower, as a sharp oil downdraft pushed WTI crude back near $61 a barrel and the S&P Energy Index 1.5% into the red. The VIX held little changed near 15, but risk aversion was evident in rates as Treasury yields dove, with the 10-year falling to 2.38%, near the lowest of 2019 so far and below the 2.39% effective Fed Funds rate.
- Philip Grant
Tuesday, May 21, 2019
Peanut allergy
The Gauls are on the rampage, The Wall Street Journal reports today. Citing data from Dealogic, The Journal notes that French corporations have allocated a post-2008 high of roughly $100 billion to foreign acquisitions in each of the last two years (equating to roughly 4% of France’s 2018 nominal GDP) with the United States a particularly attractive target. Eighteen stateside deals have been consummated by French companies already this year.
That shopping spree coincides with an increase in France’s corporate debt load, now at 143% of GDP, up from 116% in 2008 and well above the 74% seen in the U.S., per the Bank for International Settlements. The rise in corporate debt comes as the European Central Bank marks the fifth anniversary of its foray into negative interest rates, along with the recently-paused corporate bond buying program which was in place since 2016 and held some €178 billion in assets as of April 30.
A spokesperson for drug maker Sanofi S.A., which bought Waltham, Mass.-based Bioverativ, Inc. for $11.6 billion in March 2018, got to the crux of the matter, explaining to The Journal: “Obviously, cost of funding is one of the key elements to take into account for debt-funded deals.”
While the ECB’s aggressive monetary policy has helped spur corporate consolidation, underlying economic activity remains turgid. Thus, euro-area core CPI rose to 1.3% year-over-year in April, the highest reading since April 2017 but still far below the near-2% threshold favored by the central bankers (core CPI growth has averaged 1% since the ECB pushed the deposit rate below zero). Meanwhile, the European Commission now forecasts 1.2% real GDP growth this year in the eurozone, down from a 1.9% guesstimate for 2019 at the end of last year.
But hope springs eternal. Over the weekend, ECB governing council member Klaas Knot said in an interview with Corriere della Sera that “if the economy continues to rebound. . . then I think we are on course” to reach that 2% inflation bogey. Knot attributed weak European growth to globalization, stating: “the only thing that we can do is to keep the pressure up, make sure the economy continues to perform at high levels of capacity utilization and the economy continues to print GDP numbers in excess of potential growth.”
Taking no chances, the mandarins are prepared to go back to the well. In an April press conference, soon-to-be-outgoing President Mario Draghi said that the ECB is prepared to “adjust all its instruments” if data aren’t to their liking. More specifically, the Financial Times surmises that “additional measures [designed] to keep the cost of credit cheaper for longer” will be in store if growth and inflation continue to disappoint.
Then, too, investors see no policy normalization any time soon. Interest rate futures currently predict 29% odds of a rate cut by year end and virtually no chance of a hike. One month ago, the odds of a rate cut, and rate hike were both between 7% and 8%. Meanwhile, the March 2020 three-month Euribor futures contract has risen to 100.35, suggesting a deposit rate of negative 35 basis points 10 months from now. That compares to 99.88 last spring, when investors were expecting a return to positive rates and the April 6, 2018 edition of Grant’s Interest Rate Observer suggested that call options on this instrument would be a good way to profit from the ongoing financial repression in the eurozone.
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March 2020 three-month Euribor futures, one-year chart. Source: The Bloomberg
With positive nominal interest rates not forthcoming any time soon, Europe’s financial institutions continue to falter. The Stoxx 600 Banks Index is now down 25% over the last 52 weeks, badly lagging the 5% decline in the broad Stoxx 600 Index. Bank valuations have descended into consignment-type depths, with that Stoxx gauge now trading at 0.58 times book value, less than half of the 1.23 times book value fetched by the KBW Banks Index in the U.S.
The travails of Deutsche Bank, A.G., which has seen shares plummet by 93% since 2007 and carries a €43.5 trillion ($48.8 trillion) derivatives book equal to nearly three times 2018 Eurozone GDP, are front and center. But other institutions are also attracting unwanted attention. Last week, BlackRock, Inc. backed out of a deal to rescue Banca Carige S.p.A. (founded in 1483), which the ECB had placed the Italian lender in administration in January. In response, Italian deputy prime minster Matteo Salvini told reporters: “It’s an important bank. Obviously, we won’t let things collapse.”
Don’t blame the ECB, according to governing council member Benoit Coeuré. Speaking in French parliament last Wednesday, Coeuré estimated that negative interest rates are costing eurozone banks €8 billion in annual lost income, which he termed “really peanuts.” Instead of positive nominal rates, Coeuré offered a familiar solution for the banks’ woes: Industry consolidation.
Recap May 21
Stocks rallied, with the S&P 500 rising back above yesterday’s opening level while the NYSE FANG+ Index was able to recoup about half of yesterday’s 2.7% drop. Treasury yields edged higher as rangebound action continues in rates, and the VIX finished below 15 for the first time since May 3.
- Philip Grant
Monday, May 20, 2019
Concession stand
One down, two to go?
One down, two to go?
Track changes
Morningstar reports today
Morningstar reports today
Recap May 20
Concession stand
One down, two to go? This morning, the Federal Communications Commission announced it will recommend approval of the proposed merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq), the fourth- and third-largest wireless carriers in the U.S., respectively. That follows a Bloomberg report from Sunday evening that the pair had agreed to concessions including the divestiture of Sprint’s Boost Mobile pre-paid unit, as well as commitments to build out 5G network infrastructure in rural areas of the country.
FCC chairman Ajit Pai explained his rationale in a statement: “Two of the FCC’s top priorities are closing the digital divide in rural America and advancing United States leadership in 5G, the next generation in wireless connectivity. The commitments made today by T-Mobile and Sprint would substantially advance each of these critical objectives.”
While the FCC’s blessing is an important step for the pair, regulatory roadblocks remain. The Department of Justice must also sign off on the combination, a decision which could come relatively soon as the DoJ’s 180-day review period is set to conclude in early June. Then, too, the attorneys general of more than a dozen states have signaled opposition to the merger (Almost Daily Grant’s, March 29).
But the concessions announced today could swing the tide in the company’s favor. Bloomberg Intelligence analyst Jennifer Rie took an optimistic bent in a note today, assessing the odds of both DoJ and state attorneys general approval as “more likely than not.”
The initial reaction suggested Mr. Market concurred with Rie’s viewpoint. Sprint shares surged by as much as 27%, closing the gap to T-Mobile’s all-stock offer to just 4% following the market open. That’s down from a 26% discount seen last week. Likewise, Sprint’s senior unsecured 6 7/8 notes due 2028 jumped more than points to 104, narrowing the spread over Treasurys to 401 basis points from 501 basis points.
For its part, The Wall Street Journal notes that Pai’s endorsement “marks a departure from the stance taken by past FCC leaders who stood in the way of deals that would leave the U.S. wireless market with fewer than four nationwide competitors.” Sure enough, Bloomberg reports this afternoon that the DoJ continues to “lean against” clearing the merger, a headline which helped widen Sprint’s discount to T-Mobile’s all-stock offer back to 11% in the late afternoon.
It is no stretch to say that Sprint’s financial health might depend on the tie-up. On May 7, CEO Michel Combes referenced his company’s shaky stand-alone prospects after revealing a larger than expected loss of higher-value, postpaid wireless users: “We are making the best of the limited financial and low-band spectrum resources that we have. . . we are hopeful to complete our merger with T-Mobile.”
For an updated look at the potential broader implications of a scuttled Sprint/T-Mobile tie up, see the most recent, May 17 edition of Grant’s Interest Rate Observer.
Track changes
Morningstar reports today that a $39 billion inflow in passively-managed assets in April pushed the total to $4.3 trillion, within $6 billion of eclipsing the total assets invested in active management, (which saw a $22 billion outflow for April) for the first time.
“This is a milestone that has been a long time coming as the trend toward low-cost fund investing has gained momentum,” noted Kevin McDevitt, senior analyst at Morningstar and author of the report. McDevitt relays that active U.S. equity managers have seen funds decrease in every year since 2006, with passive strategies enjoying symmetrically-consistent growth over the same period.
With passive investing on the cusp of supremacy, the index makers mix in some active management of their own. Last week, S&P announced that Uber Technologies, Inc. (UBER on the NYSE), will be added to various S&P Dow Jones Indices, including the S&P Total Market Index, as early as tomorrow. As noted in a Bloomberg interview with an S&P spokesperson, Uber is the first company to achieve “fast-track” entry into S&P indices, since the methodology for prompt index inclusion was changed earlier this year.
As Uber gets the fast-track treatment, ride share drivers cut corners to keep their heads above water. On Thursday, Washington, D.C.’s ABC 7 news reported that drivers at Regan National Airport have been “simultaneously turn[ing] off their ride share apps for a minute or two to trick the app into thinking there are no drivers available -- creating a price surge.” Sam Sweeney reports: “These drivers tell ABC 7 they do have a sense of guilt. They say they don’t want to do this, but because Uber and Lyft keep reducing their pay, they tell us they have no choice.”
Recap May 20
A tech-led selloff left the S&P 500 down by 0.7%, while the NYSE FANG+ Index shed 2.7%, leaving that gauge of ten popular stocks down 13% from its May 6 close. Treasury yields rose across the curve, while oil bucked largely bearish commodity action to leave WTI back over $63 a barrel. The VIX held steady north of 16.
- Philip Grant
Friday, May 17, 2019
The sound of silence
An emailed invitation from the Federal Reserve Bank of New York:
An emailed invitation from the Federal Reserve Bank of New York:
Fruit flies
Chinese fruit prices have been on the march,
Chinese fruit prices have been on the march,
Influx capacitor
Yesterday, VanEck Securities Corp. rolled out
Yesterday, VanEck Securities Corp. rolled out
Recap May 17
The sound of silence
An emailed invitation from the Federal Reserve Bank of New York:
John Williams, President and CEO (Speaker)
Date: Monday, May 20, 2019
Time: 1:00 PM EDT
Subject: Welcome Remarks
Event: Fed Listens Capstone Roundtable Discussion
Organizers: Federal Reserve Bank of New York
Location: Federal Reserve Bank of New York
33 Liberty Street, New York, NY 10045
Text is not expected. Q&A with the audience in the room is expected. This event is open to the press to watch via webcast, though not to attend in-person.
In other words, on Monday you can watch the Fed listen.
Fruit flies
Chinese fruit prices have been on the march, with a benchmark index of seven fruits compiled by the Ministry of Agriculture and Rural Affairs jumping to RMB 7.59 ($1.07) per kilogram today. That’s up 23.3% from a month ago and 33.4% year-over-year.
Those figures are downright conservative compared to statistics from the Xinfadi Produce Wholesale Center in Beijing, which reports to state-run The Beijing News that its calculation of average fruit prices shows a 78% year-over-year increase to RMB 6.15, with so-called golden nuggets (A.K.A. tangerines) doubling from a year ago. For context, the World Bank pegged Chinese per capita gross national income at RMB 62,000 at year-end 2017.
Asked by Caixin for comment, a spokesperson for the National Bureau of Statistics cited extreme weather for the price spike, “but did not elaborate.”
Consumers in the Middle Kingdom have been more loquacious. The Epoch Times notes that an online article posted by the Chinese Nutrition Society urging citizens to eat a pound of vegetables and half a pound of fruit per day featured a recurring reaction in the comment section: “We cannot afford it.” Caixin likewise notes that “the phrase ‘fruit freedom’ – or the ability to buy as much fruit as one wants – [has become] a buzzword in China’s online lexicon.”
More broadly, the NBS reported yesterday that its consumer price index rose 2.5% year-over-year in April, matching the third-highest reading since 2013, with the measured rise in food prices at 6.1% year-over-year. The NBS finds that fruit prices are higher by 11.9% year-over-year, while pork prices have jumped by 14.4% on account of the African swine fever outbreak among China’s pig population (Almost Daily Grant’s, April 2).
Meanwhile, the Sino-American trade spat grinds on. On Sunday, the Chinese side offered some topical rhetoric, stating that they won’t swallow any “bitter fruit.”
Influx capacitor
Yesterday, VanEck Securities Corp. rolled out the VanEck Vectors Municipal Allocation exchange-traded fund (MAAX on the NYSE Arca).
This is no ordinary collection of muni bonds. As explained in the press release, the ETF “is designed around a proprietary model that uses momentum, along with both duration and credit risk indicators, to tactically allocate among selected VanEck Vectors Municipal Bond ETFs.”
In other words, as noted by Bloomberg’s Brian Chappatta, MAAX is “an ETF of ETFs.” For his part, Chappatta rhetorically wonders why the “traditionally buy-and-hold [muni] market need[s] an ETF that allocates among other ETFs?”
Unsurprisingly, an uptick in popularity goes a long way toward explaining the newfound financial innovation. Inflows into muni bond ETFs reached $661 million at the end of April, says Bloomberg, the second-strongest weekly capital infusion in the past eighteen months.
That comes on the heels of strong performance, as the Bloomberg Barclays Municipal Bond Index has generated a 6.8% total return over the past year, topping both the Bloomberg Barclays High Yield Index’s 6.1% and the 4.1% generated by the S&P/LSTA Leveraged Loan Index.
That strong rally has led to some fancy prices. The ratio of the 30-year benchmark municipal bond yield to the Treasury long bond fell below 87% yesterday (the lower the ratio, the more expensive munis are on a relative basis), a record low going back to at least 2001. On a shorter horizon, the ratio of 10-year benchmark munis fell to 72.5% of the comparable Treasury yield, itself near a record low.
For a survey of some less-horrifically overvalued municipal bonds, see the Feb. 9, Oct. 19, 2018 and Aug. 10, 2018 editions of Grant’s Interest Rate Observer.
Recap May 17
Stocks came under some pressure, with the S&P 500 falling back into the red for the week as higher beta groups such as industrials, tech and consumer discretionary underperformed. Gold fell for a fourth straight day after touching $1,300 an ounce on Monday, while Treasury yields finished little changed. The VIX settled near 16.
- Philip Grant
Thursday, May 16, 2019
Looney tunes
From CNN:
From CNN:
Post no bills
An update on Post Holdings, Inc., the cereal and processed food maker
An update on Post Holdings, Inc., the cereal and processed food maker
QT Progress report
Recap May 16
Looney tunes
From CNN:
A playful rabbit sculpture by Jeff Koons has become the most expensive work by a living artist ever to sell at auction.
The American artist's "Rabbit," a stainless steel figure measuring just over 3 feet tall, sold for more than $91 million Wednesday evening at Christie's in New York, smashing auction estimates.
Christie's initially estimated that Koons' faceless "Rabbit" would sell for between $50 and $70 million. But after more than 10 minutes' bidding, the winning offer came in at $80 million which -- including auctioneer's fees -- resulted in a final sale price of $91,075,000.
Evidently, Trix aren’t just for kids.
Post no bills
An update on Post Holdings, Inc., the cereal and processed food maker which was a Grant’s pick-to-not-click in the Sept. 16, 2016 issue. Since publication time, POST shares are up 36% counting dividends, compared to a 41% total return in the Russell 3000 Index. On the credit side, the senior unsecured 5% notes due 2026 last changed hands at 99.5 cents on the dollar and have generated a 15.1% total return, compared to 17% for the Bloomberg Barclays U.S. Corporate High Yield Index.
Improving margins figure prominently in the bull story. Over the 12 months ending Sept. 30 (the company’s fiscal year-end), Post will generate $382 million in adjusted net income on $5.8 billion in revenue, if analyst consensus is on the beam. That compares to just $187 million in adjusted net income on $5.2 billion in revenue two years prior.
That margin expansion is all the more impressive considering the secular decline in cereal, Post’s core business. U.S. consumers bought $8.3 billion worth of cereal in 2017 according to Nielsen. That’s down from $8.8 billion in 2016 and compares to $12.7 billion in cereal bought by Americans in 2009, per the estimate of research firm IBISWorld. In fiscal 2018, Post’s consumer brands unit chipped in 29% of revenue and 38% of gross profit.
As the legacy business shrinks, Post management wheels and deals. One day before the earnings release, Post announced the acquisition of TreeHouse Foods, Inc.’s private, ready-to-eat cereal business. Later this year, the company is expected to IPO a minority stake in the Active Nutrition segment, the highest-growth portion of the Post portfolio with a 5.5% year-over-year revenue advance in the latest quarter. Proceeds from that offering can be used to help pay down the company’s $6.2 billion debt load, which equates to five times fiscal 2019 consensus adjusted EBITDA.
Mr. Market continues to give his blessing to single-B-plus rated (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”) Post, bestowing a relatively generous 23 times trailing adjusted earnings multiple. That compares to 14.7 times trailing earnings for the S&P 500 Packaged Foods Index.
For Post bulls, the deal-making acumen of a management team headlined by the venerated 84 year-old nonexecutive chairman William P. Stiritz, counts as a primary attraction. Since its 2012 formation as a spinoff from Ralcorp, Inc., Post has undertaken more than a dozen acquisitions, for total considerations of at least $8.2 billion (financial terms for several deals, including the recently announced TreeHouse private brands label, were undisclosed). For context, Post's current market cap is just over $8 billion.
Vicki Bryan, founder and CEO of BondAngle, LLC, tells Grant’s today that Post’s chronic deal-making helps prevent investors from getting a true picture of the company’s performance and financial health.
On top of the stream of acquisitions, Post is constantly rejiggering their segment reporting, including in the second quarter. This prevents investors from getting an apples-to-apples look at their performance. I call it ‘structured amnesia.’
Post’s financial machinations extend beyond the gathering of corporate assets. On Aug. 2, the company announced the spin-off of its private brands business into a newly formed entity called 8th Avenue Food & Provisions, in partnership with private equity firm Thomas H. Lee Partners, Inc. The unit chipped in $849 million in revenues last year, equivalent to 13.6% of Post’s top-line for fiscal 2018.
In carving out that business unit, Post received proceeds of $250 million, as well as 8th Avenue’s assumption of $625 million in debt. Post maintains 60.5% of the common equity for 8th Avenue, while Thomas H. Lee received preferred stock with a cumulative, quarterly compounding dividend, as well as the remaining 39.5% ownership in the venture. As Thomas H. Lee controls voting rights to the newly formed company, those results are no longer consolidated onto Post’s financial statements.
For her part, Bryan flags the 8th Avenue deal as a concerning one, particularly for Post’s creditors:
By spinning off the private brands unit, Post has reduced profit visibility and, more importantly, reduced asset coverage against its substantial borrowings. This is particularly worrisome considering that intangible assets such as goodwill foot to $8 billion, more than two-thirds of the $11.3 billion in total assets on the balance sheet.
What’s more, 60.5% Post-owned 8th Avenue is itself highly leveraged. Accordingly, the parent company may be currently or in the future compelled to support the unit through paying expenses or disbursing additional cash. We know that it is one of Post’s lower-margin businesses, reporting gross margins of 16.2% in the six months ended March 31, compared to 31.4% for the parent company.
In short, they have further weakened what was already a weak hand for bondholders.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.686 trillion this week, down $15.5 billion on a sequential basis, with mortgage-backed securities and Treasury holdings down by $5.8 billion and $9.7 billion, respectively, from a week ago.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down 13.3%, for a simple annualized pace of 8.4%.
Recap May 16
Stocks rose again, with the S&P 500 gaining nearly 1% to claw back to unchanged for the week after Monday’s steep selloff, back within 2.5% of the closing highs reached on April 30. Treasury yields ticked higher, with the short end underperforming to leave the curve a bit flatter, and strength in the energy patch helped WTI crude rebound to $63 a barrel. After touching 21 earlier in the week, the VIX settled below 15.5.
- Philip Grant
Tuesday, May 14, 2019
Can you hear me now?
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE)
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE)
Recap May 14
Can you hear me now?
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq) have opted for new tactics in lobbying government regulators to approve their merger announced in April 2018. In the face of apparent opposition from staffers at the Department of Justice and Federal Communications Commission, the pair (the fourth- and third-largest wireless carriers in the U.S., respectively) are discussing concessions, including potentially selling pre-paid business units or airwave licenses as well as “far less attractive options,” such as establishing a new fourth carrier which would lease network capacity from the combined entity.
On April 16, The Wall Street Journal reported that DoJ staffers told the pair the merger “is unlikely to be approved as currently structured.” That same day, the Capitol Forum relayed that the DoJ expressed “continued concerns regarding efficiencies and a potential delay in any of the deal’s benefits reaching consumers” at an early April meeting with the pair.
But investors remain relatively sanguine about single-B-plus rated Sprint’s prospects. The company’s senior unsecured 6 7/8 notes due 2028 trade near 96 cents on the dollar, while Sprint shares remain at a 26% discount to the all-stock offer price (as reflected in T-Mobile shares), both little changed from six weeks ago. That steady price action in the face of less-than encouraging media reports stands in contrast to the precipitous decline in Sprint’s bond and stock prices in early 2016, when its status as a viable enterprise came into question.
A bearish analysis of Sprint in the Dec. 23, 2016 edition of Grant’s Interest Rate Observer argued that Sprint’s stagnating top-line, persistent cash burn (negative on a free cash flow basis in each of the last four years, with more red ink in store for fiscal 2019 and 2020 according to estimates compiled by Bloomberg), and hefty debt load presented risks in excess of the prospective skimpy returns.
While likely delivered with an eye toward influencing regulators, recent language from Sprint management seems to concur with that assessment, as CEO Michel Combes remarked on the Jan. 31 conference call: “As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments and without additional low-band spectrum, we will face challenges to provide customers with coverage comparable to that of the big two carriers.”
For its part, T-Mobile management is preparing for life as a standalone company. Last week, Germany’s Handelsblatt reported that the TMUS c-suite is preparing a plan B if the merger is blocked.
As for the remedies proposed by the pair, Amir Anvarzadeh of Asymmetric Advisors writes this morning that the suggestions are both unlikely to move the needle and impractical from a business competition standpoint:
The problem is that spinning off the prepaid business (which makes the bulk of both carriers' customer base) leaves them at a huge disadvantage in terms of converting customers to post-paid users in the future.
Selling off airwaves would also be silly given that Sprint was just saying that without adequate low band radio spectrum, they will be at a great disadvantage while its 2.5Ghz spectrum is one of the most attractive assets they have. I’m not sure if either option is feasible.
Meanwhile, one anonymity-seeking investor acquainted with the situation finds the contrast between widespread reports suggesting the merger will fail to garner regulatory approval on the one hand, and the sanguine trading in Sprint’s equity and debt on the other, to be curious, telling Grant’s:
I continue to believe that the DOJ, FCC and state attorneys-general are not convinced that the proposed deal efficiencies are merger specific or verifiable enough to accept highly visible harms that inure from a permanent change in industry structure (four players to three).
Resolution to this saga is likely near. The Capitol Forum notes that the DoJ is expected to reach a final decision before early June, when the FCC’s scheduled 180-day review period comes to conclusion.
Recap May 14
Stocks staged a solid rebound with the S&P gaining nearly 1% after falling to a six-week closing low yesterday, but the broad index did lose some steam by day’s end. The VIX fell back to 18, down 12% on the day, and Treasury yields edged higher after yesterday’s strong rally with the 10-year yield rising back above the three-month by one basis point after inverting yesterday. WTI crude ticked back to near $62 a barrel.
- Philip Grant
Monday, May 13, 2019
Cut rate
The latest escalation of the U.S./China
The latest escalation of the U.S./China
Swing LO
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled
Recap May 13
Cut rate
The latest escalation of the U.S./China trade spat has both countries considering their options. This morning, Hu Xijin, editor-in-chief of The Global Times, speculated on Twitter that China might retaliate against the latest tariff hikes by selling down their $1.1 trillion pile of Treasury bonds (representing nearly 7% of the $16.1 trillion in U.S. debt held by the public). But that potential supply deluge didn’t prevent a strong rally in rates: The 10-year yield dropped this morning to 2.40%, the lowest since March, crossing below the three-month bill yield to once again push the curve into inversion.
As international tensions percolate and risk appetite withers, the market increasingly expects the Fed to ride to the rescue. Interest rate futures currently price 59% odds of a rate cut by October, nearly double the 31% likelihood anticipated one month ago.
But comments from a pair of senior Fed officials suggest the FOMC is less than eager to follow Mr. Market’s suggested path. This morning, Minneapolis Fed president Neel Kashkari told CNBC that a still-robust labor market indicates no pressing need for policy support: “If we saw job growth really slowing down, then you might say. . . we need to do something. I’m not quite in that camp yet because we continue to see the job market exceed expectations.”
Fed vice chairman Richard Clarida likewise took a sanguine view in a Boston speech this morning, remarking that “the U.S. economy is operating at or close to our maximum-employment and price stability [meaning a measured 2% annual loss in purchasing power] goals.”
Jim Bianco, president and eponym of Bianco Research, argues today that the Fed would be wise to heed the market’s advice. The 10-year yield has dropped below the three-month yield on seven occasions in the last 50 years, and recession has followed each time, commencing 311 days later on average. Bianco writes:
The yield curve is a market signal that the Fed is too tight. Many think it ‘predicts’ a recession. We believe it actually ‘causes’ a recession.
A recession occurs because something ‘breaks’ the economy. FOMC policy that is overly restrictive is perhaps the leading reason an economy breaks. It is the cumulative effect of a Fed mistake week after week, month after month that causes a recession.
Swing LO
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled a fresh series of measures designed to bolster the cash-leaking state-owned oil company Petróleos Mexicanos (Pemex), including an $8 billion syndicated loan as well as fresh tax breaks. Proceeds from the loan will be used to refinance a portion of Pemex’s towering $106.5 billion debt load. The new measures follow a $5.5 billion aid package disbursed in March.
But with that generosity comes the expectation that Pemex will do some heavy lifting. Last Thursday, AMLO announced that his administration has rejected a trio of private company bids to build an oil refinery in his home state of Tabasco, instead tapping Pemex for the job. The outside bidders had submitted budgets in the range of $10 billion to $12 billion for the project, and anticipated completion between 2023 and 2025. Instead, Pemex will build the facility for $8 billion, and target completion by May 2022. “We’re not going to start any work we can’t finish in my term,” AMLO declared.
Count some observers as skeptical. Gonzalo Monroy, an independent energy analyst in Mexico City, told The Wall Street Journal that: “You can’t build a monster refinery like this, at such a low cost, on such a short timeline. López Obrador will have to sacrifice one of those things. That’s what the companies that were bidding on this project were saying.”
Pemex investors are likewise uneasy about the ambitious plan. Luis Maizel, senior managing director at LM Capital Group, LLC, remarked to Bloomberg: “Building it yourself is stupid, and its bad for Pemex because they don’t know what their costs will be or when they will finish it.” Maizel anticipates further government support for split-rated (triple-B-plus at S&P, triple-B-minus at Fitch) Pemex: “[AMLO] can calm things down by saying ‘we assure you that Pemex will always fulfill its obligations prior to the government withholding taxes.’”
Creditors are taking these developments in stride, as the Pemex senior unsecured 6 3/4 notes due 2047 traded at 91 cents on the dollar this morning, little changed from last week’s levels. By contrast the Mexican 4.6% dollar-pay bond due 2047 slumped to 95.8 today, down from an average 96.8 seen last week.
For more on the implications of the increasingly intertwined relationship between Pemex and its sovereign patron, see the March 23, 2018 edition of Grant’s Interest Rate Observer.
Recap May 13
Stocks were clobbered with the S&P 500 falling 2.5%, the biggest decline since Jan. 3 to leave the broad index roughly 5% below its high water mark reached April 30. Treasury yields gapped lower across the curve, and monetary alternatives rallied as gold rose above $1,300 an ounce for the first time in a month and bitcoin ripped 11% to $7,800. The VIX closed above 20 for the first time since January.
- Philip Grant
Friday, May 10, 2019
Bank teller
From Reuters:
Millions of $50 Australian dollars ($35) banknotes in Australia have an embarrassing typographical error that was overlooked by the country's central bank before they were printed and circulated.
The goof first became known on Thursday when a listener on radio outlet Triple M sent the station a magnified photo of the Reserve Bank of Australia's (RBA) new A$50 note highlighting the word "responsibility" misspelt as "responsibilty" three times.
An RBA spokeswoman said in an emailed statement to Reuters the Bank "is aware of it and the spelling will be corrected at the next print run."
Practice makes perfect.
Mr. Erdogan's wild ride
The Turkish whipsaw continues. This morning the lira rallied by 2% against the dollar after the local central bank suspended its one-week repo auction, effectively raising interest rates by 150 basis points to 25.5% without effecting a direct change to the benchmark rate. Jason Tuvey, senior emerging markets economist at Capital Economics, told Reuters that political considerations likely dictated the roundabout policy tightening: “The central bank’s moves suggest it is under political pressure to not hike interest rates, so it has to go through the back door.”
Politics indeed loom large for Turkish asset prices, as the lira swooned on Tuesday after the country’s top court annulled local election results that saw the opposition CHP party take control of the Istanbul mayoralty. The lira is down 14% against the dollar since late March, the weakest of any currency tracked by Bloomberg. The do-over elections are set for June 23.
President Recep Erdogan addressed the spiraling lira in a speech to parliament Tuesday, declaring that “full blown economic sabotage” was afoot and promising that “whatever we did to the terrorists threatening our borders, we will do the same” to those economic saboteurs.
Key indicators suggest Erdogan has some work to do. The measured rate of Turkish inflation jumped 19.5% year-over-year in April, almost double the average five-year monthly inflation rate of 10.5%. At the same time, the year-over-year change in GDP declined throughout 2018, reaching negative 3% in the fourth quarter for its worst showing since 2009. The lira has lost 66% of its value against the greenback over the last five years.
There are some signs of relief, however. According to data from the central bank, Turkish households and businesses sold a net $1.2 billion in dollars and euros in the week ended May 3, the fourth straight week of net sales of so-called hard currency.
Then, too, Turkish banks are hard at work propping up the lira. Bloomberg reports that financial institutions were selling dollars and buying lira in Asia overnight “in order to give maximum impact to their purchases.” That follows a report from the Financial Times on April 30 noting that the Turkish central bank has engaged in swap transactions with local banks designed to bulk up its holdings of FX reserves. Those moves came with some curious accounting techniques: “The central bank had told the FT that the dollars borrowed in these transactions were added to the asset side of its balance sheet while the corresponding lent liras were not deducted.” But even with those maneuvers, the coffers are dwindling. As of May 3, foreign exchange reserves fell for a third straight week to $72.5 billion, down 30% from the failed coup attempt in July 2016.
