Krafting an exit after struggling to restore growth

After a less than sparkling recovery in Q4 FY14 organic revenue growth to under +3.5% YoY, the Kraft management seems to have thrown in the towel to the current financial masters at Heinz (Berkshire Hathaway and 3G Capital) and agreed to its 'merger' offer. While conceding most of the plum jobs in the new combine to the Heinz crew, Kraft management have managed to extract terms that are by no means too shabby, not withstanding that probably over 75% of the exit value to Kraft shareholders will be in the new KraftHeinz shares rather than straight cash.

Being somewhat generous in the below analysis by not including pension liabilities or deal costs (including severence etc), and pricing in a market average growth rating of approx +5% CAGR for both groups as well as for the NPV of the $1.7bn of planned cost synergies,  the post merger value of the offer to Kraft shareholders comes to over $73 per share (including the $16.5 ps cash component) as against the stand alone valuation for Kraft which tops out at around $54 per share.  This suggests that on a comparable underlying growth rating for both groups, that the Heinz shareholders are conceeding to the Kraft ones an above weighting (c. 68%) of the synergy benefits.  The other side of this coin however, may well be that the Kraft employees end up as the ones that ultimately pay this price.  There seems no greater love than for a management to lay down their workers careers for their shareholders.  Whether this is reflected in their own termination settlements however is another matter!

Valuation implications of merger

ITV's turn to buy into the de Mol format dream

The story is an old one.  Broadcaster facing erosion of its distribution monopoly buys successful production business to supplement the lack of creative output from its own in-house content origination arm.  Whether it was TVS’s purchase of MTM, Thames TV’s acquisition of Reeves or Pearson’s serial offending with Grundy and then All American, the narrative was the same. The tale started with the presentation of the strategic imperative of developing content into a fragmenting media environment and usually concluded with the short term financial justification of EPS accretion.  What was usually omitted was that the creative talent walked off with the ‘moolah’ and set up across the street in competition or just simply failed to repeat their initial success within the more constricting culture of a big broadcaster or indeed even a Telco.  The original ‘hit’ series usually had a few more seasons in it before it was retired and with some judicious use of ‘fair value’ provisioning to write down the carrying value of the acquired assets, the acquiring company could still nurse some fairly decent reported numbers into their own P&L for maybe up to 5 years.  All this though was just the usual financial smoke and mirrors act to obscure the same old reality that buying a few years of declining cash flow from someone’s creative labours is not a value accretive pastime unless it can fundamentally change the creative ethos of the acquirer; not an easy task for a big commercial broadcaster.

So here we are again. ITV continues to hoover up content origination assets, this time with its acquisition of John de Mol’s latest wheeze, Talpa Media.  Talpa, is a producer of format shows including “The Voice” and we are reminded by ITV that John de Mol was also the creator of “Big Brother”.  Somewhat strangely, “Endomol” which was the company co-founded by John de Mol and which produced Big Brother didn’t merit a mention in ITV’s press release on its Talpa purchase. For those that may have forgotten, Endemol was the production company that was sold in 2000 for €5.5bn to Telefonica who then sold out ultimately to a Mediaset controlled entity in early 2007 for €3.1bn. Having funded the acquisition largely with debt, the story then goes from bad to worse with debt reported to have grown to over €4bn by 2011, followed by a covenant breach and then a debt to equity swap in 2012. Okay, perhaps the omission to mention Endemol was not an accidental oversight after all!

An average EBITDA of €65m pa (vs 2014: €61m) for 2015-19 could secure 91% of the €1.1bn max consideration

So, has ITV managed to avoid the mistakes of its predecessors and pluck out the one perfect apple? Well to answer this one needs to have some idea of what it might actually pay for Talpa.  For €233m of revenues and €61m of EBITDA, ITV is paying an initial sum of €500m. Contingent on average EBITDA exceeding €50m pa for 2015 & 2016 a further €100m is due and then another €400m should average EBITDA for 2017-19 equal or exceed €75m. For the next payout however, the EBITDA hurdle for average EBITDA is raised to €115m for 2020-22, albeit the deferred element relating to this drops to only €100m. The very structure of this deal however points to the real winners in this negotiations; John de Mol (again).  The big ticket is the 2^nd deferred element of €400m and this can be achieved with an average annual growth in EBITDA of only +5.5% (as shown in the below chart). Given that the 1^st deferred element is contingent of achieving an EBITDA that is almost €10m pa less that already achieved in 2014, one might be excused in expecting Talpa to push returns into 2016-19 by recognising additional investment in the preceding period.  As for the jump in the contingent threshold for 2020-22, that is probably more to sell the deal to ITV shareholders as being a high growth business still at that stage. Excluding the last deferred element of €100m, I would expect this deal to cost €1bn, or around €800m NPV.  On a 5 year average EBITDA threshold of €65m pa to 2019, this would suggest an average EBITDA yield of 8% and EBITDA multiple of over 12x. If you believe that John de Mol will manage to increase Talpa’s average EBITDA by over 50% for the remaining 9% of the maximum sale value, then this may not look too demanding. If however, history repeats itself and 2017-19 marks the peak, then think Endemol, All American, MTM, Reeves etc,etc…

Yahoo unveils 'SpinCo'. Well it can't be plainer than that surely?

