Almost Daily Grant's
“Almost Daily” is the end-of-day delectation from Grant’s.
ADG tells you what happened. It speculates on what may happen and tracks and develops Grant’s themes. Look for it after the New York close of trading—almost daily.
You can always find ADG here. Click below to opt-in to an almost daily email, delivered straight to your inbox.
ADG is for everyone—paid-up subscribers, naturally (the noble ones!), and future subscribers alike.
We hope you enjoy it.
Sign-Up
Monday, April 6, 2020
Grant's credit primer
Socially distant
(Prospective) deal of the day
Get to the choppa
"Whatever it takes" is the law of the land,
"Whatever it takes" is the law of the land,
Recap April 6
Grant's credit primer
Excesses in lending and borrowing impaired the economy's immune system long before the arrival of Covid-19. Grant's was early to the story - read here a free sampler of our prescient analysis.
Socially distant
Bloomberg reports today that 6 of the 10 largest U.S. mutual funds focused on environmental, social and governance (ESG) themes have lagged the broad S&P 500 so far this year, which was down by 22% year-to-date through Friday. That performance shortfall comes despite a substantial tailwind, as the energy sector (to which the ESG crowd gives wide berth) has played a starring role in the selloff with a 48% drop in the S&P Energy Index through Friday.
For an in-depth look at the opportunities and risks which have spawned from the ESG movement including a pair of picks-to-not-click, see the March 6 edition of Grant’s.
(Prospective) deal of the day
Stirrings in the leveraged loan market: Restaurant group and casino operator Landry’s, Inc., is conducting creditor meetings today in hopes of securing a $250 million leveraged loan with an October 2023 maturity according to Bloomberg. It would mark the first U.S. primary loan deal in more than a month. For those funds, Landry will pay a pretty penny: Indicated terms call for a 1,400-basis point spread over Libor, along with discounted pricing of 96 cents on the dollar. For context, the Invesco Senior Loan ETF (BKLN on the NYSE Arca exchange) currently offers a yield of 5.33%.
The house always wins – almost always anyway.
Get to the choppa
“Whatever it takes” is the law of the land, as the Fed’s balance sheet assets jumped by more than $1.1 trillion in the two weeks ended March 31 to $5.6 trillion, a figure which, analysts at Bank of America illuminatingly relay, equates to more than $1 million in growth per second. There’s more where that came from. BofA forecasts a $9 trillion balance sheet by June (equivalent to 42% of 2019 nominal GDP), while Evercore ISI analysts believe that footings could reach $12 trillion by mid-year, or 57% of last year’s economic output. For context, Fed assets stood at 20% of GDP last fall, while the European Central Bank holds assets equivalent to 40% of last year’s GDP and the Bank of Japan holds 107%.
As the Fed ramps up its shopping spree (with the attendant conjuring of dollars from the digital ether), a prominent gold mining executive warned that fresh supply of the Money of Kings looks set to stall. On last week’s earnings call, Novagold Resources, Inc. CEO Thomas Kaplan observed:
What we’ve seen in the gold industry is that gold production has effectively peaked.
This is the longest period in which we have seen really no new great discoveries in the gold market. What’s worse is that even if you do make the discovery, the timeline from discovery to production is now calculated on average to be in excess of 20 years.
While precious metal miners worry about the state of future production, supply constraints continue to bedevil the gold market, as distant future contracts continue to command large premiums over spot prices. As of mid-day, June gold futures were quoted at more than $1,690 an ounce, compared to $1,650 an ounce spot prices.
With those supply and liquidity-spurred price dislocations comes opportunity: Precious metals trader Tom Wacker advises by email today that: “By my calculations, you can make about 5.5% annualized and totally hedged by taking delivery of COMEX warehouse receipts for April and selling the June contract against it.”
Recap April 6
A whopping 7% rip higher for the S&P 500 extended the broad average’s rebound to 20% above the March 23 lows, while Treasurys came for sale with the 2- and 10-year yields rising to 0.26% and 0.67%, respectively. WTI crude finished near $26 a barrel, giving back a portion of its two-day rally to end last week and the VIX fell to 45, its fifth decline in the last six trading sessions.
- Philip Grant
Friday, April 3, 2020
Debtor in Chief
Lobby horse
Where the rubber meets the road
Mr. Market drinks from a firehose.
Mr. Market drinks from a firehose.
Recap April 3
Debtor in Chief
Dusting off “The Art of the Deal.” According to a New York Times report yesterday, the Trump Organization is in discussions with its lender Deutsche Bank A.G. over potential financial relief, including payment delays on the portions of the company’s nine-figure outstanding loan balance. “These days, everybody is working together,” Eric Trump, executive vice president of the Trump Organization, told the Times. “Tenants are working with landlords; landlords are working with banks. The whole world is working together while we fight through this pandemic.”
Financial relief begins at the top.
Lobby horse
Bloomberg reports today that Adidas A.G. is in talks with German state-owned bank KfW for a €1 billion ($1.1 billion) to €2 billion financing package. That’s a change in course for the athletic apparel giant, which earlier this week backtracked from plans to skip April rent payments to its German landlords following a public outcry.
Such drastic steps seem unusual for Adidas, which sported a €2.9 billion cash balance as of year end (offsetting much of its €4.8 billion in total debt) and whose 1.25% unsecured notes due 2021 remain above par. Then again, a March 20 New York Times dispatch covering pandemic-era corporate lobbying may shed some light:
The sportswear company Adidas is seeking support for a long-sought provision allowing people to use pretax money to pay for gym memberships and fitness equipment — despite the mandatory closure of fitness facilities in many jurisdictions during the outbreak.
Where the rubber meets the road
Mr. Market drinks from a firehose. U.S. investment-grade companies issued $111 billion in fresh supply this week according to Bloomberg, edging out last week’s record for weekly primary market activity and bringing year-to-date issuance to 63% above the same period last year. Even the junk bond market, which is excluded from the warm embrace of the Federal Reserve’s newly instituted corporate bond purchases, is showing signs of life with $2 billion in new supply yesterday, its busiest day in more than a month. Let’s review a trio of notable recent deals near the intersection of investment grade “haves” and high yield “have nots.”
After finally closing its contentious merger with Sprint Corp., the “new” T-Mobile U.S., Inc. came to market yesterday with a mammoth $19 billion, five-part debt offering: The bond market was accommodating, with the 30-year tranche priced at a 325 basis point spread over Treasurys. That compares to initial price talk of 375 basis points and a 369-basis point pickup for the triple-B component of the Bloomberg Barclays Investment Grade Index (T-Mobile clocks in at triple-B-minus).
As for the new entity, $71.2 billion in pro forma 2019 revenues and $23 billion in adjusted Ebitda will be provisionally supplemented by a projected $6 billion in annual run-rate synergies. However, CreditSights notes that Sprint’s lease accounting treatment excludes some $7 billion in annual expenses (see the Dec. 23, 2016 edition of Grant’s for more on that financial Statue of Liberty play), which would expand the pre-synergy leverage ratio to just over three turns of debt. In addition, the target company has a slew of near-term debt maturities, with $2.4 billion coming due this year and $4.3 billion in 2021, against which the year-end balance sheet showed $7.8 billion in cash.
While wireless communication continues apace during the near-worldwide lockdown, other business models are less compatible with current circumstances. This morning, triple-B-rated FedEx Corp. issued $3 billion in fresh debt across 5-, 10- and 30-year maturities. The logistics giant paid spreads of 350 to 410 basis points over Treasurys, a notable premium to its existing 10-year note issued in 2019 which closed yesterday at a 278-basis point spread. FedEx, which has drawn down its $1.5 billion short-term credit facility and cut the pay of CEO Kevin Smith by 91% through Sept. 30, sported a leverage ratio of 2.8 times trailing adjusted Ebitda as of Feb. 28. Under the terms of a credit agreement in place until March 2025, FedEx must maintain a debt load of no more than 3.5 times Ebitda.
Finally, there’s Restaurant Brands International, Inc., the franchisor of Burger King, Popeye’s and Tim Hortons and Grant’s pick-to-not-click since March 2017. Rated double-B-plus (the penthouse of junk), RBI came to market yesterday with a $500 million, first-lien senior secured bonds due 2025 at a 537-basis point spread over Treasurys. That compares to a first-lien term loan due 2026 which last changed hands at 91 cents on the dollar for a 365-basis point pickup.
RBI is faced not only with a steep debt burden of its own ($11.8 billion in net debt, or 6.6 times trailing adjusted Ebitda), but also the potential need to offer assistance to stricken franchisee Carrol’s Restaurant Group, Inc. (the fourth-largest such operator in the U.S.), which has seen its stock price fall 86% in the last year to $1.50 a share while its term loan due 2026 is quoted to yield more than 10%. For more on the risks to the franchisor/franchisee business model, see the Sept. 20 edition of Grant’s as well as the issue dated today.
Recap April 3
A modest selloff left the S&P 500 lower by 3% for the week, something of a win for the bulls on a day in which the Bureau of Labor Statistics reported March non-farm payrolls at minus 701,000, the first decline since 2010. Treasury yields similarly finished little changed, gold rose to $1,621 an ounce and energy continued its strong rally with WTI crude approaching $29 a barrel, up 41% in the last two days. The VIX fell to 47.
- Philip Grant
Thursday, April 2, 2020
Grant's credit primer
Nevertheless, they persisted
A bolt from the electronic heavens this morning,
A bolt from the electronic heavens this morning,
QE progress report
Recap April 2
Grant's credit primer
Excesses in lending and borrowing impaired the economy's immune system long before the arrival of Covid-19. Grant's was early to the story - read here a free sampler of our prescient analysis.
Nevertheless, they persisted
A bolt from the electronic heavens this morning, as President Trump took to Twitter:
Just spoke to my friend MBS (Crown Prince) of Saudi Arabia, who spoke with President Putin of Russia, & I expect & hope that they will be cutting back approximately 10 Million Barrels, and maybe substantially more which, if it happens, will be GREAT for the oil & gas industry!
The market took those words at face value, as WTI crude vaulted higher by more than 20% to $25 a barrel. The President’s ambitious assertions (upsized to 15 million barrels per day in a subsequent tweet) were met with a cool response from the other interested parties, with a statement from Saudi Arabia calling for a “fair agreement” among producers to bring the market into balance. A subsequent report from Bloomberg spelled it out: The Saudis are asking for production cuts across the G-20, including non-OPEC+ members in North America. Meanwhile, Russian state newswires denied that Vladimir Putin has even spoken with the Saudi crown prince.
While political gamesmanship figures prominently during the current price war, demand destruction from the global pandemic is both ominous and similarly hard to quantify. In a report yesterday, Rystad Energy estimated global oil demand at 77.6 million barrels per day (mbpd) in April, down a gasp-worthy 22.7% from the same month in 2019. For the full year, Rystad pencils in a 6.4% year-over-year demand drop, accelerating from a minus 4.9% full-year demand decline estimate from a week ago (for context, world demand has fallen in only three of the last 39 years).
With suppliers engaged in a high-stakes poker game and the demand on ice, energy bulls (including Grant’s) have been thrown for a loss. After today’s bounce, the price of WTI crude and the S&P Energy Index are each lower by roughly 50% year-to-date.
The $64 billion question for beleaguered energy investors: Will someone please switch on the light at the end of the tunnel? Leigh Goehring and Adam Rozencwajg, co-founders and eponyms of resource investment firm Goehring & Rozencwajg, LLC, tell Grant’s today that U.S. demand over the past three weeks is down 11% year-over-year, suggesting that the dire picture painted by Rystad may not come to pass. The pair instead anticipate a peak-to-trough demand decline of 10 mbpd to 12 mbpd, half of that forecasted by Rystad for the month of April.
Similarly, the supply boost from the current price war may be less severe than believed, as Goehring explains:
The impact of $20 oil is so extreme that Saudi must be thinking twice about what they did. In waging the 2014 to 2016 price war, crown prince Mohammed Bin Salman contradicted his advisors and it led to a 33% decline in FX reserves. This version will further strain internal government finances and risk emboldening political opposition. Interestingly, MBS had four senior officials arrested the day before commencing the price war.
A deal will be eventually announced. The market believes that Saudi Arabia can increase production to 12 mbpd from 9.6, we don’t think they can get above 10.5 mbpd on a sustained basis. Remember that processing facilities equivalent to 500,000 bpd are still offline due to the drone attack last fall.
How much more oil can they really put into the market? It may not be that much.
As for the domestic shale industry, one of the primary sources of Saudi Arabian and Russian ire and the source of swift supply growth in the post-2009 era, Rozencwajg tells Grant’s that in contrast to the 2014 to 2016 period, the corporate response has been swift and severe:
You’ve got cash flows across the industry collapsing by more than 50%, budgets have been slashed, and there is no ability to tap capital markets. They’ve got to cut the rigs. Companies are going back and cutting capex a second time. Diamondback Energy did it today. Budgets are down 50% to 70%. At that level you’re going to see massive declines. The shale era is over. It probably peaked in the fourth quarter and is set to begin a long terminal decline.
As a result of these cuts, damage to the supply side will linger for a decade. You’re only talking about 1 mbpd in additional output due to the price war. That’s basically a rounding error.
By way of comparison, Goehring points to the 1990s bear market in gold, which reached $250 an ounce in 1999. “You want to invest in commodity markets where if the price stays where it is, you won’t have the industry anymore. The global oil industry doesn’t work at $20 a barrel or even $25. Saudi Arabia cannot abide it, nor can Russia or the U.S.”
QE progress report
Reserve Bank credit (i.e., the Fed’s sum total of interest-bearing assets) leapt to $5.575 trillion, a $604 billion increase from a week ago and up 22.7% from a year ago. That pushes the three-month annualized growth rate to a whopping 90%, compared to a 43% three-month annualized pace last week.
Triple digits next Thursday?
Recap April 2
Perky price action left the S&P 500 higher by 2.3%, bringing the broad index back to near unchanged for the week, while Treasurys came for sale with the 2-, 10-, and 30-year yields rising to 0.22%, 0.64% and 1.26%, respectively.
Gold jumped by nearly 2% to $1,617 an ounce, and the VIX fell to 51, its lowest close since March 10.
- Philip Grant
Tuesday, March 31, 2020
He ain't lying
Rethinking old reliable
The unstoppable force (Canada’s seemingly invincible housing market) meets the immovable object of a global pandemic.
The unstoppable force (Canada’s seemingly invincible housing market) meets the immovable object of a global pandemic.
Recap March 31
He ain't lying
New York Governor Andrew Cuomo was asked at a press conference today about the risk of purchasing redundant medical equipment:
We are broke. The last thing I want to do is buy a single ventilator that I don’t need.
For a detailed look at the unpleasant facts behind that blunt remark, see the January 10 edition of Grant’s.
Rethinking old reliable
The unstoppable force (Canada’s seemingly invincible housing market) meets the immovable object of a global pandemic.
On the heels of heady price appreciation, including a 5.4% compound annual growth rate in the Teranet-National Bank Home Price Index in the 10 years through February, Canadian real estate is some of the world’s most expensive. According to the Demographia 2020 International Housing Affordability Survey, Toronto and Vancouver rank as the sixth- and second-least affordable markets among the 92-city sample size, with median house prices of 8.6- and 11.9-times the median household income, respectively.
Copious leverage fed that decade-long boom. Household debt service equaled 15% of GDP at year-end, (by comparison, the U.S. ratio peaked at 13% in 2007), a figure which does not capture private and payday lenders. Household debt, exclusive of HELOC and private debt, stood at 176% of personal income on Dec. 31, compared to a 2007 high-water mark of 144% in the U.S.
Households were under strain even before recent developments. According to the Office of the Superintendent of Bankruptcy Canada, consumer insolvencies topped 35,000 in the fourth quarter of 2019, the highest reading since 2010.
With the economy now on ice, leveraged Canadians are gasping for air. According to a survey from MNP International published on Monday, 49% of respondents report they are “on the brink of insolvency,” defined as within C$200 ($142) per month of being unable to pay their bills. That’s up from 39% reporting such dire straits in December.
Needless to say, it’s not hard to imagine this widespread stress translating into broader economic trouble. Mathieu Labrèche, spokesman for the Canadian Bankers Association, told Bloomberg last Thursday that Canada’s six largest banks have deferred payments (or are in the process of doing so) on roughly 4.5% of the mortgages in their portfolio, a number which is likely to grow as the disruption in commerce continues. According to a survey today from Nanos Research Group, nearly 20% of Canadian respondents reported they may miss a mortgage, credit card or auto loan payment in the next four weeks.
Then there is the shadow banking system, which has mushroomed during the long boom. According to the Bank of Canada, total assets for so-called non-banking financial intermediaries (NBFI) rose to C$1.5 trillion as of year-end 2017, up 30% from two years prior and double the 2006 level (for context, nominal GDP summed to C$2.1 trillion in 2019). Distress among the group appears to be on the rise: Bloomberg reported Friday that Vancouver-based mortgage lender Trez Capital has suspended redemptions, while Morrison Laurier Mortgage Corp. has halted dividend payouts as well as new project investments in a bid to preserve cash.
***
A key question for investors: What sort of pain might an end to the housing miracle deal to Canada’s five largest banks, a cohort which has each delivered undisturbed dividend payouts for well over a century?
Last May, the Bank of Canada attempted to quantify that risk in a paper titled “Assessing the Resilience of the Canadian Banking System.” In a severe scenario (defined as an 8% peak-to-trough decline in real GDP, a 12.6% peak unemployment rate and a 41% peak-to-trough correction in home prices), total bank losses would reach an estimated C$116 billion across consumer and business loans. Under those circumstances, the large banks would see their common equity tier-1 capital ratios fall to the low 8% range from the current 11.6%, a funding level low enough to compel the banks to suspend dividend payments as mandated by the Office of the Superintendent of Financial Institutions.
Crucially, even in that unpleasant outcome, the Bank of Canada believed that mortgage debt will continue to perform: “The absolute amount of mortgage losses remains low because of mortgage insurance coverage and because recovery rates on defaulted uninsured mortgages are relatively high, as borrower equity absorbs much of the decline in house prices.”
Hilliard MacBeth, financial advisor and author of “When the Bubble Bursts: Surviving the Canadian Real Estate Crash” registered vigorous disagreement with that conclusion in a Friday commentary: “This [assumption] is nothing short of delusional since, in Canada, personal bankruptcy wipes out all debt.” Reached by Grant’s on Friday, MacBeth predicted that Canadian banks will “almost certainly” breach the 8% minimum CET1 ratio and trigger automatic dividend suspensions. This afternoon, the Canadian Bankers Association reports that nine lenders (including the country’s six largest) have availed themselves of the BoC’s brand-new Standing Term Liquidity Facility to burnish their balance sheets.
Undaunted, Canadian Imperial Bank of Commerce (CM on the Toronto Exchange) CEO Victor Dodig offered reassurance to CIBC investors who have absorbed a negative 20% total return in local terms and negative 28% in dollars over the last two-plus years. In a BNN interview today, Dodig noted that the bank hasn’t cut its dividend since 1868: “Reliable income is incredibly important." Last year’s payout footed to C$5.68 per share, an indicated 7.2% dividend yield.
For more on the bear case for Canadian banks, and CIBC in particular, see the Feb. 9 2018 edition of Grant’s.
Recap March 31
A 1.5% decline in the S&P 500 wrapped up a 12.5% drop for the month and 20% first-quarter tumble for the broad index. Notable curve flattening in Treasurys left the 2- and 10-year yields at 0.25% and 0.66%, respectively, the narrowest differential in more than two weeks and down from 68 basis points on March 19.
Spot gold was hammered by 3% to $1,577 an ounce, while WTI crude consolidated near $20 a barrel and the VIX fell to a three-week low near 53.
- Philip Grant
Monday, March 30, 2020
Volatility chronicles
Hedging ain't easy.
Hedging ain't easy.
Trickle-down theory
It's alive!
It's alive!
Wet powder
The customer's yachts are in dry-dock.
The customer's yachts are in dry-dock.
Recap March 30
Volatility chronicles
Hedging ain’t easy. On Friday, exchange traded fund provider Direxion announced that it will accelerate deleveraging on 10 separate ETF products, including products tracking the Russian and Brazilian stock markets along with the price of gold and energy prices. Instead of the prior goal of 300% of the daily performance (or inverse performance) of a given asset or index, the ETFs will now target 200% moves.
While Direxion had announced on March 20 that such change would be going into effect on May 19, the provider apparently had second thoughts and announced a week later that the leverage cuts will be implemented by tomorrow.
Trickle-down theory
It’s alive! This morning, double-B-rated YUM! Brands, Inc. sold $600 million in five-year notes, marking the first high-yield corporate bond sale since March 4. A reported $3 billion order book allowed YUM to upsize the offering from an original $500 million, while the issue priced at 7.75%, the low end of the indicated 7.75% to 8% range. That compares to the senior unsecured 4 3/4 notes due 2030, which last changed hands at 90.5 cents on the dollar for a yield-to-worst of 6.04%.
While YUM had to pay up for the privilege, the return of primary junk issuance marks another positive step following a raft of fresh high-grade debt last week. Deals included triple-B-rated O’Reilly Automotive, Inc. and Weyerhaeuser, Inc. issuing fixed-rate notes at issuer-friendly prices relative to the underlying ratings category. “We’re bringing markets back by starting with strength and hoping to continue to build on that, going wider, deeper and bigger every day,” Richard Zogheb, global head of debt capital markets at Citigroup, tells Bloomberg. “We’re telling companies to be ready to go and assess on a day-to-day basis.”
For investors, gauging the credit markets on a company-by-company basis may be the way to go for the time being. In his latest commentary for LCD, Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC, writes today that while the option-adjusted spread on the ICE BofA High Yield Index widened by 581 basis points from Feb. 29 to March 23, the average issue within the index saw far more punishment, with a 835 basis point widening. As the high-yield index is market cap-weighted, relative outperformance from larger names accounted for that discrepancy. Fridson reports that while the heavier-weighted component of the index widened by 548 basis points, the smaller issues endured a 1,179 basis point OAS surge over the period.
Wet powder
The customer’s yachts are in dry-dock. Graham Bippart, editor of financial publication Private Funds CFO, reports that at least two limited partners in European private equity funds have defaulted on capital calls. A primary culprit: With publicly traded asset valuations in retreat, the relative portion of illiquid private securities in those LP portfolios had reached unsustainable levels, a phenomenon known as the denominator effect.
Then, too, LPs face pressure on two fronts. “Suddenly, distributions [i.e., cash payouts from existing investments] are going through the floor,” Eamon Devlin, a partner at MJ Hudson, told the publication. “At the same time, general partners have increased their capital call rates. Some LPs weren’t expecting draw-downs until summer this year on any of their funds.”
At the same time, general partners have no shortage of potential recourse against LPs who are unable to come up with previously committed capital. Bippart relays a number of widely used remedies available to private equity sponsors who have issued a capital call, including collecting daily interest and withholding distributions. In addition, GPs “can force up to an 80% haircut on the LPs interest, giving the other LPs the option to acquire that portion. If no other LPs want to buy [the stake], it can be offered to a third party. One person remarked that the haircut can often be higher than 80%.”
Recap March 30
Stocks continued their torrid rally, with the S&P 500 jumping more than 3% to extend its five-session gains to 17.5%, erasing nearly half of the peak-to-trough losses since the Feb. 19 highs. Treasurys reversed an early rally, as the 10-year yield finished at 0.71% after testing 0.6% this morning. Energy prices were strafed again, with WTI crude tumbling 6% to $20 a barrel, while gold finished slightly lower at $1,622 an ounce. The VIX slipped to 57, its lowest close since March 12.
- Philip Grant
Friday, March 27, 2020
They said it
Back to the drawing board
All that shimmers
All that shimmers
Dollar tree
The Financial Times reports this afternoon
The Financial Times reports this afternoon
Recap March 27
They said it
Yesterday evening, Fitch affirmed its triple-A rating on U.S. sovereign credit. However, the rating agency offered the following words of caution:
The risk of a near-term negative rating action has risen given the magnitude of the shock to the economy and public finances from the coronavirus and the commensurate and necessary fiscal policy response, particularly in the absence of a credible consolidation plan for the country’s pre-existing, longer-term public finance and government debt challenges.
Back to the drawing board
All that shimmers is not gold. Yesterday, Signet Jewelers Ltd. (SIG on the NYSE) announced that it has suspended its $0.37 per share common-stock dividend. That follows its decision last week to draw down $900 million from its asset-backed loan revolver facility to bolster operating liquidity.
Perhaps most concerning: Signet disclosed that CarVal Investors, LLC, has terminated its agreement to purchase accounts receivable from the baubles retailer, exercising an option to walk away if the cumulative net yield on the portfolio fell below an undisclosed, previously agreed-upon threshold. That is an ominous development, as roughly half of the company’s sales are financed through customer financing arrangements administered by third parties, primarily CarVal and Castlelake L.P.
Signet declared in its 10-K filing that it believes CarVal’s termination will not be material to financial results, as it reached a nonbinding memorandum of understanding with its other partner Castlelake to purchase 100% of the funding obligations henceforth.
However, it would be a different story if Castlelake followed CarVal out the door. From the 10-K: “if both sub-prime investors were to terminate and Signet is unable to find other potential providers to supply a similar third-party credit program and alternative payment options, Signet’s ability to extend credit to customers could be impaired and Signet could be required to revert back to an in-house credit program, which could have an adverse effect on the conduct of Signet’s business.” SIG’s leverage was daunting even prior to the pandemic shock, as net debt stood at $3.1 billion compared to $405 million in adjusted Ebitda for the year ended Feb. 1.
For an early bearish look at Signet, which has absorbed a 91% share-price decline since publication date, see the June 3, 2016 edition of Grant’s.
Dollar tree
The Financial Times reports this afternoon that net foreign currency reserves at Turkey’s central bank shrank to just $1.5 billion at the end of February, after accounting for short-term swap operations with local banks. The intervening four weeks look to have provided no assistance on that front: Net foreign assets (which include such swap arrangements) fell to $19 billion as of yesterday from $27.4 billion at the end of February and more than $35 billion at year end, suggesting the net reserves have also dropped further.
Needless to say, that lack of FX ammunition could pose problems. “The net reserve level is not sufficient to enable the central bank to make a sustained defense of the currency,” Paul Gamble, head of emerging Europe sovereign ratings at Fitch, told the FT: “If they try that it could worsen market pressures. Many central banks intervene to ease volatility when it comes to exchange rate movements, but Turkey does not have sufficient reserves for a more prolonged defense of the currency.”
Price action in the FX market seems to validate that concern, as the lira has fallen to nearly 6.5 per dollar, compared to 2.5 per greenback in 2015 and near the 6.9 nadir reached in the August 2018 currency panic. In a speech yesterday, President Recep Erdogan called on the Federal Reserve to expand dollar swap lines to every central bank in the G20 (of which Turkey is coincidentally a member) “to boost confidence in the global economy.”
As FX reserves evaporate and the lira slides, Turkish foreign-currency borrowers could soon feel the pinch. Bloomberg pegs total external debt maturing in the next 12 months at $172 billion. With options (and dollars) dwindling, Erdogan et al. might be forced into drastic measures. A reminder from independent strategist and long-time Turkey bear Russell Napier, who told Grant’s in the Aug. 7, 2015 edition: “If Turkey imposed exchange controls, that is a de facto default.”
Recap March 27
A modest (by current standards) 3% dip cut the weekly gains on the S&P 500 to 10% and extended the year-to-date decline on the broad index to 21%. Risk aversion reigned elsewhere, with Treasurys back in frenetic rally mode as yields on the 2-, 10- and 30-year fell to 0.25%, 0.69% and 1.26%, respectively. Energy prices were clubbed again, with WTI crude tumbling below $22 a barrel. Gold dipped slightly to $1,622 an ounce, and the VIX rose to 65, marking the 10th straight session the CBOE’s volatility index has remained above 60.
