Almost Daily Grant's
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Thursday, January 16, 2020
Did you just say Yutes?
One step closer. Yesterday, Bloomberg reported that bankrupt utility PG&E Corp. (PCG on the NYSE) is nearing a deal with a group of creditors to approve its reorganization plan. That dispatch was well received by the stock market, as PCG shares jumped to their highest since August but nonetheless 34% below their levels at the time of a bearish Grant’s analysis on Feb. 22, 2019.
A completed deal with the bondholders would be the latest success for PG&E in its efforts to emerge from reorganization following the deadly 2017 wildfires in northern California. The company has already reached settlements with victims and insurance providers for a combined sum of about $25 billion, less than the $30 billion or more in fire-related liabilities estimated by CFO Jason Wells in a deposition dated Jan. 31, 2019.
Next on the agenda, if the creditor deal indeed goes forward: Garnering approval from the California Public Utilities Commission and governor Gavin Newsom, no sure thing as Newsom rejected a prior reorganization proposal on Dec. 17. Success on these efforts would help pave the way for the potential emergence from Chapter 11 by June 30, the state-imposed deadline for PG&E to participate in the AB 1054 insurance fund for future wildfire liability.
Hope springs eternal. In upgrading PCG shares to “buy” with a $15 price target (18% above current levels), analysts at Citi Research wrote yesterday: “Even if the shareholders give a concession to bondholders, the strategic value of the deal is significant.” Namely, agreement would preclude the creditor group from presenting an alternative plan, which may help the company in negotiations with Newsom.
The idea of receiving an equity stake in a reorganized entity is less than appealing to some. Yesterday, a group of wildfire victims filed a petition with the bankruptcy judge arguing that the proposed terms of the combined cash and stock payout compare unfavorably with the all-cash settlement reached with PG&E’s insurers. Of the “newco” equity, the claimants write: “No one can assure the stock will actually [achieve the stated] value when it is issued, or later even.”
That is to be sure. Beyond the volatility in the stock and uncertainty regarding the outcome of negotiations with the creditor group and state government, PCG’s operating performance continues to sag. In the 12-months ended Sept. 30, capital expenditures outpaced operating cash flow by $1.6 billion. Though the CFO testified last year that he expects an additional $1.8 billion cash burn in 2020, the Street cheerfully pencils in $670 million in FCF for 2020. As for shareholders, they can expect substantial dilution from the equity financing, with the Citi analysts projecting the issuance of 1.18 billion new shares from a rights offering. For context, the current share count stands at 529 million.
Indeed, PG&E was in dubious economic health prior to wildfires. As noted last February by Grant’s, the company generated $25.5 billion in cash flow from operations from 2013 to 2018, far below the $31.4 billion in capex over that period, compelling PCG to borrow to fund the $4.4 billion in cumulative dividends paid out from 2013 until they were halted in September 2017. What’s more, capex spending in that period was more than double depreciation and amortization, bringing the company’s earnings quality into question. In 2017, PG&E revised the useful life of its electricity-generating assets to 120 years from a prior ceiling of 100 years, thus shifting more spending to “growth” capex, which expands the rate on which dividend and debt service payments are calculated.
Then, too, some generous estimates underly the bullish case. For instance, Citi pencils in revenues of $19.7 billion for 2021, yet PCG generated a $16.4 billion top line over the 12 months ended Sept. 30, well below the high water mark of $17.7 billion in revenue for calendar 2016. The analysts expect 2021 operating cash flow to jump to $6.3 billion, up from $4.6 billion in the last 12 months and $4.4 billion in 2016.
In fairness, it’s easy to understand that optimism considering the gangbusters stock-price performance of the industry lately. After falling by just 2.4% in the bear market conditions in the fourth quarter of 2018, the S&P Utilities Index has jumped 26% in the last year to trade at more than 21 times trailing earnings, up from 16 times as recently as summer 2018 and a 30-year average of 15.5 times.
Trailing 12-month price-to-earnings ratio of the S&P Utilities Index, 30-year chart. Source: The Bloomberg
However, the pre-fire problems which plagued PG&E apply to the sector at large. From 1999 to 2018, the S&P 500 Utilities Index managed to cover capex with cash from operations only seven times, while free cash flow exceeded dividend payouts in only one of those years, 2003. The Feb. 22, 2019 Grant’s offered a reminder for the currently high-flying utilities bulls: “Safety is inherent in no investment.”
Not-QE progress report
The Fed’s portfolio of securities held outright ticked to $3.769 trillion, up $10.6 billion from a week ago. Increases in holdings maturing in one to five years ($12.9 billion), 16 to 90 days ($6 billion) and 91 to 365 days ($5.3 billion) were partially offset by an $8.7 billion decline in longer-dated Treasurys, while mortgage-backed securities holdings dropped by $4.4 billion.
Since the introduction of “not-QE” in September, the Fed’s total balance sheet assets are up by 11%, and are back within 7% of their 2017 high-water mark.
Recap Jan. 16
A late rally in stocks kept the bullish momentum firmly intact, extending the January gains for the S&P 500 to 2.7%, on pace for an 82% yearly advance. Treasury yields ticked higher in bear-steepening formation, WTI crude rose back towards $59 a barrel and gold retreated to $1,552 an ounce. The VIX sank to 12.3.
- Philip Grant
Almost Daily Grant's will resume Tuesday
Wednesday, January 15, 2020
Grande central
Today, the U.S. and China signed the long-awaited phase-one trade deal agreement. China agreed to purchase $200 billion in American goods over the next two years in return for partial tariff relief and the Trump administration removing its “currency manipulator” designation on its economic rival.
With political risk on the wane, optimism reigns for the Chinese renminbi. The RMB currently trades at 6.89 per dollar, the strongest level in more than five months and up from 7.18 per greenback in September, which was the weakest exchange rate since 2007.
That turnaround, Bloomberg noted yesterday, has spurred improved risk appetite in a number of assets, including industrial commodities (copper is up 9% since early December while steel rebar is up 22% from November) and equities with the mainland CSI 300 and offshore Hang Seng Indices rising 9% and 11%, respectively, in the last six weeks (the Fed’s not-QE program probably didn’t hurt either). The dollar retreat is broadly welcome for global investor sentiment, according to Marc-Andre Fongern, head of research at MAF Global Forex: “The resulting appreciation of the Chinese [RMB] can be expected to breathe life back into the FX world.”
China can use the help. The Middle Kingdom is expected to post fourth-quarter GDP growth of just 6% from a year ago, matching the third quarter figure and the lowest since data collection began in 1992. Similarly, M2 money supply grew at just 8.2% year-over-year in November, barely half of its 20-year average of 15.2%.
Prospects for a near-term turnaround appear minimal. Today, the State Grid Corporation of China, the country’s largest utility, is projecting output growth of as low as 4% over the next five years, according to internal reports viewed by the Financial Times.
China’s precariously-leveraged economy is not well suited to endure cyclical rough patches, as commercial bank assets equal nearly half of world GDP and more than the combined footings of U.S. and Japanese banks (Almost Daily Grant’s, Nov. 11).
Faced with that daunting backdrop, local regulators are trying to spur economic activity while reining in the country’s fearsome debt load. On Jan. 2, the People’s Bank of China announced a 50 basis point cut in the reserve ratio requirement for banks, unleashing some $115 billion in previously dormant cash into the financial system. Last Friday, China’s Banking and Insurance Regulatory Commission announced that it helped dispose of RMB 2 trillion ($290 billion) in non-performing debts in 2019, and has presided over a $2.3 trillion reduction in the size of the so-called shadow-banking system over the last three years (the Financial Times pegged the shadow banking system at $8.4 trillion back in September).
Players in China’s all-important property sector have not been shy about taking advantage of the reprieve, which has included a 50 basis point drop in the average yield on sub-investment-grade bonds in the country as measured by the ICE BofAML Index. Bloomberg reports today that local property companies sold $8.3 billion in dollar-denominated debt last week, the highest figure since June 2017, as the companies rush to take advantage of the calmer waters and refinance their obligations. That yield decline is particularly fortuitous considering the property sector has endured four straight years of declining sales growth and faces $28 billion in dollar-bond maturities this year and another $41 billion in 2021, according to Bloomberg.
That brings us to something of an avatar for current conditions: Single-B-plus-rated China Evergrande Group Ltd. (3333 on the Hong Kong stock exchange), China’s second-largest developer-cum-electric vehicle manufacturer. On Jan. 4, Bloomberg reported that Evergrande initiated nationwide discounts of up to 13% on apartments through Feb. 20. While such sales are not uncommon during the Lunar New Year festival, Bloomberg notes that “this year’s promotion has come earlier and lasts longer.”
Evergrande is a highly-speculative credit, disclosing that last year saw the slowest sales growth since 2012, while posting negative free cash flow for eight of the last nine years, if analyst estimates for 2019 are on the beam (full results for the year have yet to be reported). After a sharp decline today, its 8 3/4% dollar-pay senior secured bonds due 2025 are now priced to yield more than 12% and a spread of 1,048 basis points over Treasurys. A July 2, 2017 Grant’s analysis of Evergrande featured this assessment: “We suspect that the company name will one day become proverbial, like ‘Bank of United States’ or ‘Hindenburg.’”
For China’s heavily-encumbered entities, today’s trade deal has one plus. According to the text from the phase-one agreement: “China shall allow U.S. financial service suppliers to apply for asset management company licenses that would permit them to acquire non-performing loans directly from Chinese banks.”
Recap Jan. 15
A modest uptick in stocks pushed the S&P 500 to a fresh closing high and a 2% gain through the first half of the month, while strength across the Treasury curve pushed the two- and 10-year yields to 1.56%, and 1.79% respectively. Gold rose to $1,556 an ounce, WTI crude hovered near $58 a barrel, and the VIX held near 12.5 for a fifth straight session.
- Philip Grant
Tuesday, January 14, 2020
Let's pretend
Back in the saddle. Leveraged loans, or floating-rate, tradable bank debt issued by speculative-grade corporate borrowers, have flourished once more thanks to the all-encompassing asset-price rally. While policy easing from the Federal Reserve helped spur superior performance from fixed-rate high yield bonds last year (the Bloomberg Barclays High Yield Index returned 14.3%, compared to 8.6% for the S&P/LSTA Leveraged Loan Index), that leveraged loan gauge has climbed back to 97.3, its best level since May and above the five-year average of 96.4.
The recovery is no small thing, as the domestic loan market has jumped to $1.2 trillion as of December, up from less than $500 billion at the end of 2010 (by contrast, the U.S. junk bond market has grown much less quickly, currently footing to $1.29 trillion, compared to $930 billion at year-end 2010). The rebound in prices has helped burnish sentiment among the holders of collateralized loan obligations (CLOs), the packaged and securitized collections of leveraged loans, which now hold 56% of such credits (the highest share since at least 2009) thanks to a record 241 CLO deals in 2019, according to analysts at Wells Fargo.
A new survey of CLO investors by J.P. Morgan finds that 57% of respondents hold a cash position of 5% or less, yet 54% of the surveyed field indicate they want to add risk (time to call the margin clerk?) compared to 16% that want to reduce it. Bloomberg, reporting the data, characterizes them as bearish, though we wonder what bullish would look like. Anyway, Bloomberg also relates, “Nobody at the `CLOs, In Need of a Hug’ conference hosted by Bank of America last week seemed very worried about issuers’ ability to manage their lowest-rated credits, according to a recap of the meeting issued by the bank.”
While the consensus points to more good times in the offing, concerning developments have appeared in this fast-growing corner of the credit market. In the second half of 2019, credit rating downgrades for loans outpaced upgrades by a factor of 3.1 times according to S&P Global’s LCD unit, the largest such skew since 2009. That jump in negative rating action, analysts at Wells Fargo theorized on Jan. 8, can be chalked up to “aggressive loan underwriting” in 2017 and 2018, and subsequently disappointing operating performances relative to market expectation.
Indeed, the proliferation of “add-backs,” those expressions of hope for future cost savings that promoters use to burnish a pro forma income statement, all but guarantee future operating disappointments (the hopes so rarely materialize). According to data from LCD, more than 90% of corporate borrowers in 2016 failed to reach their earnings target in the second year after taking out a leveraged loan, leaving the average loan borrower toting a net debt load equivalent to 5.9 times Ebitda by the second year, compared to the average management forecast of just 3.1 times net debt to Ebitda at that time.
As for new deals, Matthew Mish of UBS Securities found in November that new deals have averaged 5.4 turns of net debt on an as-presented basis, but 6.7 times debt to Ebitda after stripping out add-back credits. Mish also notes that the ratings composition for leveraged loans has deteriorated compared to prior cyclical turning points, with the proportion of loans held by CLOs rated single-B-minus footing to 16%, compared to 7% in 2015 and 9% in 2007.
Loan transactions with Ebitda adjustments by year. Source: LCD
With the fundamental health of the fast-growing leveraged loan cohort under question, some observers are expressing concern over systemic risk. On Dec. 19, the Financial Stability Board published a white paper on CLOs, finding that exposures “are concentrated among a limited number of large global banks and have a significant cross-border dimension.” The FSB, which was only able to identify the end holders for 79% of loans and 86% of CLOs, also noted that bank exposures “could increase further in stress as a result of revolving credit facilities being drawn down by leveraged borrowers and banks being unable to syndicate loans they intend to distribute.”
Luckily (for the issuers at least) a renewed source of demand for the syndicated loans may be forthcoming. Yesterday, the Financial Times reported that Japan’s Financial Services Agency is set to loosen restrictions on the country’s $3 trillion (by assets) regional banking system, as the near-two decade experiment with zero- and negative-interest rate policy in the Land of the Rising Sun has starved lenders of interest income: The Tokyo Stock Exchange Bank Index trades at just 0.45 times book value and generated a 4.41% return on equity last year, worse than even the 0.61 times book and 6.3% RoE in 2019 for banks in the E.U. Stoxx Index (for more on the unenviable position of Japan's lenders, see the Aug. 9 edition of Grant's). Per the FT, plans “include letting regional lenders participate in areas outside their core business.” Japan’s larger institutions need no encouragement to reach for yield. According to a December report from the Bank of Japan, larger banks held $116 billion of CLO debt as of March, double the 2015 figure and roughly 15% of global supply.
Recap Jan. 14
A solid rally across the Treasury complex left the two- and 10-year yields at 1.57% and 1.81%, respectively, the flattest spread between the pair in nearly a month. Gold and oil mostly held steady, finishing at $1,547 an ounce and $58.50 a barrel, and an afternoon dip helped push stocks just below unchanged on the S&P 500. The VIX remained just below 12.5.
- Philip Grant
Monday, January 13, 2020
To heel
Some adult supervision for the Wild West of finance?
Some adult supervision for the Wild West of finance?
How the other half lives
It was no December to remember.
It was no December to remember.
Recap Jan 13
To heel
Some adult supervision for the Wild West of finance? Japan’s Financial Services Authority announced Saturday a tightening of margin limits on cryptocurrency positions to two times cash from the prior limit of four times.
That follows the introduction of the “Fifth Anti-Money Laundering Directive,” across the European Union on Friday. As noted by Coindesk, also on Friday, the new regulations feature “enhanced know-your-customer and reporting obligations, [along with] greater power and reach to financial intelligence units and law enforcement.”
Tighter leverage, more regulation and a higher cost to operate: Not exactly a winning combo.
How the other half lives
It was no December to remember. According to research from Black Box Intelligence (formerly known as TDn2K), U.S. restaurants suffered a 2.1% comparable-store sales decline in the last month of the year relative to 2018, the worst monthly showing in more than two years. While external factors such as a late Thanksgiving and a difficult comparison with 2018 exacerbated the drop, comparable-store sales were down 0.14% on a rolling three-month basis.
Needless to say, a stagnant top-line bodes poorly in a time of rising costs. This morning, Carrol’s Restaurant Group, Inc. (TAST on the Nasdaq), the largest franchisee of Burger King restaurants in the U.S. and the fourth-largest nationally, pre-announced results for the fourth quarter with a 2% rise in same-store Burger King units. Though strong relative to the broad environment, that figure was short of expectation and TAST shares fell by 13%, extending their post-summer 2018 decline to more than 60%.
Back in August, CEO Daniel T. Accordino commented that 3% to 4% annual comp-store sales growth is needed to offset rising operating expenses. According to the Bureau of Labor Statistics, wage inflation in the restaurant industry summed to 4.4% last year, and analysts at Bernstein Research expect a similar bump in 2020. While the company disclosed no bottom line results today, the sales disappointment augurs nothing good. In the first nine months of 2019, single-B-rated Carrol’s posted an operating loss of $4.1 million, while interest expense over that period summed to $20.4 million.
That balance sheet stress is not limited to Carrol’s. In September, S&P downgraded the credit rating of NPC International, Inc., the number-two U.S. franchisee with about 1,600 Wendy’s and Pizza Hut restaurants, to triple-C-minus from triple-C-plus, and warned of “escalating risk that NPC could pursue a debt restructuring over the next six months to address its capital structure and avoid a covenant breach.”
While franchisees try to keep their heads above water, the “asset-lite” model (in which restaurants sell most or all of their stores to franchisees, collecting a percentage of sales without bearing day-to-day operating costs) employed by the largest restaurant operators remains the apple of Mr. Market’s eye. The S&P Restaurant Index currently trades at 18.3 times enterprise value to Ebitda using estimates from calendar 2020, up from less than 11 times EV to Ebitda in 2012. By comparison, the broad S&P 500 trades at 12.6 times EV to forward Ebitda.
Might intensifying distress at the ground level force franchisors to take remedial action, in tandem with a valuation re-rating from Mr. Market? In a Sept. 20 Grant’s industry analysis featuring a trio of picks-not-to-click, John Hamburger, president of the Franchise Times Corp., estimated that up to 20% of domestic restaurants would close in the event of a recession. Gene Lee, CEO of Darden Restaurants, echoed that sentiment at a conference today, asserting that more “marginal” restaurants will disappear during the next recession than in the unhappy 2007 to 2009 epoch.
As for the yawning sentiment gap between the hard-up restaurant operators and their richly valued franchisors, Hamburger had this to say at the Spring 2018 Grant’s conference:
I’m here to tell you this Shangri- La doesn’t go on forever. 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 Jan 13
Another day, another strong advance for U.S. equities as the S&P rose another 70 basis points, extending its post Oct. 2 gains to nearly 14%. Treasurys were weaker across the board, with the two- and 10-year yields rising to 1.55% and 1.84%, while gold and oil both came for sale, falling to $1,548 an ounce and $58 a barrel, respectively. The VIX closed at 12.37, its lowest since Dec. 17.
- Philip Grant
Friday, January 10, 2020
Price proppers
You can’t accuse them of disorganization. The Federal Reserve’s inflation mantra has been nothing if not consistent: They want more of it. Just yesterday came a trio of such declarations, with Minneapolis Fed president Neel Kashkari suggesting on a television appearance that he would be in favor of “more accommodation” if “inflation continues to weaken.” After lamenting the “downward trend in inflation expectations,” John Williams of the New York Fed consoled his audience: “there is still time to avert this fate.”
St. Louis Fed president Jim Bullard conveyed the message most directly, pronouncing in a speech: “If we did get some upward inflation pressure, at this point I think it would be a welcome development even if it pushed inflation above target for a time. . . so bring it on is what I would say."
That cohesive rhetoric comes as the Fed’s preferred measure of inflation, the personal consumption expenditure index, rose 1.6% from a year ago in November, matching its five-year average growth rate. Other measures show more progress. The core consumer price index has run at or above a 2% annual growth rate for 21 consecutive months, while the New York Fed’s underlying inflation gauge was up 2.35% from a year ago in November.
A longer-term view should supply further comfort: Since the central bank’s chartering in 1913, headline CPI has averaged 3.2% annual growth.
There are signs that inflation is percolating. Recent developments in the commodity complex are one example. Yesterday, analysts at Bernstein Research reported that 2019 well productivity at the oilier shale basins fell 7.6% year-over-year.
While faltering productivity could work to push oil higher, similar upside pressure in key foodstuffs may be in the offing. The breakout of African swine fever, which killed up to 55% of the hog population in China this year according to Rabobank, has been complemented by weather-related supply pressures stateside. Untimely frosts conspired to help curtail U.S. production by 6% in 2019, while an historically wet harvest helped drive corn, soybean and wheat stocks as of Dec. 1 lower by 4.6%, 13.3% and 9% respectively from their year ago levels, according to today’s report from the U.S. Department of Agriculture. Then, too, the U.S. Dollar Index, which has remained very strong in recent years to help keep a lid on commodities, might be rolling over.
U.S. Dollar Index, 10-year chart. Source: The Bloomberg
The prospect of higher commodity prices is one thing (recall that those inputs are excluded from the so-called core PCE on which the Fed relies). Wage inflation is another. While today’s reading of non-farm payrolls showed a softer-than expected 2.9% year-over-year rise in average hourly earnings (the lowest reading since July 2018) signs of renewed strength are visible. Yesterday, fast food chain Taco Bell announced it will pay some store managers in the Midwest and Northeast as much as $100,000 a year, up from the current range of $50,000 to $80,000. On Jan. 1, 20 states raised their minimum wages, with another four set to do so later in the year.
With the measured unemployment rate at just 3.5% according to the Bureau of Labor Statistics (down from a post-1946 average of 5.7%), hotter wage growth could soon appear in the data, according to James McCormack, global head of sovereign and supranational ratings at Fitch:
For regions of the world where we do think there is a possibility of inflation picking up, we could see that in the U.S. That would be a big surprise to everyone, but actually the labor market is very tight. Some of the leading indicators of labor inflation like unit labor costs are picking up.
The potential for eroding consumer subsidies financed by previously loss-tolerating venture capitalists represents another upside risk for prices. As noted by The Atlantic’s Derek Thompson in August, WeWork parent The We Co., Uber, Inc., and DoorDash, Inc. lost about $13 billion last year, with customers reaping the benefits of artificially lower prices that are indirectly paid for by VC’s. With WeWork having already pulling back its generosity (Almost Daily Grant’s, Nov. 19) and DoorDash in merger discussions with rival Grubhub, Inc., according to a report from The Wall Street Journal on Wednesday, those days may be coming to an end. As for Uber, a spot check for a Friday afternoon ride from The Woolworth Building in TriBeCa to Columbus Circle (29 minutes away according to Google maps) was quoted at $42.08: Not exactly a bargain, as competitor Lyft, Inc. offered the same ride for $33.
Inflation in 2020: Time to bring it on?
Recap Jan. 10
Stocks gave back early gains to leave the S&P 500 lower by day’s end, but the broad index still managed a 1% gain over the first full week of the year. A bull-flattening rally across the Treasury curve left the two- and 10-year yields at 1.56% and 1.82%, respectively, while WTI crude slumped to near $59 a barrel and gold rallied to $1,561 an ounce. The VIX stayed at 12.5.
- Philip Grant
Thursday, January 9, 2020
'Nar pow
Not quite late-cycle. As the U.S. economic recovery plods along for a record 127th straight month, the housing market has gradually emerged from its protracted post-2008 slumber. Helped by favorable rate gyrations (the average 30-year fixed mortgage rate now stands at 3.74% according to Bankrate.com, down from 4.09% in June and 4.8% in November 2018), so-called existing home sales rose to a 5.35 million seasonally-adjusted annual rate in November, up 2.7% from a year ago and the fifth straight monthly increase.
In addition, November housing starts rose 3.2% from a year ago to a seasonally-adjusted annual pace of 1.365 million units, while permits for future construction rose to a 1.48 million annual rate, the highest figure since May 2007. Despite that uptick in supply, inventories fell to a 3.7 month supply in November from 4.0 months’ supply in 2018, helping push median prices for existing homes to $271,300 in November according to the National Association of Realtors, up 5.4% from a year ago.
Anecdotally at least, the good times have continued into 2020. On Tuesday, CNBC’s Diana Olick reported that “open houses, which are usually pretty rare the first week in January, were plentiful in markets across the nation this year, as buyers hope to get in before the competition gets even worse.” That evident supply shortage has been a long time coming: Freddie Mac finds that the number of American households has expanded by 10.2 million from June 2009 to March of last year, eclipsing the 8.6 million new housing units which have come online during that period.
While the late-aughts housing bubble and subsequent burst inflicted more than its share of psychological pain, the current backdrop offers more durable footing: According to the St. Louis Fed, household debt stood at just 77% of GDP as of the second quarter, down from 97% in 2007.
Structural factors associated with the E-Z money era are also casting bullish tidings. As Rick Palacios, Jr., director of research at John Burns Real Estate Consulting, told Grant’s back in July: “There is now this massive pool of capital, institutional capital, ready and waiting on the sidelines to scoop up any inventory [of single family homes] that they can possibly get their hands on.”
Off the mat; gradually. U.S. housing starts, 20-year chart. Source: The Bloomberg
***
The shifting market conditions looks to be serving Lennar Corp. (LEN on the NYSE), the largest American homebuilder and subject of a bullish July 26 Grant’s analysis, particularly well. Yesterday, Lennar announced stronger than expected revenues of $7 billion and earnings per share of $2.13 (topping the consensus of $6.5 billion and $1.90 a share, respectively), while deliveries of 16,420 new homes represented a 16% year-over-year increase.
Underpinning the robust results was Lennar’s decision to shift its attention down the price curve, as the average home delivered during the quarter (which ended Nov. 30) was priced at $393,000, down from $421,000 in the fourth quarter of 2018. That pivot could help alleviate a supply shortage at the low end, as only 24% of homes constructed since 2011 have measured less than 1,800 square feet (a designator for “affordable”), compared to 31% of new homes built during the 2001 to 2007 period.
While shifting towards lower priced units to capitalize on current cyclical dynamics, Lennar has also incorporated unhappy lessons from the housing bust, announcing on June 25 plans to raise its share of lots held by option instead of outright purchase, thus offloading land value risk while bolstering margins. Yesterday, CEO Rick Beckwitt told conference call dialers-in that Lennar now controls 33% of its inventory via option (up from 26% as of May 31) and is now targeting a 50/50 split by the end of 2021.
Despite a 21% share price advance since July 26 (double the 11% gain for the S&P Homebuilders Index over that period) Lennar currently trades at just 9.3 times consensus EPS for the 12 months ended Nov. 30, 2020 compared to 14.2 times for the index. In addition, the company generated $1.49 billion in free cash flow over the 12 months ended Nov. 30, a healthy sum relative to its $17.9 billion market cap. As deputy editor Evan Lorenz noted in July: “free cash flow is also somewhat countercyclical: In a downturn, Lennar can choose to buy less land, thus boosting cash.” For instance, FCF registered at $1.1 billion in 2008, double that of two years prior.
The economic recovery may be getting long in the tooth. But for Lennar, might further good times lie ahead?
Not-QE progress report
The Fed’s portfolio of securities held outright rose to $3.759 trillion, an uptick of $18.6 billion from a week ago. Short term bills accounted for the largest sequential changes, with issues maturing within 90 days adding $20 billion while those maturing in one to 5 years falling by $6.1 billion.
Since the not-QE program got underway in September, total balance sheet assets at the Fed are up by 10.3%, and remain 7.5% below the mid-2017 high-water mark.
Recap Jan. 9
Stocks raced higher once more, with the S&P 500 tacking on a 70 basis point gain to extend its post Oct. 2 advance to 13.4%, or a nearly 60% annualized pace. Gold pulled back slightly to $1,551 an ounce and WTI crude held just below $60 a barrel, while Treasurys finished flat to slightly stronger to leave the two- and 10-year yields at 1.58% and 1.86%, respectively. The VIX fell to 12.5.
- Philip Grant
Tuesday, January 7, 2020
Highly unusual
Throw it in reverse. Yesterday, Axios reported that the Vision Fund, SoftBank Group Corp.’s, in-house V.C. arm, has “walked away” from a number of recent investments, well after submitting term sheets to their would-be investees. Quoth Axios: “this is highly unusual behavior, even for the idiosyncratic SoftBank.” While the bull market continues apace, evidence suggesting a turn in fortunes for the deal-happy conglomerate – dubbed the “epitome of the cycle” by Grant’s in December 2017 -- is mounting.
In November, SoftBank reported a $6.5 billion net loss the six months ended Sept. 30, its first such shortfall in 14 years, thanks to write-downs on Vision Fund portfolio companies including WeWork parent The We Co. and Uber Technologies, Inc. That explosion of red ink comes at precisely the wrong time, as SoftBank is trying to raise an additional $108 billion for a second Vision Fund while continuing to pay a 7% dividend on the approximately $40 billion in preferred shares held by Vision Fund investors.
Newfound difficulties with local lenders suggest that the Vision Fund 2 faces an uphill fundraising climb. On Dec. 23, Reuters reported that Japan’s three biggest banks are hesitant to lend SoftBank the funds needed to undertake its bailout of WeWork and are considering steps to mitigate their own risk such as requiring SoftBank to post some of its 26% stake in Alibaba Group Holding, Ltd. as collateral.
Recent weeks have brought further bad tidings to SoftBank CEO Masayoshi Son, as Business Insider reported yesterday that automated chain restaurant Zume Pizza, Inc., into which the Vision Fund invested $375 million in November 2018, will lay off up to 80% of its staff and let the lease on its Seattle engineering office (cooking of the future!) expire in order to save cash. That follows the December report from The Wall Street Journal that dog-walking app Wag Labs, Inc., recipient some $300 million in Vision funds in early 2018, let go “a significant portion of its workforce.” This afternoon, car rental startup Getaround, which raised $300 million from the Vision Fund in August 2018, announced it will lay off about 25% of its staff, according to website The Information.
Senior level departures serve as another red flag. On Dec. 27, Fast Retailing founder and president CEO Tadashi Yanai announced his Dec. 31 resignation from the SoftBank board of directors after an 18-year stint. The Financial Times noted that while Yanai, “was openly critical of Mr. Son’s penchant for deals and his recent pivot” towards the Vision Fund, Masa “was keen to retain [the executive] as a board member.” That follows the Dec. 11 departure of Vision Fund managing partner Praveen Akkiraju, who left in order to “explore his passion for working with early-stage start-ups (operating or investing role)” according to a company email viewed by Axios.
While SoftBank deals with adversity across its portfolio, the outcome of the state attorneys general challenge of the merger between SoftBank majority-owned Sprint Corp. and T-Mobile U.S., Inc. hangs in the balance. With closing arguments in the case set for Jan. 15 in New York, observers are not optimistic that the combination will be allowed to move forward.
Legal analysts at boutique advisory firm United First Partners estimated yesterday that the states have a 70% chance of thwarting the merger, as the defendants have failed to undermine the “strong presumption of illegality” conveyed by the AG coalition. Mr. Market seems to concur that the deal won’t go through as currently structured, as Sprint shares have fallen to a 52 week low, a 36% discount to the level implied by T-Mobile’s all-stock bid. One investor who attended every day of the trial tells Grant’s today:
I now have higher conviction that the deal will be blocked. It was very clear that the state AGs succeeded in making their prima facie case of presumptive harm, shifting the burden of proof to the companies. A strong presumption of harm creates a heavy burden. T-Mobile and Sprint couldn’t just play to a tie; they needed to decisively win on these defenses, and just couldn’t because the facts and law don’t change just because the Trump DOJ/FCC cleared the deal.
Even if the judge rules in favor of the pair, that widening spread reflects the likelihood that T-Mobile will renegotiate the now-expired deal at terms more favorable to itself. SoftBank is not legally obligated to stand behind Sprint’s debt, which would quite possibly need to be restructured in the event of the T-Mobile deal being rejected (Almost Daily Grant’s, Sept. 26).
Yet, as BreakingViews noted in a Nov. 5 commentary: “it’s hard to imagine Son ever washing his hands of Sprint. Doing so would wipe out over a tenth of the Japanese group’s asset value and make it harder for other units to borrow in future.” On Dec. 9, analysts at Bloomberg Intelligence determined that SoftBank faces a combined $66 billion in debt maturities and outstanding pledges in coming years, six times pro-forma liquidity.
That Dec. 15, 2017 Grant’s analysis recalled the rueful words of junk bond investors in the wake of the 1989-1990 recession, ones which SoftBank creditors may want to keep in mind: “Asset values are contingent, but debt is forever.”
Recap Jan. 7
Treasurys came under modest pressure for a second straight day, leaving the two- and 10-year yields at 1.564% and 1.82%, respectively, while a modest pullback in stocks left the S&P 500 little changed through the first four sessions of the year. WTI crude held just below $63 a barrel and gold advanced to $1,572 an ounce. The VIX remained below 14.
- Philip Grant
Monday, January 6, 2020
Under the hood
A permanently high plateau? Calendar 2019 was another solid year for U.S. auto industry, as Edmunds.com calculates 17.05 million total new vehicle sales to mark the fifth straight year above the 17 million threshold. “Ten years ago it was like, ‘Can we ever get to 17 million?’” Jack Hollis, group vice president at Toyota Motors, commented to The Wall Street Journal, “and now we’re there every year.” But as the industry exults, a confluence of factors beneath the surface could throw automakers and their share prices for a loop.
The run of strong sales has allowed the industry to push sticker prices higher, with the average new car costing a record $34,602 in December according to J.D. Power and LMC Automotive, up from $32,700 in the fall of 2018 and representing 55% of 2018 median household income. To help buyers afford those fancy prices, dealers have turned to more generous discounting, as J.D. Power finds that so-called incentive spending reached $4,600 per vehicle on average in December, a record high.
Debt also figures prominently in the playbook, as The New York Fed pegs total auto loans outstanding at $1.32 trillion as of the end of the third quarter, up 3.9% from a year ago and 78.3% over the past decade. Terms have lengthened in tandem with the uptick in total value, as Experian reported in November that seven-year auto loans account for 31.5% of new sales, up from 10% in 2010.
That rising encumbrance could prove problematic if the cyclical winds shift from the current 126 month (and counting) post-2009 economic expansion. According to data from the Federal Reserve Bank of New York, the percentage of auto loans considered seriously delinquent (i.e. at least 90 days past due) stood at 4.71% in the third quarter, up from 4.27% a year ago and the highest reading since 2011. That’s despite friendly interest rate gyrations, with the annual percentage rate on new financed vehicles falling to 5.4% in December according to Edmunds.com, down from 5.9% in the final month of 2018 and the lowest in 22 months.
The recent uptick in slow-paying loans is occurring in tandem with a deterioration in the used-vehicle market. Auto-valuation firm Black Book reports that its Used Vehicle Retention Index (calculated using the company’s average auction value of two- to six-year-old used autos) fell to 113.3 in December from 114 in November, the fourth straight sequential decline to leave used prices lower by 2.6% year-over-year. Anil Goyal, executive vice president of operations at Black Book, noted that “after a stable market performance earlier in the year, the fourth quarter of 2019 experienced a sharp decline in used vehicle values.” As the majority of new vehicle purchases include a trade-in, softening used-vehicle prices will pressure new sales, forcing OEMs to keep incentives high, which will further pressure used values.
Used Vehicle Retention Index. Source: Black Book
The crucial role played by the used-vehicle market on the broader industry works with a lag. Thus, leases accounted for 30.1% of retail auto sales in 2016 (the peak year for auto sales in this cycle), up from 13% in 2009. That timing is significant as most such contracts last for three years, meaning that the 2016 vintage vehicles have just come back to market, potentially exacerbating those pricing pressures.
What sort of trouble might a garden variety economic retrenchment cause for the auto industry? The previous leasing cycle, which peaked in the heady days of 1999, featured 28% of sales financed by lease. When the economy slipped into recession in 2001, elevated supply of off-lease vehicles helped push the Manheim U.S. Used Vehicle Index lower by nearly 13% over the 26 months ended in April 2003, eventually forcing Ford Motor Co. to recognize significant per-vehicle lease return losses.
For more on the risks and opportunities which accompany the current state of the auto market, including a pair of actionable ideas, see the Oct. 18, 2019 edition of Grant’s Interest Rate Observer.
Recap Jan. 6
An early dip in stocks was short-lived, as the S&P 500 worked higher throughout the session to finish 35 basis points in the green and maintain the bulls’ iron grip on current proceedings. Treasurys finished modestly weaker across the curve, with the two- and 10-year yields settling at 1.54% and 1.8% respectively, while gold rallied again to $1,566 an ounce. The VIX fell below 14.
- Philip Grant
Friday, January 3, 2020
What makes markets
Two brokerage houses,
Two brokerage houses,
Asset lite
Risk-averse buyers get in line.
Risk-averse buyers get in line.
Recap Jan. 3
What makes markets
Two brokerage houses, two diametrically opposed outlooks for the new year:
“We enter the next decade with interest rates at 5,000-year lows, the largest asset bubble in history, a planet that is heating up, and a deflationary profile of debt, disruption, and demographics” – Michael Hartnett, chief equity strategist at BofA Global Research.
“Overall, the changes underlying the Great Moderation appear intact, and we see the economy as structurally less recession-prone today,” “While new risks could emerge, none of the main sources of recent recessions — oil shocks, inflationary overheating, and financial imbalances — seem too concerning for now. As a result, the prospects for a soft landing look better than widely thought,” – Jan Hatzius and David Mericle, economists at Goldman Sachs.