Turkey FX reserves, five-year chart. Source: The Bloomberg
Mr. Market is registering increasing concern, as Turkish credit default swaps rose to 494 basis points yesterday, almost double the five-year average of 252 basis points. Meanwhile, the 7 5/8 dollar-pay bonds due in 2029 have fallen to 96 cents, down from 104 in mid-March for a meaty 582 basis point spread to Treasurys.
With outsized risks, and commensurate potential rewards, some investors are taking the plunge.Thomas Clarke, partner and portfolio manager at William Blair International in London, told Bloomberg yesterday that: “I don’t want to lose sight of the fact that [the lira] is a very, very cheap currency with also a very, very high carry. We have a predisposition to buy more.” As for Erdogan, Clarke noted that: “he does have a lot of executive power over Turkey and Turkish institutions, but he does not have executive power over the financial markets.”
Not yet anyway.
Thursday, May 9, 2019
To infinity, and beyond
A slide from SoftBank
A slide from SoftBank
He said it
Art Cashin,
Art Cashin,
Suffer for your art
Retail magnate Yusaku Maezawa, founder of Zozo, Inc.
Retail magnate Yusaku Maezawa, founder of Zozo, Inc.
QT Progress report
Recap May 9
To infinity, and beyond
A slide from SoftBank Group Corp.’s 2018 investor presentation released today:
He said it
Art Cashin, longtime director of NYSE floor operations for UBS Financial Services, Inc., summed the market up this afternoon to CNBC:
You're living in a world where one Trump tweet can change everything.
Suffer for your art
Retail magnate Yusaku Maezawa, founder of Zozo, Inc. and the 22nd richest person in Japan with a net worth of $2 billion according to Forbes, is having cash flow troubles. On Sunday, Maezawa told his followers on Twitter that “I have no money. I spend it so quickly (smiley face).” The tycoon is amply leveraged, with 88% of his Zozo stock holdings pledged as loan collateral according to regulatory filings.
Maezawa’s liquidity shortage is no welcome news within the art world, as Bloomberg likewise notes that he has earned a spendthrift reputation by “pouring hundreds of millions of dollars into everything from Basquiat paintings to a Hermes-upholstered private jet and a down payment for a ride on Elon Musk’s rocket around the moon.” In May 2017, Maezawa shelled out a record $110.5 million for Basquiat’s Untitled. Four months later, an article on the auction house Christie’s website dubbed Maezawa “the art world’s new rock star.”
For Sotheby’s, the publicly-traded half of the global auction house duopoly and the oldest company listed on the New York Stock Exchange (BID is the ticker), the prospective retreat of a major bidder hasn’t dented an upbeat outlook. On last week’s earnings call, CEO Tad Smith told listeners that management: “feel[s] very good about second quarter results based on great works of art and strong demand from Asia and the Americas.” A decisive event looms in the form of next week’s impressionist and modern art auction in New York, which carries a low estimate of $305.5 million according to the company.
Sotheby’s shareholders are eager for good news. Since a bearish analysis in the September 8 edition of Grant’s Interest Rate Observer, shares are down by 18%, compared to an 8% drop in the Russell 2000 Index during that period.
With BID’s top-line in a holding pattern (forecast 2020 revenues of $1.04 billion trails the $1.06 billion achieved in 2017), margin expansion figures prominently in the bull case. The Street expects EBITDA to foot to 24.8% of revenues in 2020, up from 21.8% last year and 18.1% in 2017. Net income margins will likewise fatten to 13.1% in 2020 from 11.3% in 2017, if the analysts are on point. Sotheby’s and Christie’s together dominate the auction market, acting as the liquidity providers of first resort in the fine-art resale market. But an anonymity-seeking senior auction house executive told Grant’s last September that the model has its limitations:
It’s a duopoly without pricing power. That is the thing that is hard for people to understand. They always think the prices and volume go up, we are going to clip a standard commission against ever increasing prices and volumes. They must be printing money. The auction houses don’t manufacture anything. Every sale, they need to find new properties. They don’t do original issues. They don’t do IPOs. It is a pure secondary market.
Indeed, the art market acts as something of a derivative on global financial and economic conditions. Thus, according to the 2019 “Art Market Report” by Art Basel and UBS, auction sales registered at $29.1 billion last year, up 3% year-over-year and 30% from 2016, a year marred by Chinese capital controls, weak commodity prices and the short but sharp global equity selloff at the beginning of that year.
Meanwhile, the post-2008 surge in art prices has led to a quandary, as buyers have become wary of overpaying while sellers contend with the prospect of busted auctions. By way of response, the auction houses issue guarantees to attract new business, exposing themselves to losses if bidding interest fails to reach the reserve price, or to margin erosion if the piece in question is offloaded to a third-party guarantor.
To help offset those extra costs, the auction houses have recently hiked their commissions. As noted by Giulia Costantini, co-founder of Art Strategy Partners, at the Grant’s spring conference on April 9, buyers at the lower end (up to and including $400,000) can end up paying as much as 40% above the hammer price when factoring in taxes and the U.K. value-added tax.
Fellow Art Strategy Partners co-founder Wendy Battleson likewise noted that the fierce competition within the auction houses can present a perverse dynamic for Sotheby’s investors:
We also believe that when there is good news in the press about Sotheby’s that usually means very bad things. It is always shocking to us about the announcement of a wonderful sale at Sotheby’s that will be coming up in 2-3 months and there is a lot of talk about how much value there is in the sale and how important it is and on and on and on. Then you see the stock price creep up based on that news.
What people should really be doing is shorting the stock because if there is a great announcement it means that Sotheby’s went against Christie’s and potentially Phillips and pitched the business to the client that was selling. Then there was margin erosion, margin erosion, margin erosion and negotiations back and forth.
Ultimately that great piece of business that Sotheby’s is raving about is probably a loss leader and in a best-case scenario is probably breakeven. Good news at Sotheby’s means very bad news for their stock price.
QT Progress report
The Fed’s portfolio of securities held outright remained steady at $3.7 trillion following the $37 billion sequential decline of a week ago, the largest seen thus far. Since the Oct. 1, 2017 commencement of QT run-off, the Fed’s total balance sheet assets are down by 12.6%, a 7.9% simple annualized pace.
Recap May 9
Stocks recouped the bulk of early losses to leave the S&P 500 just below unchanged on the day, and down 2.5% for the week. A weaker dollar wasn’t enough to keep WTI crude from sliding below $62 a barrel and a strong rally in Treasurys pushed the 10-year yield to 2.45%, within eight basis points of a 52-week low.
- Philip Grant
Monday, May 6, 2019
Drivers' side
From the Associated Press:
From the Associated Press:
Service industry
The Toronto Real Estate Board released its monthly report for April today,
The Toronto Real Estate Board released its monthly report for April today,
Recap May 6
Drivers' side
From the Associated Press:
An organization representing for-hire drivers in New York City says its members will go on a two-hour strike against Uber and Lyft ahead of Uber's planned initial public stock offering.
The New York City Taxi Workers Alliance says its members voted not to drive for Uber or Lyft between 7 and 9 a.m. Wednesday.
San Francisco-based Uber is aiming to raise $9 billion in its initial public offering Thursday.
Service industry
The Toronto Real Estate Board released its monthly report for April today, showing a brisk 16.8% year-over-year sales uptick to 9,042 units. Prices likewise edged higher to C$820,000 ($607,000), up by 1.9% from a year ago, while average days on the market declined to 19 from 20. Though improved from 2018, those figures are well below the 11,630 transactions logged at an average price of C$921,000 and an average of nine days on the market seen in April 2017.
While Toronto’s housing market shows signs of stabilizing, action in formerly white-hot Vancouver remains at a standstill. April sales in the metro Vancouver region totaled just 1,829 according to the local real estate board, down 29.1% from a year ago and the weakest activity in April since 2000. Prices are also in retreat, with the benchmark index sliding 8.5% year-over-year to C$1,008,000, the lowest since May 2017.
Some participants still have hope. Tamara Vrooman, CEO the Vancouver City Savings Credit Union, which provides banking services for roughly one-quarter of the city’s residents, told Bloomberg: “We see no evidence of a [housing] freefall. We have certainly seen a lot of sitting on the sidelines and wait-and-see, but we’re also seeing signs that we may be at the trough.”
However, national data through the first three months of the year add further weight to the idea that the long-running Canadian housing boom is over. The Teranet-National Bank House Price Index has averaged a 1.9% year-over-year gain in January, February and March, down from 7.6% growth in the first quarter last year and 13% in 2017. The pace of new credit has slowed commensurately, with residential mortgage credit up 3.3% year-over-year in the first quarter according to the Bank of Canada, down from a 5.1% yearly advance in the first three months of 2018 and the weakest first quarter growth rate since 2001.
As housing turns, the Canadian economy is showing signs of strain. On Tuesday, Statistics Canada reported that February GDP grew just 1.1% year-over-year, below the 1.4% expected. A day later, IHS Markit reported that the Canadian manufacturing PMI slipped to 49.7 in April, the first contractionary (meaning sub-50) reading since February 2016, with the employment and new orders components falling to their lowest since September 2016 and December 2015, respectively.
But those worrisome economic signs haven’t discouraged Bank of Canada governor Stephen Poloz from maintaining a hawkish rhetorical bent. Speaking to Canadian lawmakers after keeping the overnight range unchanged at 1.75%, Poloz noted that with unemployment at a 40-year low and real rates in negative territory (March CPI grew by 2.1% year-over-year), policy tightening could be in order: “If [economic] headwinds dissipate, then interest rates would rise.” In an interview with Global News’ The West Block on April 28, Poloz blamed the recent slowdown on a variety of outside factors, including the fall 2018 decline in oil prices and “very nasty weather,” as well as the global trade war “that has basically been initiated by the United States.”
The central banker predicted that GDP growth will recover to a 2% pace by mid-year and will remain in that accelerated range through year-end 2020. In a speech today, Poloz played down the housing slowdown as a broader economic risk, stating that “the fundamentals of the Canadian housing market remain solid,” and forecasting that “growth will resume once the effects of reduced expectations for house price inflation,” along with the B-20 mortgage regulations requiring borrower stress tests, have been digested.
As Poloz talks up the economy and the prospect of higher rates, the debt-soaked Canadian consumer is up against the wall. According to a March report from Statistics Canada, household debt climbed to 178.5% of disposable income at year-end 2018, up for a fifth consecutive quarter. That compares to 85% of disposable income in the U.S. in the fourth quarter. Meanwhile, debt service chewed up 14.9% of Canadian household income in the fourth quarter, up from 14.2% year-over-year. By comparison, that metric peaked in the U.S. at 13.2% in the third quarter of 2007 and stood at 9.9% at year-end.
For an analysis of the potential ramifications of a Canadian housing bust, see the Feb. 9, 2018 edition of Grant’s Interest Rate Observer.
Recap May 6
No trade deal, no problem. Stocks recovered the bulk of steep early losses following the apparent breakdown of Sino/American trade negotiations over the weekend, leaving the S&P 500 less than 50 basis points in the red. By comparison, China’s Shanghai Composite Index lost more than 5% on the day.
Treasurys rallied across the curve, with the 10-year yield dipping below 2.5%. WTI crude edged back over $62 a barrel, and the VIX volatility index rose 20% for its highest close in six weeks.
- Philip Grant
Friday, May 3, 2019
Ticker tailor
Speaking on CNBC today,
Speaking on CNBC today,
If you build it
From last weekend's edition of the London Sunday Times:
From last weekend's edition of the London Sunday Times:
The buck stops over there
In a Wednesday speech in London, European Central Bank
In a Wednesday speech in London, European Central Bank
Recap May 3
Ticker tailor
Speaking on CNBC today, Vice President Michael Pence said the Fed should slash rates and abandon its mandate to keep prices low and stable.
Data dependence, Trump-style
If you build it
From last weekend's edition of the London Sunday Times:
The world’s first luxury development to be sold in bitcoin, which was promoted by the Conservative peer Baroness Mone, has stalled.
Mone, a former Tory business “start-up tsar”, and her partner, Doug Barrowman, launched the £250m development in September 2017 to worldwide publicity, with the promotional material saying the two residential towers would be completed by this summer.
The Aston Plaza project in Dubai, in which a two-bedroom flat was going to cost the bitcoin equivalent of about £185,000, is still being described on its website as “25% complete”, the figure used in the promotional material. However, government inspectors who visited the site at the Dubai science park in January last year described the venture as “on hold”, and construction has stopped.
The buck stops over there
In a Wednesday speech in London, European Central Bank vice president Luis de Guindos expressed concern over the state of the European banking system. The central banker noted that despite a lengthy period of economic expansion, Europe’s banks continue to earn returns on equity that fail to match their costs of capital. Indeed, the market takes a dim view of the sector, as the Stoxx 600 Banks Index trades at just 0.64 times book value, half of the 1.22 times book value fetched by the U.S. KBW Bank Index.
Perhaps unsurprisingly, de Guindos played down the role of the ECB’s aggressive monetary policy in that valuation gap, making only one passing mention of negative rates, and noting that: “European bank profitability has been structurally weak since well before unconventional monetary policy measures were introduced.” Instead, he cites inefficient cost structures, competition from non-financial companies and “cyclical factors” as the culprits constraining interest income. De Guindos concludes:
The structurally low profitability of the euro area banking sector remains a concern for financial stability and for monetary policy. Return on equity below the cost of capital is unsustainable in the long run. The causes of low profitability are for the most part structural and hence require structural solutions. Successful implementation of long-run profitable business plans is essential.
Consolidation remains necessary.
That advice follows the failed merger attempt between Deutsche Bank A.G. and Commerzbank A.G., Germany’s two largest financial institutions. Yesterday, the Financial Times published a postmortem of the scuttled transaction, noting that the pair would have needed to raise at least €8 billion to close the deal, a sum equal to nearly one-third of their combined current market cap. The FT quoted an unnamed regulator who described the break thusly: “Calling off the merger wasn’t a strategic transaction. They could just not afford the deal.”
For Deutsche Bank, the euro area’s third-largest bank by assets, it’s back to the drawing board. A dispatch from Bloomberg yesterday was headlined: “Deutsche Bank said to have virtually no new plan for what’s next.” Deutsche Bank shares currently trade at 0.24 times their Dec. 31 book value, down from 0.51 times at year-end 2017.
Recap May 3
Stocks snapped higher following a stronger than expected reading of April non-farm payrolls, with the S&P 500 gaining near 1% to edge back into positive territory for the week. That broad index is up 17.5% year-to-date.
Elsewhere, Treasury yields ticked lower with the 10-year settling at 2.53%, while oil managed to buck bearish commodity price action with WTI finishing near $62 a barrel. The VIX shed nearly 10% to fall back towards 13.
- Philip Grant
Thursday, May 2, 2019
Downhill from here
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex)
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex)
QT progress report
Recap May 2
Downhill from here
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex) reported an operating loss of MXN 36 billion ($1.9 billion) in the first quarter. That’s an improvement from the MXN 157 billion fourth quarter shortfall, as the rampant oil theft from company pipelines seen last fall has largely abated. Pemex likewise pledged to keep its MXN 2.1 trillion debt load stable, a move the Financial Times terms “a big change in policy.”
Chief financial officer Alberto Velázquez hailed the results: “We have advanced in all areas. The challenges will require time to resolve but the trend is clear. . . Pemex is moving in the right direction.”
Yet production continues to move in the wrong direction. First quarter output averaged 1.66 million barrels per day (mbpd), down 12% year-over-year and the lowest figure on record going back to 1990. For 2019, Pemex management is targeting 1.725 mbpd, which compares to 1.82 mbpd in 2018 and a high of 3.4 mbpd in 2004.
The Mexican government looks set to provide more help for its energy champion. Back in March, deputy finance minister Arturo Herrera told reporters that the government was considering paying up to $7 billion of Pemex’s obligations out of the public coffers. That follows a $5.5 billion rescue package including tax relief and direct recapitalization announced by President Andrés Manuel López Obrador (AMLO) in February. Pemex has some $16 billion worth of debt coming due this year and has posted negative free cash flow in every year since at least 2008.
As the state continues to cough up cash in support of Pemex, worrisome economic signs abound. Mexico's first quarter GDP contracted by 0.2% on a sequential basis, worse than any of the 11 economist estimates tabulated by Bloomberg. That follows a 6.8% year-over-year decline in gross fixed investment in December, the second-worst reading since 2009.
An analysis in the March 23, 2018 edition of Grant’s Interest Rate Observer argued that thanks to dwindling production, structural unprofitability and a hefty $166 billion in liabilities, equating to six times trailing 12-month EBITDA including pension obligations, Pemex’s debts may one day soon become those of the Mexican government.
To that end, a potentially ominous sign in Tuesday’s update: Output at the deepwater Ku-Maloob-Zaap (KMZ) oil field, which provides just over half of Pemex’s total output, fell to 837,000 barrels per day in the first quarter, down from 875,000 barrels a year ago. While that 4% decline is less severe than the aggregate 12% production drop-off, KMZ has been a rock-steady producer in the past 10 years, in contrast to the fast-depleting Cantarell oil field, which was one of the largest in the world at its 2004 peak and now generates just 158,000 bpd. Bloomberg Intelligence analyst Fernando Valle tells Grant’s today that structural factors loom large for KMZ:
Deepwater fields tend to decline quickly, and you will need capital to keep production flat. Unfortunately, as you know, Pemex required capital injections and has a very bloated cost structure, so it seems difficult to believe that they will have the wherewithal to make those required investments.
For his part, John Padilla, partner and managing director at IPD Latin America, flagged KMZ as an important catalyst in that March 2018 issue of Grant’s:
The thing to keep your eye on from Pemex’s perspective is . . . going to be when KMZ starts declining, which it will.
They [Pemex] have managed it infinitely better [at KMZ] than what they did with Cantarell. If there is one glorious thing that they’ve been able to do to date, [it] is that they’ve been able to manage KMZ’s production well, but any field that you use secondary, tertiary recovery techniques . . . you squeeze it faster and there is less of it at the end. That production will fall, and when it falls, it is going to fall very significantly.
But creditors aren’t concerned, as the company’s debt continues to rebound. After falling from near par at publication time to below 82 cents on the dollar in the fall, Pemex’s split-rated (triple-B-plus at S&P, triple-B-minus at Fitch) senior unsecured 6 3/4 bonds due 2047 have rallied back above 90, yielding a 465 basis point premium to Treasurys. Mexican sovereign credit default swaps likewise cost 114 basis points, down from 163 basis points in November.
QT progress report
The Fed’s portfolio of securities outright registered at $3.745 trillion this week, down a meaty $38 billion from a week ago for the biggest sequential decline of the program so far. Treasury holdings fell by $30 billion as the calendar flips to May, with mortgage-backed securities accounting for the remainder.
Since the Oct. 1, 2017 commencement of QT portfolio run-off, the Fed’s total balance sheet assets are down by 12.7%, for a simple annualized pace of 8.2%.
Recap May 2
Stocks finished slightly lower, extending yesterday’s selloff to leave the S&P 500 roughly 80 basis points in the red for the week so far. Treasurys also sold off with the 10-year yield rising back to 2.55%, and energy continued its pullback with WTI crude falling below $62 a barrel from $66 one week ago. The VIX jumped as high as 16 in midday before settling at 14.5.
- Philip Grant
Tuesday, April 30, 2019
Cross check
This morning, McDonald’s Corp. (MCD on the NYSE) reported mixed first quarter results. Revenues of $4.96 billion rose 2% year-over-year on a constant-currency basis to top the consensus $4.93 billion, driven by a 5.4% rise in comparable store sales. Yet that strong growth didn’t translate into improved profitability, as operating income fell 2% year-over-year to $2.09 billion. MCD shares finished the day little changed.
McDonald’s growth may be coming at the expense of its competitors. Same-store sales at Burger King, Popeye’s Louisiana Kitchen and Tim Horton’s, the trio of eateries managed by Restaurant Brands International, Inc. (QSR on the NYSE), generated same-store sales growth of 2.2%, 0.6% and negative 0.6%, respectively, in the first quarter. Overall, QSR revenues grew 1% year-over-year, matching Street expectations, driven by a 5.1% rise in restaurant count. Adjusted earnings per share fell to 55 cents from 64 cents a year ago, trailing the expected 58 cents. QSR shares fell 3% in response, and are up by 7% since June 2017, trailing the S&P 500’s 21% gain over that period.
Restaurant Brands’ difficulties are especially acute north of the border. The Tim Horton’s unit saw same-store sales contract by 0.6% and adjusted EBITDA fall by 3.2% from a year ago, while system-wide Tim Horton’s sales rose by just 0.5% on a constant-currency basis despite a 1.9% increase in the restaurant count. By way of explanation, QSR management cited adverse winter weather (what, in Canada?), along with increased promotional activity related to an advertising campaign that “did not drive the incremental engagement [the company] expected.”
Tim Horton’s is a crucial profit center of QSR, accounting for 20% of system-wide sales but 47% of total EBITDA during the first quarter.
With key operating metrics on the wane, Restaurant Brands generates shareholder value in other ways. On Jan. 23, QSR raised its quarterly dividend to 50 cents a share from 45 cents, pushing the dividend yield to 3.1% and spurring a 10% rally in the share price. The move further extends Ba3-rated QSR’s already-stretched balance sheet, as net debt stands at 5.1 times 2019 consensus EBITDA. That compares to an average 3.6 times debt to EBITDA seen in the Ba-ratings group, per an October analysis from Moody’s Investor Service.
But with an A-list cast of investors including Warren Buffett’s Berkshire Hathaway, Bill Ackman’s Pershing Square Capital and Brazilian private equity firm 3G Capital, Inc. (the majority owner), Wall Street remains unabashedly bullish on Restaurant Brands: Of the 22 sell-side analysts covering the name, 17 rate shares “buy,” with five “hold” ratings and zero “sells.” The Street likewise expects free cash flow to jump to $1.43 billion this year and $1.66 billion in 2020, well above last year’s $1.08 billion figure.
Today, QSR is valued at 18.3 times enterprise value to EBITDA, richer than the 16.8 times EV to EBITDA commanded by McDonald’s, the standard-bearer in fast food. On the credit side, Restaurant Brands’ first-lien 4 1/4 notes due 2024 trade just below par for a 209 basis point premium to Treasurys, well inside the 373 basis point spread on offer in the sub-investment grade Invesco Senior Loan ETF (BKLN on NYSE Arca).
Is that lofty valuation justified? Grant’s has argued no, laying out the bearish case for QSR’s “capital-light and debt heavy” business model in the June 2, 2017 edition. The analysis documented Restaurant Brands’ tussle with the Tim Horton's Great White North Franchisee Association, which accused the company of shifting costs from the corporate P&L to the operators in 2017, including through improper use of the franchisee marketing fund for other expenses. That discord suggested potential operating difficulties that would put a dent in QSR’s then-valuation of 38 times trailing adjusted EPS (that figure has since come down to 24 times).
More broadly, the tension between fee-generating, asset-light franchisors and their increasingly cost-squeezed franchisees continues. Even premiere operator McDonald’s is not immune. In October, 400 franchisees voted to form a self-funded alliance called the National Owners Association to advocate for their interests, including retaining control of pricing decisions. That news bodes poorly for the rest of the industry, considering the average McDonald’s generates $2.7 million per year in revenue according to monthly trade magazine QSR. That compares to $1.6 million for Wendy’s Co. and nearly double the $1.4 million average for Restaurant Brands’ Burger King.
Speaking at the Grant’s spring 2018 conference, John Hamburger, president of Franchise Times Corp., crystallized the problem:
On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel basket, trading at double-digit multiples, all the while levering up to pump out cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
Recap April 30
An 8% post earnings downdraft in Google parent Alphabet, Inc. wasn’t enough to keep stocks out of the green, as the S&P 500 erased moderate early losses to edge back above yesterday’s close, while the tech-heavy NYSE FANG+ Index lost just 1% on the day.
Treasurys rallied across the curve, with the 10-year yield dropping back to 2.5%, and commodities could only manage a flat showing despite a weaker dollar. The VIX gave back an early rally to remain just above 13.
- Philip Grant
Monday, April 29, 2019
Come on in, the water's warm
Owe negative
The Chinese economy continues to muddle along,
The Chinese economy continues to muddle along,
Recap April 29
Come on in, the water's warm
From Bloomberg:
As equities surge to all-time highs, volatility has all but vanished. Hedge funds are betting the calm will last, shorting the CBOE Volatility Index, or VIX, at rates not seen in at least 15 years.
Large speculators, mostly hedge funds, were net short about 178,000 VIX futures contracts on April 23, the largest such position on record, weekly Commodity Futures Trading Commission data that dates back to 2004 show.
Owe negative
The Chinese economy continues to muddle along, as a series of eight indicators compiled by Bloomberg encompassing market sentiment, key commodity prices and overall business conditions showed solid levels of activity in April. That follows a 6.4% reported year-over-year GDP growth rate in the first quarter, above the expected 6.3% but below last year’s 6.6% figure, itself the slowest recorded growth rate since 1990.
But even that middling (by Chinese standards) growth has come through significant exertion, as total new credit footed to 9% of last year’s GDP in the first quarter, a figure which almost matches 2009’s (on an annualized basis) credit injection of 40% of GDP. Bloomberg China economist Qian Wan writes that “policy support is still necessary – that means the government needs to keep spending and driving investment to keep domestic demand stable.”
Loose monetary policy likewise hasn’t been able to forestall increasingly frequent signs of corporate distress. Bloomberg notes today that each of China’s four biggest banks have seen their non-performing loan ratios rise to multi-year highs in the most recent quarter, with bad loans at the Bank of China Ltd. reaching the highest since at least 2006. Data from Bloomberg likewise shows that bonds from 44 Chinese companies totaling $42.9 billion are currently “facing repayment pressure,” up 23% from the end of March. Indeed, a trio of prominent names are in the headlines for all the wrong reasons.
Today, Fitch Ratings cut its appraisal of commodity trader Tewoo Group Co.’s dollar-pay bonds by six notches, to single-B-minus from triple-B-minus following a failed debt-for-equity swap late last year. Tewoo, ranked 132nd on the Fortune Global 500 list, saw its senior unsecured 4 5/8 notes due in April 2020 plunge to 71 cents on the dollar from 95 earlier this month.
Tewoo Group 4 5/8s of 2020. Source: The Bloomberg
Over the weekend, conglomerate CITIC Guoan Group Co., Ltd. failed to make an RMB 3 billion ($450 million) bond payment. Guoan, which reported RMB 178.3 billion in total liabilities as of Sept. 30, saw local courts seize RMB 7.9 billion worth of assets in March. China Lianhe Credit Rating Agency cut its assessment of Guoan to single-A from double-A-minus on April 17. One day later, courts froze the company’s 36.4% stake in Shenzhen-listed CITIC Guoan Information Industry Co., Ltd., which boasts a current market cap of RMB 17.6 billion.
Then there’s HNA Group Co., Ltd., the once-massive roll-up now listing under the weight of its gargantuan $80 billion debt load, $25 billion of which matures in less than one year. Since reversing its acquisitive business model last year, HNA sold roughly $45 billion worth of assets in 2018 according to Caijing magazine, but it hasn’t been enough. On April 17, creditors seized golf courses and other pledged assets after the conglomerate was unable to make debt payments.
Brock Silvers, managing director at Kaiyuan Capital, told Bloomberg that we can expect more of the same: “While the company seeks further liquidity, it may become increasingly selective in honoring obligations. It’s possible that HNA might not survive 2019’s planned debt obligations in its current form.” Silvers sums it up: “The situation is dire.”
China’s efforts to control its bloated credit system carry potentially wide-ranging implications. Chinese banking assets footed to $39 trillion as of Dec. 31, equivalent to 44% of total world GDP in 2018. By comparison, the U.S. and Japan, the world’s largest and third-largest economies (China is second), hold a combined $27 trillion in bank assets.
Recap April 29
More bullish price action left the S&P 500 at a closing high for a second-straight session, while the Nasdaq 100 logged a high-water mark of its own. Commodities came under pressure despite a softer dollar, and Treasury yields rose with the two- and 10-year spread ticking to 23 basis points, its widest of the year.
- Philip Grant
Friday, April 26, 2019
'gram reaper
Trouble in paradise, 2019 style.
Trouble in paradise, 2019 style.
Augean stable
Yesterday, New York attorney general’s office announced
Yesterday, New York attorney general’s office announced
Rubber duck
This morning, Uber Technologies, Inc.
This morning, Uber Technologies, Inc.
Recap April 26
'gram reaper
Trouble in paradise, 2019 style. A (translated) headline from Milan-based online news site Affaritaliani suggests discord within the Italian governing coalition of Luigi Di Maio’s Five Star Movement and Matteo Salvini’s League:
Di Maio and Salvini no longer follow each other on Instagram
Augean stable
Yesterday, New York attorney general’s office announced a court order against iFinex, Inc., parent company of crypto-trading venue Bitfinex, for “ongoing activities that may have defrauded New York investors” that trade crypto-currencies. In the complaint, AG Letitia James didn’t mince words:
Our investigation has determined that the operators of the ‘Bitfinex’ trading platform, who also control the ‘tether’ virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million of co-mingled client and corporate funds.
Bitfinex and Tether responded today with identical blog posts on their respective websites, writing that the filings “were written in bad faith and are riddled with false assertions,” while also asserting that “we have been informed that these Crypto Capital amounts are not lost but have been, in fact, seized and safeguarded.”
The AG’s involvement represents the latest chapter in the saga of Bitfinex, the exchange behind purportedly dollar-backed tether, which is used by crypto traders for conversion from fiat to crypto and back again (roughly 80% of all bitcoin trading is done through tether, according to research site CryptoCompare).
Bloomberg reported in November that the Commodity Futures Trading Commission subpoenaed Bitfinex and Tether over suspicions of manipulating the price of bitcoin. In March, Frances Coppola of Forbes spotted language changes on the Tether website to note that the so-called stablecoin is backed not only by cash but also “other assets and loans made by Tether to third parties, which may include affiliated entities.” By way of response to the AG announcement, the price of bitcoin fell 5% today to $5,250.