- Philip Grant
Thursday, March 26, 2020
Deal of the day
Home cooking
Other people's money
Here's Uber CEO
Here's Uber CEO
QE progress report
Recap March 26
Deal of the day
Primary debt markets have improved to the point where less-than pristine credits are having little trouble raising funds, even to refinance at favorable terms. Today, triple-B-rated Weyerhaeuser, Inc. sold $750 million (upsized from $500 million) in 10-year fixed-rate notes at 337.5 basis points over Treasurys. That’s well inside initial price talk of 375 basis points, let alone the 413-basis point pickup for the triple-B-rated component of the Bloomberg Barclays Investment Grade Index as of yesterday.
Weyerhaeuser, one of the world’s largest private timberland owners, will use the funds to help redeem a portion of the $569 million in 4.7% notes due in 2021, as well as for general corporate purposes. The company generated $1.28 billion in adjusted Ebitda last year, down from $2 billion in 2018. Net debt stands at $6 billion, of which $720 million comes due next year and an additional $1.87 billion in 2023.
Home cooking
Capital structure arbitrage, with Chinese characteristics.
On Sunday evening, Shenzhen-based property developer China Evergrande Group Ltd. released preliminary results for 2019, projecting that net profits fell to RMB 33.5 billion ($7.5 billion), down 50% from the prior year’s bottom line. Official results are expected at the March 31 annual meeting.
Evergrande, which also operates an electric car business (it lost RMB 4.9 billion in 2019), was facing a rocky road even before the COVID-19 outbreak. It carried a total debt load of more than $100 billion as of the end of February, according to Dealogic.
Curiously, American and Chinese investors seem to have arrived at opposite conclusions regarding the creditworthiness of single-B-plus-rated Evergrande. While the company’s senior secured 6 1/8 dollar-pay bonds due in June of next year have slumped to 80 cents for a yield-to-worst of 25.7%, RMB-denominated 6.98% senior unsecured notes of July 2022 remain just above par, for a yield-to-worst of 6.9%.
For more on Evergrande, see the June 2, 2017 edition of Grant’s.
Other people's money
Here’s Uber Technologies, Inc. CEO Dara Khosrowshahi on Twitter yesterday evening, celebrating the Senate passage of a bill offering relief to “gig economy” workers laid low by current circumstances and urging the House to follow suit:
Thanks to the Senate for supporting 1.3M Uber drivers & delivery people. Many independent workers are on the frontlines; all deserve support. Hope the House will act on this bill & government will join our push for new laws permitting co.’s like Uber to provide new benefits going forward.
In lending a hand to Uber drivers, Uncle Sam would help fill the void left by the rideshare giant’s business model. A Jan. 6 report from the Washington Post documented “Project Luigi,” Uber’s internal initiative to thwart California’s Assembly Bill 5, which came into law this year and reclassifies drivers as employees rather than independent contractors, meaning Uber can no longer avoid paying healthcare and other common benefits. Uber, peer Lyft, Inc. and delivery concern DoorDash, Inc. each chipped in $30 million to help advance the “Protect App-Based Drivers and Services Act,” onto the California ballot for this fall, a measure which would largely exempt those “independent contractors” from AB5.
Last Thursday, those “independent contractors” protested outside Uber offices in San Francisco, Los Angeles and San Diego calling for help. Forbes noted that the protesters “circulated a petition with a short list of ‘asks,’ including immediate enforcement of AB5 and reallocation of the companies’ anti-AB5 lobbying dollars.”
Charity begins at home.
QE progress report
Uncle Jerome saves the day. Reserve Bank credit (i.e. the Fed’s sum total of interest-bearing assets) rocketed higher to $4.97 trillion, up $507 billion from a week ago. That goosed the three-month annualized growth rate to 43%, double the 21% last week and triple the 13.8% growth rate logged at the end of February.
Thanks to this week’s shopping spree, Reserve Bank credit now exceeds its pre-QT highs by nearly 13%. And there’s more where that came from.
Recap March 26
Coincidence? Stocks continued their feverish rally, with the S&P 500 racing higher by 6% to extend its three-day gains to 17.5% and close within 22.5% of the Feb. 19 high-water mark. Treasurys were modestly bid across the curve, with the 2-, 10- and 30-year yields falling to 0.3%, 0.85% and 1.44%, respectively, while gold rose to $1,625 an ounce and WTI crude slumped below $24 a barrel. The VIX remained indifferent to the stock market rally, holding above 60.
- Philip Grant
Wednesday, March 25, 2020
The howitzer chronicles
Is outright debt monetization coming to the Old Continent?
Is outright debt monetization coming to the Old Continent?
Credit check
Scales of justice
On Monday, Moody's Investors Service
On Monday, Moody's Investors Service
Recap March 25
The howitzer chronicles
Is outright debt monetization coming to the Old Continent? Bloomberg reports this afternoon that the European Central Bank may begin so-called outright monetary transactions, a 2012-era mechanism which “allows the ECB to buy nearly unlimited quantities of a nation’s sovereign debt, pushing down bond yields that risk making much-needed fiscal stimulus unaffordable.”
What yields?
Credit check
Yesterday, the spread on the Bloomberg Barclays Investment Grade Index tightened to 353 basis points, off the cyclical high of 373 basis points reached on Monday. As measured by default protection prices, the rebound in corporate credit continues today, with the Markit Investment Grade CDX Index tumbling another 16 basis points to 94 basis points this afternoon, well below Friday’s high of 148 basis points. For context, spreads and CDX prices peaked at 618 basis points and 279 basis points, respectively, in December 2008.
The improved risk appetite was not lost on corporate America. Some $20 billion in domestic investment-grade bond issuance brings the two-day total above $39 billion, far above the (full week) pace of $63 billion a week ago, let alone the mere $7 billion in fresh supply in the week ended March 6.
Beyond the sales stampede, today’s batch featured some notably strong pricing, particularly at the lower end of the I.G. credit spectrum. A pair of examples: Triple-B-rated O’Reilly Automotive, Inc. sold $500 million in 10-year fixed rate notes at a 340 basis point spread vs. Treasurys, well inside initial price talk of 375 basis points. That compares to a 443 basis point spread on the triple-B component of the Bloomberg Barclays Investment Grade Index as of yesterday’s close.
Fast food leviathan McDonald’s, Inc. fared even better, as its $3.5 billion, four-part debt offering priced at a range of 280 to 285 basis points over Treasurys on the 5- and 30-year fixed-rate notes, respectively, well inside the initial price talk of 340 to 345 basis points. Triple-B-plus-rated McDonald’s, which earlier today warned of a “material” impact on results from the COVID-19 pandemic, saw its outlook cut to “negative” from “stable” by S&P Global, with the rating agency warning that deteriorating operating performance “could result in an expectation for prolonged credit measure deterioration and a downgrade.”
Scales of justice
On Monday, Moody’s Investors Service announced a two-notch downgrade of SoftBank Group Corp., to Ba3 (equivalent to single-B-minus) from Ba1. The ratings agency cited “aggressive financial policy,” in explaining the move, an example of which perhaps includes SoftBank’s decision to undertake a $4.5 billion stock buyback program two weeks ago while already facing a fulsome debt load and cash crunch across a number of the profitless enterprises in its Vision Fund portfolio. Cash and cash equivalents footed to ¥1.7 trillion ($15.3 billion) as of Dec. 31, roughly equal to scheduled bond and loan maturities over the next two fiscal years.
Then, too, SoftBank’s Monday announcement of a planned $41 billion in asset sales failed to mollify Moody’s senior credit officer Motoki Yanase, who commented: “Asset sales will be challenging in the current financial market downturn, with valuations falling and a flight to safety.”
Needless to say, the tech, telecom and venture capital colossus did not take kindly to Moody’s decision. In a statement, SoftBank lamented the “biased and mistaken views” behind the downgrade, declaring that “Moody’s ratings action is based on excessively pessimistic assumptions regarding the market environment and misunderstanding and speculation that SBG will quickly liquidate assets without any thorough consideration and without making improvements to its financial condition.”
SoftBank’s outburst spurred a sympathetic response from longtime friend-of-Grant’s Paul Isaac: “I often feel the same way about my bathroom scale.”
For a detailed primer on SoftBank, see the Dec. 15, 2017 edition of Grant’s which dubbed the conglomerate “the epitome of the cycle.” It wasn’t a compliment.
Recap March 25
A late reversal erased most of the day’s gains as the S&P 500 eked out a 1% advance, narrowing its decline to 27% from the Feb. 19 highs. Treasurys saw rare relative calm, with modest steepening action across the curve as the 2-, 10- and 30-year yields settled at 0.33%, 0.85% and 1.42%, respectively.
WTI crude rose above $24 a barrel, gold retraced some of its recent gains to finish at $1,610 an ounce, and the VIX rose 4% to 64, marking the fourth straight day the CBOE’s volatility gauge moved in the same direction as stock prices.
- Philip Grant
Tuesday, March 24, 2020
No backsies
Cough it up.
Cough it up.
Physical challenge
A second straight rip in gold took the
A second straight rip in gold took the
Recap March 24
No backsies
Cough it up. Bloomberg reports this morning that Goldman Sachs Group, Inc. and JPMorgan Chase & Co. “are demanding that managers of collateralized loan obligations put up more cash to finance the deals” currently warehoused at the banks following the collapse in prices on the underlying leveraged loans (i.e. floating rate bank debt issued by speculative grade borrowers). Year-to-date, the LSTA/LCD Leveraged Loan Index has plunged by 19%, with nearly all of those losses concentrated in March.
At $1.2 trillion in face value, the size of the loan market has grown by almost 50% in the last five years, now roughly equal to the previously-much-larger high-yield bond market. That mushrooming loan growth has been concentrated in less-than-stellar credits, as Moody’s Investors Service reports that 38% of loans carried a deep-junk rating of B3 or lower (equivalent to single-B-minus), as of July. That’s up from 22% in 2008.
As prices plumb lower, liquidity evaporates. Citing anonymity-seeking portfolio managers yesterday, LCD relayed that “bid prices have fallen as far as four to five points beyond the original quoted bid when [managers] have looked to close a trade. Likewise, some trading desks have stopped publishing [price] runs for loan quotes given the extreme price discovery ongoing in the loan market.”
With prices in free fall and liquidity nowhere to be found, Bloomberg reports that would-be loan buyers are attempting to pull the plug on financing commitments by invoking so-called material adverse change (MAC) clauses, which allow a buyer to step away in the case of certain circumstances which impair the value of the corporate assets in question. There’s just one problem, according to Jane Gray, analyst at Covenant Review: “As the market has been hot, most deals that get done don’t have a general MAC clause. The fact that lenders are looking at the MAC clause also indicates to us how weak documents have become.”
For an early look at the proliferation of leveraged loans, CLOs and the pitfalls awaiting the end of the “covenant-lite” era, see the Grant’s analysis entitled “Tomorrow’s debt hearings” from the July 13, 2018 edition.
Physical challenge
A second straight rip in gold took the yellow metal to $1,625 an ounce on the spot market this afternoon, near its recent $1,680 per ounce high and within 15% below its long-term peak reached in 2011.
Supply shortages owing to the widespread cessation of business activity play a key role. After yesterday’s announcement from Newmont Mining, Inc. (the world’s largest) that it was idling a quartet of mines across Canada and Peru, competitors have followed suit. This morning, Toronto-based Iamgold Corp. announced it has placed its Westwood mine under “care and maintenance”, while Eldorado Gold will minimize operations at the Lamaque mine in Quebec until April 13, maintaining only essential personnel on site. Yesterday, the South African government ordered mines to shut down for 21 days, while a number of refineries in Switzerland and Canada have also halted operations.
The acute shortage of physical gold has reached historic proportions, with COMEX futures for June delivery priced at a $57 premium to London spot prices this morning. According to Bloomberg, that’s the largest divergence between the most active contracts since 1980. “If you need to borrow gold in the OTC [over-the-counter] markets right now, you are going to pay a king’s ransom” commented Ole Hanson, head of commodity strategy at Saxo Bank.
While that tightening liquidity can be largely chalked up to supply and workplace disruptions resulting from the pandemic, Bill Fleckenstein, president and eponym at Fleckenstein Capital, tells ADG today that the unusual price discrepancies are symptoms of a fundamental problem:
The modern gold market is run, by design, on skimpy physical supply. In normal times, buyers of the physical metal can be overwhelmed by sellers of the paper product. That dynamic has been turned on its head.
Stateside, the extraordinary policy response from the Federal Reserve, which yesterday promised daily Treasury and MBS purchases on par with the monthly targets of prior QE programs (Almost Daily Grant’s, March 23), further stir the bullish zeitgeist. Yesterday, the yield on 10-year Treasury Inflation Protected Securities jumped to 0.8% from a post-2009 low of 0.5%, perhaps signifying renewed inflation expectations among the general investing public.
Supply will come back online, and liquidity conditions will improve as buyers and sellers return to the office. Yet the Fed’s increasingly broad-based market interventions are likely to remain, if history is any guide. Analysts at Goldman Sachs declared this morning: “We have long argued that gold is the currency of last resort, acting as a hedge against currency debasement when policy makers act to accommodate shocks such as the one being experienced now.”
They said it, so we don’t have to (again).
Recap March 24
A beastly rally left the S&P 500 up more than 9% for its largest gain since October 2008, narrowing the monthly losses to 17%. Rates moved modestly higher, with the 2-, 10- and 30-year yields settling at 0.38%, 0.85% and 1.4%, respectively, while WTI crude rose 3% to $24 a barrel. The VIX held just below 62, consolidating after conspicuous declines on Friday and Monday as the stock market buckled.
- Philip Grant
Monday, March 23, 2020
Chaos creates opportunity
The howitzer chronicles
In other words, "whatever it takes!"
In other words, "whatever it takes!"
The thing itself
The 11% sell-off in gold over the past month
The 11% sell-off in gold over the past month
Damage assessment
The recent wipeout in credit
The recent wipeout in credit
Recap March 23
Chaos creates opportunity
The marketing department of the parent company of ADG long ago discovered that its best sales tool was Grant’s Interest Rate Observer itself.
So please avail yourself of the sample attached here.
And if you agree that a serious investor really can’t afford not to subscribe, just tap www.grantspub.com/subscribe.
Easy as pie.
We thank you.
The howitzer chronicles
In other words, “whatever it takes!” Before the opening bell, the Federal Reserve pledged to purchase Treasurys and mortgage-backed securities “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.” Minutes later, the Federal Reserve Bank of New York chimed in with plans to buy $75 billion in USTs and $50 billion in agency MBS each and every day, “subject to reasonable prices.”
For context, the Fed bought $75 billion in Treasurys per month under the so-called QE2 program of 2010 to 2011, and $40 billion of mortgage backed securities per month in the 2012 to 2013 QE3 program. The newly announced weekly pace of $375 billion of Treasury and $200 billion of MBS purchases would add roughly 15% and 18%, respectively, to the central bank’s current holdings of each asset class. That is, per week.
And that’s not even all. Beyond ramping up those existing strategies, the Fed is expanding its QE into different realms, announcing the establishment of a pair of facilities, one directly lending to new corporate debt issuers and the other to a so-called special purpose vehicle which will then purchase corporate bonds on the secondary market (issues must be rated investment grade by at least two agencies and mature in five years or less) as well as ETFs which “provide broad exposure” to the investment-grade bond market.
Step aside, Mr. Market. Uncle Sam is buying you out.
The thing itself
The 11% sell-off in gold over the past month (this after today’s near-5% rally) has done little to clear growing supply bottlenecks. The Financial Times reports today that dealers, refiners and investors around the world are struggling to source adequate gold supplies. A trio of Switzerland’s largest dealers have announced production delays in recent days, while precious metals dealer Degussa announced that it is having difficulty filling customer orders, as daily demand is running at five times its average.
“There’s a disconnect between prices in the physical gold market and the prices you see on your screen,” Ronan Manly, analyst at Singapore-based brokerage BullionStar, told the FT. “I don’t think you will find a kilobar presently in Europe and the US for love nor money,” added Ross Norman, a long-time gold trader. “It’s quite extraordinary.”
There’s more (or less) where that came from, if the experience of the world’s largest gold miner is broadly representative. This morning, Newmont Mining, Inc. announced it is temporarily closing a quartet of mines in Canada and Peru on account of the virus and withdrawing financial guidance for 2020. Newmont now expects first quarter production of roughly 1.4 million ounces of gold, below the 1.6-million-ounce quarterly production schedule linearly implied by a full year target of 6.4 million ounces. On the day, Newmont shares rose 2.7%, lagging the 6.7% gain in the VanEck Vectors Gold Miners ETF.
Damage assessment
The recent wipeout in credit has pushed the spread on the ICE BofA High Yield Index to 1,009 basis points over Treasurys as of Friday (up from 356 basis points as recently as Feb. 17), surpassing the 1,000 basis point threshold which traditionally designates a distressed investment. In a commentary for LCD this afternoon, Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors LLC, reports that market pricing now suggests a 12-month corporate default rate of 9.38%. Ratings agency S&P Global is even gloomier, penciling in 10% next year and a rate as high as 13% in a more severe scenario.
The high-yield market’s pain has left even some relatively stronger issuers consigned to distressed territory. Nearly one quarter of the double-B-rated (the penthouse of junk) index component has fallen to distressed levels, including 13.5% of the non-energy cohort.
As noted by Fridson, a quartet of double-B-rated non-energy bonds have seen spreads widen into distressed territory, including electricity generator TransAlta Corp.’s 4.5s of 2022, L Brands, Inc.’s 5 5/8 notes of 2022, Springleaf Finance Corp.’s 6 1/8% notes of 2022 and information technology concern Ingram Micro, Inc.’s 5s of 2022. Beyond sharing a double-B rating (and, coincidentally, a 2022 maturity date), each of those issuers traded at a tighter spread to Treasurys vs. the median double-B issue just three weeks ago. In addition, none of the four carry a negative outlook or have been watchlisted for potential downgrade by any of the rating agencies.
Appealing? A strategy focused on these potential “bathwater babies” performed impeccably during the financial crisis. The Dean of High Yield reports that a “basket consisting of all Dec. 31, 2007 non-financial distressed double-Bs beat the ICE BofA High Yield Index by a stunning 19.59%, on a time-weighted basis.”
Recap March 23
Another leg down in stocks pushed the S&P 500 lower by 31% year-to-date to its lowest close since late 2016. Treasury yields dipped lower, with the 2- and 10-year notes settling at 0.31% and 0.75%, respectively, and the long bond yielding 1.31%. WTI crude and gold both caught a bid, settling at $24 a barrel and $1,553 an ounce, respectively, while the VIX continues its gradual descent from the heavens, finishing at 62 compared with 83 a week ago.
- Philip Grant
Friday, March 20, 2020
The howitzer chronicles
This morning,
This morning,
Cheese grater
Yesterday afternoon,
Yesterday afternoon,
Recap March 20
The howitzer chronicles
This morning, the Federal Reserve announced it will expand the use of the two-day old Money Market Mutual Fund Liquidity Facility to cover municipal debt, in order to “enhance the liquidity and functioning of crucial state and municipal money markets.” Banks and other financial institutions will now be permitted to use single-state and other tax-exempt munis maturing in 12 months or less as collateral for loans.
A bill presented today by Senator Robert Menendez (D-N.J.) would bestow on the Federal Reserve the ability to directly purchase municipal bonds on the open market, in the case of “unusual and exigent circumstance.” For context on the state of New Jersey’s and New York’s finances and the risks to its municipal creditors, see the April 7, 2017 and Jan. 10, 2020 editions of Grant’s.
Cheese grater
Yesterday afternoon, single-A-rated Walt Disney Co. (DIS on the NYSE) sold $6 billion in senior notes in a five-part offering, with maturities ranging from 2025 to 2050. The House of Mickey Mouse, the subject of a bearish Grant’s analysis on Jan. 25, 2019, paid a 275 basis point premium over Treasurys on its $1.75 billion five-year tranche, while the $1.75 billion of 30-year bonds came in at a 285 basis point spread.
It’s a far cry from last fall, when Disney placed 30-year bonds at a 2.75% coupon and 95 basis point spread over Treasurys, which briefly stood as the lowest ever 30-year borrowing cost for a corporate issuer. Issued just below 97 cents on the dollar, the senior unsecured 2 3/4s of 2049 have slipped to 75.2 cents for a 255 basis point pickup to Treasurys.
In a filing yesterday, Disney made no bones about the damage that current circumstances are inflicting: “Our businesses could also be impacted should the disruptions from COVID-19 lead to changes in consumer behavior. The COVID-19 impact on the capital markets could impact our cost of borrowing. There are certain limitations on our ability to mitigate the adverse financial impact of these items, including the fixed costs of our theme park business.” New management will be confronting these dangerous times, as longtime CEO Robert Iger abruptly resigned on Feb. 25, replaced by Robert Chapek, previously chairman of the Parks, Experiences and Products division.
Indeed, Disney’s business model serves as a type of one-stock disaster ETF. With the COVID pandemic wreaking havoc on tourism, Disney’s cyclical and capital-intensive parks segment looks set for a precipitous fall. The unit delivered $7.4 billion in revenue and $2.3 billion in operating income in the quarter-ended Dec. 28, representing 35.4% and 58.2% of consolidated revenue and operating income, respectively.
Meanwhile, the cessation of live sports has forced Disney’s ESPN unit to scramble. As Bloomberg’s Tara Lachapelle documented yesterday, viewers who tune in this weekend can expect such fare as the national stone-skipping championships, along with bratwurst eating and cherry pit-spitting contests as well as the “Stupid Robot Fighting League.” The programming shock exacerbates long-term problems at ESPN, which counted 83 million subscribers as of Sept. 28 (the end of Disney’s fiscal year), down from 99 million subscribers in 2013.
In addition, the global rollout of the Disney+ streaming service (which debuted stateside in November) has hit a snag thanks to the current difficulties, with the company announcing today that the Indian debut of Disney+ will be pushed back from the planned March 29. Other countries could soon follow suit, as French telecom giant Orange S.A. CEO Stéphane Richard said in an interview today with Le Figaro that “perhaps a postponement of several weeks [for] Disney+ would be advisable.” Those delays are painful, as the widespread shuttering of movie theaters places a larger emphasis on streaming and in-home entertainment options.
Stalling operations and ill-timed acquisitions make a formerly manageable debt load potentially burdensome. Net debt of $65 billion (after yesterday’s sale) equates to about four times trailing 12-month Ebitda. That sum is largely attributable to the 2019 acquisition of Twenty-First Century Fox, Inc. for $71.3 billion in cash and stock completed in March of last year, at a 63% premium to the target’s pre-deal announcement price.
According to a 2017 analysis from Moody’s Investors Service, that debt load is equivalent to borrowers not in the relatively rarified air of single-A, but rather in between the 3.6 times for double-B and 5.2 times for single-B. Despite Disney carrying a junk-worthy debt profile, its debt trades comparably to the current 265 basis point spread on offer for the single-A component of the Bloomberg Barclays Investment Grade Index.
Yesterday’s debt sale was earmarked for “general corporate purposes.” Near-term liquidity could be one potential use: Disney faces nearly $11 billion in principal maturities next year according to data from Bloomberg. By comparison, Disney reported $6.8 billion in cash and equivalents as of Dec. 28.
Recap March 20
A 4% decline in the S&P 500 left the broad index down 15% for the week (the worst such showing since October 2008), 29% year-to-date and 32% from its Feb. 19 high-water mark. Treasurys reverted to panic-rally mode, with the 2-, 10- and 30-year yields racing lower by 12, 26 and 31 basis points, respectively, to 0.33%, 0.88% and 1.47%.
WTI crude plunged 11% to $22.4 a barrel, extending its weekly decline to 29% for its biggest percentage loss since 1991. Gold edged higher by 1% to $1,488 an ounce, while the VIX somewhat incongruously dropped 7% to 65, well below its Monday close of 82.
- Philip Grant
Thursday, March 19, 2020
Bazooka Joe
Let's review the latest round of action from the Federal Reserve.
Let's review the latest round of action from the Federal Reserve.
Off the canvas
Yesterday, the Bloomberg Mortgage REIT (real estate investment trust) Index collapsed by 24%,
Yesterday, the Bloomberg Mortgage REIT (real estate investment trust) Index collapsed by 24%,
QE progress report
Recap March 17
Bazooka Joe
Let’s review the latest round of action from the Federal Reserve.
Shortly before midnight yesterday, the Fed announced the creation of the Money Market Mutual Fund Liquidity Facility, designed to “assist money market funds in meeting demands for redemptions by households and other investors.” The U.S. central bank has also set up currency swap-lines with an additional nine foreign central banks, offering a total of $450 billion of dollar-denominated liquidity.
That follows Tuesday’s reintroduction of the 2008-era Commercial Paper Funding Facility, intended to smooth the transmission of short-term funding to needy corporate borrowers, along with a Primary Dealer Credit Facility, which accepts collateral including municipal bonds and “a broad range of equity securities.” In addition, the Fed announced that it will purchase $75 billion of Treasurys today and tomorrow (up from a $40 billion pace announced on Sunday), as well as “at least” $200 billion worth of agency mortgage-backed securities over the coming months.
Those moves supplement Sunday’s announcement of a 100 basis point rate cut to a range of zero to 0.25% on the Federal Funds rate, which was the administered borrowing cost from December 2008 to December 2015.
Off the canvas
Yesterday, the Bloomberg Mortgage REIT (real estate investment trust) Index collapsed by 24%, extending its one-month loss to 60% and plumbing depths last seen in the bond rout of 1994. With economic activity screeching to a halt, investors are being forced to swiftly reassess the prospects of these leveraged landlords.
Reports of potential payment holiday discussions among government officials weighed heavily on the group. “The system is not designed to simply let borrowers skip payments for several months,” Cowen analyst Jaret Seiberg wrote in a report yesterday. “The broader economic chaos this could trigger would be substantial.” The announcement yesterday from UBS A.G. that it was redeeming a pair of leveraged mortgage REIT exchange-traded notes, which had fallen below a predetermined redemption threshold, added to investor alarm.
Blackstone Mortgage Trust, Inc. (BXMT on the NYSE), a commercial real estate finance company and on-and-off Grant’s pick-to-click over the years (most recently on July 13, 2018), has received a full dose of Mr. Market’s bitter medicine. Over the last four days, shares suffered a 43% swan dive, pushing the total return to negative 41% with dividends reinvested over the last 32 months. Over that period, the S&P 500 has returned negative 11%.
While BXMT’s drop can largely be chalked up to the current difficulties, a trio of company-specific factors may make investors take pause. Leverage is substantial, as the company sports a 3 times debt to equity ratio, up from 2.3 times in July 2018. Geographic factors may also figure in, as 29% of BXMT’s portfolio is housed in Europe and the United Kingdom.
Then, too, one feature of the company’s business model now resembles a bug. Unwilling to compete with bigger fish such as banks and insurance companies in lending to fully occupied trophy properties, BXMT instead targets buildings that have just lost a key tenant or are otherwise in operational flux. Needless to say, current circumstances have cast a pall over that strategy.
Yet the company employs a conservative credit profile, with a weighted loan-to-value ratio of 64%, while the $17.9 billion loan book was performing at a pristine 100% coming into the year.
Speaking at a property conference hosted by Citi on March 2, CEO Stephen Plavin pointed to stability in the form of broad access to capital: “And one of the great things about our balance sheet is, how diversified it is in terms of our sources of funding. . . we do maintain relationships with more than a dozen banks [with] bilateral credit facility relationships.”
The financial composition of BXMT’s portfolio also offers some protection. While 97% of loans in the portfolio are of the floating-rate variety, the vast majority sport a LIBOR floor, limiting the decline in interest income as rates drop (in fact, the company estimated in a Feb. 21 presentation that a 100 basis point change in LIBOR from year end in either direction would add $0.03 in EPS per quarter). In addition, safety has long been front-of-mind for management. Back in 2018, Plavin noted that “our loans do not participate in the upside. We are very mindful of the downside risks in the assets we finance.”