Asset lite
Risk-averse buyers get in line. The global stock of so-called safe assets is running low, according to researchers at Oxford Economics, who reckon that $1.7 trillion in annual issuance of developed country government debt (encompassing the U.S., Japan, Germany, France, the U.K., Canada and Australia) over the next five years will lag behind demand for such securities by about $400 billion per year.
“The largest buyers are relatively price-insensitive and will continue to accept low returns in return for safety,” Michiel Tukker, global macro strategist at Oxford Economics, told the Financial Times on Nov. 19. Indeed, Oxford pencils in $255 billion of annual central bank sovereign bond purchases over the next five years, while strategists at TD Bank estimate that the Federal Reserve and European Central Bank’s QE exertions will reduce net supply of government debt by 40% this year.
As one cohort scrambles for perceived safety, another scours the landscape for a different sort of target. Private equity firms ended the year with nearly $1.5 trillion in dry powder (i.e., idle cash waiting to be spent), a record figure which dwarfed the $450 billion in p.e. deals undertaken last year.
Making things more difficult for the p.e. titans, last year’s 30% rally in the S&P 500 has helped render bargains few and far between. Yale professor Robert Shiller wrote in the New York Times yesterday that his cyclically-adjusted price-to-earnings (CAPE) ratio points to historically rich valuations: “The CAPE ratio has been as high or higher on only two occasions: 1929, just before the 85 percent stock market crash ending in 1932, and in 1999, just before the 50 percent drop at the beginning of the new millennium.”
A shortage of safe assets - or a shortage of unsafe ones?
Recap Jan. 3
Even when the bulls lose, they win. Stocks finished lower by only 60 basis points on the S&P 500, recouping the bulk of an early-morning decline in futures following the killing of Iranian commander Maj. Gen. Qassem Soleimani, while the VIX finished near 14 after rising as high as 16.2 intraday.
The Treasury market reacted more strongly, as yields finished sharply lower across the curve with the two- and 10-year notes finishing at 1.53% and 1.79%, respectively. WTI crude and gold also enjoyed muscular bids, finishing at $63 a barrel and $1,549 an ounce, respectively.
- Philip Grant
Thursday, January 2, 2020
Diet starts tomorrow
A worthy New Year's resolution:
A worthy New Year's resolution:
Mission impossible
What can't low rates do?
What can't low rates do?
Low and slow
Long live the bond bull market.
Long live the bond bull market.
Not-QE progress report
Recap Jan. 2
Diet starts tomorrow
A worthy New Year’s resolution: Mattel, Inc., is cutting down the red ink – literally. The Wall Street Journal reports that the toymaker, which last posted positive net income and free cash flow in 2016 and endured a 50% share price decline over the past three years, has whittled the shades of red coloring on its wares by more than a third from the prior 150 rouge-tinted options previously offered.
“Complexity is really a killer,” said Roberto Isaias, Mattel’s chief supply-chain officer.
Mission impossible
What can’t low rates do? On Dec. 20, the Bank of England published Staff Working Paper No. 835, which “examines whether monetary policy pass-through to mortgage rates affects household fertility decisions.” The researchers answer in the affirmative, concluding that “each one percentage point drop in the policy rate increased birth rates by 2%.”
That finding may be of interest to Christine Lagarde, newly installed President of the European Central Bank. Recall that in November, Lagarde urged the ECB to elevate climate change to a “mission-critical priority” in its administration of monetary policy across the eurozone.
In 2014, the Intergovernmental Panel on Climate Change concluded that: “globally, economic and population growth continued to be the most important drivers of increases in CO2 emissions from fossil fuel combustion.”
Time to raise rates?
Low and slow
Long live the bond bull market. At a current yield of 1.88%, the benchmark 10-year Treasury offers a negligible premium over the 1.6% annual increase in the “core” personal consumption expenditure index as of November and remains in spitting distance of the 1.32% yield in July 2016, which was the lowest nominal borrowing cost for the world’s leading sovereign nation in 743 years.
With the skyward real yields of the early 1980s less than two generations old, might today’s microscopic creditor compensation represent something of a mirror image of what was (with the 20/20 vision of hindsight) a singular opportunity for fixed-income investors?
Historian Paul Schmelzing, a visiting scholar the Bank of England and P.h.D. candidate at Harvard University, argues otherwise. In a paper released Oct. 31, Schmelzing finds that the bond bear market of the 1970s and early 1980s was a historical anomaly, and that for over 600 years, inflation-adjusted borrowing costs in so-called developed markets have trended inexorably lower:
I show that across successive monetary and fiscal regimes, and a variety of asset classes, real interest rates have not been “stable,” and that since the major monetary upheavals of the late middle ages, a trend decline between 0.6 to 1.8 basis points per annum has prevailed.
The author continues:
Against their long-term context, currently depressed sovereign real rates are in fact converging “back to historical trend” – a trend that makes narratives about a “secular stagnation” environment entirely misleading and suggests that – irrespective of particular monetary and fiscal responses – real rates could soon enter permanently negative territory.
Schmelzing, who came to a similar conclusion in his recent papers “Eight Centuries of Global Real Rates and the ‘Suprasecular Decline’, 1311-2018,” and “Eight Centuries of the Risk Free Rate,” identified capital accretion in excess of the build-up in sovereign debt supply as the driving force behind the long downward march of rates: “It seems to me,” the author emailed to Grant’s last year, “more plausible to relate the decline to aggregate capital accumulation, which then generates diminishing returns.”
Yet the current epoch has one potentially singular characteristic: the overt push from policymakers to quicken the pace of inflation, and, of course, diminish the value of the scrip repaid to creditors at maturity. On Dec. 19, Chicago Fed president Charles Evans commented: “I do think it’s extremely important that we get inflation up. . . I actually think it’s important that we overshoot at this point in the economic cycle.” According to Schmelzing, the measured rate of inflation for the world’s top sovereign borrower has averaged 1.45% over the past seven centuries, less than the 1.6% rise in PCE and far below the 2.1% uptick for the headline consumer price index in November.
Then, too, the Jan. 25, 2019 edition of Grant’s noted that benchmark borrowers have repeatedly devalued their currency or otherwise repudiated their debts: “falling interest rates avail the investor little if the debtor won’t pay on time and in good money.” To that end, the U.S. federal budget deficit rose to 5.1% of GDP in 2019 from 3.5% two years earlier according to the Treasury Department, which, apart from the 2008 financial crisis and its aftermath, is the largest shortfall since World War II. As for the prospects of today’s sovereign creditors, the Jan. 25, 2019 Grant’s put it this way:
No prudent man would try to call the top in a [600-year] bull market, though the thought does cross our mind.
Not-QE progress report
The Fed’s portfolio of securities held outright fell to $3.74 trillion, an $11.2 billion downtick from last week’s reading. Mortgage-backed securities accounted for all of that decline, while the composition of Treasury holdings shifted with a $13 billion rise in securities maturing in one to five years offset by those coming due in 15 days or less.
Since the mid-September commencement of “not-QE,” total balance sheet assets at the Fed are up by 10.8% and are 7% below the 2017 peak.
Recap Jan. 2
New year, same bull, as stocks built off their torrid 2020 with a near 1% gain in the S&P 500, headlined by a 2.2% advance for Apple, Inc. The good tidings weren’t confined to equities, as Treasury yields dropped across the curve in bull flattening formation, while commodities were also well bid with WTI crude finishing above $61 a barrel and gold rallying to $1,529 an ounce, its best finish since late September. The VIX dropped 10% to settle near 12.5.
- Philip Grant
Friday, December 20, 2019
Damn Yankees
From Bloomberg:
From Bloomberg:
Most important meal of the day
Reuters reports that the winning bidder
Reuters reports that the winning bidder
While the iron is hot
It's been a banner year for corporate debt,
It's been a banner year for corporate debt,
Recap Dec. 20
Damn Yankees
From Bloomberg:
Metal credit cards are so 2019. Next year in the U.S., some of the 0.001% will be invited to own a customized card inlaid with diamonds, pearls and other precious gems.’
Their diamond and sapphire-studded card, which borrows from the design of one of the [New York Yankees] championship rings, was on display last month along with other gem-encrusted examples during a private event at New York’s Jewelry Week.
Coming in 2021: the New York Mets rhinestone edition.
Most important meal of the day
Reuters reports that the winning bidder for the annual charity lunch with Berkshire Hathaway, Inc. chairman Warren Buffett paid $4.57 million for the honor this year, surpassing the previous record of $3.5 million set in both 2012 and 2016.
Since the Oracle of Omaha began auctioning the lunch date for charity in 2000 at a winning bid of $25,000, the price of Buffett’s lunch has appreciated at a 29.7% compound annual growth rate. Over that same period, Berkshire Hathaway class-A shares have risen to $340,551 from $66,500, for a compound annual growth rate of 8.5%.
Lunch for the long run?
While the iron is hot
It’s been a banner year for corporate debt, as the Bloomberg Barclays High Yield Index has returned more than 14% year-to-date, on pace for the best year since 2016 and pushing the index yield-to-worst to a five-year low of 5.13%. Investment Grade has fared even better, with the Bloomberg Barclays Index logging a 14.4% gain, which would be the best showing since 2009.
Issuers are making hay while the sun shines. Nearly $20 billion in new supply in December brings total 2019 issuance across the domestic junk bond market to $270 billion. That’s up more than 60% from a year ago, when exactly zero deals were priced in a red December of plunging asset prices.
A similar supply deluge is afoot in so-called developing nations, as fresh high-yield dollar-bond supply from emerging markets reached $118 billion this year according to Dealogic, a record level and more than double the issuance seen five years ago.
“Where else are you going to go for yield?” Oleg Melentyev, head of U.S. high-yield strategy at Bank of America Global Research, rhetorically asked the Financial Times yesterday. “Retirees are forced into this market, insurance companies are forced into this market, pension funds are forced into this market and anyone else who relies on income as a source of living is forced into this market. There is no yield, so they pile into junk bonds.”
Speaking of no yield, the severe financial repression in Europe and Japan offers further opportunity for higher quality domestic issuers to secure even cheaper capital. Dealogic reports that investment grade U.S. companies have issued $129 billion in Euro-denominated debt this year, more than doubling last year’s $56 billion in issuance and easily topping the prior record of $107 billion sold in 2017.
Yunyi Zhang, strategist at Bank of America, zeroed in on the rationale: “The ECB’s [asset purchase] program is up and running, which is also very supportive, and foreign yields have collapsed, making borrowing costs very attractive.” For context, the Bloomberg Barclays Euro Aggregate Index (which measures the broad government and corporate investment grade bond market) sports a 0.2% yield, compared to 2.35% for the U.S. Aggregate Index.
In Japan, regional banks, which have seen profitability wither under the thumb of the Bank of Japan’s negative-interest rate policy, have been forced to take greater risks in their efforts to keep the lights on. In a survey of lenders conducted by Bloomberg on Tuesday, 20 of 29 banks reported they have reduced their holdings of Japanese government bonds, presumably replaced with riskier securities (five of the respondents disclosed they have been buying triple-B-rated foreign debt). The banks “are desperate, and so they are taking deeper credit risks,” said Shunsaku Sato, senior credit officer at Moody’s Investors Service.
Might a cyclical turn make the yield-reachers regret their over-reach? In a 2020 outlook published last Friday, Fitch Ratings forecasts default rates for U.S. leveraged loans and high-yield bonds will rise to 3% and 3.5%, respectively, up from 1.8% and 2.9% over the trailing 12-month period. Likewise, S&P Global LCD reported in late October that its “Weakest Links,” or those with a credit rating of B-minus or lower coupled with a negative outlook from S&P Global, rose to 9.6% at the end of the third quarter, up from 6.8% at year-end 2018 and the highest since at least 2013.
Recap Dec. 20
Stocks continued their upward path-of-least-resistance, with the S&P 500 tacking on another 50 basis point advance to finish the week higher by 1.7% and push the year-to-date gain to 28.5%. Things were mostly stable elsewhere, with the two- and 10-year yields settling at 1.63% and 1.92%, respectively, while WTI crude pulled back to $60.3 a barrel and gold ticked to $1,478 an ounce. The VIX stayed put at 12.5.
- Philip Grant
Almost Daily Grant’s will resume on Jan. 2.
Thursday, December 19, 2019
Wild Wild East
It’s finally happening. Seemingly interminable trade negotiations between China and the United States finally yielded a “phase one” deal announcement last Friday, and that agreement does appear set to move forward. Today, Treasury Secretary Steven Mnuchin told CNBC that the pact will be signed in early January. Chang Shu, chief Asia economist at Bloomberg, wrote Tuesday that the deal “is a definite positive for China. Reduced tariffs will give a direct lift to growth in the short term. More importantly, it defines a boundary in the trade war, reducing uncertainties that have plagued the economy.”
That détente could not come at a more crucial time for China, which reported third quarter GDP growth of 6% from a year ago, the lowest figure since at least 1992 and well below the 9% average over the last 20 years. Money supply growth as measured by M2 is also faltering, rising by 8.2% year-over-year in November compared to a 15.1% average growth rate over the past two decades. The situation is causing concern among the Beijing political elite, as premier Li Keqiang commented on a government website that China’s economy will face more “complicated situations” in 2020.
As growth prospects dim, the powers-that-be redouble their efforts to keep capital from escaping the country. CNN Business reports today that, after a customer at the Bank of China withdrew $50,000 over the course of a week, the State Administration of Foreign Exchange fined the bank nearly $6,000 for exceeding permissible foreign currency withdrawals. “Controls on outflows are increasingly tight,” noted Alicia Garcia Herrero, chief economist for Asia Pacific at Natixis Bank. According to the Beijing-based Chinese Academy of Social Sciences, capital outflows have equaled the equivalent of 6% of nominal GDP in each of the past two years.
With growth waning and capital leaking, China’s titanic debt load (banking assets of $40 trillion are equivalent to 47% of last year’s global GDP) presents the risk of considerable mayhem. One potential trouble spot: Distress at the local government level, particularly in so-called local government financing vehicles (LGFV), entities established by regional authorities to finance construction and other infrastructure projects. On Nov. 10, the Financial Times reported that 831 local governments have fallen into default in the first 10 months of the year, up from just 100 defaults in all of 2018.
In a Wednesday interview with the Securities Times, Ma Jun, an external advisor to the People’s Bank of China, warned that LGFV’s present potential “systemic risks” with the prospect of a default “chain reaction.” By way of solution, Ma suggested regional consolidation across the LGFVs, with stronger entities absorbing weaker ones.
Last week the Shangrao Investment Holding Group Co., an LGFV based in China’s Jiangxi province, scrapped a planned sale of $200 million in dollar-pay bonds after the Hohhot Economic & Technological Development Zone Investment Development Group, an LGFV based in Inner Mongolia, missed a Dec. 6 bond payment. Also last week, commodities trading firm Teewoo Group Corp., which is owned by the Tianjin province government, failed to repay $1.25 billion in dollar-pay bonds, marking the largest offshore bond default by a Chinese company in more than 20 years. This event is no accident, according to S&P Global: “We believe [government] bailouts will be increasingly selective, leading to more defaults by state-owned enterprises.”
Meanwhile, the cash crunch at a series of small and medium sized lenders across China continues to unfold. Yesterday, Hengfeng Bank Co., Ltd. announced that it will sell RMB 100 billion ($14.2 billion) worth of shares to local and foreign investors to help shore up its shaky finances. That follows state-led rescues at Baoshang Bank Co. Ltd. and Bank of Jinzhou Ltd. earlier this year. More broadly, Chinese companies have defaulted on RMB 130 billion of onshore bonds this year, topping last year’s record of RMB 122 billion.
Yet those developments haven’t dimmed animal spirits in the Middle Kingdom, as the spread between triple-A- and double-A-rated (equivalent to junk in China) corporate bonds has fallen to just 20 basis points, the tightest risk premium in more than a decade, according to Bloomberg. “The increase of defaults and more effective market pricing has channeled more funding into high-yield bond investment,” Liang Yu, credit analyst at Shanghai Silver Leaf Investment Co., explained. Junk in a storm?
Perhaps sensing opportunity, one controversial fund manager looks to try his luck in the Far East. Bloomberg reports today that Neil Woodford, recently deposed from his post at Woodford Investment Management after his eponymous fund was forced to suspend redemptions thanks to its holdings in illiquid and unlisted securities (Grant’s Interest Rate Observer, May 17), is “in China having exploratory meetings with investors interested in early-stage assets.”
Recap Dec. 19
Yet another round to the bulls, as the S&P 500 tacked on another 50 basis points in gains to bring its 2019 advance to nearly 28% with seven sessions left in the year. Treasurys finished little changed with the two- and 10-year yields at 1.63% and 1.92%, respectively, as did key commodities with gold finishing at $1,479 an ounce and WTI crude at $61 a barrel. The VIX held at 12.5.
- Philip Grant
Wednesday, December 18, 2019
Phone home
The high-stakes lawsuit
The high-stakes lawsuit
98 pound weakling
It's a perfect set-up.
It's a perfect set-up.
Recap Dec. 18
Phone home
The high-stakes lawsuit filed by a consortium of state attorneys general against the merger hopefuls Sprint Corp. and T-Mobile U.S., Inc. continues in Manhattan.
According to testimony today, SoftBank Group Corp., had offered to help Dish Network Corp. with the financing needed to build out a new cellular network. Recall that Sprint, which would face the risk of potential bankruptcy as a standalone company, agreed to sell spectrum assets to Dish over the summer to win deal approval from the Department of Justice. SoftBank, which owns 84% of Sprint, could see its $21 billion investment in the telecom operator wiped out if the AGs prevail and Sprint is subsequently forced into Chapter 11 restructuring (Almost Daily Grant’s, Nov. 6).
While one bit of testimony does not a ruling make, a telling exchange this afternoon could prove costly for Sprint and SoftBank alike. As reported by the Capitol Forum, Dish Network chairman Charlie Ergen “undercut a key defense argument” by stating under cross examination that the initially proposed deal, which would have reduced the number of U.S. carriers to three from four, “would tend to raise prices to consumers.”
Sprint shares rose 1% today but remain near their 52-week low and at a 33% discount to the level implied by T-Mobile’s all-stock offer. It’s safe to say, the jury is still out.
98 pound weakling
It’s a perfect set-up. With just a handful of trading sessions left in the year, 2019 is shaping up to be a banner one for fixed-income fund managers. According to EPFR Global, bond funds have seen inflows totaling $468 billion this year, the largest capital infusion on record going back to 2001.
Rising prices in tandem with that capital influx have helped push global fixed-income assets to $5.8 trillion from $4.9 trillion at the end of 2018, with the Bloomberg Barclays Multiverse Index (which tracks investment grade and high-yield debt across a range of currencies) trading at a yield-to-worst of 1.67%. That compares to 2.32% on Dec. 31, 2018.
Unsurprisingly, the broad fixed income rally has led to fruitful results at the more speculative end of the credit spectrum. In the U.S., the ICE BofA High Yield Option Adjusted Spread has fallen to 360 basis points over Treasurys from 530 basis points at year-end 2018. Even leveraged loans, relatively disadvantaged by their floating-rate status during a period of central bank easing, have fared well with the S&P/LTSA Index generating an 8.2% total return after a late slide erased returns last year.
Issuers have not failed to take advantage of the mostly hospitable conditions. As documented in a recent report from Matthew Mish at UBS A.G., newly issued leveraged loans have come to market with an average debt load of 5.5 times Ebitda this year, compared to just under 5 times in 2007. But after accounting for issuer-friendly adjustments such as add-backs (i.e. applying credit today from hypothetical future cost savings), debt from new issues rises to near 7 times Ebitda, up from just over 5 times in 2007.
Those striking figures have led some observers to express their concerns in no uncertain terms. Jason Dillow, CEO of credit investment firm Bardin Hill, summed up the game that issuers play to Bloomberg on Friday: “We have never seen a net negative adjustment to Ebitda – it only goes up. It is basically what you can get away with while keeping a straight face.” At a conference in early December, Alan Waxman of TPG Sixth Street Partners added that “it’s not normal, as a lender, to lend money against fake Ebitda and fake collateral.”
For the last word, we turn to the April 6, 2018 edition of Grant’s Interest Rate Observer:
Creditors are the loneliest corporate stakeholders. Management disdains them. The Fed debases them. Give them this, at least (it’s a kind of virtue, anyway): They never complain.
Recap Dec. 18
A second straight sideways showing for stocks left the S&P 500 higher by 27% year-to-date, while the Treasury curve continued to steepen with the two- and 10-year yields finishing at 1.63% and 1.93%, respectively, the widest spread since October 2018. A supply draw in weekly DoE inventories helped push WTI crude to near seven month highs at $61 a barrel, and the VIX enjoyed a late pop to finish at 12.5.
- Philip Grant
Tuesday, December 17, 2019
B.S. detector activated
Felix Rohatyn,
Felix Rohatyn,
Early spring for Europe's banks?
A light at the end of the tunnel, perhaps.
A light at the end of the tunnel, perhaps.
Recap Dec. 17
B.S. detector activated
Felix Rohatyn, longtime partner at investment banking firm Lazard and former ambassador to France, died over the weekend at age 91. Rohatyn, whose family twice escaped the advancing Nazis during the Second World War, famously helped bridge competing interests during negotiations to help New York City avoid bankruptcy in 1975. His efforts earned a laudatory New York Times nickname “fiscal relief pitcher,” who “when all seemed lost, came in and saved the game.”
Asked at the fall 2010 Grant’s Conference whether his experience could prove a useful template for solving today’s fiscal woes, the banker noted that the increasingly large sums involved add further complication:
I think that if you have to go into some kind of dramatic, last minute restructuring with these kinds of amounts that we’re dealing with, I would just shudder at that.
Though he graduated from Middlebury with a degree in physics, a different type of skill set gleaned from decades on Wall Street served Rohatyn well. As detailed in his 2010 memoir “Dealings: A Political and Financial Life,” New York deputy mayor James Cavanagh teasingly told the banker in 1975: “I can tell you don’t know much about municipal finance.” Rohatyn, who had expressed his surprise at the city’s misclassification of short-term debt as long term, replied: “True, I may not know much about municipal finance, but I do know about bullshit.”
Early spring for Europe's banks?
A light at the end of the tunnel, perhaps. On Thursday, Sweden’s Riksbank will hike its benchmark interest rate back to zero from the current minus 25 basis points, according to a consensus of central bank watchers surveyed by Bloomberg. The Riksbank (which is the world’s oldest central bank) was at the vanguard of the negative-rate regime with a move below zero back in 2009.
This week’s move could once again prove influential, according to Tiia Lehto, economist at Citigroup Global Markets: “The Riksbank’s desire to ‘escape’ negative rates due to various side effects is the main driver [of the prospective hike]. The analysis on Sweden strengthens the notion that zero truly is the lower bound in other advanced economies.”
Members of the European Central Bank, which just saw leadership handed over to Christine Lagarde, will likely take particular heed of the Riksbank’s expected move. The ECB, which brought rates into negative territory in 2014, has faced increasing internal resistance to the monetary experiment, with central bank governors from Spain, Austria and Italy recently voicing public criticism against the practice (Almost Daily Grant’s, Dec. 5). That debate continues to rage, as Bloomberg reported Friday that some ECB members wanted Lagarde to mention the “damaging side effects” of negative rates in her debut press conference last week. The idea was scrapped to ensure that such remarks would not be “over-interpreted by investors.”
A shift in the monetary winds would be welcome news indeed for Europe’s beleaguered banking system, which has seen its business model crimped by the sub-zero deposit rates administered from on high. The proof is in the pudding, as the Euro Stoxx Banks Index generated a 6.3% return on equity in the third quarter and trades at 0.62 times book value with a 5.8% dividend yield (that compares to an 11.8% third quarter RoE, 1.35 times price to book and 2.6% dividend yield for the U.S. KBW Index). Unsurprisingly, the central bankers are eager to identify other factors behind that discrepancy. Thus, ECB executive board member Benoît Coeuré asserted in an interview with Liberation last week that “there are too many banks in Europe and consolidation has not started. . . [the banks] have a cost base that is much higher” than global peers.
On that score at least, things are trending in the right direction, with the largest institutions culling 60,000 employees this year. Since 2008, the top ten banks in Europe by market cap have cut staff by 20% to 1.1 million according to the Financial Times. That compares to a 7% staffing decline in the top ten U.S. banks over the same period. Those cost-cutting efforts coincide with improving balance sheets across the Old Continent, with non-performing loans across the region tumbling to 3.1% as of June 30, from nearly 7% at the end of 2014.
With inviting valuations and signs of fundamental improvements, might even the prospect of the end of the negative rate regime be enough to spur a bullish revival of these institutions? Since the global stack of negative-yielding debt peaked at more than $17 trillion on Aug. 29, the Stoxx Banks Index has quietly rallied by 22%. There looks to be room for further improvement, as the Index remains 40% below its Spring 2014 levels.
Negative-yielding debt outstanding in orange (left-hand scale); Stoxx Banks Index in white (right-hand scale). Five-year chart. Source: The Bloomberg
Recap Dec. 17
Stocks took a break from their recent rampage as the S&P 500 drifted sideways, while Treasury yields mostly edged higher with the 10-year settling at 1.88%. Another round of energy strength pushed WTI crude to a three-month high of $60.6 a barrel, and the VIX remained just above 12.
- Philip Grant
Monday, December 16, 2019
Candy crush
From the Knoxville News Sentinel:
From the Knoxville News Sentinel:
Turn the page
It’s a new day.
It’s a new day.
Recap Dec. 16
Candy crush
From the Knoxville News Sentinel:
An overturned tractor-trailer carrying approximately 35,000 pounds of M&M's candy has shut down the Interstate 40 East ramp to Papermill Drive.
Something to tide us over until the helicopter money arrives?
Turn the page
It’s a new day. This morning, Valeant Pharmaceuticals International, Inc., since renamed Bausch Health Companies, Inc., announced the settlement of an investor class action lawsuit related to its 2015-2016stock-price tumble (see a quartet of bearish analyses in 2014 and 2015 editions of Grant’s including: “Drug dealer,” “Sacrificial creditors,” “Reality check” and “Saul Steinberg’s second coming”). Bausch, which famously embarked on an ambitious roll-up strategy before being forced into an abrupt unwind of that business model, agreed to cough up $1.21 billion to settle allegations that prior management withheld material information from the investing public. The specialty pharmaceuticals company admitted no wrongdoing and said the settlement would have no impact on 2019 results.
Operating results may be undisturbed by the agreement, but BHC investors may end up indirectly bearing the brunt of the old guard’s errors. According to the press release, Bausch “intends to use a combination of sources to fund the Settlement,” including “potentially accessing capital markets.” Cash and equivalents stood at $825 million in the quarter ended Sept. 30.
S&P Global cheered the news, upgrading the company to single-B-plus from single-B as “credit quality is enhanced by the reduction in uncertainty.” The ratings agency expects Bausch to “continue to steadily reduce debt,” which currently stands at just over $23 billion net of cash. That’s down from a high of $32 billion in 2016 thanks to a series of issuer-friendly refinancings, but still equals a meaty 6.4 times 2019 consensus adjusted Ebitda, well above the average 5.2 times leverage ratio for single-B-rated credits according to a December 2017 analysis from Moody’s Investors Service.
To be sure, the credit market can’t seem to get enough of Bausch debt: All of the company’s marketable bonds trade above par, while the senior unsecured 9 1/4s of 2026 issued last year have rallied to 116 cents on the dollar, for a yield-to-worst of 3.89% and a 222 basis point spread over Treasurys. For context, the ICE BofA Single-B Effective Index trades at a 5.48% yield.
As Mr. Market rolls out the red carpet, risks lurk for Bausch creditors beyond the company’s substantial debt burden and legacy of the failed roll-up strategy undertaken by former CEO Michael Pearson. Revenues have flatlined, with the $8.7 billion projected next year unchanged from 2017’s figure. In addition, the company is facing the expiration of patent exclusivity, by 2023, on products representing about 9.5% of total sales in the first three quarters of the year, according to the most recently filed form 10-Q.
While Bausch’s revenue prospects are in question, improving margins figure prominently in the bull case, as the Street expects Ebitda to equal 41.1% of revenues next year, up from 38.4% in 2017. But might management massaging render this metric less useful? A July 13, 2018 Grant’s survey of potentially troublesome leveraged loans identified some inventive use of so-called add-backs from the corporate artist formerly known as Valeant in a loan issued last year:
In calculating EBITDA, our old friend adds back “pro forma ‘run rate’ cost savings”— the money that the company expects to save through its hallmark dexterous management. So Valeant’s EBITDA is actually EBITDAH: earnings before interest, taxes, depreciation, amortization and a hunch.
You just can’t keep a good company down.
Recap Dec. 16
Another round of stock market levitation left the S&P 500 at new highs and up a meaty 27% year-to-date with 10 trading sessions remaining in 2019. Bear steepening across the Treasury curve left the two- and 10-year yields at 1.63% and 1.87%, respectively, while WTI crude rallied past $60 a barrel and gold held at $1,476 an ounce. The VIX finished near 12, down from just below 16 a week ago.
- Philip Grant
Tuesday, December 10, 2019
From the clouds
It was a bombshell. On Oct. 25, the Department of Defense announced Microsoft Corp. as the sole winner of its Joint Enterprise Defense Infrastructure (JEDI) cloud computing contract. The news surprised most observers, who had expected the deal would go to Amazon.com, Inc.’s Amazon Web Services, Inc. (AWS). That belief was pervasive enough that rival Oracle, Inc. sued filed a lawsuit alleging the process was tailored specifically so AWS could win.
Yesterday, the U.S. Court of Federal Claims unsealed the (partially redacted) AWS challenge to the decision, which alleges that President Trump’s disdain for AMZN boss and Washington Post owner Jeff Bezos unduly influenced the DoD’s decision, and concluded that “any meaningful review of [the JEDI award] reveals egregious errors on nearly every evaluation factor.”
While Amazon howls in protest, some onlookers were less-than stunned by the outcome. Tech columnist Beth Kindig, who predicted that Microsoft would win the contract in December 2018, wrote for MarketWatch on Saturday that:
Although Amazon is correct in saying the company is the leader in cloud computing, AWS is not the leader in hybrid cloud computing. Hybrid is an essential strategy for the security-conscious Department of Defense, as it can’t put its entire system in the cloud for obvious security reasons. . . Hybrid is where Microsoft excels. Oddly, that piece is missing from Amazon’s discussions.
Analysts at Bloomberg Intelligence concur, writing today that Microsoft and IBM Corp. “appear to be better positioned in a hybrid” world than Amazon and Google parent Alphabet, Inc. The analysts also note that “this hybrid approach is increasingly becoming the go-to strategy for most Fortune 2000 companies.” Last week, Laurent Seror, CEO of Dassault Systèmes SE’s cloud unit 3DS Outscale, declared that rivals are gradually taking share from AWS, as clients “want a plan B. They don’t want to put all their eggs in one basket.”
One thing’s for sure: AWS’ dominance has been a crucial component of the parent company’s smashing success during this cycle. The unit generated $25.1 billion in revenues and $6.6 billion in operating income over the first nine months of the year, up 38% and 29%, respectively, from 2018. The division accounts for 13% of Amazon’s consolidated revenues and 62% of consolidated operating income, up from 11% of revenue and 59% of operating income in the first three quarters of 2018. For context, corporate research firm MarketsandMarkets estimates worldwide cloud infrastructure spending will grow to $166.6 billion in 2024 compared to $73 billion this year, which would represent a compound annual growth rate of 18%.
An increasingly crowded competitive field in a large but finite industry is one risk for Amazon, regulatory backlash, another. Last Wednesday, Bloomberg reported that the investigators at the Federal Trade Commission have “been asking software companies recently about practices around Amazon’s cloud unit,” suggesting the agency “is taking a broader look at the company to determine whether it could be violating antitrust laws.”
While the DoD went in another direction for the JEDI award, the circumstances preceding that decision could still prove costly for Amazon. Potentially undisclosed conflicts of interests among a trio of former Department of Defense staffers with employment or financial ties to AWS (Almost Daily Grant’s, April 18 and June 5) present ongoing risks to the company. Recall that back in March, the Federal News Network reported that the DoD’s Inspector General (IG) and FBI’s Public Corruption unit have opened a joint investigation into the process.
On Nov. 4, a DoD press release announced the release, within 30 days, of an IG report examining “the award of the JEDI contract, whether any DoD officials engaged in ethical misconduct related to the contract, and whether any alleged ethical misconduct affected the integrity of the procurement process.” That 30 day deadline has come and gone, with no follow up as of yet from the DoD.
Of the Inspector General’s delay, a D.C.-based observer tells Grant’s: “With every passing day without the report’s release, the greater the likelihood that the IG has identified significant criminal wrongdoing.” Our source continues:
The Street never has fully understood that U.S. government contracts are the lifeblood of AWS. Amazon only began disclosing AWS earnings at the end of Q1 2015 after a full year of Commercial Cloud Services (the CIA cloud).
If the IG refers Amazon-affiliated individuals to the Department of Justice for prosecution, then the company will have a bigger issue on its hands: the possibility that DoD will push to suspend and/or debar AWS as a government contractor to defend the DoD from being defrauded.
Microsoft, Google, IBM, and Oracle are substantially growing their capabilities, and the CIA contract now is being recompeted for the next decade as a multi-cloud award called Commercial Cloud Enterprise.
Since winning a $600 million CIA contract award in 2013, Amazon has ridden exponential profit growth at AWS (operating income compounded at an eye-watering 73.5% annually from the first three quarters of 2014 through the first nine months of this year) to a 470% rise in its share price in the last five years. The Street is almost unanimous in expecting more of the same, with 53 “buy” ratings, three “holds” and zero “sells.” Might unexpected obstacles related to AWS derail the Amazon gravy train?
Recap Dec. 10
Stocks dipped slightly lower for a second straight day, as the S&P 500 has now lost ground in five of the past eight trading sessions after making fresh highs on Nov. 27. Bids in Texas Tea and the Money of Kings left WTI crude near $60 a barrel and gold at $1,465 an ounce, and Treasurys came for sale with the two- and 10-year yields rising to 1.65% and 1.84%, respectively. The VIX held just below 16.
- Philip Grant
Almost Daily Grant's will resume on Monday.
Monday, December 9, 2019
The sixth sense
A hedge-fund help wanted from Indeed.com:
A hedge-fund help wanted from Indeed.com:
In memoriam
Former Federal Reserve chairman Paul Volcker died yesterday in New York at the age of 92.
Former Federal Reserve chairman Paul Volcker died yesterday in New York at the age of 92.
Tail wags the dog
A bit of a surprise:
A bit of a surprise:
Recap Dec. 9
The sixth sense
A hedge fund help-wanted from Indeed.com:
Using Supernormal Cognition our private fund aspires to provide a 75% accuracy rate in the prediction of near-term financial markets. You will be our private fund’s advisor. Your long expertise and great reputation in financial investments are paramount. Depending on whom you listen to, we’ve heard that annual, gross commodity or equity ROIs between 80% and 100% are do-able.
The private fund with which you’ll work is in its second iteration within the same legal charter. The first iteration successfully used Remote Viewing to forecast market motion in derivatives.
Now that’s alternative investing.
In memoriam
Former Federal Reserve chairman Paul Volcker died yesterday in New York at the age of 92. Volcker, who took over the post from G. William Miller in 1979, famously helped squash raging inflation with a series of aggressive rate hikes (including a famous Saturday evening press conference just two months into his tenure to announce a surprise 150 basis point tightening) which culminated in a 20% funds rate in June 1981.
Thanks in large part to his efforts, inflation as measured by the consumer price index peaked at 14.8% in the spring of 1980, spurring a multi-generation bond rally that has seen the 10-year yield fall to 1.8% today from 15.8% in September 1981. After resigning his post in 1987, Volcker joined investment banking firm Wolfensohn & Co. and later served as chairman of the International Accounting Standards Board’s Trustees, as well as of President Obama’s Economic Recovery Advisory Board.
As his post-Fed career proceeded in tandem with decades of rising bond prices and waning price inflation, Volcker remained a steadfast voice for clarity of purpose at the central bank. At the spring 2006 Grant’s conference, an attendee asked the former chairman about the increasing emphasis on “core” inflation (i.e., excluding food and gas prices) as opposed to the broader headline metric. Volcker responded:
I share the suspicions implicit in your question. A great mantra of central bankers these days is ‘inflation targeting.’ I don’t understand that nomenclature. I didn’t think central bankers were in the business of targeting inflation. I thought we were supposed to be targeting stability. We all say we are in favor of stability. You hear these speeches, [then Fed chair] Bernanke saying, ‘We are in favor of stability. That is why we target inflation.’ There is a certain semantic problem for me in that connection.
