09.29.2020
Material World
When diamonds aren't forever:

When diamonds aren’t forever: The contentious-and-potentially-busted $16.2 billion merger between jewelry giant Tiffany & Co. and French conglomerate LVMH (which would have been the largest on record within the luxury goods industry) continues to boil and bubble. 

The would-be acquirer announced on Sept. 9 that it was walking away from the deal on account of pressure by the French government. Tiffany filed suit with the Delaware Court of Chancery the same day to hold its partner to the existing terms.

Yesterday evening, LVMH filed a countersuit citing a pandemic-related “material adverse effect” (MAE) on Tiffany’s business operations, language which would allow LVMH to break its agreement.  As the filing noted, TIF logged a $45 million operating loss in the first six months of the year compared to a $345 million profit in the first half of 2019, while LVMH described its former target's prospects as “dismal.”  The filing continues: 

For instance, Tiffany paid the highest possible dividends while the company was burning cash and reporting losses. No other luxury company in the world did so during this crisis. There are many examples of mismanagement detailed in the filing, including slashing capital and marketing investments and taking on additional debt. 

LVMH also got personal, accusing Tiffany’s management of acting in their own financial self interest in order to jam the deal through. Noting that CEO Alessandro Bogliolo would score a $44 million payout if the deal were to be consummated, LVMH icily observed: “His golden parachute is equivalent to Tiffany’s losses in the first half of 2020.” 

“LVMH’s specious arguments are yet another blatant attempt to evade its contractual obligation to pay the agreed-upon price for Tiffany,” countered chairman Roger Farah this morning. 

Delaware Chancery Court is set to hear the case in January, but Mr. Market is hedging his bets.  TIF shares changed hands at $116 at day’s end, below LVMH’s initial $120 a share bid last fall, let alone the $135 a share price that the sides agreed upon in November 2019.

***

Others are similarly turning to MAE clauses to escape deals after having second thoughts. In June, Simon Property Group (the largest shopping mall operator in the U.S.) sued mall developer Taubman Centers in an effort to back out of a $3.6 billion merger agreement that was signed in February.  Notably, Simon accused Taubman of violating the merger agreement (despite the fact that it was the acquiree who sued to halt the deal) for renegotiating a credit facility with lenders to provide liquidity in exchange for “a secured interest in certain unencumbered assets.” That agreement, Simon contends, would “substantially reduce [Taubman’s] financial and operational flexibility.”  A trial date in Oakland County Superior Court is set for Nov. 16. 

Coronavirus-related MAE claims are about to get their first legal test across the pond as well. Last week, Payment processing firm WEX, Inc. went to trial in hopes of escaping an agreement to buy a pair of travel-payment businesses eNett and Optal, for $1.7 billion, after having announced in June it was terminating the deal as the pair suffered “a disproportionate effect” from the pandemic and lockdowns.  The target companies, subsidiaries of Siris Capital Group and Elliott Management-owned Travelport Worldwide, filed parallel claims in the U.K’s Commercial Court of the Business and Property Courts of England and Wales, setting the stage for a landmark ruling in the U.K. as to whether the events of 2020 are grounds to back out of a merger agreement.  

Might the MAE-inspired legal battles augur a more extended slump in deal activity? The pandemic has certainly taken a toll.  According to data from Mergermarket, worldwide M&A activity registered at $902 billion (inclusive of pending deals) in the first half of the year, down 53% from a year ago and the lowest total since 2010. Concerningly, the most recent full-month data aren’t looking much better: Global completed deal volumes plunged 65% in August compared to a year ago, according to Goldman Sachs, while completed deal volumes in the U.S. collapsed by 78% from August 2019. 

Recap Sept. 29

Stocks came under moderate pressure, with the S&P 500 slipping 50 basis points to give back a portion of yesterday’s advance, while key commodities diverged with gold jumping back over $1,900 an ounce and WTI crude slumping toward $39 a barrel.  Treasury yields went nowhere, as usual, and the VIX remained near 26.  

- Philip Grant

09.28.2020
Pop Up Video
Deal of the day:

Deal of the day:  Big Hit Entertainment, the record label behind Korean boy-band BTS, priced an initial public offering at KRW 135,000 ($115) per share (the top end of its range) for a total valuation of $4.1 billion, which would be South Korea’s biggest IPO in three years.  The institutional tranche of the offering was reportedly oversubscribed by a cool 1,000 times. 

As that chart-topping debut demonstrates, it’s a good time to go public.  Stateside, some $95 billion worth of IPOs have debuted so far this year, already closing in on the full-year post-2000 issuance record of $96 billion established in 2014. 

The deal frenzy has opened the door for all sorts of inventive structures, as so-called special purpose acquisition vehicles, or SPACs (a.k.a. “blank check” companies) have proliferated, raising more than $41 billion in the year to date through Thursday, more than the last 10 years combined.  Up next, “SPACs of SPACs,” as Bloomberg reports that Boston based Easterly Partners is planning a $100 million fund to invest in the blank check funds.  

Red Baron
A headline-grabbing win for Uber

A headline-grabbing win for Uber Technologies, Inc., as a London court ruled that the ride share giant is “fit and proper” to conduct operations in the city.  The decision beats back a challenge from regulator Transport for London (TfL), which declined to renew Uber’s license last fall following revelations of a spate of unauthorized drivers using fraudulent identification photos. 

It was, however, an incomplete victory, as the court granted an 18-month license, well short of the five-year maximum authorization. As a TfL spokesperson explained, the company remains on something akin to double-secret probation: “This 18-month license with a number of conditions allows us to closely monitor Uber’s adherence to the regulations and to swiftly take action if they fail to meet the required standards.”

Then, too, today’s victory removes only one legal roadblock in London, as the U.K.’s top legal body continues to deliberate over the company’s reliance on independent contractor status for its drivers, allowing Uber to avoid paying health insurance and other benefits, a battle which is also playing out in California and other jurisdictions (Almost Daily Grant’s, Sept. 15).  Britain’s Supreme Court is expected to deliver its ruling as soon as October.  

“If the Supreme Court says that Uber’s drivers are workers, and not genuinely self-employed as Uber maintains they are, drivers will be entitled to holiday pay, the national minimum wage and certain other entitlements,” Joseph Lappin, partner and head of employment at U.K. law firm Stewarts, tells the Financial Times. “I suspect that Uber will lose in the Supreme Court. [In that case], Uber’s costs would swell.”

Fever Pitch
The good times are here again for the private equity industry,

The good times are here again for the private equity industry, at least if the reappearance of so-called dividend recapitalizations is any indication.  Thus, Bloomberg reports that some $8.6 billion worth of such dividend recap deals (in which funds are used for payouts to a company’s private equity promoters) have been priced this month through Sept. 18. That’s equivalent to about 25% of total loan deal volume and already the busiest full month period for such recap deals in an even three years. 

While p.e. looks to capitalize on the stirring post-March recovery in asset prices, some question the self-reported performance benchmarks which have underpinned the industry’s marketing efforts. Ludovic Phalippou, professor of finance at Oxford’s Saïd Business School, argued in a mid-September online event with the Securities and Exchange Commission that the p.e. industry’s heavy use of subjective and easy-to-game metrics, most notably the internal rate of return (IRR), provide investors with a misleading picture of risk and return.  

Citing documents from p.e. giant Apollo Global Management touting a 39% IRR over the last 30 years, Phalippou dryly retorted: “A $1 billion investment earning 39% annually over 30 years would be worth $20 trillion. And $20 trillion is the GDP of the United States. I think we would have noticed.” 

For a closer look at p.e. through the years, along with a way to profit from a reversal in the torrid current conditions, see the July 10 issue of Grant’s

Recap Sept. 28

A bull rampage saw the S&P 500 rise more than 1.5%, as the broad index now sits higher by nearly 4% this year so far and has closed to within 6.5% of its Sept. 2 high-water mark.  The Treasury curve steepened a bit with the 30-year yield ticking to 1.42%, while gold jumped 1% to $1,888 an ounce and WTI crude rose to about $41 a barrel.  The VIX gave back early gains, holding near 26. 

- Philip Grant

09.25.2020
Call Me Irresponsible
A dubious achievement for European banks today,

A dubious achievement for European banks today, as the Stoxx 600 Banks Index fell to its lowest level since 1988.  With a 45% year-to-date decline (that compares to a 14.5% drop for the broad Stoxx 600 Index), the gauge sits 61% below its June-2014 levels when the European Central Bank rolled out its negative interest rate policy, and a cool 85% off its high-water mark reached in April 2007.

While European banks gasp for air, financial institutions Down Under celebrate a friendly governmental edict.  This morning, Australia’s Treasurer Josh Frydenberg announced an overhaul of so-called responsible lending obligations, a move which Bloomberg describes as “effectively end[ing] a decade of ever-increasing regulation for the banks.”  

Among the changes:  In order to remedy, as Frydenberg put it, “excessive risk aversion which has built up and restricted the flow of credit,” banks will no longer be obliged to conduct due diligence regarding whether a loan is suitable for a given applicant. Instead, that responsibility will now shift to the borrower from the lender. 

Mr. Market liked the sound of that. In response, the VanEck Vectors Australian Banks ETF jumped 9% and now sits 35% above its March nadir.

Sideline Judge
Where to next?

Where to next? As the potent post-March rally in stocks and bonds has shown signs of fatigue, investors have been heading for the hills of late, at least according to fund flows from benchmark products. 

Thus, domestic equity funds lost $25.8 billion in assets during the week ended Sept. 23 according to data from Bank of America and EPFR Global, the third-largest weekly outflow on record. Last Friday, the Invesco QQQ Trust Series 1 ETF, which tracks the Nasdaq 100 Index and sports $128 billion in assets, saw a $3.5 billion outflow, the largest one-day loss since October 2000.  