While the market remains gripped in the throes of panic, and the economic damage from present circumstances promises to be severe, the recent wipeout has conferred on BXMT what the value tribe knows as a margin of safety. Shares now trade at just 68% of book value, compared to a premium of 140% prior to the current crisis and 117% five-year average, while the current dividend yield stands at 13.6% (Blackstone Mortgage Trust achieved dividend coverage of 109% last year).
BXMT price-to-book ratio, five-year chart. Source: The Bloomberg
One publicity-shy investor BXMT bull told Grant’s yesterday that the crash presents an opportunity in any non-worst-case scenario:
For a portfolio at a 64% loan-to-value, with loans that have a LIBOR floor and liabilities that do not, markets are pricing in not only default risk among borrowers, but also in a severe downward repricing of collateral (commercial real estate) values...when we are back into a zero interest rate environment for the foreseeable future.
One cautionary note: The last insider purchase came from director Leonard Cotton, who bought 3,000 shares in fall 2018. BXMT’s battered investors would surely appreciate a show of confidence from the c-suite.
QE progress report
The Cavalry has arrived, as Reserve Bank credit (i.e. the sum total of interest-bearing assets held by the Fed) jumped $241 billion to $4.46 trillion, triple last week’s sequential increase. That pushed the three-month annualized growth rate to 21.1%, up from 15.3% from a week ago and 13.9% on March 4.
Recap March 17
A major bounce in the energy complex pushed WTI crude oil back above $25 a barrel, with a 25% gain its largest in percentage terms since at least 1983. Gold slid by 1% to $1,471 an ounce, its lowest since mid-December.
Stocks finished slightly higher, as a placid day by recent standards saw the S&P 500 confined to a “mere” 6% peak-to-trough range, while the VIX fell 7% to 71. That “placid” price action was also on display in Treasury complex, as the 2-, 10- and 30-year yields settled at 0.48%, 1.19% and 1.81%, respectively, each within 6 basis points of yesterday’s closing level.
- Philip Grant
Tuesday, March 17, 2020
Risk parody
Headline of the day, from The Onion:
Headline of the day, from The Onion:
He said it
Here's Ed Yardeni,
Here's Ed Yardeni,
Ports in the storm
Signs of life from the corporate bond market,
Signs of life from the corporate bond market,
Recap March 17
Risk parody
Headline of the day, from The Onion:
Congress Allocates $2 Trillion To Bail Out Struggling Bailout Industry
He said it
Here’s Ed Yardeni, eponym of Yardeni Research, Inc. and former economist at the Federal Reserve, speculating to Barron’s on the next next thing:
They're increasingly likely to go to Congress and ask for authorization to buy corporate bonds. I can see them setting up liquidity facilities in the credit and muni markets, where we're seeing spreads blow out.
Ports in the storm
Signs of life from the corporate bond market: This morning, some of the country’s most creditworthy concerns managed to tap the bond market, after no issuers came forward yesterday. Let’s review a trio of deals from three bedrocks of corporate America.
Verizon Communications, Inc. sold $750 million worth of 7-year fixed-rate notes, $1.5 billion in 10-year notes and $1.25 billion in 30-year bonds, at spreads of 215 basis points, 240 basis points and 250 basis points over Treasurys, respectively, according to Bloomberg. That compares to initial price talk of 230, 240 and 270 basis point spreads. Verizon, rated-triple-B-plus at Standard & Poor’s and single-A-minus at Fitch Ratings, sports net debt of $132 billion, compared to $44 billion in Ebitda last year. Operating income of $30.3 billion covered the $4.7 billion in interest expense more than six times over.
Next up, ExxonMobil Corp., which issued fixed-rate notes across five maturities ranging from 2025 to 2050. Prices on the offering range from 225 basis points on the shortest maturity issue due 2025, to 260 basis points on the fixed rate note due 2050. That compares to initial price talk of 235 basis points over Treasurys for the five-year notes and 275 basis points for the 30-year bonds.
Exxon, which was downgraded by S&P to double-A from double-A-plus yesterday (Moody’s Investors Service still rates the oil major triple-A), is set to implement swift operational changes, according to CEO Darren Woods: “Based on this unprecedented environment, we are evaluating all appropriate steps to significantly reduce capital and operating expenses in the near term.” Net debt of $57 billion compares to $27.3 billion in 2019 Ebitda, while XOM produced $6.8 billion in operating income last year, slightly more than nine times the $746 million in interest expense.
Finally, single-A-plus-rated PepsiCo, Inc. came to market with a $6.5 billion six-part fixed-rate offering, with maturities ranging from 2025 to 2060. Those issues priced at 160 basis points over Treasurys on the five-year note, and 230 basis points on the 40-year bond, inside of initial price talk which varied from 190 basis points over Treasurys to a 245 basis point spread. Pepsi’s net debt stood at $27.9 billion on Dec. 31, equivalent to just over two times last year’s $13.5 billion Ebitda, while $10.7 billion operating income covered the $935 million interest expense more than 11 times over.
More broadly, the Bloomberg Barclays Investment Grade Index finished yesterday at a 242 basis point option-adjusted spread over Treasurys, topping the early 2016 peak of 221 basis points but shy of the October 2011 high of 260 basis points, let alone the 618 basis point pickup reached during the abyss of December 2008. I.G. default protection prices as measured by the Markit CDX Index closed at 124 basis points, unchanged from yesterday and down slightly from Thursday’s recent high of 139 basis points. Of course, one of the biggest risk’s for investment-grade bondholders is the fast-growing stack of credits at the bottom end of the spectrum. According to CreditSights, roughly half of the high-grade market sports ap triple-B rating (the final rung above junk), compared to 36% in 2005.
Recap March 17
Reports that the Trump administration is preparing direct financial assistance for U.S. citizens spurred an epochal selloff in the Treasury complex, as the 2- , 10- and 30-year yields exploded higher by 13, 34 and 38 basis points, respectively to 0.49%, 1.06% and 1.67%.
Stocks caught a bid that could be considered modest by current standards, with the S&P 500 rising 5.5% to narrow the broad index’s losses to 10% over the last 52 weeks. Energy prices continued their descent with WTI crude tumbling below $27 a barrel. Both gold and the VIX showed muted reactions to today’s price action and news flow, rising 1% to $1,529 an ounce and falling 11% to 73.3, respectively.
- Philip Grant
Monday, March 16, 2020
Recap March 16
Liquidity check
Last Thursday,
Last Thursday,
Spinal tap
The parade of companies opting
The parade of companies opting
Recap March 16
An 11% drop in the S&P 500 extended year-to-date losses to 25.5%, as the broad index closed at its lowest since Dec. 24, 2018. A third straight move of at least 9% marks the first instance of such share-price whiplash since 1929.
Needless to say, fear is palpable. The VIX rose above 83, up more than 40% on the day and topping the 80.8 high-water mark from November 2008. Treasury yields raced lower once more, with the 2-, 10- and 30-year maturities settling at 0.37%, 0.74% and 1.35%, respectively. Brent crude fell below $30 a barrel for the first time since the 2016 oil crisis, while gold extended its slide to $1,500 an ounce, down 11% from a week ago.
Liquidity check
Last Thursday, the municipal bond market saw $29.8 billion in trading volume according to Bloomberg, the highest one-day turnover in almost a decade and more than double the year-to-date average of $13.7 billion. A daily average of 3.17 million shares in the VanEck Vectors High-Yield Municipal Index ETF (HYD on the NYSE Arca) changed hands last week, nearly 7 times the average volume over the past year.
Yet despite that surge in transactions, illiquidity reigns. CreditSights relays this morning that the par volume of so-called bid wanteds in the municipal bond market jumped to $11 billion last week, nearly double the $6.5 billion in the week prior and a $3.7 billion weekly average year to date. In addition, the average municipal bond closed-end fund saw its average discount to net asset value widen to 8.42% as of Friday, nearly double the 4.69% gap on March 6.
As for the aforementioned VanEck fund, that ETF sported a whopping 17% implied NAV discount at day’s end, up from 12.4% at the close on Friday.
Spinal tap
The parade of companies opting to tap their credit lines continues. On Friday evening Micron Technology, Inc., announced after the close that it will draw down its entire $2.5 billion revolving credit facility “as a precautionary measure” for “general corporate purposes.” Micron appears to be in decent enough shape, with $7 billion of cash and cash equivalents on its balance sheet as of Nov. 30 against total debt of $5.6 billion, while the company has generated positive free cash flow in seven of the past eight years. The maturity schedule is also forgiving, with no substantial principal payments due on its borrowings this year or next.
Others who have availed themselves of their credit facilities stand on shakier ground. This morning, Penn National Gaming, Inc. disclosed in a filing that it has drawn down its $700 million facility “to ensure it maintains ample financial flexibility.” The company states that “there are currently no plans to deploy the drawn-down funds.”
Rated Ba3 and single-B-plus at Moody’s and Standard & Poor’s, respectively, Penn showed $10.8 billion in total debt (inclusive of financing and operating lease obligations) against $1.58 billion in adjusted Ebitda for 2019. Cash and cash equivalents footed to $438 million as of year end (down 9% year-over-year) a sum reduced by the Jan. 29 purchase, for $164 million in cash and convertible preferred stock, of a 36% stake in online publisher Barstool Sports.
This afternoon, the Financial Times reports that beer giant Anheuser-Busch InBev S.A./N.V. told its bankers late last week that it will draw down the entirety of its $9 billion facility, as it attempts to cope with a $95 billion marketable debt load (4.5 times trailing adjusted Ebitda) accumulated thanks to a global M&A spree that included coughing up $65 billion for SAB Miller plc in 2016. On Feb. 27, ABI warned that it expects first quarter earnings to fall by as much as 10% from a year ago but maintained its full-year guidance, anticipating a rebound in the second half of the year.
The company is a subject of some disagreement among the rating agencies. Moody’s assesses ABI at Baa1 (equivalent to triple-B-plus), Standard & Poor’s at single-A-minus and Fitch at triple-B. The bond market is taking a more cautious view, as ABI’s 5.55s of 2049 currently trade at a 295 basis point spread over Treasurys, well above the 216 basis point pickup on offer (as of Friday’s close) for the Bloomberg Barclays Investment Grade Index. For more on ABI, see the Feb. 9, 2018 edition of Grant’s.
- Philip Grant
Friday, March 13, 2020
Recap March 13
Now it's getting serious
A headline from the New York Post:
A headline from the New York Post:
Credit check
Going viral
CoindDesk reports today that
CoindDesk reports today that
Drifting too far from the shore
Dislocations in the bond market
Dislocations in the bond market
Recap March 13
A tremendous, beautiful rally left stocks up bigly, as the S&P 500 roared higher by more than 8% to erase the bulk of yesterday’s losses and narrow the weekly decline to less than 10%. Pronounced selling pressure on the long end of the Treasury curve pushed the 2- vs. 10-year spread to 50 basis points, its widest since June 2018. Gold was hammered again, falling 3% to $1,524 an ounce, while WTI crude rebounded back above $33 a barrel. The VIX dropped 25% to 57.
Now it's getting serious
A headline from the New York Post:
KFC suspends iconic 'finger lickin' good' slogan amid coronavirus fears
Credit check
This morning, aircraft lessor AerCap Holdings N.V. announced it will draw down all of its $4 billion unsecured revolving credit facility. CEO Aengus Kelly described the move as “a precautionary measure, given recent market volatility. . . AerCap continues to maintain a strong liquidity and financial position.”
AerCap, the world’s largest owner of commercial aircraft, is rated triple-B at Standard & Poor’s and triple-B-minus at Fitch, the last stop before junk. Against $29.5 billion in total debt, including some $14 billion of maturities in 2020 through 2022, the company generated $4.3 billion in adjusted Ebitda last year.
Going viral
CoinDesk reports today that the New York Department of Financial Services “is requiring the state’s sanctioned cryptocurrency firms to provide detailed coronavirus preparedness plans.” Among the checklist: “employee protection strategies, increased cyber-risk mitigation, disaster communication plans and procedures to ensure the continued functioning of critical operations ‘at a minimum.’”
Investors in the digital ducats could use some risk mitigation of their own. Over the last month, the price of bitcoin has been sawed in half to $5,160. That compares to a 24% drop in the S&P 500 and 3.5% decline in gold since Feb. 13.
Drifting too far from the shore
Dislocations in the bond market have grown more acute this week, as formerly rock-solid corridors of the market have come under swift scrutiny. Yesterday was the worst showing for investment grade credit since Oct. 10, 2008, as spreads on the ICE BofA Investment Grade Index jumped 26 basis points to 222 basis points over Treasurys. That’s more than double the 105 basis point pickup just three weeks ago on Feb. 21.
The speed and ferocity of that move has strained some of the structural foundations of the market. Yesterday, the iShares Core U.S. Aggregate Bond Fund, the world’s largest debt ETF, closed at a 4.4% discount to its net asset value, the largest divergence since 2008. The VanEck Vectors High Yield Municipal Bond ETF closed at a record 8.3% NAV discount, a chasm that expanded to 12.4% today.
A report from Bloomberg yesterday explained the significance of the persistent gap:
It’s not uncommon for an ETF to drop below its net-asset value – but it is unusual to see a continuation of that. In normal market environments, such a decline presents an arbitrage opportunity for certain middlemen known as authorized participants. Typically market makers will buy shares of the ETF as its price drops and redeem these shares with the issuer in return for the underlying bonds. The authorized participant will then sell those securities to capture a relatively risk-free profit.
That transmission mechanism has, for now at least, been disrupted. One bond investor tells Grant’s of a “peculiar” experience this week, in which they bid on a strip of bonds within an ETF at an above-market price yet received a “nothing done” from the authorized participant. Our source continues:
Apparently, the seller only received bids on 35% of the bonds on its list, and it needed 60% to trade anything. I’d never heard of such a rule. Then I wondered, is that a rule of the ETF or the authorized participant? It seems to be the AP. . . I think the ETF discounts may be here for a while.
Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, sums things up today: “The distance between the ETF [price] and the NAV provides a great measure of liquidity in the underlying market.”
- Philip Grant
Thursday, March 12, 2020
Recap March 12
The Fed’s mid-afternoon announcement of a dramatic expansion of its liquidity operations (new injections are set to top $5 trillion, compared to an existing $4.22 trillion in Reserve Bank credit) did nothing to stop the latest free fall in stocks. The S&P 500 lost a sneezing, coughing 9.5%, its worst day since Oct. 19, 1987, to extend year-to-date losses to 23%.
Another day of steepening across the Treasury curve left the 2- 10- and 30-year yields at 0.46%, 0.8% and 1.41%, respectively, while gold lost nearly 4% for its worst day since 2013 to finish at $1,575 an ounce and WTI crude fell back below $31 a barrel. The VIX finished at 75.5.
The edge
A headline from today’s U.K. Telegraph:
‘Abnormally warm winter’ spurs bears to stir from hibernation a month early
Mystery finally solved.
Credit check
Another day, another round of pain in the travel and leisure industry. This morning, Hilton Worldwide Holdings, Inc. announced it has drawn down the full balance of its $1.75 billion credit line. In reaction, the company’s $1 billion senior unsecured 4 7/8s of 2030 slid to 94 cents on the dollar for a 520 basis point spread over Treasurys, down from 104 cents a week ago. Hilton, rated double-B-plus (the top rung of junk), carries a debt load of $8.9 billion net of cash, equivalent to just over four times 2019 adjusted Ebitda.
Further up the ratings spectrum, single-A-minus-rated Carnival Corp. announced it will cease all voyages under its Princess Cruises brands for the next 60 days “in an abundance of caution,” sending its senior unsecured 1% euro-pay notes of 2029 lower by nearly 7 points (not to be confused with basis points) to 73.5 cents on the euro. Carnival shows net debt of $11 billion, two times 2019 Ebitda. The company faces $1.8 billion in principal debt repayments this year, according to data from Bloomberg, vs. a cash balance of $518 million as of Nov. 30.
More broadly, credit protection costs for junk debt as measured by the Markit CDX Index jumped 70 basis points to 661 basis points this afternoon, topping the 2015 highs but still well below the 1,895 basis point peak reached in March 2009, the beginning of the now-defunct bull market. Markit’s Investment Grade CDX Index rose 14 basis points to 129 basis points this afternoon, still below the 150 basis points logged in 2011, let alone the 279 basis point peak on Dec. 5, 2008.
State of nature
As of yesterday, the global stack of negative-yielding debt as measured by the Bloomberg Barclays Index stood at $13.7 trillion, below the peak of $17 trillion logged last August. Might a previously unthinkable move to sub-zero rates in the U.S. send that stack much higher?
The swift repricing of interest rate futures suggests that such an extreme outcome is looking less unrealistic. As of mid-afternoon, the market expects the Fed to slash the Funds Rate by 97 basis points to 0.12% by July 29. That’s well below the implied 0.35% a week ago and 1.43% a month ago.
The prospect of government debt trading to yield less than nothing is a welcome one, according to one of the leading lights of contemporary central banking. In a Jan. 6 blog post for the Brookings Institution, former Fed chair and current Citadel capital-introduction professional Ben Bernanke argued for the benefits of negative rates:
The Fed should also consider maintaining constructive ambiguity about the future use of negative short-term rates, both because situations could arise in which negative short-term rates would provide useful policy space; and because entirely ruling out negative short rates, by creating an effective floor for long-term rates as well, could limit the Fed’s future ability to reduce longer-term rates by QE or other means.
While Dr. Bernanke, the architect of pre- and post-crisis monetary policy, focuses on mechanistic considerations, other economic luminaries approached the question of negative borrowing cost from a more philosophical lens. Speculating on the potential appearance of negative rates, the July 26 edition of Grant’s included the following remarks from the celebrated Irving Fisher, recipient of Yale University’s first economics Ph.D. in 1891 and author of the 1933 essay “The Debt-Deflation Theory of Great Depressions:”
“The rate of interest,” says Fisher, “is equal to the degree of impatience upon which the whole community may concur in order that the market of loans may be exactly cleared.”
Could that rate be negative? Yes, the Yale visionary allows. But he treats that special case as a theoretical plaything, almost as something unnatural.
“Nature,” he writes, “is, to a great extent, reproductive. Growing crops and animals often make it possible to endow the future more richly than the present. Man can obtain from the forest or the farm more by waiting than by premature cutting of trees or by exhausting the soil. In other words, Nature’s productivity has a strong tendency to keep up the rate of interest. Nature offers man many opportunities for future abundance at trifling present cost. So also hu¬man technique and invention tend to produce big returns over cost.”
That July 26 analysis concluded:
To today’s creditors, the world’s central bankers offer a program of less income and more inflation. Bullish? By the sound of it, not permanently.
QE progress report
A fresh acceleration, even prior to today’s announcement: Reserve Bank credit (i.e., the Fed’s sum total of interest-bearing assets) rose to $4.22 trillion as of yesterday, a $77.5 billion uptick from last week’s reading. That gain pushed the three-month annualized rate of gain to 15.1% from 13.9%, and year-over-year growth to 5.6% from 4.6% a week ago. Needless to say, we can expect these figures to accelerate substantially in the coming days.
- Philip Grant
Wednesday, March 11, 2020
Recap March 11
That 70's Show
A throwback to days of yore:
A throwback to days of yore:
Credit check
That was then
Bloomberg reports this morning that volatility in the Japanese yen registered its highest level this week since 2008.
Bloomberg reports this morning that volatility in the Japanese yen registered its highest level this week since 2008.
CoCo Crisp
Recap March 11
A 4.7% decline left the S&P 500 on the cusp of bear market territory, down 19% from mid-February as the broad index finished at least 100 points above or below its prior close for a third straight day. The VIX settled at 54, its fourth consecutive close above 40. The Treasury curve steepened, with the short end catching a bid and the long end coming for sale, while commodities were hammered with the CRB Index reaching its lowest since January 2002.
Liquidity concerns at the corporate level are growing more acute. Bloomberg reports today that Boeing Co. will draw down the remainder of its $13.8 billion credit facility, while Wynn Resorts Ltd. is planning to draw “a portion” of its $850 million revolver to burnish its own balance sheet. Bloomberg also relays this afternoon that private equity giant Blackstone Group, Inc. “is asking companies it controls to draw down their bank credit lines to help prevent any liquidity shortfalls amid signs of mounting stress in markets.”
That 70's Show
A throwback to days of yore: Bonds selling off on the prospect of higher deficits.
Italian two-year note yields jumped as high as 7 basis points to 0.41% following reports that Prime Minister Giuseppe Conte is looking to double an existing stimulus package to as much as €16 billion ($18.1 billion).
Stateside, as the U.S. government prepares its own COVID-19 response, the 30-year Treasury yield has snapped back to 1.37%, virtually double its Monday intraday low of 70 basis points. Meanwhile, the iShares Barclays 20+ Year Treasury Bond ETF (which owns some of the most liquid securities in the world) closed at a 3.2% discount to its implied net asset value, a dislocation that Bloomberg ETF analyst Eric Balchunas describes as “unusual.”
Credit check
Yesterday evening, S&P Global announced that it is reviewing the entire exploration and production sector for downgrades. The rating agency observed that a pair of factors may prevent the E&P cohort from bouncing back as quickly as it did during the last oil price plunge in 2015-2016:
During the previous downcycle, many producers were successful in significantly reducing their costs and improving their balance sheets through asset sales and equity issuance, which helped reduce the number and order of magnitude of rating actions.
However, we don't expect producers to be able to achieve anywhere near the efficiencies gained last time. Nor do we believe most companies will be able to raise capital as efficiently as they did during the previous cycle, given capital market access and coronavirus concerns. It's likely rating actions in the investment-grade category could be more severe than during the last cycle.
How might things shake out? A stress test analysis from CreditSights finds that with WTI crude at $35 a barrel (compare to closing level), 5 of the 12 investment-grade E&P names that it covers will see net leverage rise above 3 turns on a hedged basis and 8 of 12 will be levered above 4 times on an unhedged basis. For context, a fall 2017 analysis from Moody’s found that the average triple-B-rated (the last stop before junk) company sported a leverage ratio of 2.7 times. As for the junk-rated E&P contingent, CreditSights writes that “most. . . would see leverage north of 15 times.” That compares to a leverage ratio of 7.2 times for triple-C-rated corporates (the bottom rung of high yield) in that 2017 Moody’s study.
As for the big picture, energy debt accounts for just under 9% of both the iShares iBoxx $ High Yield and Investment Grade Corporate Bond ETFs.
One of many - Price chart of Marathon Oil Corp.’s senior unsecured 4.4s of 2027. Source: The Bloomberg
That was then
Bloomberg reports this morning that volatility in the Japanese yen registered its highest level this week since 2008.
It’s a far cry from the quaint days of just two months ago. Here’s a Bloomberg dispatch from Jan. 17:
Global currency volatility has dropped to the lowest level ever recorded. Less than 48 hours after the U.S. and China put pen to paper on a trade deal that reaffirmed an agreement not to devalue their currencies, the JPMorgan Global FX Volatility Index – which tracks the options market to measure expected price swings – is trading lower than at any point since it was created almost three decades ago.
A good rule of thumb: "The lowest volatility on record” is a phrase rarely followed by: “and they lived happily ever after.”
CoCo Crisp
Today, Deutsche Bank A.G. announced it will not redeem the $1.25 billion of 6.25% AT1 contingent convertible bonds (CoCos) on their April 30 call date, sending the securities down 5 points to 82 cents on the dollar. The perpetual bonds, created after the 2008-era crisis at the behest of regulators, serve as a kind of financial fire extinguisher. In the case of balance sheet erosion, share price decline or other unscripted events, the issuer can cancel coupon payments and/or write down principal repayments.
DB’s decision not to call the bonds is an unusual one, as Reuters notes that “banks almost always redeem [CoCo debt] when the first ‘call’ date comes due, or risk stoking speculation over their cash and solvency position.” Ironically, DB sold $1 billion in fresh AT1 CoCo debt just over a month ago at a 6% yield, its first sale of those contraptions since 2014. On Feb. 10, Reuters described the sale as “sooth[ing] investor worries” over whether the 6.25% AT1 debt would be called in April. Evidently, those worries were well founded.
For more on the so-called CoCo bonds and Deutsche Bank, see the Feb. 12, 2016 edition of Grant’s.
- Philip Grant
Tuesday, March 10, 2020
Recap March 10
Signs of life from the bulls, as reports that the Trump administration is preparing taxpayer bailouts for various afflicted industries spurred a 5% bounce on the S&P 500. Treasury yields ripped higher to unwind a chunk of their recent rally, with the 2-, 10- and 30-year yields rising 15, 25 and 29 basis points, respectively, to settle at 0.53%, 0.78% and 1.29%.
Energy continued to bounce off yesterday morning’s lows with WTI crude gaining 11% to near $35 a barrel, while gold was clubbed by 2% to finish at $1,650 an ounce. The VIX fell 8 points to 46.5.
Paging Sheriff Nottingham
From Bloomberg:
Robinhood maxed out [its] credit line last month
Channel stuff
Time for a re-rating? Let’s take an updated look at Nielsen Holdings plc. (NLSN on the NYSE), the near-century old aggregator of television and other consumer preference data. The subject of a bullish analysis in the Sept. 6 edition of Grant’s after a 63% share price slide over the previous three-plus years, NLSN has continued to confound the bulls, sinking an additional 24% in the intervening six months (the S&P 500 has lost 3% over that period).
Nielsen is split into two primary businesses. Global Media, the unit which measures television ratings, performs the bulk of the corporate heavy lifting, earning a 42.4% Ebitda margin in the fourth quarter and growing revenues at 2.3% from a year ago. Global Connect, the company’s market analytics business, by contrast generated a 15.8% Ebitda margin and has seen its top line contract for years before managing 1.6% revenue growth in the fourth quarter.
While Nielsen has clearly had its share of difficulties, fourth quarter performance wasn’t among them. On Feb. 27, the company reported fourth quarter revenues of $1.69 billion and adjusted Ebitda of $504 million, topping consensus expectations of $1.68 billion and $501 million, respectively. Guidance for 2020 was uninspiring with management expecting $1.87 billion in Ebitda using the midpoint of the provided range, trailing the consensus $1.89 billion and igniting an 8% selloff in response.
A long-stagnant income statement perhaps explains that frustrated reaction, as expected 2020 revenues and Ebitda of $6.6 billion and $1.87 billion compare to $6.3 billion and $1.89 billion, respectively, in 2016. But that lack of growth has done little to erode the company’s powerful domestic franchise. “You can’t operate in the United States without paying Nielsen,” a publicity-shy industry source told Grant’s last fall. Then, too, revenues are highly predictable thanks to the company’s subscription-centric business model, as NLSN customers typically commit more than 70% of its annual revenues at the beginning of each year. Yet at just 7.4 times enterprise value to consensus 2020 Ebitda, Nielsen is valued far below other subscription-based businesses like Moody’s Corp., Equifax, Inc. and FactSet Research Systems, Inc., which currently trade at 26, 16 and 27 times E.V. to Ebitda, respectively (though the trio earned Ebitda margins of 49%, 34% and 35% last year, well above Nielsen’s consolidated figure).
Facing a moribund share price with a performance disconnect between its two business lines, management is taking action. On Nov. 7, the company announced the (long awaited by NLSN bulls) spinoff of that consumer-facing Global Connect unit to create two publicly-traded concerns. The spin-off should be complete in eight months. “Both of these companies can run faster standing on their own” CEO David Kenny told Reuters in November. “There [are] very limited synergies between the two businesses.”