Indeed, the nearly four-decade decline in interest rates which followed Volcker’s term has fostered a philosophical shift regarding the erosion of purchasing power. The Financial Times reported Dec. 2 that the Fed may soon implement so-called symmetrical inflation targeting, i.e., actively seeking a measured rise in prices of more than 2% to “make up” for past shortfalls. That policy change has garnered broad support, as both chairman Jerome Powell and New York Fed president John Williams have referenced a “symmetrical 2% inflation target” in recent speeches.
The shifting inflation mandate assumed by the Fed bears decreasing resemblance to the law which governs the central bank. As historian Alex J. Pollock noted 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.”
For his part, Volcker had this to say about inflation mission-creep from the Grant’s speaker’s podium in 2006:
I can remember my old professors at Harvard, in 1951 or so, saying a little inflation is a good thing. ‘We don’t want very much, but 2% is good.’ Of course, 2% is OK or even good, 3% isn’t so bad, but if you get into a little problem, do you even worry about 4% or 5%, or do you redefine the index and take out everything that is rising?
Tail wags the dog
A bit of a surprise: Bloomberg reports today that WeWork parent The We Co. is in talks with Goldman Sachs to arrange a $1.75 billion line of credit. As few creditors wants exposure to the recently bailed out office space company, DJ David Solomon’s bank has found a solution. Bloomberg relays that: “In a twist aimed at making the financing more palatable to other lenders, SoftBank Group Corp. will be listed as the borrower and WeWork will be a co-borrower.” In other words, SoftBank will be the ultimate guarantor.
While SoftBank and its $100 billion V.C. arm the Vision Fund retain some Wall Street cachet (relative to WeWork, at least), other aspects of Son’s massive portfolio are likewise faltering. On Friday, CNBC’s David Faber announced that T-Mobile U.S., Inc. is considering cutting its bid for rival Sprint Corp., which is 84% owned by SoftBank. As Sprint shares currently trade at a 52-week low and 31% discount to the implied T-Mobile bid price, the market seems to believe that such an outcome (or the scuttling of the merger entirely) is more than possible.
The Wall Street Journal reports today that the Vision Fund has agreed to sell its near 50% stake in dog-walking startup Wag Labs back to Wag. While terms of the deal are undisclosed, the fact that Wag “is letting go a significant amount of the remainder of its workforce today” according to the Journal suggests a less-than-robust price.
Then too, Renaissance Capital notes today that SoftBank-backed software company OneConnect Financial Technology has proposed a $4.9 billion valuation for its upcoming debut, far below the $7.5 billion valuation achieved in a SoftBank-led funding round last year. OneConnect may join Uber Technologies, Inc., and Vir Biotechnology, Inc. as recent Vision Fund portfolio companies that have seen shares fall by nearly 40% from their last private rounds before listing. That losing streak is understandably hampering fundraising efforts, as the U.K.Telegraph reported over the weekend that the planned Vision Fund sequel “is expected to fall significantly short” of the $108 billion target.
That could prove problematic, as analysts at Bloomberg Intelligence write today that SoftBank faces $66 billion in outstanding pledges and debt maturities over the next several years against $11 billion in current pro forma liquidity, concluding that “given SoftBank’s wholly owned operations don’t produce much free cash flow, the company may rely on new bond sales, cash on hand and dividends from its 66.5%-owned domestic telecom entity SoftBank Corp. to meet its debt service needs.”
Even Masa Son’s closest business allies can’t resist getting their digs in, as Alibaba founder Jack Ma said at a panel discussion with Son that “when you have too much money, you will make a lot of mistakes.” Undaunted, Son replied that the Vision Fund will, “continue to invest more and more.”
Recap Dec. 9
Stocks fluttered a bit lower, while Treasurys caught a modest bid to leave the two- and 10-year yields at 1.62% and 1.82%, respectively. WTI crude pulled back to $59 a barrel and gold held steady at $1,460 an ounce, and the VIX defied the low-key market action by jumping more than 17% to finish above 16.
- Philip Grant
Friday, December 6, 2019
Kingmaker
Buzzfeed's Mark Distefano
Buzzfeed's Mark Distefano
Bird is the word
This was one to chirp about
This was one to chirp about
Recap Dec. 6
Kingmaker
Buzzfeed’s Mark Di Stefano reports today on Twitter that Condé Nast is “in full damage control” after the British version of GQ magazine put Xi Jinping on its annual list of the worst dressed men in the world.
For a lesson on proper decorum regarding China’s President-until-further-notice, we naturally turn to Donald Trump. From the South China Morning Post back in April:
US President Donald Trump has said he called Chinese President Xi Jinping a “king” during a visit to China 18 months ago and said his Chinese host “liked it.”
Bird is the word
This was one to chirp about. Yesterday, Twitter, Inc. entered the high-yield bond market in style, selling $700 million in 3 7/8% senior unsecured notes maturing in 2025. This matches a September issue from Restaurant Brands International, Inc. as the lowest yield for an eight-year speculative-grade note on record. Investor enthusiasm for the issue was such that Ba2/double-B-plus-rated Twitter managed both to upsize the allotment from a planned $600 million and narrow the yield from initial price talk of 4.5%.
While commending Twitter’s “strong fundamentals,” including “positive free cash flow generation, net cash [and] moderate leverage,” research firm CreditSights noted that the micro blogging site showed slowing revenue growth and declining Ebitda and free cash flow on a year-over-year basis in the third quarter, concluding that “we think the bonds are priced for perfection.”
The notes remained the apple of Mr. Market’s eye in today’s trading debut, rising to 100.375 cents on the dollar as of lunchtime to narrow the spread to 196 basis points over Treasurys from 213 basis points at issuance.
Twitter’s gangbusters high-yield foray highlights the feverish demand for issues at the upper end of the speculative-grade credit ladder. Year-to-date, the double-B-rated component of the Bloomberg Barclays High Yield Index has enjoyed a 14.2% total return, topping the 12.4% gain for High Yield as a whole. It’s been a different story at the other end of the spectrum, as the triple-C-rated equivalent has generated a relatively meager 5% return for 2019 so far.
The stark underperformance of the most speculative of corporate debt during a period of rising asset prices in the longest running economic expansion on record seems counterintuitive. Indeed, Lehmann Livian Fridson Advisors chief investment officer Martin Fridson noted in an Oct. 22 commentary that only once on record (going back 30 years) have triple-C’s underperformed the broad ICE BofAML U.S. High Yield Index in years which featured a total return of 7% or greater.
What gives? Faltering credit quality across the energy sector represents one obvious explanation. A Nov. 22 report from S&P Global noted that the oil & gas realm saw its distressed ratio (defined as an option-adjusted composite spread of at least 1,000 basis points over Treasurys) jump to 35% as of mid-October, up from just 9% last year (the overall high-yield distress ratio stood at 8.6% on Oct. 15, up from 7.6% a month earlier).
Can the historically-anomalous triple-C performance this year be chalked up to the poor across the board showing in energy credits? In a commentary for S&P’s LCD unit Wednesday, Fridson notes that even when exempting energy, some 38% of triple-C issuers saw their spreads widen in November, compared to 27 % of issuers in the single-B and double-B ratings buckets.
In addition, the 20 worst performing non-energy issuers rated triple-C were scattered across 14 separate industries, ranging from healthcare, retail, software, telecom and tobacco. Fridson concludes: “This evidence refutes any notion that high-yield investors can rest easy because credit deterioration is so tightly concentrated as to be avoidable by putting one or two categories off limits.”
The triple-C conundrum: Historical outlier, or canary in a coal mine?
Recap Dec. 6
A blockbuster reading of November non-farm payrolls included a net 266,000 job gain, with a 3.5% unemployment rate and a 3.1% annual rise in hourly earnings, better than the expected 180,000 gain, 3.5% unemployment and 3% wage gain.
That good economic news spurred a near 1% rally in the S&P 500, pushing the broad index back into the green for the week and within 30 basis points of its November high-water mark. Treasurys came for sale, with the two- and 10-year yields rising to 1.61% and 1.84%, respectively, while gold tumbled more than 1% to $1,460 an ounce. Energy was well bid after the Organization of the Petroleum Exporting Countries agreed on an additional 500,000 barrels per day production cut, as WTI crude rose back above $59 a barrel. The VIX fell 6% to 13.7.
- Philip Grant
Thursday, December 5, 2019
MIKE [GO]
A short-lived synergy:
A short-lived synergy:
Pivot table
Meet the new boss.
Meet the new boss.
"Not-QE" progress report
Recap Dec. 5
MIKE [GO]
A short-lived synergy: Users of the Bloomberg terminal who typed the eponymous owner and Democratic Presidential candidate’s name followed by the return key were swiftly redirected to Mike Bloomberg’s campaign home page. Unfortunately for terminal customers eager for a quick way to find out the latest on Bloomberg 2020, the shortcut was turned off by mid-afternoon.
Mayor DeBlasio would never do something like that.
Pivot table
Meet the new boss. As European Central Bank president Christine Lagarde is set to convene her first policy meeting next Wednesday, the odds of additional easing from the current negative 50 basis point deposit rate appear to be dimming. “We don’t expect they’ll cut rates further,” Sarah Hewin, chief economist for the Americas and Europe at Standard Chartered Bank, told Bloomberg. “I’m not sure there is a consensus that negative rates are bad, but I’m wondering whether this transition from [Mario] Draghi to Lagarde – a new broom at the helm – if there’s an opportunity [for skeptics] to vocalize their concerns.”
Dissenters have duly availed themselves of the opportunity. Bank of Spain governor Pablo Hernández do Cos asserted last week that further cuts “could prove troublesome” to the banking sector, while Austrian Central Bank governor Robert Holzmann told Trend magazine in November that the bank should raise rates out of negative territory “as soon as possible.” Bank of Italy governor Ignazio Visco was particularly blunt in a recent interview with Germany’s Handelsblatt: “The longer [rates] remain negative and the lower they go, the higher is the likelihood of significant side effects. I’m not encouraging this.”
While central bankers turn an increasingly wary eye toward the negative rates experiment, the so-called tiering feature (introduced by the ECB on Oct. 30, tiering allows banks to exempt up to six times their reserve requirements from negative deposit rates) continues to take hold. Bloomberg Opinion columnist Marcus Ashworth estimates that €800 billion ($880 billion) in fallow funds held by area banks are no longer subject to a 50 basis point penalty. For context, the European Banking Federation [EBA] pegs total capital and reserves across the EU at €3.43 trillion.
Regulatory assistance for European banks may soon arrive in another form. EU governments agreed last Wednesday on new rules to speed foreclosures of bad business loans, measures which should, according to Reuters, “reduce the losses banks incur when lenders offload non-performing loans [NPL’s].” The stack of bad debt held by EU banks is already on the wane, with the EBA reporting area non-performing loans at 3.1% as of June 30, down from nearly 7% at the end of 2014. Among the region’s more notable trouble spots, Ireland has seen its NPL ratio drop to 4.6% from 21.6% over that near-five-year period, while NPL’s in Spain, Italy and Portugal fell to 3.5%, 7.9% and 8.9% from 8.1%, 17% and 18%, respectively.
Despite improving balance sheets and prospective regulatory relief, European banks remain thoroughly out of favor. The Stoxx 600 Banks Index remains firmly in the lower end of its five-year range, trading at 8.6 times consensus 2019 earnings and with a current price to book ratio of 0.59. Analysts expect the group to generate a 7.6% return on equity in 2020, up from 6.3% in the quarter ended Sept. 30, and the index sports a dividend yield of 5.6%.
By comparison, the U.S. KBW Banks Index trades at 11.9 times forward earnings and 1.27 times book, while analysts expect return on equity to dwindle to 10.9% next year from 11.2% in the third quarter. That U.S. bank gauge sports a 2.7% dividend yield.
E.U. Stoxx Banks Index, five-year price chart. Source: The Bloomberg
Time for a bounce on the Old Continent?
"Not-QE" progress report
The Fed’s portfolio of securities held outright rose to $3.686 trillion this week, up $11.3 billion sequentially and $26 billion from two weeks ago (recall that last week’s figures came over the Thanksgiving holiday).
A $39 billion uptick in Treasurys over the last two weeks, (including $13.7 billion in bills maturing in 16 to 90 days and $18.3 billion in 91 days to 1 year bills) was partially offset by a $12.4 billion drop in mortgage-backed securities maturing in 10 years or more.
Total balance sheet assets are up by 8% since early September and are now 9% below their fall 2017 levels prior to the commencement of QT balance sheet run-off.
Recap Dec. 5
Stocks floated a bit higher, as the S&P 500 now sits higher by 24.3% year-to-date with 17 trading sessions left in calendar 2019. Treasurys sold off, with the two- and 10-year yields rising to 1.59% and 1.8%, respectively, while WTI crude and gold both finished little changed, at $58.3 a barrel and $1,477 an ounce. The VIX held at 14.5.
Also today, the Saudi Aramco IPO priced at the high end of the range, bestowing a $1.7 trillion valuation for the majority state-owned oil producer.
- Philip Grant
Wednesday, December 4, 2019
Truffle shuffle
Yesterday, Sergey Brin and Larry Page
Yesterday, Sergey Brin and Larry Page
Brave new world
A trio of sightings in financial services:
A trio of sightings in financial services:
Recap Dec. 4
Truffle shuffle
Yesterday, Sergey Brin and Larry Page announced that they will step down as president and CEO, respectively, of Alphabet, Inc., leaving management of the Google parent to Sundar Pichai. In a letter explaining the move, Page and Brin wrote that “we’ve never been ones to hold on to management roles when we think there’s a better way to run a company.”
A fellow tech stalwart apparently shares that feeling, as Bellevue, Washington-based Expedia Group, Inc. (EXPE on the Nasdaq) announced today that CEO Mark Okerstrom and CFO Alan Pickerill have resigned, effective immediately. Chairman Barry Diller explained the departures as the result of a strategy disagreement with the board. Mr. Market sided with Diller, as EXPE shares bounced by 7% today, narrowing the stock’s losses to 20% since a bearish analysis in the January 12, 2018 edition of Grant’s Interest Rate Observer.
Then there’s Jack Dorsey, CEO of both Twitter, Inc. and Square, Inc., the latter a subject of a March 21, 2019 bearish Grant’s analysis (SQ shares are down 14% since). Dorsey announced on Twitter (naturally) last Wednesday that he will be spending up to six months next year in Africa, explaining that the continent: “will define the future (especially the bitcoin one!).”
Lisa Ellis, analyst at MoffettNathanson, LLC, who rates Square shares a “buy,” told Bloomberg that Dorsey’s planned hiatus could be a good thing for the payments processor if he names a chief operating officer in his absence. However, Ellis warned, “if he does not, he is putting the day-to-day operations of Square at risk.”
Will the last CEO to leave Silicon Valley please turn out the lights?
Brave new world
A trio of sightings in financial services:
Yesterday, Japan’s Government Pension Investment Fund (GPIF), one of the world’s largest with $1.5 trillion in assets, announced it will no longer lend stocks to those looking to engage in short-selling as the activity is inconsistent with the fund’s “stewardship code.” That decision couldn’t have been made lightly, as the associated loss of fee income will likely sting considering that the fund labors under the yoke of the Bank of Japan and its zero interest rate policy. From fiscal 2001 to the second quarter of this year, the GPIF has managed just a 3.02% annualized rate of return.
Stateside, Chief Investment Officer Magazine reports today that the California Public Employees’ Retirement System (CalPERS) has cut loose most of its external active equity managers, reducing the fund’s allocation to $5.5 billion from $33.6 billion and to three managers from 17. The fund holds $387 billion in assets.
Yesterday, Italian bank Unicredit SpA, attempting to cope with the negative interest rates imposed by the European Central Bank, announced it will eliminate 8,000 jobs as part of a restructuring,. According to calculations from Bloomberg, that brings total job losses this year in the global banking industry to 73,400, with 86% of that figure in Europe.
Recap Dec. 4
Stocks caught a solid bid to recoup a chunk of recent losses and leave the S&P 500 just under 1% in the red for the week so far, while Treasurys gave back a portion of yesterday’s gains to leave the two- and 10-year yields at 1.57% and 1.77%, respectively. A bigger-than-expected weekly supply draw helped spur an energy rally that pushed WTI crude back towards $58.50 a barrel, while gold ticked slightly lower to settle at $1,475 an ounce. The VIX slipped back below 15.
- Philip Grant
Tuesday, December 3, 2019
Spin doctor
Bloomberg headline of the day.
Bloomberg headline of the day.
Your honor, your honor
To the courtroom.
To the courtroom.
Recap Dec. 3
Spin doctor
Bloomberg headline of the day:
AMAZON HAD GOLDMAN SACHS CEO SOLOMON AS DJ BEFORE CLOUD SPEECH
Your honor, your honor
To the courtroom. A trio of prominent, large-cap U.S. companies face legal matters, the outcomes of which could well bear on future events. Let’s review:
Next week, Sprint Corp. (S on the NYSE) will head to federal court to attempt to fend off a lawsuit from a coalition of 13 state attorneys general challenging its all-stock merger with T-Mobile U.S., Inc. (TMUS on the Nasdaq), a potential combination of the country’s third- and fourth-largest mobile operators.
Investors are unconvinced that the deal will go through. Sprint shares fell to a six-month low yesterday and trade at a 29% discount to the deal price implied by TMUS shares, compared to a 13% discount in August. Sprint CEO Michel Combes seems to share in the doubt, telling employees at a Nov. 6 townhall meeting: “If, God forbid, we do not prevail in the litigation, there will be a discussion among the parties about next steps.”
Those next steps may prove less than welcome for highly leveraged Sprint and its majority owner, SoftBank Group Corp. As for its would-be dance partner, T-Mobile CEO John Legere announced on Nov. 18 that he will depart the company next year. One potentially important detail: The merger agreement expired on Nov. 1.
While Sprint executives and Mr. Market prepare for various contingencies, a report from today won’t help with the PR effort. Recall that in September the Federal Communications Commission accused Sprint of improperly pocketing government subsidies from the Lifeline low-income assistance program in 2017, instead of passing them along to customers (Almost Daily Grant’s, Sept. 26). Today, the Journal relays that the problem was wider in scope than originally thought, with Sprint “also ma[king] mistakes in tallying how many subscribers were using their Lifeline services in 2013 and 2014.” A Sprint spokesperson told the WSJ that the incidents “are separate and unrelated.”
Out west, the California Public Utilities Commission released a 700 page report yesterday detailing the causes of the November 2018 Camp Fire, which killed 85 people and destroyed the town of Paradise. Unsurprisingly, the CPUC fingered embattled utility PG&E Corp. (PCG on the NYSE) for “shortcomings” in power line inspection and maintenance, which “were not isolated, but rather indicative of a pattern.” Perhaps most damagingly of all, the commission asserted that PG&E crews had failed to climb and inspect the tower, which sparked the blaze, since at least 2001. Thanks to these findings, PG&E may be subject to additional fines and penalties from the CPUC, while state authorities may consider filing criminal charges against the company.
The latest developments follow a court ruling last week rejecting PG&E’s efforts to change the so-called reverse condemnation law, which prevents the company from passing wildfire-related costs on to its customers. The company, which filed for Chapter 11 in January under the weight of $30 billion in wildfire-related liabilities, faces a creditor-led reorganization proposal which would potentially wipe out the company’s remaining equity value. For more on PG&E, see the Feb. 22 edition of Grant’s Interest Rate Observer.
Then there’s Tesla, Inc. and its celebrity CEO Elon Musk. Jury selection is now complete in the defamation suit filed by Thai cave diver Vernon Unsworth against Musk, who referred to the litigant as “pedo guy” in a series of Twitter messages last summer after Unsworth dismissed Musk’s offer of a mini-sub to help rescue a trapped Thai boys soccer team as a “PR stunt.”
Musk later apologized, claimed the term was “a common insult in South Africa” (Musk’s country of birth) in subsequent court documents and that he “meant to insult him back by expressing my opinion that he seemed like a creepy old man.” If a subsequent email with Buzzfeed reporter Ryan Mac is allowed to be introduced as evidence, the Tesla boss might have some trouble convincing a jury of that assertion. In September 2018, Musk told Mac on email: “I suggest that you call people you know in Thailand, find out what’s actually going on and stop defending child rapists, you f****** a******. . . As for this alleged threat of a lawsuit, which magically appeared when I raised the issue (nothing was sent or raised beforehand), I f****** hope he sues me.”
Musk, who is set to called as a witness for the first time in his career later today, faces more than reputational damage. While Unsworth is asking for damages “in excess” of $75,000 in Federal Court, one legal observer predicted to Grant’s today that Unsworth’s council “will ask for much, much more.” Musk received $2.3 billion in compensation last year, more than the next-65 highest paid executives combined in a New York Times study of 200 CEOs published in May.
Trial secured.
Recap Dec. 3
Another selloff in equities extended the S&P’s losses to nearly 2% over the past three sessions, though a late rebound pared the decline. Treasury yields darted lower, leaving the two- and 10-year yields at 1.54% and 1.71%, respectively, while key commodities managed a bullish session with WTI crude settling at $56.3 a barrel and gold reaching a near one-month high of $1,477 an ounce. The VIX closed at 15.8, its most elevated finish since Oct. 9 and up 35% from last Wednesday.
- Philip Grant
Monday, December 2, 2019
Powderfinger
The good times continue apace for private equity. Bloomberg reports today that Dyal Capital Partners raised more than $9 billion to invest in limited-partner interests of existing buyout funds. That’s a record haul for a fund pursuing the strategy, topping a $5.3 billion fund raised by a Dyal predecessor fund in 2016.
P.E. funds are increasingly willing to part with pieces of their general partnerships. According to Pitchbook Data, Inc., a record 24 U.S. p.e. firms sold stakes last year, triple 2015’s figure. The increased activity comes at a time of flush coffers, as global private equity assets under management reached $3.56 trillion at the end of 2018 according to Preqin Ltd. That’s up 17% year-over-year and nearly double the industry AUM at the end of 2011.
The flood of capital into p.e. has some observers concerned about future returns. Indeed, pension fund behemoth California Public Employees’ Retirement System (CalPERS) reported a 7.7% return from its p.e. allocations in the 12-months ended June 30, down from 16.1% in the prior fiscal year. CalPERS CIO Ben Meng put it this way: “When you have so much liquidity available, naturally the price for illiquidity will come down.” That price may have further to fall, as Research Affiliates, LLC, using calculations designed to “mimic a representative example of leveraged buyout investment rules and exposures,” forecasts that p.e. will generate a real return of just 0.2% over the next 10 years.
Higher price tags figure prominently in the downshift in return expectations. S&P’s LCD unit reports that the average U.S. leveraged buyout carried a purchase price equivalent to 12.9 times Ebitda in the third quarter to bring the year-to-date average to 11.5 times. That’s up from 10.6 times Ebitda last year and 9.7 times in 2007. But, the actual valuation expansion might be far higher, as a Sept. 19 report from S&P Global found that so-called add-backs (i.e. applying hypothetical future cost-savings today) represented 49% of reported Ebitda at deal inception.
One anonymity-seeking p.e. investor, outbid for a target by a rival paying a price premium “which would blow your mind,” summed up the current zeitgeist to LCD: “People are not horsing around in this market.”
Those increasingly fancy valuations (along with abundant use of the financials-flattering add-backs) coincide with rising debt burdens. A Nov. 21 research note from Morgan Stanley found that 57% of companies which have undergone an LBO carry net leverage above six times Ebitda. That’s up from 51% in 2007. With rising encumbrance comes an increased risk of impairment, as a survey of p.e. lenders from research firm Credit Benchmark suggests a 6% default probability for leveraged loans issued by private equity-owned firms, up from 5.44% a year ago and well above the 2.36% default likelihood of leveraged loans from their publicly-traded counterparts.
Meanwhile, the blistering rally in asset prices this year has provided little support for the ranks of leveraged loan issuers, with cash flow coverage falling to 3.1 times interest expense in the third quarter according to LCD, down from 3.6 times at year-end 2018 and the weakest coverage since at least the third quarter of 2016.
Today brought news of another development which might make those p.e. Johnny-come-lately’s take pause, as marketing firm Acosta, Inc. filed for bankruptcy protection in Delaware, listing liabilities of between $1 billion and $10 billion, supported by less than $1 billion in assets. Taken private by Thomas H. Lee Partners in 2011 for slightly over $2 billion, Acosta was sold three years later in a so-called secondary buyout to the Carlyle Group L.P. for $4.75 billion.
“We think we have reached a peak in the private equity market,” Morgan Stanley Wealth Management chief investment officer Lisa Shalett wrote on Oct. 28: “Investors tempted to chase the double-digit returns that many earned in private investment vehicles this past decade need to downgrade their expectations.”
Recap Dec. 2
Stocks took a breather from their extended winning streak, as the S&P 500 fell nearly 1% following a weaker-than expected reading of the November ISM Manufacturing Index, which printed below 50 (indicating contraction) for a fourth straight month. That’s the longest streak since the summer of 2009.
Treasurys likewise came under pressure, with the two- and 10-year yields settling at 1.60% and 1.82%, while WTI crude and gold finished at $56 a barrel and $1,462 an ounce, respectively. The VIX jumped 16% to 14.70, its highest close since mid-October.
- Philip Grant
Tuesday, November 26, 2019
Big RxR Blues
Good news from the Great White North this morning, as railroad workers in Canada announced a tentative agreement to end a weeklong strike against Canadian National Railway Co. (CNR on the Toronto Stock Exchange). The deal comes as a cadre of farmers were set to descend on Ottawa today and tomorrow to pressure the groups to end the standoff, which had halted shipments of various commodities across the country.
Allegations of worker mistreatment fueled the dispute. Yesterday, the still-striking union released an audio recording of an Oct. 19 incident in which a supervisor told an operator who had completed a 10 hour and 20 minute shift that the employee then needed to move his train to a new location several hours away. When the operator balked at the request, he was suspended for 14 days without pay.
That incident colors the now-widespread use of precision scheduled railroading (PSR), a managerial tactic pioneered by late industry executive Hunter Harrison and now widely adopted across the North American Class 1 rail industry (The BNSF Railway Co., which is owned by Berkshire Hathaway, Inc., is the remaining holdout). PSR emphasizes efficiency and cost control in a manner which recalls the zero-based budgeting most famously applied by Brazilian private equity firm 3G Capital, Inc.
So far, the results of this industrywide foray speak for themselves, as operating margins for the S&P Railroads Index rose to 38.4% as of Sept. 30, the seventh sequential increase in eight quarters and far above the 30.5% margins recorded in 2012. As profits go up, staffing goes down. The U.S. Surface Transportation Board (STB) reported September industry employment at 136,865, down 7.6% from a year ago. In October, a coalition of U.S. railroads filed a lawsuit to force unions to negotiate potentially reducing train crews to as low as a single operator from the currently-mandated two.
Some observers expect more of the same, with analysts at Bloomberg Intelligence writing today that: “We believe [further PSR implementation] should drive some meaningful fluidity and profitability improvements in 2020.” For its part, Wall Street has duly rewarded the industry for shaping up their income statements, as the S&P Rails Index enterprise value has risen to 12.7 times consensus 2019 Ebitda from 7 times Ebitda at year-end 2012.
While the railroads cut costs and reap the rewards, volumes continue to dwindle. According to the Association of American Railroads (AAR), total U.S. traffic fell 8.4% from a year ago during the week ended Nov. 16, bringing the year-to-date decline to 4.5%. Those slumping volumes inform the remarks made by Larry Gross, president of Gross Transportation Consulting, to Grant’s back in July:
One-half of the operating ratio [i.e. operating expenses as a percentage of revenues, or the inverse of margins] is cost-cutting. The other half, obviously, is the revenue side. Inherent in the PSR mantra is a lot of discipline on the pricing side of the equation. I would characterize that a big chunk of PSR is deciding what the railroad is good at and being very selective in the customers and the freight that the railroad handles. It sloughs off freight that introduces too much complexity with too many touches into the system and concentrates on the freight that it can handle most efficiently.
Now there’s a limit to how far you can take that. That is one of the really interesting questions right now about where the railroads are at in their ability to sort of sustain the trajec¬tory that they’ve been on. . . As you continue this, you can probably drive the operating ratio down, but what the problem is, what happens on the volume side. . . They’re certainly in a mode right now where volume is declining, although profitability is improving. That’s not feasible indefinitely.
To be sure, the PSR regime has few friends among the customers of the Class 1 railroads. Last week, the National Grain Feed and Association (NGFA) released a statement lamenting the current state of affairs:
NGFA-member companies believe unreasonably high rail rates have become more prevalent and significant given the rapid consolidation of the North American freight rail marketplace and the implementation of the so-called ‘precision scheduled railroad’ operating model by six of the seven Class I railroads.
Will regulators put the clamps on the railroad industry’s ability to raise prices and impose hefty demurrage (late) fees on their customers? On Oct. 7, the STB released a policy statement which would compel operators to provide more information about such fees, as well as to close loopholes which had exempted certain commodities from demurrage fee-oversight.
That follows a Sept. 12 STB proposal to establish a “final offer rate review,” which would enhance the ability of smaller customers to challenge fees and surcharges that they consider unreasonable. In response, the AAR decried that proposal as “a winner-take-all approach that disregards due process rates and undermines the important principal of regulatory predictability.”
With valuations at a premium, volumes on the wane and the prospect of further resistance to profit-expanding initiatives from employees and customers alike, the rail industry might be primed for a pullback. For more on the bear case, see the July 12 edition of Grant’s Interest Rate Observer.
Recap Nov. 26
Stocks continued their torrid run, with the S&P 500 rising another 30 basis points for a second straight record high and extending its post-Oct. 1 gains to nearly 9%. Treasurys were bid, with the two- and 10-year yields finishing at 1.59% and 1.74%, respectively, while WTI crude and gold likewise both finished in the green at $58.30 a barrel and $1,463 an ounce. The VIX remained below 12.
- Philip Grant
Monday, November 25, 2019
Gig factory
Time to pump the brakes?
Time to pump the brakes?
Open road
This morning,
This morning,
Liquidity check
Back to the well.
Back to the well.
Recap Nov. 25
Gig factory
Time to pump the brakes? The U.K.’s Transit for London regulator announced today it has stripped Uber Technologies, Inc. of its license to operate in the city due to a glitch in the company app that permitted unauthorized users to pose as drivers. By TfL’s count, bogus, unregulated Uber drivers have accounted for more than 14,000 rides in the city. Uber, which has 21 days to appeal the ruling, can continue to operate in London in the meantime.
As for the potential impact of a ban in the city, we turn to Uber’s S-1 regulatory filing which noted that “any inability to operate in London, as well as the publicity concerning any such termination or non-renewal, would adversely affect our business, revenue, and operating results.” The April filing also included this language: “In 2018, we derived 24% of our Ridesharing Gross Bookings from five metropolitan areas – Los Angeles, New York City, and the San Francisco Bay Area in the United States; London in the United Kingdom; and São Paulo in Brazil.”
It’s not just London where Uber is facing existential regulatory threats. Recall that, in September, California Governor Gavin Newsom signed into law Assembly Bill 5, which would classify so-called gig employees, i.e. the drivers who work for Uber and Lyft, Inc., as employees instead of independent contractors. The reclassification, set to take effect on Jan. 1, forces Uber and Lyft to pay health insurance and other benefits for its drivers. By way of response, the rideshare companies announced plans in October to introduce a measure for next year’s ballot dubbed the “Protect App-Based Drivers and Services Act,” which would largely exempt their “not-employees” from AB5.
If that bill fails, Uber will face substantial legal roadblocks in three of its five largest markets.
Open road
This morning, Kirkland Lake Gold Ltd. announced it will acquire Detour Gold Corp. (DGC on the Toronto Stock Exchange) for C$4.9 billion ($3.7 billion) in stock, a 24% premium to the target’s closing price on Friday. The sale comes after an intense proxy battle with shareholder Paulson & Co. led to the removal of a majority of Detour’s board of directors last year, along with a 52% rise in the stock price since April 2018.
At the Grant’s spring conference last year, John Hathaway, co-manager of the Tocqueville Gold Fund, identified Detour as his top pick for an industry takeover candidate:
It is a trophy asset. It is in Canada, which is a prime jurisdiction considering political risk, and we figure that a large miner could pay a huge premium without diluting its shareholders.
Liquidity check
Back to the well. Bloomberg reports today that China is set to offer $6 billion in sovereign dollar-pay bonds, with maturities ranging from three to 20 years. That figure would represent a doubling over last year’s offering size and triple that of 2017, which had marked China’s first dollar bond sale since 2004.
The anticipated offering follows a highly successful Euro-bond foray on Nov. 5, as China sold €4 billion ($4.4 billion) of debt across seven, 12 and 20 year maturities, drawing brisk enough demand to price each issue about 20 basis points tighter than the initial target. In total, Chinese borrowers have issued $195 billion in dollar-denominated debt so far this year (including a record $78.5 billion from property developers), on pace to eclipse 2017’s high-water mark of $217 billion.
While China wades deeper into the overseas debt market, slowing economic growth and heavy debt burdens combine to ratchet up corporate distress in the Middle Kingdom. In a research note yesterday, analysts at S&P Global forecast record defaults in 2020, owing to a 34% increase in offshore bond maturities to $51 billion along with an increased concentration of industrial companies, state-owned enterprises and property developers rated single-B-minus or below.
Tightening corporate purse strings are taking a visible toll in the world’s second-largest economy. The Financial Times reported Thursday that state-owned China Construction Bank Corp. has halted work on a 475 meter skyscraper project in the city of Wuhan, Hubei province after the Greenland Holdings Corp Ltd., one of China’s largest property developers with $60 billion in revenue during the 12-months ended Sept. 30, “failed to make a ‘significant’ project payment.”
According to the FT, more than a dozen “super” skyscraper projects (at planned heights of 300 meters or more), have fallen behind schedule or been postponed outright due to cash flow trouble. “Demand for office space has weakened considerably due to the slowing economy,” Cherry Hu, analyst at Cushman & Wakefield said. “The situation is not going to improve any time soon.”
Indeed, in its 2019 Financial Stability Report, The People’s Bank of China dubbed 586 banks and other financial institutions to be “high risk,” representing 13% of the national total. That’s up from 420 such lenders a year ago.
Recap Nov. 25
The bulls retained a firm grip on the proceedings, as the S&P 500 rose another 75 basis points to a fresh closing high, extending its advance to nearly 9% since the beginning of October. WTI crude and gold finished at $58 a barrel and $1,454 an ounce, respectively, while the Treasury curve continues to flatten with the two- and 10-year spread dropping below 14 basis points. The VIX closed below 12 for the first time since September 2018.
- Philip Grant
Friday, November 22, 2019
Last call
It was the best of times, or something. While the U.S. enjoys its longest economic expansion on record and the S&P remains perched at all-time highs, speculative juices still flow. Dealogic reports today that “blank check” special purpose acquisition companies (vehicles which raise money from public markets to make deals) have attracted $12.6 billion year-to-date, topping 2007’s record of $12.1 billion with five weeks to spare (we overlook a decade’s worth of inflation).
Those sunny facts obscure an increasingly chilly response to the financial maneuverings of a pair of prominent and intertwined operators.
As soon as next month, The Saudi Arabian Oil Co. (a.k.a. Aramco), the world’s largest producer of crude oil, will (if all goes well) finally debut on the Saudi Tadawul stock exchange in Riyadh. Sponsors are getting increasingly creative in their attempts to ensure robust demand, as the Financial Times reports today: “Saudi banks are offering loans with zero interest for up to three months and the company is promising a bonus share for every 10 shares to individuals who hold their listing allocation for a minimum of 180 days.”
The local focus (and unusual buyer perks) follows a retrenchment of the Kingdom’s ambitions, as Aramco is now hoping for a $1.7 trillion valuation after foreign investors recoiled at the $2 trillion valuation that Crown Prince Mohammad bin Salman has long targeted. In response to tepid overseas demand, company executives have scrapped roadshow visits to London, New York and Asia. Needless to say, that move didn’t impress non-Saudi observers. A headline yesterday on Oilprice.com asked: “Is the Aramco IPO the Ultimate Pump and Dump?”
Questions over the actual size of Saudi Arabia’s oil cache may help explain the cool reception. In their third quarter commentary, natural resource investors Goehring & Rozencwajg Associates, LLC note that in 1977 the four U.S. companies active in Saudi Arabia published a reserve report listing 100 billion barrels of proved reserves and 50 billion of probable reserves in the country. Five years later, the Saudis announced that proved reserves had jumped to 160 billion barrels, then (without providing any supporting data) boosted the figure to 260 billion barrels in 1988. Though the Kingdom has pumped nearly 100 billon barrels since, the latest prospectus estimates crude reserves at 261.5 billion barrels as of Dec. 31, 2018 (for more, see the April 11 edition of Almost Daily Grant’s).
A soft or failed Aramco debut could reverberate widely. In a Daily Telegraph column Wednesday, Ambrose Evans-Pritchard wrote that the expected $25 billion capital raise “will barely cover the Kingdom’s fiscal deficit [which S&P expects to top 8% of GDP this year] for six months.” Former CIA director David Petraeus put it bluntly during a CNBC interview last week: “It’s a fact that Saudi Arabia is running out of money.”