On the bond side, investors pulled $4.86 billion from high-yield funds over the week ended Sept. 23, the largest migration since March, while BlackRock’s iShares National Muni Bond ETF, the largest municipal bond ETF with some $18 billion in assets, saw a $150 million outflow yesterday, also the biggest since March. 

While investors pare back their bets in stocks and bonds, the so-called risk free corner of the market remains in deep freeze. The MOVE Index, which measures Treasury market volatility, slumped yesterday to its lowest reading on record going back to 1992.  Over the past six weeks the 10-year yield has shuffled between 0.64% to 0.75%, while the 30-year yield has remained in a 1.32% to 1.52% band over the same period. 

Of course, risk averse punters seeking shelter in the currently-inert Treasury market must contend with a different problem: Namely, the determined efforts from the Federal Reserve to stoke inflation, and losses on a real basis to government bondholders.  On Aug. 27, chairman Jerome Powell introduced the concept of symmetrical inflation targeting, or allowing measured prices to rise at more than 2% for sustained periods prior to any policy tightening in response. 

Those hoping to earn interest on their cash shouldn’t expect much help from Washington. As The Wall Street Journal documents today, Congress appears to be on board with the scheme, judging by Powell’s reception during testimony in front of the House and Senate this week:

Lawmakers who have in the past raised concerns about allowing higher inflation didn’t press Mr. Powell over the changes or raise any objections this week.

In fact, a pair of congressmen offered effusive praise for the plan to tolerate higher inflation: “I am not at all exaggerating when I say this new framework is the most important thing that has happened to monetary policy – indeed, in economic policy – in 40 years,” declared Rep. Denny Heck (D., Wash.) on Tuesday. The move is “great news,” added Rep. Trey Hollingsworth (R., Ind.). Addressing the chair, Hollingsworth effused: “I really appreciate you doing that and I think it’s going to be a positive for the Fed and for the American economy going forward.”

In other words: Great quarter guys. 

Recap Sept. 25

Stocks caught a strong bid with the S&P 500 rising 1.6%, though the broad index still marked its fourth straight weekly decline to leave year-to-date gains at 2%. Treasurys held still, gold slipped to $1,866 an ounce and WTI crude remained at $40 a barrel. The VIX sank nearly 8% to 26.5.  

- Philip Grant

09.24.2020
The Sold to You Chronicles
What recession?

What recession?  Yesterday marked a milestone in speculative-grade credit, as issuance reached a record $329.8 billion so far this year, edging out the prior full-year sales record of $329.6 billion established in 2012. 

Friendly price action over the past six months has helped facilitate that barrage, as the yield-to-worst on the Bloomberg Barclays High Yield Index settled at 5.83% yesterday, far below its March 23 high of 11.69% and not far from its year-end 2019 yield of 5.19%. Roughly 65% of new deals have come to market with coupons below 6% since July, according to Bloomberg. Some have fared far better, as double-B-plus-rated Ball Corp. sold a 10-year bond in August at a 2.875% coupon, a record low for a junk issue with a maturity of at least five years.   

Of course, the market recovery is particularly striking in light of the still-virus-addled economy. In a Tuesday commentary for LCD, Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, highlights the now-historic divergence between bond yields and commercial activity: 

Capacity utilization, which came in at 71.4% in August 2020, was not out of line for a recession month. The atypical thing was the high-yield index’s option-adjusted spread [OAS] on Aug. 31, 2020, 502 basis points. From Dec. 31, 1996, the inception date of OAS data on the ICE BofA U.S. High Yield Index, through the end of 2019, there were five months in which capacity utilization nearly matched August 2020’s, i.e., that were in the range of 71.4% plus or minus 1%. August’s 516 basis point OAS was far below the bottom range of OAS in those months, which was 561 basis points to 1,812 basis points.

The municipal bond market is similarly percolating, as states and municipalities have raised $315 billion so far this year, putting issuance on pace for roughly $411 billion per the estimates of Bloomberg’s Joe Mysak.  That would rival the $424 billion benchmark established in 2016.

That deal flow is unusual, in that local governments have traditionally pulled back from the bond market in times of fiscal belt-tightening. And, as Mysak notes, the borrowing binge contains some eye-catching deals when demand returned to the market following that March wipeout:

Issuers began doing things they almost never consider, including borrowing to cover operations and engaging in refundings known as “scoop-and-toss” in order to put off final maturity for a few years.

Then there’s the stock market.  U.S. listed companies have raised $91 billion this year through Tuesday via the IPO market, according to data from Dealogic, topping the prior high-water mark of $84 billion set in 2000. It’s not just formerly-private enterprises looking to cash out.

Bloomberg notes today that, according to an insider activity metric developed by Sundial Capital Partners, management and directors at public companies have sold the most stock relative to purchases over the past four weeks than in any such period since 2012. Last week, corporate insiders unloaded some $975 million worth of shares according to data from the Securities and Exchange Commission, more than double the prior week’s total.  In contrast, open market purchases footed to $11 million. 

Kevin Caron, portfolio manager at Washington Crossing Advisors, told Bloomberg: “There is this sense of hesitation and pause among business owners awaiting a number of uncertainties that are out there in the face of relatively full valuations.” “They’re voting with their feet,” added Dan Genter, chief executive officer at RNC Genter Capital Management. 

Mr. Market, please copy. 

QE Progress Report
We did it!  Thanks to a $40.6 billion sequential increase, Reserve Bank credit (meaning the sum total of interest bearing assets on the Fed balance sheet) rose to $7.03 trillion, its first reading above the $7 trillion line in an even three months.  Thanks to that uptick, the three-month annualized growth rate rose to minus 4.9% from minus 6.4% a week ago, while footings are up 86% year-over-year, down from 87% last week. 
Recap Sept. 24

Stocks ended modestly higher in see-saw trading, as the S&P 500 toggled between gains of 1.3% and losses of nearly 1% intraday. Treasurys maintained their inertia, with the 30-year yield edging lower to 1.4%, while  Gold caught a modest bounce to finish at $1,868 an ounce and WTI crude held near $40 a barrel. The VIX finished little changed at 28.5 after jumping above 30 this morning. 

- Philip Grant

09.23.2020
Herding Cats
"Price stability" is so last year.

“Price stability” is so last year.  Instead, so-called average inflation targeting is now the monetary law of the land. Fed chair Jerome Powell described the new policy epoch in his Aug. 27 “Jackson Hole” conference virtual speech: 

Our new statement indicates that we will seek to achieve inflation that averages two percent over time. Therefore, following periods when inflation has been running below two percent, appropriate monetary policy will likely aim to achieve inflation moderately above two percent for some time. . . We will steadfastly seek to achieve a two percent inflation rate over time.

Chicago Fed president Charles Evans appeared to try and shift the goal posts yesterday, stating: “We could start raising rates before we start averaging two percent [inflation]. It’s still -- we need to discuss that.”

Yet, vice chairman Richard Clarida said the following during an interview with Bloomberg Radio this morning:

We’re not going to even begin to think about lifting off, we expect, until we actually get observed inflation -- and we measure it on a year-over-year basis, equal to two percent.

Forget forward guidance.  How about present guidance? 

Arguing Over the Check
Bankrupt NPC International, Inc. announced last week

Bankrupt NPC International, Inc. announced last week that it is seeking $725 million for its portfolio of Wendy’s and Pizza Hut restaurants that it looks to sell off while under court protection. NPC filed for Chapter 11 on July 1, saddled with $903 million in debt (or well more than the hoped-for sales price) thanks to a 2018 leveraged buyout. 

Pizza Hut and Wendy’s are less than thrilled with NPC’s plan.  The Wall Street Journal reported yesterday that the pair each filed objections with U.S. Bankruptcy court for the Southern District of Texas expressing concerns over the sale and asking for a greater hand in vetting potential bidders. Pizza Hut’s petition laid out the argument:

Without Pizza Hut’s consent to a change of control, the debtors will not be selling an operating Pizza Hut franchise, but brandless leasehold interests and personal property, resulting in lower sale proceeds and diminished returns to the debtors’ creditors.

John Hamburger, president of the Restaurant Finance Monitor, tells Grant’s that he anticipates the Wendy’s locations should generate brisk demand (even from the company itself, which has the right of first refusal on all sales). In any event, financial flexibility will be front and center: 

Wendy’s would prefer that NPC’s stores be split into smaller franchisee groups.  They don’t want another high-leverage franchisee that lacks the cash to remodel stores or develop new restaurants. 

Meanwhile, Pizza Hut parent Yum! Brands has indicated no particular willingness to buy out NPC’s restaurants, with CEO David Gibbs declaring on its second quarter earnings call, that Yum! is “committed to the asset-light model.” Pizza Hut has struggled markedly during the lockdowns, posting a 10% year-over-year comparable store sales decline in the second quarter. 

The credit markets are getting more optimistic on privately-held NPC, which has seen its first-lien term loan rebound to 74 cents on the dollar from just 37 cents in April. Yet Hamburger notes one detail that could complicate the transaction, while simultaneously shining a light on wider industry dynamics: 

When NPC bought 140 Wendy’s locations in 2017, they agreed to remodel 90 by 2021 – an obligation which now falls to the next owners.  Banks are unlikely to be as aggressive as they were pre-Covid in terms of extending credit, and so would-be buyers will probably need lots of equity.

More broadly, NPC’s plight underscores years of pressure on the franchisee business model, which has borne the brunt of declining traffic in tandem with rising labor costs in recent years, while the franchisors have themselves thrived. At year-end 2019, the S&P Restaurants Index traded at 28 times trailing earnings with an enterprise value of 17.3 times Ebitda, far above the 21 price-to-earnings and 13.5 times EV-to-Ebitda ratios sported by the S&P 500 on Dec. 31. 