Baa3/double-B-minus-rated Nielsen, currently leveraged at 4.6 times net debt to consensus 2020 Ebitda, moved to shore up its balance sheet last year by slashing its quarterly dividend to $0.06 a share (or a 1.6% trailing dividend yield) from $0.35, ahead of some $1.1 billion in corporate debt maturities over the next two years. Then again, the company managed to survive the events of 2007 to 2009 with an eye-watering nine times net debt to Ebitda after undergoing a leveraged buyout in 2006.
Might the long awaited spin off help nudge Mr. Market to rethink his views? The Nielsen c-suite appears unguardedly bullish. On Feb. 28, CEO Kenny bought $1 million worth of shares, while chairman James Attwood Jr. followed suit with a $4.1 million open-market purchase on March 6. Activist investors Elliott Management Corp. are also involved, accumulating a stake beginning in the summer of 2018 and commenting in a filing last year that the firm believes NLSN shares to be “substantially undervalued.”
Concurring with the bullish actions of Elliott and NLSN management alike, Grant’s concluded in September: “Critics wonder just how deep is Nielsen’s famous media moat. Deep enough, we judge.” For more on the bull case, see that Sept. 6 issue.
- Philip Grant
Monday, March 9, 2020
Survey says
Consumers expect inflation to gradually rise. That’s according to a survey conducted by the Federal Reserve Bank of New York in February and released today. Concurrent with rising prices, the public anticipates “moderated” income growth, while spending growth and the path of house prices are expected to rise modestly.
The market seems to see things a bit differently. Today, 10-year Treasury inflation-protected break-evens, which measure future inflation expectations by comparing the nominal Treasury yield with that of Treasury Inflation Protected Securities (TIPS), collapsed to 1.01% from 1.32% on Friday. That’s easily the lowest since March 2009.
Credit check
The carnage in junk debt continues apace. Today, Markit’s High-Yield CDX Index, which measures the cost to insure against default on a basket of senior unsecured debt obligations, jumped to 556 basis points, up from 441 basis points Friday and nearly double the 289 basis points quoted as of Feb. 20.
The timing for such a flare up could be better, as the corporate sector is increasingly vulnerable. S&P’s LCD unit reports today that a record 58% of domestic leveraged loan debt is now rated single-B or lower. Nearly 15% of that stack is rated single-B-minus, another record and double that of two years ago.
Recent shocks to the economy will do no good for the hordes of companies unable to pay the bills through operations alone. Last March, Ben Breitholtz of Arbor Research told Grant’s that from Jan. 2018 to Jan. 2019, the percentage of companies within the S&P 1500 Index with operating income insufficient to cover interest expense over each of the prior three years grew to 13.6% from 12.4%. More broadly, the Bank for International Settlements found in September 2018 that about 12% of firms across western economies fit that “zombie” category, up from virtually zero in 1989.
Upside down
As government bond yields plunge further into microscopic territory, rising prices take center stage. With their latest harrowing rally, the 10- and 30-year Treasury yields plunged 22 basis points and 29 basis points, respectively, to 0.59% and 1.07%. Thanks to those moves, the longer dated obligations of Uncle Sam have generated total returns of 11% and 27%, respectively, for the first two-plus months of the year.
The traditional roles of stocks and bonds, i.e., capital appreciation and yield, have been turned on their heads. Thanks to a 23% swan dive today and 39% plunge in the last month, the Alerian M.L.P. exchange traded fund is now priced to yield 16%. More broadly, the SPDR S&P 500 ETF Trust now sports an indicative yield of 2.28%, nearly matching the 2.64% yield (as of Friday) on the triple-B component of the Bloomberg Barclays Investment Grade Index.
Then there are the less traditional sources of price appreciation. A scan of retail web sites today shows that a 12 oz bottle of Purell brand hand sanitizer, previously on sale for $3.98 (now sold out) at Wal-Mart, was on offer this morning on eBay for $25. That’s a pre-tax gain of 528% for the lucky seller. Similarly, a cannister of 75 Clorox wipes, previously quoted at $5.99 at Staples and also out of stock, is available from a third-party reseller/hoarder on Amazon.com for $59.99 for a pre-tax gain of 902%.
Protection ain’t cheap. Amazon.com offer from this morning
So much for the “stocks for capital appreciation, bonds for income” rule of thumb.
Recap March 9
The biggest drop in oil prices since the Gulf War helped things turn from bad to worse, as the S&P 500 lost 7.6% for its worst showing since October 2008. Within the broad index, financials dropped 10% and energy stocks lost 20% (nothing like a one day bear market), while just nine names finished in the green including Autozone, Inc., Dollar Tree, Inc., H&R Block, Inc., Clorox Co. and Dollar General Corp.
WTI crude finished at $31 a barrel, down 25% but off its earlier lows. Gold was little changed at $1,677 an ounce and the VIX settled near 55 after rising above 60 this morning, which was its highest since December 2008.
- Philip Grant
Friday, March 6, 2020
Keep the Bronco in park
Headline of the day,
Headline of the day,
Getting warmer
Today, the Markit North American
Today, the Markit North American
Bubble bath
The feverish rally in U.S. Treasurys
The feverish rally in U.S. Treasurys
Getting warmer
Many happy returns?
Many happy returns?
Recap March 6
Keep the Bronco in park
Headline of the day, from the New York Post:
Yankees minor-league team quickly cancels 'OJ Simpson Trial' night
Getting warmer
Today, the Markit North American High Yield CDX Index, which measures the price of protection against a basket of speculative-grade corporate bonds, jumped 42 basis points to 451, the biggest one-day gain in a decade to push the gauge well above its five-year average of 365 basis points. “This is the first day [where we are] seeing some panic in the market,” John McClain, portfolio manager at Diamond Hill Capital Management, told Bloomberg.
It's been a swift fall to earth for junk bonds. Marty Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors, LLC, found that on Dec. 31, the ICE BofAML US High Yield Index reached a 372 basis point premium to his estimated fair value. That’s a record margin of overvaluation going back to at least 1997.
That fair value measurement is based on six financial and economic indicators: credit availability, (derived from the Federal Reserve’s quarterly survey of senior loan officers), capacity utilization, industrial production, the current speculate-grade default rate and the current five-year Treasury yield. These indicators have traditionally explained about 80% of the variance within the benchmark high-yield index. Fridson also accounts for unconventional monetary policy, shifting fair value spreads tighter by 148 basis points when the Fed is undertaking QE-type activities (i.e. asset purchases).
Needless to say, the value restoration project is now well underway. Fridson advises Grant’s this afternoon that yesterday’s closing spread of 505 basis points represents a premium of just 97 basis points to his computed fair value, a spread that is within the margin of error of 125 basis points. Today’s trading will certainly bring that valuation closer still to the Dean of High Yield’s fair value bogey. As for current monetary policy, Fridson says: “I think we have to conclude that the Fed is [currently] engaged in extraordinary monetary intervention, whether you call it QE or something else.”
Bubble bath
The feverish rally in U.S. Treasurys continued further into uncharted territory today, as yields dove lower with an intensity that put recent price moves in the shade. By day’s end, the two- and 10-year yields stood at a remarkable 0.52% and 0.79%, respectively, while the 30-year bond fetches 1.31%. A month ago, those yields were 1.45%, 1.64% and 2.11%, respectively.
A look at 10-year compound annual growth rates in the CPI from 1913 (the year the Federal Reserve came into being) shows that only from 1928 to 1942 did inflation grow at less than the 0.7% yield currently on offer for the 10-year note, while other cyclical ebbs included a 1.3% 10-year CAGR in the summer of 1962 and 1.4% in July 2018.
Overall, headline CPI has compounded at a 3.1% annual clip since 1913.
Getting warmer
Many happy returns? Today marks the 11th anniversary of the 2009 intraday stock-market lows and commencement of the (still) ongoing bull market. Since reaching its high water mark on Feb. 19, the S&P 500 has declined by as much as 15.8%, and sits 12.2% below its peak as of today’s close. Prior brushes with bear territory (typically defined as a 20% drawdown) included a 19.2% peak-to-trough decline in 2011 and a 19.8% selloff that ended on Christmas Eve of 2018.
By length, the 132 month-and-counting stock run already tops previous bull runs of the 1990s tech bubble (113 months commencing in Oct. 1990) and the post-World War II boom (86 months from June 1949) for the top spot. In terms of total return with dividends reinvested, the current 443% composite gain trails the 525% seen in the 1990 bull run along with the 488% total return from 1949 to 1956.
Is the existing bull indeed on its last legs and set to be consigned to the history books? We’ll know more later.
Recap March 6
A late bounce helped stocks pare their losses as the S&P 500 finished 170 basis points lower, erasing more than half of the day’s losses to leave the broad index higher by 60 basis points for the week. Treasurys similarly partially retraced their massive early moves, with the 2-year finishing at 52 basis points after trading below 40 basis points intraday.
Energy prices were absolutely demolished after the OPEC-plus supply cut agreement fell apart, leaving WTI crude down nearly 10% to $41.50 a barrel, while gold finished little changed at $1,674 an ounce. The VIX finished at 42 after reaching 54 a bit after 3pm ET.
- Philip Grant
Thursday, March 5, 2020
Sour patch
Taking it down a notch. As the COVID-19 virus continues to take a toll on economic growth prospects, the 24% year-to-date tumble in West Texas intermediate crude seemingly stands as a foremost example of demand destruction. On Tuesday, analysts at Goldman Sachs forecast an outright contraction in global demand in 2020, which would be only the fourth annual decline in the last 40 years.
Set to meet with their bankers for semi-annual financing reviews, U.S. shale producers are running out of time. “Things are so bad now,” Shaia Hosseinzadeh, founder of OnyxPoint Global Management L.P., told Bloomberg yesterday. “The banks can kick the can down the road and say ‘there’s no point of pushing everybody into bankruptcy, we’ll wait until October.’ But if it’s business as usual, it’s going to be a horror show.”
The growing ESG (environmental, social and governance) movement may act as a further constraint to industry activity. Today, Swiss banking giant UBS Group, A.G. announced that it will no longer finance environmentally-sensitive projects such as Arctic offshore and Canadian oilsands drilling, and that its overall energy and utility lending fell by 40% last year to $1.9 billion. Over the same period, so-called sustainable and “impact” investments rose 56% to $488 billion.
The major integrated oil players are likewise adjusting. Prior to its annual investor meeting on Tuesday, Chevron Corp. announced that it will upsize shareholder payouts by up to 20% over the next five years, funding the increased dividends and buybacks through cost-cutting, including pulling back on certain projects. Today, Exxon Mobil Corp. declared that it will slow down its pace of production in the Permian Basin, declaring in a slide deck that it will operate at a “reduced pace” in 2020 and 2021 relative to previous plans. Overall, XOM expects capital spending to come to “no more” than $33 billion this year, which would represent a mere $2.5 billion year-over-year uptick at the high end, compared to a $12.5 billion capex jump in 2019.
It’s not just corporate America which is attempting to “right-size.” Today, oil ministers from the Organization of the Petroleum Exporting Countries agreed to recommend 1 million barrels per day (mbpd) in production cuts, with a further 500,000 bpd from non-OPEC member states like Russia. That agreement is contingent on support from the Russians, no sure thing as the Russian energy minister Alexander Novak was not present for the meeting and had previously expressed his opposition. According to Bloomberg, skepticism that Russia will comply with the cut factored prominently in today’s roughly 2% declines in WTI and Brent Crude.
But while OPEC+ intrigue garners headlines, a secular shift may be quietly underway. In a report Tuesday, analysts at J.P. Morgan Cazenove concluded that the oil industry “is not well-placed to meet global energy needs in the medium term as demand recovers in 2021 [and beyond].” The analysts explain: “Cumulative underspend on oil projects, on track to reach $1 trillion by 2030, means the industry is at a point of no return with supply set to peak at 102 mbpd in 2022.” The truism that low prices cure low prices will likely come into play as well: “Continued pressure on oil prices is only going to accentuate a structural supply deficit that has already taken hold.”
The production retrenchment is showing up in the data: In a Jan. 9 report, analysts at Bernstein Research found that 2019 peak-rate well productivity at the oilier shale basins fell 7.6% year-over-year. More recently, Baker Hughes Corp. relayed that the U.S. oil rig count slipped to 678 last week, down 20% year-on-year.
Another indicator lends credence to the bull view. In their fourth quarter 2019 commentary, Leigh Goehring and Adam Rozencwajg, co-founders and eponyms of natural resource investment firm Goehring & Rozencwajg Associates LLC, argued that so-called high-grading practices (i.e., companies drilling their best wells first when forced to cut back on activity) in the domestic shale patch throughout this cycle could lead to faster well depletion than is commonly believed:
In 2013 we estimate the top half of all shale wells were 200% more productive as the bottom half. By 2019 this spread had collapsed to only 90% more productive. As rigs are laid down, our research tells us that the narrowing in drilling productivity will have a large impact on shale oil production growth.
Reached by Grant’s today, Goehring identified further differences between the current environment and prior cyclical inflections:
We believe the unexpected decline is because of the high graded effect being felt right now. The 220 oil drilling rigs that have been laid down in the last six months are twice as productive as rigs laid down in in previous drilling downtowns of 2009, 2012 and 2016. Therefore, when they are laid down, the impact on production is much greater than in the previous cycles.
If U.S. output does decline, Goehring continued, it will be difficult for the rest of the world to pick up the slack:
Regarding the international oil world, as we have chronicled, conventional oil production outside of the US and Canada has already turned negative. We calculated conventional oil production outside of the US and Canada was 47.2 mbpd in 2010 and that by 2018 that have fallen by 1.3 mbpd to 45.9 mbpd.
Stateside, there are signs of a potential sea-change. The U.S. Energy Information Agency’s so-called 914 monthly production report for December (the most recently available data) showed a sequential 38,000 barrel per day onshore output decline, a surprising result as the EIA had previously projected a 15,000 b/d increase during that monthly period.
For a survey of oil-related names which may stand to thrive in such a bullish scenario while offering a margin of safety, see the Jan. 24 edition of Grant’s.
Not-QE progress report
A $25 billion sequential increase pushed Reserve Bank credit (i.e. the sum of interest-bearing assets) on the Fed’s balance sheet to $4.144 trillion. That’s up 13.9% on a three-month annualized basis and 4.6% year-over-year, slightly up from 13.8% and 4.1%, respectively, last week.
Since the Fed began “not-QE” last fall, total balance sheet assets are up by 10.6%, within 8% of the 2017 highs.
Recap March 5
Spin-cycle action continues as the S&P 500 lost 3.7%, the fifth 3%-plus move in the last six sessions to narrow the 52-week gains on the index to 8.6%. Treasury yields gapped lower again but this time in flattening formation, with the two- and 10-year yields settling at 0.59% and 0.91%, respectively. WTI crude fell to $46 a barrel, gold charged higher to $1,672 an ounce and the VIX rose 23% to just under 40.
- Philip Grant
Tuesday, March 3, 2020
Price taker
The Fed's surprise decision
The Fed's surprise decision
Better safe than sorry
The c-suite in retreat?
The c-suite in retreat?
Credit check
Stocks may be solidly red for the year and Treasury yields are diving to record levels, but
Stocks may be solidly red for the year and Treasury yields are diving to record levels, but
Recap March 3
Price taker
The Fed’s surprise decision to slash the funds rate by 50 basis points this morning to a range of 1% to 1.25% (marking the first inter-meeting cut since fall 2008) was insufficient for President Donald Trump:
The Federal Reserve is cutting but must further ease and, most importantly, come into line with other countries/competitors. We are not playing on a level field. Not fair to USA. It is finally time for the Federal Reserve to LEAD. More easing and cutting!
It’s not only the Commander-in-Chief demanding easier money. Jim Bianco, president and eponym of Bianco Research LLC, noted this afternoon that interest rate futures are now pricing in a 100% chance of an additional 25 basis trim to the Funds rate at the March 19-20 meeting, with 53% odds that the central bank opts to make it 50 basis points.
Today’s developments add fresh context to the Sept. 21, 2018 Grant’s analysis dubbed “Jay Powell, prisoner of history.” An excerpt:
To modern central bankers, interest rates are not market-determined prices but the knobs on the control panel of state: Adjust them to achieve the desired macroeconomic outcome. The trouble is that the outcome is so often the undesired one.
Confronted with the next debt liquidation, recession or monetary crisis, the Fed may face numerous constraints. Jerome H. Powell, heir to the policies of Janet Yellen and Ben Bernanke, is no free agent but a prisoner of the history of the past ten years and more.
Based on recent developments, parole for Powell appears no closer.
Better safe than sorry
The c-suite in retreat? Citing data from Bank of America, Bloomberg notes today that share buybacks among U.S. firms totaled just under $1.5 billion last week. That’s down from roughly $2 billion over the past four weeks and a change from past practice, in which “corporate America [has] tended to step up buying during market sell-offs.”
Malcom Polley, chief investment officer of Stewart Capital Advisors, told Bloomberg that “companies are really protecting their liquidity just in case.”
Credit check
Stocks may be solidly red for the year and Treasury yields are diving to record levels, but the primary corporate bond market came back to life this morning. As of 9:30AM ET, seven U.S. issuers, including Sherwin Williams Co., Texas Instruments, Inc. and McDonalds Corp., sold fresh debt according to Bloomberg, marking the first domestic bond sales since Feb. 21.
Even with the primary market closing its doors at the end of the month, U.S. high yield issuance came to $31 billion in February according to Bloomberg, its most prodigious output for the second month of the year since 2012.
Credit quality is increasingly front of mind. As of yesterday, the Bloomberg Barclays double-B index component (the top rung of high-yield) was priced at a 325 basis point option-adjusted spread, nearly 50 basis points below its peak during the 20% stock market selloff of December 2018. By comparison, the triple-C Index component has already broken through its December 2018 spread peak, fetching a 1,017 pickup over Treasurys yesterday compared to its 1,001 basis point high water mark in December 2018.
A silver lining: The ratings basement of high-yield is less crowded on a cyclical basis. Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, tells Grant’s today that the ratio of issues in the ICE BofA High Yield Index rated triple-C and lower was 14.5% as of Feb. 29, well below the 17.5% ratio in February 2017 and 24% at the onset of the Great Recession in January 2008.
While high-yield has seen thinning ranks of its most speculative issues, it’s a different story for leveraged loans (i.e. floating-rate bank debt to speculative-grade issuers), a market which has grown by $700 billion domestically since 2010, double the growth of high-yield. S&P Global Ratings finds that 65.1% of U.S. leveraged loans were single-B (a notch above triple-c-plus) or lower as of Dec. 31, compared to 37.4% at the end of 2007.
For more on leveraged loans and the particularities of this cycle, see the Feb. 7 edition of Grant’s.
Recap March 3
Haywire price action in the Treasury pit dominated the days proceedings. This afternoon, the 10- and 30-year yields sprinted to fresh record lows of 0.91% and 1.5%, respectively then swiftly reversed course to finish at 0.99% and 1.61%, while the two-year yield fell an eye-watering 20 basis points to 0.7%. That pushed the 2- vs. 10-year spread to 29 basis points, up from less than 13 basis points a week ago.
Elsewhere, stocks gave back early post-rate cut gains to leave the S&P 500 lower by 3%, erasing the bulk of yesterday’s bounce and extending year-to-date losses to 7%, while gold ripped by 3% to $1,638 an ounce.
A pair of hopeful signs: WTI crude managed a 1% advance to just over $47 a barrel, and the VIX rose by a relatively modest 10% to 36.8.
- Philip Grant
Monday, March 2, 2020
Devalue investing
As China contends with the COVID-19 virus and associated curbs on economic activity, early impact assessments are grim. Last week’s reading of February Manufacturing PMI tumbled to 35.7 from 50 in January and consensus estimates of 45. Services fared even worse, with the non-manufacturing PMI falling to 29.6 in February from 51.4 a month earlier.
Look out below. China manufacturing PMI. Source: The Bloomberg
A debt jubilee with Chinese characteristics? Yesterday, China’s Banking and Insurance Regulatory Commission announced that approved small- and medium-sized businesses can apply for extensions on principal and interest payments due between Jan. 25 and June 30.
Meanwhile, state mouthpiece The Global Times declares that it may “be necessary for China to start weighing a large-scale stimulus package that will likely exceed the 4-trillion-yuan ($574 billion) stimulus plan announced in 2008.”
By contrast, it’s business as usual for semi-autonomous Hong-Kong, at least according to Eddie Yue Wai-man, chief executive of the Hong Kong Monetary Authority following the retirement of Norman Chan last year after a decade-long stint. During a meeting with the Legislative Council today, Wai-man explained that: “Our money market has been operating in an orderly manner, with the exchange rate and Hibor (Hong Kong Interbank Offered Rate) remaining stable. The banking system has been operating normally and is capable of resisting shocks.” According to the HKMA boss, total deposits grew 2.9% in 2019 and have remained stable in the first two months of the year.
While the HKMA preaches calm, recent actions suggest the powers-that-be are more than a little concerned. Last week, the Hong Kong government announced a de facto “helicopter money drop,” allocating an HKD$10,000 ($1,284) one-time payment to each permanent adult resident. Thanks in part to that outlay, which Bloomberg Economics pegs at 4.2% of 2018 GDP, the city’s budget deficit is expected to rise to a record HK$139.1 billion this year, compared to a HK$49 billion surplus in 2019.
That concern appears well-founded as Hong Kong’s economic vigor, already on the wane in 2019 (GDP contracted in the second, third and fourth quarters on a sequential basis, a first since 2008), looks to be deteriorating further. Retail sales plunged by 21.2% in February from a year ago, while M2 money supply growth came to 2.4% year-over-year in January, far below the 7.4% average growth rate since 1996.
A slump in the Hong Kong housing market presents a bigger potential risk, and one unlikely to be mitigated through universal income-type programs. Derek Chan, head of research at real estate firm Ricacorp, explained the situation on Friday: “On average, homeowners have slashed 8% off their asking prices, but those who are more eager to sell are offering more than 10% discount[s] to lure buyers.” Chan told the South China Morning Post that buyer inquires have declined by half since late January.
An extended period of corporate distress or pressure on the housing market could cause substantial mischief. Hong Kong’s private-sector credit reached 304% of GDP in the third quarter 2019 according to the Bank for International Settlements, double the 151% ratio seen across G-20 economies and well above the 165% for the city at the onset of the 1997 Asia debt crisis. According to CEIC Data, Hong Kong’s banking system is one of the most levered in the world at approximately 850% of local GDP.
Meanwhile, some observers wonder about the durability of Hong Kong’s dollar peg,, by which the HKMA fences its currency to near 7.8 to the dollar by selling HKD at 7.75 and buying them at 7.85. In a November interview with the South China Morning Post, Chinese economist and PBoC advisor Yu Yongding cautioned: “We don’t see an immediate risk of [currency] delinking based on the city’s balance of payments and financial statistics, but we need to keep a close eye on that possibility. If Hong Kong’s current account falls into deficit, and the government intervenes by using its foreign exchange reserves, then a crisis could [follow].”
To that end, foreign reserves at the HKMA, which grew at an 11% annualized pace in the 10 years ended 2017, have flatlined over the past two years, staying put near $445 billion as of January. With virus-related impacts aggravating an economy already in recession and a towering debt load potentially requiring drastic government action, could the city’s nearly four-decade long peg to the dollar be at risk? For more on the opportunities and risks which would arise in that unscripted event, see the May 31, 2019 edition of Grant’s.
Recap March 2
Flat as recently as mid-morning, the S&P 500 staged a blockbuster rally thereafter to finish nearly 5% in the green and narrow the year-to-date loss to 4.4% for the broad index. Another round of intense bidding in short-term Treasurys suggests the market is expecting rate cuts or similar stimulus sooner than later (central banks from the G-7 will conduct a conference call tomorrow): Thanks to another 5 basis point decline, the two-year note now yields a record low 0.86% while the 2- vs. 10-year spread has widened to 27 basis points, its largest in nearly two-months.
Elsewhere, energy prices enjoyed a solid rebound with WTI crude rising 6% to $47.3 a barrel, while gold finished at $1,593 an ounce, up 50 basis points. The VIX finished at 32, down 25% from its intraday high.
- Philip Grant
Friday, February 28, 2020
Eat and run
The bell is ringing. Yesterday, food delivery unicorn DoorDash, Inc. filed confidentially for an initial public offering later this year. With Goldman Sachs tapped as lead underwriter, IPO preparations have apparently been underway for some time. Bloomberg noted yesterday that DoorDash had quietly added Google alumna Shona Brown to the previously all-male board, “on the same day that [Goldman] Chief Executive Officer David Solomon said his bank will no longer take a company public if it lacks a director who adds to the board’s diversity.”
Appearances are important for DoorDash, which lost about $450 million on an estimated $1 billion in revenues last year, according to a Dec. 4 report from digital media company The Information. The company garnered a $12.6 billion valuation in a May funding round that included SoftBank Group Corp. and T. Rowe Price.
Competition in the food delivery realm is spirited, featuring publicly traded Grubhub, Inc. (the subject of a bearish Grant’s analysis from Sept. 20, 2019) along with Postmates, Inc. (which pulled its own planned IPO in October, citing market conditions) and Uber Technologies Inc,’s Uber Eats unit all vying for customers nationwide. As there is little differentiation of the delivery task, the companies compete on price. On Wednesday, Grubhub announced that it will debut a $9.99 monthly subscription platform offering unlimited free delivery on orders over $12.
For other players in the delivery “space,” familiarity breeds contempt. According to a Feb. 7 report from The Information, SoftBank’s decision to invest “hundreds of millions” into DoorDash via its Vision Fund two months after acquiring a 15% stake in Uber did not sit well with the latter’s c-suite:
In a Halloween meeting at Uber’s headquarters in 2018, Uber CFO Nelson Chai protested when Vision Fund partner Ervin Tu described portfolio companies and limited partners as “a family.”
Chai told Tu that when he talked to Uber investors, they saw SoftBank as a risk because it invests in competing firms, according to a person with direct knowledge of the meeting. Chai added that the Vision Fund “should be the Berkshire Hathaway” of tech, but because of such moves “you’re not,” the person said.
Indeed, SoftBank has tried to bring its “family members” closer together. On Jan. 31, the Financial Times reported that Uber and DoorDash held merger talks in mid-2019 “at the behest” of the Japanese tech behemoth. Though the negotiators didn’t reach a deal, “the two sides have not ruled out” returning to the bargaining table.
Meanwhile, the industry is banding together to try and ward off looming regulatory peril. Last fall, a consortium of so-called gig economy concerns including DoorDash, Uber, Postmates and Lyft, Inc. pledged a collective $110 million for lobbying efforts to battle California’s Assembly Bill 5, which would oblige the companies to classify their workers as employees instead of independent contractors, putting the employers on the hook for healthcare expenses as well as their share of Social Security and Medicare taxes.
On the other side of the country, the New York City Council yesterday debated six bills which would each cap the fees that delivery companies can charge at as little as 10%. Currently, delivery apps can charge as much as 30%, while Grubhub reported a “net capture” (meaning revenues as a percentage of gross food sales) of 21.3% in the fourth quarter, up from 20.8% year-over-year. Passage of a cap would be particularly damaging to Grubhub, which controlled some 71% of sales in NYC as of last October, according to data analysis firm Second Measure.
The courts present another risk to the delivery companies. On Monday, restaurant group Great New Hampshire Restaurants, Inc. sued Grubhub and DoorDash, contending that delivery drivers “do not adhere to the high standards expected of GNHR products and services,” leading to customer complaints “under the mistaken belief that GNHR is responsible for the poor service.” That follows a November lawsuit from D.C. Attorney General Karl Racine against DoorDash, alleging “deceptive” business practices, including misleading customers by pocketing tips meant for its drivers. In January 2019, a class-action lawsuit claimed Grubhub improperly charged restaurants for fielding customer phone calls, regardless of whether those calls led to an order through the Grubhub website.