For an early, and in-depth, look at the curious Bitfinex/Tether relationship, see the Sept. 8. 2017 edition of Grant’s Interest Rate Observer.
Rubber duck
This morning, Uber Technologies, Inc. filed an amended form S-1 with the Securities and Exchange Commission ahead of a planned IPO later this spring. The ride-share giant set a target price range of $44 to $50 per share, valuing the company at $91.5 billion on a fully-diluted basis at the top end of the range.
That’s down from a purported $100 billion high-end valuation previously reported by The Wall Street Journal on April 10, as well as a $120 billion figure pushed by lead underwriters Goldman Sachs and Morgan Stanley last year. But that’s not to say Mr. Market has cooled too much. A top-of-the-range IPO price would value Uber at more than eight times 2018 revenues of $11.3 billion. By comparison, the NYSE FANG+ Index of ten popular tech stocks currently trades at 4.5 times 2018 sales.
As Uber sets its sights lower, the red ink continues to flow. Operating losses footed to $1.13 billion for the first three months of the year (the results have yet to be audited), up slightly from the $1.05 billion loss a year ago. In the five years ended 2018, Uber’s cumulative operating loss stands at $12.1 billion.
Perhaps more concerningly, revenue growth is dwindling. The unaudited $3.1 billion first quarter top line represents a 19% year-over-year increase. That compares to 69%, 53%, 37% and 22% year-over-year revenue increases across the first, second, third and fourth quarters of 2018, respectively. (Figures have been adjusted for divested assets in Russia and China.)
The persistent losses and top-line slowdown haven’t dented the ambitions of Uber’s c-suite. In a February interview with the Financial Times, CEO Dara Khosrowshahi outlined his long-term goals: “I want to run the bus systems for a city. I want you to be able to take an Uber and get into the subway. . . get out and have an Uber waiting for you." The Uber boss likewise drew inspiration from perhaps the premiere corporate success story of this cycle: “Cars are to us what books are to Amazon.”
Of course, Amazon was profitable on a net income basis by 2003, its ninth year of existence. By contrast, 10-year old Uber warned in its S-1 that they “expect our operating expenses to increase significantly in the foreseeable future, and we may not achieve profitability.” Colleague Fabiano Santin noted some other differences in the Nov. 2 edition of Grant’s:
Jeff Bezos’s business was something truly different, offering customer-written book reviews and suggestions of other books and products of interest. Uber lacks such differentiation. Amazon’s physical infrastructure depended mostly on scalable warehous¬es and servers, whereas Uber depends on vehicles and roads over which it has no control. Bezos had a clear plan that, from day one, was contingent only on logistics and scale, whereas Uber’s plan hinges on yet-undeveloped [self-driving] technology and the political will of governments.
Uber’s problem is a fundamental one: There is no indication that the ride-share business model, in which vehicle maintenance and other costs are shunted onto the company drivers (famously designated as “independent contractors,” rather than employees who might otherwise qualify for health insurance and other benefits) is a better one than that of legacy cab companies. Writing in Vol. 44 of Transportation Law Journal in 2017, transportation analyst Hubert Horan got to the heart of the matter:
It is inconceivable that hundreds of thousands of independent, poorly-financed Uber drivers could ever achieve lower vehicle ownership, financing, licensing and maintenance costs than professional fleet managers at tradi¬tional taxi/limo companies, or that the drivers could do a better job balancing long-term asset costs against local market revenue potential.
Not only does shifting operating costs and capital risk from Uber’s investors onto its drivers fail to eliminate them from the overall business model, but the shifting makes the costs and risks higher.
Meanwhile, ride-sharing competition continues to rage. On Wednesday, the Nikkei Asian Review reported that China’s Didi Chuxing, which is 15.4% owned by Uber, “has started recruiting drivers in Bogotá as it readies its Colombian roll out,” intensifying Didi’s attempted Latin American land grab. SoftBank Group Corp. owns a stake in both Uber and Didi.
Recap April 26
Another green day for stocks left the S&P 500 at a fresh closing high and up 1.1 % for the week. A weaker dollar didn’t prevent a sharp oil selloff, as WTI fell back below $63 per barrel following some Trump Twitter commentary. Treasurys rallied with the 10-year yield dropping to 2.5%, and the VIX fell back below 13.
- Philip Grant
Thursday, April 25, 2019
Modern monetary practice
At the end of today’s policy communique, the Bank of Japan
At the end of today’s policy communique, the Bank of Japan
Sincerely yours
Things are once again heating up in emerging markets,
Things are once again heating up in emerging markets,
QT Progress report
Recap April 25
Modern monetary practice
At the end of today’s policy communique, the Bank of Japan said it is considering “the introduction of an ETF Lending Facility, which will make it possible to temporarily lend ETFs that the Bank holds to market participants.” The BoJ’s QE program has already sucked volume out of the Japanese Government Bond market, as entire days now pass without benchmark issues changing hands. With approximately 80% of Japan’s ETF market in the hands of the BoJ, the central bank is opting to play market maker rather than take a step back.
While the BoJ eyes the securities lending business, the Swiss National Bank posted first quarter results that would make any fund manager jealous. Profits for the period registered at CHF 30.7 billion ($30.1 billion), with overall mark-to-market gains on its equity portfolio footing to CHF 17.4 billion. That compares to an overall CHF 6.8 billion loss, including CHF 3.3 billion in equity-related losses, in the first quarter last year.
In a bid to prevent unwanted currency appreciation, the SNB prints francs out of thin air, sells them to buy euros then diversifies into other assets like U.S. equities. In doing so, the gnomes have accumulated an asset stockpile equivalent to 115% of last year’s GDP, compared to 39% for the European Central Bank and 19% for the Federal Reserve. Then, too, the SNB’s negative 0.75% overnight interest rate stands apart from the ECB’s negative 0.40% deposit rate, let alone the positive 2.4% Fed Funds Rate.
Sincerely yours
Things are once again heating up in emerging markets, as a pair of mainstays appear to be running headlong into crisis.
Argentina is one such specimen, with Bloomberg noting that based on credit default swaps, the implied probability of default over the next five years had risen to 61% this morning. The country is beset on all sides, with runaway inflation (CPI rose 54.7% year-over-year in March) occurring in tandem with a sharp economic contraction as fourth quarter GDP fell 6.2% year-over-year. Even with a $56 billion bailout from the International Monetary Fund last year (the IMFs largest ever), the Argentine peso continues to sink, now trading at 45 per U.S. dollar, compared to less than 21 a year ago.
With Argentina’s economy on the ropes, an unfriendly face (to investors at least) looks to return to the scene. Left-wing former President Cristina Fernández de Kirchner appears eager to reclaim her old job, releasing a new book tomorrow titled “Sincerely.” Fernández, who oversaw Argentina’s prior descent into default in 2014 and famously feuded with creditors including Elliott Management thereafter, currently enjoys the upper hand. An April poll conducted by Buenos Aires-based consulting firm Elypsis showed 44% of respondents with a positive view of the former president, compared to 28% for the more market-minded incumbent Mauricio Macri.
Writing today, strategists at Brazil’s XP Investments note that markets appear to be pricing in a Fernández return to power and accompanying leftward lurch, a prospect which is overshadowing positive developments including an improving Argentine trade balance. The XP team concludes: “After having followed emerging markets for 18 years, we know that fundamentals are all but irrelevant in panic times like this one.”
The political upheaval has added further woe to Argentina’s beleaguered creditors. The dollar-denominated century bonds due 2117 have fallen to their lowest since issuance, now fetching 68 on the dollar for a yield-to-maturity of 10.6%.
As Argentina faces potentially drastic political change, Turkey resumes its economic slide. Today, the Turkish lira fell to its weakest level in six months, now fetching 5.95 per dollar compared to 5.2 in February. With inflation continuing to rage (CPI rose 19.7% year-over-year in March), the Central Bank of the Republic of Turkey has opted for a counterintuitive approach. Today, in announcing no change in rates, the CBRT dropped language in the statement suggesting it will tighten policy as needed.
That decision didn’t sit well with some investors. Win Thin, global head of currency strategy at Brown Brothers Harriman & Co., told Bloomberg: “This is much worse than expected and supports the view that policy has gone off the rails. . . no sane central bank would be leaning dovish at a time like this for Turkey.”
Mr. Market shrugs. The iShares J.P Morgan U.S. Dollar Bond ETF remains near 52-week highs despite the evident struggles of Turkey and Argentina, which account for a combined 6.4% of the fund’s total assets. More broadly, the U.S. Dollar Index sits at a 52-week high of its own, pressuring foreign borrowers who have seen local currencies lose value against the greenback.
Meanwhile, a pair of ominous economic signs have appeared in the last 24 hours. Bloomberg, citing data from the Dutch statistics office, reports that global trade suffered a sequential 1.9% decline in the three-months through February, the worst three-month period in a decade. Also, yesterday evening, bellwether South Korea logged a 0.3% sequential GDP decline in the first quarter compared to an expected 0.3% gain. Exports, which account for roughly half of the South Korean economy, saw volumes fall by 2.6% from the fourth quarter.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.739 trillion this week, down $4.5 billion on a sequential basis and $13.6 billion below the trailing four-week average. Mortgage-backed securities accounted for all of the decline for a second straight week.
Recap April 25
A second straight sideways showing saw the S&P 500 remain just under Tuesday’s closing highs, up by just under 1% for the week so far. Treasury yields edged higher across the board, while another dollar rip helped push WTI crude back under $65 per barrel. After spiking to a two-week intraday high in midday, the VIX retreated this afternoon to finish at 13.
- Philip Grant
Wednesday, April 24, 2019
Beast of burden
This morning, AT&T, Inc. (T on the NYSE) reported mixed first quarter results. Adjusted EBITDA of $14.8 billion topped the expected $14.76 billion, while revenues of $44.8 billion were a bit light of the $45.11 billion top-line consensus.
But as headline figures were broadly in-line, other key metrics showed sharp deterioration. Namely, subscriber counts shrank by a greater-than expected pace across the video division (which lost 627,000 compared to an expected decline of 389,000) as well as the postpaid wireless unit (down 204,000 versus a consensus loss of 50,000). Investors voted with their feet, as T shares fell by 4%. But the bond market took a different tack, as the senior unsecured 3.4% notes due 2025 climbed back above par this morning for the first time since 2016, and up from 93 cents on the dollar in late November.
For Baa2/triple-B-rated AT&T, which has undertaken a pair of ambitious acquisitions (DirecTV in 2015 for $67 billion and Time Warner, Inc. in 2018 for $110 billion) in recent years, a towering debt load is the elephant in the phone booth. The company carries $176 billion in borrowings, which, along with additional operating lease and unfunded pension liabilities, brings its total indebtedness to $213 billion, the most for any investor-owned, nonfinancial company in the world. The consolidated leverage ratio sits at 3.8 times 2019 consensus EBITDA, well above the 2.7 times average for the Baa category according to data compiled by Moody’s Investors Service in October.
Eager to avoid a credit-rating downgrade, management is now prioritizing the paydown of that debt load. In the earnings release, CEO Randall Stephenson reported that the company is “on plan to meet our de-leveraging goals with strong free cash flow and asset sales.” Concurrent with today’s first quarter results, AT&T announced it will sell office space at 30 Hudson Yards, the third-tallest building in New York, to real estate firm Related Cos. for $2.2 billion.
AT&T’s newfound emphasis on balance sheet repair at the expense of growth comes as no surprise to Craig Moffett, co-founder and one-half eponym of research firm MoffettNathanson, LLC. Speaking at the Grant’s fall 2018 conference, Moffett said AT&T will be forced to pivot toward shareholder unfriendly strategies in the pursuit of debt reduction. The analyst noted that even after coughing up that hefty price tag for Time Warner, the Street’s expectation for fiscal 2019 adjusted EBITDA remained below where it had been at the end of 2016, i.e. prior to the merger.
Following today’s first quarter results, Moffett zeroed in on the broader implications of AT&T’s strategic about-face toward creditors, and away from the stock market.
For the better part of a year, we’ve warned that AT&T’s servitude to the debt market would translate to better short-term profitability but weaker long-term growth. . . This narrative is no longer controversial; there is now broad consensus about what we will see in 2019: better EBITDA, perhaps, but weak subscriber trends.
Moffett also draws attention to the sprawling and less than complementary nature of AT&T’s asset portfolio following its corporate shopping spree:
Beyond the short-term narrative about prioritizing the debt markets (free cash flow), over the equity markets (growth), a bigger and more fundamental question looms. How do all these pieces fit together?
AT&T is delivering on their short-term free cash flow commitments, but, in the process, they are paying a rather steep long-term price.
For our part, Grant’s believes that the former Ma Bell’s machinations are something of an allegory for this EZ money era (see the Jan. 25 edition of Grant’s Interest Rate Observer for more on AT&T). Central bank administered, bottom-scraping interest rates serve to pull forward demand, incentivizing corporate investment, share buybacks and increased leverage. In a research report today, analysts at Bernstein Research suggest that this dynamic may be close to exhausting itself:
U.S. equities are highly dependent on buybacks. 2018 saw $1 trillion of buybacks announced by U.S. companies compared to a total net flow of all active and passive funds of ‘merely’ $100 billion. Many investors seem comfortable that, with the Fed on hold, U.S. corporates can merrily carry on issuing issuing triple-B-rated debt and buying back stock. We disagree.
The low quality of U.S. corporate debt plus a slowing in growth, we think, leads to rising credit spreads over the next 12 months which [will] in turn put the kibosh on buybacks.
Recap April 24
Stocks cruised to a sideways finish, with the S&P 500 hardly wandering more than a few basis points from the unchanged mark all day to consolidate yesterday’s push to a closing high-water mark. A greenback rally that pushed the U.S. Dollar Index to a ten month closing high didn’t prevent the Goldman Sachs Commodity Index from likewise finishing in the green, while Treasurys were again well bid as the 10-year yield fell back to 2.52%. The VIX edged higher to 12.8, its highest close in two weeks.
- Philip Grant
Tuesday, April 23, 2019
So, they'll have two?
An afternoon headline from The Wall Street Journal:
An afternoon headline from The Wall Street Journal:
Cyprus hill
Kicked in the 'coin
Timing is everything.
Timing is everything.
Recap April 23
So, they'll have two?
An afternoon headline from The Wall Street Journal:
Deutsche Bank Considers Forming ‘Bad Bank’
Cyprus hill
Bloomberg reports today that the Republic of Cyprus is preparing to come to market in a two-part euro bond offering with issues maturing in 2024 and 2049. Proceeds are earmarked for the repayment of an emergency €2.5 billion ($2.8 billion) Russian loan from 2012, in the teeth of the European debt crisis.
With fundamentals improving, the small E.U. member state continues to strike while the iron is hot. Just two months ago, triple-B-minus-rated Cyprus managed to place €1 billion in 15-year notes (then the longest issue in Cyprus’ history) at a 2.75% coupon. That issue was oversubscribed by eight times according to International Financing Review and has since rallied to 107 cents on the euro for a yield-to-worst of 2.19%. By comparison, the split-rated U.S. borrows at 2.57% for 10 years.
Following the banking crisis of 2012 to 2013, in which Cyprus became the first eurozone country to employ capital controls and, also, inflict haircuts on deposit holders, things are clearly on the upswing in the eastern Mediterranean. In September, S&P Global Ratings upgraded Cyprus’ credit rating to investment-grade territory, citing an anticipated growth acceleration through 2021 that will allow the government further to ease its debt burden, which stood at 102.5% of GDP as of year-end according to Eurostat, down from 108% in 2014. At a business forum last Thursday, finance minister Harris Georgiades said the government is targeting a debt to GDP ratio of 90% by the end of 2020.
Then, too, the banking system is on the mend, as an IMF research report from November found that non-performing loans had declined to 39% of debt outstanding, representing 85% of GDP, as of June 30. That’s down from 48% of total loans and 161% of GDP at the peak of the crisis in 2014.
A feel-good comeback, to be sure (move over, Tiger Woods). But 2.19%?
Kicked in the 'coin
Timing is everything. From The Wall Street Journal:
Masayoshi Son, the billionaire founder of SoftBank Group Corp., made a huge personal bet on bitcoin just as prices for the digital currency peaked, losing more than $130 million when he sold out, according to people familiar with the matter.
The investment came at the peak of the bitcoin frenzy in late 2017 after the digital currency had already risen more than 10 fold that year. The exact size of the bet couldn’t be determined, but bitcoin peaked at nearly $20,000 in mid-December 2017 and Mr. Son sold in early 2018 after bitcoin had plummeted, the people said.
Still, one needn’t weep for Masa Son, who has a net worth of $24 billion according to Forbes and whose SoftBank Group Corp. (9984 on the Tokyo Stock Exchange) is worth ¥12.6 trillion ($113 billion), with shares up a whopping 58% thus far in 2019.
A 37% year-to-date rally in Alibaba Group Holding Ltd. (BABA on the NYSE), which is 29% owned by SoftBank and now sports a market cap of $485 billion, has helped. A ¥600 billion share buyback, equal to just over 5% of SoftBank’s current market capitalization, has also contributed to the ascent. Announced on Feb. 6, the buyback was 64% completed as of the end of March, according to the company.
With shares riding high, the deal-minded Son continues to look for new targets. This afternoon, Bloomberg reports that SoftBank is considering an investment to buy 5% of German online payment company Wirecard A.G. Wirecard has seen its shares fall by more than 25% since January following investigative reports published by the Financial Times questioning the company’s accounting practices.
For more on Son and SoftBank, see the Dec. 13, 2017 and Feb. 22 editions of Grant’s Interest Rate Observer.
Recap April 23
A big day for the bulls saw the S&P 500 rise nearly 1%, finishing at a fresh record high and extending the year-to-date gains to 17%. The tech-heavy NYSE FANG+ Index jumped nearly 3% to sit higher by 29% for 2019, and within 8% of its own high-water mark.
Elsewhere, a strong U.S. dollar rally didn’t prevent another green finish in the energy patch, as WTI crude rose above $66 a barrel for the first time this year. Treasurys were also bid, with the 10-year yield falling two basis points to 2.57%.
- Philip Grant
Monday, April 22, 2019
Meet the new boss
This morning, The Kraft Heinz Co.
This morning, The Kraft Heinz Co.
Sold to you
China’s Shanghai Composite fell by nearly 2% today,
China’s Shanghai Composite fell by nearly 2% today,
Recap April 22
Meet the new boss
This morning, The Kraft Heinz Co. (KHC on the Nasdaq) announced that CEO Bernardo Hees will be leaving the company at the end of June. Hees, who was named CEO in 2015, has overseen a rough recent stretch including a $15.4 billion noncash asset write down, stagnant revenues, shrinking operating profits and a subpoena from the Securities and Exchange Commission related to questionable accounting practices. Upon his departure, Hees will return to Brazilian private equity firm 3G Capital, LLC (which owns a 22% stake in KHC), where he has been a partner since 2010.
As for succession at Kraft Heinz, 3G is keeping it in the family. Hees will be replaced by Miguel Patricio, fresh from a 20 year career at fellow 3G portfolio company Anheuser-Busch InBev S.A./N.V. (ABI on the Brussels Stock Exchange and BUD on the NYSE), most recently as chief marketing officer.
Kraft Heinz and Anheuser-Busch share something in common besides management overlap and 3G ownership: Daunting debt loads, particularly so for their investment-grade status. According to an October analysis from Moody’s, the average North American non-financial corporate rated Baa (the lowest rung of investment grade) carried net debt of 2.7 times EBITDA as of year-end 2017. By comparison, Baa3-rated Kraft-Heinz carries 4.3 turns of leverage based off 2019 consensus estimates, while Baa1-rated Anheuser-Busch is leveraged to the tune of 4.8 times estimated EBITDA.
Let it be said that Grant’s Interest Rate Observer had the Brazilians’ number. See the issues dated March 25, 2016, March 24, 2017, and Feb. 9, 2018.
Sold to you
China’s Shanghai Composite fell by nearly 2% today, following a Friday statement from the politburo describing first quarter economic conditions as “generally stable and better than expected.” Of course, an abundance of new credit figures prominently in that better than expected start to 2019, as total new financing expanded by an amount equal to 9% of last year’s GDP, rivaling the full-year pace of 2009’s massive economic stimulus (Almost Daily Grant’s, April 12).
The politburo statement potentially signifies that the burst of credit growth will be soon abating. Dai Ming, fund manager at Hengsheng Asset Management Co., told Bloomberg that “people have come to a clear consensus that there won’t be any aggressive stimulus that floods the economy with excessive liquidity, indicating limited room for valuation recovery.” Valuations have already been fattening. Even after yesterday’s pullback, the Shanghai Composite has been the best performing stock market in the world, up 29% year-to-date.
As Beijing hints that it may tap the monetary brakes, China’s corporate sector races to raise cash. Bloomberg relays today that since January, nine companies have announced plans to issue rights offerings totaling RMB 40.5 billion ($6 billion), more than double the full-year 2018 figure. Anne Stevenson-Yang of J Capital Research concurs, noting in a report today that 200 Chinese firms have conducted initial public offerings across the local A-share, Hong Kong and U.S. markets over the past 12 months, as companies look “to grab everything that is not nailed down.” Stevenson-Yang cautions that financial shenanigans are particularly prevalent among this cash-raising cohort:
Investors know well—or should know—that fraud is thick on the IPO playing grounds in China, and the incentives to generate nosebleed valuations by fraudulent means are core to the playbook. After all, there are no penalties in China for committing securities fraud in the U.S., where Chinese authorities believe U.S. regulators should look out for their own.
As we recently reported, three insiders at UXIN Ltd., an online dealer and financier of used cars that listed in the U.S. at the end of June last year, managed to take home around $450 million in cash before lock-up had even expired. Listing in an overseas market. . . is the lowest-risk way known to man of robbing a bank.
Among the tricks employed by Chinese IPO candidates to achieve more favorable valuations: Making up profits and, then, overstating capital expenditures to explain away the lack of cash on the balance sheet, generating revenues by selling products below cost (i.e. the Uber model) and using up-front fees generated from a franchise network business model to goose gross revenues on a one-time basis.
Recap April 22
Stocks erased early losses to finish little changed in very light trading, as the SPDR S&P 500 ETF saw just 38 million shares change hands, the lowest volume session since August and less than half of the one-year average daily turnover of 86 million shares.
A strong day for oil headlined the commodity action, with WTI crude approaching $66 a barrel on news the Trump administration will reportedly end sanctions waivers for Iranian exports. Treasurys sold off, with the 10-year yield rising three basis points to 2.58%, and the VIX gave back most of its early gains to finish below 12.5.
- Philip Grant
Thursday, April 18, 2019
Born on the bayou
Amazon.com, Inc.’s Web Services (AWS) unit
Amazon.com, Inc.’s Web Services (AWS) unit
QT progress report
Recap April 18
Born on the bayou
Amazon.com, Inc.’s Web Services (AWS) unit has been the engine behind the company’s spectacular recent performance, with operating income of $7.2 billion last year, up 68% year-over-year and accounting for 59% of Amazon’s total operating income. The near-consensus cadre of bullish analysts (48 out of 50 tracked by Bloomberg have a “buy” rating on Amazon) call for more of the same. But will an ongoing government kerfuffle derail the AWS miracle?
Last Wednesday, the Department of Defense (DoD) cleared itself of wrongdoing following an internal investigation into the forthcoming award of the $10 billion cloud computing Joint Enterprise Defense Initiative (JEDI) program. Yet the Pentagon’s self-exoneration was not comprehensive, as Bloomberg noted that: “The investigation uncovered evidence of unethical conduct that will be referred to the DoD inspector general for a separate review.”
The JEDI contract has been hotly contested among some of the largest cloud-computing companies in the U.S., and for good reason. The winner-take-all award has been narrowed to two contenders, AWS and Microsoft Corp. According to an updated timeline issued by a Federal judge Tuesday, the JEDI mandate will be awarded sometime after mid-July.
With the stakes high, Uncle Sam’s corporate suitors are pulling no punches. In December, recently-eliminated Oracle Corp. filed suit with U.S. Court of Federal Claims asserting that the JEDI process has been marred by conflicts of interest. The suit alleges that a pair of Amazon-connected former DoD staffers unduly influenced the proceedings in favor of AWS. One of whom, Deap Ubhi, worked in business development at AWS from 2014 to 2016 before joining the DoD, during which period he continued to praise Amazon from his Twitter account (including tweeting “once an Amazonian, always an Amazonian” in January 2017) while criticizing Oracle, Alphabet, Inc.’s Google and other Silicon Valley firms.
According to an April 5 report by The Capitol Forum, in January 2017 Ubhi lamented missing a conference call between Defense Department officials and AWS personnel, writing via email: “I am ex-AWS, and would have liked to have been on the call.” Eight months later, when acting as the DoD’s lead JEDI project manager, Ubhi asked DoD higher-ups to name him “the point of contact for all industry conversations.” After reportedly recusing himself from the JEDI procurement process in late October, Ubhi left the DoD, returning to AWS in November 2017.
In March, the Federal News Network reported that the FBI is involved in the DoD inspector general investigation, potentially signaling “some sort of wrongdoing involving DoD civilian personnel and/or DoD procurement procedures.”
In addition to Ubhi, other former DoD officials have seen their actions around JEDI come under scrutiny. In August, Vanity Fair reported that Sally Donnelly, a former senior advisor to Secretary of Defense James Mattis from January 2017 to March 2018, “sold her stake in [consulting firm] SBD Advisors, LLC for $1.17 million two days before she went to work for Mattis.” But Donnelly continued to receive payments from the company, which counted Amazon as an active client. Two weeks after Donnelly left the Pentagon, SBD was purchased by C5 Capital, “a private equity firm with direct ties to Amazon.”
Anthony DeMartino, Donnelly’s colleague at SBD, who was also named in the Oracle lawsuit, likewise consulted for Amazon before moving to the DoD to serve as Mattis’ deputy chief of staff.
The close proximity of Donnelly and DeMartino to the Secretary of Defense was a favorable development for AWS, as The Capitol Forum reported on March 15 that Mattis “expressed interest in meeting with Amazon CEO Jeff Bezos at a dinner” with Donnelly in early 2017, according to emails received via a Freedom of Information Act request. Mattis and Bezos met in Seattle in August 2017.
As controversy over JEDI continues to swirl, another government agency pivots away from the winner-take-all format. On March 22, the CIA unveiled a new Commercial Cloud Enterprise (C2E) initiative, in which the agency disclosed plans to use “multiple commercial cloud vendors that can provide” necessary services.
An anonymity-seeking, D.C.-based source believes that the CIA’s move might suggest wider government dissatisfaction with AWS, which commanded 46% of worldwide public cloud infrastructure market share as of year-end 2017 according to the International Data Corporation:
The AWS story, as sold to enterprise customers and the Street, is built upon the intelligence community (IC) reference case and the cash that has come in from that deal. The IC’s movement toward a multi-cloud environment is an admission that use of AWS has not been successful as claimed, increasing the likelihood of massive IC contracts for the other hyperscale cloud providers.
Amazon.com, Inc. ten-year stock price, 37% compound annual growth rate. Source: The Bloomberg
Continued cloud dominance is crucial to sustaining Amazon’s success. Analyst consensus calls for Amazon’s net income margin to jump to 6.4% in 2019 from 4.3% a year ago, thanks to expected growth in AWS. But at the same time, the core e-commerce business is showing signs of a slowdown, as Bloomberg estimated last week that gross merchandise volume growth fell to 19% last year from 24% and 27% in 2017 and 2016, respectively.
While the C.I.A.’s move toward multiple cloud vendors highlights the difficulty in growing AWS’ commanding public cloud market share, legal risks surrounding JEDI represent a potentially underappreciated pitfall to the AMZN bull case. Our D.C.-based observer concludes:
If AWS is found to have committed wrongdoing related to DoD’s JEDI contract, it could be debarred as a government contractor. My prediction: Amazon bulls expecting continued blistering growth from AWS will be in for disappointment.
Asked for comment on Thursday afternoon, Amazon had not responded by press time.
QT progress report
A $5 billion sequential decline in mortgage-backed securities holdings left the Fed’s portfolio of securities held outright at $3.744 trillion, a figure which sits $17.6 billion below the trailing four-week average. Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 11.8%, a 7.7% annualized pace.
Recap April 18
Stocks traded flat once again to finish the holiday shortened-week little changed, as the Nasdaq 100 Index managed to eke to a fresh closing high while the S&P 500 sits about 1% below its own high-water mark. Commodities finished mixed with WTI crude and gold finishing at $64 per barrel and $1,275 per ounce, respectively, and Treasurys rallied as the 10-year yield retreated from a near one-month high to 2.56%. The VIX closed just above 12, near the year-to-date low.
- Philip Grant
Tuesday, April 16, 2019
Sick Burn
Revenge of the Squares?
Revenge of the Squares?
Indication of interest
Today, Bank of America Corp. (BAC on the NYSE)
Today, Bank of America Corp. (BAC on the NYSE)
Recap April 16
Sick Burn
Revenge of the Squares? Authorities are trying to put the clamps down on Burning Man, the annual Nevada gathering “that connects each individual to his or her creative powers, to participation in community, to the larger realm of civic life, and to the even greater world of nature that exists beyond society,” according to the festival’s website. From today’s Wall Street Journal:
The Bureau of Land Management wants to encircle Burning Man’s makeshift desert town with thousands of physical barriers and have security guards screen attendees, called “Burners,” for contraband. The agency. . . is also calling for organizers to place dumpsters on site and to haul out trash privately to lessen the impact on nearby communities.
If implemented, the measures would send the festival’s total expenses up nearly 60% from its current $38 million, said Marnee Benson, the festival’s associate director of government affairs. Money isn’t the only issue, though. “The vision the BLM has laid out for Burning Man is not the vision we would choose to produce,” Ms. Benson said.
All sorts of visions have emanated from the desert festival. From an Oct. 9, 2013 GreenBiz profile of SolarCity Corp. founder Lyndon Rive:
The idea of starting SolarCity came in 2004 during a drive to the Burning Man festival with his cousin, famed tech entrepreneur Elon Musk. Rive said he wanted to start another company and that he was passionate about trying to solve global environmental challenges. Musk suggested going into solar. Musk is now chairman of SolarCity as well as CEO of Tesla Motors and SpaceX.