Interestingly, Hamburger points out that the quick-serve business model has thrived of late and franchisees are currently flush with cash. However, several recent tailwinds are set to abate:

Quick-service restaurant franchisees took loans, which has yet to be resolved (either paid back or converted to grants), and rent deferrals, to be paid back by year-end or 2021.  Banks which write loans have deferred principal and even interest. That will have to get back on an amortization schedule, and franchisors deferred remodeling and developing commitments.  That will need to be worked into the cash flow equation.  

The key question: Might the franchisors, who have long collected royalties without direct exposure to a rugged operating environment, end up on the hook for some or much of franchisees’ capital needs?  

Restaurant Brands International, Inc. a frequent Grant’s pick-not-to-click and avatar of the asset-light business model, exemplifies Mr. Market’s potential for a change of heart.  Since the most recent bearish Grant’s analysis on Aug. 29 of last year, shares are down 28%, far worse than the 11% decline in Carrol’s, RBI’s largest franchisee, over that period. Meanwhile, double-B-rated RBI now sports a bloated balance sheet featuring net debt of 5.8 times consensus Ebitda estimates for 2021.  For context, the median double-B-rated credit carries 3.8 turns of net leverage, according to data from Moody's. 

Note:  The emailed edition erroneously reported QSR's leverage ratio at 9.6 times.  The corrected version now appears on this website. 

Recap Sept. 23

Stocks were flattened as the S&P 500 lost 2.3% and finished near the lows of the day, as the broad index has now lost nearly 10% from its Sept. 2 high-water mark.  The Treasury complex finished little changed, as a hefty $53 billion auction of five-year notes priced at a record low 0.275%. Gold was hammered again, falling to a two-month low of $1,860 an ounce, while WTI remained near $40 a barrel. The VIX jumped to 29, up 8% on the day. 

- Philip Grant

09.22.2020
Civvl Servant
The thrills of modern technology.

The thrills of modern technology.  A new tech start-up will soon offer job-seekers entry into the exciting field of evicting delinquent homeowners and renters laid low by 2020, Vice’s Motherboard reported yesterday.  Upstart app Civvl recently launched a national advertising campaign soliciting job seekers to “be hired as an eviction crew.”  

The Civvl website explains further: “Literally thousands of process servers are needed in the coming months due courts being backed up in judgements that needs to be served to defendants." That’s despite the Center for Disease Control ordering a moratorium on evictions through year-end thanks to the coronavirus. 

Vice notes that Civvl is a subsidiary of gig-economy mainstay OnQall, developer of manual labor apps such as LawnFixr and CleanQwik. Of course, recent experience has demonstrated the differences between so-called gig workers and employees. Vice relays the following:

Civvl did not respond to a question about how the company ensures evictions are legal, though based on the Terms of Service, it appears to pass all risk onto the companies using its platform, stating that it simply "provides lead generation to independent contractors," and does not actually carry out the work itself.  

From Sea to Shining Sea
Momentum investing writ large in Norway.

Momentum investing writ large in Norway. In its annual white paper published yesterday, the Government Pension Fund Global (GPFG) disclosed plans to upsize its allocation to U.S. equity markets. The fund, which manages some NOK 10.49 trillion ($1.15 trillion), would shift about $51 billion (or 6.5% of its assets) to U.S. and Canadian stocks from European ones, bringing the total North American allocation to 48%.  That follows the March decision to upsize its global equity portfolio allocation to 70% from a prior bogey of 65%. 

As Bloomberg noted yesterday, the GPFG traditionally weighted its holdings more towards Europe, which was a function of Norwegian trade patterns.  Other considerations are now front-and-center. "The changes we are proposing will ensure the investments better represent the distribution of value creation in listed companies globally," commented finance minister Jan Tore Sanner in a news release. 

There is no doubt that U.S. equities have been the place to be over the last quarter century.  The MSCI USA index commands a $29.2 trillion market value, dwarfing the MSCI World ex USA gauge’s $15.1 trillion aggregate market cap.  The United States now represents a cool 65.5% of global market cap among so-called developed countries, up from 59% in spring 2018, 49% in spring 2010 and 37% in spring 1995. 

How much room for further concentration remains?  Noting that Japanese equities reached 41% of global market cap at the end of 1988 compared to 30% in the U.S. (despite accounting for only 16% of world output at the time compared to 28% stateside), the Feb. 7 edition of Grant’s detailed the sentiment of that late-80s financial epoch: 

In reply to Gallup’s wintertime 1989 survey question about which country was “the world’s leading economic power,” 58% of respondents (they were American) picked Japan, nearly twice as many as chose the United States, and a majority projected that Japan would continue to dominate in 2000. 

Yet, between 1989 and 2000, the Nikkei 225 fell a cumulative 53.3%, including reinvested dividends, versus a positive 383% return for the S&P 500 (both measured in dollars). That decline came despite a 26% rally in the yen. Over the same span, U.S. GDP as a percentage of the world’s total rose to 30% from 28% while Japan’s slipped to 14% from 15%.

For some specific ways to capitalize on such a future shift, see that Feb. 7 edition of Grant’s.  

 

Recap Sept. 22

The bulls got the upper hand today, as stocks rebounded to the tune of 1% on the S&P 500 to erase yesterday’s losses and leave the broad index higher by about 3% year-to-date.  Treasurys held steady (as is their wont these days), while gold edged lower to $1,910 an ounce and WTI held just below $40 a barrel. The VIX finished at 26.8, remaining near the midpoint of its three-month range.

- Philip Grant

09.21.2020
Collared Green

The Securities and Exchange Commission and Department of Justice separately announced insider trading charges this afternoon against Yinghang “James” Yang, a senior index manager at S&P Dow Jones, along with his friend and alleged co-conspirator, sushi restaurant manager Yuanbiao Chen.  Details of the allegations, from the SEC press release: 

Between June and October of 2019, Yang and Chen repeatedly purchased call or put options of publicly traded companies hours before public announcements that those companies would be added to or removed from a popular stock market index that Yang helped his employer manage.

Bringing new meaning to the term: Index arbitrage. 

Central Command
As the pandemic and lockdown

As the pandemic and lockdowns continue to crimp the world economy, central banks across the Old Continent look to respond with an extra dose of the dual pillars of post-2008 monetary policy: ever-lower interest rates and more ambitious forays into financial markets. Now follows a review of recent happenings.

Last week’s minutes from the most recent Bank of England policy meeting included hints that negative interest rates could be on the way, as the Monetary Policy Committee was briefed on how negative rates “could be implemented effectively, should the outlook for inflation and output warrant it at some point during this period of low equilibrium rates.”  The BoE declared it will “begin structured engagement on the operational considerations” related to negative rates during the fourth quarter. 

Some observers believe that the move below zero is now a fait accompli. “The more [the BoE] talks about this option the more it looks as if it has all but made up its mind,” Allan Monks, economist at J.P. Morgan, commented to the U.K. Telegraph on Friday. 

It’s a notable change in tack for BoE governor Andrew Bailey, who succeeded the Brookfield Asset Management-bound Mark Carney six months ago.  Asked about the prospect of sub-zero rates in March, he replied: “It’s not an area I would want to go to.”  That was then.  The BoE’s next meeting is scheduled for Nov. 5. 

Of course, negative rates are old hat across the Channel, with the European Central Bank taking its benchmark deposit rate below zero in 2014 and cutting it to a record-low minus 50 basis points last fall.  The excursion below zero has evidently done little to revive dormant inflation, as core CPI rose just 0.4% in August from a year ago, down from a 1.2% annual rate in July. That’s the lowest reading on record going back to 2001. 

Rather than force rates deeper into negative territory, the monetary mandarins consider further ramping up asset purchases. The Financial Times reports that the European Central Bank is conducting “a sweeping review” of its Pandemic Emergency Purchase Programme (PEPP), “as debate is intensifying on the [governing] council over whether it should start drawing up plans to wind down the PEPP or consider expanding it further.”

The PEPP, which was initially slated to buy €750 billion ($878 billion) worth of corporate and sovereign bonds in March and expanded to €1.35 trillion in June, allows the ECB to bypass prior restriction on buying speculative-grade debt and accumulating more than one-third of a given country’s sovereign debt stock. The program, which has some €823 billion in remaining capacity as of last week, is scheduled to run through June of 2021.

Total assets at the ECB footed to €6.48 trillion as of last week.  That’s up 38% from a year ago, well below the 87% year-over-year jump in Reserve Bank credit at the Federal Reserve over that period. However, the ECB has been far more aggressive relative to the size of the underlying European economy, as balance sheet holdings stand at 49% of 2019 nominal GDP for the euro area. By comparison, Reserve Bank credit equates to about 33% of U.S. output following that spring shopping spree. 

The powers that be at the ECB have no compunction about taking that figure higher.  Speaking to French and German parliaments today from Frankfurt, president Christine Lagarde declared that she is “not at all aligned with this idea of the exhaustion of the toolbox.” Transitioning from mechanic to military analogies, Lagarde reiterated: “Has the ECB fired its last cartridges? No, not at all, not at all. We can find answers to help economies.”  

Meanwhile, Sweden’s Riksbank, the world’s oldest central bank, recently commissioned Wall Street behemoth BlackRock to conduct an assessment of its own corporate bond-buying scheme, which began on Sept. 1 and is scheduled to run through June. The consultant’s findings are shrouded in mystery, as reporters from Bloomberg received the following response to a request for information: 

[The Riksbank] sent a heavily redacted document consisting of 19 pages. “The Swedish corporate bond market exhibits a number of singularities when compared to other Anglo-Saxon markets,” the document showed. Almost everything else was blacked out.

Some were less than pleased with the lack of candor. “It becomes a black box, run by the Riksbank, with highly unclear working methods and motives,” comments Andreas Halldahl, head of Swedish fixed income at Storebrand Asset Management. “It only brings more uncertainty and destroys another market that worked just fine without them.”