Leaving aside regulatory and legal risks, the long-term commercial merits of the delivery business model appear to remain in question. On an Oct. 29 earnings call, Grubhub CEO Matt Maloney bluntly laid out the inherent limitations of his business line:
Extremely large delivery/logistics companies can generate slim margins, but only because of the hub and spoke efficiencies they gain at substantial scale. The point-to-point nature of our business mostly eliminates that aspect of operating leverage.
Critically, it appears that Seamless, Grubhub’s most profitable division, stopped growing in the fourth quarter, as gross food sales not delivered by GRUB drivers ticked lower by 0.4% from a year ago, compared to a 10% uptick in the third quarter. Adjusted Ebitda per order came to $0.58 in the fourth quarter, down from $0.98 year-over-year. Nevertheless, GRUB continues to command a princely valuation, with an enterprise value at a princely 40 times consensus 2020 adjusted Ebitda.
An observation for would-be DoorDash shareholders: Perhaps Maloney means what he says.
Recap Feb. 28
A powerful late rally pushed the S&P 500 back to within 80 basis points of unchanged, erasing the bulk of another round of stomach-churning losses and leaving the broad index down 11.5% for the week. Underscoring the chaos of today’s action, the SPDR S&P 500 ETF Trust (one of the most liquid funds in the world with some $300 billion in assets) finished the day down roughly 40 basis points, far from the underlying index.
Elsewhere, the swan-dive in Treasury yields continues apace as the 2- and 10-year finished at 0.92% and 1.15% respectively, as the spread between the two widened to 23 basis points, double that of a week ago. Oil and gold were both bludgeoned, sinking to $45.3 a barrel and $1,584 an ounce, respectively, as the Money of Kings saw its worst intraday selloff since June 2013. After testing 48 all afternoon, the VIX raced lower into the close to settle at 40.
- Philip Grant
Thursday, February 27, 2020
Under Siege 3
From the Financial Times:
From the Financial Times:
This bond's for you
It's not just stocks.
It's not just stocks.
Not-QE progress report
Recap Feb. 27
Under Siege 3
From the Financial Times:
Steven Seagal, the straight-to-video action movie star, has been fined $314,000 for allegedly touting a cryptocurrency without disclosing payments he received for the work.
This bond's for you
It’s not just stocks. Junk spreads have galloped wider in the last few days with the Bloomberg Barclays High Yield Index jumping to a 425 basis point option-adjusted pickup over Treasurys yesterday, compared to 340 basis points just a week prior. Meanwhile, Bloomberg reports that no investment grade bond sales will likely take place this week, the first such fallow week since July 18, “a rarity outside of holidays and seasonal slowdowns.”
Of course, between virus-related scares and questionable economic growth prospects, there is no shortage of emerging risk factors for corporate creditors. Extended maturity profiles present another wild card, as Bloomberg noted last week that “blue-chip companies are borrowing for longer and longer periods in the corporate bond market, locking in record-low borrowing costs for years as money managers accept greater risks in exchange for higher yield.”
According to CreditSights, 29% of investment grade (IG) corporate bonds issued last year carried a maturity of more than 10 years, up from 19% in 2016 and 11% in 2009. Overall IG duration (meaning sensitivity to changes in interest rates, measured in years) reached 8 years in 2019, the highest figure since the 1970s. By comparison, high-yield carries an average duration of just 3.5 years. Longer duration securities are more vulnerable to losses in the event that interest rates rise or spreads widen, perhaps in the event of a downgrade.
With half of the $6 trillion IG market sitting at triple-B, the lowest credit rating before junk, the prospect of longer-dated borrowers joining the lower credit caste via downgrade could further rattle the $1.3 trillion high-yield market.
Kraft Heinz Co., which was downgraded to junk on Feb. 14, is Exhibit A. KHC has some $21 billion in marketable debt outstanding, a figure which will place the processed food maker among the largest three borrowers in the high-yield index when its debt is reclassified in the coming days. With $13 billion of its borrowings not maturing for at least 10 years, the addition of KHC will single handedly raise the duration of U.S. high-yield to 3.6 years from 3.5, according to analysts at Citigroup, Inc.
***
This morning, beer behemoth Anheuser-Busch InBev S.A./N.V. (ABI in Brussels and BUD on the Big Board) reported disappointing fourth quarter results featuring $13.33 billion in “organic” revenue and $5.34 billion in adjusted Ebitda, shy of the expected $13.68 billion and $5.89 billion, respectively, while Ebitda margins of 40.1% were down from 43.7% a year ago. The company now projects a 10% year-over-year decline for first quarter earnings, while maintaining full-year guidance through a hoped-for rebound in the second half of 2020.
Anheuser-Busch sports a leverage ratio 4.5 times trailing Ebitda after accounting for the planned sale of its Australian operations to Asahi Holdings, Inc. That leverage ratio equates to a credit rating of between the junk categories Ba (3.6 times) and single-B (5.2 times), according to a 2017 analysis from Moody’s. This morning, management reiterated its goal of reducing leverage to “around two times” Ebitda in the undetermined future.
For ABI, which is reversing course on a roll-up strategy which included paying $65 billion for rival SAB Miller plc. in 2016 (a price tag equating to 18 times trailing Ebitda for the target company), outside threats loom to the mass market beer model, notably the emergence of alternative intoxicants such as hard seltzer, craft beer and partially-legalized marijuana. The beermaker likewise reported today that the COVID-19 outbreak “has led to a significant decline in demand in on-premise channels,” i.e., bars and restaurants. On Feb. 5, the company announced that CFO Felipe Dutra will step down at the end of April, ending a 15 year term in that seat.
The rating agencies agree to disagree over Anheuser-Busch’s credit profile, with Moody’s dubbing the company Baa1 (equivalent to triple-B-plus), Standard & Poor’s at single-A-minus and Fitch at triple-B. Grant’s, analyzing the ABI’s debt in the Feb. 9, 2018 issue, determined that “the Goliath of the forgettable mass-market mouth¬wash” was vulnerable to spread widening as the market seemed not to fully appreciate the fragility of its balance sheet and the risks of mass consumer migration away from its products. ABI’s dollar-pay 4.9s of 2046 sit at a 165 basis point spread over Treasurys, compared to the 126 basis point pickup on offer at publication time.
Were Anheuser-Busch’s operating slump to continue and/or asset sales and other deleveraging moves were derailed, a hypothetical downgrade to junk would carry substantial ripple effects. The company’s $95.5 billion in marketable debt features a weighted average maturity of 14.38 years, with more than half of the debt stack ($50.1 billion) set to mature in 2030 or later, four times that of Kraft Heinz.
Not-QE progress report
Turn those machines back on! Reserve Bank credit (i.e. the sum of the Fed’s interest-bearing assets) registered this week at $4.119 trillion, down $25 billion from last week’s reading.
That result continues the notable recent ebbing of balance sheet growth from the breakneck pace seen last fall, as the three-month annualized growth rate of bank credit is now 13.8%, down from 14.7% a week ago and 21.2% on Jan. 29.
Recap Feb. 27
Another brutal day as the S&P suffered a 4.5% swan dive, finishing at session lows and extending the week’s losses to 10.8%. Bespoke Investment notes that only on a quartet of notorious occasions in the post-WWII era has the broad index lost 10% in a week; October 1987, April 2000, September 2001, and October 2008.
Elsewhere, Treasurys ripped higher again with a second straight day of curve steepening, as the 2- and 10-year yields finished at 1.07% and 1.26%, respectively. Oil was strafed again as WTI crude sank to $46.3 a barrel, and the VIX ripped by 40% to 38.6, taking out the high-water mark from the February 2018 volatility spasm. Gold finished little changed at $1,638 an ounce.
- Philip Grant
Wednesday, February 26, 2020
Value-free zone
Today, the S&P Municipal Bond Index rose
Today, the S&P Municipal Bond Index rose
Waffle fries
No happy meal here.
No happy meal here.
Recap Feb. 26
Value-free zone
Today, the S&P Municipal Bond Index rose to its fifth straight record close going back to Jan. 1, 1998.
Mass migration into safe havens helps explain that bid, as do external factors like the Trump administration’s capping of state and local tax deductions in the 2017 Tax Cuts and Jobs Act (now, filers can only deduct up to $10,000 of those levies against Federal tax liabilities, whereas before they could do so for the entire amount). Some observers expect the good times to continue for state and local borrowers: “There is no end in sight” to the puny muni yields, Daniel Berger, senior market strategist at Refinitiv, tells The Wall Street Journal today.
Even compared to Treasurys, the muni market offers a value proposition which could be described as sparse. The Bloomberg BVAL Triple-A Muni 30-Year Yield Index currently trades at a ratio of 89% of the corresponding 30-year Treasury yield (the lower the ratio, the more expensive munis are on a relative basis), near a record low. For context, that ratio has averaged 100% over the last five years and sat at 120% in early 2015.
BVAL Triple-A Muni 30-Year Yield vs. Treasury ratio, five-year chart. Source: The Bloomberg
Still, investors need income, particularly those in high-tax jurisdictions. The Aug. 10 and Oct. 19, 2018 editions of Grant’s identified eight closed-end municipal bond funds trading at substantial discounts to net asset value. Though the octet has since generated an average total return of 26% with dividend reinvestment, the funds all (with the exception of Nuveen North Carolina Quality Municipal Income Fund, which was merged into another fund last fall) remain at least 5% below net asset value.
Those microscopic yields aside, fundamental factors may give the thoughtful would-be muni investor pause. Speaking at the Grant’s spring 2018 conference, Oaktree Capital Management L.P. co-founder Howard Marks provided his view on the asset class:
I haven’t owned a muni in 40 years. Most state and local governments are in terrible shape, especially if you put the pensions on the balance sheet. The ques¬tion of whether the bonds are going to be paid is often a political decision, not an economic decision. I don’t think there is such a thing as political analysis. It sounds to me like an oxymoron, so I don’t own any munis.
Waffle fries
No happy meal here. Yesterday, Carrol’s Restaurant Group, Inc. (TAST on the Nasdaq), the country’s largest Burger King operator and fourth-largest franchisee overall, announced a $10 million net loss for the fourth quarter, down from a $2 million profit in the same quarter of 2018. Red ink amounted to $32 million for the year compared to a $10 million net profit in 2018 while adjusted Ebitda dropped 20% to $86 million.
Chairman and CEO Daniel Accordino explained: “Comparable restaurant sales growth for our Burger King restaurants was at the low-end of our annual expectations and full year adjusted Ebitda relative to 2018 levels was adversely affected by several factors, including increases in commodity and labor costs and the excess sales discounts to certain customers over a ten week period last summer.” Already in a foul mood, Mr. Market nicked TAST shares by 18% over the past two days, extending the stock’s 18-month decline to 74%.
Perhaps more relevant for the broader industry is the franchisees’ scaled-down capital spending plans. In yesterday’s report, Carrol’s guided capex spending to just $55 million to $65 million this year, down from a prior projection of $98 million for 2020 as the company will instead tend to its fragile balance sheet (net debt equals 5.5 times trailing adjusted Ebitda, while a $9 million operating loss obviously failed to cover $27 million in interest expense).
Carrol’s will now open 12 new Burger King locations this year from a prior plan of 21 openings and plans to remodel 12 Burger King restaurants this year compared to 74 in 2019. Of those diminished corporate ambitions, Accordino declared: “we are laser focused on capital allocation and will only invest in the highest return projects.”
That retrenchment could complicate life for Burger King parent Restaurant Brands International, Inc. (QSR on the NYSE), as Carrol’s has the right of first refusal to buy franchise locations in large portions of the U.S. Carrol’s has company in its woe, as Bloomberg reported last week that NPC International, Inc., the second-largest franchisee, is considering a bankruptcy filing as it works with lenders to restructure $800 million worth of leveraged loans. That follows a Feb. 14 downgrade from Standard & Poor's to SD (as in selective default) from triple-C-minus, after the company “elected not to make interest payments due Jan. 31, 2020 on its first- and second-lien term loans.”
While major franchisees struggle for survival thanks to a brutal operating environment, the S&P Restaurant Index continues to command a premium valuation, fetching an enterprise value of 18.6 times consensus Ebitda for 2020 compared to 12.7 times EV to Ebitda for the S&P 500. For more on QSR and the industry as a whole, see the Sept. 20 edition of Grant’s.
Recap Feb. 26
A head fake for the bulls, as the S&P 500 gave back early gains of as much as 1.75% to finish modestly lower, extending losses to 8% over the last five sessions and 3.5% year-to-date. Treasurys saw bull steepening action, as the two-year yield dropped four basis points to 1.16% while the long bond finished little changed, and WTI crude slumped to $48.7 a barrel. The VIX rebounded from early weakness to settle at 27.5, little changed on the day.
- Philip Grant
Tuesday, February 25, 2020
Recap Feb. 25
Bulls, avert your eyes: A second straight equity flush left the S&P 500 weaker by 3% for a second straight day as the broad index fell to its lowest close in nearly three months. Treasurys continued their rampage with the two- and 10-year yields dropping to 1.22% and 1.34%, respectively. A weaker dollar didn’t help key commodities, as WTI crude plunged below $50 and gold fell 1.5% to $1,635 an ounce. The VIX rose 12% to 28.
While stocks finished at their lows of the day, late price action in other realms provides a bit of hope for the suddenly beleaguered bulls. As of mid-afternoon, the 10-year yield sat below 1.31% and the VIX resided north of 30 before each settled down a bit into the close.
Deal of the day
From the Financial Times:
Big Hit Entertainment Co., the company behind South Korean boy band BTS, is pushing ahead with plans for an initial public offering this year aimed at raising nearly $1 billion.
Open house
A reappraisal underway? This morning, Realogy Holdings Corp. the world’s largest real-estate brokerage franchisor (brands include Century 21 and Coldwell Banker) reported fourth quarter revenues and adjusted Ebitda of $1.33 billion and $119 million, respectively, trailing the consensus $1.4 billion and $126 million. Yet, despite the miss in a less-than forgiving tape, RLGY shares rose by 1% to their highest level in just under a year.
That bullish response comes as the broker faces existential threats. For the year, Realogy reported $5.6 billion in revenue and $218 million in free cash flow, down from $6.1 billion and $568 million, respectively, in 2017. Over that two-year span, RLGY shares have tumbled 51%, while net debt stands at nearly six times the Street’s estimate of $560 million in adjusted Ebitda for 2020.
While the emergence of V.C.-backed competitors like Compass, Inc. who eschew profitability in favor of grabbing market share has played a role in that decline, self-inflicted wounds also factor in for Realogy. From 2016 to early 2019, the company burned through nearly $900 million in buybacks at substantially higher stock prices. RLGY shares, scorned by the Street (no “buys,” four “holds” and a pair of “sells” among the six analyst recommendations logged by Bloomberg) is a hotbed of bearish sentiment, with some 30% of the float sold short.
Peering into that corporate wreckage in an Aug. 7 analysis, Grant’s offered a bullish verdict on the company’s senior unsecured 9 3/8 notes due 2027, which then traded at less than 85 cents on the dollar for a yield-to-worst of 12.5%: “The essential bear story on Realogy is that the legacy 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.”
Those bonds, are underpinned by a maintenance covenant barring the company from engaging in any further buybacks until net leverage falls to less than four turns of Ebitda. In addition, single-B-rated Realogy generated $400 million by disposing of its Catrus Relocation unit last fall, and discontinued its dividend on Nov. 7, saving an additional $41 million annually. Since Grant’s had its say last summer, the notes have rallied to 107 cents on the dollar for a yield-to-worst of 7.6%.
Might recent setbacks to the growth-over-profits business model augur a revival for the legacy brokers? In a report yesterday, analysts at CreditSights wrote that “the perspective on Realogy’s ability to compete on the luxury markets against Compass has also gained some relief from the asterisks now attached to Compass as a capital draining, unprofitable operation in the SoftBank family tree.”
Ryan Schneider, CEO of Realogy, expressed similar sentiments on today’s earnings call, noting that the industry has become “more rational” in terms of competition. The RLGY boss explained:
More rational doesn’t mean it’s not intense, to be blunt. But as an industry, we’ve been competing against private capital that’s been going after market share at all costs. To see the scrutiny of those companies be stronger has helped the competitive environment.
Only last summer, Compass completed a series-G fundraising round at a $6.4 billion valuation, quadruple that of Realogy’s market cap, from investors such as SoftBank’s Vision Fund. On Jan. 27, Compass confirmed that it had laid off 40 employees across its marketing, M&A and information technology divisions, equating to 1.6% of its total non-agent workforce.
With the implosion of fellow Vision Fund portfolio company WeWork still fresh in the public memory and a number other Vision Fund names retrenching in recent weeks, media comparisons between WeWork and Compass appear to have struck a nerve in the latter’s c-suite.
In an internal email last week slipped to Grant’s, Compass president Leonard Steinberg wrote:
Just like a bad virus, false or misleading news has the capacity to snowball and grow like an avalanche. Just one piece of salacious news - true, partially true or completely misleading or false - can snowball to become a narrative. And that can become viewed as fact, even if it's inaccurate or misleading.
A perfect example of this is how Softbank's investment in Compass has now been rephrased because of the WeWork mess. Instead of mentioning the dozens of large institutional investors like Goldman Sachs, Founders Fund, Wellington Management, and [sic] Institutional Venture Partners, Fidelity Investments, Dragoneer Investment Group, Canada Pension Plan Investment Board, etc., all of whom have invested sizable chunks, it is just the Softbank investment that is mentioned in most articles as of mid-2019 because of the salacious element Softbank's investment in WeWork provides to the media machine. Unfair? Possibly. Reality? Absolutely.
While I believe the comparison between WeWork and Compass is laughable (Compass and WeWork are as different as a cup and a car), what is more laughable is that virtually all of these media posts never mention Softbank's successful investments such as their $20 million investment in ALIBABA that is now worth a paltry $125 BILLION. Yes, Softbank is an investor in WeWork AND Alibaba. (and lots of other stuff). Softbank is a multinational conglomerate holding company, and its Vision Fund has investments in over 70 companies alone.
The gentleman protests – time will tell whether too much.
- Philip Grant
Monday, February 24, 2020
Credit chronicles
Bloomberg’s Javier Blas notes on Twitter that thanks to the latest leg lower in oil majors, the dividend yield on triple-A-rated Exxon Mobile, Inc. (XOM on the NYSE) jumped to 6.13%, its highest implied payout since 1986. For context, the Bloomberg Barclays Single-B Index, comprised of credits well below investment grade, currently trades at a yield-to-worst of 5.03%.
Private practice
Time for a reset. A new report from Bain & Co. and Harvard University economist Josh Lerner finds that private equity has averaged a 15.3% return over the last decade. While that figure sounds good, investors who simply put their money in the SPDR S&P 500 ETF Trust would have generated an average of 15.5% per year over that period.
It’s a far cry from the salad days of the pre-crisis era. According to research from Cambridge Associates, p.e. topped the S&P 500 by 600 basis points annually from 1980 to 2006 after fees. The industry likewise fared better in the trial-by-fire of 2008 and early 2009, generating a return of negative 30% over the 12 months ended March 31, 2009 according to Preqin. That compares to a 38% drop in the S&P 500 over that period.
Yet p.e.’s pedestrian recent performance hasn’t deterred institutional investors from showering cash on the asset class. According to data from Pitchbook, private capital fundraising totaled a record $888 billion last year. Global private equity accounted for $474 billion of that total, likewise a record figure and up 6% from a year ago.
Newfound fundraising innovations have helped the major p.e. players further stock their coffers, with KKR & Co., Inc. recently closing on a $1.3 billion ESG-based Global Impact Fund, matching similar moves undertaken by rivals Apollo Global Management, Inc., The Blackstone Group, Inc. and others in the past year. As capital pours in, p.e. morale remains stout: “I’ve never been more bullish on this industry,” one respondent wrote in advisory firm Semaphore’s 2020 Confidence Survey. “I continue to be amazed at how damn easy it is to make money,” another respondent said.
Bulging so-called alternative investments from the world’s largest pension funds likewise speak to p.e’s fundraising prowess. According to a Feb. 10 analysis of global pension assets conducted by Willis Towers Watson’s Thinking Ahead Institute, the average allocation to private equity, real estate and infrastructure funds stood at approximately 23% at year-end, up from just 6% 20 years ago.
As allocators increasingly turn to private equity, expectations reach sky-scraping levels. On Oct. 24, Dan Rasmussen of Verdad Advisors L.P. told the audience at the Grant’s 2019 fall conference that a survey of institutional investors found that 94% of respondents expect p.e. to outperform the public market over the next five years. Misconceptions likewise abound, with 76% believing their p.e. portfolio features credit ratings of double-B (the top tier of junk) or better. Instead, Moody’s pegs that double-B-rated p.e. portfolio component at just 2%.
Meanwhile, the longstanding run-up in asset prices has made the task of finding value a much more arduous one: According to Bain and Lerner, the average multiple of enterprise value to Ebitda for a leveraged buyout (LBO) reached 11.5x in the U.S. last year, up from 10.9 times in 2018 and 9.9 times in 2007. Extra dollops of debt accompany those higher prices: More than 75% of p.e. deals last year carried net debt of more than six times Ebitda, compared to just over 60% in 2007. That figure is actually even worse than it may appear, as calculated Ebitda figures often include cosmetic adjustments such as projected future cost savings known as add-backs.
The leverage pile-on is taking place in tandem with an observable downtick in corporate financial health. A Feb. 6 report from S&P Global found that the incidence of “weakest links”, i.e., domestic leveraged loans with a corporate credit rating of single-B-minus or worse along with a negative outlook, rose to a record high 145 issuers at year-end, representing 10.9% of total leveraged loan supply. That’s up from 95 loans, or 6.8% of the total as of the end of 2018. Encompassing both loans and bonds, the global supply of weakest links rose to 292 issuers in December, a fresh post-2009 high.
Last word goes to Rasmussen, from the Grant’s conference podium:
We are in a situation where the greatest minds in investing consider it to be their best idea to put larger and larger portions of their portfolios into illiquid, highly leveraged microcaps subordinated to triple-C- and single-B-rated leveraged loans and junk bonds. I’m skeptical, as I’m sure you can tell, that this would be a good decision. I challenge you to consider whether private equity is not in fact the greatest idea of institutional investors but, rather, the biggest mistake in their portfolios.
Recap Feb. 24
Stocks were clubbed as the S&P 500 tumbled by 3.4%, finishing near session lows to mark the largest one-day decline since February 2018 and erase the year-to-date gains on the broad average. Treasurys continued their epochal rally, leaving the 10-year at 1.36% and the 30-year at 1.83%, each a record closing low. Another 1% rally in gold pushed the Money of Kings to $1,660 an ounce, while WTI crude fell back towards $51 a barrel. The VIX spiked 46% to 25, its highest close since Dec. 24, 2018.
- Philip Grant
Friday, February 21, 2020
Green(back) shoots
It’s an historic day in the Treasury pits, as the 30-year bond fell to a record low 1.89% intraday yield, while the 10-year note yield slipped to 1.44%, approaching its all-time nadir of 1.36% recorded in July 2016. With economic activity on ice worldwide thanks to the spreading CORVID-19 virus, risk aversion reigns for now. Concerning data add to the zeitgeist, as this morning’s reading of the February IHS Markit Composite PMI fell into contraction for the first time since the October 2013 government shutdown.
One thing’s for sure: Between the Fed and the Trump administration, Uncle Sam is working overtime to counter any slowdown and keep the record post-2009 economic expansion rolling. On Feb. 12, the Treasury Department announced that the budget deficit in the first three months of the fiscal year came to $389 billion, up 25% from a year ago. On Jan. 15, White House advisor Larry Kudlow declared that a second tax cut package (following the 2017 Tax Cuts and Jobs Act) is in the offing for later in the year.
As growth prospects come under question and the core personal consumption expenditures index (the Fed’s preferred inflation gauge) remains below 2%, easier monetary policy is on the minds of our monetary mandarins. Last week, Philadelphia Fed president Patrick Harker said that: “If the situation gets significantly worse and we start to see significant impact on the U.S. economy, then we’d have to think about accommodation.”
Fed governor Lael Brainard went a step further in a speech today, arguing that the central bank shouldn’t wait for a slowdown to manifest: “We should clarify in advance that we will deploy a broader set of tools proactively to provide accommodation when shocks are likely to push the policy rate to its lower bound.”
Meanwhile, a dispatch from Reuters suggests that virus-related disruption has already reached the state of Illinois. A trio of sightings from today’s article:
- Morton Industries is trying to find a domestic source for tooling and fixtures used to shape metal that it previously imported. But limited domestic supply and a rush to secure the supplies that formerly flowed from China have sent prices up as much as 30%, said Kevin Baughman, vice president of operations at Morton.
- Morey Corp. expects to face shortages for circuit boards and casting parts next month if the stocks are not replenished. The electronics manufacturer has reached out to vendors in the United States, but its sourcing director, Tanveer Khan, said the price difference between domestic and Asian suppliers is as much as 30%.
- A Moline-based supplier of Caterpillar, Inc. and Deere & Co. that declined to be named said it is paying 40% more to domestic vendors for components that used to come from China - costs it is passing on to customers.
The inexorable Treasury price momentum in the face of stimulative government policy and in the absence of (real) yields of any significance is something of a mirror image to the government bond market in the era of Paul Volcker. Between 1980 and 1983, the U.S. ran budget deficits equal to 3.7% of GDP as the Reagan administration attempted to combat a double-dip recession. During the recession-free 2016 to 2019 period, deficits averaged 3.8% of output.
The Feb. 9, 2018 edition of Grant’s noted the symmetrical extremity which existed at the onset of the current bull market in Treasurys. Namely, a long bond priced to yield nearly 14% in May 1984, for a roughly 9% yield after accounting for the (then finally receding) rate of inflation. Muscle memory, fostered by years of one-way price action, seemed to drive prices:
Supply was thought to be bearish not, perhaps, because the supply of bonds was greater than the demand for bonds at prevailing yields and prices (though that was certainly true), but be-cause the very thought of fixed-income securities had 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.
The great inflation of the 1970s seemed to come from out of nowhere. With a long look in the rearview mirror, one identifies fiscal indiscipline (Vietnam, the Great Society), abetted by monetary disruption (the end of Bretton Woods) and, perhaps, by a demographic bulge, as the villains of the piece. Maybe in five to 10 years our own lapses from fiscal and monetary best practices will stand out as the causes of an inflation problem that today seems only incipient.
Treasury bulls, please copy.
Recap Feb. 21
A notable selloff pushed the S&P 500 lower by 1%, cutting the 2020 gains on the broad index to 3.4%, while the latest UST rally pushed the 3-month bill yield to a 9 basis point premium over the 10-year note. WTI crude pulled back to $53.3 a barrel, while gold extended its recent run to $1,643 an ounce. The VIX jumped to 17.4, the highest since Feb. 4.
- Philip Grant
Thursday, February 20, 2020
Millennial falcon
From investigative website The Smoking Gun:
From investigative website The Smoking Gun:
Aaron's Judge
This morning, furniture, appliance and electronics retailer
This morning, furniture, appliance and electronics retailer
Not-QE progress report
Recap Feb. 20
Millennial falcon
From investigative website The Smoking Gun:
A 36-year-old Ohio woman who called 911 to complain that her parents had shut off her cellphone service is facing a felony charge, records show.
Seloni Khetarpal was arrested Thursday for disrupting public services after twice dialing the police emergency line and asking for cops to be dispatched to her [family residence]. Khetarpal is pictured below in happier times.
.
Aaron's Judge
This morning, furniture, appliance and electronics retailer Aaron’s, Inc. (AAN on the NYSE) reported fourth quarter results largely in line with estimates; $1 billion in revenue and $1.15 in adjusted earnings per share vs. expectations of $1.01 billion and $1.06 per share, respectively.