Indication of interest
Today, Bank of America Corp. (BAC on the NYSE) chief financial officer Paul Donofrio told listeners-in to the first quarter earnings call to expect net interest income (NII) growth of 3% this year, down from 6% in 2018.
Peer Wells Fargo & Co. (WFC on the NYSE) telegraphed similar deterioration last Thursday. CFO John Shrewsberry said he now anticipates NII will decline by 2% and 5% for 2019, down from an estimated range of plus 2% to minus 2% supplied just two months ago, owing to “tightening loan spreads resulting from a competitive market with ample liquidity and continued upward pressure on deposit pricing.”
For the money center banks, the recent rate hikes have spurred a margin-eroding consumer migration into income generating accounts. In the first quarter, Bank of America saw interest bearing deposits rise 11.8% year-over-year to $907 billion, while non-interest bearing deposits fell 9% year-over-year to $395.5 billion.
The margin pressures cited by both Bank of America and Wells Fargo were anticipated by Christopher Whalen, publisher of the Institutional Risk Analyst, in the Oct. 19 edition of Grant’s Interest Rate Observer. Arguing that rising interest rates would confer less of an advantage on the big institutions than was widely anticipated, Whalen identified the key problem:
The average cost of funds for the whole industry right now is a little over 1%. The average earnings on total earning assets is barely 3%. You’ve got about 2 points of spread. If funding costs keep rising faster than earnings, then you will see net in¬terest margin contract by Q1. How do you think the Street will react to that?
Whalen reiterated his views in a blog post Sunday, while quantifying the extent to which rising costs could impact profitability:
At Q4 2018, total funding costs for the banking industry were just shy of $40 billion. As noted in a previous comment, we expect quarterly bank funding costs to be over $60 billion by year-end 2019. To provide some perspective, the net income of the entire US banking industry was $59 billion in Q4 2018. Since 2014, when bank funding costs troughed at $11 billion per quarter, interest expense has grown four fold and at an accelerating rate.
As lending spreads have collapsed, with the 10-year yield currently offering a 17 basis point premium over the three month Treasury note compared to 267 basis points five years ago, the environment has swung from accommodative to constricting for the banks:
Between 2008 and 2014, the FOMC subsidized the U.S. banking sector to the tune of tens of billions per quarter in incremental income. Now as the financial markets slowly claw their way back to normal, banks and leveraged investors are entering a dangerous period of falling margins over funding and uncertainty about the future direction of interest rates.
Without a complete capitulation by the FOMC and short-term rate cuts, we see no avenue for banks to avoid a squeeze on net interest income in coming quarters. Yes, President Trump and Larry Kudlow are right about the Fed and interest rates.
As lending spreads contract, the credit cycle continues to age. “We are in the trough,” Whalen told Grant’s today. “Defaults are going to rise in 18 to 24 months,”
Recap April 16
A flat finish for stocks saw the S&P 500 give back early gains as well as recoup a sharp afternoon downdraft, while the tech-heavy Nasdaq 100 reached an all-time intraday high before pulling back a bit to finish just below the Aug. 29 peak.
Commodities came under pressure, with gold falling to a fresh 2019 low of $1,276 an ounce, and Treasurys were also for sale with the 10-year yield rising to 2.59%, the highest since late March.
- Philip Grant
Monday, April 15, 2019
I really think so
Last Thursday, European Central Bank
Last Thursday, European Central Bank
Strangers things
A new frontier in innovation: Annoyance-as-a-service.
A new frontier in innovation: Annoyance-as-a-service.
Down the rabbit hole
In a recent research note,
In a recent research note,
From hunger
Analytics firm TDn2K reports
Analytics firm TDn2K reports
Recap April 15
I really think so
Last Thursday, European Central Bank governing council member François Villeroy de Galhau dismissed comparisons between the Eurozone and Japan. Speaking at the International Monetary Fund’s semi-annual meeting in Washington, Villeroy noted that it might be “fashionable” to make such a comparison but retorted: “I don’t think it is accurate. The Eurozone is not a situation of Japanization.”
Yet the results in measured rate of inflation suggest some merit to the comparison. Since April 2013, the year-over-year change in Eurozone CPI inflation has averaged 0.9%, matching that of Japan during the same period.
Strangers things
A new frontier in innovation: Annoyance-as-a-service. From Bay Area online news site Mission Local:
In recent weeks, Mission residents have been receiving curious missives in their mailboxes inquiring whether they’d be game to monetize their kitchens and living rooms by having strangers drop in and start doing office work.
It’s a [pitch] from Cobo, a startup hoping to capitalize on what its founder calls “a billion-dollar market”: Placing lonely freelancers pining for company into people’s homes, monetizing that home, and taking a cut.
Down the rabbit hole
In a recent research note, UBS Group A.G. chief economist Daniel Kalt forecast tighter monetary policy in Switzerland, writing that the Swiss National Bank will likely raise interest rates from the current negative 0.75%, which is the lowest of any major central bank according to Bloomberg.
But on Saturday, SNB chairman Thomas Jordan talked about about pushing rates deeper into negative territory. In a speech in Washington, Jordan remarked that: “We always stress the point that we have room to lower interest rates still further.”
From hunger
Analytics firm TDn2K reports that comparable restaurant store sales rose by 1.15% year-over-year in March, raising the rolling three-month growth rate to 0.8%. TDn2K notes that for the first time since 2015, restaurants have managed four consecutive quarters of positive same-store sales growth.
But is that upturn in industry fortunes enough? Over the last 12 months, TDn2K’s same-store sales figure has shown an average year-over-year growth rate of 0.96%, far below the 2.3% average rise in headline CPI since April 2018.
The less-than-stellar growth profile doesn’t seem to bother Mr. Market, as the S&P Restaurants Index commands an enterprise value of a healthy 16.5 times 2019 consensus EBITDA, compared to 11.7 times enterprise value to forward EBITDA for the S&P 500 Ex-Financials Index. But as growth in sales lags behind the rate of inflation, franchise operators continue to be squeezed. According to a November franchisee survey reported by Restaurant News, almost 90% of respondents were “unsatisfied with their cash flows.”
For more on the group, including an analysis of a pair of picks-to-not-click, see the Feb. 8 issue of Grant’s Interest Rate Observer.
Recap April 15
Stocks recouped modest early losses to leave the S&P 500 within 1% of the Sept. 20 high water mark, while the Goldman Sachs Commodity Index rose back to near its 2019 high despite weakness in WTI crude and gold, which finished at $63.50 per barrel and $1,288 per ounce, respectively. Treasurys caught a modest bid with the 10-year yield finishing at 2.55%, and options volatility remains muted as the VIX settled below 12.5.
- Philip Grant
Friday, April 12, 2019
A TAM too far
In a form S-1 filed yesterday ahead of an initial public offering, Uber Technologies, Inc. calculated the total addressable market (TAM) of $5.7 trillion for its core ride share business, along with a $2.8 trillion TAM for its Uber Eats business and a $3.8 trillion total market for its Uber Freight unit. In total, the $12.3 trillion market identified by Uber for those three businesses represents 14.5% of 2018 world GDP.
The unicorn, which racked up an $11.3 billion operating loss last year, is expected to garner a valuation of $90 billion to $120 billion upon listing.
Faulty transmission
Some eye-catching credit data out of the People’s Bank of China today: Total credit grew by a record RMB 2.8 trillion ($420 billion) in March, far above the RMB 1.85 trillion consensus estimate. During the first quarter, total new financing ballooned to RMB 8.2 trillion, up 40% from a year ago and equivalent to 9% of China’s reported 2018 GDP. Extrapolated to a full year, the credit expansion is just behind the 40% jump in total financing as a percentage of GDP seen in the massive stimulus year of 2009.
That liquidity surge coincides with a “recovery extending across both sectors and geographies, with every major sector and each one of our regions showing better revenue results than Q4,” according to the China Beige Book.
Beyond opening the credit spigots, Beijing is trying to stoke economic growth in other ways. Last week, Xinhua’s Economic Information Daily reported that policymakers are crafting tax cuts and other fiscal policies to help spur consumption. In addition, the National Development and Reform Commission announced Monday that small and midsize cities (populations of between one and five million) will relax hukou, or household registrations, in a bid to boost real estate markets.
Regulators have also targeted the stock market. Bloomberg reports that nearly 700 firms bought back stock between December and January after authorities relaxed rules around the practice, up from 609 corporate buybacks in 2018 through early November. Mark Huang, analyst at Bright Smart Securities, explained to Bloomberg that: “China is looking to developed markets like the U.S., where buybacks are a key approach to sustaining a long-term bull market.”
Those exertions are bearing fruit, if asset prices are any guide. Thus, China’s Shanghai Composite Index has ripped higher by 28% year-to-date, while contracted project sales from an index of nine property developers jumped 20% in March, according to data from Bloomberg. That follows a 9.4% year-over-year advance in February property investment according to the National Bureau of Statistics, the hottest reading since 2014.
But the stimulus barrage has yet to translate into much acceleration in the money supply (M2 grew at 8.6% year-over-year, up from 8.3% average growth in 2018 but far below the 16% average since March 1996), nor improve the balance sheets of China’s debt-soaked corporations. S&P Global Ratings cut its assessment of 13 companies in the first quarter, the highest level of downgrades since 2016, with analyst Cindy Huang noting that “despite a slew of easing measures from the policy makers, small private firms still lack sufficient liquidity.” Peer Fitch Ratings has issued 30 corporate downgrades year-to-date, compared to just five upgrades. That follows a jump in yuan-denominated debt defaults to RMB 119.6 billion last year according to Singapore-based DBS Bank, four times 2017’s level.
With RMB 2 trillion of bad debt sitting on Chinese bank balance sheets according to research from UBS Group A.G., things are likely to get worse before they get better. A survey of 202 bankers conducted by China Orient Asset Management Co. finds that 83% of respondents believe that bad loans will increase in 2020.
Why that disconnect between free flowing liquidity and rising corporate distress? Zhu Min, head of Tsinghua University’s National Institute of Financial Research and former deputy governor of the PBoC, told Caixin that while a decade of easy money has goosed financial markets, stimulus has not helped larger banks adequately lend to smaller companies which need liquidity and can often offer little collateral. Zhu asks: “How can financial institutions lend money to small-to-micro companies if all of their money has been invested in the stock market?”
- Philip Grant
Thursday, April 11, 2019
A permanently low plateau
“As I say, we wish they hadn't raised,”
“As I say, we wish they hadn't raised,”
Tip of the iceberg
From Caixin
From Caixin
Field of dreams
The Saudi Arabian Oil Co. (Aramco) made history
The Saudi Arabian Oil Co. (Aramco) made history
QT Progress report
Recap April 11
A permanently low plateau
“As I say, we wish they hadn't raised,” Larry Kudlow, director of the National Economic Council, told The Hill about the Fed’s December hike. “I notice from the various reports and so forth that they've changed their view. I don't think rates will rise in the foreseeable future, maybe never again in my lifetime.”
Kudlow is 71 years old.
Tip of the iceberg
From Caixin:
Figures from China’s Ministry of Finance (MOF) show that official on-budget borrowing, known as explicit debt, of all local governments combined amounted to nearly 18.4 trillion yuan [$2.8 trillion] at the end of last year. But an official with one of the country’s financial regulatory bodies told Caixin that the unofficial, off-the-books liabilities of most provinces, known as implicit debt, could be around 2.5 times bigger. Added together, the total debt of local governments would amount to more than 70% of the country’s gross domestic product (GDP) in 2018.
Field of dreams
The Saudi Arabian Oil Co. (Aramco) made history this week by placing $12 billion in bonds in a deal that attracted a massive $100 billion order book. That’s a record level of demand for an emerging market issuer and one of the most oversubscribed bond offerings in history according to Bloomberg. By comparison, Saudi Arabia itself attracted $67 billion in orders for its international bond market debut in 2016.
That impressive order book didn’t translate into favorable price action, as all five of the 3- to 30-year Aramco tranches saw their prices decline and spreads over Treasurys widen in the first three days of trading. Yet even after that pullback, Aramco’s senior unsecured notes of 2029 trade at a 118 basis point spread, compared to 126 basis points over Treasurys for the identically rated single-A-plus Saudi sovereign 10-year note. The relationship between the pair (Aramco chairman Khalid Al-Falih is also the Saudi oil minister) is close and ambiguous enough to give some pause. One unnamed investor who met with the company told The Wall Street Journal that political unknowns loom large:
All the cash flow and [earnings] numbers are good, but who owns the reserves? It’s the Kingdom. And who takes the big decisions on whether Aramco should pay a special dividend, or help in some other way with funding Saudi? You have to assume it’s the government.
More broadly, the rabid investor appetite for Aramco debt underscores the current euphoria in credit. Year-to-date global corporate issuance stands at a record $695 billion and represents more than half of full-year 2018’s new supply of $1.34 trillion, according to data from Refinitiv. Hans Mikkelsen, head of investment-grade strategy at Bank of America Corp., summed it up: “The new issue market is wide open. It’s probably never been as open as it is now.”
Favorable market conditions have helped that record queue for Aramco debt, but what else are investors signing up for? As noted in the prospectus, Saudi Arabia’s famous Ghawar oil field (the world’s largest) is currently capable of producing just 3.8 million barrels per day, far below the Energy Information Administration’s 2017 estimate of 5.8mbpd.
That revelation comes as no surprise to Leigh Goehring and Adam Rozencwajg, the eponyms of natural resource investment firm Goehring and Rozencwajg Associates who have long argued (including on the Oct. 2, 2017 edition of the Current Yield podcast) that the Ghawar future potential is far more limited than widely believed. Reached by Grant’s this afternoon, Goehring commented:
Ghawar output will continue to decline, and we can now model it going forward. Most reservoir engineers believe that an oil field’s production will begin to decline when half the recoverable reserves are produced (there are all sorts of theories of why this is true, but it’s grudgingly accepted).
The problem with Ghawar is that we have never had an updated reserve report on what the recoverable reserves of the field might be. We have tried using various indirect methods, which led us to believe that Ghawar had about 25 billion barrels of reserve left. Given that Ghawar has produced about 75-80 billion barrels of oil already, this would mean that the field was way past its half-way point.
But these are all indirect measurements (and guesses).
However, with the publishing of the Aramco prospectus, we have now audited Ghawar numbers for the first time in almost 45 years. The numbers state (page 88 in the prospectus) that Ghawar has 48 billion barrels of liquids left. They have produced say 75 to 80 billion, so we know that total recoverable reserves are approximately 125 to 130 billion barrels. With only 48 billion barrels remaining, the field is over 60% depleted.
QT Progress report
The Fed’s portfolio of securities held outright remained at $3.748 trillion this week, a figure that sits $22 billion below the trailing four-week average. Since the Oct. 1, 2017 commencement of the QT balance sheet run-off, the Fed’s total assets are down by 11.7%, for a simple annualized pace of 7.8%.
Recap April 11
A quiet session saw stocks drift sideways, leaving the S&P 500 little changed for the week and within 1.5% of its closing high reached on Sept. 20 of last year. Commodities saw their recent winning streak emphatically snapped with the CRB Index falling more than 1%, and Treasurys traded weaker across the curve to push the 10-year yield back to 2.5%. The VIX held just above 13.
- Philip Grant
Wednesday, April 10, 2019
I'm your huckleberry
“U.S. hedge funds from time to time have appeared in this country over the last 10 years,
“U.S. hedge funds from time to time have appeared in this country over the last 10 years,
Recap April 10
I'm your huckleberry
“U.S. hedge funds from time to time have appeared in this country over the last 10 years, with the same hypothesis of shorting Canadian banks, and it hasn’t worked out very well for them,” Brian Porter, CEO of the Bank of Nova Scotia, said yesterday. “There are always going to be those that take an opposing view, and we’ll prove them wrong over the long term.”
Gabriel Dechaine, banking analyst at the National Bank of Canada, likewise came to his industry’s defense in a note today: “A trend that is making us believe that sector sentiment is becoming too bearish is the re-emergence of a vocal ‘short Canada’ investment crowd.” Dechaine writes that a Stanley Cup victory for the woebegone Toronto Maple Leafs (last title, 1967) is more likely than a jump in loan losses.
One well-known investor is publicly taking the challenge: Steve Eisman, portfolio manager at Neuberger Berman and a protagonist in Michael Lewis’ The Big Short. “Canada has not had a credit cycle in a few decades and I don’t think there’s a Canadian bank CEO that knows what a credit cycle really looks like,” Eisman, who is short various Canadian banks and mortgage lenders, fired back in an interview yesterday with BNN Bloomberg television. “I just think psychologically they’re extremely ill prepared.”
While Canadian bank advocates and their skeptics exchange words, the formerly-white hot housing market is now in deep freeze. March sales in Vancouver collapsed by 31.4% year-over-year according to the local real estate board, the worst showing since 1986 and down 46% from the 10-year average for March. Prices also lurched lower, with the benchmark detached home price falling 10.5% year-over-year to C$1.44 million ($1.08 million). Things are more stable in Toronto, where March sales and benchmark prices were little changed from a year earlier, but those figures remain 40% and 14% below their respective levels from March 2017.
As the housing market sputters, the highly-leveraged Canadian consumer displays increasing signs of distress. According to the Bank for International Settlements, Canada’s household debt stands at 100.2% of GDP as of the end of September, by far the highest ratio among G7 economies (the U.K. is next at 86.5%), while the debt service ratio, or the percentage of disposable income allocated to principal and interest payments, rose to 14.9% in the fourth quarter per Statistics Canada, just shy of the 2007 peak.
That debt burden is starting to weigh on consumers. Auto loan delinquencies rose to 0.97% at year-end according to Equifax, Inc., the highest since 2009. At the same time, 36% of new auto loans in the fourth quarter were leases, the largest such share since 2007. Bill Johnston, vice president of data and analytics at Equifax Canada Co., noted that “we’re starting to see consumer behavior shift to keep the payments as low as possible.”
On the credit card front, delinquencies of at least 90 days remained at a relatively low 0.79% as of February, down from 0.88% in the same month last year according to data from Bloomberg. But, as noted by the Royal Bank of Canada, consumers cut their average monthly payment to just 38% of outstanding balances in February, down from 50% in October and the lowest such ratio since 2015. RBC credit analyst Vivek Selot commented:
That deterioration in payment rates may be attributed to some stress on the consumer. Considering that fragile household balance sheets could be a precipitating factor for the credit cycle to turn, any signs of consumer credit quality deterioration seem worthy of attention.
Indeed, the Office of the Superintendent of Bankruptcy reports that consumer insolvencies rose 5.4% year-over-year in February, bringing the rolling three-month average to its highest level since 2011.
The slowing housing market and increased consumer stress has taken a toll on one of the banks’ primary profit centers. According to the Bank of Canada, residential mortgage growth registered at 3.2% year-over-year in February, the lowest reading since 2001 and barely half of the 6% monthly average logged since the housing boom gathered steam in 2009. Back in March, Edward Jones & Co. investment strategist Craig Fehr noted to Bloomberg that mortgages frequently represent “the largest and most profitable and steady of the businesses that these banks operate.” Fehr concluded: “The bread and butter of profitability for Canadian banks – is going to have a little less butter on the bread.” Meanwhile, expectations remain high, with a 2019 analyst consensus of 15.7% return on equity for the S&P/TSX Bank Index, up from 14.2% last year and a five year average of 15%.
For those unfazed by CEO taunts and eager to investigate the bearish case for Canada’s lenders, an analysis in the Feb. 9, 2018 edition of Grant’s Interest Rate Observer identifies one bank that stands out from the rest.
Recap April 10
Stocks caught a modest bid, recouping some of yesterday’s losses as the small-cap Russell 2000 rose more than 1% to extend its year-to-date gains past 17%. Treasurys rallied across the board as the 10-year yield dropped three basis points to 2.47%, and commodities continued their impressive advance with the CRB Index rising to a five month high with WTI crude and gold finishing at $64.5 a barrel and $1,308 an ounce, respectively.
- Philip Grant
Monday, April 8, 2019
Discount double check
The passive price war goes stealth.
The passive price war goes stealth.
Permanently high plateau 2.0
Cheez whiz
Recap April 8
Discount double check
The passive price war goes stealth. From Bloomberg today:
BlackRock, Inc., the world’s largest issuer of exchange-traded funds, has slashed the cost of its iShares Broad USD High Yield Corporate Bond ETF by waiving part of the management fee, regulatory documents show. But rather than shout about the move, the discount was announced without fanfare – in a footnote on page 94 of a revised filing last month.
Permanently high plateau 2.0
In Barron’s this weekend, J.P Morgan chief U.S. equity strategist Dubravko Lakos-Bujas offered a novel perspective on the nature of asset prices in the modern era:
We are all used to using the word “cycle”; we’re all used to looking at historical charts and graphs and equations and relationships. The reality is that maybe the word “cycle” is no longer even relevant, given that we have so much unconventional central-bank involvement.
Cheez whiz
So far this year, the Renaissance U.S. IPO Index is up a cool 32%, more than double the 15% advance logged by the S&P 500. The booming market for new issues is making bull-market noises.
This morning, CEC Entertainment, Inc., parent company of children’s restaurant Chuck E. Cheese’s, announced plans to list shares on the New York Stock Exchange. This will be no straightforward offering. Instead, the transaction will feature a reverse merger between CEC’s own parent company Queso Holdings, Inc. with a special purpose acquisition company called Leo Holdings Corp. The press release explains:
Concurrent with the closing of the transaction, Leo will domesticate as a Delaware corporation, following which Queso will merge with and into Leo with the result that CEC will continue as a wholly-owned subsidiary of Leo, which will be renamed Chuck E. Cheese Brands, Inc.
CEC was bought by Apollo Global Management, LLC in 2014 for $1.3 billion including debt. In February 2017 Reuters reported that the private equity giant had hired Deutsche Bank A.G. and Credit Suisse A.G. to solicit bids for its portfolio company, with Bloomberg reporting that Apollo was seeking a roughly $2 billion sale price.
With no buyer in hand, the deal was withdrawn six months later. As a public entity, CEC is expected to garner an enterprise valuation of about $1.4 billion, which is 7.5 times forecast 2019 adjusted EBITDA of $187 million, while the anticipated $300 million of proceeds “will be used to pay transaction expenses and de-leverage the Company’s existing capital structure.”
De-leveraging appears wise. CEC ended 2018 with total debt of $982 million, 6.5 times trailing 12-month adjusted EBITDA, while operating income of $66 million failed to cover the $76.3 million in interest expense.
As Chuck-E-Cheese’s prepares to re-join the ranks of publicly-traded companies, recent IPO Lyft, Inc. has a bone to pick with its underwriters. Digital news site The Information relayed Friday that the ride-share company, which debuted on March 29, threatened to sue Morgan Stanley after the New York Post reported the investment bank had offered Lyft investors a chance to hedge their positions through short sales, despite being subject to lock-up restrictions.
For Lyft, which generated a $943 million adjusted-EBITDA loss in 2018 on revenues of $2.2 billion and warned in its S-1 filing that it “may not be able to achieve or maintain profitability in the future,” the attention paid to short-sellers has been mutual. According to S3 Partners, LLC, short interest in LYFT exceeded 38% of the 32.5 million share float as of Tuesday, despite prohibitive borrowing costs that reached an annualized rate 101.4% as of Tuesday. Lyft stock finished the day at $70.23 a share, down from the $72 issue price and 20% below the intraday peak see on its March 29 debut.
Meanwhile, new issue supply continues apace as the IPO pipeline remains robust. This morning, social media site Pinterest, Inc. filed a form S-1 detailing plans to offer up to 75 million shares at a range of $15 to $17 per share, valuing the company at $11.3 billion using the high end of the range. That’s down from a $12.3 billion valuation achieved during the most recent fundraising round in 2017. As noted by Business Insider on March 24, an unusual bit of language in Pinterest’s filing may give some investors pause:
Pinterest's S-1 paperwork, filed publicly Friday, disclosed an unusual stipulation that retains full voting rights for CEO Ben Silbermann's shares in the company from 90 days to 540 days after his "death or permanent incapacity."
The clause means that after Silbermann dies, whoever inherits his shares will retain his super-voting powers for a period of time.
Recap April 8
A reflation-type trade headlined today’s action, as commodity prices continue to run with the CRB Index green for a fifth straight day to leave WTI crude and gold near $65 a barrel and $1,300 an ounce, respectively. Treasury yields also rose, with the 10-year finishing at 2.52%, well off the 52-week low of 2.36% reached on March 27. Stocks finished sideways, with the S&P 500 erasing early losses, and the VIX settled just above 13.
- Philip Grant
Friday, April 5, 2019
Nevertheless, he persisted
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc.
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc.
Recap April 5
Nevertheless, he persisted
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc. (8604 on the Tokyo Stock Exchange) expects to close over 30 of its 156 domestic retail branches, “previously considered a sacred cow by the group.” In addition, Nomura will eliminate roughly half of its 11 administrative departments and “revisit its policy of maintaining hubs in Japan, the U.S. and Europe.” That comes after the investment bank reported a ¥101.2 billion ($911 million) loss for the nine months ended Dec. 31, its worst such showing since 2008.
Nomura’s misadventures are no outlier. In early March, Mizuho Financial Group, Inc. was forced to take a ¥680 billion write down that included ¥150 billion worth of losses related to its portfolio of overseas bonds (Almost Daily Grant’s, March 7). More broadly, the Tokyo Stock Exchange Bank Index has seen its return on equity decline in each of the last five years, to 5.33% in 2018 from 9.77% in 2013. The index trades at a paltry 0.47 times book value, worse than even the EURO Stoxx Bank Index’s similarly-depressed 0.62 price-to-book ratio and far below the 1.18 times book valuation commanded by the U.S. KBW Bank Index.
Of course, much like Europe, Japan’s macro-economic backdrop features negative interest rates and aggressive central bank asset purchases. The BoJ has accumulated ¥557 trillion in assets, equivalent to 101% of 2018 nominal GDP (that compares to about 39% in Europe and 19% in the U.S.), as policymakers continue to up the ante in their quest to achieve a 2% measured rate of inflation.
With its gargantuan portfolio, the BoJ wields substantial control of the country’s capital markets. As noted by the Financial Times on Sunday, the central bank now holds close to 80% of outstanding ETF assets, equating to approximately 5% of Japan’s total market capitalization, while data from Bloomberg pegs the BoJ ownership of the Japanese Government Bond Market at 43%.
Financial institutions are beginning to publicly balk at these monetary machinations. Last week, Makoto Takashima, president of Sumitomo Mitsui Banking Corp. and chairman of the Japanese Bankers Association, told Bloomberg that the Bank of Japan must “carefully consider” the impact of deepening its subzero interest rate policy: “It will be a quite difficult decision to make. Simply speaking, that would cause policy side-effects to further grow.” Back on March 3, Mizuho Bank, Ltd. CEO Koji Fujiwara expressed similar reservations over any escalation of Japan’s radical monetary policy: “I think the BoJ’s actions so far have been beneficial, but I think the time has come to look carefully at the negative side effects and reconsider.”
For his part, BoJ Governor Haruhiko Kuroda opined in March that “I don’t think our ETF buying is having any effect on market function.” The central banker said in a speech today that the BoJ “needs to continue easing persistently.” Of Japan’s banks, Kuroda attributed their profit woes to “structural factors, such as a dwindling population,” while pledging vigilance “to the risk [these structural factors] could erode [banks’] capital base and have a negative impact on financial intermediation.”
With BoJ policy already extreme by most objective measures, Kuroda’s determination to maintain ultra-loose policies in the face of banking industry protests can be potentially explained by a speech at Oxford University on June 12, 2017. In that address, the BoJ governor articulated his plan to rouse the Land of the Rising Sun from its longstanding disinflationary torpor. Namely, manipulate expectations such that citizens begin to expect rising prices, which would then presage the real McCoy:
I took office as Governor of the Bank of Japan in March 2013 and immediately introduced a monetary policy regime -- quantitative and qualitative monetary easing, (QQE) -- that is quite different from past regimes. QQE consists of two pillars: (1) directly working on people's expectations through a price stability target of 2 percent and a strong and clear commitment to doing whatever it takes to achieve this, and (2) directly encouraging a decline in long-term interest rates through large-scale purchases of long-term Japanese government bonds (JGBs).
In practice, QQE has produced its intended effects. Inflation expectations climbed notably after the introduction of QQE. This demonstrates that a strong determination by the central bank pushes up people's forward-looking inflation expectations.
On that score, success remains elusive. According to a Bloomberg survey of 2,127 Japanese households conducted in February and March, half of respondents “have never heard of” Kuroda’s grand monetary stimulus, “the highest level since the question was introduced in September 2013.” Meanwhile, year-over-year CPI inflation has averaged 0.45% over the last 36 months.
Recap April 5
Stocks rallied once again, with the S&P 500 tacking on a 2% gain this week to bring the year-to-date advance to a gaudy 15.5%.
Commodities finished higher for a sixth straight day to push the CRB Index to its best close since November, despite strength in the greenback as the Dollar Index finished within a few ticks of its own 52-week high. Treasury yields finished little changed, but with some flattening across the curve as the three month vs. 10-year spread narrowed to (positive) seven basis points.
- Philip Grant
Thursday, April 4, 2019
Off to sea once more
The May 30, 2014 issue of Grant’s featured a bullish analysis
The May 30, 2014 issue of Grant’s featured a bullish analysis
QT progress report
Recap April 4
Off to sea once more
The May 30, 2014 issue of Grant’s featured a bullish analysis of Dorian LPG Ltd. (LPG on the NYSE), which ships liquified petroleum gas (LPG) worldwide through its fleet of 22 very large gas carriers (VLGC). Trading at $20.31 a share at publication time, LPG stock cratered to $6 two years later, and currently fetch $7.22. Now following is a look at what happened and where things stand.
That May 2014 analysis noted that “a bet on Dorian is a clear bet on the earnings power of its ships – and the price of crude and on the demand for LPG.” Instead, over the last five years Dorian has been run aground by low prices, overcapacity and accompanying concerns over the appraised value of the company’s VLGC fleet.
Industry growth has been brisk, as LPG (a mix of propane and butane which can be used for cooking, heating and fuel) is a clean and relatively easy to transport form of energy. But those virtues – plus an accommodating credit market – have helped spur a capacity glut. The overall VLGC count has jumped to 270 as of Feb. 5, up from 158 as of April 2014. An additional 46 ships, representing 17% of global supply, are on order.