 

Recap Sept. 21

Stocks took a fall on the last official day of summer, with the S&P 500 losing more than 1%, though the broad index managed to finish well off its worst levels of the day.  Similarly, the VIX rose to 27.5, a 6.5% advance on the day but far below its intraday peak of 31. 

Treasurys caught a bid with the 30-year yield slipping to 1.42%, while a strong rally from the greenback helped put the hurt on the commodity complex, with gold, WTI crude and natural gas clobbered by 2%, 3.5% and 10%, respectively. 

- Philip Grant

09.18.2020
When you Give a Mouse a Cookie
Wedesday's status-quo meeting

Wednesday’s status-quo meeting of the Federal Open Market Committee left some observers miffed: The Financial Times documents today in a story headlined: “Investors vent their frustration over Fed’s balance sheet inertia.” 

Though Reserve Bank credit (the sum total of interest-bearing assets on the Fed’s balance sheet) has nearly doubled from a year ago, footings have held steady just below the $7 trillion threshold for more than 10 weeks.  As the FT notes, some take a dim view of the recent breather: 

Krishna Guha, vice-chairman at Evercore ISI, termed the Fed’s current approach to bond-buying “weak”, and urged the Fed to “deploy all its instruments.”

The reversal in tech is one potential source of agita, as the Nasdaq 100 is 12% off its Sept. 2 highs and finished at a one-month low today.  

You’re only as good as your last form H.4.1. 

Live Long and Prosper
Private equity is going public via the latest Wall Street fad.

Private equity is going public via the latest Wall Street fad. In recent weeks prominent industry players have embraced so-called special purpose acquisition vehicles, also known as blank-check companies, as shareholders invest first then find out what they bought later. 

On Wednesday, Apollo Global Management filed a form S-1 to clear the path for an initial public offering of its newfangled SPAC, Apollo Strategic Growth Capital, which will set out to raise $750 million from investors. Apollo, which reported $414 billion in assets as of June 30, will be looking for, among other things, a company “which is not reliant on financial leverage to generate returns.” 

Examples abound, with peer TPG announcing plans to raise a combined $800 million for a pair of tech and environmental, social and governance-focused SPACs and KKR partner Clifton Robbins raising $720 million (upsized from $600 million) for a SPAC with former Goldman Sachs chief operating officer and former Trump administration official Gary Cohn.  Others look to get in on the action, with Reuters reporting this afternoon that private equity firm Rizvi Traverse Management is exploring a reverse merger through a SPAC to bring Playboy Enterprises back into the public domain, after Rizvi Traverse helped take the iconic titillator private in 2011. 

In total, some 85 SPAC’s have come public so far this year in the U.S., raising an aggregate $39 billion according to PitchBook. That compares to 48 deals for roughly $10 billion in 2019, which was previously a record for SPAC activity. 

For issuers, at least, the appeal is easy to understand. “For a private equity firm, they get a large economic stake in the business for less upfront investment,” comments Cameron Stanfill, an analyst at PitchBook specializing in venture capital and SPACs.  Jeffrey Smith, a partner at Sidley Austin, put it this way: “Why do a SPAC? The economics are so good, it’s almost, why not do a SPAC?” Why, indeed. 

It’s not just through dabbling in public deal structures that p.e. is capitalizing on the current financial fever dream.  With leveraged loan prices recovering (the LSTA/Leveraged Loan Price Index yesterday finished at 94, far above its March nadir of 76 and approaching January’s high of 97) and capital markets wide open for business, p.e. operators are looking to strike while the iron is hot. So far this month, 17% of the $22 billion in leveraged loan deal volume has been used to fund dividend payouts for private equity promoters, according to data from S&P’s LCD unit. That’s the highest such proportion since early 2015 and up from an average of less than 4% over the last two years. 

“You have some very high leverage deals,” John Gregory, head of Leveraged finance capital markets at Wells Fargo, told the FT yesterday. “But if it’s a good company that people are familiar with and investors have money that they need to invest then transactions tend to go through. It’s a bull market trade for sure.” 

More broadly, in the post-2009 bull market private equity has deployed lots of leverage in service of paying fancy prices. Thus, Bain and Co.’s 2020 Global Private Equity Report found that a p.e. acquisition cost the typical buyer a multiple of 11.5 times Ebitda last year, compared with 9.9 times in 2007. Then, too, nearly 75% of buyout deals last year featured net debt in excess of six times reported Ebitda, up from about 60% in 2007.  Strip out so-called add-backs, or the now widespread practice of applying credit for hypothetical cost-savings, and that leverage figure would be still higher. 

For more on the P.E. industry, as well as ideas on how to potentially profit on a return to earth for this currently in-orbit asset class, see the May 29 and July 10 editions of Grant’s

Recap Sept. 18

Stocks came under pressure with the S&P 500 taking a 1.1% loss, though the broad index finished well off the lows of the day, while Treasurys were slightly weaker with the 10- and 30-year yields rising to 0.7% and 1.45%, respectively.  Gold ticked higher to $1,958 an ounce, WTI crude held just above $41 a barrel and the VIX closed below 26. 

- Philip Grant

09.17.2020
Snow Where to Go
Fast-growing and money-losing cloud company

Fast-growing and money-losing cloud company Snowflake, Inc. enjoyed a blockbuster public debut yesterday, as shares went skyward from their $120 a share IPO price, which was already upsized from a projected $85 a share.  SNOW shares finished the day at $254 a share, giving the company a $71 billion market capitalization, and the $319 a share intraday peak valued SNOW’s equity at a cool $88.4 billion.  

Not only is that orders of magnitude above the $12 billion valuation achieved in the most recent private funding round conducted all the way back in February, but it tops the company’s own best case scenario.  Thus, Snowflake’s S-1 filing explains that the company: “Believes the addressable market opportunity for our Cloud Data Platform is approximately $81 billion as of January 31, 2020” (hat-tip to a friendly ADG reader).  

As Die Hard villain Hans Gruber quipped (in misquoting Plutarch): “When Alexander saw the breadth of his domain he wept, for there were no worlds left to conquer.” 

The Dehydration Chronicles
Now youse can't leave.

Now youse can’t leave. The continuing saga of H2O Asset Management, the London-based subsidiary of French bank Natixis SA with £20 billion ($25 billion) under management, is once again front-and-center.  At issue: Several funds managed by the firm offer investors daily liquidity (meaning the ability to quickly redeem their investments) while allocating a material portion of assets to highly illiquid debt securities. 

Recall that In June 2019, Morningstar suspended its rating on H2O’s Allegra Fund, precipitating some £3 billion in withdrawals over the next three days. 

Recent weeks have brought further bad tidings. On Aug. 28, French regulator Autorité des Marchés Financiers sent a letter to H2O ordering the manager to freeze three bond funds on account of “valuation uncertainties on the significant exposure of these funds to private securities.” In the regulator’s judgment, hard-to-sell assets are rife across that trio of funds, accounting for as much as 35% of Allegro, as well as up to 30% of the Multibonds Fund and 25% of H2O’s Multistrategies Fund.   

To try and remedy the situation, H2O will “side-pocket” the assets in question, meaning shunt them away to a separate entity, allowing investors to maintain daily liquidity from the existing pool of more liquid positions. Unfortunately for those investors, there is a lot less to withdraw.  Through the first seven months of the year, the three funds posted losses of 37%, 35% and 64%, respectively. 

Specific culprits are hard to identify, a Sept. 1 report from Fitch Ratings explained:

The private assets that drove the H2O fund suspensions are not readily identifiable, as the funds are not required to publish statements of portfolio holdings on a monthly basis. The most recent publicly available information is from the funds’ 2019 annual reports and indicates small exposures to private assets, hedge funds managed by H2O, defaulted Venezuelan sovereign bonds and subordinated bank capital instruments.

Another detail that raised regulatory alarm: The H2O funds close affiliation with oft-sued German entrepreneur Lars Windhorst, which was first reported by the Financial Times last year. H2O disclosed in a letter yesterday that it has applied haircuts on Windhorst-linked debt securities by some 60%, while one of the Windhorst-backed companies, Chain Finance, has yet to repay a €500 million ($590 million) bond more than a month past its August 11 maturity date.  H2O owns roughly 77% of that issue, per Bloomberg. 

Other curious details appeared today. The FT reports that the asset manager utilized a series of “a loose network of minor brokerages” as counterparties in order to shift its exposure to troubled Windhorst-linked debt instruments, an “unusual” arrangement for such a large firm.  H2O used the entities, which included “a mysterious company [named] ‘Merit Capital’ that H2O refuses to identify,” to conduct so-called buy-and-sell-back transactions. 

Following last summer’s revelations, H2O told investors that it had sold a material chunk of the illiquid debt instruments in question. Instead, the manager apparently used its network of lesser-known brokerages to hold the bonds in question for a predetermined period, allowing H2O to avoid breaching caps on illiquid securities which apply to open-ended funds in the U.K. 

Analysts at Bloomberg Intelligence write today that “we suspect delays and further write-downs are likely” before the situation is resolved.  The episode may continue to haunt parent company Natixis.  B.I. notes that H2O accounted for nearly 20% of total asset-management fees in 2019 despite making up less than 3% of total AUM as of June 30.  

Mr. Market seems to have rendered his own judgement:  At the end of 2017, Natixis sported a €20.7 billion market cap and traded at 117% of book value, a hefty premium to the 83% price-to-book ratio then commanded by the Stoxx 600 Banks Index.  Today, Natixis is valued at just €6.9 billion, equivalent to 40% of book and in-line with its peer group.
 

QE Progress Report
Reserve Bank credit (i.e., the sum total of interest-bearing assets at the Fed), rose $23 billion from a week ago to $6.991 trillion.  That’s the biggest sequential increase in a month, but it wasn’t enough to keep the three-month annualized growth rate from falling to minus 6.4% as today marks the twelfth week of Reserve Bank credit holding just below $7 trillion.
Recap Sept. 17

Stocks absorbed a moderate selloff with the S&P 500 falling nearly 1% to trim gains for the week-thus-far to 0.5%, while Treasurys caught a slight bid with the 30-year yield settling at 1.43%.  Gold slipped to $1,954 an ounce, WTI rose to $41 a barrel, and the VIX rose to 26.5. 