Of course, a rainy day in the desert augurs no good things for the Vision Fund, SoftBank Group Corp.’s $100 billion venture capital arm, as the Public Investment Fund of Saudi Arabia (PIF) is the largest outside investor after contributing $45 billion in 2016. So far, SoftBank has struggled in fundraising efforts for a sequel to the Vision Fund, as Bloomberg reported last week that “VF2” has thus far attracted $2 billion in assets, a bit light of the $108 billion fundraising target.
While SoftBank and Masa Son grasp for new capital, lenders are growing increasingly concerned. The FT reports today that: “Mitsubishi UFJ Financial Group, Japan’s biggest bank, is likely to withhold additional loans to finance SoftBank’s $9.5 billion rescue package for lossmaking office-sharing group WeWork.” Such a decision would not be made lightly, as the FT notes that the Vision Fund is “one of the most lucrative fee payers for the banking industry.”
Recap Nov. 22
Stocks were nearly unchanged, wrapping up a sideways week that leaves the S&P 500 about 30 basis points below Monday’s high-water mark. The Treasury curve continues to flatten, with the two- and 10-year spread narrowing to less than 15 basis points for the first time in six weeks. Gold and WTI crude both ticked a bit lower, finishing at $1,462 an ounce and $58 a barrel, respectively, and the VIX tumbled late to finish below 12.5.
- Philip Grant
Thursday, November 21, 2019
Real vision
Change is the only constant. News this morning of merger discussions between newly commission-free brokerages Charles Schwab Corp. and TD Ameritrade Holding Corp. along with the reports of hedge fund Moore Capital Management returning outside capital highlights a Wall Street in flux. To be sure, technological innovation, in concert with bottom-scraping interest rates, have upended many a legacy business model.
Real estate is no exception. Thanks in large part to the breakneck growth and aggressive maneuvering of newcomers like Compass, Inc. (financed by the seemingly limitless capital of the SoftBank Group Corp.-backed Vision Fund), legacy brokers have been laid low.
Realogy Holdings Corp. (RLGY on the NYSE), the world’s largest franchisor of residential-real-estate brokerage (Century 21 and Coldwell Banker are among its brands), is the poster child for this industry shake-up. With adversity comes opportunity: The Aug. 7 edition of Grant’s Interest Rate Observer featured a bullish analysis on the single-B-rated Realogy senior unsecured 9 3/8 notes of 2027, which then traded just below 85 cents on the dollar for a 12.5% yield-to-maturity.
As would be expected of a company offering yields like that in 2019, Realogy’s balance sheet and income statement are hairy. If the sell-side is on the beam, 2019 adjusted Ebitda of $592 million would represent the fourth straight annual decline from $785 million in 2015. Realogy’s leverage ratio now stands at an unsightly seven turns of Ebitda, in tandem with an uptick in net debt to $4.1 billion on Sept. 30 from $3.5 billion at the end of 2018.
On Nov. 7, the company reported third quarter revenue and adjusted Ebitda of $1.63 billion and $223 million, below the consensus expectations of $1.67 billion and $241 million, respectively. Among the Wall Street analyst cohort, six analysts dub Realogy shares a “hold” and two a “sell.” Zero say “buy.” Short interest currently stands at 33% of the float.
The perhaps-unforeseeable emergence of Compass-type competition was compounded by unforced error, as Realogy management spent $877 million in stock buybacks over the three years ended February 2019 at prices of as high as $33.8 per share. Today, RLGY shares fetch $10 and change for a market capitalization of $1.2 billion and an enterprise value of $5.3 billion. By way of comparison, Compass raised series-G funding in June at a $6.4 billion valuation, up from $4.4 billion in September of 2018.
Facing those daunting facts, even Realogy bulls tread lightly. The Aug. 7 Grant’s summarized the crux of the investment opportunity:
The essential bear story on Realogy is that the legacy business model is doomed and management can do nothing to save it. However that may be, it’s a model that keeps making money—more than enough, we think, to service the 9 3/8s.
Though bruised, Realogy remains a cash generator, with analyst-projected free cash flows of $230 million and $241 million in 2019 and 2020, respectively. Management is taking active steps to deleverage, announcing on Nov. 7 the sale its Cartus Relocation business to SIRVA Worldwide, Inc. for $400 million, as well as the cancellation of its nine-cents-a-share quarterly dividend, saving an additional $41 million per year.
Realogy’s creditors in the 9 3/8s issue have an ace up their sleeve in the form of a debt covenant, which restricts the company from engaging in further share repurchases until net leverage drops below four times Ebitda. Over the past 14 weeks, the credit markets have come around to the value proposition in those securities, as the 2027 notes have rallied to 101 cents on the dollar, for a yield of 9.09% and a 748 basis point pick-up over Treasurys. Research firm CreditSights delivered its verdict on Nov. 7, lowering its rating on RLGY credit to ‘market perform’ from ‘outperform’ but noting they “still favor the 9 3/8 [notes] for coupon and covenant protection on buyback.”
As for Realogy’s cyclical tormentor Compass, the spectacular implosion of WeWork parent and fellow Vision Fund portfolio company The We Co. has spurred something of a sea change. On Oct. 9, Compass CEO Robert Reffkin drafted an employee memo outlining eight characteristics which distinguish Compass from We, including a business model “that is completely different” and a “culture of frugality.” Reffkin also told Bloomberg television on Oct. 4 that Compass “could be” profitable within 12 months. CFO Kristen Ankerbrandt was more circumspect in an interview with The Real Deal two days later: “I don’t have a specific date I can give you when we’ll be profitable.”
Those discordant messages from Compass management are instructive, as the unicorn’s chief operating officer, chief financial officer, chief marketing officer and chief technology officer positions have all turned over since the spring of 2018. That revolving door suggests an organization in flux, shall we call it, as The New York Times on Nov. 12 reported on the experience of Chicago-based Compass broker Tricia Ponicki:
Ponicki started at a Compass office in Chicago in February. She said she had been drawn by the generous compensation; the company also promised more resources to aid home sales.
But there was so much turnover in Compass’s marketing offices that it took three months to produce a brochure for a house. When she requested a For Sale sign, she was told they were back ordered. Her husband made the sign instead.
“Right from the beginning, I was constantly being misled and misled,” she said.
Compass employees and agents have generated less revenue per person than other online brokerage firms and, sometimes, even traditional ones, according to research by Mike DelPrete, an independent real estate strategist and visiting scholar at the University of Colorado.
Might the pendulum be swinging back towards the old guard? On Realogy’s Nov. 7 conference call, CEO Ryan Schneider observed that “Something [has] changed in the ecosystem and I strongly believe it’s the investor focus on profitability.”
"Not-QE" progress report
A $5.9 billion sequential advance left the Fed’s portfolio of securities held outright at $3.66 trillion. Treasury holdings rose by $18.8 billion from a week ago, with a $7.2 billion uptick in notes maturing in five to 10 years and a $9.6 billion increase in holdings maturing in 10 years or longer. Mortgage-backed securities holdings fell by $12.9 billion.
Recap Nov. 21
Stocks edged lower for a second straight day, as the S&P 500 sits lower by 55 basis points this week so far, while Treasurys sold off and the curve continued to inch flatter, with the two- and 10-year yields settling at 1.61% and 1.77%, respectively. WTI crude rose above $58 a barrel, its best finish since the drone attack on Saudi production facilities in mid-September, and the VIX rose to 13.2, its highest close of the month so far.
- Philip Grant
Wednesday, November 20, 2019
Fly trap
Yesterday, the House Financial Services Committee held a hearing dubbed:
Yesterday, the House Financial Services Committee held a hearing dubbed:
Recap Nov. 20
Fly trap
Yesterday, the House Financial Services Committee held a hearing dubbed: “America for Sale? An examination of the Practices of Private Equity Funds.” As the title suggests, it was a politically charged afternoon on Capitol Hill, with no shortage of spicy rhetoric on both sides. “I believe private equity is the epitome of capitalism,” Rep. Roger Williams (R-Texas) declared. Alexandria Ocasio-Cortez (D-N.Y.) cited the abrupt (at least based on the company’s bond prices) 2017 bankruptcy and subsequent liquidation of Toys R Us, Inc. in her retort: “We’re talking about reining in private equity, which is responsible for wiping out tens of thousands of jobs at Toys R Us alone.”
While the political class goes back and forth on the societal merits of private equity, investors continue to vote “yea” with their feet. Citing data from p.e. fundraising firm Triago, the Financial Times reports today that eager shoppers in the secondary market are paying premiums of up to 7% for interests in top-drawer buyout funds. That compares to slight NAV discounts in recent years.
Antoine Dréan, chairman of Triago, tells the FT that time is more important than a discount: “If you just allocate money to a fund you often have to wait a long time before it gets called, and it can kill your returns.” The secondary market for p.e. ownership stakes is projected to reach $90 billion in trading volume this year, up from less than $40 billion in 2016.
Yet signals from the credit market indicate that the loan and high-yield syndication machine – the one that funds p.e. deal making -- may be in need of repair. The S&P LSTA Leveraged Loan Index has fallen to 95.5 from 97 in May, which is still well above last December’s low of 93.8. However, the share of loans indicating distress (i.e., trading at less than 80 cents on the dollar) has jumped to its most elevated level since 2016.
Rizwan Akhter, managing director at York Capital Management, tells Reuters today that “it’s not clear that there is a recession coming next year, but the loans market is positioning as if one is coming.” Akhter said his firm is, accordingly, more selective on price: “We would not even look at single-B-minus rated new issue loans” unless they carried at least a 400 basis point premium to Libor, “whereas last year deals were routinely getting done at Libor +350 or +375.”
The potential for broad-based cyclical deterioration presents one risk for p.e. portfolio companies and their lenders, disappointing profitability another. According to a September analysis of the p.e. class of 2016 by Olen Honeyman and Hanna Zhang of S&P Global, the median company was generating 35% less Ebitda two years hence than promoters had planned. And it was showing a leverage ratio 2.5 times higher than the deal-doers had forecast.
A pair of examples color the idiosyncratic risks that face p.e. lenders. On Monday, S&P Global downgraded physician staffing concern Envision Healthcare Corp. to single-B from single-B-plus, owing to a leverage ratio that is approaching nine times Ebitda compared to the agency’s expectation of seven times, resulting from a “much lower-than-expected cash flow generation.” Envision, which was taken private by KKR & Co., Inc. in June 2018 and is now embroiled in controversy over so-called surprise billing practices (Almost Daily Grant’s, Sept. 11), has seen the price of its $5.4 billion term loan due 2025 fall to 81.75 cents on the dollar to yield 9.82%. In May, that loan traded at 97 cents.
Then there’s Shutterfly, Inc. (Almost Daily Grant’s, Sept. 27), which Apollo, Inc. took private in June. And when, in September, the market said “no thanks” to a loan and high-yield bond offering, Apollo itself had to take down $300 million in unsecured bonds.
As for the secured side of the coin, Apollo was obliged to increase the spread on the term loan to 600 basis points from 525 basis points, along with other concessions such as an issuer discount and principal amortization of 7% per year. Both the loan and the 8.5%, 1st lien notes due 2026 were priced at significant discounts to par, at 95 cents and 94.37 cents on the dollar, respectively.
Outside fiduciaries have proven to be the smart money (at least so far), as the notes have fallen to 84 cents on the dollar from issuance six weeks ago, with the spread widening to 1,025 basis points from 799 basis points on Oct. 4 (price data on the loans are not available on Bloomberg).
Envision and Shutterfly: A pair of outliers, or coal-mine canaries?
Recap Nov. 20
Early afternoon headlines suggesting the U.S./China “phase one” trade deal is off sparked a selloff in stocks, though the S&P 500 managed to pare its losses and finish less than 40 basis points in the red. Incredibly, that modest loss is still the biggest one-day decline since Oct. 8.
Treasurys were again bid across the curve in bull-flattening fashion, with the two- and 10-year yields finishing at 1.58% and 1.74%, respectively, while WTI crude enjoyed a snap-back rally back above $57 a barrel to erase yesterday’s drop. The VIX gave back a mid-day spike to finish below 13.
- Philip Grant
Tuesday, November 19, 2019
WeFast
From Bloomberg:
WeWork is revising some of the amenities that boost its appeal to millennial and gig-economy members.
So-called Honesty Market stands, where tenants at select WeWork buildings can buy things like granola bars, potato chips and soda on the honor system at any hour of the day, have been shuttered in some U.S. locations, according to people with knowledge of the matter.
That setback follows a Reuters report this morning, since corroborated by the company, of an active investigation by New York Attorney General Letitia James. Among the areas of AG scrutiny, per Reuters: “is whether WeWork’s founder and former chief executive, Adam Neumann, indulged in self-dealing to enrich himself.”
Has the AG read the prospectus?
Bum rush
You just can’t keep a good company down. Yesterday, toymaker Mattel, Inc. (MAT on the NYSE) sold $600 million in senior unsecured notes due 2027 and priced to yield 6%. The return is a triumphant one for double-B-minus-rated Mattel, which was forced to pull a $250 million offering in August after receiving an “anonymous whistleblower letter.”
A Nov. 6 expose in The Wall Street Journal clarified that the company and its auditor PricewaterhouseCoopers attempted to bury an accounting error in 2017 which would have forced an earnings restatement. Brett Whitaker, Mattel’s director of tax reporting at the time, told the Journal: “It was well known within Mattel that if we took this approach, at worst we might get a slap on the wrist from the Securities and Exchange Commission. But if a company disclosed a material weakness, a senior executive said to me it would be the ‘kiss of death.’”
Accounting and management adventures aside, Mattel creditors are lending to a company already loaded with leverage, as net debt of $3.2 billion stands at 7.7 times consensus 2019 adjusted Ebitda. Operating income of $125 million in the 12 months ended Sept. 30 failed to cover the $190 million in interest expense incurred over that period.
As Mattel’s experience suggests, the capital markets remain wide open for would-be issuers of all stripes. The yield on the Bloomberg Barclays Global Aggregate Index has fallen to just 1.41% from 2.2% in November 2018. By comparison, Bloomberg’s global CPI metric is up 3% from a year ago.
While the longest domestic business expansion on record and unprecedented accommodation from global central banks have played their roles in establishing this lopsided borrower vs. lender dynamic, another structural factor looms large. At the fall 2019 Grant’s conference, Peter Chiappinelli of GMO, LLC, identified that catalyst: Index flows into passive bond products. As evidenced by Mattel’s prompt return to the credit market, bond buyers increasingly don’t read the headlines.
Much as in stocks, fixed income has been increasingly dominated by this shift, as passive investment products (which are largely identical to one another in terms of holdings, i.e., they purchase the investment-grade “Agg”) are set to account for 40% of bond fund assets, up from 16% in 2009. Similar to the equity indices, the Agg is weighted by market capitalization, which means that the more debt an issuer takes on, the greater its relative weight within the index and the more flows it attracts (the so-called bums problem). Our speaker went on to summarize the less-than appealing setup that passive creditors now face:
So, let me get this straight. The passive Agg for the past 10 years, and looking forward, is offering the lowest expected returns in its history. It is offering today close-to-zero real yields, and the global Agg is a negative real yield. It has got deteriorating credit quality at exactly the wrong point in the cycle.
Recap Nov. 19
Stocks shuffled sideways for a second straight day, as the S&P 500 continues to consolidate at all-time highs and a near 25% advance for 2019 so far. Treasurys were bid in bull-flattening formation, with the two- and 10-year yields settling at 1.6% and 1.78%, respectively, while energy was hammered with WTI crude seeing its biggest one-day drop since September to finish near $55 a barrel. The VIX extended its two-day gain to 7% but still remains below 13.
- Philip Grant
Monday, November 18, 2019
Sitting in limbo
He's set to roam.
He's set to roam.
Broken arrow
Nevertheless, they persisted.
Nevertheless, they persisted.
Recap Nov. 18
Sitting in limbo
He’s set to roam. This morning, T-Mobile U.S., Inc. announced that CEO John Legere will depart the company on May 1, with chief operating officer Mike Sievert set to take the top job. Legere, who was in the running to take over at wounded unicorn We Cos., according to The Wall Street Journal, denied that such a move was in the cards but also asserted: “I’m not retiring.”
That declared leadership change comes as T-Mobile’s prospective merger with Sprint Corp. hangs in the balance. While the Department of Justice and Federal Communications Commission have both given the thumbs up to the proposed combination, a coalition of more than a dozen state attorneys general has filed suit to block the merger. The trial is set to begin in early December.
Uncertainties regarding the tax implications for a deal loom large. On Nov. 8, T-Mobile sent a letter to the Internal Revenue Service asking for relief from a proposed rule which would limit TMUS’ ability to utilize Sprint’s operating loss-carryforwards, which stood at $21.3 billion as of March 31 (for context, that compares to $24 billion in market capitalization for the acquiree). Sprint’s counsel and The Broadband Tax Institute (an advocacy group which represents both companies) has likewise lobbied the IRS. One potentially crucial detail: The merger agreement signed by the companies expired on Nov. 1, meaning that either party can now walk away without penalty.
The market is growing increasingly skeptical, as Sprint shares trade at a 27% discount to the implied value of T-Mobile’s all-stock bid. That compares to a 23% discount a month ago and a 13% gap on Aug. 19. A scuttled deal would carry major implications, particularly for Sprint-majority owner SoftBank Group Corp. (Almost Daily Grant’s, Nov. 6).
Broken arrow
Nevertheless, they persisted. This December will mark the seventh anniversary of Japanese prime minister Shinzo Abe’s return to power, along with his “Abenomics” monetary stimulus regime. The Bank of Japan has spared no effort in hopes of jump-starting the economy, keeping rates below zero since the end of 2015 and engaging in extensive monetary stimulus.
On a relative basis, the BoJ’s QE (which includes not just bonds but also equity exchange traded funds) has left its global peers in the dust, with a balance sheet equivalent to 104% of 2018 nominal GDP. That’s up from less than 40% at the end of 2012 and compares to the 20% and 39% of GDP held on the balance sheets of the Federal Reserve and European Central Bank, respectively.
Yet those extensive machinations have yielded results which can be described as pedestrian at best. Last week, Japan’s Cabinet Office announced that third quarter GDP grew at an annualized 0.2%, far below the consensus 0.9%. Inflation has also remained stubbornly impervious to Abenomics, with year-over-year CPI growth averaging just 0.8% since December 2012, below the 2% target set by the BoJ. Wage growth in the Abe era has averaged just 0.3% through September, according to Bloomberg. In a statement following its Oct. 31 monetary-policy meeting, the BoJ removed a pledge to keep rates “extremely low” until at least next spring, perhaps signaling they will remain in place still longer.
“The change in the guidance reflects the BoJ’s agony of having little room for further easing,” Hiromichi Shirakawa, chief Japan economist at Credit Suisse A.G. and BoJ alum, told Bloomberg. “The BoJ is trying to buy time and maintain expectations for more stimulus.”
Japan’s financial institutions have faced their own type of “agony” during this Abenomics epoch. The Tokyo Stock Exchange Banks Index trades at 0.44 times book value and generated a 5.3% return on equity last year, lagging the 0.59 times book and 7.3% RoE for Europe’s Stoxx Banks Index and far behind the 1.28 times and 11.8% for the U.S. KBW Bank Index.
Profitability for Japan’s banks may get worse before it gets better. Morningstar, Inc. analyst Michael Makdad told Bloomberg television Thursday that first half profits were primarily “driven by gains on sales of bonds after U.S. interest rates declined.” The cost side of the equation might be faced with imminent upward pressure, as Moody’s analysts last week described current nonperforming loan ratios as “unsustainably low.”
Then, too, the struggles of Japan’s banking system carry wider implications, as the yield-hungry institutions have been big buyers of collateralized loan obligations, those pooled and securitized bank loans issued by speculative-grade borrowers. But that might be changing, as Bloomberg reported last week that Norinchukin Bank’s CLO holdings dropped “slightly” from the ¥8 trillion ($73 billion) June figure in the third quarter.
The news is significant as Norinchukin has been one of the world’s most enthusiastic CLO bidders, with a portfolio that has more than doubled from ¥3 trillion as of March 31, 2018 and represents nearly 10% of the $750 billion global supply of CLOs. The apparent pullback follows an October warning from the BoJ that CLO prices “could fall substantially” in case of an economic downturn.
For more on the Japanese banks and the unintended mischief brought by negative interest rates and EZ monetary policy, see the Aug. 9 edition of Grant’s.
Recap Nov. 18
Stocks shook off modest early losses, as the S&P 500 finished in the green to log another new high and extend its year-to-date advance to nearly 25%. Treasurys were bid across the curve with the 10-year yield falling below 1.82%, and gold ticked higher in tandem to finish at $1,472 an ounce. The VIX rallied off the multi-month lows reached Friday, settling at 12.5.
- Philip Grant
Friday, November 15, 2019
Fools' gold
Sound money for the 21st century?
Sound money for the 21st century?
Modern family
Maybe it was just a coincidence.
Maybe it was just a coincidence.
Recap Nov. 15
Fools' gold
Sound money for the 21st century? Bloomberg reports:
The throng behind the Tether stablecoin and the Bitfinex trading platform plan to issue Tether Gold before Christmas. The token will be backed 100% by bullion reserves, according to Paolo Ardoino, who serves as chief technology officer for Bitfinex and Tether.
Of course, those 100% claims might be taken with a grain of salt, as Tether’s claims of full U.S. dollar backing have been challenged by a class action lawsuit by users as well as one from the New York Attorney General (Almost Daily Grant’s, May 31). And, of course, Tether co-founder William Quigley had this to say in a Bloomberg radio interview on Sept. 4:
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.
Modern family
Maybe it was just a coincidence. Tmall, the online retail site owned by Alibaba Group Holding, Ltd. (BABA on the NYSE), announced it was “taking action” against online rumor mongers regarding Alibaba’s Singles Day online shopping event. Chinese online publication Sixth Tone explains:
The April 24 post by Yin Liqing, a department manager at Beijing Infobird Software Co. Ltd., said that Tmall’s Singles Day sales records from the past decade fit almost perfectly into a linear model, with more than a 99% overlap.
Yin went on to call Alibaba founder Jack Ma a “big liar” who had “cheated the whole world for 10 years,” and to predict that this year’s Singles’ Day sales record would fall between RMB 267.53 billion and RMB 268.9 billion [$37.6 billion at the midpoint].
Alibaba announced RMB 268 billion in Singles Day sales on Monday, up from RMB 214 billion last year and RMB 168 billion in 2017.
Stateside, e-commerce behemoth Amazon.com, Inc. was the subject of a Washington Post story today detailing the continued presence of knock-off merchandise on the site, including a faux $640 Hermès bracelet offered for $24.99. The company ramped up efforts to combat the counterfeiting practice in 2017, but data from web-shopping analytics firm SimilarWeb indicate that users visited 17.6 million webpages selling questionable goods via Amazon (which gets a 15% cut of all sales, legit or otherwise, through its site) in October. An unnamed former AMZN executive told the Jeff Bezos-owned WaPo:
Because [AMZN is] allowing so much onto the site, they can’t handle the manual follow-up these things require. It tells me they just don’t want to find it. They want the selection.
While Alibaba and Amazon face questions over their reported sales and business practices, other tech giants have seen their ad-based revenue models come under renewed scrutiny. A Nov. 6 article on Dutch news site the Correspondent shared the enlightening experience of Steve Tadelis, now an economics professor at the Berkeley Haas School of Business, with Alphabet, Inc.’s Google search engine. During a 2011 to 2013 stint at the online auction site Ebay, Inc., Tadelis attempted to measure the efficacy of web-based advertisement through Google’s keyword search. In 2012, the professor halted Google ads to one-third of the United States to measure the intensity of the sales drop which would surely follow:
Together with his team, he carefully analyzed the effects of the ad stop. Three months later, the results were clear: all the traffic that had previously come from paid links was now coming in through ordinary links. Tadelis had been right all along. Annually, eBay was burning a good $20m on ads targeting the keyword ‘eBay’.
The marketing department anticipated a disaster: sales, they thought, were certain to drop at least 5%.
Week 1: All quiet. Week 2: Still quiet. Week 3: Zip, zero, zilch.
The experiment continued for another eight weeks. What was the effect of pulling the ads? Almost none. For every dollar eBay spent on search advertising, they lost roughly 63 cents, according to Tadelis’s calculations.
That anecdote is corroborated by a July report from consulting firm AlixPartners, LLP, which found that 60% of the $79 billion in digital ad spending on Facebook, Inc. and Google’s YouTube was wasted. Some big spenders are taking notice. Bloomberg reported Wednesday that consumer products giant Nestle S.A., “is shaking up its approach to advertising.” Nestle, which currently allocates 40% of its roughly $20 billion in annual marketing expense to digital media, will be “taking back control on digital-media operations,” according to Sebastien Szczepaniak, global head of sales and e-business. “We’re going to see double effectiveness in the next couple of years. That’s big money I’m talking about here.”
On the other side of the coin, an anonymity-seeking direct-to-consumer marketer who worked at several ad agencies tells Modern Retail today:
I’m in Facebook every day, and I’m freaking out right now. We’re in the fourth quarter, and usually every fourth quarter, there’s a massive conversion bump [i.e.. spending on online ads leads to more sales]. We’ve been spending millions the past couple months in anticipation of this, and we still haven’t seen it. We’re like two weeks away [from Black Friday]. It blows my mind.
Indeed there appears to be more than meets the eye across some of the biggest names in tech. Or is that less?
Recap Nov. 15
Stocks caught a strong bid, with the S&P 500 rising 75 basis points to finish at another high-water mark and extend its post Oct. 8 gains to nearly 8%. Treasurys sold off a bit, with the two- and 10-year yields rising to 1.61% and 1.83%, respectively, while gold fell to $1,467 an ounce. WTI crude rallied to $58 a barrel, near a two-month high, and the VIX sank to 12, testing its lowest close of the year.
- Philip Grant
Thursday, November 14, 2019
Block chain
This just in:
CME Group, the world's leading and most diverse derivatives marketplace, today announced that it will launch Block Cheese futures and options in January 2020, pending regulatory review.
Beware fat fingers.
Falling down
A trio of corporate issuers identified by Grant’s in 2018 for their creditor-unfriendly tactics have run into severe distress. The mishaps underscore potential pitfalls that broadly reside in credit and specifically this class of floating rate, speculative-grade bank debt.
First up, McDermott International, Inc., which in May 2018 issued a $2.3 billion first-lien, senior secured term loan to help finance its 2017 acquisition of Chicago Bridge & Iron Co. In acquiring CBI, McDermott also took delivery of a $744 million charge related to gas-turbine and liquid natural gas project cost overruns from the target company.
Running that cost through McDermott’s income statement would have run its leverage ratio to 6.28 times Ebitda, placing the company in violation of its debt covenants, specifically, a leverage cap of 4.25 times Ebitda. To avoid it, McDermott instead adjusted the CBI purchase price to account for the extra $744 million in the quarter ended Oct. 30, 2018, a move which analysts at Covenant Review described thus:
Since the increased costs do not flow through the company’s income statement, they potentially inflate the company’s covenant EBITDA—which builds off of GAAP net income—while also allowing the company to avoid credit agreement caps on addbacks for charges on the [relevant] projects. In addition to influencing the company’s covenant compliance, the use of purchase price accounting distorts the ability to use McDermott’s reported EBITDA as a proxy for its cash flow.
The sleight of hand did not lead to prosperity. Since being identified in the Dec. 14, 2018 edition of Grant’s, the loan has fallen to 58 cents on the dollar from 96, for a yield of 19.6%. McDermott shares now trade for less than a dollar, and Standard and Poor's cut the company’s debt to double-C on Oct. 28, its fourth downgrade of the year.
That Dec. 14 analysis likewise shone a light on the machinations of privately-held Neiman Marcus Group Ltd. The company caused a kerfuffle in March 2017 by reclassifying its MyTheresa online business and other properties as unrestricted subsidiaries, thus shunting those assets to equity owners Ares Management L.P. and the Canadian Pension Plan Investment Board and out of debtholders’ reach.
Last year, creditor Marble Ridge Capital accused the board of “intentional and constructive fraudulent transfers,” which would constitute default under the Neiman Marcus senior-note indenture. In response, the company offered to negotiate with other creditors, offering concessions including a coupon increase and senior claims on various ground leases, in exchange for a maturity extension. Grant’s noted: “As for more truculent and less privileged lenders – Marble Ridge, for instance – they would get nothing, not even the recourse to which they were entitled under the (for now) functional debt-letter agreements.” Investors have taken notice, as the double-C-rated Neiman Marcus term loans due 2020 have fallen to 74 cents on the dollar from 86 last December, and now yield 39.5%.
Yesterday was a day to forget for Party City Holdings, Inc., which saw shares plunge by 21% after the largest holder, Thomas H. Lee Partners, L.P., announced it had distributed its 37.8% stake and waived the right to nominate future board members. That follows a 67% plunge last week after the company reported a 5% year-over-year sales decline in the crucial month of October and slashed full-year earnings guidance to $0.87 per share from $1.31, using the midpoint of the provided ranges.
On July 13, 2018, Grant’s identified the company’s term loans as a “potential disaster,” on account of aggressive stock repurchases, Ebitda add-backs (i.e. the tangible present credit for hypothetical future cost-savings), and the absence of maintenance covenants, as well as contractual fine print allowing the company to take on additional debt that would take seniority in the capital structure. Recent revelations have dealt a costly lesson to holders of the Party City first-lien term loans due 2022, which were issued last year at 275 basis point spread over Libor:
A swan-dive for the Party City 2022 first-lien term loans. Source: The Bloomberg
For the last word, let’s return to that Dec. 14 issue of Grant’s:
The truth of it is that corporate creditors constitute an abused class of persons. The Federal Reserve debases them, and corporate managements out¬smart them. Perhaps an enterprising politician could adopt them as a new grievance community.
Recap Nov. 14
Stocks shook off early losses, with the S&P 500 storming back into the green to mark another closing high and extend its year-to-date gain to a formidable 23.5% with six weeks left in the year. Treasurys were bid sharply across the curve, as the two- and 10-year yields settled at 1.59% and 1.82%, respectively, while gold continues to follow interest rates, rallying back to $1,470 an ounce. The VIX remained near 13 for a fourth straight session.
- Philip Grant
Tuesday, November 12, 2019
Blackout warning
From SFGate.com:
From SFGate.com:
Bumper to bumper
The pile-up continues.
The pile-up continues.
Recap Nov. 12
Blackout warning
From SFGate.com:
A Santa Rosa brewery owner fed up with multiple years of devastating fires sparked by PG&E power lines made a bold statement last week by way of one of his company's beer names: "F— PG&E." [The brewery spelled it out.]
The blowback on Facebook — which included responses from non-California residents — was bad enough. But then, commenters began adding 1-star reviews to Shady Oak's Yelp page, dragging the company's rating down to 3 stars.
Bitter beer face?
Bumper to bumper
The pile-up continues. According to data from WardsAuto, October U.S. new vehicle sales registered at a 16.55 million seasonally adjusted annual rate in October, down 5.4% from a year ago and the slowest October reading since 2014. As activity wanes, dealers ramp up the discounts. According to an Oct. 29 report from J.D. Power and LMC Automotive: “Incentive spending is on pace to exceed $4,000 per unit for a fourth consecutive month as record levels of old model-year inventory persist.”
An unwanted supply build has spurred some manufactures to action. Citing a quartet of dealers, Bloomberg reports today that Fiat Chrysler Automobiles N.V. has revived a decades-old industry practice called a sales bank, in which the manufacturer continues production in the face of weak demand and pressures dealers to take on the excess inventory. The company denied that assertion, though research firm Edmunds reports that it took Fiat Chrysler 101 days to sell a vehicle on average in the third quarter, well above the 77 day industry mean. Rising supply is an issue not just for FCA, as overall volumes for used vehicles up to five years old rose by 4.7% through the first nine months of the year from the comparable period in 2018, according to J.D. Power.
Though sales have softened and inventories and dealer concessions remain elevated, prices continue to march higher. The average cost of a new vehicle rose to $34,000 for the first time in October per J.D. Power and LMC Automotive, up from $32,700 a year ago. Debt helps explain that pricing power: According to data from the New York Fed, auto loans outstanding stood at $1.3 trillion as of the end of the second quarter, up 4.8% from a year ago and up 76% over the past decade.
A report yesterday from The Wall Street Journal profiled a customer who took out a $45,000 loan from Ally Financial, Inc. to finance the purchase of a $27,000 Jeep Cherokee; negative equity from prior trade-ins furnished the balance. That experience is growing more common. According to Edmunds, roughly 33% of trade-ins in the first nine months came from consumers with negative equity on their existing vehicle, up from 28% in 2014 and 19% in 2009. Unsurprisingly, borrower distress is also on the rise: Fitch Ratings finds that 60-plus days delinquencies on securitized subprime auto debt balances rose to 5.2% in June on a rolling 12-month basis, up from 4.8% a year ago.
While aggressive auto lending and extended repayment schedules (seven-year loans now account for 31.5% of sales according to Experian, up from less than 10% in 2010) have helped perpetuate a strong cyclical run for the auto industry, the value of used vehicles is perhaps the most crucial variable. As most new sales involve a trade-in, used-vehicle prices underpin industry activity. On that score, things have taken a negative turn: Manheim, Inc. reports that the firm’s used vehicle index fell by 0.4% from a year ago in October, the first such decline in almost three years.
Leases figure prominently in the equation, as penetration peaked in 2016 and most have a three-year tenor (Grant’s Interest Rate Observer, Feb. 23, 2018). According to Manheim, three-year-old vehicle prices fell by 4% sequentially in October, compared to seasonally-typical 1.5% to 2% decline for the month. Anil Goyal, executive vice president of Black Book Market Research, LLC, indicated more of the same in a report today: “Used vehicle values dropped steeply last week with broad declines across all segments. The buying sentiment was very negative in auto auctions across the nation.”
Daniel Ruiz, founder of automotive research firm Blinders Off Research LLC, identifies the key piece of the puzzle in an email to Grant’s today:
I think the biggest story in autos right now is what’s happening with used-vehicle values. There will be residual effects to new-vehicle sales velocity, subprime delinquency rates, fleet expense for car rental companies, and more impacts that have not been seen yet.
How might one position for a potentially bigger shift in industry conditions? The Oct. 18 edition of Grant’s Interest Rate Observer has some ideas.
Recap Nov. 12
The bond market reopened today after a long weekend, with Treasurys bid across the curve to leave the two- and 10-year yields at 1.65% and 1.92%, respectively. Gold managed a feeble bounce to finish at $1,458 an ounce, while WTI crude finished a bit below $57 a barrel.
Stocks ticked slightly higher, as the S&P 500 moved by less than 10 points for a sixth straight day to finish just below its closing high, while the VIX remained near 13.
- Philip Grant
Monday, November 11, 2019
Hot and sour soup
Trouble in Hong Kong is intensifying: The death of a protestor over the weekend spurred escalating violence today, as demonstrators set one man alight while police shot another.
The unrest is taking a notable toll on Hong Kong’s economic health. Third quarter GDP fell by 2.9% year-over-year, the sharpest contraction in over 10 years, while September retail sales plunged by 18% from a year ago. Bloomberg reports today that major banks located in the city urged staff to consider leaving work early to ensure their safety, as demonstrators barricaded over 120 locations throughout the Special Administrative Zone, according to the Associated Press. Hong Kong chief executive Carrie Lam promised that the government “will spare no effort,” to end the mayhem, perhaps indicating a more severe crackdown is in store.
In the past, the mainland government has helped combat slowdowns through initiatives like relaxing travel restrictions to boost tourism. Even if ruler-for-life Xi Jinping were so inclined, its hard to imagine Chinese tourists flocking to the geopolitical hot spot. “There is no liquidity bail-out for Hong Kong, ever,” independent economist Andy Xie told Reuters. “This is it. It’s not coming back.” For a detailed look at the risks and opportunities in Hong Kong, see the May 31 edition of Grant’s Interest Rate Observer.
Then again, the mainland is occupied with its own financial problems, with third quarter GDP growth of 6% its lowest since 1992. Early fourth quarter indicators are likewise grim. According to data from the People’s Bank of China released today, total aggregate financing grew by just RMB 619 billion ($87 billion) in October, well below the expected RMB 950 billion and down from RMB 737 billion a year ago. The M2 measure of money supply rose by 8.4% year-over-year in October, down from the 20-year average pace of 15.1%.
The dwindling flow of new credit underscores Beijing’s reluctance (or inability) to shower the economy with fresh monetary stimulus. Adam Wolfe, emerging market economist at Absolute Strategy Research, told the Financial Times Friday that: “Investors should not expect anything on the scale of the 2015 reflation.” Considering China’s leverage-choked financial system (banking assets of $41 trillion as of June 30, surpassing a combined $36 trillion in U.S. and Japanese banking assets and equal to nearly half of 2018 global GDP), waning credit and money supply growth augurs no good things for economic growth and financial stability.