Guidance, however, was jarringly poor, as the company expects $4.22 billion in revenues this year along with $3.90 in earnings per share using the midpoint of provided ranges, far below bulled-up Wall Street expectations (nine “buy” ratings with one “hold” and no “sells”) of $4.48 billion and $4.54 a share, respectively. In response to that 2020 outlook (which analysts at Stifel Nicolaus termed “puzzling”), AAN shares tumbled by 19%, narrowing their advance to 17% since a June 30, 2017 bearish analysis in Grant’s.
Founded in 1955, Aaron’s is the largest so-called rent-to-own (RTO) retailer in the U.S. The RTO business model features a customer paying for the use of a laptop or La-Z-Boy for a given term. If current on his or her payments at the end of the lease (often 12 to 24 months), the customer gets to keep the item. Paying effective interest rates that can run far above those charged by credit cards, RTO customers are largely situated in the basement of the credit spectrum.
Beyond its longevity, Aaron’s stands as something of a retail success story in the age of Jeff Bezos, generating positive free cash flow in each of the last five years, and growing adjusted Ebitda at a 6.1% compound annual growth rate since 2015. AAN is valued at just 11.5 times its updated 2020 earnings projection and features a sturdy balance sheet: Net debt of $283 million compares to $435 million in 2019 adjusted Ebitda while operating income of $106 million last year covered interest expense more than six times over.
Perhaps ironically for such a conservatively-financed corporate concern, speculative-grade consumer lending is increasingly front-and-center to the business model. Revenues at its Progressive Leasing unit (which finances customer purchases at stores not owned by Aaron’s) accounted for 53.9% of the consolidated top-line after bad debt expense last year, up from 49% of total revenues in 2018.
Aaron’s store count continues to dwindle, falling to 1,502 at the end of 2019 from 1,689 the year prior and 1,726 locations in 2017. Over that three-year period, the proportion of company-owned stores rose to 77.7% from 68%, while Aaron’s bought out 18 franchised stores last year after bringing 270 under the corporate roof in 2017 and 2018. In that Grant’s analysis from June 30, 2017, deputy editor Evan Lorenz explained how those transactions flatter the corporate income statement:
The cost of acquiring franchisee stores shows up in cash flows from investing activities under ‘acquisition of businesses and contracts, net of cash acquired’. The purchase price of a franchisee’s store includes that seller’s floor inventory. Normally the cost of acquiring retail stock is a charge to cash flow. Not so when you buy a store lock, stock and barrel.
So when Aaron’s leases a couch or a TV which it hauls out from the storeroom of a former franchisee, the cash-flow metrics look better than they really are. Still and all, the store net-work is declining.
Regulatory and legal risks also factor in, as the company took an $179 million charge to settle a 2018 civil investigative demand from the Federal Trade Commission regarding financial disclosures from the Progressive Leasing business. Two weeks ago, California governor Gavin Newsom introduced legislation which would place RTO oversight under the direct purview of the state’s financial regulator, news which sent AAN shares lower by more than 10% on Feb. 4.
Other legal developments shine a less-than flattering light on AAN’s business. On Tuesday, debt collection firm Turtle Creek Assets, Ltd. (TCA) filed a lawsuit in Georgia state court alleging that AAN knowingly sold the litigant tainted delinquent accounts. Turtle Creek CEO Gordon Engle explained:
As our staff began client actions on accounts, we were distressed to learn that many of the individuals had previously settled with Aaron's, returned the merchandise, had never signed lease agreements with Aaron's or were not even Aaron's customers. In fact, there were numerous instances where no valid paperwork existed or perhaps never had.
The breadth of the tainted accounts is so pervasive that it threatens to render the entire portfolio uncollectable. By our estimate, approximately 20,000 of the accounts (consumers) Aarons sold TCA have already been prosecuted criminally by Aaron’s prior to the sale to TCA.
One thing’s for sure: Credit quality of Aaron’s customers is on the wane. According to the form 10-K filed today, the proportion of AAN customers sporting a FICO score of 600 or less jumped to 6.7% in 2019, nearly double the 3.7% figure in the prior year. At the upper end of the spectrum, only 13.2% of customers featured FICO scores of 700 or better, down from 18.4% in 2018.
With regulators cracking down, consumer credit quality deteriorating and provocative allegations on file in the courts, Aaron’s management has been taking self-protective measures. In 2019, the AAN C-suite sold $12.7 million worth of shares on the open market, mitigated by a single $130,000 purchase.
Not-QE progress report
Reserve Bank credit (i.e. the sum of the Fed’s interest-bearing assets) rose $9.8 billion this week to $4.144 trillion, the latest slowdown in balance sheet expansion as the three-month annualized growth-rate is 14.7%. That’s down from 15.4% last week and 38.3% at the end of last year.
Since the September commencement of “not-QE,” total balance sheet assets are up by 11%, within about 7% of the pre-QT high-water mark.
Recap Feb. 20
A sharp late-morning selloff was followed by a modest afternoon rebound, leaving the S&P 500 lower by 40 basis points for the day and little changed for the week so far. Another powerful bull-flattening Treasury rally pushed the 3-month bill yield 6 basis points above the 1.53% on the 10-year, the most severe inversion since Oct. 9. Key commodities caught a bid, with gold rising to $1,620 an ounce to extend its torrid run and WTI crude closing near $54 a barrel for its best finish in nearly a month. The VIX jumped to 15.5, a two-week high.
- Philip Grant
Tuesday, February 18, 2020
Let's review
Time for a second look. On Jan. 21, the European Central Bank commenced a wide-ranging review of its monetary policies, following last fall’s ascension of former International Monetary Fund head Christine Lagarde to ECB president. There is, of course, plenty to evaluate, as more than five years of negative nominal interest rates and a renewed €20 billion ($22 billion) monthly asset purchase program has yielded little in the way of tangible results. Eurozone economic and inflation data remain moribund, as fourth quarter GDP grew 0.9% from a year ago, its weakest since 2013, while CPI inflation has averaged just 1.2% year-over-year in the last 12 months.
In urging local governments to promote economic growth through looser fiscal policy, Lagarde told European parliament last week that “the longer our accommodative [monetary] measures remain in place, the greater the risk that side effects will become more pronounced.” Evidence of such direct impact is already abundant.
Last week, Italy drew more than €50 billion in bids for a €9 billion sale of 1.49% yielding bonds due 2036, a record order book and a record low yield for that maturity. Italy, which is teetering near economic stall-speed (economist consensus pegs 2020 GDP growth at just 0.3% after a 0.3% sequential contraction in the fourth quarter) and sports Europe’s largest marketable sovereign debt load, is rated at the bottom rung of investment grade at Moody’s and Fitch.
On Thursday, the Republic of Greece 10-year yield touched 0.92%. That’s another benchmark of accommodation for the double-B/double-B-minus-rated sovereign issuer, which last month attracted a record order book of €14 billion for a 15-year bond offering at 1.88%. Greece, the recipient of a trio of E.U. and IMF bailouts since 2010, famously saw its 10-year bond yield skyrocket to north of 35% during the teeth of the European sovereign credit crisis of 2010 to 2012.
The ECB’s presence is helping to spur advanced-level FOMO among investors. Antoine Bouvet, senior rates strategist at ING Group, described the appeal of Italian and Greek bonds to the Financial Times yesterday: “Bunds on steroids: safe bonds but with a bit more yield.” For context, the triple-A/double-A-plus-rated U.S. currently pays 1.55% to borrow for 10 years.
On the corporate side of the ledger, E-Z money has produced its own peculiar outcomes. On Feb. 5, single-A-rated LVMH Moet Hennessy Louis Vuitton S.E. sold €7.5 billion in euro-denominated notes to help finance its $16 billion acquisition of U.S.-based luxury retailer Tiffany & Co. The deal, Europe’s largest corporate bond sale in nearly four years, saw two of the tranches priced to yield less-than zero and the highest coupon at 0.45% for an 11-year tenor, outpacing the expectations of LVMH CEO Bernard Arnault (incidentally, France’s richest man) who predicted 0% to 1% financing costs back in November. Yesterday, Bloomberg’s Tasos Vossos reported on Twitter that the ECB bought portions of each of the five euro-denominated offerings. While the size of those purchases is unknown, the ECB is authorized to buy up to 70% of a given issue, according to its website.
The idea that central banks would pick winners and losers in the cross-border M&A realm was, unsurprisingly, met with some political resistance. In December, a group of Italian parliament members asked Lagarde whether the ECB “does not feel it has, in practice, funded the acquisition of Tiffany by LVMH with public money” In January, the ECB president replied that “issuers of bonds bought under the corporate sector purchase program are free to make their own business decisions on how to allocate resources.”
Under the watchful, benevolent eye of the supranational central bank, of course.
Recap Feb. 18
A modest 30 basis point dip in the S&P 500 obscured more visible risk aversion elsewhere, as bull flattening across the Treasury curve pushed the 30-year bond yield below 2% this morning, not so far away from the 1.53% on offer for the 3-month bill. Gold surged again, rising above $1,600 for the first time since 2012, despite notable strength in the buck as the Dollar Index tests the 100 level for the first time since May 2017. The VIX jumped to near 15, up 8% on the day.
- Philip Grant
Friday, February 14, 2020
Down in the bottom
The basement is getting crowded. The rising cohort of triple-B-rated corporate bonds (the last full stop before junk) is a defining feature of the current cycle, as 50.1% of the Bloomberg Barclays Investment Grade Index carried that as of last year, up from roughly 35% in 2007.
Fortunately for investors, triple-B was the place to be last year, returning 16.3% to top the 14.5% gain for the broader Bloomberg Barclays IG Index. In addition, a report from Bank of America in January found that just 0.3% of triple-B issuers were downgraded to junk last year, a record low. “We expect less than $100 billion of Fallen Angels [companies demoted to junk status from investment grade] during the next recession,” the BofA analysts say.
However, that appears to be changing.
Yesterday, packaged food giant Kraft Heinz Co. (KHC on the Nasdaq) reported that sales in the fourth quarter fell 5.2% from a year ago and projected Ebitda will dip 8% this year following a 14% slide in 2019. In addition, the company announced another $450 million non-cash write down while maintaining its $0.40 per share quarterly dividend payable March 27, equivalent to a 5.75% dividend yield at current share prices. With profitability on the wane and a robust debt load suddenly looking more daunting, KHC creditors have voted with their feet. The company’s senior unsecured 4 3/8% notes due 2046 fell 5 points this morning to less than 91 cents on the dollar, for a yield-to-worst of 5.03%. Shares are down 65% from an initial bearish analysis in the March 25, 2016 edition of Grant’s.
The rating agencies have lowered the boom. Fitch Ratings this morning downgraded KHC to double-B-plus (the top level of junk) from triple-B-minus. After the market close, Standard & Poor’s followed suit, cutting Kraft Heinz to double-B-plus from triple-B-minus. With two agencies deeming KHC as sub-investment-grade, the index makers will reclassify the company's $30 billion marketable debt as junk, placing KHC as the third-largest corporate high-yield issuer in the U.S. “Kraft is to investment grade as Velveeta is to cheese,” Christian Hoffmann, portfolio manager at Thornburg Investment Management, told Bloomberg. “The ingredients dictate what something is and Kraft Heinz is junk.”
As for other potential fallen angels, we turn to Ford Motor Co. (F on the NYSE), which was downgraded to Ba1 from Baa3 by Moody’s Investors Service in September. Ford, which will generate less than $10 billion in adjusted Ebitda this year for the first time since 2009 if analysts are on the beam, is increasingly leaning on its financing division. Ford Motor Credit generated $3 billion in operating profit last year, nearly half of the consolidated total. According to Bloomberg Intelligence analyst Joel Levington, financing contributes 15% to 20% to the bottom line in a “normal operating environment.”
For Ford and the global automotive industry at large, supply chain disruption associated with the coronavirus outbreak could spell trouble. Bloomberg reports today that Fiat Chrysler Automobiles N.V. will halt operations at a Serbian assembly plant due to a lack of parts, following similar moves from Nissan Motor Co. Ltd. and Hyundai Motor Co. in recent days. With Moody’s already rating Ford debt “junk,” a downgrade from either S&P or Fitch from their current triple-B ratings would knock Ford’s $38 billion in marketable debt into junk according to CreditSights. For more on the bear case on Ford, see the Oct. 18 issue of Grant’s.
Then there’s Petróleos Mexicanos, i.e., Pemex. The state-owned oil giant saw its credit rating downgraded to junk last year by Fitch, while S&P rates the company triple-B-minus and Moody’s rates Pemex at Baa3 (equivalent to triple-B-minus) with a negative outlook. The company, which is suffering a long-term production decline, 10 straight years of cash burn and a debt load of more than 8 times trailing Ebitda inclusive of pension liabilities, is increasingly dependent on the credit markets to operate. A Feb. 5 presentation from the finance ministry estimated that Pemex will require MXN 199 billion ($10.7 billion) in external financing this year, up from MXN 114.4 billion in 2019. Were either S&P or Moody’s to pull the trigger, CreditSights estimates that $57 billion in fixed-rate dollar-pay marketable debt will be demoted to junk.
With the current economic expansion not getting any younger, might a demotion of one or more major issuer into junk spur (or exacerbate) broader problems? According to Moody’s, the supply of junk-rated debt set to mature in the next five years stands at $1.19 trillion, a record level and up 13.6% from the five-year maturity schedule a year ago. Then, too, defaults across high yield have increased, as Fitch Ratings calculates a 3.3% high-yield default rate last year, well above the long term, non-recession average of 2.4%. People may be concerned, but not concerned enough to sell. The Bloomberg Barclays High Yield Index trades at a 340 basis point option-adjusted spread over Treasurys, down from a 10-year average of 477 basis points and within shouting distance of the post crisis low of 303 reached in October 2018.
Recap Feb. 14
A second straight sideways showing for stocks left the S&P 500 up 1.5% for the week, within a few basis points of its high-water mark. A solid commodity bid pushed WTI crude above $52 a barrel for the first time in two weeks, while gold rose to $1,582 an ounce, approaching its multi-year high of $1,589. Treasurys enjoyed a bull-flattening rally, as the 2- and 10-year yields fell to 1.43% and 1.59%, respectively, for the narrowest spread since Nov. 29. The VIX fell back below 14.
- Philip Grant
Thursday, February 13, 2020
Like a hurricane
The currency markets have never been so calm.
The currency markets have never been so calm.
Not-QE progress report
Recap Feb. 13
Like a hurricane
The currency markets have never been so calm. That’s according to the J.P. Morgan Global FX Volatility Index, which touched an all-time low on Jan. 17 and remains near that record level going back to its inception in 1989. However, if recent trading action in a quartet of currencies is any indication, a turn may be in store.
J.P. Morgan Global FX Volatility Index; 30-year chart. Source: The Bloomberg
This morning, the Swiss franc traded above 0.94 per euro, its strongest level in nearly five years and up from 0.83 in April 2018. That price appreciation in the traditional monetary port-in-a-storm is unlikely to be met with the approval at the Swiss National Bank, which has undertaken strenuous currency suppression maneuvers over the years by printing francs to buy euros and then diversifying into other assets such as U.S. equities. Expecting (still) easier money to combat the rising franc, futures are now pricing a seven basis point cut to the benchmark policy rate from the current negative 75 basis points (tied with Denmark for the world’s lowest) by December, according to data from Bloomberg.
While one safe haven ascends to heights that policymakers might find uncomfortable, the currency Down Under plums new cyclical depths. Thanks to a 5% drop against the greenback this year, the Australian dollar remains near its weakest level since 2009. With economic growth prospects waning thanks to devastating local wildfires as well as diminished activity associated with the coronavirus pandemic and general weakness in the Chinese economy, easier monetary policy may be on the horizon. Shane Oliver, head of investment strategy at AMP Capital Investors, told Bloomberg last week that “the Reserve Bank of Australia may cut rates [by 50 basis points] to the 0.25% lower bound if the knock-on impact to GDP gets worse from here, and we may see quantitative easing come in as well in the second half of the year.”
On the emerging market front, the Turkish lira has weakened to 6.04 to the dollar today, an eight month low and off from less than 5.5 per dollar in August. After crossing the 6 threshold last week, local authorities ordered banks to sell $4 billion in foreign currency against the lira to help stem the slide, efforts that appear thus far ineffective.
Jason Tuvey, senior emerging markets economist at Capital Economics, noted in a report Monday that existing Turkish central bank reserves of $106 billion are dwarfed by an estimated $190 billion in gross external financing needs over the next 12 months, concluding that “indirect intervention through state banks cannot be maintained.” Under the forceful leadership of President Recep Erdogan, the Turkish Central Bank has aggressively eased monetary policy, cutting the benchmark one-week repo rate to 11.25% in December, continuing the precipitous drop from 24% in June 2019. That strategy may be stirring renewed inflationary pressures, as CPI rose 12.2% from a year ago in January, the third straight jump after an 8.6% annual reading in October.
Finally, to Brazil, where the local currency is also in sharp retreat. The real traded at 4.35 per dollar yesterday, the weakest exchange rate on record and representing an 8% loss against the buck for 2020 (the real has been the worst performing currency in the world this year). By way of response, the Banco Central do Brasil (BCB) intervened in the market yesterday by selling $1 billion worth of currency-swap contracts, which allow the bank to support the real without drawing on FX reserves. A commentary today from XP Investments, Inc. highlights the risk of accelerating turmoil: “very few people, locals and offshores alike, seem eager to bet on the real and stand in front of this stampede. That’s the evidence we’ve been getting in our conversations here in New York and from our interactions with locals too.”
The BCB’s efforts to lift the FX rate are undermined by simultaneous exertions to prop up the economy. Last week, economists at UBS Group A.G. cut their Brazilian 2020 growth forecast to 2.1% from 2.5%, while the BCB cut the benchmark interest rate 25 basis points to 4.25%, an all-time low and the fifth cut since the end of July.
A rule of thumb: The phrase “Volatility is at all-time lows” is rarely followed by “and they lived happily ever after.”
Not-QE progress report
Reserve Bank credit (i.e. the sum of the Fed’s interest-bearing assets) rose $15.1 billion this week to $4.135 trillion, representing a 3-month annualized growth rate of 15.4%. That’s down from an 18.2% three-month annualized rate of growth last week, and 26.2% on Nov. 13.
Since the September commencement of “not-QE,” total balance sheet assets are up by 11.2%, within 7% of the pre-QT high-water mark.
Recap Feb. 13
January inflation data came in hotter than expected, with so-called core CPI rising 2.3% from a year ago, the 23rd straight reading of at least 2%. Those figures didn’t scare the bond market, as bull flattening action in the Treasury complex pushed the 2- and 10-year yields to 1.44% and 1.61%, respectively, while this afternoon’s auction of the 30-year bond priced at an all-time low of 2.06%.
Elsewhere, stocks drifted sideways to leave the S&P 500 on the cusp of record highs, while WTI crude rose back above $51.50 a barrel and gold climbed to $1,577 an ounce. The VIX ticked above 14 after closing below that handle for the first time in three weeks yesterday.
- Philip Grant
Wednesday, February 12, 2020
He said it
Here’s Fed chairman and former Carlyle Group, Inc. partner Jerome Powell at this morning’s Humphrey-Hawkins congressional testimony:
It's been a particularly good time to be at the top of the income spectrum.
That's Armour-e
To the penalty box. Yesterday, Under Armour, Inc. (class A shares: UAA on the NYSE) reported fourth quarter results that could be described as wanting. While the $0.10 of adjusted earnings per share matched consensus and revenues of $1.44 billion were only slightly below the expected $1.47 billion, the sportswear maker’s outlook was strikingly poor. Projected 2020 revenues and EPS of $5.2 billion and $0.115 (using implied midpoints of management’s provided range), respectively, were well below the Street’s expectation of $5.51 billion and $0.47 per share.
Additional expenditures related to an attempted turnaround may add a further near-term eyesore, as management announced it may spend up to $425 million in a “restructuring initiative,” including $250 million to potentially “fore[go] opening a flagship store in New York City while pursuing sublet options for the long-term lease.” A decision is expected on those initiatives by the end of the first quarter.
The dreary results and guidance spurred analysts at Citigroup, Inc. (who rate the stock “buy”) to describe the update as a “huge disappointment.” Mr. Market agreed, as shares in UAA sank by 18% and are down 59% from an initial bearish analysis in the June 12, 2015 edition of Grant’s. It’s a far cry from the glory days, when the company managed to post annual revenue growth of at least 20% or more for 26 consecutive quarters through the third period of 2016.
During the tail-end of that remarkable streak in April 2016, chairman and then-CEO Kevin Plank had this to say when summarizing yet another jump in the top-line:
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 [NBA star and noted Davidson College man] 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.
Those unusual remarks took on new meaning last fall. In November, The Wall Street Journal reported that the Department of Justice and the Securities and Exchange Commission were conducting a joint investigation “examining whether the sportswear maker shifted sales from quarter to quarter in an effort to appear healthier.” Under Armour subsequently confirmed it has been cooperating with the probe since July 2017. During that two-plus-year interval prior to the Journal’s report, the C-suite disposed of $2.8 million worth of UA shares, mitigated by a single open market purchase of $230,000 in May 2018.
Management turnover has been elevated. On Jan. 1, co-founder Kevin Plank stepped aside as CEO (he remains chairman of the board), replaced by chief operating officer Patrik Frisk. That follows other high-level exits in recent years, including chief digital officer Robin Thurston and chief merchandising officer Henry Stafford in Spring 2016, while Kip Fulks, who co-founded the company with Plank, departed last year after taking a sabbatical in 2017.
That skeptical UAA analysis in the June 12, 2015 edition of Grant’s centered on a question posed by deputy editor Evan Lorenz: “What does it take for a once excellent brand to become merely good?” At publication time, Wall Street expected Under Armour’s success to continue long into the future, as the analyst consensus penciled in $10 billion in revenues for 2020, or roughly double the company’s updated outlook for this year.
Even though operating performance has sagged and the UAA shares have been pummeled, Under Armour continues to command a healthy valuation on a price-to-earnings basis. The class-A shares trade at 51 times trailing earnings and 133 times the upper end of full-year 2020 EPS guidance. By comparison, Nike, Inc. shares fetch 33 times forward EPS estimates, and Adidas A.G. trades at 29 times forward earnings.
Interestingly, the bond market is a bit more skeptical. The split-rated (Baa3 at Moody’s, double-B at S&P) senior unsecured 3 1/4 notes due 2026 last changed hands at 96.3 cents on the dollar for a 246 basis point spread over Treasurys. That’s wider than the 202 basis point option-adjusted spread seen on the Bloomberg Barclays Ba Index (equivalent to double-B), let alone the 129 basis point pickup on offer for the Bloomberg Barclays Baa Index.
Recap Feb. 12
Yet another stout equity rally left the S&P 500 at its fourth closing high in the last five sessions and extended the year-to-date gains to nearly 5%. Treasury yields rose again, leaving the 2- and 10-year at 1.44% and 1.63%, respectively, while key industrial commodities enjoyed a bounce with WTI crude back to $51.50 a barrel and copper to $260 a pound, each up roughly 4% from recent lows. The VIX fell below 14 for the first time since Jan. 23.
- Philip Grant
Tuesday, February 11, 2020
Judge dread
A bombshell. A U.S. Federal Court has sided with telecom operators Sprint Corp. and T-Mobile U.S., Inc. in dismissing an antitrust lawsuit from 13 state attorneys general attempting to block the pair’s all-stock merger. News of that market-rattling announcement, which sent shares in S and TMUS soaring by 77% and 12% respectively, was disseminated yesterday to both parties, according to the Financial Times.
Two hurdles remain to completion: Securing approval from a Federal Judge in a review of a Department of Justice Consent Decree under the 1974 Tunney Act as well as from the California Public Utilities Commission. Those steps should be relatively drama-free, as research firm CreditSights now pegs the odds of the deal closing at more than 90%.
In announcing his decision, U.S. District Court Judge Victor Marrero heaped praise on T-Mobile, asserting that the company has “redefined itself over the past decade as a maverick that has spurred the two largest players in the industry to make numerous pro-consumer changes. The proposed merger would allow the merged company to continue T-Mobile’s undeniably successful business strategy for the foreseeable future.” Marrero was evidently convinced not only that Sprint was a dead company walking were the deal to be blocked but also that nascent competitor Dish Network Corp., which purchased Sprint’s divested pre-paid business, presents a viable future competitor in the mobile phone market.
The thwarted litigants signaled they will continue the fight. California AG Xavier Becerra’s office promised this morning that “our coalition is prepared to fight for as long as necessary to protect innovation and competitive costs” and that it was “reviewing all options,” while New York AG Letitia James added that the ruling is “a loss for every American who relies on their cell phone.” George Slover, senior policy council at Consumer Reports, sided with the AGs: “Going from four established nationwide wireless networks to only three. . . will be extremely damaging to competition.”
As evidenced by the drastic share-price reactions, the news caught Mr. Market off guard. One investor attuned to the situation told Grant’s they were indeed “shocked” by the ruling, as applicable case law under the 1914 Clayton Act shifts the burden of proof to defendants in determining whether a merger will harm competition. Our source likewise notes that Judge Marrero agreed with the states on a number of core issues yet ruled for the defendants anyway, concluding that the states “have an uphill battle” in any appeal as the nature of the decision “constrains the issues in dispute.”
Getting to the finish line will remove a major overhang for Sprint, which would have likely needed to undergo debt restructuring if the deal were nixed by regulators or the courts (Almost Daily Grant’s, Feb. 1, 2019).
While the apparent removal of that dire outcome is certainly cause for relief, Sprint’s euphoric shareholders should prepare for a revised, discounted bid relative to the original exchange ratio of 0.1026 T-Mobile shares, as the merger agreement expired on Nov. 1. CreditSights concludes: “T-Mobile and Sprint are likely to renegotiate the terms of their merger. Since the deal was announced in April 2018, Sprint looks less valuable and T-Mobile looks better than ever.” Sprint shares currently trade at a 12% discount to the level implied by TMUS’s previous bid.
Sprint majority owner SoftBank Group Corp. is, in turn, relieved of the prospect of either pouring additional billions into Sprint or seeing the company for which it spent more than $20 billion for an 84% stake potentially enter bankruptcy. After a 12% pop today, SoftBank’s U.S. listed American Depository Receipts have rallied 25% over the past five days (activist investor Elliott Management Corp. was revealed to have a position in the company last week) and are up 32% from an initial Grant’s bearish analysis on Dec. 15, 2017.
That bullish reaction to news of the U.S. telecom market shrinking to three established carriers from four features a bit of irony. In Japan, e-commerce giant Rakuten Mobile, Inc. is set to roll out full-scale wireless service across the country in April, expanding Japan’s competitive field to four entrants from the current three. That arrival is none-too-welcome for SoftBank’s majority-owned telecom subsidiary, which generates the vast majority of the company’s cash flow.
Recap Feb. 11
Stocks finished slightly higher in relatively subdued action, as the S&P 500 gave back larger gains but still managed to establish its third closing high in the last four trading sessions. Treasurys were weaker across the curve as the 2- and 10-year yields rose to 1.42% and 1.6%, respectively, while WTI crude oil rebounded above $50 a barrel and gold edged lower to $1,568 an ounce. The VIX remained just above 15.
- Philip Grant
Monday, February 10, 2020
Headline of the day
From the Financial Times:
From the Financial Times:
Curb your enthusiasm
Things are looking up for corporate America.
Things are looking up for corporate America.
Recap Feb. 10
Headline of the day
From this Financial Times:
Private equity became too focused on money, says Guy Hands
Curb your enthusiasm
Things are looking up for corporate America. According to FactSet’s latest quarterly earnings summary released on Friday, blended earnings growth (incorporating both actual results and estimates from those companies yet to report) across the S&P 500 has registered 0.7% year-over-year for the fourth quarter, with 64% of the index reporting results so far. That figure is well above the projected 1.7% decline for the quarter as of Dec. 31 and would mark the best overall showing for the index since the fourth quarter of 2018, which saw 13.3% earnings jump thanks in part to the Trump Administration’s Tax Cuts and Jobs Act.