- Philip Grant

09.15.2020
Legal Eagles
Uber Technologies, Inc. came to market
Uber Technologies, Inc. came to market with $500 million worth of senior unsecured notes yesterday due 2028.  The offering was well received, with the issue garnering a coupon of 6 1/4%, inside initial price talk of 6 3/8% and was B2/single-B-minus-rated Uber’s lowest borrowing cost yet.  Proceeds from the notes will go towards redeeming an equal amount of the 7 1/2% notes due 2023. 
 
The bond market may see clear skies ahead, but a series of potentially acute regulatory and legal threats continue to dog Uber’s operations.  Let’s review the latest: 
 
On the home front, California’s AB-5 legislation, which was signed into law earlier this year and is designed to bring ride-share “independent contractors” into employee status (thus allowing them to collect traditional benefits such as health care) has yet to work as intended. Over the weekend, The Wall Street Journal reported that the law has instead served to block freelance employees such as entertainers and journalists from securing gigs.  
 
For its part, Uber asserts in a regulatory filing that at least 150,000 of its current 210,000-strong California driver fleet would no longer be able to keep their “side hustle” if AB-5 was actually enforced.  Uber, Lyft and a handful of other gig-economy unicorns have coughed up a combined $180 million to lobby for Proposition 22, a competing ballot initiative which will be put to referendum this fall. 
 
“[The regulatory end run is] such a frustrating example of the way you can buy your way into a regulatory environment that suits you,” Veena Dubal, a law professor at University of California, Hastings, told the Journal. “They have been defying the order since Jan. 1. Meanwhile, a yoga studio doesn’t have that luxury.” 
 
While Uber and friends look to beat back the Golden State political class, foreign jurisdictions also look askance at the company’s business practices.  On Sept. 1 the Hong Kong Court of Final Appeal rejected a plea from 24 drivers who were convicted for carrying passengers without proper permits in 2018, receiving fines of up to HK $4,500 ($570) and casting doubt on the legality of the ride-share business model. The South China Morning Post deemed the ruling “a devastating blow to Uber,” as Hong Kong is reportedly a profitable market for the company (now that’s a unicorn). 
 
Legal drama continues to cloud London operations as well, as last year the Transport for London regulator stripped Uber of its license on account of safety breaches related to unauthorized drivers using fraudulent photos, with Uber eventually granted a temporary 15-month permit.  In a court hearing yesterday, the Licensed Taxi Driver’s Association alleged that Uber knew about the deceptive practices in October 2018 but did not inform authorities until May of last year. 
 
For its part, Uber termed the situation “a matter of deep regret and frustration,” but assured the court that “robust systems” were now in place to prevent any recurrence of the fraud.   A ruling on Uber’s appeal is expected as soon as the end of the week, according to Bloomberg. 
 
Not all the legal challenges are external ones. On Aug. 27, a group of 190 current and former Uber employees filed a lawsuit in California State Superior Court, accusing  the company of improperly using the IPO price to determine tax liability on restricted shares, rather than the price at the end of the insider lock-up period (i.e., when they could actually sell) six months after Uber’s NYSE debut. Following a 40% decline in Uber stock over that period, the employees allege they lost some $8 million in taxes which were wrongly linked to the higher share price. Uber, which claimed at the time that the sped-up stock grants were “in the interest of the [restricted stock unit] holders, as well as in the best interests of the company,” declared that the claims “are simply without merit.” 
 
Meanwhile, pandemic- and lockdown-related pressure on economic activity has counterintuitively helped limit bloodletting on the income statement. Thus, Uber posted a $1.4 billion net loss in the second quarter, down from a whopping $5.2 billion in the year-ago period, as revenues shrank 29% year-over-year to $2.2 billion.  With full year revenues expected at $11.7 billion compared to $14.2 billion last year, Wall Street consensus calls for a full-year adjusted Ebitda loss of $2.4 billion, compared to a $7.4 billion in “adjusted adjusted” losses for calendar 2019.  
 
Benjamin Graham and David Dodd’s classic tome Security Analysis features a passage which may be germane to Uber creditors: “Bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.”
 
Recap Sept. 15

Stocks took a late dip but still enjoyed solid gains, to the tune of a 50 basis point rise in the S&P 500, while Treasury yields ticked modestly higher with the 30-year finishing at 1.43%.  WTI crude caught a bid to close above $38 a barrel, gold finished little changed at $1,961 an ounce, and the VIX fell to 25.5.

- Philip Grant

09.14.2020
No Reservations
A slow motion financial accident in the Middle East?

A slow motion financial accident in the Middle East?  Turkey’s economy continues to flash danger signs as the lira’s slide continues apace, falling to an exchange rate of nearly 7.5 to the dollar this morning.  That compares to 6.8 in early August, 5.6 lira to the buck in January and just over 3 in the summer of 2016, prior to the failed coup against president Recep Erdogan.  

The Central Bank of the Republic of Turkey (under the direction of finance minister and Erdogan’s son-in-law Berat Albayrak) has, perhaps counterintuitively, acceded to the president’s demands for looser monetary policy despite the weakening lira, cutting the one-week repo rate to 8.25% from 24% over the 10 months through April. Inflation has hotted up accordingly, with CPI rising by 11.8% year-over-year in August, the 10th straight month of double digit price increases. 

The lira’s downward drift is especially alarming, as it comes despite Turkey selling down its cache of foreign currencies in an effort to support its own. Gross FX reserves slipped to $44.9 billion as of Sept. 4 according to the CBRT, down more than 40% so far this year and the lowest since 2005, when nominal GDP footed to $501 billion compared to $774 billion in 2019. 

The rating agencies have taken notice. On Friday, Moody’s downgraded Turkey’s sovereign debt rating to B2 (five notches into junk territory) from B1, while maintaining a negative outlook.  The rating agency didn’t mince words: “Turkey’s external vulnerabilities are increasingly likely to crystallize in a balance-of-payments crisis.”   Moody’s writes that, after accounting for required reserves and foreign-exchange liabilities, net reserves “are now close to zero.”  

While some $44 billion in commercial bank reserves parked at the CBRT could help repay maturing external debt, “such a situation would increase the risk that the government impose restrictions to safeguard its scarce FX assets,” i.e., capital controls. Then, too, with the CBRT holding a $53 billion net short FX position in the swap market, up from $30 billion in March, “all the commercial banks’ reserves at the central bank are insufficient to cover this short position if the swaps were not rolled over.”   

Perhaps most concerning, Moody’s concludes: “The country’s institutions appear to be unwilling or unable to effectively address these challenges.” 

By way of response, Erdogan went the casual dismissal route, declaring of Moody’s Saturday: “Do what you want to do, your ratings are of no importance.”

As the political class keeps calm and carries on, foreign investors hit the bricks, withdrawing a record net $7 billion from local debt markets in the first half of the year while the ratio of non-Turkish ownership in the stock market has fallen below 50% for the first time since 2004.

The citizenry, too, is voting with their pocketbooks.  The Turkish Ministry of Trade reports that gold imports footed to $15 billion over the first eight months of the year, up 153% from the comparable period in 2019.  A dispatch today from The Wall Street Journal notes that average daily trading volume at the Grand Bazaar in Istanbul jumped to 4,500 pounds upon reopening from its coronavirus hiatus in June, a 10-fold increase from the baseline level.

“I’ve been at the Bazaar for 20 years and I had never experienced that,” Ozgur Anik, general manager at Ozak Precious Metals AS, tells the Journal of that surge in activity. “When gold prices are at [a] record high, people normally sell their gold. This time, they keep buying more.” 

Recap Sept. 14

A bull stampede to start the week, as the S&P 500 jumped 1.3% to leave the broad index higher by nearly 5% so far this year.  Treasurys finished little changed with the 30-year yield settling at 1.42%, gold rallied nearly 1% to $1,967 an ounce and WTI crude held near $37 a barrel.  The VIX closed below 26 for the first time in two weeks. 

- Philip Grant

09.11.2020
Suggested retail price
Attack of the day trader.

Attack of the day trader.  Retail investors have taken control of South Korea’s stock market, accounting for 87.5% of trading volumes in the first eight days of September according to exchange data. In March, retail participation stood at 51.4%.  

The hobby has been lucrative, as the benchmark Kospi Index is up a cool 65% from its March nadir. “Retail investors appear to be seeking short-term profits after hearing their next-door neighbors earned lots of money from stocks after the March selloff,” Yoo Seung-Min, chief strategist at Samsung Securities Co., tells Bloomberg. 

Retail has a bit less stock market muscle stateside, accounting for roughly 20% of trading volume over the first six months of the year. That is however a notable jump from the steady 15% retail share over the last five years. 

Some look to get that Main Street participation level a bit higher. Twitter user @HotlantaCapital posted a photo of the following deal this morning:


 
Notably, the $50 gift card includes a $6.95 “stock trade” fee, a curious line item in this era of zero-commission structures across all the major retail trading platforms. 

Shovel ready
Time waits for no underwriter.

Time waits for no underwriter. The Financial Times reports today that corporate advisors are urging their clients to issue debt ahead of the presidential election.  “It is not a difficult argument to make to an issuer of ‘why are you waiting, you have financing to do, you have one of the best environments right now, and you have the potential for a lot of volatility in November,’” explains Jonny Fine, head of investment grade debt syndicate at Goldman Sachs.  

You don’t need to tell corporate America twice.  Investment grade bond issuance reached a record $210 billion in August, bringing the year-to-date tally to $1.53 trillion per Bank of America.  That’s 65% above last year’s pace and easily tops the prior full-year high water mark of $1.37 trillion set in 2017. 