Indeed, problems in the banking system have recently re-emerged following the troubles seen this summer at Baoshang Bank Co., Ltd. and Bank of Jinzhou Co., Ltd. The FT reported Friday that police arrested nine people in the city of Yingkou for posting online remarks suggesting that Yingkou Yanhai Bank Co., Ltd. “was in deep financial crisis.” Yingkou, which saw the third-fastest loan growth from 2010 to 2018 among Chinese lenders, reported an 85% increase in provisions during the first three quarters of the year compared to 2018.
That follows a Nov. 1 run on Yichuan Rural Commercial Bank Co., Ltd. in China’s Henan province, which authorities countered with an injection of more than RMB 30 billion into the bank. On Thursday, Guangdong Nanyue Bank Co., Ltd. opted against redeeming an RMB 1.5 billion, 6% coupon note due next month, sparking concern over its financial health. More broadly, non-performing loans across the banking system stood at RMB 2.2 trillion at the end of June according to the China Banking and Insurance Regulatory Commission, the highest level in at least 15 years.
Stress in regional banks has bled into the stock market, as Chongqing Rural Commercial Bank Co., Ltd. saw its shares decline by nearly 2% today to fall back below its Oct. 29 IPO price. Bloomberg notes that such a development is both rare and ominous:
For years, stock debuts in China have offered near certainty, typically priced at no more than 23 times earnings and then popping by the 44% limit on their first day.
While small banks shudder and investor psyche shifts, the absence of meaningful new stimulus from Beijing has manifested in increased distress among local governments. Citing court documents, the FT reported yesterday that 831 local governments have fallen into default in the first 10 months of the year, up from just 100 defaults in all of 2018. Zhong Zhengsheng, director of macroeconomic analysis at CEBM Group, explained that: “Cities and provinces are having trouble financing new projects as they must spend a significant portion of their cash paying off debt.”
The belt-tightening is forcing some to get creative. Yesterday, the New York Times reported that, in their efforts to build a hospital in the city of Ruzhou, Henan province, administrators solicited loans from the doctors and nurses who were to staff the facility. “If employees didn’t have the money,” the Times found, “they were pointed to banks where they could borrow it and then turn it over to the hospital.”
Around and around we go.
Recap Nov. 11
The bond market was closed for Veterans Day, while the S&P 500 recouped most of its early losses to finish 20 basis points in the red. Gold continued its slide to $1,455 an ounce, the lowest since early August, and the VIX rose back to near 13.
- Philip Grant
Friday, November 8, 2019
Lap of luxury
From the Daily Mail:
From the Daily Mail:
Down in the bottom
There's more where that came from.
There's more where that came from.
Recap Nov. 8
Lap of luxury
From the Daily Mail:
How much would you spend on a loo? For the super-rich in China, the answer seems to be £1 million.
A lavish gold toilet featuring a bullet-proof seat studded with more than 40,000 diamonds has been spotted at a trade fair in Shanghai.
The luxurious lavatory is worth $1,288,677 (£999,497), according to its manufacturer from Hong Kong.
That bulletproof seat is a good deterrent against frogman attack.
Down in the bottom
There’s more where that came from. Yesterday, Apollo Global Management, Inc. CEO Leon Black said that he expects assets under management to double in the next five years, to $600 billion. That figure, Black told attendees at the firm’s investor day, “does not represent the end game for Apollo” but just “a step along the way.”
Black’s ambitious mindset is understandable considering the charmed run enjoyed by the industry. According to Preqin Ltd., global private equity assets under management reached $3.56 trillion at the end of 2018, up 17% year-over-year and nearly double the industry AUM as of year-end 2011.
The surging popularity of private equity is also easy to understand, as post-crisis monetary policy has ensured microscopic interest rates and all but forced investors out of traditional return-generating strategies. According to buy-side analytics firm eVestment, private equity accounted for 27% of U.S. and U.K. pension fund allocations last year, up from 25% in 2017. PricewaterhouseCoopers likewise projects that pension assets assigned to “alternative investments” (including p.e. as well as property and infrastructure funds) will rise to $21 trillion by 2025 from $10 trillion in 2016, which would be an 8.6% compound annual growth rate.
Expectations rise with assets. In its 2020 Long Term Capital Market assumptions bulletin, J.P Morgan Asset Management raised its 10 to 15 year expected return from p.e. investments to 8.8% per annum from 8.25%. David Kelly, chief global strategist, summed up the zeitgeist in a media briefing Wednesday: “Private equity is the new stock.”
Yet, while the funds continue to pour in, exits -- the p.e. owner successfully turning over a portfolio company to public investors – are scarce. The Wall Street Journal reported yesterday that the California State Teachers’ Retirement Association (CalSTRS), which, at $238 billion under management, is the second largest public pension fund in the U.S., reported a 36% annual drop in carried interest paid (reflecting realized gains) in 2018 compared to the year before. That figure encompasses real estate, private equity and other alternative investments.
Private equity sponsors, too, continue to struggle to bring their deals back to market. According to Preqin, global exits registered at 408 in the third quarter, down from nearly 600 in the third quarter of 2018 and the fifth consecutive quarterly decline (for an in-depth analysis of an attempted Apollo exit, see the July 12 edition of Grant’s).
The infrequency of exits coincides with a credit quality deterioration in leveraged loans, i.e. tradable, speculative grade bank debt that is a key cog in the p.e. machine. According to a Sept. 22 report from the Bank for International Settlements, leveraged loan supply across the U.S. and Europe stood at more than $1.4 trillion in the third quarter, up from $750 billion in 2013.
That breakneck growth pace has left some observers more than slightly concerned. In an Oct. 30 interview with Bloomberg, Arena Investors CEO Daniel Zwirn had this to say:
Certainly, leveraged lending and the associated middle-market corporate private credit markets have been grossly out of control, in partnership with private equity.
Zwirn went on to identify the lofty valuations and aggressive leverage profiles widely seen across issuers of those leveraged loans:
So the equity pays 11 times [Ebitda] because they can get their returns since they’re borrowing seven or eight times and lenders are saying it’s going to be OK because there’s someone with three or four turns below me. And each of them is wrong. And that is going to end badly.
Signs of trouble abound. According to S&P’s LCD unit, 282 issuers within the S&P/LSTA Index suffered a rating downgrade in the year-to-date through Oct. 11, up from 244 for all of last year and just 33 in 2017. That has pushed the proportion of leveraged loans rated triple-C (“In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitments on the obligation.”) to 7.5% of loans outstanding at the end of September, according to S&P. That’s the highest level since 2013 and up from 6.3% in June.
Needless to say, the increasing prominence of private equity in tandem with a cyclical credit deterioration presents a delicate backdrop. At the fall 2019 Grant’s conference, Verdad Advisers L.P. founder and portfolio manager Dan Rasmussen identified some eye-opening assumptions among investors about both the composition of p.e. portfolios and their expected future performance. For more, see the Nov. 1 edition of Grant’s.
Recap Nov. 8
A late uptick pushed the S&P 500 into the green, leaving the broad index higher by 75 basis points for the week and marking the third closing high logged in the last five trading sessions. The VIX sold off in tandem, finishing near 12 for the lowest close since July. The dual rout in Treasurys and gold continued, as the 10-year yield edged to 1.94% (it was 1.53% a month ago), while the money of kings fell to $1,459 an ounce to finish the week with a meaty 4.5% loss.
- Philip Grant
Thursday, November 7, 2019
Time share
Forget subscriber counts.
Forget subscriber counts.
Trend zone
“Passing on at least parts of the negative interest rates to parts of the customers – not to Joe Six-pack or Herman the German obviously.
“Passing on at least parts of the negative interest rates to parts of the customers – not to Joe Six-pack or Herman the German obviously.
Not-QE progress report
Recap Nov. 7
Time share
Forget subscriber counts. That was the message Netflix, Inc. CEO Reed Hastings delivered to attendees at a conference yesterday:
Time will be the real competition. You’ll hear some subscriber numbers but you can just bundle things so that’s not going to be that relevant. So the real measurement will be time -- how do consumers vote with their evenings? What mix of all the services do they end up watching?
That sentiment is a change, as Hastings had this to say regarding a subscriber threshold in an April 2017 “earnings interview”:
Well, I'm – we’re super excited, expecting to cross 100 million this weekend. That's a big accomplishment. But it's really just the beginning. When you look at YouTube having 1 billion active users and 1 billion hours every day, when you look at Facebook's multi-billion numbers, we see that the internet is just a phenomenal opportunity.
Hastings’ pivot coincides with a recent run of disappointment on the subscriber front. On Oct. 16 Netflix guided fourth quarter domestic and international paid subscriber additions to 600,000 and 7 million, respectively, far below the consensus 1.28 million and 8.04 million. Even those revised figures now appear daunting, according to Lee Horowitz of Evercore ISI. In a note Tuesday, Horowitz cited download statistics for the Netflix app to project international subscription growth of only 6.4 million. The company likewise announced it will no longer break out subscription data by region beginning in January.
Meanwhile, that newly preferred “time” metric appears to be a work in progress. The Oct. 16 letter to shareholders noted that the company “we believe we [account for] less than 10% of TV screen time in the US (our most mature market) and much less than that in mobile screen time.” Netflix made a similar observation in the second quarter letter and made no mention of the time metric in the first.
Trend zone
“Passing on at least parts of the negative interest rates to parts of the customers – not to Joe Six-pack or Herman the German obviously. The issue is getting more important by the day.” Commerzbank A.G. CFO Stephan Engels delivered that remark today, in explaining the bank’s decision to extend the implementation of negative rates to small business owners and retail clients.
The status quo doesn’t appear to be working for Commerzbank, which today announced that projected 2020 revenues will be below this year’s top line, down from a prior expectation of a slight increase and the second guidance cut in 12 weeks. Commerzbank, Germany’s second-largest bank, trades for less than 25% of book value and generated a 3.1% return on equity last year (that compares to 1.27 times book and 11.8% RoE, respectively, for the U.S. KBW Bank Index).
But might a respite from the yoke of negative rates be on the horizon? On Oct. 24, the Swedish central bank announced its intention to raise its policy rate back to zero from minus 25 basis points at the upcoming meeting in December, a potential watershed moment as the Riksbank was at the vanguard of radical policy, taking rates below zero in 2009. Some members of the European Central Bank’s Governing Council are increasingly outspoken about their opposition to the practice, with Robert Holzman telling Austrian magazine Trend that “negative rates are the wrong signal at this point, therefore they should be withdrawn as soon as possible.” Interest rate futures currently price a 44% change of another ECB rate cut by next September and 4% odds of a rate hike. One month ago, those figures were 88% and 1%, respectively.
Recent price action is likewise cause for optimism, as the global supply of negative-yielding debt has fallen to $12.5 trillion as of this morning, down from $17 trillion in August and the lowest level in over three months. Then, too, an avatar of the E.U. sovereign debt bubble has lost some air of late: The Austrian 2.1s of 2117 have fallen to 160 cents on the Euro from more than 210 in August, pushing the yield to maturity to 1.1% from 61 basis points. In tandem with that receding tide of negative- and near-negative-yielding debt, the E.U. Stoxx Bank Index has enjoyed a 25% rally since Aug. 15.
Green shoots, 2019 edition?
Not-QE progress report
The Fed’s portfolio of securities held outright registered at $3.64 trillion, up $18 billion from last week’s reading. Upticks in bills maturing in the next 15 days ($24 billion) and between one and five years out ($10 billion) were partially offset by a $16 billion decline in Treasury securities with a 16 to 90 day maturity schedule.
Total balance sheet assets are now up 7.5% from the summer and remain 10% below the levels seen prior to the commencement of QT in the fall of 2017.
Recap Nov. 7
A major selloff in Treasurys pushed the two- and 10-year yields to multiweek highs of 1.67% and 1.92%, respectively, with that 25 basis point differential the widest since July. Stocks edged higher to leave the S&P at another record finish, up by 60 basis points this week so far. The move in rates meant more pain for gold, which lost 2% to $1,468 an ounce, while WTI crude rose to $57 a barrel. The VIX settled near 13 for a fourth straight day.
- Philip Grant
Wednesday, November 6, 2019
Soft serve
Hindsight is 20/20. Earlier today, SoftBank Group Corp. reported a ¥704 billion ($6.5 billion) operating loss for the six months ended Sept. 30. The Vision Fund, SoftBank’s $97 billion in-house V.C. arm, was the culprit, absorbing a $8.9 billion loss thanks largely to writedowns in cash hemorrhaging portfolio companies such as WeWork parent The We Company and Uber Technologies, Inc. (UBER on the NYSE).
While calling the quarter “a mess”, SoftBank chairman and CEO Masayoshi Son maintained an upbeat message, declaring: “There is no change in our journey, no change in our vision.” Noting that WeWork’s Japanese unit is now showing a profit, Son asserted that: “We don’t need to do anything tricky or invent anything. Time will take care of things. Let it ripen and we will reap a profit.”
So far, they have harvested something different, paying some $10.7 billion for a 29% stake (a blended $38 billion valuation) in We Co. prior to its October bailout. As of the most recent $7.8 billion valuation, SoftBank and the Vision Fund are sitting on losses of about $8.4 billion.
Meanwhile, the public markets have been less-than kind to Uber. On Tuesday, the ride-share giant reported $3.5 billion in third quarter revenue, topping the consensus $3.39 billion, and promised to turn a profit on an adjusted basis by 2021, but shares fell 10% in response. This morning, Uber underwriter Goldman Sachs Group, Inc. priced a two million share block at $26.90 (a 4% discount to Tuesday’s closing level), coinciding with the expiration of lock-up restrictions preventing insiders from selling their stakes. The Vision Fund owns a bit more than 222 million shares in Uber, representing a loss of $4.1 billion from the company’s May trading debut and $850 million from its Sept. 30 closing price.
As problems at We and Uber take center stage, other SoftBank investments have fared better this year. One quick winner for SoftBank was its €900 million ($1 billion) convertible bond investment in controversial German concern Wirecard A.G. The company, which has been subject to short-seller scrutiny and a series of Financial Times exposés over its business and accounting practices, managed to sell another €900 million convertible bond in September, allowing SoftBank to recoup its investment (while maintaining additional upside potential through call options) just one day after shareholders approved the initial deal. On Sept. 22, the FT explained the thinking of Son et. al:
A senior SoftBank executive told the Financial Times that the Wirecard trade was inspired by Warren Buffett, who has a record of making highly structured investments in seemingly troubled companies that then benefit from his reputation.
No investment better solidified Masa Son’s reputational bona fides than his brilliantly timed $20 million investment in China’s Alibaba Group Holding, Ltd. (BABA on the NYSE) in 2000. On Friday, Alibaba bucked a weakening Chinese growth environment by announcing that third quarter revenues and operating income rose 40% and 51% from a year ago (to $16.7 billion and $2.8 billion, respectively), extending BABA’s year-to-date gain to 33%.
Yet the increasingly chilly Sino-American relationship presents a risk to Alibaba and its investors. Bloomberg reports that a bipartisan Senate bill to block the Federal Retirement Thrift Investment Board (which holds assets of about $50 billion) from investing in securities listed in mainland China will be introduced today. That follows a Sept. 27 report from CNBC indicating that the White House is considering “possibly blocking all U.S. financial investments in Chinese companies.”
Sprint Corp., (S on the NYSE), one of SoftBank’s largest investments, has logged gains of 17% year-to-date, as the Federal Communications Commission and Justice Department have both approved B2/single-B-rated Sprint’s prospective merger with T-Mobile U.S., Inc. That leaves a lawsuit from a coalition of state attorneys general as the final, high-stakes hurdle, as failure would likely mean debt restructuring for Sprint (Almost Daily Grant’s, Feb. 1).
As research firm MoffettNathanson LLC wrote on Monday, the merger is likewise crucial for SoftBank, which owns 84.2% of Sprint, a stake worth $20.8 billion, or 25% of SoftBank’s market cap.
As with We, where [SoftBank] ultimately stepped in but still kept We’s consolidated liabilities off their balance sheet, Softbank doesn’t want Sprint’s $34 billion of debt on their balance sheet. . . A buy-in [meaning Sprint’s results and debt would be consolidated into SoftBank’s operations] would be triggered by even a modest increase in SoftBank’s equity stake; they’re already bumping up against their 85% limit.
But neither can they simply let Sprint go bankrupt. In a chapter 11 filing, SoftBank’s equity would be wiped out.
The Sprint trial is set to begin in early December.
While SoftBank contends with large losses in some investments and existential risk in others, Masa Son’s preparations for a sequel to the Vision Fund continue unabated. As noted by Bloomberg’s Tim Culpan today, the Vision Fund’s structure, which includes a $3 billion annual obligation to pay a 7% coupon to investors in preferred shares which account for roughly $40 billion of fund assets, makes raising more money all but essential:
All this explains why SoftBank not only wants to raise a second $100 billion fund, but truly needs to: From the fund’s inception through to June 30 this year, it earned $3.2 billion in management performance fees, twice the $1.6 billion it received in distributions as an investor. That distribution is supposed to rise over time as more investments come to market or get acquired, but the decline in publicly traded shares and the cooling mood toward unicorns doesn’t augur well for the future.
With the first Vision Fund tapped out, there’s not a lot of money around to keep pushing up valuations, which in turn drive earnings of both the fund and SoftBank. And with public markets turning sour, hopes of a steady flow of distributions from cashed-out investments are also dimming.
On Dec. 15, 2017, Grant’s termed SoftBank “the epitome of the cycle.” For the sake of the bull market, we had better be wrong about that.
Recap Nov. 5
This afternoon’s stronger-than-expected 10-year note auction helped spur a solid rebound across the Treasury complex, leaving the two- and 10-year yields at 1.6% and 1.82%, respectively. Gold rallied back to $1,492 an ounce in tandem with Treasurys, while WTI crude ticked lower to $56.50 a barrel. Stocks cruised sideways for a second straight day, and the VIX fell below 13.
- Philip Grant
Tuesday, November 5, 2019
Child's play
From CNN:
From CNN:
Block party
The command economy received its orders
The command economy received its orders
Recap Nov. 5
Child's play
From CNN:
This year's highly anticipated holiday doll will be decked out with more than 5,000 Swarovski crystals and beads. Her cost: $5,000, but only three are available for sale — one at each of American Girl flagship stores in New York, Los Angeles and Chicago.
Block party
The command economy received its orders. Following an Oct. 24 meeting with the Communist Party’s Central Committee Political Bureau, China’s ruler-for-life Xi Jinping declared that the Middle Kingdom must “accelerate the development of blockchain and industrial innovation.”
That high-level endorsement spurred a ferocious rally in bitcoin and crypto-related securities, as more than 60 tech-related companies rose by their daily limit on the Shenzen and Shanghai exchanges. “Most of these companies, especially those that are just beginning to state their connection with blockchain today, are trying to take advantage of the hype,” Li Shiyu, fund manager at Guangdong Xiaoyu Management Co., told Bloomberg. “It shows how much excitement can be triggered by something stressed as a priority by the top man himself.”
China’s crypto-project is indeed underway, as local telecom giant Huawei Technologies Co., Ltd. announced a “fintech research cooperation agreement” with the People’s Bank of China yesterday, according to Coin Telegraph.
Of course, the Chinese Communist Party might have political designs beyond modernizing the country’s payments infrastructure. The promise of cryptos is that they allow users anonmyously and cheaply to transact with one another. Under a government-administered blockchain, the powers-that-be will know every user and every transaction that user has engaged in.
The introduction (or co-opting) of blockchain technology by government entitites is not confined to China. Reuters reports today that an EU draft document suggests that the European Central Bank “usefully explored the opportunities as well as challenges of issuing central bank digital currencies. . . “
While central banks plan their digital futures, the ranks of so-called HODLers of the worlds most popular crypto continue to expand. Coindesk reports today that the number of IP addresses holding at least 1,000 bitcoin sits near an all-time high, up some 30% year-over-year and well above the levels seen in late 2017 and early 2018, when a single bitcoin fetched more than $15,000 compared to $9,400 today.
Crypto investor Willie Woo identified two potential explanations for the ownership distribution:
The two options are we have high-net-worth investors coming in or it could be cold storage practice at the exchanges and custody solutions. The latter explanation cannot be ruled out, but it does not coincide with other data we have on the timing of when supply increased at these entities. For now, I’m going with the first explanation.
Indeed, Coinbase notes that even when removing known exchange IP addresses, the so-called rich list grew by nearly the same 30% over that 12 month period, suggesting that adoption by high net-worth individuals might be the primary catalyst.
While current data indicate a wider base of bitcoin HODLers, a pair of professors have refreshed their mid-2018 study of the factors behind the crypto complex’s parabolic rally in late 2017. John Griffin of the University of Texas and Amin Shams of Ohio State University assert that the near 10-fold rally in bitcoin from July to December 2017 came from an unusual source, telling Bloomberg yesterday:
Our results suggest [that] instead of thousands of investors moving the price of bitcoin, it’s just one large one. Years from now, people will be surprised to learn investors handed over billions to people they didn’t know and who faced little oversight.
The pair zeroed in on tether, the purportedly dollar-backed “stablecoin,” and the affiliated Bitfinex exchange (Almost Daily Grant’s, Oct. 18), examining transactions in bitcoin and tether over the 12 months ended on March 1, 2018. Griffin and Shams determined that Bitfinex-based bitcoin purchases increased when the price of the crypto fell by certain amounts. The professors write:
This pattern is only present in periods following printing of tether, driven by a single large account holder, and not observed by other exchanges. Simulations show that these patterns are highly unlikely to be due to chance.
This one large player or entity either exhibited clairvoyant market timing or exerted an extremely large price impact on bitcoin that is not observed in aggregate flows from other smaller traders.
In response, Tether general council Stuart Hoegner termed that research: “A transparent attempt to use the semblance of academia for a money grab.” Hoegner asserted that “macroeconomic experts and stakeholders in the cryptocurrency ecosystem understand that is the global rise of digital currency that has driven the markets and demand for tether.”
Time will tell on that front, as the U.S. Justice Department opened a criminal investigation into potential bitcoin manipulation in 2017, while the New York Attorney General has accused iFinex, Inc., the company which owns both Bitfinex and Tether, of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds.”
What’s in your (digital) wallet?
Recap Nov. 5
Another sharp selloff in Treasurys pushed the 10-year yield to 1.85%, its highest finish in nearly two months. The move in rates seemed to hurt gold, which fell more than 1.5% to $1,485 an ounce, while WTI crude continued its recent rally by rising to a five-week high above $57 a barrel. Stocks cruised sideways after the S&P 500 logged fresh closing highs on back to back sessions yesterday and Friday, and the VIX remained at 13.
- Philip Grant
Monday, November 4, 2019
Under the bridge
Will the referees blow the whistle? The Wall Street Journal reports today that Under Armour, Inc. (UA on the NYSE) is facing a federal investigation “examining whether the sportswear maker shifted sales from quarter to quarter in an effort to appear healthier.” The Department of Justice is conducting a criminal investigation alongside a civil inquiry from the Securities and Exchange Commission, according to the Journal.
For its part, Under Armour stated it has been cooperating with an SEC request for information related to revenue recognition made in July 2017. But, as has been noted by independent research firm Probes Reporter since the summer of 2017, there was no disclosure of that investigation prior to today’s report.
Asked on today’s earnings call why investors were kept in the dark over that seemingly-material information, chief financial officer David Bergman asserted that UA was barred from discussing the matter and is now looking to turn the page: “We’re focused on 2020 and beyond.” UA likewise declined to answer another analyst query over whether the investigation would take a material toll on operations. While keeping mum on those SEC and DoJ probes, the Under Armour C-suite, has, since July 2017, unloaded some $2.6 million in company stock to investors likely unaware of the civil and criminal investigations.
The timing of the now-revealed regulatory action is important, as it seemingly coincides with a sea change in UA’s operating results. The company had posted 26 straight quarters of annual revenue growth topping 20%; a run that ended in the fourth quarter of 2016.
A pair of interesting details coincide with the end of that remarkable streak, as accounts receivable bulged by 44% year-over-year in 2016, more than doubling the 21% increase in net sales. Meanwhile, Dicks Sporting Goods, Inc. (DKS on the NYSE) told the SEC in a June 2016 correspondence that it had returned $45 million in merchandise including “cold-weather compression” gear to an unnamed vendor earlier that year, providing no concessions in return. If UA was that unidentified merchant, might they have under-accrued sales return reserves?
During the tail end of that 26-quarter sales boom, founder and CEO Kevin Plank couldn’t resist drawing a parallel between his company and Golden State Warriors superstar (and Under Armour spokesman) Stephen Curry. Thus, in April 2016:
Our first-quarter revenues grew 30%, with the growth coming from every facet of our business. And to be clear, that 30% number was no accident. When Stephen Curry decided to average 30 points this season to take the scoring title while wearing the number 30, we thought that putting up 30% growth on our end was the best way for us to demonstrate our pride and support of Stephen and the Warriors.
That seeming non-sequitur takes on new potential significance following today’s revelations. As for the 47-year-old Plank, he announced last month that he will step down as CEO on Jan. 1.
Since 2017, the company has struggled with revenue declining 0.9% in the third quarter on the back of 1% growth in the first two quarters of the year. Additionally, earnings have entered a protracted decline, with the Street penciling in $154 million in net income this year compared to $212 million in 2016. UA shares have declined by 60% since a bearish analysis in the June 12, 2015 edition of Grant’s Interest Rate Observer. Yet the company still trades at more than 30 times consensus 2020 earnings per share. For the latest on Under Armour from Grant’s, see the May 4, 2018 edition.
Recap Nov. 4
Another strong day for stocks helped the Dow Jones Industrial Average reach a fresh closing high, following the S&P 500’s lead last week. Treasury yields likewise moved higher across the curve, with the 10-year settling at 1.76%. WTI crude rallied back near $57 a barrel, while gold ticked lower to $1,510 per ounce. The VIX remained below 13.
- Philip Grant
Friday, November 1, 2019
The Daily Beast
On Monday, state-owned oil giant Petróleos Mexicanos (a.k.a. Pemex) announced that it had cut its marketable debt to $99.6 billion, 6.1% below the year-end 2018 level. That’s the first such reduction in a decade. In addition, third quarter production showed a small uptick to 1.694 million barrels per day, up 1.2% from the second quarter.
Stemming, for now at least, the longstanding output slide (production peaked at 3.4mbpd in 2004) didn’t provide much help to the income statement. Third quarter revenues for Pemex registered at MXN 350.5 billion ($18.2 billion), down more than 20% from a year ago. Red ink likewise continues to flow, with a third quarter net loss of 87.4 billion pesos bringing the year-to-date shortfall to MXN 176.4 billion, topping 2018’s full-year loss of MXN 175.6 billion.
By way of response, Pemex opted to cut costs by apparently firing nearly all of its public relations staff, as spending on “social communication” fell to MXN 2 million in the first nine months of the year, down 99% from MXN 205 million spent over that period last year.
With in-house PR talent now in short supply, Pemex might be on the hunt for alternative spokespeople. One potential fill-in: Mexican President Andrés Manuel López Obrador (AMLO). Though a Bloomberg headline from today suggests he might need a bit of refinement:
AMLO: I DIDN'T INTEND TO COMPARE THE PRESS TO ANIMALS YESTERDAY
Her cup spilleth over
Yesterday, the European Central Bank introduced its so-called tiering system to help area banks contend with sub-zero interest rates by reducing the amount of capital subject to the confiscatory rate. As far as money markets are concerned, the debut was a smooth one: The ECB’s short-term benchmark rate was unchanged from the prior reading, suggesting the market has calmly digested the regime. Michael Leister, head of rates strategy at Commerzbank AG, said that the smooth roll-out of tiering “implies that more rate cuts are feasible.” Others were more effusive: “In other words, the ECB nailed it with the tiering,” Piet Christansen, senior analyst at Danske Bank A/S, told Bloomberg.
One thing is for sure. Help for Europe’s banks comes not a moment too soon. Danske Bank currently trades at just over half of its book value, less than half its five-year average valuation of 1.17 times book.
Today, Danske Bank reported third quarter results that fell short of expectations and projected that full-year profits will be at the lower end of a previously provided range of DKK 13 billion to 15 billion ($1.95 billion to $2.2 billion). Corporate austerity is on the agenda, as CFO Jacob Aarup-Andersen said on the conference call that: “There is no doubt that when we get to 2023, we expect to [have] fewer staff.” Danske Bank holds $575 billion in assets, equivalent to 164% of Denmark’s nominal 2018 GDP.
Meanwhile, today marks the debut of former IMF head Christine Lagarde as ECB president, taking over from Mario Draghi after his eight-year term. A profile in today’s Wall Street Journal explained her advanced political acumen, with Carlos Bowles, vice president of the ECB’s staff trade union saying of his new boss: “She’s fantastic, the way she talks to people like she’s a close friend and explains tricks. It creates complicity.”
One trick of the trade: “In October, she explained to American viewers how she pretends to drink wine at international meetings without drinking it, to stay sharp.”
The wine might be fake, but the punchbowl is real.
Recap Nov. 1
A stronger than expected reading of the October jobs report provided more bullish fodder for stocks, as the S&P 500 sat higher by nearly 1% late in the session to close at a new record high. Treasury yields rose across the curve to give back a portion of yesterday’s sharp rally, while WTI crude jumped back above $56 a barrel. The VIX dropped below 13.
- Philip Grant
Thursday, October 31, 2019
Knife Catchers, Inc.
The space between the basement and penthouse
The space between the basement and penthouse
Not QE Progress Report
Recap Oct. 31
Knife Catchers, Inc.
The divergence between the basement and penthouse in speculative grade credit has almost never been so wide. Year-to-date, the Bloomberg Barclays High Yield Index has generated an 11.88% total return, while the triple-C-rated index subcomponent lags far behind at 5.69%.
That performance disparity is remarkable in that steep index gains usually signify broad risk appetite, but the sluggish performance of the triple-C cohort seemingly indicates otherwise. In an Oct. 22 commentary for S&P’s LCD unit, Lehmann Livian Fridson Advisors chief investment officer Martin Fridson noted that only once in the past 30 years has the triple-C-rated component trailed broader high-yield indices in a year when total returns topped 7%. Randall Parrish, head of credit at Voya Investment management, summarized the current zeitgeist to Bloomberg today: “Triple-C notes stand out as cheap and no one wants to touch them.”
The haves vs. have-nots’ phenomenon is likewise visible in leveraged loans (i.e. floating-rate, tradable bank debt issued to speculative-grade borrowers). Higher quality credits continue to see brisk bidding interest, as Bloomberg reported Tuesday that issuer-favorable repricings jumped to $13.2 billion in October, nearly triple the $4.8 billion seen a month ago.
Yet things are fast deteriorating at the deeper end of the pool: According to research from Morgan Stanley last week, 4.2% of the S&P/LSTA Leveraged Loan Index is trading below 80 cents on the dollar, compared to 1.3% a year ago. Similarly, Wells Fargo last week found that 9% of collateralized loan obligation (a.k.a. CLOs; packaged and securitized leveraged loans) portfolio loans have dropped below 90, up from 2.4% last year. CLOs increasingly dominate the leveraged loan realm, with 72% of loans packaged into the contraptions as of the end of the third quarter according to Goldman Sachs, up from less than 50% in 2011.
Yesterday, Fitch Ratings noted that so-called loans of concern jumped to $107 billion, or 8% of the institutional loan market, in October, from $75 billion, or 5%, in July. Accordingly, Fitch raised its projected loan default rate for 2020 to 3% from 2%. Likewise, LCD relays that its “Weakest Links,” or those with a credit rating of B-minus or lower coupled with a negative outlook from S&P Global, rose to 9.6% at the end of the third quarter, up from 6.8% at year-end 2018 and the highest since at least 2013. Downgrades now exceed upgrades by nearly three to one, easily the worst ratio going back to at least September 2015.
With storm clouds in credit continuing to accumulate, the unpleasant prospect of cascading downgrades across corporate America becomes more realistic. Yesterday, CreditSights reported that markets are currently pricing some $230 billion of triple-B-rated debt (7% of outstanding domestic triple-B-rated credit) at levels consistent with junk ratings, according to the option-adjusted spread on those issues. The firm estimates that nearly $70 billion of that stack is “at risk” of an actual downgrade in the next 12 months, up from $47 billion in July.
The evidently degrading credit conditions are bad news indeed for managers who have been forced to grope for yield by investing in speculative-grade issues. A Tuesday report from Moody’s Investor Service aptly summarizes the particular risks of this cycle:
Despite their mounting frustrations over poor credit quality and contractual protections, investors have maintained a voracious appetite for higher yield, fueled by post-crisis quantitative easing. The strength of this appetite has kept high-yield bond and leveraged loan outstandings at historical highs and paved the way for unprecedented erosion in capital structures and credit quality. Leverage has grown alongside high acquisition multiples and larger equity contributions from sponsors than typical historically.
To compensate, private equity sponsors have been the strongest advocates for greater flexibility in loan and bond documents. While some investors argue there is some comfort taken from the larger initial equity contributions, it will not protect investors exposed to weak credit protections in loan agreements and bond indentures.
As noted by Bloomberg Businessweek, typical CLOs are structured with a maximum 7.5% allocation to triple-C. Exceeding that threshold would put managers “in a bind: either unload the debt, and fast, or risk tripping ratings triggers that prevent them from making some payments to their investors.” That phenomenon has already appeared in some vehicles, as a pair of CLOs sold by Cutwater Asset Management are well over their respective triple-C allocations, holding 14% and 19%, respectively.
The swelling ranks of lower-rated issues is spurring competition for CLO space, as Michael Herzig, head of business development at THL Credit, Inc., told Bloomberg Television on Tuesday:
What you see is an increase in the ante to get into a portfolio as a B3 company, so that new issues that might be coming rated B3 have to pay a much higher rate to qualify for that limited space in CLO portfolios.
How to deal with this potential onslaught? Some are preparing to swing for the fences: Bloomberg reports that Z Capital Credit Partners has issued two CLOs which can invest up to half of their assets in triple-C-rated loans.
Not QE Progress Report
The Fed’s portfolio of securities held outright registered at $3.624 trillion this week, up $14 billion sequentially and $46 billion from the recent lows registered on Sept 25.
Recap Oct. 31
Stocks forestalled a spooky outcome, as a rebound off early lows left the S&P 500 only marginally weaker. Yet terrifying signs of risk aversion were visible elsewhere, with Treasury yields diving across the board to leave the two- and 10-year yields at 1.51% and 1.68%, respectively. WTI crude fell back to $54 a barrel, while gold jumped to a five-week high of $1,512 an ounce. The VIX rose 7% to finish back above 13.
- Philip Grant
Tuesday, October 29, 2019
Ring that bell
The call came through. Yesterday, AT&T, Inc. (T on the NYSE) unveiled a series of strategic initiatives in response to prodding from activist investor Elliott Management Corp. As part of the agreement, AT&T announced that it will add a pair of new board members, separate the chairman and CEO roles upon the retirement of CEO Randall Stephenson along with “a full review of the [company’s] portfolio and no more major acquisitions.”
Management reiterated its vow to trim leverage yesterday by pledging to reduce T’s net debt load to 2 to 2.25 times Ebitda by 2022, from 2.5 times at year-end 2019, and to undertake a stock buyback. The company also projected earnings per share of $4.50 to $4.80 in 2022, compared to a sell-side consensus of $3.57 for full-year 2019.
Elliott nodded its assent and the stock market concurred, as T shares rallied 4% yesterday to extend their year-to-date gains to 34%, compared to a 23% rise in the S&P 500 Communications Index. Even with that rally, valuations appear comparatively undemanding with enterprise value equal to just under eight times forward Ebitda, compared to 10.6 times EV to Ebitda for the relevant index.
That relatively cheap valuation can largely be attributed to the company’s attempts to diversify through acquisition, which included the purchase of DirecTV in 2015 and Time Warner Media, Inc., two years later, at 19% and 39% premiums to their respective pre-deal prices. The combined $176 billion price tag helped push AT&T’s net debt load to a whopping $192 billion (those figures exclude pension and post-retirement liabilities), making it the most encumbered nonfinancial company in the world on an absolute basis.
From a hindsight-aided perch, it’s hard to evaluate those deals in much of a positive light. The Street pencils in $182 billion in revenues and $60 billion in Ebitda for 2020, which would represent compound annual growth rates of less than 3% and 4%, respectively, from year end 2016. Those attempts to diversify through acquisition likewise earned the mockery of John Legere, CEO of rival T-Mobile U.S., Inc., who posted the following image on Twitter yesterday:
In the third quarter results released yesterday, Ma Bell disclosed that the entertainment group (which includes DirecTV) suffered a 21.6% annualized loss in premium video subscribers in the quarter, while revenues at the WarnerMedia segment (nèe Time Warner) fell 4.4% from a year ago. In light of those results, research firm MoffettNathanson LLC asks:
Will investors buy the story that a high fixed-cost business like AT&T is going to spin declining revenues into higher Ebitda and higher free cash flow? Year after year for the next three years?