Dorian’s income statement reflects those difficult business conditions. Adjusted EBITDA fell to $62 million in calendar 2018, from $202 million in the fiscal year ended March 31, 2016. Meanwhile, net debt stands at a hefty $676 million, although refinancing needs are distant as the next principal repayment, in the form of a $179 million term loan, isn’t due until 2022.
The company’s latest form 10-Q addressed the potential for asset write-downs on its ships, noting that outside appraisals “showed indications of impairment on 21 of our ships.” However, a company-conducted sensitivity analysis found that no impairments would need to be taken if daily spot time charter equivalent (TCE) rates fell 25% below their 10-year average of roughly $30,000 per day, while a 30% drop would trigger $34.6 million worth of write-downs on six VLGCs. CFO Ted Young explained the discrepancy, and Dorian’s reasoning, to Grant’s:
Getting a shipbroker assessment is like getting an assessment on your home from the local realtor. It is based on last done. Well, guess what? There was no last done. No modern ships have really changed hands at all. There has been one fleet sale in 2015/16 that included some modern ECO VLGCs which was a distressed situation and the buyer clearly got a really good deal. So, those assessments will imply values that are somewhat below our depreciated carrying value.
Are better days ahead? TCE rates rebounded in the quarter ended Dec. 31, rising to $30,000 per day, up from $17,000 a day in 2016 but still well below the $45,000 seen in 2014. Then, too, the overcapacity problem is mitigated by the fact that 9% of world VLGC supply is aged 25 years or older, with another 3% between 20 and 25 years old. For its part, Dorian boasts a particularly young fleet, with an average age of 4.6 years, less than half the 9.4 year industry average.
Mr. Market has applied his own inventory discount. Dorian’s $1.08 billion enterprise value equates to roughly $49 million for each of its 22 VLGCs. In early January, peer DryShips, Inc. took delivery on four VLGCs at a price of $83.5 million per vessel. Assuming a 25 year life and five years of straight line depreciation (equating with Dorian’s average VLGC age), yields a per ship valuation of roughly $66 million.
That newer fleet, which includes three ships fitted with eco-friendly exhaust scrubbers and another ten vessels set to be retrofitted in 2019 and 2020, represents a significant competitive advantage for Dorian. Next year, the International Maritime Organization will implement new regulations that include capping the sulphur emissions of seaborne vessels/VLGCs at 0.5% from the current 3.5%, an ordinance that Bloomberg reports will be enforceable in Singapore with jail time of up to two years for violators. Young tells Grant’s that the company is well positioned for those changes:
Putting aside the scrubbers that we’ll have on ships, if you just look at some of the fuel differences we put out there the savings can be anywhere from $2,000 to $3,000 a day.
One of the big things is that the younger, newer ships, of which we have the largest fleet, end up making more money per day because freight is quoted in dollars per metric ton. When you make that calculation, from dollars per metric ton to time charter equivalent per day, the biggest part of that calculation is the fuel consumed. Our newer and fuel efficient vessels not only carry a bit more cargo but they also consume less fuel over the course of the voyage so that translates to a higher voyage return.
The company has its admirers. Last May Norway’s BW LPG Ltd., which sports a market cap of NOK 4.9 billion ($571 million) compared to Dorian’s $402 million, launched an unsolicited all-stock bid that would have left Dorian shareholders with 46% ownership of the combined entity, before withdrawing its deal in October after reportedly declining Dorian’s request to improve the terms.
At the current price and sporting a daunting leverage ratio of 10.9 times net debt to trailing 12-month EBITDA, LPG shares represent an option. Should fundamentals continue to improve, the stock should do quite well, but if they flatline or deteriorate for an extended period, Dorian will face the risk of insolvency. Short interest currently stands at 5.4% of the float, and the Street is bullish, with five “buy” ratings, one “hold” and zero “sells.”
QT progress report
The Donald is not going to like this. The Fed’s portfolio of securities held outright fell to $3.78 trillion, down a meaty $23 billion from a week ago, with Treasurys accounting for all the sequential decline. Today’s figure represents a $31.4 billion drop from the trailing four-week average.
Since the Oct. 1, 2017 commencement of the QT run-off, total balance sheet assets are down by 11.7%, for an annualized pace of 7.9%.
Recap April 4
Another rangebound session saw the S&P 500 finish higher by 0.2%, near its best levels of the day, while Treasurys also finished little changed with the 10-year yield settling at 2.51%. Commodities and the dollar both finished higher, with the CRB Index rising for a fifth straight session despite weakness in crude as WTI fell back to $62 a barrel. The VIX finished below 14.
- Philip Grant
Tuesday, April 2, 2019
They mostly come at night, mostly
It’s alive! Just after midnight eastern time,
It’s alive! Just after midnight eastern time,
I'm a hog for you baby
It’s been a tough road for the U.S. farming industry,
It’s been a tough road for the U.S. farming industry,
Recap April 2
They mostly come at night, mostly
It’s alive! Just after midnight eastern time, the price of bitcoin surged by as much as 23% to cross back over $5,000 for the first time since November, while remaining 15% in the green this afternoon.
What accounts for the abrupt liftoff in the world’s premier cryptocurrency? One potential clue is the nearly identical level of activity in tether, the purportedly dollar-backed crypto. While bitcoin (with an aggregate market value of $83.3 billion) has logged $18.7 billion of trading volume in the past 24 hours, the much-smaller tether (market value: $2.1 billion) has registered $18.8 billion over the same period, according to data from CoinMarketCap.com. By comparison, ethereum, which sports a market cap of $16.6 billion, has seen 24 hour trading volume of $8.5 billion.
For more on tether, see the Sept. 8, 2017 edition of Grant’s.
I'm a hog for you baby
It’s been a tough road for the U.S. farming industry, which is seemingly beset on all sides. Agricultural commodity prices remain low, with spot corn and soybean currently fetching $3.62 and $8.99 per bushel, respectively, each roughly 22% below their respective 10-year average prices.
Meanwhile, the ongoing Sino-American trade war continues to crimp overseas demand, as the U.S. Department of Agriculture reports that soybean deliveries to China fell more than 80% year-over-year since September. That helped push soybean stocks to a record 3.7 billion bushels as of year-end 2018.
By the same token, the USDA forecast Friday that corn plantings will rise 4.1% in 2019 to 92.8 million this year, an unwelcome development considering that “American silos are already bulging with the grain,” according to Bloomberg. Adding insult to injury, devastating floods have afflicted large swaths of the Midwest during the heart of spring planting season.
The USDA estimates that net farm incomes plunged 16% year-over-year in 2018 to $63.1 billion, down from more than $120 billion as recently as 2013. Rising operating costs play a prominent role in that shrinkage. According to the All Farms Index tabulated by the Federal Reserve Bank of Minneapolis, the prices received component fell to 84.9 in January from 95.1 in June, while prices paid registered 109.3 and has remained north of 100 since 2011.
Source: The Federal Reserve Bank of Minneapolis
Things are particularly grim in Minnesota and surrounding states. The Minneapolis Fed reports that in-state farmers have seen total input costs for seed, fertilizer, pesticides, fuel and electricity rise by 50% since 2006, after adjusting for CPI-measured inflation. As a result, Minnesota farmers reported real median net income of $26,055 last year, down 8% from 2017 and the lowest figure since the early 1980’s, per an estimate from Dale Nordquist with the University of Minnesota’s Center for Farm Financial Management.
Unsurprisingly, that one-two punch is leading to increasing distress. The Minneapolis Fed reports that the ninth district (encompassing Minnesota, Wisconsin, North and South Dakota and Montana) has seen farm bankruptcies rise to more than 100 in the 12 months ended in December, up from 46 in calendar 2015.
As farmers struggle under the weight of low prices, bulging stockpiles and the wrath of mother nature, Grant’s asked grains expert and paid-up subscriber Keith Bronstein whether a supply disruption could augur better days ahead:
The flooding is currently a localized disaster for those producers in areas affected.
Can this become sufficiently widespread to have a true impact on U S production of row crops? The answer is a resounding yes, but it is too soon to make that statement. Early planting is a boon to yields and, given relatively depressed prices, it is easy to imagine farmers making extensive use of crop insurance policies if things get very late. I think we need to revisit this in 2.5 weeks to see how conditions have changed (or not) as snow melt and runoff and rain or lack thereof play themselves out over this period.
In summary, some notable areas are experiencing great misfortune but it is not yet a “national” story.
One farm commodity that has decisively broken higher is hogs. The emergence of African swine fever in China has led to the culling of an estimated 100 million hogs, a figure that compares to the U.S. inventory of 74.3 million hogs as of the first quarter. That sudden shortage of Chinese supply has spurred a major change in world fundamentals. Arlan Suderman, chief commodities analyst at INTL FCStone, Inc., estimates that “hog feeding in China is down by more than 30%, while some estimates coming out of China are much higher than that.” The Farm Journal notes that replacing a 31% decline in Chinese output “would require all of the annual production of Canada, the U.S., Mexico and Brazil.”
That supply swing is already having a major impact, as lean hog prices have jumped to $84 per hundredweight, up 58% since Feb. 22. Bronstein observes:
China will be an increasingly aggressive buyer of pork around the world yet is not the only place experiencing the spread of this particular disease. . . China is restricting imports from Vietnam to try and preclude a more aggressive disease spread.
North America, probably thanks to distance and very advanced containment regimens, seems pretty safe now. North America should have an expanding hog population and expanding exports. With cheap feed, it’s a pretty good business to be in.
Recap April 2
A quiet day for stocks saw the S&P 500 test either side of unchanged early before settling into a sideways drift, while Treasurys rebounded from yesterday’s selloff as the 10-year yield dropped three basis points to 2.47%.
Commodities continued their recent rip, as the CRB Index finished at its best level since late November. That move is all the more impressive considering the U.S. Dollar Index also finished green and remains near a 52-week high.
- Philip Grant
Monday, April 1, 2019
Motley Crew
Asset prices are off to the races, as the S&P 500 logged a 13% gain through March 31, the best quarterly showing since the summer of 2009. Credit has likewise marched higher, with the Bloomberg Barclays High Yield Index jumping 7.3%, the steepest quarterly rise since 2003, while the Markit iBoxx Leveraged Loan Total Return Index rose by 4.8% for its best quarter since 2010.
The Fed’s dovish swivel figures prominently in the bull move in credit, as interest rate futures now expect rate cuts instead of further tightening and the “QT” asset run-off is set to end in six months. At the same time, loan defaults reached a seven-year low in March as the post-2009 economic expansion is now three months shy of a record length.
A mismatch between new supply and demand also helps. Junk bond volumes tallied $59 billion in the first quarter, down 5.5% year-over-year and the slowest pace of issuance since 2016. On the loan side, new volume fell to $85.2 billion in the first quarter, down a hefty 68% year-over-year according to data compiled by Bloomberg.
That dearth of supply has further tilted the balance of power in favor of the borrowers. On March 22, the Financial Times reported on the “near-total control” of sellers in the leveraged loan market, a development raising “concerns that a borrower could load up on more debt, extract cash from the company or seek expensive acquisitions.” Even the sharp downdraft seen at the end of 2018 has done little to level the playing field. An unnamed fund manager told the FT that “we were hoping there would be an improvement [in terms for investors] after December’s volatility, but that doesn’t seem to be the case.”
Last Thursday a report from Moody’s Investor Services noted “unprecedented flexibility” on the part of borrowers to make investments free of obligations to maintain certain leverage levels, as well as an “aggressive use of investment capacity” that allows issuers to shift assets beyond creditors’ reach, leaving investors “in uncharted territory.” Indeed, Moody’s determines that 2018 saw the weakest credit agreement protections on record, a fact that bodes ill for recoveries when the cycle turns.
On that score, a prominent cautionary tale finds itself back in the news. On Thursday, the J. Crew Group, Inc. term-loan B fell to 66 from 92 as recently as Oct. 22, 2018, after the fashion retailer reported a full-year adjusted EBITDA decline of more than 50% with cash on hand dropping to $25.7 million at the beginning of February from $107 million a year earlier. The company, taken private in 2011 by Leonard Green & Partners, L.P. and TPG Capital, earned the ire of creditors in 2017 by transferring $250 million worth of intellectual property to a foreign subsidiary (out of the grasp of supposedly-senior bondholders) and then issuing $250 million in fresh debt backed by the same IP.
A slightly different saga featuring private-equity owned PetSmart, Inc. continues to unfold. In April 2017, PetSmart bought online pet supply company Chewy, Inc. for $3.35 billion. Just over a year later, PetSmart transferred a chunk of Chewy’s equity to an unrestricted subsidiary, out of the reach of the company’s creditors. Those jilted bondholders sought legal recourse against PetSmart for alleged “fraudulent” behavior, claiming that PetSmart was already out of compliance with a fixed-charge coverage ratio test. On Thursday, a federal judge ordered the company to turn over documents related to the transfer of Chewy equity. A day later, Bloomberg reported that PetSmart creditors rejected the company’s offer to add new investor protections in return for dropping their litigation. PetSmart’s term loan reached a post-2017 high of 89 cents on the dollar Friday, potentially indicating that the lawsuit is gaining traction.
More recently, the March term loan and senior note offering financing the $10 billion leveraged buyout of Johnson Controls International plc’s car-battery unit represents another measuring stick. After analyzing the senior notes documentation, credit research firm Covenant Review called those covenants “extremely aggressive and containing numerous flaws.” Features that might make creditors cringe include “wildly off-market” compliance calculations that “arbitrarily” exclude various borrowings, as well as a “phony” test that could overlook additional debt used to fund such restricted payments and the ability to “transfer unlimited IP to unrestricted subsidiaries and other entities.” What’s more, so-called add-backs to EBITDA give “the company credit for expected revenues that have not yet been (and may not be) earned.”
As issuers continue to push the envelope, the cycle continues to age. In a March 4 interview with Bloomberg, Carlyn Taylor, global co-leader of corporate finance and restructuring at FTI Consulting, predicted that a spike in defaults is on the way, sooner or later:
The expansion is pretty long in the tooth and there's definitely a lot of buildup. The activity level of restructuring is rising, maybe not at the rate of bankruptcies, but the pipeline of companies we think are going to end up in restructuring, based on metrics that we analyze, that volume has gone up. And we're so busy, which we don't think is just market share, because we think our competitors are also very busy.
Recap April 1
The second quarter started in familiar fashion, as stocks raced higher with the S&P 500 gaining more than 1% and the financials index tacking on nearly 2.5%. Treasury yields likewise ripped higher across the curve, with the 10-year back to 2.5% from less than 2.38% on Wednesday, and commodities also enjoyed a strong rally with the CRB Index gaining 1%. WTI crude finished near $62 a barrel and is up by 42% from the Dec. 24 lows.
- Philip Grant
Friday, March 29, 2019
Blocked number
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq).
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq).
Recap March 29
Blocked number
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq). Yesterday, Charles Gasparino of Fox Business reported that regulators will begin their “final review” of the pending deal next Thursday, following a three week hiatus in which the Federal Communications Commission heard additional arguments from both sides of the debate.
The Trump administration appears sympathetic to the combination. Gasparino tweeted on Tuesday that T-Mobile and Sprint management were making “headway” on their lobbying efforts, with Department of Justice antitrust chief Makan Delrahim purportedly “open” to allowing the combination of America’s third- and fourth-largest wireless carriers. Back in May 2017, FCC chairman Ajit Pai told listeners at the American Enterprise Institute that the prospective consolidation of national carries to three from four wouldn’t necessarily concern him: “I don’t claim to know in a vacuum what. . . the right number of competitors should be.”
Sprint and T-Mobile have taken an offensive tack of late. On March 18, the Capitol Forum reported that the pair jointly submitted an FCC filing accusing rival Dish Network Corp. and consulting firm The Brattle Group of making “serious false statements” in producing a study “that fabricates harms on low income consumers when none exist.”
Apart from attacking its enemies, Sprint has argued that it must merge with T-Mobile to ensure its viability. On Sprint’s Jan. 28 earnings call, CEO Michel Combes told listeners that: “As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments, and without additional low-band spectrum we will face challenges to provide customers with coverage comparable to that of the big two carriers.”
The effectiveness of that tactic is in question, with Bloomberg reporting yesterday that “some U.S. officials” are “skeptical” of Sprint’s claims “that it won’t be an effective competitor if they block the merger.” One unnamed individual “said Sprint asserted it may eventually run out of cash if the merger fails.” Former FCC wireless bureau chief Fred Campbell went on the record to dub Sprint’s arguments as “relatively weak” and “probably not enough to get a merger through that’s anti-competitive.”
An analysis in the Dec. 23, 2016 edition of Grant’s drew a different conclusion, based on Sprint’s onerous debt burden, stagnant revenues and five straight years of cash burn (more of the same is expected in 2019 and 2020). Research firm MoffettNathanson, LLC concluded in a Jan. 31 report that if the deal is rejected, Sprint’s debt “will likely have to be restructured,” while Bloomberg Industries analyst Stephen Flynn writes today that “Sprint may need financial help from its 84.5% equity owner SoftBank Group Corp.” if the merger is blocked.
Mr. Market has expressed only mild concern about the deal prospects, as Sprint’s senior unsecured 6 7/8 notes due 2028 have ticked below 96 cents on the dollar, compared to above 99 a month ago. Sprint shares likewise trade at a 26% discount to the deal closing price based on T-Mobile stock price. Yet those markdowns pale in comparison to the dual credit and equity swoon in early 2016 when the company’s survival prospects appeared to be in question.
Sprint 6 7/8s of 2028. Source: The Bloomberg
A thumbs-up from federal regulators wouldn’t necessarily signal an all-clear. Dealreporter relayed yesterday that a coalition of 18 state attorneys general led by New York are considering a lawsuit to stop the deal, regardless of the DoJ and FCC’s findings. Bloomberg adds that “there’s some concern among the states that political considerations could be influencing the Justice Department’s decisions on mergers,” with Delrahim’s prior attempt to block the AT&T, Inc./Time Warner, Inc. tie up due to Trump’s “incessant criticism” of CNN one such example.
With the TMUS deal decidedly up in the air, Sprint’s problems could soon become SoftBank’s. In a commentary yesterday, Amir Anvarzadeh of Asymmetric Advisors writes that the state-level opposition and DoJ skepticism over Sprint’s claims of financial hardship as a standalone entity have pushed his forecasted approval odds south of 40%: “None of this is good news for SoftBank, which has been banking on taking Sprint’s $30 billion of net debt and its negative cash flow from its balance sheet.”
Meanwhile, SoftBank, which Grant’s dubbed “the epitome of the cycle” (it wasn’t a compliment) on Dec. 15, 2017, has enjoyed a rollicking rally. Shares have risen 48% year-to-date, as a buyback encompassing more than 10% of shares outstanding and a 32% rise in Alibaba, Inc. (SoftBank owns 29% of BABA) have provided the bullish jet fuel. Anvarzadeh writes that the Sprint saga, along with pricing pressure in SoftBank’s domestic telecom unit, may soon change the narrative: “We think investors should be positioned for these negative catalysts before the buyback program comes to completion.”
Recap March 29
Stocks rose again to leave the S&P 500 with a solid 1% gain for the week and 13% for the quarter (the best such performance since 2009), as Lyft, Inc. shares enjoyed a 9% gain in their first day of trading.
Commodities were also bid, with WTI crude popping back above $60 a barrel. Treasury yields ticked mostly higher across the board, as the 10-year yield rose back above the three-month for the first time since last Thursday.
- Philip Grant
Thursday, March 28, 2019
Prognosis negative
Today, the Financial Times reports that Deutsche Bank A.G.
Today, the Financial Times reports that Deutsche Bank A.G.
QT progress report
Recap March 28
Prognosis negative
Today, the Financial Times reports that Deutsche Bank A.G. is looking to raise between €3 billion ($3.4 billion) and €10 billion in equity to help consummate the planned merger with peer Commerzbank A.G., “a move designed to end the debate over whether Germany’s largest lender has enough capital.” That sum is not insignificant: The duo combined are worth €23.6 billion. Meanwhile, the FT notes that Deutsche Bank has raised some €30 billion since 2010, twice its standalone market cap.
The Deutsche Bank/Commerzbank saga puts into relief the struggles of Europe’s banks. More broadly, the Euro STOXX Bank Index generated an aggregate 7.51% return-on-equity last year, far behind the 11.82% ROE logged by the U.S. KBW Bank Index. The valuation gap is also substantial, as the Stoxx Bank Index trades at 0.58 times forward 2019 book value, compared to 1.12 times for the KBW U.S. Banking Index.
What gives? Borrowing costs are one key difference. The European Central Bank’s deposit rate has been negative since June 2014, penalizing banks for their reserves, while the Fed Funds rate sits at (positive) 2.4%. The less-than vigorous state of Europe’s financial institutions has gotten the attention of ECB president Mario Draghi. In a Frankfurt speech yesterday, Draghi raised the possibility of providing some assistance to the banks: “If necessary, we need to reflect on possible measures that can preserve the favorable implications of negative rates for the economy, while mitigating the side effects, if any.”
While the outgoing Draghi (his term ends on Oct. 31) didn’t elaborate on what sort of “mitigating” steps the ECB might take, Bloomberg notes that other central banks with sub-zero benchmark rates such as the Bank of Japan and the Swiss National Bank have adopted “a so-called tiering system that excludes most of the reserves commercial banks deposit from the penalty that a negative policy rate imposes.”
Draghi’s potential negative rate workaround has elicited a range of reactions from his fellow functionaries. ECB governing council member Ewald Nowotny told the press in Vienna today he “would like to see a certain mitigation” for the effects of sub-zero rates, terming the SNB’s tiering practice a “nuanced system.” ECB chief economist Peter Praet advocated further study in an interview with Bloomberg today, saying “we need to be convinced that it would address a monetary-policy question in an efficient way.” Dutch central bank governor Klaas Knot is adamantly opposed: “We as policy makers should stay far away from [tiering].” Bloomberg notes that Knot “argued that there’s little proof that banks’ low profits are the result of low interest rates.”
But as the monetary mandarins debate further interventions to minimize the “side effects, if any” of the ongoing negative-rate epoch, one observer argues that the central bankers are missing the point. In a commentary yesterday, Jeffrey Snider of Alhambra Investment Partners wrote that the ECB’s efforts to incentivize credit growth through penalizing idle reserves has backfired, demonstrating the differences between theory and practice:
It all sounds very good on the chalkboard, in the regression analysis of complex yet oversimplified computer models. Give banks reserves and then punish them when they aren’t put to good use; problem solved.
The real world, however, is much more complicated – and in many ways far simpler. Maybe banks don’t want to use reserves because the implications, meaning risks, of doing so are perceived to be consistently much greater than the deposit rate NIRP penalty.
Thus, the real solution would instead be to figure out why banks are perceiving the world this way rather than rejiggering the NIRP nonsense one more time.
Monetary competence does not come easily to the modern central bank. It has morphed into expectations manipulation, which, ironically, requires everyone to believe that it is the most technically capable instrument for policy there is. This is why we are all taught from Econ 101 forward the near infallibility of the central banker, and also why at the very same time through experience and observation we see that’s just not the case.
They really have no idea what they are doing. The ECB is not a collection of newfound doves, they are chickens without their heads. Either way, it does not amount to anything good, and adds more weight to the considerable and growing list of everything bad.
That’s not to say the ECB doesn’t have advocates for more activism. Bjorn Wahlroos, outgoing chairman of Nordea Bank, expressed eagerness for more intervention at a shareholder meeting in Helsinki today. Referencing Draghi’s famous 2012 promise to do “whatever it takes” to defend the Euro, Wahlroos said of the ECB, which carries assets on its balance sheet equivalent to 39% of 2018 Eurozone GDP (compared to the Fed’s 19% of American output): “I call upon the ECB to remember that statement and realize that they haven’t done whatever it takes.” Wahlroos believes that Draghi and co. should once again ramp up asset purchases, “on a scale that will create an upward-sloping yield curve,” in order to ensure that “any idiot who can borrow money can make money.”
QT progress report
The Fed’s portfolio of securities held outright registered at $3.77 trillion, down $6.7 billion from a week ago and $14.5 billion below the trailing four-week average. Mortgage-backed securities accounted for the bulk of this week’s decline, with Federal agency debt securities holdings also dropping by $62 million, the first change for that line item since the second week of June.
Since the fall 2017 commencement of QT, total balance sheet assets are down by 11.2%, for a simple annualized pace of 7.7%.
Recap March 28
Stocks rose a bit, leaving the S&P 500 virtually unchanged over the past two weeks and higher by 12% year-to-date. Treasury yields ticked higher across the board, while the Dollar Index enjoyed a strong rally.
The surging greenback put the crimps on gold, as the Money of Kings dropped nearly 1% to a three-week low of $1,290 an ounce, but the iShares Emerging Markets USD Bond ETF managed to rise to near its best levels of the year. The VIX fell below 14.5.
- Philip Grant
Wednesday, March 27, 2019
Play ball!
A historical quirk in tomorrow’s Opening Day schedule.
A historical quirk in tomorrow’s Opening Day schedule.
Back to the well
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350%
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350%
Recap March 27
Play ball!
A historical quirk in tomorrow’s Opening Day schedule. From MLB.com:
The Jacob deGrom-Max Scherzer and Blake Snell-Justin Verlander matchups represent just the third and fourth times the top two finishers in Cy Young voting faced each other the following Opening Day -- and the other two were also in the same year!
On Opening Day 1979, the 1978 winner in the AL (Ron Guidry, Yankees) took on runner-up Mike Caldwell (Brewers), while the reigning NL Cy Young winner (Gaylord Perry, Padres) faced off against Burt Hooton (Dodgers).
Back to the well
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350% and settled at 750%, up from 23% on Friday. The reason for this skyward catapult? A government-manufactured shortage of liras. Today, Bloomberg reports that “some foreign banks were unable to meet their obligations at the close of trading [yesterday], forcing the central bank to extend hours for transferring funds to Turkey to 9 p.m., according to a senior Turkish official, who spoke on condition of anonymity.”
The measures imposed by Turkish President Recep Erdogan’s government have had one desired effect, as the lira has strengthened to 5.35 to the dollar, well ahead of the 5.85 conversion rate seen on Friday. That rebound was cause for celebration within Erdogan’s inner circle. The state-run Anadolu Agency quotes Treasury & Finance Minister Berat Albayrak (and the President’s son-in-law) as taunting the naysayers in Istanbul yesterday evening, asking: “Did we not witness some people claiming that one dollar would rise to eight liras, 15 liras as we head to [Sunday’s] elections? Check your phones and see how much liras to the dollar. Inshallah [God willing], it’ll be better.”
But that modest currency appreciation (the lira was 5.42 to the dollar last week) has come at the expense of other assets. The Borsa Istanbul 100 Index has seen an 8% decline through three sessions this week, including a 5.7% plunge today. The yield on Turkey’s 10-year, dollar pay bonds has jumped to 7.74% from 7.02% a week ago, while five-year sovereign credit default swaps have jumped to 459 basis points from 334 in the past week, approaching the 14-year wides of 575 basis points reached in September.
Meanwhile, the fallout has spread to other emerging market mainstays, as the South African rand fell as much as 1.7% against the dollar to its worst level since Christmas. Henrik Gullberg, currency strategist at Nomura International plc, writes today that “given prohibitively high rates in lira, it looks like the rand’s high external beta makes it the favorite currency to use as a proxy for emerging market risks.”
More broadly, the lira depreciation and sharp upward pressure on Turkish bond yields over the past year has claimed at least one institutional victim. Today, GF Securities Co. disclosed its GTEC Pandion Multi-Strategy Fund SP lost $139 million last year to leave the fund with a negative capital position and prime-broker Citigroup, Inc. holding the bag on “as much as $180 million in losses.” According to Bloomberg, Pandion’s demise “stemmed mainly from trades in the Turkish lira.”
In the Aug. 7, 2015 edition of Grant’s, Russell Napier, independent strategist and founder of the Electronic Research Interchange, suggested that the imposition of Turkish capital controls would spur a broader emerging markets crisis. Grant’s asked Napier today whether Turkey’s decision to effectively prevent investors from withdrawing capital from the country will indeed presage larger-scale trouble:
This is a major step in this direction. It will be something of a test case as to whether one can move to de facto capital controls without de jure capital controls. So, in theory capital moves freely but in practice through de facto state control of the banks, selling lira and buying foreign currency is almost impossible. Most governments have beefed up their tools for 'macro prudential regulation' and I have long argued that these can be used as capital controls.
As an example, if the government of Italy mandates that a certain percentage of Italian bank assets must be committed to Italian government debt then is that a capital control? I would argue it is, but they would say its macro prudential regulation. I have argued that the possible new monetary goal of the Fed is something unlikely to be implementable without de facto capital controls. Yield curve management, through enforced buying of Treasurys on savings institutions, is a firm of capital control and I think something that is necessary given the nature of the new strategic monetary target the Fed is discussing.
I do expect this to spread. Argentina signed a deal for the largest support package in IMF history. Even that has not been enough to stop the currency from falling to an all-time low.
Restricting the free movement of capital was imposed on Cyprus by the European Commission. We need to realize that this is not a policy only likely in emerging markets.
Turkey’s decision to jam overseas borrowing costs skyward has historical precedent. In the fall of 1997 the Hong Kong Monetary Authority took its overnight rate to 280% in a bid to protect a currency peg to the dollar as the Asian financial crisis was getting underway. Napier (who is speaking at the April 9 Grant’s spring conference – advt.), identified some crucial differences between the two situations:
The key to defending an exchange rate is not the interest rates you are prepared to set but the ensuing level of deflation you are prepared to endure. Hong Kong is not a democracy and it had a very sound commercial banking system.
In 1998 the high interest rates led to major declines in both wages and property prices. Commercial bank balance capital was not impaired by that major decline in property prices. The people did not go to the polls to demand action against lower wages as there were no polls to go to. They did not go to the streets either possibly as the PLA had just arrived. I think it is stating the obvious to say that Turkey is no Hong Kong. Hong Kong weathered all that with open capital accounts - Turkey will not.
As mentioned above, Turks turn out to vote this weekend.
Recap March 27
Stocks ticked moderately lower, as ten of eleven S&P 500 sector groups finished red but none by more than 1%, while another feverish rally in the Treasury complex saw the 30-year yield drop to 2.83%, just 43 basis points above the effective Federal Funds Rate.