It’s not only in the primary market where issuers are making hay: Citing data from Refinitiv, the FT noted Tuesday that domestic bond issuers have refinanced $250 billion worth of debt so far this year,  almost double the 2019 run-rate.  

Along with achieving lower interest costs, companies are pushing back the day when principal comes due, with the share of I.G. debt maturing in 15 years or more standing at 30% according to Ice Data Services.  That’s up from 24% in 2015.  The stock of outstanding U.S. corporate debt with a maturity of 2035 or later now exceeds $2 trillion, a record figure. 

Meanwhile, buoyant asset prices obscure deteriorating corporate fundamentals. According to data from CreditSights the median investment grade issuer sports net debt of 23% of total enterprise value.  In mid-2015, that ratio stood at 19%. 

A survey of investment grade picks-to-not-click in the April 6, 2018 edition of Grant’s deemed corporate bond investors “the doormats of Wall Street.”  To wit:

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 Sept. 11

A hotter than expected reading of August CPI didn’t bother the bond market, as Treasury yields ticked lower to leave the 10- and 30-year at 0.67% and 1.42%, respectively.  Stocks finished little changed as the S&P 500 finished the holiday-shortened week lower by roughly 2.5%, while gold fell to $1,950 an ounce and WTI held near $37 a barrel.  The VIX closed below 27,  down from near 36 on Tuesday morning. 

- Philip Grant

09.10.2020
The Winner Takes it All

Headline of the day, from the Financial Times:

Central banks will win the tug of war in markets.

Old Faithful
A scalding corporate financing environment is allowing all manner of enterprises to tap public equity markets,

A scalding corporate financing environment is allowing all manner of enterprises to tap public equity markets, as the volume of U.S. initial public offerings approached $19 billion in July according to Bloomberg. That’s the most active month since September 2014, which featured the debut of Chinese e-commerce behemoth Alibaba Group. “This is the busiest summer [on record], bar none,” Ashley MacNeill, Morgan Stanley’s co-head of technology equity capital markets for the Americas, told Bloomberg on Aug. 24. 

With stocks remaining near record highs and up smartly in this pandemic plagued 2020, a pair of tech-focused entities are set to grace the domestic public markets with their presence:

Cloud data firm Snowflake, Inc. filed its amended form S-1 with the Securities and Exchange Commission on Tuesday, disclosing plans to sell 28 million shares for between $75 and $85 each, with a midpoint price valuing Snowflake at $22.3 billion. For context, the company raised $479 million in February at a $12.4 billion valuation. 

Snowflake, which was founded in 2012, has enjoyed brisk top-line growth with revenues ($242 million in the six months ended July 31 from $105 million over the same period in 2019) and has caught the eye of blue-blooded investors Berkshire Hathaway and Salesforce Ventures, which have each agreed to buy $250 million worth of class A shares at the IPO.  

That fast-expanding top line has yet to translate into profitability, with the company reporting a $171 million net loss over the six months through July 31, little changed from the $177 million loss in the comparable period last year, while stock based compensation rose to $39 million from $34 million. 

Another tech unicorn looks set to join the public ranks, as yesterday, video game software developer Unity Software, Inc. filed its own amended form S-1 to sell 25 million shares to public investors at a range of $34 to $42 a share, valuing the company at just over $9 billion using the midpoint of that range. That’s up from a $6 billion valuation in a private fundraising round in May 2019.  

Much like its presumptive public peer Snowflake, Unity Software boasts sturdy top-line growth and persistent red ink, as revenues footed to $351 million in the six months through June, up from $253 million in the same period last year, along with net losses of $54 million and $67 million, respectively.  Stock-based compensation expense rose to $22 million from $15 million in the first half of 2019. 

Both Snowflake and Unity, which was founded in 2004 in Denmark and reorganized as a Delaware-based corporation in 2009, will be classified as “emerging growth companies” under the 2012 Jumpstart Our Business Startups Act (JOBS Act).  As the Unity filing spells out, the designation is a helpful one for these “emerging” eight and 16-year-old concerns, allowing for:  

[An exemption from] auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002.  

Reduced obligations with respect to financial data, including presenting only two years of audited financial statements and only two years of selected financial data.

Reduced disclosure obligations regarding executive compensation in our periodic reports, proxy statements, and registration statements.

An exemption from compliance with the requirement of the Public Company Accounting Oversight Board regarding the communication of critical audit matters in the auditor’s report on the financial statements.

Meanwhile a more newfangled enterprise looks to make its own public debut across the pond, with less auspicious results.  One-year old concern Guild Esports, which is co-owned by English soccer legend David Beckham, announced in a statement yesterday that it is preparing its IPO on the London Stock Exchange at a £50 million ($64 million) valuation. 

More ambitious plans were reportedly thwarted. The Financial Times noted Tuesday that Guild had previously attempted to debut at a £100 million price tag earlier this year, eventually scaling back its goals after “tak[ing] into account market volatility and discussions with investors and advisers in recent months.”

Perhaps London needs its own JOBS Act. 

 

Correction
A pair of price-and-time errors in yesterday’s edition:  August auto sales came to a seasonally adjusted annual rate of 15.2 million according to J.D. Power, up from 8.8 million in April and 12.2 million in May. The cited 17 million SAAR figure was from August of 2019.  In addition, steel prices peaked at $940 a ton in summer 2018 (not summer 2019), falling to between $550 and $600 a ton in the summer and fall of 2019. 

 

QE progress report
The Fed’s Spring credit impulse continues to fade, as Reserve Bank credit (i.e. the sum total of interest bearing assets on the balance sheet) registered at $6.97 trillion, the eleventh straight weekly reading just below the $7 trillion mark.  The three-month annualized growth rate has now fallen to minus 4.5%, though Reserve Bank credit remains higher by 87% year-over-year.  
Recap Sept. 10

A renewed round of selling pressure forced the S&P 500 to reverse early gains and settle near session lows with a 1.75% loss, while Treasurys caught a bid with the 10- and 30-year yields slipping to 0.68% and 1.43%, respectively.  A surprise build in weekly crude oil inventories helped push WTI crude back to $37 a barrel, and gold ticked slightly lower to $1,950 an ounce. 

- Philip Grant

09.09.2020
Rock scramble
Let's review the latest with Cleveland-Cliffs, Inc. (CLF on the NYSE),

Let’s review the latest with Cleveland-Cliffs, Inc. (CLF on the NYSE), America’s largest iron ore miner-cum-steel manufacturer and Grant’s pick-to-click on a pair of occasions last year.  So far, the results have been less than rewarding, with shares down 38% from an initial bullish analysis on June 28, 2019.  Now follows a review of what went wrong, and the prospects for this 173-year old corporate institution. 

Of course, the unpleasant events of 2020 figure prominently in the equation.  And as Cliffs mines iron ore and converts the ore into pellets which it sells to steelmakers, the price path of that trio helps guide CLFs corporate fortunes.   

A sharp post-COVID rebound in the price of iron ore (to $128 a ton from $74 in April) has been offset by a much lower premium for pellets ($28 from $70 in June 2019), while domestic spot steel prices of $535 a ton are far below the $940 per ton featured in the initial analysis.   

The company is also highly exposed to the health of the auto industry. With steel and iron ore shipments down 56% and 24%, respectively and vehicle production on ice for the bulk of the second quarter, Cliffs absorbed $159 million in idling costs, contributing to a $112 million Ebitda loss for the quarter (Ebitda stood at positive $248 million in the second quarter of 2019).  

Then, too, the March purchase of AK Steel Corp. for $3.1 billion (including the assumption of $2.2 billion in debt) followed by near-cessation of economic activity in the second quarter helped push CLF’s pro-forma leverage ratio to 8.6 times by Bloomberg Intelligence’s reckoning, the highest since 2016 when iron ore fetched less than $50 a ton. 

The bond market is wary, with B/1-single-B-minus-rated CLF’s senior unsecured 5 3/4% notes of 2025 remaining at 93 cents on the dollar for a 746 basis point spread over Treasurys, well above the 514 basis point pickup over Treasurys on the single-B-rated portion of the Bloomberg Barclays High Yield Index.

Of course, the auto industry has enjoyed a strong rebound after production all but shut down this spring, with August sales clocking at a robust 17 million seasonally adjusted annual rate according to J.D. Power.  In a phone interview with Grant’s today, Cliffs chairman, president and CEO Lourenco Goncalves noted that as dealers largely remained open during the pandemic while production was shut, inventory levels have dwindled, necessitating a pickup in output from auto OEM’s. 

Goncalves also noted that the evident shift toward suburban living from urban centers (see booming new home sales data) could act as a further secular tailwind, as does the relative popularity of SUV’s and larger vehicles, which comprise a relatively larger portion of CLF’s automotive revenue. The executive concludes that: “It’s a different approach for a different generation.”

A return to more normal conditions may provide relatively swift relief from that concerning leverage ratio.  On the July 28 call, Cliffs noted that net liquidity (as measured by cash and cash equivalents, along with lending capacity under the company’s asset-based lending facility) had risen to $1.25 billion from $982 million on June 30.

By way of preserving cash, CLF discontinued its $0.06-per-share quarterly dividend in April, equating to an annual savings of about $96 million.  Asked if a return to such payouts was in the cards, Goncalves replied: “No intention to reinstate the dividend. No one buys it for the dividend, they buy the stock for long-term returns.”  

As for buybacks, on which the company allocated $300 million towards in 2018 and 2019, the plain-talking Goncalves declared: “I will not be buying back stock for the rest of my life. It’s a fool’s game and might make a few investors happy for half an hour. It’s the only decision I regret in six years running CLF.”

Meanwhile, a resumption of near-baseline economic activity should help further ease liquidity concerns, as Cliffs management forecast idling costs of less than $50 million in the third quarter and of a negligible amount for Q4 during the July 28 conference call.