Though triple-B-rated AT&T has attempted to mollify both creditors and shareholders through management’s planned share buybacks and debt paydowns, bond investors might be justified in viewing yesterday’s announcement with some skepticism. Research firm CreditSights explains:
While the 2022 net leverage target implies further deleveraging over the next three years, we believe actual net debt reduction will be modest at below $5 billion per annum. In addition, we believe that deleveraging progress will be back-end-weighted since: (1) management has signaled that share buybacks will be front-loaded and (2) Ebitda will be broadly flat in 2020.
We believe that AT&T’s absolute debt position is more of an issue for the credit than net leverage, and unfortunately the company’s new financial guidance and capital allocation implies only modest improvement on this metric.
Free cash flow after dividends is forecast at $14 billion to $15 billion per annum. Coupled with the capital allocation policy of applying 50% to 70% of excess FCF for share buybacks, which management indicated is likely to be front-loaded, this leaves only $5 billion to $7 billion remaining for annual net debt reduction. We view the early prioritization of shareholder returns as particularly problematic given our aforementioned skepticism with regard to AT&T’s ability to deliver on its Ebitda growth target.
Since a bearish analysis of AT&T’s long-dated debt in the Jan. 25 edition of Grant’s Interest Rate Observer, the company’s 4.5%, senior unsecured 2048 bonds have seen their spread over Treasurys narrow by 46 basis points, compared to 35 basis points in tightening for Bloomberg’s triple-B-rated 30-year corporate bond index. That January analysis contains a prospectively attractive pair trade for those who continue to believe that AT&T’s debt is vulnerable to significant downside.
Recap Oct. 29
Stocks cruised sideways as the S&P 500 digested yesterday’s move to fresh closing highs, while Treasurys likewise finished little changed as the two- and 10-year yields settled at 1.64% and 1.83%, respectively. Crude oil and gold both ticked a bit lower, and the VIX held at just over 13.
- Philip Grant
Monday, October 28, 2019
Care bears
Put it on the tab. On Friday, the Treasury Department announced that the fiscal budget deficit clocked in at $984 billion for the year ended Sept. 30, up 26% from the year ago level as a 4% rise in receipts was dwarfed by an 8.2% jump in outlays. Federal debt held by the public currently stands at $16.9 trillion, or 79% of trailing 12-month seasonally-adjusted gross domestic product as of June 30. That’s up from 77.5% a year ago and 65.9% of GDP at year-end 2011.
Things could have been worse, as the White House’s Office of Management and Budget had forecast a $1.085 trillion shortfall for the year in its July 2018 Mid-Session Review. Nevertheless, this marks the fourth consecutive year of expanding government deficits, the longest such stretch since the 1980 to 1983 era. Tax policy aside, that period was marked by a pair of recessions along with punishing inflation and unemployment (year-over-year change in CPI and unemployment averaged 8.9% and 8.4% over that period). In contrast, this epoch features the longest economic expansion on record, a 1.7% rise in the September consumer price index and a 3.5% rate of joblessness.
At 4.6% of gross domestic product, the current deficit stands as “the largest outside of a war, recession or the first few years following a recession” in U.S. history, according to Bianco Research. Yet the government’s increasing profligacy has largely faded from the public eye, as a January study from Pew Research Center found that 48% of respondents cited deficit reduction as a top priority for Congress, down from 72% in 2013.
That newfound comfort from Joe and Jane Six Pack is shared in the halls of power. At his confirmation hearing in January 2017, Mick Mulvaney, Director of the Office of Management and Budget, had this to say:
I believe, as a matter of principle, that the debt is a problem which must be addressed, sooner, rather than later. I also know that fundamental changes are needed in the way Washington spends and taxes if we truly want a healthy economy. This must include changing our government’s long-term fiscal path – which is unsustainable.
My commitment to you today is to take a fact-based approach to get our financial house in order.
Less than three years later, the facts have evidently taken Mulvaney in another direction. Asked why President Trump included no mention of the deficit during his State of the Union Address in February, he replied: “Nobody cares.”
It’s not just the populace at large and the politically opportunistic which have adopted the Dick Cheney mantra that “deficits don’t matter.” Writing in Bloomberg Opinion today, retired economics professor Karl Smith asserted that, despite the “usual hand-wringing” over the government’s financial state, “the deficit is reducing the risk of an economic crisis, not increasing it.” Smith explains: “Cutting the deficit would slow economic growth and make a recession more likely.”
John Williams, president of the Federal Reserve Bank of New York, evidently concurs with that line of reasoning. In a post-speech Q&A last week paraphrased by Bloomberg, Williams argued that “it’s important to have fiscal policy helping [to] support the economy in a downturn.”
With the government’s checkbook leaking red ink during good times (at least as measured by the CPI, unemployment rate and price level of the S&P 500), we can expect more where that came from when the cyclical tide turns. Thus, the average recession over the last 50 years has added fiscal deficits on the order of 4% of GDP, as contracting business activity crimps tax receipts while counter-cyclical policies attempt to prop up the economy.
The question: Might the unprecedented, late cycle state of government finances help set the stage for the end of the long-running bond bull market and/or the “nobody cares” doctrine? Of the persistently sluggish rise in measured prices since the financial crisis, Fed chair Jerome Powell remarked in March: “It is a major challenge. It’s one of the major challenges of our time.”
Taking note of Powell’s sentiment and Uncle Sam’s deteriorating balance sheet, the May 3 edition of Grant’s Interest Rate Observer speculated on the future course of inflation through historical analogy:
The eternal cause of inflation is the loss of confidence in money, the very thing the central bankers now say they want to bring about. The fundamental cause of that loss of faith is a persistent excess of aggregate demand over aggregate supply, with credit, not savings, financing the inflationary increment of spending. That condition, too, would seem to be in place, given the prospect of a $1 trillion federal deficit during a more-than-satisfactory business expansion.
If the measured rate of inflation continues to fall short of expectations, it wouldn’t be the first time. “The deficits in the last three years, while believed to have spurred the economy, have clearly not been inflationary,” The New York Times reported at the close of the 1964 fiscal year. “The wholesale price index is the same as it was six years ago.” For the calendar year, the CPI would rise by just 1.3%. (We leave for another day a discussion of the differences in computing that index then and now.) In 1964, too, it seemed that inflation had gone to heaven.
Spoiler alert: It hadn’t.
Recap Oct. 28
Stocks finally broke through, with the S&P maintaining early gains throughout the day to finish at a new high, up 21.25% year-to-date. Treasurys continued their recent selloff, with the 10-year yield rising to a six-week high at 1.84%, while both WTI crude and gold came for sale, falling below $56 a barrel and $1,500 an ounce respectively. Despite the bullish stock action, the VIX was bid all day, finishing at its highs above 13.
- Philip Grant
Friday, October 25, 2019
The Snapper
Many happy returns, sort of. Last week, Snap-on, Inc. (SNA on the NYSE) reported third quarter results that included the 43rd consecutive “beat” of the consensus earnings per share estimate. In reaction, shares have levitated by 6% over the last six trading days to climb back into the green with a 4% gain since a June 3, 2016 bearish analysis in Grant’s Interest Rate Observer. By comparison, the S&P 500 is up by 43% over that period.
Founded in 1920, Snap-on sells high-end tools and diagnostic equipment for automobile repair and heavy industrial uses. The company utilizes an extensive network of franchisees, who deliver door-to-door service to customers and bear their own credit risk, eating up to 25% of the loss when a loan goes bad.
While revenue growth has crept higher, profitability has advanced at a relatively brisk pace. Thus, third quarter sales stood at $902 million, representing a 2.3% compound annual growth rate from the $806 million top line five years ago. Earnings growth continues to lap that of the top line, as adjusted net income of $165 million is up from $104 million in the third quarter of 2014. So, a 9.7% compound annual growth rate over the last five years.
With sales flattish, margin expansion is a key cog in the bull story. Net income margins reached 16.9% in the 12 months ended Sept. 28, up from 14.8% in 2017. The Street, which is largely cautious on the name with five “buys”, five “holds” and two “sells” according to Bloomberg, expects more of the same, penciling in an 18.3% margin for 2020.
Financial services play a crucial role. Snap-on Credit, the company’s in-house finance subsidiary, kicked in $61 million in operating earnings on $84 million in revenue for the quarter. That compares to $38 million and $54 million, respectively in the third quarter of 2014, for compound annual growth rates of 9.4% and 9.9%, respectively.
The corporate balance sheet is clean, as net debt of $1.1 billion represents less than the consensus $1.06 billion in adjusted Ebitda for calendar 2019, while operating income of $952 million over the last 12 months covers the $48 million in interest expense 20 times over. But A2/single-A-minus-rated Snap-on’s credit profile contrasts sharply with that of its customer base. As noted by CFO Aldo Pagliari on last week’s conference call, yields on contract receivables (i.e., direct to franchisee loans) stood at 9.2% in the third quarter, while finance receivables were 17.7%.
As those, uh, robust interest rates suggest, the typical Snap-on franchisee is not in the most advantageous financial position. Likewise, a less-than harmonious dynamic is documented in the form of numerous complaints against the company on the parody website “crap-on.com.”
A trio of developments in the third quarter results suggest potential further deterioration in operating conditions. Franchisees and customers are taking longer to pay, with long-term contract receivables days outstanding rising to 83 from 79 a year ago and long-term financial receivable days outstanding climbing to 257, from 248 days a year ago. Bill Whiteside, senior vice president at forensic research firm Behind the Numbers, LLC, tells Grant’s by email today that: “We think this trend is magnified by the fact that the sales mix has shifted more towards smaller ticket items (a concern in itself). If the mix was shifting more towards big ticket diagnostics items one might expect a bigger percentage to be financed.”
At the same time, loan originations waned to $254 million in the third quarter, 5.1% from a year-ago. That slowdown in new credit correlates with an inventory buildup in excess of sales growth, with total inventories rising to $754 million from $707 million a year ago, up 6.7%.
Asked about the inventory build on the conference call, Snap-on CEO Nicholas T. Pinchuk explained it as: “Primarily to support higher levels of demand across critical industries, including demand for U.S. manufactured hand tools.” For their part, the analysts at Behind the Numbers “view the inventory increase with skepticism” and note that “if the company must idle production to stem the increase, it will put pressure on future margins.”
Meanwhile, the cyclical backdrop appears to be darkening, as a recent analysis from Moody’s Investors Service finds that auto loan delinquencies across both prime and subprime credits are at their highest levels since 2011. As noted by Bloomberg today, subprime auto lender Santander Consumer USA Holdings, Inc., has been forced to buy back an increasing number of loans after they went bad “within months of being made.”
In tandem with that uptick in slow-payers, the market for used vehicles (which help underpin new purchases through trade-ins) continues to soften, with the Labor Department reporting a 1.6% decline in prices in September, the worst reading in one year. For more on the problems and potential opportunities in the auto market, see the Oct. 18 edition of Grant’s.
While the stock has treaded water for years, short-sellers have circled, as short interest currently stands at more than 14%, compared to 3.8% in June 2016. One cohort that seems to see the bear case is Snap-on management: Over the last nine months, the C-suite has disposed of more than 160,000 shares on the open market with nary a purchase, cashing out some $25.5 million. CEO Pinchuk has set the tone by personally disposing of 73,000 shares to net himself $11.3 million.
Recap Oct. 25
A third straight rally in stocks pushed the S&P 500 to the cusp of new highs, while interest rates rose across the board with the 10-year yield finishing at 1.8% for the first time in five weeks. Gold and WTI crude both managed green closes, finishing at $57 a barrel and $1,505 an ounce, respectively, and the VIX dropped below 13.
- Philip Grant
Thursday, October 24, 2019
Protest chic
From Bloomberg:
If anyone needed further evidence of Hong Kong’s sky-high real estate prices they found it this week with news that a car parking spot sold for almost $1 million.
The space went for HK$7.6 million ($970,000), making it the most expensive place to park an automobile in the city, and perhaps anywhere in the world.
Front row seats rarely come cheap.
When doves fly
A perfect score. This morning, the European Central Bank conducted the final policy meeting of the Mario Draghi epoch, leaving the deposit rate at negative 50 basis points to wrap up Draghi’s eight-year term with a total of eight rate cuts and zero hikes.
During the press conference, Draghi issued a vote of confidence in his successor Christine Lagarde, stating that she “needs no advice” from him on the job. Instead of proffering guidance, Draghi promised that rates won’t rise from their subterranean lair until inflation “robustly converges” with the central bank’s almost 2% goal. Draghi and Lagarde might be waiting for some time: September CPI rose 0.8% year-over-year across the eurozone, the lowest since November 2016.
As the ECB steers dovish monetary policy to a reductio ad absurdum, Europe’s banking industry continues to flounder. The Financial Times reported Tuesday that “bank executives in Europe are depressed, despondent and concerned.” Commerzbank A.G., Germany’s second largest lender (and recent owner of various newly-public Unicorns as noted in Tuesday’s Almost Daily Grant’s), last month announced it would shoot for a 4% return on equity “over the medium term,” down from an 8% target in place since 2016 but up from the 3.1% RoE logged in 2018. The shares trade for just under 25% of June 30 book value.
While banks in the eurozone contend with a negative interest rate policy which grinds towards a sixth anniversary next May, the Nords look to pull the plug. Today, Sweden’s Riksbank said it will “probably” raise rates back to zero in December, ending its own four-and-a-half year experiment with paying borrowers to borrow. In a press conference, Riksbank governor Stefan Ingves said that negative interest rates have served as an effective policy, but that the central bank is “aware that many people think they are strange.”
In Japan, where negative overnight rates have been in force for three and a half years, bank efforts to keep the lights on have entailed a walk on the wild side. Thus, the Bank of Japan today released its semiannual financial system report, which found that area banks have bulked up holdings of collateralized loan obligations (those securitized collections of leveraged loans, i.e. floating-rate bank debt from speculative-grade issuers) to ¥12.7 trillion ($117 billion) in the year ended March 31, up 80% from a year ago.
Then there’s the U.S. As the Fed gingerly cuts, the President took to Twitter once more this morning:
The Federal Reserve is derelict in its duties if it doesn’t lower the Rate and even, ideally, stimulate. Take a look around the World at our competitors. Germany and others are actually GETTING PAID to borrow money. Fed was way too fast to raise, and way too slow to cut!
While Trump looks at Europe and Japan with envy, domestic bankers bring a different perspective. At an FT conference today, Morgan Stanley CFO Jon Pruzan said: “The negative-rate experiment, if you will, around the world, has effectively not worked. So we’re hoping we’re not going to mimic a policy that hasn’t worked.” Christiana Riley, head of U.S. operations at Deutsche Bank A.G., went into full supplication mode: “Speaking from the eye of the storm in Europe, I can only echo [him]. Please don’t do this, don’t do it. It defies all logic.”
Trump’s hoped-for arrival of NIRP onto U.S. shores may not be imminent, but next week should bring us one step closer. Interest rate futures currently price 91% odds of a 25 basis point rate cut from the current 1.75% to 2% range for the funds rate at next Wednesday’s Fed meeting. That’s up from 58% odds of a cut one month ago.
Recap Oct. 24
Stocks hovered slightly higher, leaving the S&P 500 up by 80 basis points for the week so far to close within 50 basis points of its July 26 highs. A stronger dollar didn’t prevent gold and WTI crude from rallying back above $1,500 an ounce and $56 a barrel, respectively, while a modest rally in the two-year note left the Treasury curve at its steepest since July 30. The VIX fell back below 14.
- Philip Grant
Tuesday, October 22, 2019
He said it
Facebook CEO Mark Zuckerberg
Facebook CEO Mark Zuckerberg
The bold and the beautiful
Back to the drawing board.
Back to the drawing board.
Just wing it
Just how dire is The We Co.'s financial state following the pulled IPO?
Just how dire is The We Co.'s financial state following the pulled IPO?
Recap Oct. 22
He said it
Facebook CEO Mark Zuckerberg, ahead of congressional testimony tomorrow to advocate for his Libra digital currency project:
The financial industry is stagnant and there is no digital financial architecture to support the innovation we need.
Surely, Zuckerberg does not forget the ATM.
The bold and the beautiful
Back to the drawing board. A report yesterday from consultants McKinsey & Co. finds that more than half of the world’s banks may not be economically viable in a downturn, as returns on equity already lag increases in the cost of capital. “We believe we’re in the late economic cycle and banks need to make bold moves now because they are not in great shape,” Kausik Rajgopal, a senior partner at McKinsey, told Bloomberg. “In the late cycle, nobody can afford to rest on their laurels.”
Germany’s Commerzbank A.G., which trades at less than 25% of its June 30 book value and generated a 3.1% return on equity last year, has taken that advice to heart. Barron’s reported yesterday that Germany’s second-largest bank “loaded up” on shares in a number of money-losing Unicorns in the third quarter, including Uber Technologies, Inc., Lyft, Inc., Slack, Inc. and Beyond Meat, Inc.
Further bold moves might be needed. Since the close of trading on July 1, Uber, Lyft, Slack and Beyond Meat shares are down 25%, 42%, 27% and 29%, respectively.
Just wing it
How dire is The We Co.’s financial state following the pulled IPO? The Wall Street Journal reported yesterday:
[We] is planning to cut thousands of employees, but delayed the layoffs earlier this month because it couldn’t afford the severance costs, people familiar with the matter have said.
Though the WeWork parent company can’t pay its bills, ousted former CEO Adam Neumann still has an ace in the hole in the form of benefactor SoftBank Group Corp., which already owns 30% of the company and is poised to inject an additional $8 billion (in the form a $5 billion loan and $3 billion in shares purchased from We staff) into the floundering enterprise. The Journal provides further details today:
[SoftBank] is to buy nearly $1 billion of stock in [We Co.] from Mr. Neumann, who was forced out as chief executive after pushback from prospective investors scuttled the IPO.
The Japanese conglomerate will also extend him roughly $500 million in credit to help repay a loan facility of the same amount led by JPMorgan, and also pay Mr. Neumann a $185 million consulting fee.
While SoftBank averages down on We, investors in SoftBank’s majority-owned Sprint Corp. continue to hope that the telecom operator’s prospective merger with T-Mobile U.S., Inc. will beat back a legal challenge from a coalition of state attorneys general. SoftBank, which spent more than $20 billion to acquire its 84% stake in Sprint, would risk its investment going belly-up if the deal were scuttled (Almost Daily Grant’s, March 29).
Yesterday, the Colorado AG backed out of the lawsuit after Dish Network Corp., which is slated to buy divested assets from the pair, agreed to locate its new headquarters in the state. That follows a similar defection from the Missouri AG in October after T-Mobile committed to build out its 5G network across most of the state within three years of the deal closing.
The AG lawsuit is now the final roadblock to the merger being consummated, after the Federal Communications Commission formally announced its approval last week. Yet, according to Democrat FCC commissioner Jessica Rosenworcel, the Republican-led agency’s process was less than rigorous:
Three of my colleagues agreed to this transaction months ago without having any legal, engineering or economic analysis from the agency before us.
Former FCC lawyer Gigi Sohn likewise asserted:
The FCC majority prejudged the merits of this merger two months before the Justice Department found the combination of T-Mobile and Sprint to be anticompetitive and required the creation of a new fourth competitor to pass legal muster. Despite this radical change in the merger, Chairman Pai has refused to put the new arrangement out for public comment.
You win some, you lose some.
Recap Oct. 22
A strong two-year note auction this afternoon helped spur a bid in the Treasury complex, with the two- and 10-year yields dropping below 1.6% and 1.76%, respectively. A late selloff in stocks sent the S&P 500 back below the 3,000 mark and the VIX back above 14. WTI crude rallied to north of $54 a barrel, and gold settled at $1,488 an ounce.
- Philip Grant
Monday, October 21, 2019
Peg leg
Look out below. On Friday, China announced that third quarter GDP expanded by an annualized pace of 6%, the slowest self-reported growth rate in 27 years. The slowdown coincides with a burst of inflation, with CPI rising by 3% year-over-year in September led by a 69% surge in pork prices.
Signs of weakness in China’s all-important housing market compound those dual pressures. Home prices across 70 major cities rose 8.4% from a year ago in the so-called Golden September peak season, down from 8.8% in August and the slowest growth rate in 12 months. In addition, Bloomberg notes that 28 of those 70 cities saw house price declines on the secondary market (which is subject to less government interference), the highest ratio in more than three years. Then, too, property sales by floor area, a leading demand indicator, saw annualized growth of just 2.9% in September, down from 4.7% in August.
With demand potentially on the wane, Raymond Cheng, property analyst at CGS-CIMB Securities Ltd., relays that property developers are offering discounts of 5% to 10% in order to spur sales. The debt-saddled sector, which is facing more than $80 billion in maturities by June 2020 according to Bloomberg, is turning to American investors for fresh capital.
Last week, B2-rated, Shenzen-based developer Kaisa Group Holdings Ltd. issued $400 million in three year senior secured notes priced to yield 12.25%. Edward Lau, Kaisa’s chief financial officer, told The Wall Street Journal that “American investors are becoming more aware that they can’t ignore us anymore because of our big issue sizes and the low-yield environment.” That may be so, but Kaisa was forced to pay a premium for funding relative to a similar three-year note which priced in April at 11.25%. Additionally, in April, B2-rated developer China Evergrande Group sold senior secured dollar bonds maturing in 2024 at a 10.5% coupon. Those notes have since fallen to 92.6, for a yield-to-worst of 12.69%.
Those super-sized interest rates underscore a growing solvency problem across China’s corporate sector. Thus, Bloomberg reported Friday that 45 companies have defaulted on their debt in the year-to-date, already exceeding last year’s record of 40 defaults (total defaulted payments foot to RMB 102.9 billion, compared to last year’s record of RMB 122 billion). There’s more where that came from according to Huang Weiping, analyst at Industrial Securities: “There will be more defaults in the fourth quarter compared to the previous three quarters.”
China’s debt problem is daunting relative both to its own economy and that of the rest of the world. Total banking assets footed to $41 trillion as of June 30, compared $13.6 trillion in nominal GDP last year. That compares to $17.6 trillion in U.S. commercial banking assets, and nominal output of $20.5 trillion last year.
With growth on the wane and a daunting debt burden, might the powers-that-be ride to the rescue with another round of economic stimulus? Comments from Yi Gang, governor of the People’s Bank of China, suggest that such help may not be forthcoming. In a letter to the International Monetary Fund steering committee last week, Gang noted: “When introducing further stimulus, countries need to pay due attention to potential negative effects,” and for China in particular, “maintaining a stabilized leverage ratio” is a primary current goal, according to Gang.
While growth is gradually slowing on the mainland, activity is hitting a wall in China’s special administrative zone. Real output growth for Hong Kong is now expected to drop at just 0.3% 2019, if the economists are to be believed (down from 1.2% last year and 3.5% in 2017), while inflation is heating up to the tune of a 3.5% jump in August CPI relative to last year.
Hong Kong 2019 GDP growth estimate. Source: The Bloomberg
Those unwelcome developments have had no ill effect on the Hong Kong dollar, which has firmly maintained its peg to the U.S. greenback within the 7.75 to 7.85 range targeted by the Hong Kong Monetary Authority. Mitul Kotecha, senior emerging markets strategists at Toronto-Dominion Securities, told Bloomberg on Oct. 10 that the worst may be over for the HKD: “If the peg hasn’t come under pressure after this many weeks, is it going to come under pressure any time soon?”
Yet there are signs that capital is beginning to migrate elsewhere, which, in tandem with rising inflation and slowing growth, may make the HKMA’s U.S. dollar peg more difficult to maintain. Net hedge fund redemptions in Hong Kong topped $1 billion in the third quarter, according to Eurekahedge Pte., the largest such withdrawal in 10 years. Then, too, the Financial Times reported Thursday that European banks have seen “a sharp increase in Hong Kong customers opening overseas accounts,” while “an executive at a Singaporean bank with operations in Hong Kong said more accounts have been opened in the last three months than ever before.”
What opportunities might an acceleration of capital flight provide the thoughtful investor? The May 31 edition of Grant’s Interest Rate Observer has some ideas.
Recap Oct. 21
Another rally in stocks pushed the S&P 500 back above the 3,000 mark and within about 50 basis points of its July 26 high water mark. Treasury yields pushed higher across the curve, with the 10-year finishing above 1.8% for the first time in more than a month, while, conversely, three-month Libor fell to 1.95%, its lowest since March 2018. Gold and oil both finished moderately lower, and the VIX fell to 14.
- Philip Grant
Friday, October 18, 2019
Today in hedging
Here's Mario Draghi,
Here's Mario Draghi,
Manifest destiny
Into the wild frontier.
Into the wild frontier.
Recap Oct. 18
Today in hedging
Here’s Mario Draghi, with less than two weeks remaining in his term as ECB president:
There are mild signs of overstretched valuations in the euro area in some riskier segments of the financial markets, as well as in real estate markets, with marked differences across regions.
Better cut rates again to be safe.
Manifest destiny
Into the wild frontier. The Financial Times reports today that Fidelity Investments, Inc. “is now engaged in a full rollout” of custodial and trade execution services for cryptocurrencies. CEO Abigail Johnson, who told the FT that the asset management firm began adding clients in the first quarter, said of the digital asset class: “It’s not going away. As long as the value is there, people will look to preserve that value.”
As traditional institutions join the crypto party, a pair of upstarts battle for market share in the futures trading market. Today, the Binance crypto exchange announced it will allow traders to apply up to 125 times leverage on their holdings of digital ducats, topping competitor BitMEX, which currently allows a staid 100 times leverage on futures.
Binance, which told reporters Monday that its bitcoin futures product has already exceeded spot trading volumes just one month after introduction, has earned the ire of its Seychelles-based rival. On Sept. 4, the BitMEX Twitter account offered a sarcastic congratulations to Binance for the roll-out, adding: “Glad to see you enjoyed reading our documentation as much as we enjoyed writing it!”
While the nascent exchanges battle it out for dominion in crypto futures, another criticism of bitcoin’s utility enters the fold. Last week, the Bank for International Settlements released a report from the G7 Working Group on so-called stablecoins (those pegged to the value of other assets), that described the functional drawbacks of current digital currencies.
The first wave of crypto assets, of which bitcoin is the best known, have so far failed to provide a reliable and attractive means of payment or store of value. They have suffered from highly volatile prices, limits to scalability, complicated user interfaces and issues in governance and regulation, among other challenges. Thus, cryptoassets have served more as a highly speculative asset class for certain investors and those engaged in illicit activities rather than as a means to make payments.
Despite its practical shortcomings, bitcoin remains the world’s most valuable crypto by far, with a $144 billion total valuation, compared to $18 billion for the next-largest crypto, ethereum. However, that ubiquity does not translate into turnover. The purportedly dollar-backed tether (USDT) stablecoin, with a mere $4 billion “market cap”, has seen year-to-date average daily trading volumes of $20.8 billion through Sept. 27, easily eclipsing $17.3 billion for bitcoin.
Tethers’ prolific trading profile is likely attributable to the stablecoin’s usage by crypto exchanges as a workaround for the know-your-customer and anti-money-laundering laws which apply to the banking system. “I don’t think people actually trust tether – I think people use tether without realizing that they are using it, and instead think they have actual dollars in a bank account somewhere,” Thaddeus Dryja, research scientist at the Massachusetts Institute of Technology, told Bloomberg.
Tether has carved out a prominent place in the crypto food-chain, but the courts lurk as a potential apex predator. Recall that in April, New York Attorney General Letitia James accused iFinex, Inc., which operates both Tether and the Bitfinex exchange, of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds.” Last week, a class-action lawsuit targeting iFinex contained even more incendiary accusations. From the complaint:
This action concerns a sophisticated scheme that co-opted a disruptive innovation — cryptocurrency — and used it to defraud investors, manipulate markets, and conceal illicit proceeds.
Part-fraud, part-pump-and-dump, and part-money laundering, the scheme was primarily accomplished through two enterprises — Bitfinex and Tether — that commingled their corporate identities and customer funds while concealing their extensive cooperation in a way that enabled them to manipulate the cryptocurrency market with unprecedented effectiveness.
At the heart of this scheme was Tether’s claim “that the number of (USDT) tokens in circulation will always equate to the dollars in its bank account.” This claim enabled Bitfinex and Tether to signal to the market that there was rapidly growing demand for cryptocurrencies because each USDT printed represented another U.S. dollar invested into the market.
This claim was a lie.
Tether issued extraordinary amounts of unbacked USDT to manipulate cryptocurrency prices. Because the market believed the lie that one USDT equaled one U.S. dollar, Bitfinex and Tether had the power to, and did, manipulate the market on an unprecedented scale to profit from boom-and-bust cycles they created.
For its part, Tether “vigorously disputes the findings and conclusions claimed by that source, which relied on flawed assumptions, incomplete and cherry-picked data, and faulty methodology.”
Of course, the whole kerfuffle could have been avoided had investors simply followed the advice proffered by Tether co-founder William Quigley in a Bloomberg radio interview on Sept. 4:
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.
Recap Oct. 18
Stocks edged a bit lower, leaving the S&P 500 higher by 70 basis points for the week and about 1% below its July 26 highs. Gold and oil likewise finished just below unchanged, while a rally in short-dated Treasurys left the two- and 10-year spread at 17 basis points, the steepest since the end of July. The VIX finished above 14, rising for a third straight day after a 33% plunge in the five trading days ended Tuesday.
- Philip Grant
Thursday, October 17, 2019
Mystery train
The signal’s gone from green to yellow. The Association of American Railroads reports that domestic carloads and intermodal units registered at 510,820 in the week ended Oct. 12, down 7% from a year ago. Year-to-date, rail loads have slumped 4% from their 2018 levels, according to the AAR.
That slowdown has likewise translated into the results of industry mainstays. Thus, Union Pacific Corp. (UNP on the NYSE) this morning reported an 8% drop in overall volumes for the third quarter compared to last year. Revenues declined 7% from a year ago. UNP CEO Lance Fritz remarked on a CNBC interview today: "It feels to me like the economy is slowing, and it's slowing quite a bit."
Likewise, peer CSX Corp. (CSX on the NYSE) yesterday reported a 5% year-over-year revenue decline and 9% drop in intermodal volumes during the quarter compared to last year’s levels. That slowdown looks set to continue, as Mark Wallace, CSX executive vice president for sales, told conference call listeners that he expects “somewhat muted” activity during the traditionally strong fourth quarter: “Hopefully, people order a lot of stuff online and we have the pleasure and honor of moving a lot of that stuff.” Despite those top-line pressures, both UNP and CSX were able to deliver record low operating ratios (meaning expenses as a percent of net sales) in the quarter, spurring modest share price rallies in reaction.
Those operational achievements can be chalked up to so-called precision scheduled railroading (PSR), the managerial initiative pioneered by the late executive Hunter Harrison which emphasizes cost control and operational efficiency. As with the zero-based budgeting techniques used in other industries, cost gets whittled down to the bone, and investors reap the benefits.
Indeed, they have: Operating income margins within the S&P Rails Index reached 37.5% as of June 30, up from 31.7% five years earlier. That enhanced profitability has left Mr. Market duly impressed, as the index has doubled in the past five years while valuations have likewise grown richer (see the below chart). Meanwhile, the PSR regime continues apace, as a coalition of eight industry operators filed a federal lawsuit last week to force unions to negotiate over potentially trimming their crews to a single operator, from a current two per train.
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S&P Rails Index, EV to trailing Ebitda ratio; five-year chart. Source: The Bloomberg
Yet the bounties brought by the PSR concept have their limitations. An in-depth analysis of the railroad industry in the July 12 edition of Grant’s Interest Rate Observer quoted Matt Rose, former CEO of Burlington Northern Santa Fe, discussing the strategy’s inherent limitations in a December 2018 interview with Railway Age:
“[T]he easiest way to reduce operating ratio is to take out track and reduce maintenance expenses,” said Rose. But that’s hardly the deal that the industry implicitly struck with the government and the public, he observed, in the run-up to the landmark 1980 deregulation. “The Staggers Act wasn’t, ‘Railroads, haul only what you want to haul on your network,’” Rose went on. “It’s ‘Haul everything, and you have the ability and the flexibility to differentially price on your network.’ That’s the deal, and it’s in the public’s best interest to move more tons to the railroad network, not to move tons off the railroad network.”
To that end, federal regulators are scrutinizing one of the lynchpins of PSR: Railroads’ growing use of demurrage (late) fees against shippers in order to keep trains on schedule, not to mention raise additional revenues for themselves. On Oct. 7, The Surface Transportation Board released a proposed policy statement, offering new regulations requiring railroads to provide additional information on demurrage levies as well as a new rule to close loopholes which have exempted demurrage regulations on various commodities transported via boxcar. Randy Gordon, president and CEO of the National Grain and Feed Association (NFGA), minced no words over what PSR hath wrought in a May 23 press release:
We believe that in far too many cases, current demurrage and accessorial charges and practices are egregious and merely exemplify the market power of today's Class I railroads, reflecting their ability to unilaterally impose one-sided terms and conditions on their customers.
Frankly, NGFA members in some segments of our industry believe they are at a 'tipping point' in their relationship with Class I rail carriers because of these and other practices, particularly with the increased adoption of the so-called precision scheduled railroad operating model.
Indeed, the prospective abatement of a multi-year tailwind from the PSG initiatives, in tandem with premium valuations and the prospect of a cyclical economic downturn present a potentially potent bearish cocktail for the rail industry. For more, including a quartet of picks-to-not-click, see the July 12 edition of Grant’s.
Recap Oct. 17
Stocks cruised sideways for a second straight day, as the S&P 500 continues to mark time just below its high-water mark reached in late July. Treasury yields ticked higher across the curve, leaving the two- and 10-year yields at 1.60% and 1.76%, respectively. WTI crude rallied back to $54 a barrel, while gold held at $1,492 an ounce. The VIX remained below 14.
- Philip Grant
Tuesday, October 15, 2019
Is it safe?
The hits keep coming. Last week’s rolling power outages in California will be added to utility PG&E Corp.’s (PCG on the NYSE) already-substantial tab, if governor Gavin Newsom has his way. Yesterday, Newsom asked the company to provide each affected household with $100 and each small business with $250 in compensation in the form of a rebate or bill credit for the power loss, which occurred for more than 48 hours in parts of Northern California.
"It's decisions that were not made that have led to this moment in PG&E’s history and the state of California as it relates to our major investor-owned utility,” Newsom said. “It is not conditions. This is not, from my perspective, a climate change story as much as a story about greed and mismanagement."
With residents in the dark last week and politicians affixing a metaphorical bulls-eye on the company, PCG did itself no favors. On Thursday, the San Francisco Chronicle reported that 10 to 12 staff members, including the head of the gas division, held a wine tasting event for clients at the Silver Oak Winery in Napa on Monday and Tuesday (which also marked the two-year anniversary of the Camp Fire, California’s deadliest blaze). Bill Johnson, CEO of the company, subsequently apologized for the “insensitive, inappropriate [and] tone-deaf” decision to hold the event.
While the company continues to earn itself few friends, a bigger problem lurks for PCG in the form of $30 billion or so in liabilities related to the 2017 wildfires, according to a deposition from CFO Jason Wells in January. That compares to $10.6 billion in book equity as of June 30.
Last week, Judge Dennis Montali of U.S. Federal Bankruptcy Court in San Francisco issued an order ending the company’s exclusive control of its reorganization. Instead, creditors including Elliott Management will be permitted to offer their own plan in competition with one advocated by the company and shareholders ahead of a June 2020 deadline to exit bankruptcy.
Now allowed to go forward, the bondholder plan involves a recapitalization allowing creditors to take control of the company and effectively wipe out existing shareholders, who instead advocate for a mix of fresh debt and equity issuance to pay the wildfire claims.
The court’s decision spurred some unusual gloom from the sell-side, as analysts from Citigroup handicapped 75% odds of the stock going to zero on Thursday, after Judge Montali made his ruling: “[The] bond holder group now has [a] higher opportunity to win.” Shares fell 29% in reaction to the ruling and are down 59% since a bearish verdict in the Feb. 22 edition of Grant’s Interest Rate Observer.
That Feb. 22 analysis highlighted the legal and regulatory gauntlet that PCG (then sporting a $9.2 billion market cap despite being in the throes of chapter 11) faced in exiting bankruptcy with shareholder equity still intact, noting that wildfire claims of even $10 billion would impair the equity. Deputy editor Evan Lorenz added:
If climate change is making California more fire-prone and inverse condemnation [a statute holding utilities responsible for fire caused by their equipment, regardless of actual fault] remains the law of the state, there is a question of whether PG&E can, in fact, exit court protection. Before a judge can approve a bankruptcy exit plan, the plan must be feasible.
While PCG is subject to unique weather and legal factors related to its California domicile, this episode lays bare the problems inherent in the utilities industry; traditionally considered one of the “safest” segments of the stock market but one whose members consistently fail to cover property, plant and equipment spending with internal cash flow.