Commodities came under pressure, with WTI crude and gold falling to $59 a barrel and $1,309 an ounce, respectively, as the Dollar Index enjoyed its fourth green finish in the last five sessions. The VIX edged higher to 15.
- Philip Grant
Tuesday, March 26, 2019
TRY hard
On Friday, the Turkish lira plummeted by more than 6% against the dollar.
On Friday, the Turkish lira plummeted by more than 6% against the dollar.
Depends where you sit
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions.
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions.
Recap March 26
TRY hard
On Friday, the Turkish lira plummeted by more than 6% against the dollar. Persistently high inflation, economic retrenchment (fourth quarter GDP fell 3% year-over-year) and dwindling foreign exchange reserves helped set the stage for that mini-panic (Almost Daily Grant’s, March 22), while a J.P. Morgan Chase & Co. analyst call for further lira depreciation likely exacerbated the rout.
Two days later, Turkish President Recep Erdogan warned that investors speculating on a weaker lira would face unpleasant side effects, telling listeners at an Istanbul campaign stop that “If you get involved in provocative acts, saying ‘foreign currencies will strengthen, this will happen, that will happen,’ you will pay a very heavy price.” It didn’t take long for Erdogan’s threats to come to pass. Over the weekend, both the country’s Banking Regulation and Supervision Agency and Capital Markets Board separately announced they were investigating J.P. Morgan.
Turkey also put the clamps down on investors looking to cash out of the local currency. Bloomberg reports today that foreigners seeking to exit their positions “are finding they cannot execute their trades because local lenders are under pressure not to provide liras, according to four bankers who declined to be identified.”
That logjam has helped drive the offshore lira rate to a staggering 367% overnight implied yield today. That’s up from 96% yesterday and 23% Friday.
Turkey’s offshore borrowing rate goes skyward. Source: The Bloomberg
The repressive measures have been moderately successful thus far; as the lira has rallied back to 5.4 per dollar, compared to 5.76 on Friday and 5.42 one week ago. Turkey is holding local elections across the country on Sunday.
Depends where you sit
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions. Today, The Wall Street Journal reports that the ride-share company is expecting shares to price above the previously indicated range of $62 to $68 thanks to “strong investor demand” on the company’s roadshow. Last week, Reuters relayed that the offering was already oversubscribed by the second day of the investor tour.
With pricing for the deal expected tomorrow, analyst Tom White of D.A. Davidson is looking to get the jump on things. Last week, White gave Lyft its first “buy” rating and applied a $75 price target on the company. In an interview with Bloomberg yesterday, the analyst explained that while he can confidently forecast revenue growth, the other side of the ledger is more difficult to predict:
The expenses side is a little trickier, especially when it comes to the incentives Lyft deploys to attract drivers. They give an overall number, but you don’t understand how much is attracting riders versus drivers.
That’s where the art comes into play. With investing I think there’s an element of science and hard numbers and math, but there’s also a bit of art and creativity that you need to employ as well.
Those waiting for profitability best get themselves comfortable. White expects red ink out to at least 2022, the furthest year in his model.
While investors don’t seem to mind operating losses as far as the eye can see, a different set of Lyft stakeholders is a bit less sanguine. Yesterday, Business Insider reported that the company was forced to move the location of its San Francisco roadshow after protesting drivers blocked the entrance to the Omni Hotel.
Less art, more math. Source: Business Insider
Recap March 26
Stocks finished off their best intraday levels but still managed a solid advance on the S&P 500, with energy taking the lead as WTI crude edged back over $60 a barrel. Commodities performed well as a whole, with the CRB Index rising 0.5% despite the best close for the U.S. Dollar Index in two weeks.
Treasury yields ticked higher across the curve, as the 10-year settled at 2.42%, one basis point above the overnight Fed Funds rate. The VIX lost 9% to fall back below 15.
- Philip Grant
Monday, March 25, 2019
Platform heels
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay:
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay:
Turf wars
Earlier today, former Fed chair turned
Earlier today, former Fed chair turned
Private investigations
On Friday, the Securities and Exchange Commission filed suit against private
On Friday, the Securities and Exchange Commission filed suit against private
Recap March 25
Platform heels
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay: The documents for a shelved initial coin offering (ICO) called the “Sponsy blockchain project.” For a starting ask price of $60,000, would-be buyers would receive “thousands of lines of code,” and “industry-leading” software, along with a full set of fundraising documents “designed and approved by investment bankers.”
Alphaville’s Jemima Kelly spoke with Sponsy progenitor Ivan Komar, who lamented the legal advice which hindered the coin launch:
We hired a lawyer and that was a big mistake for us. Because our lawyer basically told us that we should not launch any ICO before we built a real product that might have some users. And I asked him why, because I saw so many ICOs out there who did not have any idea for any product, yet they managed to raise tens of millions of dollars.
We would not have tried to build a product first, we would have tried to run a token sale as soon as possible, to jump into this crypto craze bandwagon, and raise as much money as possible before building any product. And that’s exactly what others were doing.
Komar also observed:
The core business model would run just as well in the centralized world without any tokens or crypto or blockchain... They can easily eliminate the crypto functionality out of this. The core component is a platform — it doesn’t require any crypto or blockchain component to work. Just a typical, centralized server.
As for the auction, no bids have been submitted, yet.
Turf wars
Earlier today, former Fed chair turned distinguished fellow at the Brookings Institution Janet Yellen weighed in on modern monetary theory. Yellen told attendees at a Credit Suisse conference in Hong Kong that she “is not a fan” of the idea that the government can finance its own spending through money printing (with the Fed monetizing the government’s debts) as opposed to taxation.
But while Yellen scorns MMT in name, she endorses something like it in spirit. According to Reuters, Yellen told a group of bankers last Thursday that were the Fed to “reach the limits in terms of purchasing safe assets like longer-term government bonds,” expanded QE covering corporate debt and equities would be an attractive option. Though not currently allowed under federal law, “it could be useful to intervene directly in assets where the prices have a more direct link to spending decisions.”
The Feb. 22 edition of Grant’s examined the relationship between MMT, which is largely dismissed by mainstream economists, and post-2008 monetary machinations, which suffer no such establishment derision:
There’s a refreshing candor in radical polemic. [Economist Stephanie] Kelton et al. want the Fed to print the money and turn it over to the Treasury without the intermediate, Wall Street-fattening step of issuing securities. And for their inquisitive trouble, they are shouted down as crazies.
What’s crazy? Bond-market-destroying negative interest rates, enforced by the central banks, would be one candidate; asset-price-levitating (and society-polarizing) QE, another.
The San Francisco Fed the other day issued an economic report posing the question “How Much Could Negative Rates Have Helped the [Post-2008] Recovery?” The author’s conclusion, in a word: plenty.
Query: Just who’s crazy?
Private investigations
On Friday, the Securities and Exchange Commission filed suit against private, peer-to-peer lender Direct Lending Investments, accusing the firm of systematically overstating returns by 2-3% per annum. The SEC’s move adds another chapter to the Direct Lending saga. In a March 8 analysis of corporate health at this stage in the economic cycle, Grant’s noted the curiously consistent performance of the vehicle before an abrupt end to the proceedings:
A 2017 [Direct Lending] presentation featured performance data that showed an almost unvarying monthly appreciation of a little less than 1%. In 2016, net monthly returns varied by no more than six basis points. In five of those 12 months, investors earned exactly 85 basis points. A splendid, soothing, reassuring achievement it was: “The Fund’s $1 billion portfolio has generated consistent returns,” said the sales documents, not exaggerating. Yet assets under management did not grow.
The default came two weeks ago [investor redemptions were halted on Feb. 11]. Voip Guardian Partners I, the non-payer, represented no less than-one quarter of Direct’s portfolio. According to Bloomberg, Voip lends to small telecommunications companies against the collateral of accounts receivable. The big telecoms pay the small telecoms, the small telecoms pay Voip, and Voip pays direct.
Or did. Unpaid, Direct has run to federal prosecutors. Voip, denying criminality, asserts its financials are “immaculate” and that they have been for the “years” in which its faithfully done business with Direct. Pending clarification of the facts and resolution of the charges, it’s worth recalling that Direct was committed to preserving capital “during a recession.” It seems to have made no representation about the tail end of the corporate credit boom.
Indeed, there appears to be much more to the story than the dispute with Voip. Bloomberg, which reported the lawsuit this morning, also noted that Direct Lending founder Brendan Ross resigned a week ago, after the company “found evidence that the valuations of another investment may have been materially overstated.”
Recap March 25
A quiet day in equities saw the S&P 500 drift sideways in a tight range, while the largest sector-level move was a modest 0.55% gain for consumer discretionary. But the calm stock market contrasts with wild action in rates. Today, another powerful rally took the two-year Treasury yield to 2.25% (it stood at 2.97% in November), while the 10-year yield dropped as low as 2.38% intraday, below the 2.41% effective Fed Funds overnight rate.
Elsewhere, gold caught a bid to rise to $1,322 an ounce, near a one-month high, while a weaker dollar also helped the iShares J.P. Morgan USD Emerging Market Bond ETF recoup most of Friday’s losses. The VIX gave back early gains to remain at 16.5.
- Philip Grant
Friday, March 22, 2019
Still the smartest guys in the room
From The Wall Street Journal:
From The Wall Street Journal:
Salt in the wound
It’s been a smooth ride for third world debtors,
It’s been a smooth ride for third world debtors,
Recap March 22
Still the smartest guys in the room
From The Wall Street Journal:
Former Enron Corp. Chief Executive Jeffrey Skilling is looking to get back into the energy business, with a little help from his friends.
Just weeks after serving more than 12 years in federal custody on fraud, conspiracy and insider-trading convictions following Enron’s fall, Mr. Skilling has been holding meetings with former Enron executives and others, hoping to win backing for a new energy venture, people familiar with the matter said.
At least one former colleague has agreed to support Mr. Skilling’s comeback attempt: Lou L. Pai, the onetime head of Enron’s energy-services unit, has pledged to invest in the venture and indicated to others he is involved with Mr. Skilling, the people said.
Mr. Skilling has met with individuals who specialize in cryptocurrency, blockchain and software development in recent weeks, two of the people said.
Salt in the wound
It’s been a smooth ride for third world debtors, as the iShares J.P. Morgan U.S. Dollar Bond ETF reached a 10-month high Wednesday despite the Dollar Index remaining in the upper end of its 52-week range. Yet Turkey and Argentina, the largest and sixth-largest weightings in the index, respectively, are back in the soup.
Yesterday’s reading of Argentina’s fourth quarter GDP registered an alarming 6.2% year-over-year decline; the worst reading since 2009. As output goes into reverse, inflation accelerates. February CPI rose a whopping 51.28% year-over-year, more than double the 25.44% CPI reading logged in February 2018.
Those grim figures are spurring the government into action. Yesterday, the Central Bank of Argentina raised the policy rate by 87 basis points to 65.76%. On Wednesday, Bloomberg reported that the central bank asked Argentinian bank treasurers to raise their deposit rates, as the 30-day Badlar savings rate of 42.06% lags well behind both the overnight rate and the measured rate of inflation.
Meanwhile, the Argentina single-B-rated, dollar-pay 7 1/8 century bonds due 2117 trade at 75 cents on the dollar (they were issued at 90 cents), for a yield-to-worst of 9.52%. That’s off from the 80 cents seen in early February but above the sub-70 cent lows logged in December.
A relatively strong FX reserve position burnishes the bull case. Argentina’s central bank reported $68.2 billion in international reserves as of yesterday, the highest in at least five years and compared to less than $50 billion three months ago, while the country reached an agreement with the IMF Monday for an additional $10.9 billion in funding. The inviting yield and bountiful reserves aside, history isn’t exactly on the side of the creditors: The Land of Silver has defaulted on its international obligations on eight separate occasions in less than 200 years of modern history (Almost Daily Grant’s, June 19, 2017).
Trouble is likewise reappearing in Turkey. As the lira came under heavy pressure against the dollar this morning, the Central Bank of the Republic of Turkey announced that “considering the developments in financial markets,” it will suspend one-week lira repurchase auctions “for a period of time.” That move did little to stem the lira rout, as the Turkish currency fell more than 6% against the dollar to 5.81, the weakest level since October.
The developments in Turkey’s economy have likewise been grim. Inflation is heating up, with CPI rising 18.7% year-over-year in February, while GDP contracted 3% year-over-year in the fourth quarter. Turkish citizens are hoarding dollars, with central bank data showing that foreign currency holdings among residents rose to a record $175.8 billion as of March 15, up $4 billion in a week.
That rush out of liras is taking a toll. The Turkish central bank reported yesterday that international reserves fell to $28.5 billion as of March 15, down $6.3 billion in the first two weeks of the month. Henrik Gullberg, strategist at Nomura plc. in London, told Bloomberg that there’s only one reasonable explanation for that decline: “Since external debt payments can’t explain the decline in reserves, markets are assuming there is intervention going on.”
The lira’s sharp slide is putting the squeeze to those who borrowed in dollars. The Turkish government dollar-pay 5 3/4s of 2047, issued in May 2017 at 98.25, traded at 77.86 at midday for a yield-to-worst of 7.66%. On the corporate front, Bloomberg reported Wednesday that Turkish conglomerate Dogus Holding A.S., owner of the Nusr-Et steakhouses featuring celebrity chef Nusret Gökce (a.k.a. “Salt Bae”) is struggling to repay its obligations despite restructuring $2.5 billion in debt in December. The company, which has been selling assets, reported TRY 28.6 billion ($4.92) in liabilities at year-end, up 17% year-over-year.
Thanks, but do you have any pepper? “Salt bae” in action.
Two emerging market mainstays may be on the rocks, but hope springs eternal. Today, the Financial Times reports that single-B-rated Ghana’s $3 billion debt sale attracted a whopping $21 billion order book, allowing the West African nation to cut the yield on its 31-year bond to 8.95% from an expected 9.5%. After the rousing success of that sale, Ghana’s deputy finance minister Charles Adu Boahen is thinking big: “I think right now a 50-year bond is very possible but the question is at what price. This is a market-sounding exercise and there’s encouraging appetite.”
Recap March 22
Risk off, bigly. The three-month vs. 10-year Treasury spread inverted today for the first time since 2007, sending a historically unmistakable recession signal (if the inversion remains for 10 days, that is), and triggering a massive rally across the yield curve as the 10-year fell 10 basis points to 2.41%.
Stocks were hammered, with the S&P 500 losing 1.7% and the small-cap Russell 2000 suffering a 3.6% swan-dive. The VIX raced higher by 23% to 16.75, the most elevated weekly close since January. Gold bucked largely bearish commodity action to edge higher by $4 to $1,313 an ounce.
- Philip Grant
Thursday, March 21, 2019
You're un-fired
Yesterday’s Fed meeting featured a dovish trifecta.
Yesterday’s Fed meeting featured a dovish trifecta.
Canada goosed
Things are no great shakes in the Great White North.
Things are no great shakes in the Great White North.
QT Progress report
Recap March 21
You're un-fired
Yesterday’s Fed meeting featured a dovish trifecta. The central bank cut its view of 2019 U.S. economic growth, announced the end to “QT” balance sheet runoff in September and suggested that the tightening cycle underway since late 2015 would be put on ice “for some time,” leaving the overnight Fed Funds Rate in a 2.25% to 2.5% range.
This is a big shift from just three months ago when Chairman Jerome Powell proclaimed that “we have a strong forecast for 2019” and to expect “some further gradual [rate] increases” this year. Of QT, Powell remarked: “I think that the runoff of the balance sheet has been smooth and has served its purpose and I don’t see us changing that.” Two days later, Bloomberg reported that President Trump “has discussed firing” the Fed chairman. We can surmise that those discussions have abated in the interim.
Anyway, interest rates swiftly adjusted to the Fed’s new tack. Yields dove across the curve, with the seven-year note trading as low as 2.38% this morning, well below the 2.41% effective Fed funds rate. In addition, the gap between the three-month Treasury bill and the 10-year note flattened to as little as three basis points this morning, the narrowest differential in nearly 12 years.
The spread between the 10-year and three-month yields is an important indicator, James Bianco, president and eponym of Bianco Research LLC notes today. On six occasions over the past 50 years when the three-month yield exceeded that of the 10-year, economic recession invariably followed, commencing an average of 311 days after the initial signal. Bianco concludes that the market, like Trump, believes that the current Funds rate isn’t low enough:
While Powell stressed over and over that the Fed is at “neutral,” . . . the market is saying the rate hike cycle ended last December and the economy will weaken enough for the Fed to see a reason to cut in less than a year.
Canada goosed
Things are no great shakes in the Great White North. After reviewing the latest fiscal budget released yesterday, Fitch Ratings this morning commented that Canada’s gross government debt load “is higher than other triple-A-rated sovereigns, excepting the U.S., and remains close to a level that is incompatible with triple-A status.”
As a spendthrift government spurs rating agency-angst, the Canadian yield curve augurs a different kind of trouble. Today, the Canadian 10-year yield trades at 1.68%, down from 2.6% in the fall and well below the Bank of Canada’s 1.75% overnight funds rate.
Meanwhile, the correction in Canada’s long-running housing bubble continues apace: Statistics Canada reported last week that the new home price index saw its first year-over-year decline since 2009 in January (see the March 5 Almost Daily Grant’s for more).
That news augurs poorly, according to Steve Eisman, portfolio manager at Neuberger Berman who famously shorted mortgage-backed securities in the run-up to the U.S. housing bust and financial crisis. In an interview today in the Financial Times, Eisman reiterated he is short various Canadian banks. While not calling for an outright housing collapse, the manager believes that “a simple normalization of credit that hasn’t happened in 20 years” is nigh.
QT Progress report
An $8.2 sequential decline in mortgage-backed securities left the Fed’s portfolio of securities held outright at $3.78 trillion. That’s down $13.1 billion from the trailing four-week average.
Since the Oct. 1, 2017 onset of QT, total balance sheet assets are down by 11.1%, a 7.6% simple annualized pace.
Recap March 21
No slowdown here. Stocks ripped higher with the S&P 500 gaining more than 1% to finish at its best level since Oct. 10, as tech led the way with a 2.5% advance and a 3.5% gain in the Philadelphia Semiconductor Index to a record close. Treasury yields finished mostly higher after yesterday’s aggressive rally, though the long bond rallied to leave the 30-year yield at 2.96%.
The greenback staged a nice recovery, as the Dollar Index jumped nearly 1% to recoup all of yesterday’s losses. Commodities held up pretty well considering, with the CRB Index losing only 0.1% while gold and WTI crude held near $1,310 an ounce and $60 a barrel, respectively.
- Philip Grant
Tuesday, March 19, 2019
Lyfted
From Reuters:
Lyft, Inc.’s initial public offering is oversubscribed based on commitments made so far by investors, making it more likely that the ride-hailing startup will fetch or even exceed the $23 billion valuation it is seeking, people familiar with the matter said on Tuesday.
The roadshow began yesterday.
Our man in Rio
“Waste places” no more? Emerging market equities have fared well of late, with the MSCI Emerging Market Index rising 14% from its late October lows as the Fed has backed off its rate hike regime and hinted at an imminent end to the QT balance sheet runoff program.
If market expectations are on the beam, more good tidings could be on the way for EMs. According to the latest Bank of America Merrill Lynch Investor Survey, a net 50% of respondents believe the dollar is overvalued, a 16-year high. A weaker greenback of course allows smaller countries to more easily service their largely dollar-denominated debt loads.
Brazil, the fifth-largest constituent in the MSCI gauge, has been at the forefront of the recent bull move. After suffering a 28% dollar-denominated decline from January to September of last year, the benchmark Ibovespa Index has since risen by 48% in dollar terms (when now-President Jair Bolsonaro pulled into the campaign lead shortly after being stabbed), taking the benchmark index above the 100,000 level for the first time yesterday.
There’s more where that came from, according to Bernd Berg, strategist at Woodman Asset Management who anticipated both the real (Brazil’s local currency) selloff of 2015 and asset price rally last fall: “The Brazilian stock rally should accelerate this summer. Pension reform would be a major boost and fresh impetus for a second leg of gains.” Berg sees the Ibovespa rising to 150,000 by the end of next year.
Beyond the possibility of pension reform, bulls can point to the relatively low cost of money, as the benchmark SELIC interest rate remains at a record-low 6.5%, down from 13.75% as recently as January 2017 (the Brazilian Central Bank is expected to leave rates unchanged at tomorrow’s meeting). Inflation remains relatively subdued despite a recent uptick, with the CPI up 3.89% year-over-year in February, well below the 6.17% five-year average reading.
Meanwhile, Brazil looks to solidify economic ties with world powers. Bolsonaro is in the U.S. to meet with Donald Trump today after visiting CIA headquarters on Monday, while economy minister Paulo Guedes told reporters that commerce secretary Wilbur Ross has agreed to visit Brazil, the first such trip in 10 years. That’s not to say the Brazilians are putting all their eggs in a red, white and blue basket. The University of Chicago-educated Guedes said of economic ties with the world’s second-largest economy: “We are dancing with the Chinese, and they dance well.”
But faltering growth presents a risk to the bull case. Yesterday’s release of the IBC-Br Economic Activity Index fell 0.41% on a sequential basis, far worse than the expected 0.1% decline and the third month-over-month drop in the last five readings. On Friday, analysts surveyed by the central bank cut their 2019 GDP growth forecast to 2.01% from 2.28% on March 8 and 2.49% one month ago, while local brokerage XP Securities LLC slashed its own estimated growth level to 1.5% from 2%, noting that “it’s entirely plausible to see 2019 GDP below that” lowered 1.5% figure. Hopes for a growth pickup are abating, says XP, “as cries of a confidence-led expansion get drowned in a sea of poor economic data this quarter.” Declining GDP expectations match last year’s pattern, when the Central Bank-surveyed analysts predicted 2.6% real growth at the outset of the year. Actual 2018 output growth footed to 1.1%.
Then there’s pension reform, crucial to both stabilizing Brazil’s shaky fiscal position as well as bulls’ hopes for higher asset prices. A report from Fitch Ratings on Thursday argues that the measures “will face significant legislative hurdles and is likely to under-deliver on market expectations for long-term fiscal savings.” Analysts at XP also argue that passage will be more drawn out than investors might hope:
Success in the House will not depend on just one vote session, but on successive rounds in which, after the basic text, re¬presentatives will vote on the so-called highlights, themes that will be separated from the rest of the proposal, so they can be voted on individually. This series of voting sessions will be the most critical moments, real tests of strength and en-durance for the negotiating skills of Bol¬sonaro’s government.
It is for this exact reason that we assert that this short proceeding heralded by the government is too optimistic.
An analysis in the Jan. 12, 2018 edition of Grant’s contended that the strong post-2016 rally in Brazilian asset prices, in tandem with rising deficits and limited political will for pension reform, left both local equities and the real vulnerable to a tumble.
An Oct. 5 follow-up said of Bolsonaro and socialist opponent Fernando Haddad: “The question is not, ‘Which of the two candidates is more bullish?’ but rather, ‘Who’s the less bearish?’” One thing’s for sure, policy success is more priced-in than it was six months ago.
Recap March 19
Stocks gave back early gains to leave the S&P 500 unchanged on the day, while Treasury yields ticked slightly higher across the board with the 10-year settling at 2.61%. Modest dollar weakness helped the CRB Index edge into the green, and the VIX closed at 13.56, a one-week high.
- Philip Grant
Monday, March 18, 2019
If you build it they will come?
From The Wall Street Journal:
From The Wall Street Journal:
Racing to a red light
This morning, Lyft, Inc. took another step
This morning, Lyft, Inc. took another step
Recap March 18
If you build it they will come?
From The Wall Street Journal:
The first U.S. exchange company to launch bitcoin futures has pulled the plug on them, the latest sign that mainstream financial firms are losing their enthusiasm for cryptocurrencies.
Cboe Global Markets, Inc. said in a notice to traders last week that it “does not currently intend to list additional XBT futures contracts for trading.” XBT is the symbol for the bitcoin futures listed by Cboe.
Racing to a red light
This morning, Lyft, Inc. took another step towards an initial public offering, disclosing in an amended SEC form S-1 that it will offer 30.8 million shares at a price of between $62 and $68 per share. If priced at the high end of that range, Lyft will garner a total valuation of between $21 billion and $23 billion, according to a Bloomberg report citing a company source.
Projected to debut in the second quarter, Lyft is on pace to beat its fellow ride-share unicorn Uber Technologies, Inc. to the public markets, with Uber expected to file its own IPO paperwork some time in April according to Bloomberg. As Reuters noted on Thursday, being first to market is important to Lyft, as Uber is expected to garner a valuation of as much as $120 billion according to investment bankers, potentially crowding out its smaller rival.
Upstart Lyft’s brisk domestic growth will underpin its marketing strategy to investors, as U.S. market share rose to 39% at year-end 2018, up from 22% in 2016. The company will also emphasize its profile as a pure play on the ride share market, in contrast with Uber, which “plans to portray itself as a global logistics and mobility platform, and will spend less time on metrics specific to its core ride-hailing business,” per Reuters. Back in the fall, Uber CEO Dara Khosrowshahi drew a parallel between his company and Jeff Bezos’ behemoth, telling the Financial Times that “[C]ars are to us what books were to Amazon.” On that score, Khosrowshahi has his work cut out for him.
The Nov. 2 edition of Grant’s included an analysis of just why Uber’s Amazonian ambitions seem far-fetched: Primarily, a lack of profits. Last year, as Lyft’s revenues doubled to $2.2 billion from $1.1 billion, net losses on an adjusted EBITDA basis grew by 36% to $943 million. Uber, which last year generated 43% year-over-year revenue growth and an $11.3 billion top line, reported negative $1.8 billion in adjusted EBITDA, an improvement from the $2.2 billion adjusted EBITDA shortfall in 2017.
Might the passage of time allow the pair to eventually transition into the black? Writing in the Naked Capitalism blog on March 5 following the release of Lyft’s original S-1 filing, transportation expert Hubert Horan concludes that the filing documents provide little comfort:
Lyft’s prospectus provides absolutely no data demonstrating that it has the ability to profitably raise prices over time, increase operational efficiency or win significantly greater market share. It cites “growing the rider base” as the first plank of its future growth strategy, but provides no data showing what it thinks its current share of the market is, no estimates of future aggregate market growth, no evidence of what might drive that growth, and no explanation of what its future growth potential might be. Lyft makes no attempt to lay out a possible path to future profitability, or even a timeline as to when breakeven might be achieved.
With profitability a far-flung hope, the ride-share companies are getting creative. Lyft’s S-1 notes that the company utilizes a bespoke metric called “contribution.” Yes, contribution. Contribution is intended “to evaluate the effectiveness of our business strategies, and to communicate with our board of directors concerning our financial performance.” Unsurprisingly, the results are flattering. The contribution line-item showed a $920 million gain last year, compared to the $943 million adjusted EBITDA loss.
In a Breakingviews post Friday, columnist Richard Beales wrote of that newfound accounting innovation: “It’s a metric that’s supposed to represent a steady-state level of profitability, excluding the costs associated with growth.” But, of course, growth is what investors are paying for. The prospective valuation represents “the kind of eye-watering multiple of sales that only rapidly expanding companies attract. Switching off growth in the foreseeable future, even in return for profit, would knock that down sharply."
As the pair’s IPO preparations continue, one major Uber investor is looking to ensure that things go smoothly. On Wednesday, The Wall Street Journal reported that a SoftBank Group-led consortium “is in late-stage talks to invest $1 billion or more into Uber’s self-driving unit. . . a move that would help the ride-hailing firm bolster its pitch to investors.” Lyft looks to be following a similar script in hopes of showing a good top line this quarter. Recently, some users have received email promotions offering discounts of as much as 50% for 10 rides.
Recap March 18
Another solid day for stocks saw the S&P 500 extend its year-to-date-gains to 13%, as a 1% rip in the Dow Transport Index helped offset a red finish in the tech-heavy NYSE FANG+ Index. Commodities remained strong with the CRB Index making its best close since late November and WTI crude rising to $59 a barrel. Treasury yields rose across the curve with the 10-year ticking back above 2.6%.
- Philip Grant
Friday, March 15, 2019
There's one for you, 19 for me
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE)
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE)
Patch work
The Organization of the Petroleum Exporting Countries struck a vigilant
The Organization of the Petroleum Exporting Countries struck a vigilant
Recap March 15
There's one for you, 19 for me
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE) issued an alarming press release: “After a periodic review of our tax books and records, Coty now estimates that our pending March 15, 2019 dividend will be classified as a taxable dividend.” What’s more, six prior quarterly dividends paid out since Sept. 14, 2017 that had been designated as tax-free returns of capital have been reclassified as taxable dividends.
COTY shareholders have been inconvenienced but may not mind too much. Shares rose by 1% the day after the disclosure, and are up a cool 67% year-to-date. The short interest stands at just over 15% of the float, according to Bloomberg.
Patch work
The Organization of the Petroleum Exporting Countries struck a vigilant tone in its monthly report released yesterday. Noting a combination of softer-than expected global demand and an uptick in anticipated non-OPEC supply, the cartel urged its members to stick to their quotas: “This highlights the continued shared responsibility of all participating producing countries to avoid a relapse of the imbalance and continue to support oil-market stability in 2019.”
Recent fundamental trends help explain the producers’ concern. The International Energy Agency estimates world oil demand at 99.8 million barrels per day (mbpd) as of Jan. 31, up from 98.8 million year-over-year. Supply growth has outpaced that, reaching 100.4 mbpd at the end of January, up from 97.6 million in the first month of 2018.
Yet energy prices have enjoyed a solid rebound, recouping nearly half of the plunge seen in the fourth quarter with West Texas Intermediate crude rising 27% this year to $58 a barrel.
The OPEC (and Russian) supply cuts agreed to in December, in tandem with involuntary, politically-driven Venezuelan export declines, have already made an impact. Total OPEC production footed to 30.5 mbpd as of Feb. 28, down from over 33 mbpd as recently as November. Stateside, production growth continues apace, standing at a near-record 12 mbpd as of March 8, according to the Department of Energy. But the increased production hasn’t translated into much excess supply: U.S. inventories stand at 44.9 million barrels, just over the five-year average of 43.9 million.