Coronavirus aside, the AK Steel integration has shown promise, with CLF management implementing some $151 million of synergies with its newfound unit to top its initial $120 million estimate. That helped bolster cash flow guidance to between $50 million and $100 million across the third and fourth quarter, well above the $30 million Wall Street consensus. At $7.4 billion, Cliffs enterprise value currently stands at a bit less than 10 times consensus 2021 Ebitda, and roughly 6.5 times both 2022 consensus and the aggregate CLF and AKS Ebitda figures for 2019.   

Skepticism remains widespread, with 23% of the float sold short. That’s up from 10% last summer but below the near 28% threshold reached in fall 2019.  Management has taken notice. Asked about a series of screeds against short-sellers and skeptical Wall Street analysts during investor events in recent years, Goncalves argued the following: 

Short-selling is a phenomenon driven by somebody else’s money.  No one is using their own money to short.  In our case, they short because they don’t do their homework.  It’s not a smart move to short CLF at this moment when we are in a clear auto rebound; there are better stocks to short.

Anyway, Cliffs bulls can take solace in a partnership-type of mentality from management, as corporate insiders have snapped up $1.2 million worth of CLF shares in the past year, with no open market sales over that period. Goncalves notes to Grant’s that: “We believe in our business and we put our money where our mouth is; sometimes we want to buy and we can’t. I would love to buy more, and so would the board.”

A businessman’s risk in the Rust Belt. 

Recap Sept. 9

A strong rebound left the S&P 500 nearly 2% in the green, leaving the broad index sitting higher by 5% year to date, while the VIX closed below 30 for the first time in a week.  Treasurys likewise changed direction from yesterday with the 30-year yield rising to 1.46%, while WTI crude bounced back to $38 and gold jumped to $1,956 an ounce. 

- Philip Grant

09.07.2020
Ready to 'ware
A cyberattack has forced the temporary closure of BancoEstado, one of Chile’s largest depositories.

A cyberattack has forced the temporary closure of BancoEstado, one of Chile’s largest depositories. 

Technology news site ZDNet reports: “While initially, the bank hoped to recover from the attack unnoticed, the damage was extensive, according to sources, with the ransomware encrypting the vast majority of internal servers and employee workstations.”

It’s not the only recent example of bitcoin-seeking hackers wreaking havoc on financial infrastructure.  Last week, New Zealand’s NXZ exchange suffered four straight days of electronic assaults, including an offshore denial of service attack on Friday morning that compelled the exchange to remain closed. The Kiwis are bringing in the big guns to investigate, with NXZ declaring that it was working with “national and international cyber security partners. . . to address the recent cyber-attacks.” 

Martin Boer, director of regulatory affairs at the Institute of International Finance, offered this assessment to the Financial Times: “A sophisticated [cyber] attack — the suspicion is that it does come from a foreign, state-backed adversary.”

Grande dame
Everything must go.

Everything must go.  Property giant China Evergrande Group Ltd. (3333 on the Hong Kong exchange) announced a month-long sales promotion that includes base discounts of 30% on all residential real estate, along with other incentives that could push savings to 43%. Its largest such price concession since the company began offering biannual sales in 2011, Bloomberg reports. 

The pressing need to book sales is understandable. Evergrande sports a whopping 12 turns of leverage, triple the industry average and nearly double that of the next-most encumbered Chinese property developer, Sunac China Holdings Ltd.  A pandemic-related earnings hit has exacerbated the problem, as total profits over the first six months of the year fell to RMB 6.54 billion ($980 million), a 56% drop and the third straight decline over that January to June period. For context, nationwide property sales registered at RMB 8.1 trillion in the first seven months of this year per the South China Morning Post, down 2.1% from a year ago. 

The company has paid lip service to cutting down its debt burden, announcing a plan this spring to reduce leverage by RMB 150 billion annually over the next two-plus years, but progress on that front has been wanting. Total debt stood at RMB 835 billion as of June 30, up 4% from its year-end level, while the gearing ratio (meaning net debt to equity, inclusive of minority stakes) rose to 199% from 159% on Dec. 31.  Analysts at Bloomberg Intelligence guesstimate that gross margins could drop below 21% next year, compared to 25% in the first six months of 2020.

For its part, Evergrande’s management remains upbeat in the face of daunting challenges: “We’re confident that total debt, net debt and net gearing will all substantially decline by year end,” declared CEO Xia Haijun on last week’s earnings call. To that end, the property giant cut its forecast investment in its money-losing electric car business (how’s that for synergies?) to RMB 29 billion from RMB 45 billion. A sense of urgency bordering on desperation colors the c-suite’s optimism. In announcing sales targets of at least RMB 100 billion across the crucial selling months of September and October, chairman Hui Ka Yan termed the initiative “a military order.”  

Then, too, the maturity schedule presents its own hurdles. Evergrande has some $19 billion in dollar-denominated bonds coming due between 2021 and 2025, according to Bloomberg, as well as an HK$8 billion ($1 billion) term loan due on November 30 this year.  

Despite single-B-plus-rated Evergrande’s extensive debt load and relatively front-loaded maturity schedule, yield-hungry bond investors have taken recent news in stride. After falling below 60 cents in March, the developer’s dollar-denominated 8 3/4 senior secured notes of 2025 have snapped back to their pre-coronavirus levels at 85 cents on the dollar while the 6 1/4% senior secured dollar pay notes due next year are hovering near par.

Might Evergrande serve as an avatar for the precariously leveraged Chinese economy, which features total banking assets of $43.8 trillion as of June 30, equivalent to one-half of 2019 global GDP? An Aug. 17 paper from the National Bureau of Economic Research concluded that “a 20% fall in real-estate activity could lead to a 5% to 10% fall in GDP, even without amplification from a banking crisis, or accounting for the importance of real estate as collateral.” 

For an early look at Evergrande and the Chinese economic miracle, see the June 2, 2017 edition of Grant’s

Recap Sept. 8

Stocks were clobbered with the broad S&P 500 and Nasdaq 100 Indices falling 2.8% and 4.8%, respectively, with each gauge finishing at the lows of the day.  Oil also came under heavy pressure with WTI sliding to $37 a barrel and Brent crude below $40 for the first time since June. Gold edged higher to $1,939 an ounce, Treasurys were bid with the 30-year yield falling four basis points to 1.43%, and the VIX rose a relatively modest 3% to near 32.

- Philip Grant

09.04.2020
Inside Man
Financial press confirms a report yesterday from Zero Hedge that

Financial press confirms a report yesterday from Zero Hedge that SoftBank Group Corp. has been the options market “whale” devouring call options in an array of tech-related stocks, a move perhaps directly contributing to the Nasdaq’s dizzying ascent this summer.  The call buying spree, which The Wall Street Journal pegs at $4 billion, follows SoftBank’s reported $10 billion worth of tech-stock common equity purchases earlier this summer. 

Masa Son and co. have company. While the role of retail investors in the recent gangbusters rally has been well-ventilated, new data highlight the intense speculative flows coming from smaller players.  Citing data from the Options Clearing Corporation, Bianco Research notes that, as net bullish options activity surged in August: “small traders are dominating the options market and 75% of the volume is in contracts that expire in under two weeks.”

As one whale and many minnows ride the magic wave, the captains of some larger vessels look to bail.  The Financial Times reports that corporate executives unloaded $6.7 billion worth of their company shares in August, the busiest single month for insider selling since November 2015. 

Insiders at high-flying tech companies have been particularly eager to cash in, as firm StoneX (nèe INTL FCStone) reports that insider sales among Nasdaq 100 companies jumped to $10.4 billion in the second quarter, up 171% from a year ago.

StoneX macro strategist Vincent Deluard sums it up to the FT: “Insiders at Nasdaq 100 index companies are harvesting a once-in-a-millennium bonanza.”

Backed Into A Corner
Time to put your money where your mouth is.

Time to put your money where your mouth is. Both proponents and skeptics of the purportedly dollar-backed tether cryptocurrency (USDT) now have an easier opportunity to express their views, as yesterday derivatives exchange Opium debuted credit default swaps on tether. The newfangled CDS securities would pay out in the event of a sharp decline from the $1 USDT price level established by the so-called stablecoin.  Tether, widely used as a way to trade into cryptos from fiat currency and back again without being subject to the know-your-customer and anti-money laundering regulations common in traditional banking, is a key cog in the crypto “ecosystem” with $58 billion in trading volume over the past 24 hours, nearly double that of bitcoin at $31 billion.  

Tether and the associated Bitfinex crypto exchange have long been the subject of scrutiny regarding the claim of one-to-one backing by U.S. dollars (Almost Daily Grant’s, May 21), including a lawsuit from the New York State Attorney General accusing the pair of improperly commingling funds and a class action suit accusing Tether and Bitfinex of conducting: “a sophisticated scheme to fraudulently inflate the price of crypto commodities [including] bitcoin.” The class action litigants claim that Tether issued up to $3 billion worth of tokens without any dollar backing, a move which allegedly played a key role in skyrocketing crypto prices during late 2017. 

Yesterday, the pair filed a motion in New York to dismiss the lawsuit, describing the plaintiff claims as “ridiculous.”  By way of evidence, iFinex (the entity behind both Tether and Bitfinex) posted a “proof of funds” on its website in the form of a 2018 letter from the law firm Freeh, Sporkin & Sullivan LLP stating that “the amount of fully-backed USD Tethers in circulation as of June 1st, 2018 was equal to $2.538 billion of USD Tethers.” 

However, recently updated language on the Tether website appears to offer plenty of rhetorical wiggle room on that dollar backing claim:

[USDTs are] backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.

For comparison, this language appeared on the Tether website in late 2017:

All tethers are pegged at one-to-one with matching fiat currency (e.g., 1 USD? = $1) and are backed 100% by actual assets in our reserve account.