The stronger-than-expected start to fourth quarter earnings season adds fuel to the already-revved up bull crowd, who are basking in a 15% rally since mid-October. Noting that the S&P 500 aggregate market cap of $25 trillion is just a fraction of the $300 trillion in global household assets, Fundstrat Global Advisors, LLC head of research Tom Lee contends in a recent report that U.S. equities will benefit from a flight-to-safety among worldwide investors: “There is not enough S&P 500 to go around.”
U.S. equity bulls have an ace up their sleeve, too, in the form of a persistent bid from price-insensitive “investors.” According to the most recent form 13-F released on Thursday, the Swiss National Bank now owns a record $97.5 billion in domestic stocks, up from $94 billion three months ago and $78 billion last year.
In addition, the cyclical winds remain favorable with the post-crisis economic expansion now on to a record 128th consecutive month. Some observers believe that a new paradigm is indeed upon us, with Bridgewater co-chief investment officer Bob Prince telling Bloomberg television last month from Davos that “we’ve probably seen the end of the boom-bust [economic] cycle.”
With earnings growth swinging back into positive territory and cyclical tailwinds continuing to blow, Wall Street has high hopes for the rest of the year. According to FactSet, consensus earnings growth will quicken to 2.5% year-over-year in the first quarter of 2020, followed by growth rates of 5.1%, 9.8% and 11.9% for the remaining three quarters of the year.
That expected acceleration in corporate profit growth runs headlong into the widespread supply-chain interruption resulting from the coronavirus pandemic in China, starting with a key cog for the world’s most valuable company. Bloomberg reports today that Apple, Inc., supplier Hon Hai Precision Industry Co., Ltd. (a.k.a. Foxconn) told workers that a resumption of iPhone production is delayed “until further notice” following an extended Lunar New Year Holiday which was supposed to end today.
With China accounting for roughly 17% of world output, compared to 4% during the 2003 outbreak of severe acute respiratory syndrome (SARS), Bloomberg concludes that: “even if the outbreak peaks soon and producers impose double overtime to make up for lost production, the final end-demand for gadgets of all stripes could take a severe beating.” Jim Bianco, president and eponym of Bianco Research, concurs with that assessment, predicting today that “earnings forecasts and company guidance about the damage to the global supply chain might become the biggest earnings story of 2020.”
The bond market is sniffing trouble, as diving Treasury yields in recent weeks have helped precipitate another inversion of the 3-month vs 10-year spread, a sometimes historically OK prediction of recession if maintained for 10 or more days (Almost Daily Grant’s, June 6).
The recent rally has pushed valuations to fancy levels even assuming that the projected earnings acceleration actually materializes. To borrow again from FactSet, the S&P 500 now commands a forward price-to-earnings ratio of 18.8 (that’s using the full-year projected earnings growth of 8.3% from 2019), up from a 10-year average of 15 times forward earnings. But might the S&P’s price tag be much higher? For a thorough analysis of the S&P valuation methodology suggesting that index-level investors are actually paying far more, see the Jan. 24 edition of Grant’s Interest Rate Observer.
Recap Feb. 10
A minor early dip in stocks proved short-lived, as the S&P 500 soon jumped into the green and finished at new highs, extending the year-to-date gains to nearly 4%. Jubilation was in short supply elsewhere, with Treasury yields ticking lower once more as the 2- and 10-year notes finished at 1.38% and 1.56%, respectively. Commodities were once again a wall of red apart from a minor rally in gold, with WTI crude falling to $49.50 a barrel. The VIX finished little changed at 15.3.
- Philip Grant
Friday, February 7, 2020
Sentiment check
On Wednesday, Bloomberg detailed the bourgeoning use of leverage in the fine art market, as collectors increasingly utilize credit lines backed by high-priced works. The loans, usually extended by the wealth-management arms of global banks, are sized at up to 50% of collateral value and feature interest rates of as low as 1% for a “select few.”
According to Deloitte’s Art & Finance Report for 2019, such secured debt outstanding reached at least $21 billion globally last year, up 40% from 2016. There is room for further growth, as Deloitte reports that 69% of collectors are interested in using all or part of their collection as collateral compared to 57% a year ago. Freya Stewart, head of financial services at advisor and boutique lender The Fine Art Group, equated the practice to taking out a mortgage, telling Bloomberg that borrowers “are not necessarily buying another house. They are using the money to do something else.”
Meanwhile, one bold-faced connoisseur looks to throw his weight around. Amazon.com, Inc. CEO Jeff Bezos, the world’s richest man, spent a cool $71 million on a pair of works in November according to art dealer Josh Baer. Bezos’s newfound hobby, Bloomberg speculates, “could have a significant impact” on the market. The Amazon boss is unlikely to need much help from the loan officer to help further his collection, as he has sold $3.5 billion worth of AMZN shares this week alone.
Hut hike
Here comes the sun. According to restaurant analytics firm Black Box Intelligence, January registered the best industry performance in more than four years, as comparable store sales jumped 2.3% from a year ago while traffic narrowed its longstanding decline to just 0.7% year-over-year. That’s only the fifth time since 2016 in which traffic fell by less than 1% from the prior year’s reading. Thanks partly to favorable winter weather across the Northeast and Midwest during the first month of the year, 77% of national markets reported positive performance, an almost perfect inverse of December which featured only 22% of markets experiencing comp. store sales growth.
But while the industry basks in a strong start to 2020 and enjoys the favor of Mr. Market (the S&P Restaurants Index trades at an enterprise value equivalent to 19 times consensus Ebitda for 2020), the diversion in fortunes between “asset-lite” franchisors and their put-upon franchisees continues to loom as a significant problem.
On its fourth quarter earnings call yesterday, Yum Brands, Inc. (YUM on the NYSE) disclosed that bad debt expense in its Pizza Hut division more than doubled last year to $22 million, as financial distress at NPC International, Inc. resulted in a jump in unpaid royalty fees. NPC, the second-largest franchisee in the U.S., absorbed a credit ratings downgrade to triple-C-minus from S&P last September, with the company’s first-lien term loan due 2024 falling to 46 cents on the dollar to yield 26.5%.
Grant’s has long contended that the plight of the franchisees, who bear the brunt of weak operating performance in tandem with ever-rising costs, would ultimately knock the gilded, asset-lite franchisors for a loop (see the Sept. 20 issue for more). Some Wall Street analysts appear to be coming around to this view, as Barclays Capital put it this way in a Jan. 29 report:
Franchisee profitability remains topical, as many franchisees have become increasingly vocal in pushing back against large, complex, and /or expensive initiatives that have not demonstrated a consistent return on investment. Ultimately, while franchised systems are appreciated by investors for their stability, sentiment regarding the franchisor (i.e. corporate) can turn fast, resulting in a vulnerable ‘house of cards’ scenario.
The franchisors may be asset-lite, but they are liability-heavy. Jack in the Box, Inc., Restaurant Brands International, Inc. and Wendy’s, Inc. (to name three) carry net debt equal to 4.3 times, 5 times and 7.6 times consensus 2020 Ebitda, respectively.
Recap Feb. 7
A modest pullback in stocks left the S&P 500 higher by a sturdy 3.5% for the week. While equities remain jubilant, risk aversion continues to reign elsewhere, including vigorous bull-flattening in the Treasury complex as the 2- and 10-year yields tumbled to 1.4% and 1.58%, respectively. Key industrial commodities came for sale, with WTI crude falling back below $50.5 a barrel and copper sinking 1% to approach three-year lows. Gold and the VIX both edged higher, settling at $1,570 per ounce and 15.6, respectively.
Thursday, February 6, 2020
Crypto carve-out
From Coinbase:
From Coinbase:
Credit chronicles
A debtor's delight.
A debtor's delight.
Not-QE progress report
Recap Feb. 6
Crypto carve-out
From Coinbase:
SEC Commissioner Hester Peirce wants to give legitimate crypto projects a shot at success without running afoul of U.S. securities laws.
Under Peirce’s proposal, unveiled during a speech at the International Blockchain Congress in Chicago Thursday, crypto startups would have a three-year grace period from their first token sale to achieve a level of decentralization sufficient to pass through the agency’s securities evaluations, including the Howey Test, the famous U.S. Supreme Court assessment.
Laws are for bear markets.
Credit chronicles
A debtor’s delight. The rally in stocks, ongoing economic expansion (now in a record 128th consecutive month) and dive in benchmark interest rates since December has served as a potent combination in spurring risk appetite in the deep end of the credit pool.
A strong rally in junk bonds has pushed double-B-rated debt (the highest rung below investment grade) to a 3.77% average yield this morning, just 30 basis points away from the all-time low. Similar dynamics are visible in leveraged loans, the publicly-traded bank debt issued by speculative-grade borrowers. Single-B-rated loans saw spreads fall to 333 basis points over Libor at the end of January, the lowest monthly average in six years and down from 400 basis points a year ago.
With borrowing costs grinding lower, issuers rush in. According to data from Dealogic, global junk bond issuance registered at $73.6 billion in January, the highest monthly total in 25 years. Loans also saw a surge in activity, as Refinitiv reports that the domestic institutional term loan pipeline stood at $87.6 billion as of January 31, roughly triple the year-ago figure.
The recent deal spurt includes some notable transactions. Bloomberg reported on Tuesday that private equity-backed machinery supplier Husky Injection Molding Systems Ltd. is offering $450 million in payment-in-kind toggle notes, or securities which give the issuer the option of paying with additional debt instead of cash. Proceeds of the offering will be earmarked for a dividend recapitalization to the company’s p.e. sponsor, Platinum Equity, L.L.C.
Today, Apollo Credit Management priced a $2.15 billion collateralized loan obligation (a structured and securitized collection of leveraged loans) comprising four existing CLOs packaged into one new deal. It’s one of the largest CLO issues since the financial crisis and compares to an average CLO size of $450 to $500 million last year through October, according to a research report from J.P. Morgan.
While issuers rush to get deals out the door and unusual (and notorious) deal structures appear, loan investors are getting choosier. On Tuesday, Bloomberg reported that five separate issuers have been forced to pull refinancing or repricing deals over the preceding week. “The tougher deals are just not getting done,” Bill Housey, senior portfolio manager at First Trust Advisors, told Bloomberg. “And that is a sign of a healthy market.”
Could that deal fatigue be signaling something else? Evidence of fundamental deterioration is increasingly apparent across leveraged loans, a market which has jumped to $1.2 trillion as of December, up from less than $500 billion at the end of 2010 (high-yield supply has grown by only $360 billion, to $1.29 trillion over that period). A report yesterday from S&P’s LCD unit found that the universe of so-called weakest links, or domestic leveraged loans with a corporate credit rating of single-B-minus or worse along with a negative outlook, rose to a record high 145 issuers at year-end, representing 10.9% of total leveraged loan supply. That’s up from 95 loans equating to 6.8% of the total as of the end of 2018. Faltering credit quality is broad-based, with 9 of the 10 sectors seeing an uptick in weakest links during 2019. The services and leasing segment represented the lone outlier.
Then, too, a report this week from Fitch Ratings documents decay in the measured health of the CLO market, which not only accounts for more than half of leveraged loans, at $673 billion, but saw 15% growth in assets during 2019 according to Refinitiv. Performance of those securities started to flag late in the year, with the average CLO logging a net loss of 29 basis points on average in the fourth quarter.
Meanwhile, defaulted loan volume within CLOs jumped to 0.4% in the fourth quarter, doubling on a sequential basis and rising more than three-fold year-over-year. As defaults rise, recovery values diminish, with 16.7% of portfolios sporting a 91% to 100% recovery level, down from 22.6% a year ago. By contrast, portfolios in the 71% to 90% recovery bucket rose to 68.1% from 63.9%, and the 51% to 70% level grew to 11% from 8.5% in the fourth quarter of 2018.
Heavy issuance in tandem with deteriorating fundamentals and diminishing recovery values: Not exactly a winning combo. For an in-depth look at the state of corporate credit and the implications of an adverse change in economic conditions, see the brand new edition of Grant’s.
Not-QE progress report
Reserve Bank credit (i.e. the sum of the Fed’s interest-bearing assets) rose $4.7 billion this week to $4.12 trillion, while securities held outright registered at $3.818 trillion, up $18.7 billion from a week ago thanks to an increase in Treasury holdings.
Compared to three months ago, reserve bank credit has grown at an annualized pace of 18.2%, down from a 21.2% three-month annualized growth rate as of last week. Total balance sheet assets remain about 7% below their 2017 peak.
Recap Feb. 6
A fourth straight rally extended gains on the S&P 500 to 3.7% for the week, erasing last week’s 3% wipeout with room to spare and pushing the broad index to a fresh closing high. Key commodities were also well bid, with WTI crude bouncing above $51 a barrel and gold rebounding to $1,567 an ounce. Treasurys were little changed apart from some minor curve flattening, leaving the 2- and 10-year yields at 1.45% and 1.64%, respectively, and the VIX closed below 15 for the first time since Jan. 24.
- Philip Grant
Tuesday, February 4, 2020
All in the family
The hits keep coming at the Vision Fund,
The hits keep coming at the Vision Fund,
Go big or go home
At the corner of Wall Street and Main:
At the corner of Wall Street and Main:
Recap Feb. 4
All in the family
The hits keep coming at the Vision Fund, SoftBank Group, Corp.’s in-house V.C. arm. From the Financial Times this afternoon:
The US head of SoftBank’s $100bn Vision Fund is leaving after expressing concerns about “issues” at the technology conglomerate. . . Michael Ronen, a former Goldman Sachs banker who joined SoftBank in 2017, told the Financial Times he had been “negotiating the terms of my anticipated departure” for several weeks.
SoftBank is also in discussions about Ron Fisher’s future at the company, according to three people briefed on the talks. Mr. Fisher is one of founder Masayoshi Son’s longest-serving lieutenants and was a leading advocate of SoftBank’s outsized bet on WeWork, people with direct knowledge of the matter told the Financial Times.
A SoftBank spokesperson said Mr. Fisher was “a valued member of the SoftBank family” and was “not going anywhere.”
Query: Does Fisher know that?
Go big or go home
At the corner of Wall Street and Main Street: The Financial Times reported yesterday that Goldman Sachs Group, Inc. is nearing a deal with Amazon.com, Inc. to offer loans to small- and medium-sized businesses over the e-commerce giant’s platform. Goldman, which “has begun building technology to facilitate” the project, could launch by the end of March according to the FT. That follows a declaration from CEO David Solomon at Goldman’s first-ever investor day last week that the brokerage will be expanding newer business lines such as transactional and consumer banking in order to boost returns.
The stated push to diversify from capital markets-reliant businesses is an understandable one. In 2019, Goldman’s investment banking and global markets divisions, which include fixed income, commodities and currency (FICC) and equities trading, accounted for a combined $22.4 billion, or 61% of consolidated revenues. Rival Morgan Stanley is a bit more diversified, generating $20.4 billion in top-line from its sales and trading and investment banking units, or 49% of its consolidated total for 2019. Last year, Goldman saw its return on equity sink to 10% from 13.3% in 2018.
Settlement expenses for the Malaysia Development Berhad (1MDB) scandal accounted for roughly half of the RoE decline, with Goldman accruing a $2 billion fine in December after admitting that senior executives had bribed counterparts at the state-owned development bank for business. Today, the Federal Reserve announced it has permanently barred Andrea Vella, described by Bloomberg as the bank’s “top dealmaker in Hong Kong,” over the episode.
Beyond the financial and reputational damage inflicted by the 1MDB fallout, the episode highlights the less predictable nature of Goldman’s earnings and heightened enterprise risks compared to the traditional money center banks with which it is attempting to compete.
In a Nov. 5 assessment of the bank for The Institutional Risk Analyst, publisher Christopher Whalen noted that Goldman maintains more deposits at competitors than it does internally for customers. The bank, the fifth largest in the U.S. by assets, is just the 14th largest in terms of deposits. At the same time, Goldman carried derivatives exposure equivalent to 5,400% of assets at the end of the third quarter, compared to 1,900% and 2,600% for J.P. Morgan Chase & Co. and Citigroup, Inc., respectively.
Whalen concludes:
Given the negative factors of liquidity and visibility, we believe that it will become increasingly difficult for GS to grow and deliver consistent profits given the competition from JPM and other larger global universal banks. . . We believe that an appropriate acquisition of a regional bank with substantial core deposits would greatly enhance the stability and risk-adjusted return on capital of GS. Such a change, however, implies less emphasis on trading equities and FICC, the traditional core revenue lines of the firm.
Reached by Grant’s today, Whalen reiterated his view that Goldman needs to pursue a transformative acquisition to allow it to compete with the big fish:
Growing deposits or AUM for asset management organically is incredibly difficult in this market. Those are the two most competitive sectors in finance. I have mounting concerns about the viability of the GS model if investment banking and trading remain the real legs of two legged stool. Huge risks, weak returns. Remember, GS is just a broker dealer. The bank is an irrelevance unless they grow assets several hundred percent.
Recap Feb. 4
Stocks enjoyed another strong rally, extending yesterday’s rebound to push the S&P 500 back within 1% of the all-time highs reached on Jan. 17. Treasurys also displayed some risk appetite, as bear-steepening price action pushed the 2- and 10-year yields to 1.41% and 1.6%, respectively, while gold fell more than 1% to $1,554 an ounce and the VIX dropped 10% to just over 16.
The only fly in the bullish ointment was oil, as WTI crude extended its freefall with another 1% decline to $49.6 a barrel, a fresh 52-week low.
- Philip Grant
Monday, February 3, 2020
Today in high finance
From the Financial Times:
From the Financial Times:
Bizzle brothers
A downshift in the Valley?
A downshift in the Valley?
Recap Feb. 3
Today in high finance
From the Financial Times:
Citigroup has suspended one of its most senior bond traders in London after the US investment bank accused him of stealing food from the office canteen.
H.R. head inspector Javert was unavailable for comment.
Bizzle brothers
A downshift in the Valley? As part of a strategic overhaul, video streaming giant Netflix, Inc. (NFLX on the Nasdaq) will eliminate 15 or more positions in its marketing department, according to a Jan. 28 dispatch from the Hollywood Reporter. Newly installed chief marketing officer Jackie Lee-Joe, who reportedly initiated the downsizing, is “said to have felt that Netflix over-hired.” More broadly, the company “has been looking to rein in how much cash it is burning.”
While a belt-tightening strategy from one of the foremost corporate success stories of this cycle (NFLX has seen revenues triple since 2015 and share price rally of 467% in the past five years) seems incongruous, Netflix has plenty of company among Silicon Valley and V.C.-backed enterprises dialing back from growth mode. Last week, ride share unicorn Lyft, Inc. (LYFT on the Nasdaq) cut 90 sales jobs as part of a corporate restructuring, while real estate firm Compass, Inc. laid off roughly 40 people across its IT, marketing and M&A divisions, becoming the latest SoftBank Group Corp.-backed startup to shed headcount in hopes of stemming red ink (see the Jan. 7 Almost Daily Grant’s for more examples). Of course, the fall 2019 implosion of WeWork parent The We Co., which rode SoftBank cash to a $47 billion paper valuation and status as New York’s largest commercial landlord, stands as a foremost example of a formerly spendthrift culture in dramatic reversal.
More broadly, data from employment firm Challenger, Gray and Christmas found that tech companies cut 64,166 jobs in 2019, more than quadruple the 14,166 job losses in the year prior. Tech “is maybe the most volatile sector” in corporate America, Russell Hancock, president at analysis firm Joint Venture Silicon Valley, told San Francisco’s KPIZ5 television last year. “Remember, product life cycles come and go.”
As tech companies retrench, one industry mainstay looks to be feeling the effects. Last week, Facebook, Inc. (FB on the Nasdaq) reported that revenues for the fourth quarter rose 25% from a year ago, its slowest ever pace of top-line expansion as a public company and well below the 34% year-over-year jump in expenses during the period. In his 2018 investor letter, former Facebook vice president and current founder and CEO of Social Capital Chamath Palihapitiya identified the crucial role that startups play in the Silicon Valley ecosystem:
Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon. We don’t necessarily know which channels they will choose or the particularities of how they will spend money on user acquisition, but we do know more or less what’s going to happen. Advertising spend in tech has become an arms race: Fresh tactics go stale in months, and customer-acquisition costs keep rising.
What might a wider shift from the “growth now, profits later (maybe)” ethos yield for the economy as a whole? An inspection of this key topic in the May 17, 2019 edition of Grant’s introduced the “bizzle,” a term conjured by paid-up subscriber Paul Isaac to describe the happy knock-on effects of increased spending by V.C. and private equity firms during boom times.
That phenomenon cuts both ways. A Sept. 30 Washington Post report detailed flagging employee morale at Uber Technologies, Inc. after the company undertook its own cost-cutting program, which included more than 1,000 layoffs and a pullback in office perks:
Starbucks showed up in coffee dispensers, and craft coffee from Stumptown, a roaster based in Portland, Ore., went away. Office supplies like giant sticky notes dried up, and the company no longer hands out ‘Uberversary’ balloons.
That May 17 Grant’s analysis concluded: “Capital is cheap and the bizzle goes on – each subject to Mr. Market’s own kind of disruption, of course.” Might that disruptive day be nearing?
Recap Feb. 3
Stocks caught a solid bounce, with the S&P 500 recouping 70 basis points after last week’s 3% plunge, while Treasurys gave back some gains with the 2- and 10-year yields rising to 1.35% and 1.52%, respectively, as the spread between them has been cut in half since Dec. 31.
While stocks and rates partially retraced last week’s action, it was more of the same for oil as WTI crude was hammered again to fall below $50 a barrel for the first time in more than a year. The VIX fell 4% to 18.1.
- Philip Grant
Friday, January 31, 2020
Real talk
As comfortable with trillions as most of us are with tens and hundredds
As comfortable with trillions as most of us are with tens and hundredds
Dial tone
On Wednesday, telecom behemoth AT&T, Inc.
On Wednesday, telecom behemoth AT&T, Inc.
Recap Jan. 31
Real talk
As comfortable with trillions as most of us are with tens and hundreds, the Fed is good at math, all right. Now it’s making progress in English, too.
As tabulated by Jim Bianco of Bianco Research LLC, the “Federal Reserve Obfuscation Index” measures clarity of communication by both gross word count and the Flesch-Kincaid Index, which attempts to measure the schooling level needed to comprehend a given statement. Under current chair Jerome Powell, the frequency of $10 words has declined sharply from the Ben Bernanke and Janet Yellen epochs.
Dial tone
On Wednesday, telecom behemoth AT&T, Inc. (T on the NYSE) reported fourth quarter results featuring $14.37 billion in adjusted Ebitda and $46.82 billion in revenue, light of the Street expectation of $14.68 billion and $46.99 billion and down 4.4% and 2.4%, respectively, from a year ago. In response, T shares have dipped by 3% over the past three days but sit 28% higher over the past year.
Among the most attractive features for stockholders: A plum quarterly dividend of $0.52 cents per share, equating to a 5.5% dividend yield. AT&T has raised its payout each year going back to the 1980s. While certainly impressive, that achievement is increasingly in conflict with a bloated balance sheet. The company’s marketable debt load stands at $151 billion after excluding cash, along with pension liabilities and operating leases of $18.8 billion and $21.8 billion, respectively as of Sept. 30. In toto, AT&T owns the dubious distinction of the world’s most indebted non-financial company. A pair of major acquisitions – DirecTV, Inc. for $67 billion followed by the 2018 takeover of Time Warner, Inc. (now WarnerMedia) for $109 billion – helped balloon Ma Bell’s borrowings. Then, too, projected dividend payouts of $14 billion and share repurchases of $10 billion in 2020 would eat up the bulk of the $28 billion in free cash flow that management is projecting for this year.
While the current net (marketable) debt ratio of 2.55 times is well below the 3.1 turns of leverage at year-end 2018, progress towards AT&T’s stated goal of 2 to 2.25 times leverage by year-end 2022 (revised up from a target of 1.8 times in July 2018 following the Time Warner acquisition) may be slower than previously expected. Speaking on the earnings call Wednesday, CFO John Stephens left rhetorical room for leverage to tick higher in the near term, stating that: “depending on the timing of share retirements and asset monetizations, you will see our net debt to adjusted Ebitda ratios fluctuate throughout the year.”
With revenues and Ebitda in decline, the potential for shareholder-friendly maneuvers taking precedence over deleveraging should concern the company’s creditors, according to a Wednesday report from Craig Moffett, co-founder and one-half the eponym of MoffettNathanson, LLC:
Prioritizing share repurchases over debt retirement may make sense if one views the dividend as sacrosanct (in that case, buying back stock is a matter of simple interest rate arbitrage), but, if one views leverage as, well, leverage, then deferring debt reduction is a potentially dangerous game.
Noting that AT&T’s DirecTV and WarnerMedia businesses are in decay, with video subscriber growth collapsing by 15% year-over-year in the fourth quarter and WarnerMedia revenue sinking 3.3% from a year ago, Moffett concludes that the clock “is counting down to the obsolescence of at least two of AT&T’s most important businesses.”
No such concern is evident among triple-B-rated AT&T’s numerous creditors, with the senior unsecured 4.5s of 2048 currently bid to 113 cents on the dollar, for a yield to worst of 3.7% and 170 basis point pickup over Treasurys. For more on the bear case on AT&T, see the Dec. 13, 2019 edition of Grant’s.
Recap Jan. 31
A severe selloff left the S&P 500 lower by 3% for the week, erasing gains for January as the broad index wraps up the first month of the year slightly lower.
Fearful price action reigned across the board, as Treaury yields darted lower in bull-steepening formation to leave the 2-year yield at 1.32% (its lowest since fall 2017) and the 10-year at 1.51%. WTI and copper tumbled again, finishing at $51.5 a barrel and $5,588 a ton, and gold rallied to $1,587 an ounce. The VIX spiked 22% to 19, its highest finish since the first week in October.
- Philip Grant
Thursday, January 30, 2020
Circle of trust
The Wall Street Journal reports today on a "bruising" price war
The Wall Street Journal reports today on a "bruising" price war
Logan's Run
Time for a higher purpose?
Time for a higher purpose?
Not-QE progress report
Recap Jan. 30
Circle of trust
The Wall Street Journal reports today on a “bruising” price war underway across Latin America as competitors Uber Technologies, Inc., Didi Chuxing Technology Co. and Rappi Inc. vie for market share in food delivery. An unusual feature of the contest: All three are backed by SoftBank Group Corp. and the company’s $100 billion in-house V.C. arm, the Vision Fund (the fund has invested $20 billion into the trio).
Noting that V.C. operators rarely back companies that directly compete with one another, the Journal concludes that the strategy has “created a sort of circular firing squad in which SoftBank-backed companies use SoftBank cash to attack one another.” Further complication the squabble, Uber took an 18.8% stake in Didi in 2016 (since reduced to 15.4% following additional fundraising), carrying the position at $7.95 billion as of Sept. 30.
Meanwhile, SoftBank boss Masayoshi Son’s attempt to put together Vision Fund 2 has been complicated by the $8.9 billion loss taken by the company in the six-months ended Sept. 30 as a result of write-downs in the Vision Fund portfolio. On Jan. 16, technology magazine Wired U.K. reported that the Public Investment Fund of Saudi Arabia, which kicked in nearly half of the original fund’s assets, has “suspended plans to invest in the new venture for now.”
For a detailed look at SoftBank and the potential implications of a wider reversal in fortunes for Masa Son’s V.C. behemoth, see the Nov. 1, 2019 edition of Grant’s.