Meanwhile, the Kingdom of Saudi Arabia, OPEC’s biggest swing producer, has slashed production to 10.1 mbpd in February from 11.1 mbpd three months ago. The Saudis were whipsawed last fall by President Trump’s decision to issue broad waivers to previously announced Iranian sanctions, leaving the market in oversupply. Mohammad Darwazah, director at Medley Global Advisors, tells Bloomberg that the Saudis are now less inclined to listen to Trump’s exhortations for lower prices: “We’re going to see quite a different Saudi Arabia maybe than what we saw in the fall. I don’t think they’re going to be as accommodative.”
Domestic demand has been solid. Colin Fenton, managing partner at BlackLight Research LLC, notes in a report Monday that the crucial PADD 3 region covering the U.S. Gulf Coast saw runs (meaning refiner demand) at 8.6 mbpd in the week ending March 1, “916,000 bpd above the cyclical average, by our math.” The Midwest PADD 2 region saw 3.5 mbpd that same week, 54,000 bpd above Blacklight’s cyclical average.
More broadly, there is good reason to expect that the IEA’s demand forecast of 100.6 mbpd in 2019 will be upgraded. “Please remember that the IEA has now revised its demand projection higher in seven of the last eight years, by 1.2 mbpd on average,” notes Leigh Goehring and Adam Rozencwajg, the eponyms of natural resource investment firm Goehring and Rozencwajg Associates. The pair “don’t expect 2019 to be any different.”
Grant’s, continuing to cast our analytical lot with BlackLight, Goehring and Rozencwajg in a bullish stance on energy prices, last fall identified a quartet of cheap companies that, we believe, offer attractive investment propositions. For more, see the Nov. 30 issue.
Recap March 15
Another strong day in stocks wrapped up a great week for the bulls, as the S&P 500 rose nearly 3% to close to within 4% of the all-time highs reached Sept. 20. By comparison, the tech- and momentum-heavy NYSE FANG+ Index sits 15% below its June high water mark.
Elsewhere, a weaker dollar helped commodities erase early losses, while Treasurys rallied again with the 10-year yield falling to 2.58%, its lowest in ten weeks. The VIX fell for a fourth time in five tries for its first sub-13 finish since October.
- Philip Grant
Thursday, March 14, 2019
All politics are local
From the New York Post:
From the New York Post:
Tethered to what again?
A report today from Frances Coppola of Forbes identifies a subtle,
A report today from Frances Coppola of Forbes identifies a subtle,
QT Progress report
Recap March 14
All politics are local
From the New York Post:
The new honorary mayor of Fair Haven, Vermont — a 3-year-old goat named Lincoln — was officially sworn into office this week. Lincoln was dressed in a sash reading “Mayor” for the Tuesday ceremony at the Fair Haven town offices.
Fair Haven, a town of about 2,500 along the border with New York just west of Rutland, does not have an actual mayor. Town Manager Joseph Gunter says the honorary pet mayor idea was conceived as a fundraiser for a playground, but it turned into a civics lesson for kids.
On the way out of the office, the honorary mayor defecated on the floor — leaving clean-up to the police chief and other attendees.
Tethered to what again?
A report today from Frances Coppola of Forbes identifies a subtle, yet significant, development in the Tether cryptocurrency saga. Tether, which has long claimed to be backed on a one-for-one basis with U.S. dollars, is a crucial mechanism for the easy conversion of fiat currency to cryptos and back again, as digital exchanges do not have access to the U.S. banking system. The purportedly dollar-backed crypto was part of a skeptical Grant’s analysis in the Sept. 8, 2017 edition subheadlined: “Tethered to what?”
As noted by Coppola, seemingly minor recent changes to language on the Tether website could carry major implications for the crypto realm. Whereas the front page had claimed that the company’s reserves were “subject to frequent professional audits,” that language was subsequently switched to “professional verifications.” A second revision removed any reference to outside oversight, instead telling website visitors that “reserve holdings are published daily” and that “all tethers in circulation always match our reserves.”
In addition, the site had claimed that tethers were “always backed one-to-one, by traditional currency held in our reserves.” An addendum, which appeared to take place on Feb. 26 (found using the Internet Archive’s “Wayback Machine”), now broadens the definition of “100% backed” to cover not only currency and cash equivalents but potentially also “other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.”
As Tether gives itself rhetorical breathing room, a Silicon Valley heavyweight lurks. In December, Bloomberg reported that Facebook, Inc. (FB on the Nasdaq) is working to launch its own “stablecoin,” or dollar-backed crypto, that will allow users to transfer funds via the WhatsApp encrypted messaging service.
That potential development is rife with possibility. Barclays analyst Ross Sandler estimated in a report Monday that such a foray into payments could translate into as much as $19 billion in revenue, with a $3 billion top-line boost as the base case (for reference, FB reported $55.8 billion in revenue for 2018). Sandler believes that “merely establishing this revenue stream starts to change the story for Facebook shares in our view.”
One potential problem with this scenario: Cryptos are something of a regulatory black hole, with anti-money laundering and “know your customer” regulations likely factoring in to Wells Fargo’s spring 2017 decision to cut ties with exchange Bitfinex and Tether (the two companies share a management team). Such stablecoins present even greater risk, as the dollar link provides regulators even more incentive to investigate potential violations. Were such “Facebookcoins” (or, perhaps, “Zuckerbucks”) found to be used for nefarious purposes such as terrorism, money laundering or disguised campaign funding, the political target on Facebook’s back would grow even larger.
QT Progress report
No change this week, as the Fed’s portfolio of securities outright holds at $3.786 trillion, with Treasurys accounting for just under 58% of the total, unchanged from six weeks ago.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 10.9%, for a 7.6% simple annualized pace of decline.
Recap March 14
Stocks drifted sideways, with the S&P 500 consolidating its steep rally to remain in the green by 2.5% for the week. The dollar caught a bid and commodities finished flat, with WTI crude advancing to $58.50 a barrel while gold tumbled back below $1,300 an ounce. Treasury yields generally finished little changed, though strength at the front end and softness in longer issues left the curve a bit steeper. The VIX fell to 13.27, its lowest close since Oct. 3.
After the close, Facebook announced that Christopher Cox, chief product officer since 2014 is leaving the company. FB shares ticked lower by 1.7% in extended hours trading.
- Philip Grant
Wednesday, March 13, 2019
Patent pending
A new chapter in financial innovation.
A new chapter in financial innovation.
Arc of the covenant
An analysis from S&P’s LCD unit yesterday calculated
An analysis from S&P’s LCD unit yesterday calculated
Recap March 13
Patent pending
A new chapter in financial innovation. From Barron’s yesterday:
Salt Financial, an exchange-traded fund shop with less than two years under its belt, filed on Tuesday to launch an ETF that will actually pay investors for investing in it, at least at the start. The negative-fee ETF is finally here, making online lender Social Financial or SoFi’s zero-fee ETFs old news.
Like SoFi’s zero-fee ETFs, Salt’s ETF will effectively zero out the cost and then some via what is called a management fee waiver. Salt’s investment advisor has pledged to add 0.05% [five basis points] of assets to the ETF, but only on the first $100 million in assets or until April 30, 2020. Once the ETF crosses that level or hits that date, it will charge its true fee of 29 basis points.
Negative-fee investment products may be the hot new thing, but a more familiar, if equally confounding, phenomenon persists: Lenders paying borrowers for taking their money. After falling below $6 trillion last year, the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index has seen its market capitalization jump back above $9 trillion. On the authority of Sidney Homer and Richard Sylla, negative interest rates had not been seen in substantial size during 3,000 years of financial history prior to this cycle.
Market cap of the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index. Source: The Bloomberg
Arc of the covenant
An analysis from S&P’s LCD unit yesterday calculated that the trailing 12-month default rate for leveraged loans has fallen to just 0.93%, down from 1.62% in February and from a long-term average of 3.1%. The sharp sequential decline is the result of iHeartMedia, Inc., which defaulted last March, being removed from the trailing 12-month calculation.
The low default rate provides another enticement to lend and borrow. LCD reports that institutional loans outstanding in the U.S. now total a record $1.17 trillion, up from $1 trillion last May. Across the U.S. and Europe, total term loans outstanding have doubled in the last 10 years to $2.65 trillion, according to the Bank for International Settlements.
That breakneck growth pace is making regulators nervous. Last Thursday, the Financial Times reported that the Financial Stability Board is investigating components of the leveraged loan market, particularly the practice of bundling loans into collateralized loan obligations (according to LCD, CLOs now account for 50% to 60% of U.S. leveraged loans). On Feb. 28, Bloomberg reported that Japan’s Financial Services Agency has been questioning local lenders about their CLO concentration, particularly Norinchukin Bank, which itself holds a nearly $62 billion CLO portfolio (roughly 9% of global supply) and bought one-third of all U.S. and European issuance in the fourth quarter (Almost Daily Grant’s, Feb. 21).
A Sept. 7 cautionary Grant’s CLO analysis, noting that the securities are divided into tranches based on risk profile and recovery potential, called attention to the acute cyclical risks that reside in the lower-rated and higher-yielding tranches:
It’s not quite true that a CLO is only as good as its loans. What is true is that a portion of a CLO is only as good as its loans, that portion being the junior one, equity and mezzanine debt. Deterioration in the quality of late-boom debt puts those segments at risk.
Late-boom conditions are on full display. Yesterday brought word that Moody’s covenant quality indicator reached a record-worst in February, eclipsing the prior nadir set in August 2015. The deterioration is comprehensive, as the agency notes that “weak covenant packages are clearing the market in all rating categories.”
Meanwhile, high profile deals continue to push the envelope. Yesterday, Bloomberg reported that a $10 billion loan and bond syndication financing Brookfield Asset Management, Inc. and Caisse de dépôt et placement du Québec’s leveraged buyout of Johnson Controls International plc is attracting strong bidding interest, “even after Xtract Research categorized its covenants, terms that protect investors, as some of the weakest and ‘most aggressive’ the firm’s analysts have seen.” Yield indications are now below initial guidance, even though some investors “had balked in particular at terms related to how easily the company can pay itself dividends.”
Recap March 13
Another solid rally in stocks pushed the S&P 500 to its best close since Nov. 7, up 12% year-to-date. Commodities fared even better, with the broad CRB ripping more than 1.1%, as WTI crude and gold rose to finish above $58 a barrel and $1,310 an ounce, respectively. Treasury yields rose slightly to snap the recent rally, while high yield was bid with equities and investment grade trading a bit lower with rates.
- Philip Grant
Tuesday, March 12, 2019
Drumroll
Confusion reigns down Mexico way. This morning, deputy finance minister Arturo Herrera told the Financial Times that the MXN 48 billion ($2.5 billion) Dos Bocas oil refinery project would be put on hold, instead using those funds to help state-owned Petroleos Mexicanos (Pemex) burnish its long-flagging oil production. But president Andrés Manuel López Obrador (AMLO for short) contradicted that assertion just hours later, stating that the refinery project will move ahead as planned. That proclamation helped spur a whipsaw in the Mexican peso, which had rallied nearly 1% against the greenback following Herrera’s claim in the FT.
Communication breakdowns aside, the Mexican government has loosened the purse strings to aid Pemex. On Feb. 15, AMLO announced a MXN 107 billion ($5.5 billion) bailout package, including tax relief and $1.3 billion in direct recapitalization to the state-owned enterprise, promising that “if more is needed, we’ll allocate more funds.” More state monies are likely on the way, according to remarks from finance minister Carlos Urzua on Friday, although he noted the timeline remains fluid: “I think in March. We still don’t know exactly.”
One thing’s for sure – Pemex can use the help. Between 2008 and 2017, the company spent $77.4 billion more on capital expenditures than it generated in cash flow from operations (non-Spanish speakers looking for full 2018 results are hindered by the non-working condition of the company’s English-language website). Meanwhile, production remains in persistent decline, with output falling to a record low 1.62 million barrels per day in January, less than half of the 3.4 million barrels per day peak achieved in 2004.
While production shrinks and losses mount, the debt pile keeps growing, with total borrowings at $106 billion on top of $66 billion in pension liabilities. The rating agencies are concerned: Fitch issued a two-notch ratings downgrade, to triple-B-minus (one notch above junk) on Jan. 29. S&P cited the oil giant’s precarious finances as rationale for lowering Mexico’s sovereign rating outlook to negative on March 1, noting the “added burden” placed on Pemex by AMLOs populist energy policies that include the planned Dos Bocas refinery discussed today. In a Feb. 29 report, Moody’s called attention to the implications of Pemex’s struggles on Mexico’s sovereign credit profile: “If market sentiment does not improve, Pemex will require additional sovereign support in 2020 and beyond, further eroding government finances.”
By way of response, the president placed the blame on past administrations, complaining that the rating agencies “are punishing the country for the neoliberal policies implemented over the last 36 years, which were a total failure. Especially the last few years [predecessor Enrique Peña Nieto opened the oil and gas industry to private exploration in 2014].” On the bright side, AMLO continues to enjoy popular support, with a Reforma poll of 1,500 adults conducted between Feb. 28 and March 6 finding that 78% of respondents approve his performance.
But will investors share that enthusiasm? Following the February bailout, Fitch noted that that $5.5 billion bailout falls well short of the agencies’ estimated $12 billion to $17 billion of annual cash requirements needed to arrest production declines and pay down debt. Shamaila Khan, head of emerging markets at AllianceBernstein tells the FT that: “I don’t think Pemex can cling to investment grade much longer unless the government takes drastic action – and the government thinks it is taking drastic action. That’s what’s concerning.”
Grant’s issued its own bearish verdict on Pemex and Mexican sovereign credit in the March 23, 2018 edition, noting the not-insubstantial risk that the flagging oil company’s debts may one day become the liabilities of the government. That analysis included a blunt assessment from John Padilla, partner and managing director of energy consulting firm IPD Latin America: “Pemex, in any private sector context, would absolutely be considered bankrupt.”
The bond market is still optimistic, as the senior unsecured 4 7/8% notes due 2024 trade at 97.25 cents on the dollar to yield 5.53% a 312 basis point premium over Treasurys. That’s down from 101 to yield 4.7% and 199 basis point pickup last year, but well above the recent trading lows of 92 cents on the dollar reached last fall. Longer-term credits have reacted a bit more, with the senior unsecured 6 3/4% notes of 2047 now trading just below 91 cents on the dollar, down from 99 last March.
Recap March 12
Stocks built off yesterday’s strong rally with the S&P 500 extending the week’s gains to nearly 2% and come within a few ticks of the 2019 closing high, while a softer greenback helped commodities as gold pushed back above $1,300 an ounce.
Treasurys were likewise strongly bid as yields fell across the curve, with a brisk 10-year auction this afternoon helping the benchmark rate close at 2.61%, breaking out of a narrow six-week trading range. The VIX finished below 14 for the first time in more than a week.
- Philip Grant
Monday, March 11, 2019
To everything there is a season
Bag of chips
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy
Recap March 11
To everything there is a season
From KDKA in Pittsburgh:
A man is behind bars at the Allegheny County Jail after accusations that he choked another man for singing Christmas songs [this morning].
Bag of chips
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy peer Mellanox Technologies Ltd. (MLNX on the Nasdaq) for $6.34 billion in cash. Mellanox, a chipmaker specializing in data center transmission and storage, has been a hot commodity, as a bidding war began in late January with a reported $5.5 billion approach from Intel Corp. Investors approved, with NVDA shares jumping 7%.
To bag its prize, Nvidia will pay just under six times trailing revenue and 57 times trailing adjusted EBITDA, though Mellanox’s EBITDA is expected to rise to $488 million this year, nearly double 2018’s $251 million figure. The $125 per share bid represents a 53% premium to MLNX’s Jan. 29 close. The deal is subject to regulatory approval in China, which famously helped scuttle the planned $44 billion 2018 combination between Qualcomm, Inc. and NXP Semiconductors N.V.
For Nvidia, the target offers the welcome prospect of diversification. The company’s core business has faltered of late, as the crypto boom that generated brisk demand for NVDA’s graphics-processing units (GPUs) has gone the way of the dodo. Analyst William Stein of SunTrust Robinson Humphrey writes today that “investors may view [the deal] as a defensive mechanism to offset current weakness in both gaming and datacenter sales,” while Rosenblatt Securities’ Hans Mosesmann notes that competitive factors loomed large: “Nvidia may have calculated that Mellanox as part of Intel would have hindered Nvidia’s long term growth rate.”
After more than doubling revenues and nearly quadrupling adjusted EBITDA (to $11.7 billion and $4.1 billion, respectively) in the three years ended Jan. 27, Nvidia has seen a sharp reversal in its fortunes. This year, sales and adjusted EBITDA are currently projected to decline to $11.2 billion and $3.5 billion, as the company has twice been forced to cut guidance since November. Mr. Market has reacted accordingly, with NVDA shares falling by 32% since June 29, compared to a 2% gain from the Nasdaq 100 Index.
NVDA five-year price chart. Source: The Bloomberg
A bearish June 29 Nvidia analysis in the pages of Grant’s argued that the bursting of the crypto bubble would deliver operating disappointment well beyond market expectation, while the virtuous cycle seen through 2017 of rising crypto prices and strong demand for high-end GPU’s from digital miners would be replaced by reciprocal weakness.
Before the crypto bubble, the demand for high-performance memory boards varied with the quality of new video game releases. Perhaps it will again. Falling crypto prices, by denting the returns to digital mining, have also dampened the demand for high-end GPUs.
The crypto bust has left Nvidia with a surplus of product. Inventories footed to $1.58 billion as of Jan. 27, nearly doubling year-over-year from $796 million. According to a report last Wednesday from Monica Chen and Joseph Tsai of Digitimes, liquidation efforts are now underway:
With the dissipation of the cryptocurrency mining fad, graphics card players have begun cutting product prices in a bid to clear out excess inventory at the expense of profitability, according to industry sources.
Although Nvidia, AMD and graphics card vendors are expected to see rising revenues, profits will be unsatisfactory and may even be halved from previous high levels. The inventory digestion process may not end until mid- to late-2019, the sources noted.
Recap March 11
It was a big day for the bulls, as stocks ripped to the tune of a 1.5% gain in the S&P 500, a near 2% advance in the Dow Transports and small cap Russell 2000 indices, and a 3% rip in the tech-heavy NYSE FANG+ Index to erase the bulk of last week’s declines. Commodities finished generally higher with WTI crude settling at $57 a barrel, and the VIX fell more than 10% to finish below 14.5.
Treasury yields ticked slightly higher across the curve, continuing the recently rangebound trading in rates. Since late January, the 10-year yield has remained between 2.76% and 2.63%, closing today at 2.64%.
- Philip Grant
Friday, March 8, 2019
Blues brothers, 2019 edition
Set your DVR’s. From The Hill:
Set your DVR’s. From The Hill:
China check
Choose your own adventure
Blues brothers, 2019 edition
Set your DVR’s. From The Hill:
Federal Reserve Chairman Jerome Powell will appear on Sunday’s episode of “60 Minutes” for an interview on interest rates, the outlook for the U.S. economy and financial system cybersecurity risks, CBS announced Thursday. Powell was interviewed by Scott Pelley in Washington, D.C., this week, CBS said, and will appear beside his predecessors, former Fed chairs Ben Bernanke and Janet Yellen.
They’re on a mission alright.
China check
Earlier today, the Shanghai Composite Index plunged by 4.4%, the biggest one-day loss since November, as CITIC Securities Co.’s application of a rarely-seen “sell” rating on People’s Insurance Company (Group) of China Ltd. “was widely interpreted as a sign that the government wants [the recent] surge in Chinese stocks to slow down,” according to Bloomberg.
Perhaps more ominously for both China and the rest of the world, February exports from the Middle Kingdom were horrible, falling 20.7% year-over-year, compared to an expected 5% decline. It’s not just exports, as February auto sales crumbled by 18.5% from a year ago to 1.19 million units, the eighth consecutive drop.
Choose your own adventure
A pair of earnings releases you don’t see every day:
Fort Lauderdale, Fla.-based National Beverage Corp. (FIZZ on the Nasdaq), producer of the popular LaCroix soft drinks, reported fiscal third quarter results well short of expectations on both the top and bottom line. Shares fell by 20% at midday to extend the post-August decline to 53%.
CEO Nick A. Caporella broke the news to investors in style at least, via a press release titled: ‘”We Just Love our LaCroix,’ Consumers Chant.” Caporella went on to expound:
We are truly sorry for these results stated above. Negligence nor mismanagement nor woeful acts of God were not the reasons – much of this was the result of injustice!
Managing a brand is not so different from caring for someone who becomes handicapped. Brands do not see or hear, so they are at the mercy of their owners or care providers who must preserve the dignity and special character that the brand exemplifies. It is important that LaCroix’s true character is not devalued intentionally − in any way.
National Beverage Corp. is and will remain the preeminent innovator that adds zest and authenticity to the ‘sparkling water’ phenomenon in North America.
Meanwhile, Camping World Holdings, Inc. (CWH on the NYSE), which counts television personality Marcus Lemonis as CEO, issued its own fiscal fourth quarter figures yesterday. The press release was a study in suspenseful delivery, as the fourth bullet point on page one read:
Adjusted EBITDA was $312.5 million; and
We can fill in the blank: “down 21.7% year-over-year.” CWH shares lost more than 5% in early trading today.
That pair of notable releases follows Monday’s effort from Anheuser-Busch InBev S.A./N.V., (ABI:BB and BUD on the NYSE) which, though relatively lacking in entertainment value, did provide a study in confusion.
While dollar denominated revenues and “normalized” operating earnings fell year-over-year, the company reported “organic” growth figures of 5.3% and 12.4%, respectively, for those line items. A 100 basis point contraction in gross margins was reported as a 40 basis point shrinkage on an “organic” basis.
Drink organic: AB InBev fourth quarter press release
Thursday, March 7, 2019
Bottoms up
This morning, the European Central Bank cut its guesstimate
This morning, the European Central Bank cut its guesstimate
Product 19
A paper today from the Brookings Institution
A paper today from the Brookings Institution
Les Miz'
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors
QT Progress report
Recap March 7
Bottoms up
This morning, the European Central Bank cut its guesstimate for 2019 GDP growth to 1.1% from 1.7%. In response to the bleaker expected growth, ECB president Mario Draghi once again pivoted towards easier monetary policy, reviving the “Targeted Longer-Term Refinancing Operations,” a lending program with favorable interest rates designed to prop up the Old Continent’s frail banking system, less than three months after wrapping up an aggressive asset purchase program (Almost Daily Grant’s, Feb. 28). “Super Mario” also made it known that the negative 40 basis point deposit rate which has been in place since March 2016 isn’t to blame, stating that negative rates “have been very successful for the ECB and were a powerful instrument in fostering a recovery.”
Instead, Draghi ascribed the latest bout of economic pain to outside forces, particularly “the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets.” With introspection in short supply in Frankfurt, Mr. Market picked up the slack, as the Stoxx E.U. Banks Index sank by 3.3% in reaction. The Index trades at 0.59 book value, less than half of the 1.26 times book value commanded by the KBW U.S. Banking Index.
Monetary policy, Homer Simpson style
The beatings will continue until morale improves.
Product 19
A paper today from the Brookings Institution put widely-held skepticism over China’s gross domestic product figures into quantitative terms. Researchers from the Chinese University of Hong Kong and the University of Chicago re-estimated The Middle Kingdom’s output growth from 2008 to 2016 using “several local economic indicators that are less likely to be manipulated by local governments to measure local and aggregate GDP.”
The analysis concluded that actual GDP growth over that period lagged officially reported statistics by 1.7% per annum. If the Brookings researchers are on the beam, that would reduce China’s year-end 2016 GDP by some 16%. Continuing to extrapolate a 1.7% GDP shortfall through 2018 leaves last year’s Chinese GDP at RMB 71.7 trillion, far below the RMB 90 trillion reported.
While China’s output is under question, the debt remains. The ratio of total banking assets to reported GDP stood at 297% in 2018. Under the Brookings-tabulated GDP methodology, that ratio expands to 374%. By comparison, U.S. banking assets stood at $17.9 trillion at year-end, or 86% of GDP.
Les Miz'
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors with JPY 680 billion ($6.1 billion) worth of charges related to business restructurings in its securities portfolio, including losses on “past investments in foreign bonds.” The write-offs led the bank to cut its full-year net income forecast by 86%. Mizuho CEO Tatsufumi Sakai, who will forfeit performance-related pay as a result of the losses, told investors that the bank has subsequently cut “negative carry” exposure on its portfolio of overseas credits.
Mizuho’s pain is instructive. As the Bank of Japan continues its long-running experiment with negative interest rates, Japanese institutions went abroad in search of income. Tokyo-based Morningstar, Inc. analyst Michael Makdad explains:
There are lots and lots of deposits and not enough loans, so Japanese banks have had the incentive to go outside. Certainly the BoJ policy in place now for many years to keep rates extremely low – absolutely it’s a contribution.
Indeed, Makdad reports that Japanese lenders hold an aggregate of JPY 142 trillion in foreign bonds, up from JPY 48 trillion in March 2009. That’s an 11.8% compound annual growth rate.
Meanwhile, the BoJ plans its next monetary machinations. On Feb. 22, BoJ governor Haruhiko Kuroda told the Asahi newspaper that the central bank would “of course” consider additional stimulus should inflation continue to disappoint relative to the central bank’s 2% target. In January, CPI grew by 0.2% year-over-year.
QT Progress report
A $6.7 billion sequential decline left the Fed’s portfolio of securities held outright at $3.785 trillion, with Treasury securities accounting for all of this week’s portfolio runoff. Today’s figure is $27.3 billion below the trailing four-week moving average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 10.92%, at a 7.7% simple annualized pace.
Recap March 7
Risk is creeping back into the picture, as the S&P 500 fell for a fourth straight day to leave the broad index red by nearly 2% for the week. Treasurys were sharply bid across the curve as the 10-year yield fell to 2.65%, and the Dollar Index spiked to its highest finish since June 2017.
Commodities managed to hold up pretty well considering, as the CRB Index fell modestly while WTI crude inched higher to $56.50 and gold held at $1,285 an ounce. The VIX rose above 16.5.
- Philip Grant
Tuesday, March 5, 2019
Deep freeze
Yesterday, the Real Estate Board of Greater Vancouver reported February results that could be classified as ghastly, with residential home sales plummeting 32.8% year-over-year to 1,484 units. That’s the lowest February sales total since 1985 and 42.5% below the 10-year average. Prices have also broken lower, with the composite index sinking by 6.1% year-over-year. In addition, inventories have jumped, with total listings in metro Vancouver up to 11,590 homes at month end. That’s up 48.2% from February 2018.
Toronto, Canada’s largest city, has held up better, with February prices rising 1.6% year-over-year, while new listings dropped 6.2% to outpace the 2.4% decline in sales. Nevertheless, TREB president Gurcharan Bhaura asked for regulatory relief from the mortgage stress test mandated by the Office of the Superintendent of Financial Institutions. These subject borrowers to the greater of the five-year benchmark rate or the contracted mortgage rate plus 200 basis points (Almost Daily Grant’s, May 31):
The OSFI mandated mortgage stress test has left some buyers on the sidelines who have struggled to qualify for the type of home they want to buy. The stress test should be reviewed and consideration should be given to bringing back 30 year amortizations for federally insured mortgages. There is a federal budget and election on the horizon. It will be interesting to see what policy measures are announced to help with home ownership affordability.
On the score of home affordability, there is certainly room for improvement. According to Demographia’s International Affordability Survey for 2019, Toronto ranked 294th out of 309 metropolitan housing markets, with a median house price of 8.3 times median annual gross pre-tax household income, up from 7.9 times year-over-year. For context, the United States national median multiple registers at 3.5 times, while the organization designates anything beyond 5.1 times to be “severely unaffordable.” Vancouver puts Toronto in the shade, ranked second to last by Demographia (only Hong Kong is more expensive) with a median multiple of 12.6 times.
As Canada’s long-running housing bull market teeters, economic data continue to disappoint. Friday’s release of fourth quarter GDP showed annualized growth of just 0.4%, well below the 2% third quarter reading and the 1% consensus expectation, while December retail sales fell by 0.5% ex-automobiles, also worse than the expected 0.3% decline. M2 money supply growth registered 4.99% in December, down from 5.83% year-over-year and 8.65% in the final month of 2016.
Perhaps most importantly, total residential mortgage growth fell to just 3.1% year-over-year in December, the worst monthly reading since May 2001. That last data point may be especially concerning for Canada’s banks: Craig Fehr, investment strategist at Edward Jones & Co., told Bloomberg that the mortgages are, “in many cases, the largest and most profitable and steady of the businesses that these banks operate.” Fehr concludes: “The bread and butter of profitability for Canadian banks – is going to have a little less butter on the bread.”
Early indications bear that out, as a trio (the Bank of Nova Scotia, Toronto-Dominion Bank and Canadian Imperial Bank of Commerce, or CIBC) of Canada’s five largest banks reported earnings shortfalls in the quarter ended Jan. 31. Increased credit losses figured in two of those reports, with Toronto-Dominion raising its loan loss provision to C$850 million ($645 million), up 23% year-over-year. CIBC’s provision for credit losses jumped to C$338 million, more than double last year’s C$153 million and well above the expected C$258.5 million.
CIBC CFO Kevin Glass told Bloomberg that “three big” non-performing loans across different sectors hurt the bank’s credit portfolio, while asserting that the jump “is certainly not representative of any sign of underlying problem.”
Glass may not be worried, but an extended housing downturn may cause CIBC particular discomfort. For more, see the Feb. 9, 2018 edition of Grant’s.
In other news from formerly-booming housing markets, yesterday The Australian reported that Queensland-based bank Suncorp Group Ltd. warned that some investors in an A$120 million ($85 million) residential mortgage bond may not be repaid. The problem: An increase in borrowers at least 60 days past due on their mortgages to above 3% of the loan pool has triggered a clause prioritizing senior claims holders, potentially diverting principal repayment from those farther down the creditor food chain.
Meanwhile, Australian new auto sales fell by 9.3% year-over-year in February, the eleventh straight decline. On Feb. 21, Fitch Ratings reported that Australian prime auto loan asset-backed securities in arrears rose to a record high in the fourth quarter, with loans past due more than 30 and 60 days rising to 2.05% and 1.03%, respectively. That compares to a five year net loss rate of 0.51%.