Might greater scrutiny on tether pose a wider risk to bitcoin and its digital peers? A June 30 paper from Timothy Peterson, founder of Cane Island Alternative Advisors, studied price moves within the crypto market from July 2010 to May of this year and reached the following conclusion:

We can say with near 100% confidence that bitcoin’s price has been fraudulently manipulated at some point in its lifespan since 2010. We can say with 95% confidence that bitcoin was manipulated in 2013; 95% confidence that bitcoin was manipulated in 2018; and 98% confidence that bitcoin was manipulated in 2019.

Tethered to what again? 
 

Recap Sept. 4

A much stronger-than-expected August jobs report helped deal a beating to long-dated Treasurys, as the 20- and 30- year yields each jumped 10 basis points to 1.25% and 1.47%, respectively, while the S&P 500 and Nasdaq 100 lost 80 and 130 basis points, respectively, in volatile trading.  Gold ticked slightly higher to $1,942 an ounce, WTI crude slipped below $40 a barrel for the first tie since the end of June and the VIX pulled back by 10% to finish near 30. 

- Philip Grant

09.03.2020
City Slicker
A new report from Colliers International finds that Manhattan’s August office vacancy rate

A new report from Colliers International finds that Manhattan’s August office vacancy rate jumped to 11.8%, the highest since 2013 and up from 11% in July. 

That figure appears set to rise further. Colliers reports that the total Manhattan office sublease market jumped by 1.3 million square feet in August, building on a 1 million square foot increase in July.  Subleases now account for 23% of available office space in the borough, the highest ratio since the 2010 financial crisis aftermath.  That’s despite a seasonal tailwind, as sublease activity traditionally wanes in August before picking up after the Labor Day holiday. The jump is also concerning in that, as most office leases run between six and 10 years, demand declines often manifest in short-term subleases before transitioning to outright vacancies. 

With the pandemic dragging into a month six and New York’s politicians seemingly in no hurry to end the quasi-lockdowns, large tenants look to downsize. Bloomberg reported last week that hedge fund York Capital is looking to sublet some 20,000 square feet of its space in the prestigious General Motors building on Fifth Avenue, while J.P. Morgan executive Daniel Pinto disclosed in a CNBC interview that the investment banking division’s 60,000-strong staff will rotate between stints at the office and working from home, a switch that he “believe[s] will be more or less permanent.”  J.P. Morgan was long the largest office tenant in Manhattan prior to WeWork’s rapid ascent in 2018. 

Other banks look set to follow suit. Fox Business reports today that Morgan Stanley and Goldman Sachs are similarly preparing for 50% onsite staffing until “well into next year,” while employees at UBS were told that a return may not come before April of next year.  

While the coronavirus presents a plausible catalyst for the moves, other considerations may factor in. “It’s a cost-saving measure," Dick Bove, a senior research analyst at Odeon Capital Group LLC, tells Fox Business. "The ultimate result of keeping people home is they can get rid of real estate."

It’s not just Wall Street that is looking to slim down its physical footprint in New York. In a filing with the Department of Labor on Monday the 478-room Hilton Times Square declared it was “permanent closing” after the hotel shut on a temporary basis in March and furloughed employees. For its part, owner Sunstone Hotel Investors may yet be keeping its options open, as a spokesperson told The Wall Street Journal that that filing language means only that layoffs are expected to last more than six months. 

While overall asking rents held mostly steady across Manhattan office buildings in the second quarter, the rush for the exits is already pressuring prices in select neighborhoods: According to Cushman & Wakefield, asking rents for retail space in the midtown section of Fifth Avenue fell 30% from a year ago. Meanwhile, one-bedroom apartment rental prices slipped by 10.9% year-over-year in August according to the Zumper National Rent Report. 

While New Yorkers have long been known for their healthy self-regard, the city that never sleeps is objectively a key cog in the national commercial real estate machine. Statista pegs the Manhattan office market alone at 526 million square feet as of the end of the second quarter, representing roughly 13.5% of the 3.9 billion square feet worth total office space in the U.S., per the CBRE’s 2020 Real Estate Market Outlook. For comparison, the entire New York metro area population (spanning the five boroughs and sections of New Jersey, Connecticut, Long Island and the Hudson Valley) stands at an estimated 20.3 million according to the Census Bureau, or just over 6% of the nationwide total. 

It’s not just the Big Apple that is facing a painful work-from-home reckoning. This afternoon, tech company Pinterest announced it has terminated its 490,000 square foot preconstruction lease near its current headquarters in San Francisco, choosing to cough up an $89.5 million break-up fee rather than go forward with the project.  

Clearly, that broad-based pain is no good news for the banks that finance commercial real estate.  J.P. Morgan Chase & Co., for instance, set aside a $10.5 billion provision for credit losses in the second quarter, up nearly 10-fold from last year’s credit loss provision. According to Fitch Ratings, the median credit loss provision among regional banks with between $50 billion and $100 billion in assets rose five-fold from a year ago in the first six months of 2020.  

Besides making a reservation with U-Haul, how might one position for the prospect of prolonged economic pain in Gotham?  The July 24 edition of Grant’s features a pair of ways to potentially profit. 

QE Progress Report
Another week of waning momentum, as Reserve Bank credit (i.e. the sum total of interest-bearing assets at the Fed) registered at $6.96 trillion, down $13 billion from the prior reading and the 10th straight week just below the $7 trillion mark.  The three-month annualized growth rate turned negative (by 0.2%), a fitting cap to today’s market action. 
Recap Sept. 3

Stocks were trounced to the tune of 3.5% on the S&P 500 and 5.2% on the Nasdaq 100, sending those indices to their lowest closes since last Wednesday and last Tuesday, respectively.  By contrast, the yield curve remained under control as Treasury yields barely budged.  Gold fell $7 to $1,937 an ounce, WTI crude ticked to near $41 a barrel, and the VIX (which recently crept higher in advance of today’s pullback) jumped 26% to near 34. 

- Philiip Grant

09.01.2020
Divestment banker
When a roll-up unrolls.

When a roll-up unrolls. The Wall Street Journal reports that telecom giant-turned entertainment conglomerate AT&T, Inc. (T on the NYSE) is weighing a potential sale of its digital advertising businesses, led by the cloud-based AppNexus unit, which AT&T bought just two years ago for $1.6 billion.  Such a sale “is unlikely to fetch more” than the 2018 price tag, according to anonymity-seeking sources.  

Then, too, a bigger piece of the corporate portfolio may also be on its way out the door.  A Friday afternoon Journal dispatch declared that AT&T is again in talks with potential buyers for its DirectTV satellite business. It’s not the first time Ma Bell has investigated selling the division, as the Journal relayed last fall that the company was considering options for the unit including a spinoff or merger with rival Dish Network Corp.  This time, private equity players such as Apollo Global Management and Platinum Equity are reportedly in the mix as potential buyers. 

It’s been tough sledding for DirecTV, as AT&T reported an 18% annual subscriber contraction for its “premium video” unit (which encompasses DirecTV and the U-verse television platform) for the second quarter, marking the eighth straight quarter of accelerating year-over-year subscriber losses for the division. Given those grim data, it’s no surprise a DirecTV sale would deal a severe realized loss for AT&T. Indeed, analysts at Bloomberg Intelligence speculate that DirecTV will carry a $20 billion price tag, well below half the initial purchase price of $49 billion made in 2015. 

The precipitous decline in DirecTV’s operating metrics may add further complications beyond a diminished sale price. In a commentary yesterday, Craig Moffett, co-founder and one-half eponym of MoffettNathanson, LLC, broke down the daunting calculus facing AT&T as it attempts to shed the DirecTV albatross. 

Even in this credit market, it’s all but impossible to lever a business shrinking that quickly, so the capital structure of any take-out would have to be very equity-heavy.   And no private equity buyer could assume an exit from the investment – an IPO, say, or a flip to someone else down the road – again because the rate of decline is so rapid.  

So, a buyer would have to assume they would be running the business for cash.  The only way for a potential buyer to meet a reasonable return hurdle in that scenario would be to get in at a very low entry multiple.

On the other hand, unsustainable debt levels may force AT&T’s hand. The balance sheet showed $225 billion in aggregate net debt (inclusive of operating leases, post-retirement health benefits and pension liabilities) as of June 30, leaving it the most indebted non-financial company in the world.  For context, Ebitda over the past 12 months footed to $64 billion, leaving the company dangerously close to a 3.5 times leverage limit under its debt covenants.

More broadly, triple-B-rated AT&T’s revenues have remained stuck in neutral since long before the coronavirus made its unwelcome appearance.  The company posted $181 billion in revenue during calendar 2019, not far above the $164 billion top line reported three years earlier.  Yet over that period, gross marketable debt jumped to $188 billion at year-end from $124 billion on Dec. 31, 2016. 

Might a dividend cut (the company has raised its quarterly payout each year since 1998) present a clear and present risk for AT&T shareholders? The company will generate $24.2 billion in free cash flow this year, if Wall Street is on the beam, down from more than $29 billion a year ago.  At the current $0.52 per share quarterly disbursement, the dividend will gobble up nearly $15 billion of that sum, while capital expenditures will foot to about $19 billion, per analyst consensus.  

Mr. Market seems to be applying his own discount towards AT&T, as shares have returned minus 19% after dividend reinvestment since a mid-December Grant’s analysis, compared to a 13% advance for the S&P 500 over that period. 

Asset values are contingent, debt is forever. 

 

 

Recap Sept. 1

A late surge left the S&P 500 higher by nearly 1%, as the broad index now sits some 58% above its March 23 nadir.  Treasurys caught a strong bid as the 30-year bond yield fell to 1.43% (it finished last week at 1.52%), while gold and oil traded little changed to finish near $1,975 an ounce and $43 a barrel, respectively.  

A note of concern for the bulls: The VIX remained resilient, erasing the bulk of its mid-day losses to climb back above 26 and remain near multi-week highs. 

- Philip Grant

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