From the start of 2013 to June 30 of this year, PCG generated $30.8 billion in cash from operations, well below the $39.5 billion in capital expenditures incurred over that period. Yet the company paid out $4.4 billion in dividends from 2013 to 2017 before ceasing the practice following the fires. For the S&P Utilities Sector as a whole, operating cash has covered capex in only seven of the past 20 years, and only once (in 2003) did free cash flow exceed dividend distributions. Yet the group currently trades at more than 21 times earnings, compared to a 20-year average of just 15.5 times.
The Feb. 22 Grant’s put it this way: “Safety is inherent in no investment.”
Recap Oct. 15
A strong rally in stocks pushed the S&P 500 higher by 1% to leave the broad index just another 1% from its high-water mark reached in late July. Interest rates likewise rose, as the curve continues to steepen with the 10-year yield now 15 basis points above the two-year, the most since Aug. 1. Gold and WTI crude were both hammered, finishing at $1,481 an ounce and $53 a barrel, respectively, and the VIX was clubbed again to finish at 13.5, its lowest since July 29.
- Philip Grant
Monday, October 14, 2019
Disrupted
A real headline, from RealClearMarkets:
A real headline, from RealClearMarkets:
Porous the spider
Last one out, turn off the lights?
Last one out, turn off the lights?
Recap Oct. 14
Disrupted
A real headline, from RealClearMarkets:
Elizabeth Holmes Is a Visionary, and We Need More Like Her
Masa Son, are you listening?
Porous the spider
Last one out, turn off the lights? Fall has thus far been unkind to leveraged loans (floating rate, tradable bank debt issued by speculative-grade corporate borrowers), as the S&P/LSTA Leveraged Loan Index fell to 95.4 on Thursday, its lowest close since Jan. 7. That waning performance coincides with a $710 million outflow from loan mutual funds in the in the week ended Oct. 9, Lipper reports. That’s the largest in two months and brings the year-to-date withdrawal to $30.6 billion.
Perhaps the most concerning feature in the loan market is the increasing frequency of issues trading at a substantial discount to par. As noted in the below chart from Morgan Stanley, the ratio of credits within collateralized loan obligations (loans which have been packaged and securitized) trading below 90 has risen to a three-year high, well above levels seen in the December 2018 sell-off:
A broad economic slowdown (as evidenced by multiyear lows in both the manufacturing and services surveys conducted by the Institute for Supply Management) and relatively low energy prices account for some of the distress, while idiosyncratic risks also appear. Yesterday, the Financial Times reported on the public outcry over “surprise billing” in the health-care industry (when outsourced, frequently p.e.-backed providers levy hefty out-of-network expenses on unsuspecting patients), with a Stanford University study finding that such surprise billings reached 43% of emergency room visits in 2016, up from roughly 33% in 2010.
The practice has attracted the attention of Congress: KKR & Co. and Blackstone Group, Inc., owners of physician staffing companies Envision Healthcare Corp. and TeamHealth, Inc., respectively, were asked to provide “detailed information about every healthcare company they have ever owned” and attended a closed-door heading with legislators on Oct. 7. With their business models under scrutiny and revenue prospects increasingly in question, Envision and TeamHealth term loans due 2025 and 2024 fell below 81 and 80, respectively, down from 97 and 94 in early May. The pair, which are each leveraged at more than eight times trailing Ebitda according to Moody’s, have issued a combined $8.1 billion in term loans. That equals nearly 1% of total domestic leveraged loans outstanding.
As performance sags and red flags flutter, loan investors face another pitfall in the ongoing erosion of legal protections known as loan covenants. On Thursday, Bloomberg reported that a consortium of more than a dozen fund managers led by Blackstone’s GSO Capital Partners are working with underwriters “to propose new industry standards.” Among other changes, the buy-siders want more time to review the often highly complex loan covenants than the one to two days that are currently the standard.
Some industry practitioners believe change is long overdue. As, Sabrina Fox, executive advisor at the European Leveraged Finance Association, noted on Twitter:
At a certain point we need to ask ourselves what sort of market we have when investors - most of whom are not lawyers - are tasked with finding (literally hidden) risk amongst hundreds of pages of legalese with - in some cases - less than 24 hours to do so.
Of course, issuers find the status quo to be just fine. Bloomberg noted Friday that while GSO leads the charge for more time to review the fine print, another Blackstone entity is providing would-be lenders with less than 48 hours to review documents pertaining to its multibillion dollar buyout of Merlin Entertainments plc. A bit more time might be helpful: CreditSights deems the deal’s “highly porous covenant package” to be among the laxest the firm has ever seen. Maybe Blackstone can speak to Blackstone about it.
Recap Oct. 14
With the bond market closed for Columbus Day, stocks cruised sideways to leave the S&P 500 higher by 18.3% year-to-date. WTI crude fell back below $54 a barrel after climbing to a two-week high Friday, while gold rose slightly to $1,492 an ounce. The VIX sank more than 6% to 14.6, its lowest since Sept. 19.
- Philip Grant
Friday, October 11, 2019
Space force
From Bloomberg
From Bloomberg
Dine and dash
The struggles continue for the restaurant industry,
The struggles continue for the restaurant industry,
Recap Oct. 11
Space force
From Bloomberg:
Fisher Investments plans to start a diversity and inclusion task force in the wake of Ken Fisher’s vulgar comments at a conference this week, the firm’s chief executive said in a letter to employees Friday.
#Youtoo?
Dine and dash
The struggles continue for the restaurant industry, as analytics firm TDn2K reports that third quarter comparable sales fell 0.4% from a year ago. That’s the worst quarterly showing in two years, yet TDn2K expects that “sluggish sales will likely continue through the fourth quarter.” Traffic likewise continues its precipitous slide, falling 3.5% from the third quarter last year.
Adding to industry woe, dwindling sales coincide with cost pressures. Employee turnover remains at “historically high levels,” as industry staffing levels remain “a huge concern and is expected to continue,” per TDn2K. Carrol’s Restaurant Group, Inc. (TAST on the Nasdaq), which is the largest franchisee of Burger King restaurants, reported 5.2% year-over-year wage growth in the second quarter; that compares to a 1.7% average rise in the headline CPI through 2019.
The dual pressures on revenue and cost have spurred dubious strategic responses from a number of operators. As described in the Sept. 18 edition of the Restaurant Finance Monitor:
Many have raised prices, reduced portion size and spent millions of dollars on technology to cut employee hours and sell meals off-premises.
“That’s not a great strategy,” says Tim McCarthy, a former marketing agency founder and now 35-unit Raising Cane’s franchisee. “If I cheapen my product and service, charge more, and push sales to a lower margin channel (delivery) I don’t control, how does that help me?”
Yet Mr. Market has bestowed a premium valuation to the group, as the Russell 3000 Restaurants Index currently fetches an enterprise value of 17.5 times consensus 2019 Ebitda. That compares to a 12.2 times EV-to-Ebitda ratio for the S&P 500. A primary pretext for that rich valuation: The now ubiquitous asset-lite business model, in which the brands sell stores to franchisees and clip a percentage of their sales, without bearing the brunt of the current less-than-stellar operating environment (Almost Daily Grant’s, April 30).
Of course, some operators fare better than others. This morning, Wendy’s, Inc. (WEN on the Nasdaq) reported perky 4.4% same-store sales growth in the third quarter, the fastest pace since 2013. With growth easily outpacing the industry norm, the company plows full-speed ahead on delivery, announcing the planned rollout of a pair of “dark kitchens,” or delivery-only facilities with no dine-in option, by the end of the year, according to management commentary at today’s investor day. In addition, single-B-rated Wendy’s, which carries $3.3 billion in net debt (nearly eight times consensus 2019 adjusted Ebitda), is seeing brisk turnover among its franchisees, with 50% of Wendy’s 6,719 restaurants changing hands since 2013.
That eye-catching instability underscores a grim operating environment for franchisees. As noted in a Tuesday column by Jonathan Maze of Restaurant Business Online, heavy borrowing exacerbates those woes, with a pair of operators (Capital Restaurant Group, LLC and RMH Franchise Holdings, Inc.) filing for bankruptcy protection in the past year and another duo (NPC International Holdings, Inc. and Diversified Restaurant Holdings, Inc.) seeing their debt trade to distressed levels in recent months.
The Street is taking notice. An Oct. 4 report from Bernstein Research delved into the leverage buildup and associated distress currently faced by franchise industry operators:
Signs of economic stress have materialized just as the largest restaurant companies have completed their transformation into asset light, highly levered businesses; investors are increasingly worried about the risk of “piling leverage onto leverage.”
As the post-crisis economic expansion reaches month 124, the analysts note a data set which could prove relevant in the next downturn:
The Small Business Administration operates loan programs that aim to support small companies by offering guarantees to commercial bank[s] which in turn provide lower rates and better terms. Among 7(a) loans (general purpose business activities) the default rate for loans originated since 2010 is a negligible 1.3%, but for loans originated in the prior decade it is 17.2%. For 504 loans (financing for commercial real estate or equipment) the default rate for loans from 2010 on is 1.1%, but for 2000 to 2009 loans it is 20.3%.
For an in-depth industry analysis, along with updates on a trio of picks-to-not-click, see the Sept. 20 edition of Grant’s Interest Rate Observer.
Recap Oct. 11
A “phase one” trade deal between the U.S. and China helped gas the stock market higher, as the S&P 500 rose more than 1% to finish in positive territory for the week. Treasury yields jumped across the curve, with the three-month vs. 10-year spread “un-inverting” for the first time since late July. WTI crude rallied back near $55 a barrel, while gold slipped to $1,487 an ounce. The VIX dropped to 15.5.
- Philip Grant
Thursday, October 10, 2019
The King's Speech
A job opening, on LinkedIn (spotted by our friend Jim Bianco):
Who says the Fed doesn’t create jobs?
P.O. Box
It’s a gusher. The long-awaited public debut of the Saudi Arabian Oil Co. (a.k.a. Aramco) is almost a reality, as Bloomberg reports today that the state-owned behemoth is “finally going ahead” with a plan to float 2% of the company. If everything goes smoothly, Aramco will raise $40 billion, valuing the company at $2 trillion, though The Wall Street Journal reports this morning that advisors indicate a $1.5 trillion price tag “is more realistic.”
That IPO comes with hurdles both fundamental and idiosyncratic. Aramco’s long-term production capability is questionable, as the prospectus indicated relatively advanced depletion at Saudi’s Ghawar oil field, the world’s largest (Almost Daily Grant’s, April 11), and it’s fair to say that the deal comes with some unusual features. The shares will be only be listed on the Saudi’s domestic Tadawul exchange, as opposed to a global financial center such as London or New York. Then, too, the offering will be heavily marketed to domestic investors, with banks “encouraged” to lend freely to facilitate share purchases. As for the larger players, Bloomberg puts it this way:
The kingdom’s richest families, including some who had members held in Riyadh’s Ritz-Carlton Hotel during Prince Mohammed’s crackdown on corruption in 2017, have been invited to become anchor shareholders. It’s an offer they may find hard to refuse.
As Aramco works toward its long-awaited debut, the state of the U.S. IPO market could be described as less-than stellar. Since July 26, the Renaissance Capital IPO Index is down 15%, compared to a 3% drop in the S&P 500. “IPO buyers are going on strike,” Kathleen Smith, principal at Renaissance Capital, told the New York Post on Sept. 30. “We’re projecting that it’s going to be a pretty slow end of the year.”
Several high-profile names have endured particularly rocky debuts, with SmileDirectClub, Inc. shares falling 28% on its first day of trading, the worst opening since 2008. Ride-share competitors Uber Technologies, Inc. and Lyft, Inc., have seen their stock prices fall 36% and 48%, respectively, since bowing this spring, while The We Company famously pulled its offering after reportedly failing to generate sufficient demand at a $10 billion valuation. That compares to a $47 billion, SoftBank Group Corp.-led funding round just nine months ago.
Then there’s Peloton Interactive, Inc., which has absorbed a 20% stock-price drop since its Sept. 25 listing. On Tuesday, Peloton sued competitor Echelon Fitness LLC over its “cheap, copycat products” which imitate “the Peloton Bike experience.” Peleton, which sells exercise bicycles for $2,245 and describes itself as “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” in its form S-1, posted a $203 million operating loss in the 12-months ended June 30. That compares to a $48 million loss the year prior.
Cycling in a sea of red ink, Peloton is no outlier. According to Jay R. Ritter, the Joseph B. Cordell Eminent Scholar Chair at the University of Florida, 80% of IPO’s last year sported negative earnings per share, trailing only the year 2000 for the highest ratio of money losers in the last 28 years. That threshold has crossed 60% only eight times during that period, but in every year since 2013.
Echoes with the late-90’s tech bubble extend beyond just the aggregate data. Speaking on CNBC Monday, former Nasdaq CEO Robert Greifeld observed that the IPO market “remind[s] me back of the dot-com era, when you had companies going public that had no known path to profitability.” Of We Co. in particular, Greifeld remarked: “[It is] in some ways a parody of some of the hubris you see in the start-ups.”
Recap Oct. 10
A solid rally in stocks marked the sixth time in the last seven trading days in which the S&P 500 moved more than 50 basis points. Treasurys were hammered, with the 10-year yield rising to 1.67% to nearly exceed the three-month bill yield for the first time late July, though this afternoon’s 30-year auction priced at an all-time low yield of 2.17%. WTI crude rallied 2% to approach $54 a barrel, while gold fell nearly 1% to $1,494 an ounce. The VIX sank below 18.
- Philip Grant
Wednesday, October 9, 2019
ADG 10/9: How to train your Draghi
A new frontier in "whatever it takes."
A new frontier in "whatever it takes."
Recap Oct. 9
ADG 10/9: How to train your Draghi
A new frontier in “whatever it takes.” This morning, the Republic of Greece sold €487.5 million ($535 million) in 13-week bills at a yield of negative 0.02%. Greece likewise placed €1.5 billion in notes maturing March 2029 at 1.5%, the issue attracting more than €5.4 billion in orders, according to Bloomberg. By comparison, the three-month and 10-year U.S. Treasurys yield 1.65% and 1.59%, respectively.
That’s single-B-plus-rated Greece, which was, of course, bailed out by the eurozone member states and the International Monetary Fund three times since 2010. Despite recent signs of improvement, including nine straight quarters of positive year-over-year GDP growth and a budget deficit trimmed to 1.1% of 2018 output, Greece carries government debt equal to roughly 180% of 2018 GDP, easily the highest in the euro area (Italy is next at about 134%).
It’s the latest eye-watering development on the Old Continent. Recall that as a parting “gift” ahead of his Oct. 31 departure, ECB president Mario Draghi slashed the benchmark deposit rate by 10 basis points to negative 50 basis points and reintroduced €20 billion per month in asset purchases on Sept. 12. The ECB’s balance sheet currently stands at €4.7 trillion, or 38% of last year’s eurozone GDP. That compares to $3.95 trillion and 19%, respectively, for the Federal Reserve.
Needless to say, subterranean interest rates demonstrate both the Pavlovian response to the ECB’s actions, as well as a lack of concern over an inflationary awakening (eurozone CPI grew 1% year-over-year in August). Richard Barnwell, head of macro research at BNP Paribas Asset Management, summed up the peculiar zeitgeist: “The bond market is adamant [that] it needs stimulus, but equally adamant that it doesn’t work.”
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The modern central bankers’ motto
As the ECB prepares for changes at the top, the central bank’s second-in-command suggests that policy has reached the amber zone. In an interview with Market News International released this morning, vice president Luis de Guindos remarked that “although we can reduce interest rates further, the side effects of monetary easing are becoming more and more evident and more and more tangible.” However, the No. 2 dismissed the possibility of an unwind: “A policy U-turn is something I would discard. And it would not be good anyway.”
One constituency increasingly eager to see such a 180 is Euro-area banks. In early September, Deutsche Bank A.G. CEO Christian Sewing warned of potential “grave side effects” arising from ECB policy, asserting that “in the long run, negative rates ruin the financial system.” Oswald Grüebel, who helmed Credit Suisse A.G. from 2004 to 2007, then UBS Group A.G. from 2009 to 2011, was even more blunt: “negative rates are crazy.” For his part, Draghi told reporters in Frankfurt on Sept. 12 that banks should worry more about their cost structure and adapting to new technology rather “than being angry about negative rates.”
Establishment criticism of the ECB now extends beyond the for-profit banking sector. Speaking on Sept. 13 of implications for the pension fund industry, Dutch finance minister Wopke Hoekstra said that the latest rate cut carries potentially “huge consequences for a lot of things that we think are important in the Netherlands.” Even the Bank for International Settlements, known as the central bankers’ own swiss bank, questioned the other pillar of the ECB’s strategy Monday, arguing in a report that the sharp post-2008 growth in central bank balance sheets “could result in market malfunctioning when large central bank balance sheets are eventually unwound.”
Might intensifying political backlash imperil the ECB policy stance as newcomer Lagarde gets her feet wet? Today, Unicredit SpA, Italy’s largest bank by assets, announced it will pass negative rates on to clients, charging them for depositing their funds at the institution. Denmark’s Spar Nord Bank A/S, announced last week it would apply a 0.75% levy on deposits exceeding DKR 750,000 ($110,000), while Berliner Volksbank eG, Germany’s second-largest cooperative lender, is now charging 0.5% on deposits of €100,000 and above. On Sept. 25, Deutsche Bank CFO James von Moltke suggested DBK will be “robust” about passing along negative rates, perhaps in the form of additional fees.
While the creep of negative rates into Europe at large will win the ECB few new friends, the ECB’s asset purchase program could be derailed by the courts. At the end of July Germany’s Karlsruhe constitutional court conducted a hearing over the legality of QE, as the Eurozone treaty expressly forbids member state governments from directly buying sovereign debt. On Tuesday, a coalition of German academics initiated a fresh legal challenge against the practice.
Reuters, which reported the action, assesses the litigants’ likelihood of success as “low.” Then again, it’s not less-than zero.
Recap Oct. 9
Stocks caught a bid with the S&P 500 rising nearly 1% to erase the bulk of yesterday’s losses. Volatility has returned to the stage, as the broad index has now moved up or down more than 50 basis points in five of the past six trading sessions.
Elsewhere, gold and oil both held steady, while the VIX fell back below 19. Treasury yields rose across the board, though this afternoon’s 10-year note auction priced at its lowest yield since August 2016 (a month after the 10-year reached its all-time low of 1.37%).
- Philip Grant
Tuesday, October 8, 2019
QT, we hardly knew yee
This afternoon,
This afternoon,
The dreadful wind and rain
A major snowstorm
A major snowstorm
Recap Oct. 8
QT, we hardly knew yee
This afternoon, Fed chair Jerome Powell announced his intention to once again expand the central bank’s balance sheet. Just don’t call it QE:
I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed afterthe financial crisis.
New branding is clearly required. Perhaps, the open market operation formerly known as QE?
The dreadful wind and rain
A major snowstorm looks set to descend on the northern plains later this week. The Weather Channel reports this morning:
By Friday, strong low pressure will wrap up near the border of Minnesota and western Ontario, with wind-driven snow in the Dakotas, parts of Minnesota, possibly as far south as Iowa and Nebraska.
This combination of snow and wind could linger into Saturday from parts of the Dakotas into Minnesota, northern Wisconsin and Michigan’s upper peninsula.
The prospect of an early-fall frost and potential snowstorm is not a pleasant one for the farm sector, which has been beset by terrible weather as well as the Sino-American trade dispute.
Severe flooding across much of the Midwest this spring prevented the timely planting of agricultural crops. On August 29, the Illinois congressional delegation (including two senators and 18 members of congress) sent a letter to President Trump requesting federal assistance for 33 counties which endured a five month deluge through July, “the longest flood event to ever occur in Illinois.” The delegation reported that “the economic impact on the region as a result of businesses and residences being damaged is severe.”
The federal government believes things are pretty much hunky-dory. According to projections from the U.S. Department of Agriculture in late August, 2019 farm income is expected at $88 billion, up from $84 billion a year ago and the highest since 2014. Yet an analysis from the American Farm Bureau Federation disputes that claim, noting that key indicators such as cash rents on the I-State corridor (including Iowa, Indiana and Illinois) are down 11.5% with Minnesota off 12%, respectively, over the last five years. In addition, distress among the farming industry is on the rise, with the delinquency rate (loans more than 30 days past due) for commercial real-estate loans in agriculture rising to 2.5% in the first quarter of this year, up from 2.1% in the prior period (that 2.1% figure is also the long-term average).
As the plight of farmers worsen, a handful of publicly-traded businesses leveraged to the industry sport potentially significant downside risk. For bearish analysis on a trio of related companies, see the June 28 edition of Grant’s Interest Rate Observer.
But might those same dire conditions set the stage for an upside surprise in the price of agricultural commodities? The USDA’s latest crop report for the week ended Sept. 29 showed the proportion of corn acres harvested at 15%, down sharply from a 33% yield at this time last year, while soybeans stood at 14% harvested from 31% a year ago. Mature corn stocks stood at 43% compared to 92% a year ago, while 72% of the soybean crop was dropping leaves (an indicator of maturity), down from 90% last year.
Even if the forecasted October snowstorm does not materialize, an incoming cold front looks certain to inflict still more damage on crop yields. As one anonymity-seeking investor tells Grant’s, the math involving growing degree unit days (GDU is an air temperature-based metric for calculating the ability for crops to develop) looks particularly daunting as fall proceeds:
Most farmers are telling me they need another 100 to 180 more GD units. From Sept. 17 to Sept. 30, southwest Minnesota only accumulated 165 GDU total over those 14 days, and much of September was on the warm side.
There is just no way they’ll get another 100+ GDU in October. They could be lucky to get many GDU at all with this incoming cold front, and then, eventually it freezes (perhaps in the next two weeks?) and that will be that.
So, regardless of the number of bushels—the weight of those bushels will be ‘light’ (a bushel can be as low at 40 pounds and as high as 70+ pounds). Light corn has a lower carb count and lower protein count, so, lower value to ethanol users and animal feed.
Arlan Suderman, chief commodities economist at INTL FCStone, expressed similar sentiments on Twitter today:
This week's winter storm looks to be one for the history books, and virtually all the crops are still in the field. Very strong winds, Arctic air and heavy snow is not a good combination.
We typically say that temperatures must be below 28°F for two hours or more to kill a crop, but what about 30 - 31 degree with 40 mph winds for 24 hours? That would pull the heat out of the crop canopy and do a lot of damage as well.
Meanwhile, even after solid rallies today, the near-contract prices of corn ($3.96 a bushel) and soybeans ($9.21 a bushel) remain below their respective five-year averages. Agricultural commodity watchers won’t have to wait long for more information: The USDA releases its monthly WASDE crop inventory report on Thursday.
Recap Oct. 8
Stocks were hammered with the S&P 500 falling more than 1.5%, as the broad index now sits more than 4% below its July 26 high-water mark. Treasurys were bid across the curve, with the 10-year yield settling at 1.53%, 16 basis points above the record low reached in July 2016. WTI crude fell back to just over $52 a barrel, while gold advanced back to $1,504 an ounce. The VIX jumped above 20.
- Philip Grant
Monday, October 7, 2019
He said it
Here’s President Trump today, on Twitter:
As I have stated strongly before, and just to reiterate, if Turkey does anything that I, in my great and unmatched wisdom, consider to be off limits, I will totally destroy and obliterate the Economy of Turkey (I’ve done before!).
Bullish for the lira?
Put it on the tab
This morning, General Electric Co. (GE on the NYSE) announced it is freezing pension benefits for some 20,000 employees and will pre-fund $4 billion to $5 billion of its projected retirement funding for 2021 and 2022. Triple-B-plus-rated GE, which closed its pension plan to new entrants in 2012, expects those two moves to slash its projected funding shortfall by up to $8 billion. That’s roughly one-third of the company’s $22.4 billion in underfunded liabilities as of year-end 2018, the largest shortfall of any company in the Russell 1000 Index.
While GE takes drastic steps to shore up its balance sheet, the head of one of Europe’s largest pension managers expressed alarm over the state of affairs on the Old Continent. Henrik Munck, senior consultant at Insurance and Pension Denmark, told Bloomberg yesterday that “a negative spiral” could arise from the ongoing evaporation of bond yields and associated rise in liabilities faced by managers under the European Insurance and Occupational Pensions Authority (which constructs a formula used by pension managers to track their obligations).
Denmark’s 10-year sovereign yield currently stands (if that’s the word) at negative 56 basis points, while the Euro interest-rate swap curve, which Bloomberg describes as “the backbone” of the EIOPA’s calculation, has likewise collapsed in recent years (the 30-year swap currently stands at 0.24%, compared to 1.91% five years ago) as the European Central Bank has pushed the deposit rate deeper into negative territory.
The Financial Times relays that Peter Spiller, founder and principal at CG Asset Management, told attendees at a conference last week that in order to generate an inflation-adjusted £1 for retirement in 2068 through investing in gilts (British government bonds), investors must cough up £2.60 today. The U.K sovereign 3.5% notes due 2068 trade at a price-to-yield of 0.84%.
Higher interest rates in the U.S. make the pension situation only a little less daunting here. The April 5 edition of Grant’s noted the calculus offered up by Brian Slone, of Dayton, Ohio, a 13-year mem¬ber of the Millwright Local 1090 and participant in the Southwest Ohio Carpenters Pension Fund, to the Congressional Joint Select Committee on Solvency of Multiemployer Pension Plans last summer:
Someone who worked for 30 years and retired in 2000 would have contributed $85,000 over his career and received a monthly benefit of $3,130, said Slone. A younger participant who retired in 2016 would have contributed $153,000 and received a monthly benefit of $2,210 per month. And the still younger participant who retires in 2030 will have contributed $290,000 while standing to receive a monthly benefit of only $1,640.
That grim math augurs no good things for pension contributors, managers, or, (eventually) the credit of Uncle Sam. On July 24, the House of Representatives passed the so-called Butch Lewis Act, which would create a new subdivision of the Treasury Department to issue fresh debt to cover the shortfalls of insolvent multi-employer pension plans. According to the Congressional Budget Office, the legislation would tack on an additional $92 billion to the federal budget deficit over the next 10 years.
While the bill has languished in the Senate since being introduced by Sherrod Brown (D-OH) on July 25, the legislation boasts a powerful backer. On Friday, Sen. Elizabeth Warren (D-MA) declared in a statement that she “will push to pass the Butch Lewis Act to create a loan program for the most financially depressed pension plans in the country.” Warren appears to be the clear frontrunner for the Democratic presidential nomination, with her contracts trading at 51 cents on the political betting site PredictIt this afternoon, compared to 22 cents for Joe Biden and nine cents each for Hillary Clinton and Bernie Sanders.
While the implementation of Butch Lewis is no sure thing, widespread insolvency across pensions would almost certainly yield a federal response. The Jan. 26, 2018 edition of Grant’s put it this way:
Probably in no election year is actuarial science a better vote-getter than the stories of low and middle-income people who worked their whole lives for a pension (never very much even at 100 cents on the promised dollar), which financial and business circumstances are now placing on the chopping block.
As surely as Citibank got its bailout, the candidates’ pitch may go, so the retired truck drivers, construction workers and retail clerks must get theirs. And the retired firefighters and cops? Are they to be denied when their turn comes? Only one level of government has a central bank. And not by coincidence, it’s the same level of government that boasts seemingly unlimited borrowing power.
Pension crisis solved?
Recap Oct. 7
Stocks traded lower with the S&P 500 losing about 50 basis points, while Treasurys gave back a portion of recent gains with the two- and 10-year yields settling at 1.47% and 1.56%, respectively. WTI edged higher for a second straight session to $53 a barrel following eight consecutive red finishes, while gold fell to $1,491 an ounce. The VIX settled just below 18.
Interbank borrowing costs continue to fall, as three-month Libor was set below 2.03% today. That compares to more than 2.8% in late December.
- Philip Grant
Friday, October 4, 2019
Now is the winter of our streaming content
Amazon, Inc. and Walt Disney Co. are feuding over terms which the former would carry the latter’s
Amazon, Inc. and Walt Disney Co. are feuding over terms which the former would carry the latter’s
Discovery channel
The renewed bloodletting in the energy patch has seen West Texas Intermediate crude
The renewed bloodletting in the energy patch has seen West Texas Intermediate crude
Now is the winter of our streaming content
Amazon, Inc. and Walt Disney Co. are feuding over terms which the former would carry the latter’s apps on its Amazon Fire TV device (the second-largest streaming media device in the U.S., says The Wall Street Journal. There is currently no deal in place for Fire to carry the hotly anticipated Disney+ streaming-video service, which is expected to launch on Nov. 12.
Disney is likewise turning the screws on the streaming incumbent. Today, The Journal relays that the house of Mickey Mouse is refusing advertisements from Netflix, Inc. across its entertainment TV networks. Disney had initially blocked all rival streaming services from buying ad space but reversed that for all would-be competitors besides Netflix. WarnerMedia’s HBO MAX platform (a souped-up version of HBO Go) looms as still another competitor, though a dispatch from Bloomberg today details the extensive management attrition which has befallen the division following its takeover by AT&T, Inc.
The onset of intense competition is a daunting prospect for Netflix, which lost 126,000 paid U.S. subscribers in the second quarter, surprising analysts who had collectively penciled in 352,000 domestic additions. Netflix, which burned $3 billion in cash over the 12 months ended June 30, needs to respond with substantial price cuts, according to Needham Securities analyst Laura Martin (to as low as $6 a month from the current range of $9 to $16), to avert an estimated 5 million to 10 million in 2020 U.S. subscriber losses.
While NFLX shares are down 28% from early July, the company’s senior unsecured 4 7/8 notes due 2027 remain above par, priced at 102 cents on the dollar for a 314 basis point pick-up over Treasurys (that compares to 256 basis points at issuance). The Jan. 26, 2018 edition of Grant’s distilled the particularly unappealing calculus faced by creditors of double-B-minus-rated Netflix:
It’s a speculative business, the content business, but if it works, you, the creditors, will get your money back. The stockholders will get rich. Everybody’s happy.
Discovery channel
The renewed bloodletting in the energy patch has seen West Texas Intermediate crude fall for eight straight sessions through Thursday, reaching a two-month low. The rally following the September 15 attack on Saudi refining facilities has now been more than completely erased, with oil bulls beset with bad news on both the supply and demand fronts.
The World Trade Organization cut its forecast for trade growth in 2019 and 2020 on Tuesday, while the Institute for Supply Management’s September manufacturing index fell to its lowest level since the end of the financial crisis. One day later, the Energy Information Agency reported a 3.1 million barrel supply build, double the expected increase of 1.57 million.
While prices (for now at least) remain well above the sub-$30 nadir seen in the long winter of 2016, domestic operators are preparing for the worst. Bloomberg reports today that activity around the crucial Permian Basin in West Texas and New Mexico has slowed to a near-standstill, with drilling activity down 19% year-to-date. Hotel revenue-per-available-room in the Permian Basin has dwindled 21% from a year ago, compared to a 1.1% rise for the U.S. overall, according to STR, Inc. Jan Freitag, senior vice president at STR, told Bloomberg that double-digit changes in occupancy are “very, very rare. . . Normally, you get that when something like a hurricane hits.”
With energy down in the dumps, long-term help may be on the way for the bulls. A report from IHS Markit this week finds that conventional oil and gas discoveries during the last three years have plunged to a 70-year low. Keith King, senior advisor at IHS Markit, cited one key factor: “The shift of investment by U.S. independents from international exploration to shale opportunities in the United States – shorter cycle-time projects – with greater flexibility to respond to changing market conditions.”
Low prices; the cure for low prices.
- Philip Grant
Thursday, October 3, 2019
Reach and pull
As bond yields the world over continue to hug the ground, issuers reach for the sky.
As bond yields the world over continue to hug the ground, issuers reach for the sky.
Recap Oct. 3
Reach and pull
As bond yields the world over continue to hug the ground, issuers reach for the sky. Bloomberg reported on Tuesday that global corporate bond sales totaled $308 billion in September, marking the first time that new issuance topped $300 billion in a month. Corporate issuance has been particularly brisk in Europe, one of the epicenters of the negative-interest rate phenomenon. Following a record €94 billion in September supply, investment-grade European companies have placed €580 billion ($638 billion) year-to-date, setting a full-year record with three months left.
Needless to say, this vanishing interest-rate epoch has been less kind to lenders, particularly pension funds which are chasing increasingly daunting annual return targets. On Sept. 30, Pensions and Investments reported that only three of the 120 public plans tracked by the National Association of State Retirement Administrators assume an 8% annual return. That compares to 59 funds with such a hurdle in 2010. In the 12 months ended February 2019, 42 plans, or one-third of the NASRA database, trimmed their return assumptions. That helped push the median return assumption to 7.25%, down from 8% nine years earlier. Then again, who's earning 7.25%?
The paucity of available returns has predictably pushed these fiduciaries farther out the risk curve. “Because of low interest rates, we have to cast our net far and wide to search for returns,” Thijs Knaap, senior strategist at APG Asset Management, told Bloomberg.
Private equity has been all too happy to step into the void. Analytics firm eVestment finds that private equity accounted for 27% of U.S. and U.K. pension fund allocations in 2018, up from 25% a year prior. According to a projection by PricewaterhouseCoopers, pension assets allocated to “alternative investments” (including p.e. as well as property and infrastructure funds) will reach $21 trillion by 2025, up from $10 trillion in 2016, representing an 8.6% compound annual growth rate.
As the cyclical winds blow p.e.’s way, the industry doesn’t forget to reward itself. Thus, Bloomberg reported yesterday that an upcoming €210 million offering from unrated Greek phone operator WIND Hellas Telecommunications S.A. (at a mid-4% coupon) features some interesting language in the prospectus. Namely, use of proceeds include “potentially the financing of shareholder liquidity,” i.e. paying a dividend to the companies’ owners, GoldenTree Asset Management, LP and Cyrus Capital Partners, LP with those borrowed funds.
Indeed, the quality of leveraged loans, or tradable bank debt of the speculative-grade companies frequently owned by p.e. operators, is on the wane. As noted by S&P’s LCD unit today, the proportion of loans rated double-b-minus or higher has slumped to well below 40% from roughly 45% four years earlier. Over the same period, single-B or lower-rated debt now constitutes nearly 20% of the market from just over 10% in September 2015.
A July 22 academic study quantifies the risks that investors face when lending to p.e.-controlled enterprises. Brian Ayash and Mahdi Rastad of California Polytechnic University put it this way:
Tracking a sample of 484 public to private LBOs for 10 years after going private, we find a bankruptcy rate of approximately 20%, an order of magnitude greater than the 2% bankruptcy rate for the control sample.
What might explain that dramatic disparity? A Sept. 19 report from S&P Global Ratings suggests a key factor: A widespread exaggeration of earnings power. The analysis zeros in on so-called Ebitda add-backs, or cost savings that are projected to be achieved at some future date:
Our review of a large sample of merger and acquisition (M&A) and leveraged buyout (LBO) transactions that originated between 2015 and 2018 show that, overall, add-backs inflated marketing Ebitda by an average of 28% and represented 49% of reported Ebitda at deal inception.
As Ebitda (already a flattering measure) is further nipped and tucked through hypothetical cost savings, debt loads are far more burdensome than they appear.
Our data indicate that management projections at deal inception were aggressive, showing that, on average, actual reported net leverage was 3.1 turns higher than forecast for 2017 and 3.3 turns in 2018.
Overestimated earnings were the primary contributor to the leverage disparity, with reported Ebitda 35% below marketing Ebitda for both 2017 and 2018.
Meanwhile, the advisors call for an expansion in risk appetite. A February paper from Cambridge Associates concludes that “Investors may want to consider an allocation of greater than 15% to private investments. . . Families with multigenerational wealth may be particularly well positioned to consider allocating 40% or more of their assets to private investments.” More recently, a report from the government-backed British Business Bank recommended eliminating a fee cap to help allow pensioners to invest in early stage start-ups, to reap the potential for “significantly” higher returns.
After all, what better way to achieve higher returns than through paying higher fees?
Recap Oct. 3
Stocks enjoyed a solid snap-back, with the S&P 500 reversing early losses to finish higher by nearly 1% to recoup a portion of the 3% tumble over the first two days of the quarter. Treasurys enjoyed another blistering rally in bull-steepening fashion, as the two- and 10-year yields settled at 1.39% and 1.54%, respectively. WTI crude fell for an 8th straight day to finish near $52 a barrel, while gold ticked slightly higher to $1,505 an ounce. The VIX settled just above 19.
- Philip Grant
Tuesday, October 1, 2019
Utah, get me two
Tandem bicycle
Change is in the air at PMI, the trading division of
Change is in the air at PMI, the trading division of
Recap Oct. 1
Utah, get me two
From USA TODAY:
A walking beer vendor was arrested Sunday at Hard Rock Stadium in Miami for charging a fan $724 for two beers. According to a Miami-Dade Police Department affidavit obtained by USA TODAY Sports, 33-year-old vendor Nathaniel Collier used a Square reader separate from the system used by stadium company Rocket Man to temporarily get away with the scam.