Recap March 5
Stocks mostly cruised sideways with the S&P 500 remaining in a tight range, though the Dow Transports Index broke lower late in the session to finish red for an eighth straight day. Nevertheless, the transport index is up 12.5% year-to-date, topping the S&P’s 11% gain for 2019 so far.
Treasury yields finished little changed, though the long end was modestly bid and short yields ticked a bit higher to leave the curve flatter. The VIX remained at 15, and gold managed to inch higher and snap a four-session losing streak.
- Philip Grant
Monday, March 4, 2019
Head for the mountains
On Thursday, global beer behemoth Anheuser-Busch InBev S.A.
On Thursday, global beer behemoth Anheuser-Busch InBev S.A.
Recap March 4
Head for the mountains
On Thursday, global beer behemoth Anheuser-Busch InBev S.A. (ABI:BB in Brussels and BUD on the NYSE) reported solid fourth quarter results. Bullish highlights included 5.3% and 10% year-over-year growth in revenues and EBITDA, respectively (those figures are self-reported “organic growth” across a range of currencies; in U.S. dollar terms, sales and EBITDA both fell), as strong pricing growth helped burnish a meager 0.3% uptick in volumes. In addition, company management pledged to continue paying down a hefty debt burden, with CEO Carlos Brito reiterating his expectation of a leverage ratio below four times by the end of 2019, compared to 4.6 times, by management’s reckoning, as of Dec. 31.
Mr. Market approved, as ABI shares jumped by nearly 5%. But strong fourth quarter aside, its been no picnic, as shares have fallen by 21% since Feb. 9, 2018 (the S&P 500 has gained 8% over that period) while the 3.65% dollar pay bonds due 2026 have seen their spread over Treasurys widen to 120 basis points from 75.
Reaction among the sell-side tended towards relief more than exuberance, with last week’s disastrous earnings report from fellow 3G Capital, Inc. investee Kraft Heinz Co. weighing on sentiment. James Edwardes Jones of RBC notes that North American operations were “less bad than expected,” while Citi’s Simon Hales wrote that while the fourth quarter did “not demonstrate a material improvement in volume growth. . . it should mark the inflection point after a prolonged period of downgrades.” Yet overall analyst expectations for 2019 continue to march lower:
Down and to the right. Chart of 2019 adjusted EPS consensus. Source: The Bloomberg
Ample leverage and 3G ownership are not the only similarities between AB InBev and Kraft Heinz. Secular difficulties in the form of changing consumer tastes is another, unwelcome roadblock for the pair. A Friday report from Bloomberg, citing data from IWSR, noted that American beer consumption has declined by 2.8% since 2015, despite a near 15% uptick in craft beer sales during that period. The increasing prominence of cannabis as an alternative intoxicant also presents a risk: A study conducted by professors in the U.S. and Peru found that between 2006 and 2015, overall alcohol sales declined by nearly 15% in states that have legalized medical marijuana.
Secular pressures aside, much of ABI’s current predicament is traceable to the October 2016 acquisition of SABMiller plc. for $65 billion, at a princely 18 times EBTIDA. The resulting influx of debt led to the company cutting its dividend by 50% on Oct. 25. Moody’s downgraded Anheuser-Busch’s credit rating to Baa1 from A3 in December. Even so, ABI’s leverage ratio towers above the 2.5 times EBITDA carried by (also Baa1 rated) global peer Heineken N.V.
At the same time, there is little to show for that expensive SAB deal thus far. Free cash flow is expected to register at $10.9 billion this year, hardly improved from 2012’s $10 billion, while net debt has ballooned to $110 billion from $35 billion during that period.
Even ABI management’s current reckoning appears optimistic, as the 4.6 times leverage ratio cited on the conference call omits a $12 billion working capital deficit. For instance, vendor financing remains on the upswing: Accounts payable footed to 274 days of turnover at year-end, up from 180 days in 2012. By comparison, Heineken’s balance sheet shows 216 days’ worth of payables.
Grant’s Feb. 9, 2018 bearish analysis of Anheuser-Busch argued that the company’s heavy debt load and struggles with changing consumer tastes presented problems not yet reflected in the company’s bonds:
As for us, we judge that there is a good chance of operational disappointment, therefore of ratings disappointment. As the market is seemingly willing to admit no possibilities but happy ones, downside risks are palpable.
Recap March 4
A sharp mid-day decline shook stocks from their recent inertia, though a late rebound narrowed the S&P 500’s loss to 0.4% and left the broad index just above its Dec. 3 close.
Treasurys were bid with the long end outperforming to push the curve flatter, as the 10-year yield settled at 2.73%. WTI crude rallied back to $56.5 a barrel while gold continued its slide, settling at $1,286 an ounce to extend its post-Feb. 19 selloff to 4%. The VIX jumped as high as 17 intraday, before finishing at 14.5.
- Philip Grant
Friday, March 1, 2019
Property tax
Everything must go. Yesterday, Chinese state media website The Paper quoted Hui Ka Yan, chairman of real estate developer China Evergrande Group (3333 on the Hong Kong exchange), urging his employees to ramp up efforts to sell homes, authorizing 10% price discounts on all properties to do so.
That’s one way to do it: Analysts are expecting Evergrande to generate RMB 574 billion ($85 billion) in revenues this year, nearly double 2017’s RMB 311 billion top line. Meanwhile, the company’s contract sales in January fell to RMB 43.2 billion, down 33% year-over-year (Grant’s, June 2, 2017).
Cooking with gas
On Wednesday, kitchen equipment producer Middleby Corp. (MIDD on the Nasdaq) reported year-over-year net sales and EPS growth of 21% and 26%, respectively, in the fourth quarter, easily beating consensus expectations. The company also announced it will acquire the Cooking Solutions Group from Standex Corp. (SXI on the NYSE) for $105 million. Shares rallied 5% in response, but it’s been tougher going of late for a stock that managed a 1,260% appreciation from year-end 2008 to mid-2016. Since a bearish Grant’s analysis on June 17, 2016, MIDD shares are up 6%, compared to a 30% rise in the S&P 500.
Acquisitions have helped fuel the growth spurt. Unrated MIDD has made 24 deals since the beginning of 2015 (more than one per quarter, on average), headlined by the $1 billion cash purchase of equipment concern the Taylor Company in May.
The add-ons drove top-line growth (revenue decreased 0.8% year-over-year when backing out acquisitions and currency swings) but have also helped push Middleby’s leverage ratio to over three times consensus 2019 EBITDA, from less than 1.5 times at year-end 2016. At the same time, the company is increasingly dependent on the restaurant industry, as the commercial foodservice unit chipped in 63.5% of 2018 sales. That’s up from 59.2% and 55.9% in 2017 and 2016, respectively. The food processing and residential kitchen divisions accounted for 14.3% and 22.2% of total revenues.
Restaurant sales have been soft, with research firm TDn2K reporting a 1.12% industry traffic decline in the three months ended Jan. 31, while the franchisees that purchase MIDD’s wares face declining profits and rising labor costs, as well as franchisor demands to undertake expensive store remodels. Nevertheless, Elgin, Ill.-based Middleby (founded in 1888), has thrived. The company has grown revenues and adjusted EBITDA to $2.7 billion and $563 million, respectively, in 2018, up from $1.8 billion and $392 million in 2015. The sell-side expects more of the same, with six buy ratings, three holds and zero sells. With that bullishness comes high expectations: projected 2019 free cash flow is expected to jump to $433 million from $333 million a year ago.
Meanwhile, margins are under pressure, with gross profits representing 36.9% of sales in 2018, down from 39.1% year-over-year and 42.1% in 2016. Asked about the waning profitability, brand new CEO Timothy FitzGerald, replacement for longtime boss Selim Bassoul (who retired, effective immediately, on Feb. 19) struck a hopeful tone noting that integrating a host of new businesses presents its problems:
I don't know off the top of my head exactly how many acquisitions, but we've had quite a few in the last two to three years. So certainly, there's a lot of heavy lifting that happens in year one but then there's continued fine tuning that happens in second and third years, as you kind of really move into higher fruit on the tree. So we do expect. . . that we’ll move the margins for the businesses forward as we go through the year.
Middleby’s roll-up business model presents other pitfalls for investors beyond rising debt and shrinking margins. The June 2016 Grant’s analysis zeroed in on the company’s use of so-called purchase accounting, noting the potential for results to appear stronger than they actually are:
Under the rules of purchase accounting, acquirers may apportion the assets of their acquirees as they wish for 12 long months after the transaction closes. Middleby has tended to tag those assets “goodwill and other intangibles” (GOI). Most assets so designated need not be amortized. And as they are not amortized, they do not impair the optics of reported GAAP earnings.
Sure enough, the “goodwill and other intangibles” line-item continues to bulge, reaching a balance of $1.74 billion at year-end 2018. That’s up from $1.26 billion year-over-year, and $1.09 billion in 2016.
Recap March 1
Stocks caught a bid, with the S&P 500 rising 0.7% to finish the week in positive territory, as the energy sector led the way higher despite pressure on prices as WTI crude slipped back below $56 a barrel. Commodities traded broadly lower with gold sinking to $1,291 an ounce, while the Dollar Index rose.
Treasurys continued their recent weakness as yields jumped across the curve, leaving the 10-year at 2.74% and the long bond at 3.14%, its highest since mid-December. The VIX took another tumble, falling to 13.5 and testing its lowest since the early-October stock market break.
- Philip Grant
Thursday, February 28, 2019
Hundred Dollar General
From CNBC:
From CNBC:
Trudge report
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times
QT Progress report
Recap Feb. 28
Hundred Dollar General
From CNBC:
The amount of $100 bills in circulation is surging. And it’s leaving some economists scratching their heads. The number of outstanding U.S. $100 bills has doubled since the financial crisis, with more than 12 billion of them across the world, according to the latest data from the Federal Reserve.
C-notes have passed $1 bills in circulation, Deutsche Bank chief international economist Torsten Slok said in a note to clients this week.
Trudge report
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times. The catalyst: Recent comments from Bundesbank president and European Central Bank governing council member Jens Weidmann acknowledging ongoing economic softness in Europe’s largest economy. No need to lift those rates, notes the FT, which breathes a journalistic sigh of relief for Mario Draghi, who has to spend so much of his precious time “trying to curtail sniping from the sidelines by policy hawks.”
So it goes on the Old Continent, where Draghi’s balance sheet has grown to 39% of GDP, twice the relative size of the Fed’s, and where the overnight rate rests at negative 0.4% (it first settled there in March 2016); the benchmark rate has remained below zero since June 2014.
Weak data points, including flat sequential German fourth quarter GDP, a surprise contraction in December factory orders and eight straight months of declining economic sentiment across the eurozone, plausibly argue for the status quo. Other factors do too: Succession at the ECB is unclear as Draghi’s term ends on Oct. 31, while political risk is on the upswing, evidenced by growing discord between Italy and other member states as well as popular discontent movements like France’s Gilets Jaunes.
Thus, the negative-rate epoch drags on and on. According to analysts at Bank of America, some $11 trillion worth of sovereign debt is priced to yield less than zero, up 21% from October and not so far off the $13 trillion peak logged in 2016.
The resurgence of such financial anomalies (historians Sidney Homer and Richard Sylla find that substantial volumes of negative-yielding notes had never been seen in 3,000 years of financial history prior to this cycle) has even some members of the ECB concerned. Of those negative yields, governing council member Francois Villeroy de Galhau was quoted as saying on Wednesday:
If maintained for too long, they could weigh negatively on the profitability of financial intermediation with possible adverse consequences for the smooth transmission of monetary policy.
Four years and counting aren’t long enough, apparently. An analysis in the April 6, 2018 edition of Grant’s (“Let the ECB pay you”) noted the realistic potential for the central bank to enter the next recession with rates already in negative territory. But how can investors, deprived of income by these monetary machinations, profit from the ECB’s demonstrated willingness to do “whatever it takes”, for however long it takes?
Deputy editor Evan Lorenz identified interbank lending rates as a potentially attractive investment proposition. In particular, the three-month Euribor futures contract expiring on March 2020 then traded at 99.88, implying a future rate of positive 0.12%. That compared to the negative 0.33% Euribor rate on offer at publication time, as expectations of so-called policy normalization were then widespread.
Lorenz observed that if Euribor remained unchanged through that March 20 expiration, the 100.125 strike call option would deliver a 183% return, with additional upside possible were the ECB forced to further cut rates during that period. Since publication time, that contract has rallied to 100.21, or an imputed negative 0.21% Euribor rate in March of next year. That compares to negative 0.31% currently.
March 2020 three-month Euribor futures, one-year chart. Source: The Bloomberg
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.792 trillion this week, down $6.7 billion from a week ago. Mortgage-backed securities accounted for almost all of the sequential decline, while Treasurys represented roughly two-thirds of the $33.6 billion drop compared to the trailing four-week average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 10.8%, for a simple annualized pace of 7.74%.
Recap Feb. 28
Stocks turned a bit lower, snapping three days of consolidation as the S&P 500 finished at a one-week low. Treasury yields ticked higher across the board with the belly (middle) of the curve seeing additional pressure, leaving the 10-year yield at 2.72%.
Commodities finished slightly weaker with gold retreating to $1,312 an ounce, and the VIX remained below 15.
- Philip Grant
Wednesday, February 27, 2019
T-leaves
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and
Recap Feb. 27
T-leaves
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and T-Mobile US, Inc. (TMUS on the Nasdaq). The pair, America’s fourth- and third-largest wireless carriers, respectively, agreed to merge on April 29, 2018 and now await regulatory approval with an initial projected closing date just over four months away.
The credit markets have already given the deal a thumbs up. S&P’s LCD unit reported yesterday that Sprint managed to raise a $900 million term loan, upsized from an initial $400 million, at a smaller-than-expected issuer discount. Meanwhile, the Sprint 6 7/8s senior notes of 2028 have lifted above 99 cents on the dollar from 94.5 in early April (both the bonds and stock rallied into the deal announcement) narrowing the spread over Treasurys to 439 basis points from 510. During that period, the spread on the Bloomberg Barclays High Yield Index has widened to 387 basis points from just under 350.
Classically, bond investors, who stand to gain nothing more than the return of their principal with interest, are a conservative bunch, ever-cognizant of risk. Benjamin Graham and David Dodd’s Security Analysis notes that “bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.”
Anyway, for single-B-rated Sprint, which is saddled with an extensive debt load as well as stagnant revenue growth and persistently negative free cash flow (Grant’s, Dec. 23, 2016), the stakes are high indeed. Deal approval could mean a nice payoff for creditors, with analysts at Bloomberg Intelligence estimating that those 6 7/8 senior notes would see nearly 200 basis points of spread tightening in the event of a green light from Uncle Sam.
The stock market is also optimistic, as market-implied odds of deal approval sit just above 50% based on the respective trading levels of each stock, under the assumption that Sprint shares would return to their early-April price of $5.18 a share if the merger is scuttled (Sprint trades at $6.35 a share, while T-Mobile’s all-stock bid is currently worth $7.40). Based on T-Mobile’s current share price, approval would likewise suggest a 17% gain for Sprint shareholders.
The CEOs of both companies have utilized differing tactics with an eye toward swaying regulators. Sprint boss Michel Combes painted a grim picture of his company’s standalone prospects on the most recent earnings call (Almost Daily Grant’s, Feb. 1), while T-Mobile CEO John Legere maintained his typically upbeat persona in a blog post Friday:
We have had some amazing discussions and the regulators we’ve talked with continue to impress me. Their process is thorough, and that is great news for us – because we have a lot to share!
The great news is things are moving forward positively! We now have approval from 16 of the 19 needed state utility commissions, which is a huge step forward. . . Despite what others may want you to think, we’ve made steady progress – and we remain confident that we’re going to see regulatory approval, as planned, in the first half of this year!
Some observers are less than sanguine, however. On Monday, The Capitol Forum reported that T-Mobile and Sprint’s pro-approval arguments “have yet to win over the staffs of competition enforcers and telecommunications regulators.” The prospective decline in national carriers to three from four, an absence of tangible consumer benefits like improved service prior to 2021 and the likelihood of higher prices count among the regulators “grave” concerns. The Forum notes that “time is running out for T-Mobile and Sprint to persuade Justice Department staff, which is preparing a recommendation for senior department officials.”
Even a green light from Washington wouldn’t mean the merger is in the clear. In a note Sunday, New Street Research relayed that state attorneys general have hired an unnamed “leading antitrust economist” to help conduct an investigation of the proposed tie-up, a development which is “certainly cause for concern” for deal advocates. More broadly, the state AGs present a “material risk” to the deal’s closing, per New Street.
A thumbs down from federal or state regulators could deal significant pain to Sprint investors beyond a reversal to early April prices, as a Jan. 31 analysis from MoffettNathanson, LLC concluded that if the deal is rejected, Sprint’s debt “will likely have to be restructured.” Investors in SoftBank Group Corp., (Grant’s, Nov. 30) which owns 84.5% of Sprint’s equity, are likewise exposed to regulatory whim: A return to the early 2016 trading levels for S shares would equate to a loss of roughly 12% of SoftBank’s total market capitalization.
Recap Feb. 27
Consolidation continues, as stocks shook off early losses to finish unchanged for a third straight day on the S&P 500 to leave the broad index near the highs for the year. Commodities caught a strong bid, with WTI crude pushing back to $57 a barrel while gold bucked the bullish trend to finish at $1,320 per ounce.
Treasury yields rose with another round of widening seen at the back end of the curve; the 30-year long bond finished the day at 3.07%, a one-month high.
- Philip Grant
Tuesday, February 26, 2019
Tip your waitress
A trio of Sonic Corp. restaurants in central Ohio closed abruptly
A trio of Sonic Corp. restaurants in central Ohio closed abruptly
Climate change
It’s not just U.S. equities that have enjoyed a blistering start to 2019.
It’s not just U.S. equities that have enjoyed a blistering start to 2019.
Recap Feb. 26
Tip your waitress
A trio of Sonic Corp. restaurants in central Ohio closed abruptly over the weekend after employees quit en masse. At each location, the departing staff displayed some less-than polite messages for management on their way out the door.
What spurred the worker walkout? Local news site the Scioto Post reports:
One anonymous source close to management stated: “Circleville, Lancaster, and Grove City crews have all walked out and quit after the franchise was bought out by corporate. The regional director, two district managers and four general managers have all been let go. All of which have been working for the company in management for 7+ years.”
According to sources close to the situation, part of the dispute stems from pay cuts forced onto employees who saw wages reduced from at or near-minimum wage to a tipped employee wages at approximately $4.00/hr.
In December, Inspire Brands, Inc., a division of private-equity firm Roark Capital Group, acquired Sonic for $2.3 billion, or more than 15 times trailing EBITDA.
For a wide-ranging look at the troubles plaguing the restaurant industry, see the Feb. 8 edition of Grant’s.
Climate change
It’s not just U.S. equities that have enjoyed a blistering start to 2019. China’s broad CSI 300 Index ripped higher by 5.8% on Monday, which marks the biggest one-day gain in three years and brings the year-to-date advance to 22%. Mr. Market displayed particular enthusiasm towards the financial sector: Bloomberg notes that all 30 Shanghai- and Shenzhen-listed stocks that feature the word “securities” in their corporate title finished higher by the 10% daily limit yesterday.
The recent bull stampede can be chalked up to “substantial progress” on trade according to both Donald Trump and Xinhua News Agency, as well as to a friendly policy turn from Beijing. On Saturday, President-for-life Xi Jinping called for “strengthening the countercyclical adjustment of fiscal policy and monetary policy [to ensure] that the economy operates in a reasonable range.” Yesterday, Wang Zhaoxing, vice chairman of China’s Banking Regulatory Commission, declared that the Middle Kingdom’s deleveraging campaign has already achieved its goals.
With deleveraging apparently complete, re-leveraging begins anew. Thus, the People’s Bank of China reports that new aggregate financing footed to RMB 4.6 trillion in January, up 51% year-over-year. Meanwhile, Chinese margin debt outstanding has jumped by more than 8% in the last two weeks, according to the China Securities Finance Corporation, while research firm PY Standard reports that local banks increased issuance in so-called wealth-management products by 22% year-over-year in January.
The latest round of stimulus is having an impact, but will it be enough? Many corporations are already listing under the unwelcome combination of a pronounced economic slowdown (last year saw the slowest pace of real GDP growth since 1990) in tandem with stifling debt burdens. A Jan. 23 report from UBS Group A.G. found that work-out investors acquired RMB 1.75 trillion in bad debt last year, the busiest for distressed debt in two decades.
Back in December, Yu Liang, chairman of China Vanke Co. (the country’s second largest real estate developer) told employees that China’s housing market faces the prospect of an extended slump, commenting that “we need to ensure survival first, and then quality development,” according to a speech released yesterday on the company’s WeChat page.
In a Feb. 18 commentary, Anne Stevenson-Yang, co-founder of J Capital Research, wrote that while Beijing’s recent exertions have helped the banks, the reflation efforts seen in January are insufficient to stem the broad deterioration in financial conditions. If the powers-that-be hope to avoid a painful (and perhaps politically perilous) economic reckoning, they will be forced to double down:
It will take much more: The culture at Chinese banks has changed, and, if authorities really want bankers to lend, they must change incentives. Thus far, they have been unwilling to do that.
The structural problem, Stevenson-Yang relates, is that banks are obliged to increase financing efforts, while simultaneously facing scrutiny of their loan quality.
That means that China’s economy will likely continue in decline, until the tide of corporate and financial defaults swells to the point where authorities feel they have no choice but to launch a truly gargantuan stimulus, greater than the RMB 6.4 trillion in stimulus monies issued in 2016.
Recap Feb. 26
Stocks drifted sideways to finish virtually unchanged, with the VIX also cruising through a low-key session to again settle just below 15. Commodities and the dollar both ticked slightly lower.
Treasury yields traded lower across the curve, but recent moves have been far from lockstep. While the spread between five- and 30-year bonds has widened to 56 basis points from about 20 basis points in July, the short end remains inverted with the two-year yield residing four basis points above the five-year. Back in July, the two- and five-year spread also stood at (positive) 20 basis points.
- Philip Grant
Monday, February 25, 2019
Musical chairs
This morning, Barrick Gold Corp. (ABX on the TSX) announced it will launch a $17.8 billion all-stock bid for Colorado-based rival Newmont Mining Corp. (NEM on the NYSE), continuing the 2019 mining merger wave. Recall on Jan. 2, Barrick completed a no-premium, $5.4 billion takeover of South Africa’s Rangold Resources Ltd. Two weeks later, Newmont bid $12.6 billion in cash and stock for peer Goldcorp, Inc., which was 16% above the target’s closing price (Almost Daily Grant’s, Jan. 14).
The proposed Barrick-Newmont tie-up, which would take place in lieu of Newmont’s Goldcorp bid, would create the world’s largest gold miner by far, but Mr. Market wasn’t particularly impressed. NEM shares traded lower by 1%, while ABX sank by 3%.
Unsurprisingly, Newmont management is reluctant to accept Barrick’s terms, which were offered “at the market” and implied a slight discount to NEM’s closing price on Friday. NEM issued a press release this morning arguing that the planned Goldcorp merger offers superior value creation for its shareholders, noting that a prior internal analysis of Barrick “determined that Barrick’s risk and return profile is inferior on many fronts, including factoring Barrick’s comparatively ineffective operating model, poor track record on delivering shareholder returns and unfavorable jurisdictional risk.”
In an interview on Friday, after Barrick had publicly expressed interest in a deal, Newmont CEO Gary Goldberg pulled no punches: “It’s a desperate and bizarre attempt to muddle up our [Goldcorp] deal. And it’s certainly not the sort of behavior that will appeal to investors who want to invest in serious, well-run companies.”
Mark Bristow, former CEO of Rangold and current Barrick boss, shared his perspective in a Jan. 2 interview with Bloomberg: “[The] industry, if it had carried on the way it was, was going to become irrelevant, [with] too few assets with too many management teams and it needs reorganization.”
The matter at hand for investors: Will a wave of corporate consolidation help streamline production, increase operational efficiency and pave the way for higher share prices? Or do the low- or zero-premium prices being bid for these large mining assets foreshadow more disappointing days ahead?
Grant’s today put the question to John Hathaway, the co-manager of the Tocqueville Gold Fund, who anticipated a wave of industry consolidation at the Spring 2018 Grant’s conference. Hathaway believes that the proposed Barrick-Newmont combo faces an uphill battle, as “its hard to see where the value creation is coming from” in a $42 billion merger of equals while “the gold mining industry doesn’t necessarily lend itself to that kind of scale.”
Indeed, the longtime gold investor sees a substantial valuation gap between the mega players and smaller, sometimes single-asset miners. To that end Hathaway has co-founded a new investment venture named the Sprott Hathaway Special Situations Fund, designed to capitalize on the sudden thirst for deal-making.
Hathaway notes that the current market price of gold is about 35% below the cost to discover and extract the yellow metal, making it cheaper to mine for gold assets on Wall Street than underground. The fund will be a concentrated one, with position sizes of as much as 10% of total assets, while the new venture will have some attractive options from which to choose. Hathaway relays that some potential targets are currently valued at as little as three times (growing) EBITDA. The Sprott Hathaway fund will target smaller operators (i.e., no Barricks or Newmonts to be found), some of which do business in less-than ideal geographical jurisdictions. Nevertheless, that political risk can be more readily absorbed in an acquirer’s larger asset portfolio.
Recap Feb. 25
Stocks gave back the bulk of early gains but still managed a green finish on the S&P 500, leaving the broad index at 2019 closing highs for a second straight session and within 5% of the record finish logged on Sept. 20. That late selloff did coincide with a 10% spike in the VIX to leave the volatility indicator just under 15.
Elsewhere, a Trump tweet from this morning complaining about high oil prices helped send the energy complex sharply lower with WTI crude finishing near $55 a barrel, while Treasury yields ticked slightly higher across the curve.
- Philip Grant
Friday, February 22, 2019
Smothered
Cleanup in aisle four. Yesterday evening, longtime Grant’s pick-not-to-click Kraft Heinz Co. (KHC on the Nasdaq) reported fourth quarter results that could safely be described as calamitous. Net sales grew by a feeble 0.7% year-over-year, while EBITDA collapsed by 13.9%. Management guidance of another double digit slide in EBITDA in the first quarter adds to KHC’s woes, as does newly-revealed regulatory scrutiny and asset impairment charges. In response, shares suffered a 28% swan-dive to an all-time low, dragging down the S&P Packaged Foods Index to the tune of 4.5%.
With revenue stagnating, profitability on the wane and a hefty debt load of 4.5 times consensus 2019 adjusted EBITDA, balance sheet remedies are now in order. KHC announced a 36% dividend cut, to 40 cents a share per quarter, while CEO Bernardo Vieira Hees suggested the company will pursue additional asset sales after having disposed of its Heinz India and Canadian cheese businesses in the fall of 2018. Nevertheless, Standard and Poor’s placed triple-B-rated Kraft Heinz on negative watch today.
But poor operating results were just part of the problem. The company disclosed receipt of a subpoena from the SEC in October related to “an investigation into. . . the Company’s accounting policies, procedures and internal controls related to its procurement function.” Kraft Heinz took a $25 million charge for the period as a result, a figure management deemed immaterial both in the press release and subsequent conference call. So immaterial, in fact, that the C-suite declined to make note of the subpoena in either its Nov. 1 third-quarter press release or in the form 10-Q released the next day.
Perhaps the most significant problem: A $15.4 billion noncash write-down of goodwill assets related to domestic and Canadian business lines, as well as intangible assets such as the Kraft and Oscar Meyer trademarks. The writedowns are not important by themselves; they are, of course, non-cash. Rather, they tell us about management’s expectations about future profits, i.e., they will be lower. This was confirmed by CFO David Knopf on Thursday’s call.
KHC price chart from spring 2016. Source: The Bloomberg
To say the least, the Kraft Heinz business model of industry consolidation, ferocious cost cutting and focus on delivering high margins has reaped some less than welcome side effects. As growth in the packaged-foods industry remains anemic at best, KHC’s focus on maintaining “industry-leading margins” (a phrase repeated frequently during yesterday’s call) has manifested in brand erosion.
Grant’s produced its first analysis of KHC on March 25, 2016 (“Sell big food,” available here), followed by an equally bearish judgement on March 24, 2017 (“Price War for Warren Buffett,” available here). In a Feb. 23, 2018 follow-up, deputy editor Evan Lorenz noted that the company’s prioritizing of certain brands at the expense of others presented the potential for unwelcome surprises:
So, how should we assess Kraft Heinz’s ability to manage an operating business, apart from slashing its costs. “[T]he Heinz brand in the United States is now 17% bigger than it was in 2015,” CEO Bernardo Vieira Hees not¬ed of a key success on the Feb. 16 call, “which is a good example of the process we are going through with each cat¬egory.” The growth in the Heinz brand is part of KHC’s focus on big bets—on concentrating ad and innovation dollars on a few brands and product categories that management believes hold the most promise.
To put Heinz’s growth in context, overall organic sales in the United States fell by 0.3% in 2016 and by 1.5% in 2017. This implies that non-Heinz-branded sales contracted substantially over the past two years. Kraft Heinz owns 33 brands that reap $100 million or more in revenues. By focusing on a few designated winners rather than the overall portfolio, the company runs the risk of eroding the equity of its smaller brands. Neglected, the step-children may disappoint.
Whither the roll-up strategy? While Hees indicated that asset sales are on tap during the call, the CEO told the Financial Times just two days ago that industry valuations “are much more attractive than before.” On the call, Hees once again displayed an acquisitive mindset, stating that divestitures would merely set the stage for the next corporate shopping spree:
Our decision here is to execute the strategy on deleveraging faster, so we can better position the company for future consolidation.
The recent plunge begs the question of how KHC’s A-list investor roster will respond. Brazilian private equity shop 3G Capital and Berkshire Hathaway, Inc. bought H.J. Heinz Co. in 2013 and Kraft Foods Group, Inc. two years later. Last August, 3G sold 20.6 million shares of KHC (just under 2% of current shares outstanding), lowering their stake to 22%.
Might Warren Buffett ride to the rescue? Yesterday, The Wall Street Journal noted that Berkshire Hathaway, which already owns 27% of Kraft Heinz, boasted a cash balance of $103.6 billion as of Sept. 30 and has not com