Logan's Run
Time for a higher purpose? With investment luminaries such as BlackRock, Inc. CEO Larry Fink increasingly advocating for environmental, social and governance (ESG)-based guidelines, the straightforward profit motive which has long governed the land is on the defensive. “We believe a company’s ESG score will soon effectively be as important as its credit rating,” Cyrus Taraporevala, chief executive officer of State Street Global Advisors, told Bloomberg yesterday.
Market participants appear to be coming around to that view: Global issuance of so-called green bonds registered at $353 billion in 2019 according to Bloomberg, up 42% from a year ago, while electronic fixed-income platform MarketAxess Holdings, Inc. reports that secondary trading volume in those “green” securities more than doubled to $19 billion across 2019.
The ESG movement has ascended to the ecclesiastical realm, as Bloomberg reports today that the Church of England’s Pension Board has invested £600 million ($779 million) in a new environmentally friendly index designed to reduce holdings of “high-impact emissions sectors.” That figure is no afterthought, representing nearly 25% of the pension fund’s £2.8 billion total assets under management.
Of course, pioneers in the ESG indexation world face the challenge of component selection, a process which necessarily relies on subjective judgements. Jeroen Bos, head of specialized equity and responsible investing at NN Investment Partners, told Investment Europe today that “ESG ratings are opinions, not facts, so it is crucial to understand the viewpoint behind them.”
Indeed, the Dow Jones Sustainability North American Index, which “tracks the stock performance of the world's leading companies in terms of economic, environmental and social criteria” features member companies which might not be top of mind when it comes to ESG bona fides. Included in the basket are not only energy concerns such as Chevron Corp., ConocoPhillips and Suncor Energy, Inc., but also defense companies Lockheed Martin Corp., manufacturer of the Hellfire missile, and Northrop Grumman Corp., which makes Bushmaster chain guns and automatic cannons (thank you, Simon Lack).
Then again, a November report from the Intergovernmental Panel on Climate Change identified rapid global population growth as a primary culprit for climate change, concluding that the world headcount “must be stabilized – and, ideally, gradually reduced – within a framework that ensures social integrity.”
Maybe Lockheed and Northrop are ESG worthy after all.
Not-QE progress report
Reserve bank credit, i.e. the sum of interest-bearing assets held by the Federal Reserve, registered $4.115 trillion, up $906 million from a week ago. Securities held outright rose $16.7 billion to $3.798 trillion, as Treasury holdings rose by $28 billion led by a $22 billion in additional Treasury bills, while mortgage-backed securities declined by $11.3 billion.
Compared to three months ago, reserve bank credit has grown at an annualized pace of 21.2%, down from a 38.3% three-month annualized growth rate in December. Total balance sheet assets remain 8% below their 2017 peak.
Recap Jan. 30
A late rally pushed stocks into the green, as the S&P 500 gained 30 basis points to narrow its losses to less than 40 basis points for the week and the VIX dropped nearly 20% this afternoon to 15.4.
Other markets suggested less euphoric outcomes. The Treasury curve continues to flatten, briefly falling into inversion today with the 3-month bill yield exceeding that of the 10-year note. Copper extended its recent plunge with a 1% decline, while WTI crude fell below $53 a barrel for the first time since Oct. 15. Gold held steady at $1,575 an ounce.
- Philip Grant
Wednesday, January 29, 2020
He said it
Here's the newly installed Boeing Co. CEO
Here's the newly installed Boeing Co. CEO
Beyond reconciliation
A quick pivot
A quick pivot
Recap Jan. 29
He said it
Here’s the newly installed Boeing Co. CEO David Calhoun on today’s conference call:
I get a lot of media attention around the idea that I'm somehow an insider. What if I change that a little bit. What if I told you I simply had a front row seat to everything you saw?
That’s probably better than a front row seat on a 737 MAX.
Beyond reconciliation
A quick pivot. Yesterday, coffee and donut giant Tim Hortons restaurants announced it had ceased selling Beyond Meat, Inc. breakfast sandwiches across Canada, ending an offering introduced just seven months ago. The company confirmed the abrupt change first reported by Bloomberg, with these words: “Ultimately, the product was not embraced by our guests as we thought it would be.”
Tim Hortons, a Canadian institution which famously serves 8 out of 10 cups of coffee consumed nationwide outside the home according to NPD Group, Inc., is searching for ways to jumpstart sluggish performance, as comp-store sales fell by 1.4% in the third quarter. More broadly, Tim Hortons generated $825 million in adjusted Ebitda in the first nine months of 2019, down 0.6% from a year ago. By comparison, fellow Restaurant Brands International, Inc. (QSR on the NYSE) portfolio companies Popeye’s Louisiana Kitchen and Burger King saw adjusted Ebitda grow by 7.5% and 6.9%, respectively, over that period.
Those figures have triggered alarm in the corporate office, with Restaurant Brands CEO José Cil stating in October that Tim Hortons’ financial results “are not where we want them to be.” On Dec. 27, the company announced the termination of TH brand president Alex Macedo.
The evident concern from RBI and its largest shareholder, the notoriously cost-conscious Brazilian private equity firm 3G Capital, is understandable as Timmy’s punches above its weight in terms of profitability: The coffee chain kicked in 49% of total adjusted Ebitda over the first nine months of 2019 despite accounting for just under 20% of systemwide sales. Two separate cash streams help explain that discrepancy, as RBI not only earns restaurant royalties but also sells food and consumables to its Tim Hortons franchisees.
With the profit-growth dwindling despite the best efforts of the cheeseparing Brazilians, store owners and employees both sharpen their elbows. Thus, unionized workers at a Winnipeg Tim Hortons were locked out in early January after rejecting a C$0.20 cent raise to C$11.95 ($9.08) per hour, holding firm to a C$0.30 cent hourly increase demand (the workers eventually got their way and were allowed to return a week later). Franchisee discontent towards management appears to be heating up once again as well.
Yesterday, The Globe and Mail reported that a consortium of disgruntled Tim Hortons operators formerly known as the Great White North Franchisee Association is gearing up for a fresh fight with the company; rebranding and “actively” recruiting new members. The highly public dispute between RBI and the newly-dubbed Alliance of Canadian Franchisees, which had seemingly been resolved with the settlement of a pair of class action lawsuits last year, featured allegations of misappropriated marketing funds by the company (Grant’s, June 2, 2017) and the seizure of former GWNFA (now ACF) president David Hughes’ four locations in late 2018.
According to The Globe and Mail, the splinter group “is actively recruiting new members in a bid to address an array of operational concerns with management.” Among them, “low sales volumes at some restaurants [and] the frequent addition of new menu items.” In June 2019, a lawsuit filed by U.S.-based operators accused RBI management of “economic squeezing of Tim Hortons franchisees” through “aggressive cost cutting” in tandem with “unreasonable” price increases for supplies.
RBI, a died-in-the-wool proponent of the “asset-lite” restaurant model (i.e., owning the brands and collecting a percentage of revenue while leaving day-to-day operation to others), is both amply leveraged at 4.9 times consensus 2020 adjusted Ebitda and generously valued at 21 times consensus 2020 adjusted earnings per share. Since a bearish analysis of the company in that June 2, 2017 edition of Grant’s, shares are up 2%, compared to a 40% increase in the S&P Restaurants Index.
Recap Jan. 29
Stocks finished unchanged after the Federal Reserve left rates on hold this afternoon, giving back mid-afternoon gains of about 50 basis points on the S&P 500.
Elsewhere, risk aversion once again reigned with Treasurys catching another frenzied bid to push the 30-year long-bond yield to 2.04% while the three-month bill is within two basis points of inverting once more with the 10-year note. Commodities were mostly hammered, with copper extending its recent losses to sit 11% lower than its Jan. 14 close while WTI crude fell to $53 a barrel, its lowest since mid-October. Gold rose to $1,577 an ounce, and the VIX held near 16.5.
- Philip Grant
Tuesday, January 28, 2020
Take two
They're back.
They're back.
Debtors delight
The parade of landmark bond issues
The parade of landmark bond issues
Recap Jan. 28
Take two
They’re back. The International Financing Review reports today that J.P. Morgan Chase & Co., Nomura Holdings, Inc. and BNP Paribas, Inc. “are among the banks racing to sell the first managed synthetic collateralized debt obligation since the financial crisis.” The lenders are hoping to revive the notorious structured securities by the end of the first quarter. Collateralized debt obligations (CDOs), are, of course pooled and securitized credit vehicles made (in)famous by their starring role in the crucible of 2007 to 2009.
Grant’s was among the first to catch the scent of the brewing mortgage crisis. Treat yourself to our analysis in the Sept. 8, 2006 edition by clicking here.
Debtors delight
The parade of landmark bond issues continued today, as the Republic of Greece sold €2.5 billion ($2.75 billion) in 15-year bonds at a 1.88% yield, below the 2% target set by the government. That’s the first time Greece has issued 15-year paper since 2009, as daunting fiscal troubles and a trio of EU and IMF bailouts had precluded any such long-term financing options.
Mr. Market has decided to let bygones be bygones (the issue attracted an order book of nearly €19 billion). The sale, announced yesterday, came as Greece’s 10-year borrowing costs touched a record low 1.16% (that compares to 1.64% for the 10-year Treasury) and three days after Fitch Ratings upgraded the sovereign’s credit rating to double-B from double-B-minus on account of strong GDP growth and steady fiscal improvement. The rating agency expects Greek government debt to fall to 161% of GDP next year from a cyclical high of 181% in 2018.
Needless to say, fundamental progress in the Cradle of Democracy tells only part of the story. Under the all-encompassing embrace of the European Central Bank and its open-ended €20 billion in monthly QE, issuers across the Old Continent have enjoyed bottom-scraping borrowing costs. On Jan. 8, the triple-B-rated Republic of Portugal issued €4 billion in 2030 notes at a 0.475% coupon; that issue now trades at 101.5 cents on the euro for an effective yield of 33 basis points. Last summer, single-A-rated Spain borrowed €20.6 billion due 2029 at a 0.6% coupon, currently priced to yield 31 basis points. Even Baa3-rated Italy, beset by political instability (Luigi Di Maio, head of the ruling coalition member Five Star party, resigned last week) and a rickety banking system, issued $2.5 billion in 30-year bonds last October at a 4% coupon. That debt is currently priced to yield 3.97%.
With options for income dwindling, investors have been forced into a predictable response. Thus, The Wall Street Journal reports today that nations in sub-Saharan Africa have seen total borrowings rise to 50% of GDP from 27% a decade ago, with the bulk of that fresh debt denominated in dollars and euros. “Driving the issuance”, the Journal notes: “copious demand from international investors for higher-yielding debt.”
The borrowing bonanza has yielded mixed results, with the triple-C-plus-rated Republic of Zambia’s 8.97% dollar-pay notes due 2027 falling below 70 cents on the dollar for an effective yield of nearly 17%. Those African borrowers, Elina Ribakova, deputy chief economist at the Institute of International Finance, told the Journal, “need supportive, calm climates in financial markets because most investors don’t know these countries.”
Central bank asset purchases wouldn’t hurt either.
Recap Jan. 28
Trend reversal was the theme today, as stocks caught a nice lift with the S&P 500 jumping 1% to erase a bit less than half of its Friday and Monday losses. Treasurys finished weaker across the curve with the two- and 10-year yields rising to 1.46% and 1.65%, respectively, while gold dropped to $1,568 an ounce and WTI crude bounced to $53.5 a barrel. The VIX fell to 16.3, down a bit more than 10%.
- Philip Grant
Monday, January 27, 2020
Planet crypton
On Jan. 13, hip-hop
On Jan. 13, hip-hop
Creditor chronicles
Another day, another record.
Another day, another record.
Play it again Sam
Time to expand the "toolkit."
Time to expand the "toolkit."
Recap Jan. 27
Planet crypton
On Jan. 13, Hip-hop performer Akon announced via social media an agreement with the government of Senegal to build an eponymously-named city of the future in the West African nation. The singer and rapper, who has penned more than a dozen Billboard top 10 hits including “Smack that,” declared last year that Akon City would operate exclusively on a new cryptocurrency called AKoin (thanks to Emma Muhleman for sending this in). Akon expects the futuristic crypto city, which is to be built on 2,000 acres of land gifted by the Senegalese government, to be ready by 2025.
According to its website, Akon Crypto City “lends leading Smart City planning designs with a blank canvas for cryptonizing our daily human and business exchanges, with the goal of inventing a radical new way of existence.”
Creditor chronicles
Another day, another record. This morning, triple-C-rated Altice Europe N.V. sold €500 million ($550 million) in eight-year senior notes at a 4% coupon.
That’s the lowest ever for a euro-denominated bond in that rating category, putting the 4 7/8% notes issued by Matterhorn Telecom Holdings in 2015 in the dust. Altice, which supports its €37.4 net debt load with a consensus €5.8 billion in adjusted Ebitda and €900 million free cash flow for full-year 2020, has lost money on a net income basis in each year going back to at least 2012.
For a trio of similar signs of the times, see the Jan. 23 edition of Almost Daily Grant’s.
Play it again Sam
Time to expand the “toolkit.” The Wall Street Journal reports today that the Federal Reserve is “looking at” instituting de facto caps on Treasury yields by promising (threatening?) unlimited purchases to a given level. That step would revive a strategy employed by the Fed during and after World War II as well as by the Bank of Japan since September 2016.
According to the Journal, Fed officials concluded in October that yield curve caps “could be an effective way to augment their other tools,” which include direct asset purchases (i.e. QE) and so-called forward guidance (telegraphing the future path of interest rates). The ultimate goal is a familiar one: “Driv[ing] down longer-term interest rates to encourage new spending and investment by households and businesses.”
While the Fed plots ways to ensure that the E-Z money era extends far into the future, impacts of ultra-accommodative policy continue to ripple through the economy. A December analysis from real estate marketing firm Nancy Packes Data Services found that nearly half of the condominiums erected in New York during the last five years remain unsold, while inventory of the high-end dwellings stood at more than six years of supply according to the Halstead Development Marketing Report for January.
Cooling real estate conditions are not confined to the Big Apple. According to a global 45 city index of high-end housing markets from real estate consulting firm Knight Frank, prices rose just 1.1% year-over-year in the third quarter of 2019, down from 3.4% in the third quarter of 2018 and 4.2% in 2017. Enrique Martinez-Garcia, economist at the Federal Reserve Bank of Dallas, told The Wall Street Journal that, with global interest rates near record lows, “we might be reaching that point” where further monetary stimulus no longer provides a boost to activity.
One key benefit of E-Z money may be abating, but we can nonetheless expect more where that came from.
Recap Jan. 27
Another sharp leg lower in equities left the S&P 500 1.6% in the red, extending the two-day decline to 2.5% and all but erasing the monthly gains. Treasurys continued their frenzied rally, with the two- and 10-year yields sinking to 1.44% and 1.6%, respectively, while oil and gold extended their recent divergence with WTI crude falling below $53 a barrel while the yellow metal rose to $1,582 an ounce, up 25% since May. The VIX leapt more than 20% to 18, the most elevated close since Oct. 9.
- Philip Grant
Friday, January 24, 2020
Employees-of-the-month Club
From Bloomberg:
Marc Benioff’s latest book, about the need for a gentler capitalism, became a national bestseller. The company he co-founded, Salesforce.com, Inc., helped boost sales by encouraging employees to buy and expense the book published last October.
Cold fusion
They get an ‘A’ for timing. On Tuesday, state-owned oil concern Petróleos Mexicanos (a.k.a. Pemex) returned to the debt markets in triumph, selling a combined $5 billion in 11- and 40-year dollar-pay bonds at yields of 5.95% and 6.95%, respectively. That’s down from initial price talk on those issues of 6 3/8% and 7 3/8%, according to Bloomberg. Guido Chamorro, co-head of emerging market “hard currency” debt at Pictet Asset Management, concisely described investor demand: “insatiable.”
Proceeds from the sale will be used to retire bonds due in 2021 through 2024, allowing Pemex to extend its maturity profile while keeping its net debt levels unchanged. Pemex came to market at a favorable moment, as the company’s senior unsecured 6 3/4 notes due 2047 have rallied to 101.35 cents on the dollar from less than 85 cents in December 2018, returning to the levels at which Grant’s penned a bearish analysis of Pemex and Mexican sovereign debt in March 2018.
That successful balance sheet tweak follows an operational triumph in recent weeks, with the confirmation of a major crude oil deposit at the Quesqui field in Tabasco. At an estimated 500 million barrels, Pemex claims it as among the most significant such finds in the last 30 years.
Those victories likely put a spring in the step of Mexican President Andrés Manuel López Obrador, who has promised to return the state-owned oil giant to its former glory. Yet AMLO’s populist policies, which have included suspending oil and gas contracts with foreign companies and backtracking on a rule requiring Pemex to share oil infrastructure with the private sector, may not be providing much help toward that goal.
Private investors have voted on those maneuvers with their feet, as gross fixed investment (a leading indicator measuring factory and heavy equipment spending) fell 8.9% year-over-year in October, the 11th decline in the 12 months since AMLO took office. Mexico fell into technical recession last year, with year-over-year GDP declines of 1% and negative 0.3% in the second and third quarters of 2019.
Recession is what the state-owned oil giant is not capitalized for, with $104 billion marketable debt load and $69 billion in additional pension liabilities, towering over the $20.8 billion in adjusted Ebitda for the 12-months ended Sept. 30. At the same time, production has waned to barely half of the 2004 high water mark of 3.4 million barrels per day (mbpd), thanks to steady depletion at the offshore Cantarell field. That long-term decay is exacerbated by an abrupt output downturn at the Ku-Maloob-Zaap field, currently Mexico’s most bountiful (Almost Daily Grant’s, June 7).
Reversing that production slide will be an uphill battle. December production stood at 1.77mbpd according to CEO Octavio Romero, down from a September estimate for 1.8mbpd by year end. Taking an optimistic view, the AMLO government pencils in 1.85mbpd in the 2020 budget. As for the recent oil find, bulls shouldn’t get their hopes too high. Fausto Alvarez, a former senior official at the National Hydrocarbons Commission, told the Financial Times on Jan. 8 that, rather than increase production, the new discovery, “will, at best, attenuate the decline.”
The rating agencies are concerned, as Fitch downgraded Pemex to junk last June while Moody’s and S&P each assess the company at the lowest level of investment grade with a negative outlook. Aaron Gifford, an analyst at T. Rowe Price, told Reuters on Jan. 3 that: “the base case is Moody’s downgrades [Mexico’s sovereign rating] by one notch in the second quarter because of the need to continue to bail out Pemex as well as an erosion of savings used to meet fiscal targets.” Such a move would mean an automatic cut to Pemex as well, which received about $9.5 billion in subsidies from the Mexican government last year (the AMLO administration has budgeted $4.4 billion in such giveaways for 2020).
Indeed, the symbiotic relationship between Pemex and the Mexican government presents risks to the credit profile of each were AMLO forced to take stronger steps to firm up the oil giant’s faltering finances. As the March 23, 2018 edition of Grant’s noted, “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.” Then, too, Pemex debt accounts for 2.7% of assets in the iShares J.P. Morgan U.S. Dollar Bond Emerging Markets ETF, the fund’s 10th-highest weighting.
Recap Jan. 24
After days of pressure on industrial commodities and falling Treasury yields, risk aversion finally caught up with stocks as the S&P 500 dropped 90 basis points for its worst showing since October.
Further weakness in the commodity complex pushed WTI crude and LME copper below $55 a barrel and $6,000 a ton, respectively, while gold jumped to $1,571 an ounce to test its best levels since 2012. Treasurys rallied again, with the 10-year yield falling to 1.69% from 1.82% a week ago, and the VIX jumped to near 15 to wrap up the week higher by 21%.
- Philip Grant
Thursday, January 23, 2020
Credit chronicles
Let the good times roll. The renewed risk appetite coinciding with “not-QE” has not only unleashed a frenzied rally in stocks, but also worked to coax fixed income markets into uncharted territory. Yesterday, the average yield on double-B-rated corporate debt (the top rung of junk) fell to a record low 3.47%.
As borrowing costs dart lower, issuers have fully availed themselves of their tactical advantage, as evident in a trio of recent offerings.
Yesterday, aerospace defense contractor TransDigm Group, Inc. (TDG on the NYSE) announced it will launch a $7.5 billion term loan repricing to replace existing debt facilities, the largest such repricing since at least 2013, according to Bloomberg. In retiring existing term loans due 2023, 2024 and 2025 at a 250 basis point spread over Libor, unrated TransDigm is offering three maturities across 2024 and 2025, with price talk ranging from 200 to 225 basis points over Libor.
TransDigm, which sports a 45% Ebitda margin over the past 12 months (nearly triple its peer group) is the subject of a Department of Defense Inspector General investigation into alleged price gouging and was forced to return $16.1 million in “excess profits” to Uncle Sam following a preliminary IG report last year (Almost Daily Grant’s, June 11). The company currently sports net leverage of 5.5 times consensus Ebitda for the 12-months ending Sept. 30.
New frontiers are being charted in price as well as size. Last week, IT consulting firm Presidio, Inc. sold $400 million of single-B-rated 4 7/8% secured notes due 2027 to finance its leveraged buyout by private equity firm BC Partners. That yield compares to initial price talk of 6.5% according to Bloomberg, while S&P’s LCD unit notes that the secured notes “cleared at a yield below every full-year average for the same LBO paper since LCD began tracking high-yield in 2005.” For comparison, single-B-rated LBO paper averaged an 8.81% yield last year.
Those euphoric conditions are not confined to this side of the Atlantic. According to data from Bloomberg, junk issuance in Europe is approaching €10 billion ($11 billion) for January, the briskest pace since at least 2013. That supply spurt comes as the Bloomberg Barclays Pan-European High-Yield Index sports a yield of 3.32%, down from 5.5% early last year and near the record low set in the fall of 2017.
Against that backdrop, Austria’s single-A-rated Erste Group Bank A.G. sold €500 million in contingent convertible (CoCo) triple-B-minus-rated perpetual bonds at a yield of just 3 3/8% last week. That offering, which was more than 10 times oversubscribed according to Bloomberg, compares to a 5 1/8% coupon on an Erste Group CoCo in March 2019 and marks the second-lowest coupon on record for the CoCo category, Bloomberg reports. An analysis of the securities in the Feb. 12, 2016 edition of Grant’s described CoCo’s as “a kind of financial tripwire,” explaining:
They are designed to self-mutilate in re¬sponse to financial difficulties at the institution that issued them. Thus, a weakening in certain balance-sheet ratios or a decline in the common-share price might trigger the cancellation of a CoCo coupon payment or a write down of CoCo principal.
A follow-up analysis in the Jan. 11, 2019 edition concluded that the European CoCo market “constitutes one of the world’s top laboratories of the risks attending the suppression of interest rates and the resulting clamor for yield.”
Those clamors are getting louder.
Not-QE progress report
Securities held outright on the Fed’s balance sheet rose to $3.782 trillion this week, up $12.7 billion from last week’s reading as an $18.3 billion jump in Treasurys holdings was partially offset by a $5.6 billion decline in mortgage-backed securities. Of that UST component, bills maturing in 91 days to one year rose by $19.6 billion, while those maturing in one to five years fell by $5.1 billion.
Recap Jan. 23
Stocks erased early losses, with the S&P edging back into the green to finish a few points below last Friday’s high-water mark, while Treasurys were bid in bull-flattening formation with the two- and 10-year yields dropping to 1.52% and 1.73%, respectively, the narrowest differential since mid-December. Gold rallied to $1,563 an ounce, while energy prices were hit hard, with WTI crude falling below $56 a barrel for the first time since early December. The VIX jumped above 14 at mid-day before giving most of those gains back and settling just below 13.
- Philip Grant
Tuesday, January 21, 2020
Bubble screen
Football fans traveling to Miami
Football fans traveling to Miami
Lean out
Time to find the off ramp.
Time to find the off ramp.
Recap Jan. 21
Bubble screen
Football fans traveling to Miami for the Feb. 2 Super Bowl will need to cough up the dough. Bloomberg notes today that one-bedroom condos in South Beach are offered for $5,500 a night, with a four-bedroom penthouse fetching $40,000 (that’s with a four-night minimum stay), while the W Hotel in South Beach is offering rooms for $3,800, triple its regular rate. As for game tickets, resale site SeatGeek records its average transaction price at $7,100 today, compared to roughly $5,000 at this time a year ago.
Can’t afford those fancy prices? No sweat. Bloomberg reports that the StubHub ticket exchange “is partnering with financial technology company Affirm, Inc. to let customers buy tickets on a payment plan.” Loan terms will span from three to 12 months, with interest rates ranging from 10% to 30% (no negative rates here).
While taking on debt instead of just watching the game at home might strike some as a questionable decision, there are other perks for the Miami-bound. According to a spokesman at Goldman Sachs Group, Inc., CEO David Solomon a.k.a. D.J. D-Sol, will be a featured performer at Super Bowl party hosted by Sports Illustrated.
Lean out
Time to find the off ramp. Uber Technologies, Inc. announced today that it will sell the Indian operations of its Uber Eats business to local player Zomato Media Private Ltd. in return for a 9.99% stake in the company. Chief financial officer Nelson Chai explained the rationale in an SEC filing: “Our commitment is to lean in if we think we can win or be one or two [in a given region]. If we think we can’t, we’re going to be good stewards of capital, and so we will make the appropriate choices.” Mr. Market cheered the move, with Uber shares up 7% to their highest levels since August.
That disposal comes as Uber continues to try to staunch the river of red ink flowing across its income statement. On the November earnings call, CEO Dara Khosrowshahi indicated that the company is targeting profitability (on an Ebitda basis) by 2021, compared to an $8.4 billion Ebitda shortfall in the 12-months ended Sept. 30. The Street, which expects Ebitda losses to narrow to $1.9 billion in 2020 and to $283 million next year, is bulled up with 28 surveyed analysts rating Uber stock “buy,” 12 saying “hold” and zero “sells.”
While the ride-share giant exits less attractive markets in a bid to shore up its bottom line, emerging regulatory threats require pressing attention. Thus, in September the state of California passed Assembly Bill 5, which requires Uber and other “gig economy” companies to classify their workers as employees instead of independent contractors (thus shifting the burden of paying healthcare and other benefits to Uber and away from the non-employees). The law went into effect on Jan. 1.
By way of response, the company “is testing a new feature that gives some drivers in California the ability to set their fares” according to The Wall Street Journal today, “part of Uber’s effort to strengthen its case that its drivers operate with some degree of independence.” As for the commercial implications, the Journal notes that “higher fares and more [price] volatility” are likely in store for riders.
Might that regulatory end run underscore fundamental flaws in Uber’s business model? At the fall 2019 Grant’s conference in October, transportation industry expert Hubert Horan argued that the company’s efforts to dominate the ride-share industry are fundamentally incompatible with the realities of the taxi business, one of the world’s most fragmented industries. Horan continued:
Uber has no hope of sustainable profits in competitive markets. A company with $20 billion in losses in years six through ten is not rapidly growing into profitability like Facebook or Amazon. Uber’s economics are totally uncompetitive. They are actually a higher cost, less efficient producer than your traditional yellow-cab company.
All of Uber’s popularity and growth has been the result of massive, predatory subsidies that were used to drive out the more efficient operators. The market shows no willingness to pay the true cost of Uber’s services.
Reversing these losses would be one of the biggest turnarounds in corporate history, and Uber doesn’t have a profitable core to restructure around.
Count Grant’s as similarly skeptical.
Recap Jan. 21
A modest downdraft in stocks erased most of Friday’s gains, and narrowed the S&P 500’s January advance to just under 3%. Treasurys caught a strong bid, with the two- and 10-year yields falling to 1.53% and 1.77%, respectively, while gold and oil both lost a bit of ground to finish at $58.3 a barrel and $1,559 an ounce. The VIX rose to 12.8, its highest close in almost two weeks.
- Philip Grant
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.
.bmp)
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.”
.jpg)
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:
.jpg)
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?
.jpg)
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 d