That rogue vendor might have had better luck at Yankee Stadium.
Tandem bicycle
Change is in the air at PMI, the trading division of debt-saddled oil behemoth Petróleos Mexicanos (Pemex). On Friday, Pemex named Ulises Hernandez, formerly the head of resources, reserves and partnerships at the company, to head the Pemex trading division and replace 20-year veteran Víctor Briones, along with a series of other senior-level shuffles.
Speaking of the management shake-up yesterday, populist Mexican president Andrés Manuel López Obrador (AMLO) emphasized that PMI must “stay close to the government, that it is not so distant, so loose.” Of the trading unit, AMLO declared “it is a company of the nation.”
The fates of Mexico’s sovereign finances and that of Pemex are indeed increasingly intertwined. On Sept. 11, the Mexican government announced a $5 billion cash infusion into Pemex, following a $4.4 billion cash and tax break package disclosed in Mexico’s fiscal 2020 budget on Sept. 8. A day later, Pemex managed to borrow $7.5 billion to refinance a portion of $44 billion in of debt maturing over the next four years.
The issuer was certainly motivated. Patti McConachie, analyst at Columbia Threadneedle Investments, told the Financial Times that Pemex “came to market with a material discount relative to where bonds at the same maturity were trading. . . I read into it that they definitely wanted this deal to succeed.” Tim Jagger, head of emerging market debt at Columbia Threadneedle, described the operation as “kicking the can down the road a little more” and speculated that the extended maturity schedule could help delay a credit rating downgrade by 12 to 18 months.
It’s been a long, steady decline for Pemex. The company’s oil production stood at 1.68 million barrels per day in August, down from 1.8 mbpd a year earlier and far below the 3.4 mpbd high water mark seen in 2004. AMLO had previously targeted 1.8 mbpd by year-end, but signs of fatigue at the deepwater Ku-Maloob-Zaap (KMZ) field might augur still more ominously for the country’s future output (Almost Daily Grant’s, May 2).
That output slide is likewise taking a toll on the sovereign income statement. According to data from the Finance Ministry, oil revenue accounted for 16% of federal government income in the second quarter, down from more than 30% at the beginning of President Enrique Peña Nieto (AMLO’s predecessor) in 2012.
Then there’s the balance sheet. As production wanes, Pemex’s encumbrances remain, with the company on the hook for some $160 billion in net debt inclusive of pension liabilities, or nearly seven times Ebitda. Cumulative cash burn over the last 10 years stands at $72 billion.
While S&P rates Pemex at a safely-investment grade triple-B-plus, the other rating agencies beg to differ. Fitch cut its rating to junk in June, while Moody’s, which appraises Pemex debt at Baa3 (the lowest rung of investment grade), moved its outlook on the company to negative.
Creditors seem to have gotten the jump on the rating agencies. For instance, the company’s senior unsecured 5.35% notes due 2028 currently trade at 95.2 cents on the dollar, for a yield-to-worst of 5.97%. By comparison, double-B-minus-rated Petróleo Brasileiro S.A (Petrobras’) dollar-pay senior unsecured 2028 notes last changed hands above 111 for a yield-to-worst of 4.36%.
The key question: Might an accident at Pemex impugn the sovereign credit profile of AMLO’s government? On June 5, Moody’s revised its outlook on Mexican sovereign credit to negative from stable, noting that: “Weaker growth prospects in the coming years, combined with the prominent role assigned to Pemex in the context of the country’s new energy policy, is also raising concerns regarding the trajectory of government debt.”
As noted in a bearish analysis of Pemex and Mexican debt in the March 23, 2018 issue of Grant’s: “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.” Pemex five-year credit default swaps have subsequently risen to 314 basis points from 185 basis points, while Mexican sovereign CDS stand at 117 basis points, virtually unchanged.
Recap Oct. 1
The first day of the quarter was an inauspicious one for the bulls, as the U.S. ISM Manufacturing PMI for September registered its worst reading since June 2009, which was coincidentally the close of the Great Recession. That revelation coincided with a steep decline in stocks, as the S&P 500 fell 1.2% for its worst showing since Aug. 23.
Treasurys enjoyed a bull-steepening rally, as the two-year yield dropped to 1.54%, 10 basis points below the 10-year. Gold rose to $1,481 an ounce, while WTI crude was hammered again to finish below $54 a barrel for the first time in more than a month. The VIX jumped above 18.
- Philip Grant
Monday, September 30, 2019
Under the hood
According to research from Morgan Stanley,
According to research from Morgan Stanley,
Animalistic
Today, troubled U.K.-based closed-end investment fund Woodford Patient Capital Trust plc.
Today, troubled U.K.-based closed-end investment fund Woodford Patient Capital Trust plc.
Recap Sept. 30
Under the hood
According to research from Morgan Stanley, the proportion of loans within collateralized loan obligations (CLOs) currently trading under 90 cents on the dollar reached 8.1% at the end of August. That’s up from 6.5% a month earlier and matches the levels seen during the December 2018 selloff.
A similar deterioration has taken place in other credit cordons, with the ratio of high yield debt quoted at a 1,000 basis point premium to Treasurys jumping to 9.4% in August, the highest since November 2016 and up sharply from 6% in July. Likewise, 4.03% of loans in the S&P/LSTA Leveraged Loan Index trade below 80 cents on the dollar, up from 2.81% in July.
That increased frequency of stressed credits hasn’t translated into much at the index level. The S&P/LSTA Leveraged Loan Index currently trades at 96.3, compared to less than 94 on Dec. 27, while the ICE/BAML High Yield Index features an option adjusted spread of 399 basis points, compared to 538 basis points on Dec. 27.
Animalistic
Today, troubled U.K.-based closed-end investment fund Woodford Patient Capital Trust plc. (WPCT on the London Stock Exchange) disclosed that net asset value for the fund fell to £591 million ($727 million) as of Sept. 26, down 20% from £748 million three months earlier. It’s the latest setback for the investment vehicle, which has been beset by a liquidity crisis this year and is weighing the potential removal of founder and eponym Neil Woodford from his post.
Today, the board of WPCT said in a statement that it “continues to evaluate the position of the portfolio manager and remains in dialogue with other portfolio managers.” Said, Woodford: “I continue to believe that the majority of the businesses we have invested in are making good progress, in line with our pre-agreed milestones.” Since May, WPCT shares are down by 45%.
Similar strains have also emerged at Natixis S.A.-owned H20 Asset Management, which offers daily redemptions paired with illiquid corporate bond holdings. Following a decision by Morningstar, Inc. to suspend a rating on one of its funds in June, assets fell by more than £3 billion, or 15% of its total holdings, in three days.
A fundamental business model flaw lies at the heart of Woodford and H2O’s troubles, as the firms promise daily liquidity to investors, even while sporting investment portfolios rife with illiquid or untraded companies. That contradiction earned the derision of Bank of England Governor Mark Carney, who asserted in June that funds offering regular withdrawals while holding illiquid positions are “built on a lie.”
The conditions for that smash-up came together gradually. Woodford, declared “the U.K.’s most celebrated fund manager” by the Financial Times in 2014, instituted a 60% asset cap on “unquoted,” or illiquid, portfolio securities in 2015. One year later, the fund raised that ceiling to 80%, then in 2017 changed the designation to 80% of gross (as opposed to net) assets, perhaps reflecting an enhanced use of leverage.
The infrequent portfolio marks that come with private investing can lead to quirky outcomes. Through year-end 2018, Patient Capital reported £140.8 million in gains (both realized and unrealized) from its portfolio of unlisted companies, almost exactly offsetting £140.7 million in realized and unrealized losses from its publicly-traded book. To value its privately-held portfolio companies, Woodford generally uses its cost or the valuation from that company’s most recent funding round, but not always. The May 17 issue of Grant’s, which described WPCT as akin to a publicly-traded venture capital fund, explains:
For example, the value of Kymab Ltd., WPCT’s tenth-largest holding, a biotech startup, got a bump up to £29.4 million in 2018 from £16.9 million in 2017. “Price of recent investment/PWERM” is the rationale provided.
Studious document readers will note that the acronym stands for “probability-weighted expected return method, which considers on a probability weighted basis the future outcomes for the investment.” In other words, Kymab was “marked to model.”
Valuations and animal spirits in private markets have run unchecked for years. That can lead to painful reckonings when those high-flyers come public, as evidenced by Uber Technologies, Inc., SmileDirectClub., Inc. and Slack Technologies, Inc. Of the abrupt loss of investor confidence seen by Woodford and H20, that May 17 Grant’s put it this way:
For now, these are London’s troubles. They couldn’t happen here? Oh yes, they could.
Recap Sept. 30
Stocks caught a bid, with the S&P 500 finishing higher by 50 basis points to wrap up the third quarter with a 19% year-to-date gain and within 2% of its July 26 high-water mark. Treasurys were also stronger, with the 10-year yield falling one basis point to 1.67%, while the Dollar Index rallied again to approach the 100 level for the first time since April 2017. The rising greenback coincided with additional pain in gold and WTI crude, which fell 2% and 3% to $1,473 an ounce and $54.30 a barrel, respectively. The VIX settled just above 16.
- Philip Grant
Friday, September 27, 2019
Say it ain't so
Spotted yesterday in Gramercy by Twitter user @AlmingtonCap, former The We Company CEO Adam Neumann shows off his contrarian, individualist nature by going shoeless:
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Or the creditors got them.
One-stop shop
A flight to quality in the deep end of the credit pool? Month to date, the LCD/LSTA Leveraged Loan Index has gained 0.44%, while the triple-C-rated component of that index has lost 1.23%. On the bond side, the S&P U.S. High-Yield Corporate Bond Triple-C Total Return Index remains well below its April highs, bucking the broad trend as the Bloomberg Barclays High Yield Index reached a fresh record high on Monday.
John Cokinos, co-head of U.S. leveraged finance at RBC Capital Markets, tells Bloomberg that investors have indeed become more selective of late: “If you’re looking to finance a leveraged buyout in the wrong sector or a business vulnerable to a slowdown, that’s tougher. The loan market has limited appetite for new B3-rated [equivalent to single-B-minus] deals, and the high-yield market is pushing back on highly levered deals.”
Unsustainable leverage presents one potential explanation for the bifurcation. As the cycle drags on in what is the longest economic expansion on record, debt levels among the speculative-grade issuers continue to rise. According to recent data from CreditSights, net debt as a percentage of enterprise value among double-B-rated issuers rose to 35.9% as of the second quarter. That’s the highest of the cycle and compares to just 24.8% in the second quarter of 2014. For issuers rated between single-B-plus to triple-C, net debt reached 54.1% of enterprise value in the second quarter, up from 28.1% five years ago.
Whatever the explanation, a pair of recent deals underscore the quality divergence. Yesterday, double-B-minus-rated AMN Healthcare Services, Inc. managed to price $300 million unsecured senior notes due 2027 at a 4.625% coupon, down from initial price talk of 4.75%. AMN, which is leveraged at just under three times consensus 2019 adjusted Ebitda and has generated positive net income in each year since at least 2011, intends to use the proceeds to refinance existing debt.
On the other end of the spectrum sits newly p.e.-owned Shutterfly, Inc. On June 10, Apollo Global Management LLC announced the acquisition of the digital imaging company for $2.6 billion, a 31% premium to its share price prior to reports that Shutterfly was looking to sell itself. Single-B-rated Shutterfly, which carried three turns of leverage prior to Apollo’s leveraged buyout, posted an operating loss of $114 million in the first six months of the year, double the $57 million shortfall seen in the first two quarters of 2018. Margins are likewise on the wane, with consensus 2019 adjusted Ebitda footing to 14.8% of revenues, compared to 17.2% in 2018.
Yesterday’s offering of a series-B term loan to help finance the LBO was met with the cold shoulder from Mr. Market. The issue priced at a 600 basis point spread over Libor, which was twice widened from initial price talk of 525 basis points over. In addition, the loans were priced at 95 cents on the dollar, down from an initial 98 to 99 indicated range, with a principal amortization rate of 7% per annum, up from 5% initially. Recall that last week, Apollo was obliged to itself buy the $300 million unsecured debt tranche from the transaction, following insufficient demand from outside investors (Almost Daily Grant’s, Sept. 19).
Apollo’s Shutterfly struggles coincide with changes at the top. Yesterday, the p.e. firm announced it was shuffling its management team, with executives Matt Nord and David Sambur promoted to the dual position of co-lead partners of private equity. That co-head format is timely. One can buy a target company’s equity and the other can handle the debt.
Recap Sept. 27
A mid-day report that the White House is considering steps to limit investor flows into Chinese equities helped the bears keep control, as the S&P 500 finished the week 1% lower for its worst close since Sept. 4. Treasurys finished stronger, with the 10-year yield declining a basis point to 1.67%, while the Dollar Index remained near its highest since May 2017, pressuing WTI crude and gold which finished below $56 a barrel and $1,500 an ounce, respectively. The VIX settled just above 17.
- Philip Grant
Thursday, September 26, 2019
Dead air
The timing could hardly be worse. On Tuesday, the Federal Communications Commission issued a press release accusing Sprint Corp. (S on the NYSE) of improperly retaining government subsidies from the Lifeline low-income assistance program, instead of passing them along to 885,000 cash-strapped customers as was their obligation. In a statement, FCC chairman Ajit Pai didn’t mince words:
It’s outrageous that a company would claim millions of taxpayer dollars for doing nothing. This shows a careless disregard for program rules and American taxpayers. I have asked our Enforcement Bureau to investigate this matter to determine the full extent of the problem and to propose an appropriate remedy.
By way of explanation, a company spokesperson contended that “an error occurred” and promised that “while immaterial to Sprint’s financial results, we are committed to reimbursing federal and state governments for any subsidy payments that were collected.” Using the FCC’s reckoning of $9.25 per individual monthly subsidy, the improper payments would total approximately $98 million annually, or just under 1% of consensus adjusted Ebitda for the fiscal year ending March 31.
That assurance didn’t seem to appease Uncle Sam, as FCC commissioner Geoffrey Starks announced yesterday that this development may imperil the company’s controversial merger with T-Mobile U.S., Inc. (TMUS on the Nasdaq):
[T]his announcement directly impacts our review of the proposed merger between Sprint and T-Mobile, one of the largest wireless transactions in FCC history. Given the enormity of the apparent wrongdoing committed here, we must pause our Commission review.
How the merging parties were going to handle Lifeline was a prominent part of their merger pitch, so I am alarmed and concerned about such a massive inaccuracy in a core part of the transaction.
The FCC’s displeasure aside, chairman Pai is the only one who can delay an FCC vote, a move which “seems extremely unlikely,” an investor familiar with the situation tells Grant’s. Our source puts it this way: “If Pai and the other two Republicans [who hold a majority among the five voting members of the FCC] were willing to approve the deal prior to even drafting an order, it is unlikely that Sprint’s misconduct changes that view.” Pai circulated the draft order granting provisional approval in August, three months after indicating he would support the deal.
Yet for Sprint and T-Mobile, a bigger danger lurks in the form of a coalition of state attorneys general who have banded together in court to try to halt the deal. Last week, Pennsylvania AG Josh Shapiro announced that his office is joining the lawsuit, expanding the coalition to 18 states including New York and California. The trial is set to begin Dec. 7.
The market is expressing concern, as the discount between Sprint shares and the proposed 0.1026 exchange ratio with TMUS upon completion of the deal now stands at 31%, well above the 19% discount as of April 10, 2018, when Reuters first reported that a deal agreement was close.
Under U.S. law, plaintiffs bear the burden of proof. However, as our anonymity-seeking investor explains, applicable case law under section 7 of the Clayton Act provides plaintiffs with a so-called presumption to shift the burden of proof to defendants (such as in cases involving The Philadelphia National Bank in 1963, H.J. Heinz Co. in 2001 and Baker Hughes, Inc. in 2017). “The presumption is based on market share challenges, which clearly apply here. So, T-Mobile and Sprint will have the burden of proof. Their arguments – the DISH [asset sale] remedy, efficiencies, and Sprint as a flailing firm – are all factually weak and face case law which has rarely (or never in the case of efficiencies) used such arguments to overcome a presumption of harm in prior horizontal mergers.”
A scuttled merger would leave a standalone Sprint in a precarious position, as the company faces declining revenue, six years and counting of free cash burn, and a $41 billion net debt load (nearly four times adjusted Ebitda). 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.”
A failed deal would spell further bad news for suddenly-beleaguered SoftBank Group Corp., which paid $12.1 billion for a 70% stake in 2012 (the fund currently holds 84.5% of outstanding S shares). The Vision Fund, SoftBank’s $100 billion in-house V.C. arm, has likewise seen positions in Uber Technologies, Inc. and Slack, Inc. marked down sharply in the public markets, to say nothing of the unfolding train wreck at 29% owned The We Company. Yesterday, Bloomberg reported that Goldman Sachs Group, Inc. “has approached other financial institutions” in hopes of offloading some of its $3.1 billion credit line to the Vision Fund, and is offering the debt slightly below par.
Recap Sept. 26
A bull-flattening rally in Treasurys pushed the 10-year yield to just under 1.70%, just four basis points above the two-year yield. Stocks ticked slightly lower to leave the S&P 500 down by a half-percent for the week so far, while gold and oil both traded sideways. The VIX held just below 16.
- Philip Grant
Wednesday, September 25, 2019
Sentiment check
Karz for Kidz, 2019 edition. From Popular Mechanics last week:
Good news! Bugatti built a car that costs less than a Mustang GT. Bad news! It's sized for kids, they're only making 500 of them, and they're all sold out.
But they're taking names for the reserve list, anyway, in case anyone who's already made a deposit subsequently decides they have a better use for $33,000.
Ya gotta believe
Yesterday afternoon the price of bitcoin fell more than $1,000 in 30 minutes to just over $8,000, the biggest one-day decline since January 2018 and its lowest finish since June. “Even for [the notoriously volatile] bitcoin, this is a pretty rare event,” Qiao Wang, director of product at crypto research firm Messari, Inc., told Coindesk.
What caused that abrupt swan-dive? Coindesk, citing an anonymity-seeking trader, speculates that the drop “may have been exacerbated by margin calls and contract liquidations on BitMEX, a Seychelles-based exchange that provides customers with 100 times leverage.”
BitMEX’s eye-catching leverage extension is only one tactic used by crypto exchanges to drive volume, as bitcoin turnover on major exchanges fell 40% in the past month according to TokenAnalyst. Yesterday, Bloomberg reported that such venues now offer generous referral programs to those who bring friends onto a particular platform.
Binance, the world’s largest crypto exchange, offers a commission equaling as much as 40% of the trading fees incurred by new traders to those providing a referral, and allows the recipient of those funds to share them with the fee-generating trader. The exchange also sports a referral “leader board” on its webpage showing one member has earned 989.37 bitcoin through the activity, worth some $8.3 million at current prices. Bloomberg opinion writer Aaron Brown guesstimates the scale: “It would not shock me to learn that referrers collectively earn $100 million to $200 million per year, and exchanges earn $400 million to $800 million from referral programs.”
As crypto exchanges scramble to win trading volume, one key player continues to fight the power. Recall that on April 25 New York Attorney General Letitia James accused iFinex, Inc., which operates both Bitfinex and Tether, of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds.”
Yesterday, Bitfinex, the crypto venue affiliated with purportedly dollar-backed stablecoin tether, won a stay from the Appellate Division of the New York Supreme Court allowing it to withhold documents from the AG pertaining to a $900 million loan from Tether to Bitfinex. In response to the appeals court ruling, an AG spokesperson noted that “the injunction that prohibits the movement of money between Tether and Bitfinex is still in place, that has not changed.”
The kerfuffle carries potentially significant ramifications, as tether is widely used by crypto exchanges as a workaround for know-your-customer and anti-money-laundering laws. For instance, trailing 24-hour trading volume in tether footed to $31.6 billion as of late afternoon, far above any other crypto including bitcoin at $25.3 billion. Questions over the legitimacy of tether’s claims of dollar-backing are likewise brought into relief. For his part, tether co-founder William Quigley suggested a more existential approach in an interview with Bloomberg radio on Sept. 4:
Whether or not tether was backed by the dollar wouldn’t matter if everybody agreed to take tether and to value them at a dollar themselves.
Faith on the blockchain.
Recap Sept. 25
Stocks enjoyed a solid intraday rally, erasing the bulk of yesterday’s losses and leaving the S&P 500 back within hailing distance of its July 25 highs. Treasurys were hammered, with a weaker-than expected five-year note auction this afternoon highlighting a selloff that left the 10-year yield at 1.73%, up eight basis points on the day. Gold was likewise clobbered to the tune of nearly 2%, settling at $1,504 an ounce, while WTI crude continues to unwind its post-Saudi attack gains, finishing at $56.50 a barrel. The VIX fell back to 15.5.
- Philip Grant
Tuesday, September 24, 2019
Banks for nothing
He’s positive that rates should be negative. Last Thursday, Bank of Japan governor Haruhiko Kuroda declared he is “more positive” about the prospect of further easing from the BoJ’s policy rate, which currently sits at negative 10 basis points, on account of increased risks to economic growth. Following a stand-pat meeting last week, the BoJ is now expected to again cut rates at its next gathering on Oct. 31, with interest rate futures currently pricing 54% odds of an additional 10 basis point cut at the meeting.
Following the well-worn contemporary central bank playbook in his quest to hot up the economy and stoke price inflation, Kuroda looks set to deliver more of what has not worked. In the 20 years since Japan first rolled out a zero interest rate policy, real GDP and inflation as measured by CPI have averaged 0.9% and 0.1%, respectively, on a year-over-year basis.
While two decades of virtually zero borrowing costs have brought the BoJ no closer to its stated goals, Kuroda used central bank comps to make his case for more of the same: “The BoJ may look as if it has less room for easing when its policy rate of minus 0.1% is compared to around 2% for the U.S. Federal Reserve. But the ECB has reduced its deposit rate to minus 0.5%. Compared with the ECB, the BOJ may appear to have more room for additional easing.”
In addition to sub-zero policy rates, Japan and Europe each sport banking systems that could be described as gasping for oxygen. Japan’s Topix 600 Banks Index currently trades at a paltry 0.44 times book value and generated a meager 5.31% return on equity in calendar 2018. That compares to 0.55 times book and 7.22% 2018 RoE for Europe’s STOXX Banks Index, and 1.16 times and 11.8% for the U.S. KBW Bank Index.
Japan’s depressed valuations and stunted earnings power are no accident. Shannon McConaghy, portfolio manager at Horseman Capital Management L.P. noted in a July 25 Real Vision interview that Japanese banks earn an average interest rate of just 64 basis points on new loans, well shy of the 100 basis points needed to cover basic operating expenses. Makoto Takashima, chairman of the Japanese Bankers Association, spoke up in an attempt to discourage Kuroda at a news conference last week: “It’s doubtful that deepening negative interest rates is effective for monetary easing.”
As Japan’s banks find profitability in core lending activities increasingly harder to come by, yen-denominated loans from foreign issuers are at least partially filling the void, with outstanding supply of these so-called samurai loans doubling last year to $21.5 billion. Kazuyuki Ikegami, senior counselor in the Tokyo branch of Bank of Kyoto Ltd. explained the appeal to Reuters on Sept. 9:
Regional banks have less opportunity to lend because the number of local companies is falling, and we have low margins because interest rates are so low. We need the opportunities to lend that samurai loans provide us, and they’re great because they mitigate currency risk. We’re putting more people [in] the samurai loan market.
Higher-risk options are the natural next resort. Last week, Bloomberg reported that Mitsubishi UFJ Financial Group, Inc., Japan’s largest bank, is set to arrange its first European-based collateralized loan obligation (CLO) “having already been an active buyer in the region.” CLOs, or securitized pools of leveraged loans (i.e. bank debt issued by speculative-grade issuers), have been a popular option for Mitsubishi and peers. Although national level-data on CLO exposure is spotty (Japanese regulators are conducting a survey to determine local banks’ CLO holdings, per Bloomberg), a report from UBS last December estimates that Japanese banks accounted for roughly one-third of CLO inflows in recent years and as much as three quarters of triple-A-rated CLO tranches.
Some observers spy trouble ahead. On Sunday, the Bank for International Settlements sounded the alarm over CLOs in their Quarterly Review, drawing parallels with the mortgage-backed collateralized debt obligations (CDOs) that figured so prominently in the events of 2007 to 2009.
For example, U.S. subprime mortgages without full documentation of borrowers' income increased from about 28% in 2001 to more than 50% in 2006. Likewise, leveraged loans without maintenance covenants increased from 20% in 2012 to 80% in 2018. In recent years, the share of low-rated (B-) leveraged loans in CLOs has nearly doubled to 18%, and the debt- to-earnings ratio of leveraged borrowers has risen steadily.
Weak underwriting standards reduce the likelihood of defaults in the short run but increase the potential credit losses when a default eventually occurs.
Contagion risk also looms, according to the BIS:
Banks’ prime brokerage exposure to CLO holders could result in larger losses than implied by direct exposures.
The (almost) last word goes to Claudio Borio, head of the monetary and economic department at the BIS, who remarked of the current $14.8 trillion in negative-yielding debt worldwide: “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”
Haruhiko Kuroda and Mario Draghi, please copy.
Recap Sept. 24
Stocks came under pressure with the S&P 500 dropping 80 basis points, to narrow its 2019 advance to 18.4%. Treasurys enjoyed a strong bid with the 10-year yield dropping nine basis points to 1.64%, while gold rose $10 to $1,532 an ounce. WTI crude slipped to $57 a barrel, while the VIX jumped 17% to 17.4. This afternoon, the crypto complex absorbed an intense downdraft, with the price of bitcoin falling roughly $1,000 and settling at $8,560.
- Philip Grant
Monday, September 23, 2019
If you build it
Price-to-choose-your-own-adventure
At least eyeballs are countable.
At least eyeballs are countable.
Recap Sept. 23
If you build it
On Friday, S&P Dow Jones announced that homebuilder NVR, Inc. will join the S&P 500, replacing Jefferies Financial Group as of Thursday, Sept. 26. That move will mark something of a milestone, as NVR has long operated an enviable business model that has generated outsized returns. Following a 4% pullback today, NVR shares have compounded by 6,280% over the past 20 years, trouncing the 198% gain on the S&P 500 including reinvested dividends over that period.
At the Spring 2019 Grant’s Conference, John Hughes of the Quantum Capital Management identified NVR as a compelling opportunity. A unique business model plays a key role in the company’s success, Hughes explained:
They build up and down the East Coast, they are the fourth-largest homebuilder in the U.S.—and all of this is of little consequence to us. What matters most is its local market concentration, by design. It’s typical of NVR to enjoy a 20% or 30% or more market share in areas where they do build.
Since that call on April 9, NVR shares have advanced by a further 22%, compared to a 9% total return for the SPDR S&P Homebuilders ETF. Reached by Grant’s today, Hughes relayed that his fund “has not sold a share in NVR and [does] not plan to. Our positive 10-year view remains intact.”
More broadly, 12 years after the collapse of the mortgage bubble, the housing market’s vital signs look robust. August housing starts printed at 1.36 million, up 6.6% from a year ago and well above the Street expectation of 1.25 million. Building permits are likewise on the march, jumping by 7.7% year-over-year in August to 1.42 million, those figures each represent the highest readings since 2008 and compare to ten-year averages of 968,000 and 1.02 million, respectively.
U.S. housing starts by month, 20-year chart. Source: The Bloomberg
For an in-depth analysis of the U.S. housing market, along with a bullish assessment of another industry mainstay, see the July 26 edition of Grant’s Interest Rate Observer.
Price-to-choose-your-own-adventure
At least eyeballs are countable. In a note today, internet and media analysts at Barclays Capital, Inc. argue that “traditional valuation frameworks have become insufficient in a growing number of instances.” The increasing proliferation of digital businesses calls for a new approach, “as for some companies these [digitization] efforts have either not yet generated revenue, or could take years to scale, and/or [may] be cannibalistic.” Speaking of Netflix, Inc., Barclays asks “why is five to six times revenue the right number when [the company] is growing faster than software companies like Adobe, Appian and Aviva, which all trade for 10 to 20 times” sales?
Instead, the analysts suggest using “the ratio of enterprise value to adjusted/fully loaded lifetime value,” meaning “the present value of gross margins earned over the life of a customer.” The full formula is shown below, with ARPU representing average revenue per user, GM for gross margin, c is churn, i the discount rate and t representing the life of the customer with the firm in question.
The report does make note of customer acquisition costs, calculating that outlay “by using or estimating the marketing cost for a given business and normalizing it by the number of subscribers added in a period.”
While the Street tweaks its frameworks to better capture the latest new era in investing, an industry giant pivots back to basics. As noted by Zero Hedge yesterday, SoftBank Group Corp. recently listed a job opening for a valuations director.
According to the posting, a successful candidate “will be primarily responsible for determining the fair value of investments for quarterly financial reporting and providing valuable and timely insight to management on our investments.” In addition, “extensive valuation modeling experience,” including “public company comparable multiples, discounted cash flow and option pricing models” are required.
Recap Sept. 23
Stocks treaded water after a late downtick Friday pushed the S&P 500 back below 3,000, while a modest rally in rates sent the 10-year yield to 1.72%. Energy and metals both caught a bid, with WTI crude finishing at $58.50 a barrel and gold advancing to $1,523 an ounce, within $30 of the multi-year closing highs reached on Sept. 4. The VIX remained below 15.
- Philip Grant
Thursday, September 19, 2019
Masa of leverage
SoftBank Group Corp. and Vision Fund architect Masayoshi Son has doubled down, again. From Bloomberg:
[Son] has pledged 38% of his stake in the Japanese firm as collateral for personal loans from 19 banks, including Credit Suisse Group AG and Julius Baer Group Ltd., according to a June regulatory filing.
Son loaned himself around $3 billion to invest in the first Vision Fund.
The risk-loving Son, who saw $70 billion wiped from his fortune in the dot-com crash, is unlikely to be fazed. He told shareholders at the company’s June meeting that SoftBank’s investment portfolio could grow 33-fold to 200 trillion yen ($1.8 trillion) in 20 years.
All together now: The epitome of the cycle.
Polonius, call your office
As money market volatility and the Fed’s 25 basis point cut have dominated the financial news cycle, key asset gauges have hummed merrily along. The S&P 500 remains near its high water mark, up 20% year-to-date, while the yield on the Bloomberg Barclays High Yield Index fell to 5.58% this morning, the lowest since January 2018. But problems continue to bubble under the surface in speculative grade credit.
Distressed situations are increasingly commonplace. According to data from S&P Global Ratings, the ratio of high yield debt trading at a 1,000 basis point premium to Treasurys jumped to 9.4% in August, the highest since November 2016 and up sharply from 6% in July. Likewise, the proportion of loans in the S&P/LSTA Leveraged Loan Index trading below 80 cents on the dollar rose to 4.03% in August from 2.81% in July. That rise in struggling issuers corresponds with an earnings slowdown, as Creditsights finds that median trailing 12-month Ebitda across U.S. high-yield issuers rose just 6.6% from a year ago in the second quarter, down from 11.2% in the fourth quarter of last year and the slowest growth rate since the first quarter of 2017.
As the proportion of troubled credits pushes higher, issuer concessions have become more commonplace as creditors increasingly push back against their counterparties. S&P’s LCD unit reports that underwriters were forced to cut pricing on 24% of new leveraged loan issues in August, up from 20% in July and the highest of the year. More recently, a trio of notable happenings underscore this trend.
Yesterday, British tycoon Sanjeev Gupta was obliged to personally offer $150 million in equity to get a $475 million, five-year junk bond deal for his InfraBuild Australia Pty Ltd. steel and recycling business across the finish line. The reduced leverage that will result from InfraBuild’s downsized offering led Fitch Ratings to upgrade the bond to double-B from single-B, yet Bloomberg reports that the yield on the issue will approach 10%, more than double the 4.1% yield on the double-B component of the Bloomberg Barclays U.S. High Yield Index.
Last week, Claire’s Stores, Inc. withdrew a $700 million loan offering at a proposed 550 basis point spread over Libor on account of weak demand. The company, which was taken private by Apollo Global Management in a $3.1 billion leveraged buyout in 2007 and emerged from bankruptcy last year, would have seen its leverage ratio rise to 4.4 times Ebitda if the transaction had gone through from 3.3 times in February, according to Moody’s Investors Service.
A second Apollo deal has likewise received the cold shoulder from Mr. Market. Yesterday, the buyout firm bought the entire $300 million unsecured bond tranche of its debt offering to finance its acquisition of Shutterfly, Inc. Bloomberg reports that underwriters are still in the process of trying to place $1.3 billion in term loans and $500 million in secured bonds but have been met with “lackluster” demand.
Both a lender and a borrower be.
- Philip Grant
Almost Daily Grant's resumes Monday
Tuesday, September 17, 2019
Recap Sept. 17
Short-term funding markets saw a major spasm this morning, with the overnight repo rate jumping as high as 10% and pushing the Fed Funds rate to 2.25% from 2.14% yesterday. In response, the Fed injected $53 billion into the banking system, its first such intervention since the financial crisis.
Those relatively dramatic developments stood in stark contrast to what appeared to be a routine session by traditional indicators, as the S&P 500 edged higher after drifting sideways most of the day, while Treasurys were bid across the curve, WTI crude gave back a chunk of yesterday’s gains to finish at $59 a barrel and gold rose $3 to $1,501 an ounce. The VIX remained below 15 for a fourth straight day.
After the deal
Four years ago, roll-ups were the vogue of Wall Street, as so-called platform companies like Valeant Pharmaceuticals International, Inc. posted rapid earnings growth and saw their share prices go skyward. Today the strategy is in various states of disrepair, with notable roll-up investors, the Brazilian private equity firm 3G Capital Partners, in retreat. Now follows a review of recent happenings in a trio of 3G portfolio companies, each of which has been the subject of a bearish Grant’s analysis in recent years.
Packaged foods giant The Kraft Heinz Co. (KHC on the Nasdaq) is on the ropes, as KHC shares are down 34% year-to-date and 63% since an initial Grant’s appraisal in March 2016. This morning, 3G disclosed in an 8-K filing that is has divested 25.1 million shares of the company, raising some $713 million while lowering its stake in the company to 20%.
But while the firm sells, the Brazilians themselves buy. Bloomberg reports this morning that 3G insiders, including co-founder Jorge Paulo Lehmann, personally purchased some $200 million of that KHC share offering. Thanks largely to 3G and Berkshire Hathaway’s 2013 acquisition of H.J. Heinz Co. followed by the merger with Kraft Foods Group, Inc. two years later, the company carries a net debt load of $30.3 billion. That’s equivalent to five times consensus 2020 adjusted Ebitda.
While the Kraft Heinz has floundered thanks to shifting consumer tastes, brand erosion (leading to a $15.4 billion, non-cash write-down in February) and accounting problems, other factors may explain the divestment. CNBC’s David Faber reports this morning that 3G’s block sale was motivated by liquidity needs of former billionaire Eike Batista: “He needs money.”
To that end, 3G’s investment in global beer behemoth Anheuser-Busch InBev S.A./N.V. (ABI on the Belgian Stock Exchange and BUD on the NYSE) has fared far better in 2019, with shares up 51% to narrow the stock’s decline to 4% since a February 2018 Grant’s bear verdict. Yet liquidity remains front-of-mind.
Yesterday, Anheuser-Busch announced it will try once again to IPO its Asia unit, Budweiser Brewing Company APAC Ltd., targeting $4.8 billion in outside capital with an additional overallotment option of up to $1.8 billion. Earlier this summer, the company was forced to withdraw an IPO for the Asia business at a $9.8 billion fundraising target as investors balked at the valuation, with ABI instead opting to sell Australian subsidiary Carlton & United Breweries to Japan’s Asahi Group Holdings, Ltd. for $11.3 billion. Thanks in large part to the 2016 acquisition of SABMiller, plc. for $123 billion, Anheuser-Busch’s net debt currently stands at 4.7 times consensus 2020 adjusted Ebitda.
Then there’s fellow 3G portfolio company Restaurant Brands International, Inc., (QSR on the NYSE), the asset-lite franchisor that owns the Burger King, Tim Hortons and Popeye’s Louisiana Kitchen brands. Restaurant Brands is likewise deal-happy, most recently paying 19 times adjusted Ebitda for Popeye’s in 2017, helping to push its net debt to five times 2020 adjusted Ebitda.
Like Anheuser-Busch, QSR has enjoyed a strong 2019, with shares higher by 40% year-to-date and by 18% from a June 2017 bearish Grant’s analysis. But those who know the company best are heading for the exit. On Sept. 4, a 3G affiliate announced that it had sold some 17 million QSR shares, following a 24 million share disbursement in August. Unlike in Kraft Heinz, 3G insiders have likewise been persistent sellers of QSR stock over the past year, an eye-catching $3.8 billion in total.
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.