Yahoo Inc: New management has finally accepted what the markets have been trying to discount for some time; that with Jerry Wang’s legacy investments in Alibaba and Yahoo Japan, Yahoo was beginning to look like an investment trust. New CEO, Marissa Marr’s decision to split off the remaining (15.4%) stake in Alibaba into a new investment holding company therefore will provide investors with greater clarity on the value of this holding, albeit in itself, it does not alter the current value proposition for Yahoo shareholders. The headline from Yahoo may advertise that the manoeuvre will be “tax free”, but what this really means is that the tax liability is merely being transferred into a new bucket rather than being avoided. If the Alibaba stake was being discounted for this tax liability within Yahoo therefore, there ought to be no reason to assume that the discount will no longer apply when it is within the new vehicle. Perhaps we should have taken heed of the working name being given to this new company, “SpinCo”!. In the meantime, Ms Marr’s transformation of the core Yahoo business is proceeding slowly. Mobile revenues are rising rapidly (so what’s new?), but this has yet to translate into a turnaround in either Yahoo’s revenue or EBITDA trajectories which continue to erode. The markets need a healthy competitor in search to Google and will no doubt continue to wish Yahoo well, although the shuffling of its pack of investments can only distract attention for a limited duration before markets return to question this disparity in the implied growth rate being priced into the core business versus the limited delivery.



Trading Q4 FY14: After Q3’s excitement with the Alibaba listing and IPO gain, Yahoo’s Q4 returned to the more mundane job of running the core business where YoY revenue growth slipped from Q3’s +1% to a -1% YoY decline (probably mainly fx) and adj EBITDA fell by -14% to $409m (-13% to $1,362m for FY14; but -26% to $941m post stock comp). For Q4, revenues excl TAC declined by -2% to $1,179m, o/w search was flat at $462m (incl paid clicks +10% but price per click -7%) and display declined by -5% to $462m. Post stock comp, net income was down by -52%, partially recouped at the EPS line (-48% YoY from $0.33 to $0.17) due to the further contraction in share base (-7% YoY), while the adj EPS figure declined by -35% YoY from $0.46 to $0.30.

Outlook Q1 FY15: Co is guiding for revenues of $1,110m/$1,150m (vs $1,133m), revenues excl TAC of $1,020m/$1,060m (vs $1,087m), adj EBITDA of $200m/$240m (vs $306m) and adj operating income of $50m/$90m (vs $149m).


Note *1: Q3 results provided greater clarity on the potential gains tax liability on the groups holding in Alibaba with an estimated $3.28bn of tax due on the $10.32bn of realised gain at the recent IPO, an effective rate of 32%. The group has not clarified whether this potential gain liability on the Alibaba book value will be affected by its transfer to an investment company holding structure.

Tesco: Phase 2 - reset investor expectations

It’s always entertaining to see good people-management at work. As with a new Government, a new management needs to persuade the stakeholders that their predicament is substantially worse than previous team were letting on, but that with a little pain, the new team and plan (usually with a catchy name) will secure recovery by the time their contracts come up for renewal. This however requires a reset (down) in expectations, which usually is accompanied by the obligatory ‘kitchen sink’ job, followed by selected acquisitions with plenty of fair value adjustments that if handled correctly can often be written back to deliver the required ‘recovery’, albeit sometimes to below the original start point.

So far, we have had the ‘predecessor-trashing’ and now with the Dec 9 pre-announcement, we are being softened up for the reset in expectations. Management have given markets just one number (under £1.4bn for FY15 trading profit) and it is a bad one, suggesting a near -75% YoY collapse in H2 FY15. What we are not being permitted to see at this stage are the components of this performance; ie how much from a further deterioration in UK like-for-like sales or whether significant provisions and charges have been levied against this period that may not be recurring. Without these, markets will not be able to gauge properly the depth of the underlying margin trough or the businesses capacity to recover. For this (hopefully), investors will have to still await the planned announcement on the 8 January. By then, investor expectations ought to have tanked and markets will be grateful to suck up any plan that offers recovery even if to a substantially lower margin base than hoped for only a few months previously.

Enterprise Inns: Asset play or just value trap?

Enterprise Inns (ETI): With a share price at an almost 60% discount to NAV, this may appear to be a compelling asset play, albeit this argument might have also appeared valid when the discount was 30%,40% or 50%. As with banks in 2008, a balance sheet asset is only as good as the credibility it has that it can either be crystallised and returned efficiently back to shareholders or that the level of assets are a true reflection of their capacity to generate future free cash flow streams. For Enterprise Inns, the NAV of approx. 250p per share meanwhile drops to nearer 230p ps excluding intangibles (largely acquired goodwill) and this is the sum of 680p ps (£3.8bn) of fixed assets (mainly property) against an approx. 450p ps of liabilities (£2.5bn; £2.4bn being net debt). Assuming that the liability part of this remains stable (ie the group not being hit by refinancing, closure or other provisions), then the excess fixed assets over liabilities is £1.3bn (230p ps) or just 34% of fixed assets. With falling beer sales, pub industry revenues are in decline and with it, so have pub property values. Indeed, although ETI has been booking occasional small exceptional gains on estate disposals, the overall position is one where impairment charges of over £0.5bn (approx. 90p ps) have already been recognised by it on its portfolio over the past 4 years alone. With financial repression artificially supporting residential property values, there is a potential alternative use value that could provide a support, although at this stage there is little way for external investors to determine what this might actually be.

As an ongoing business, ETI’s valuation as an equity will need to take into account the lack of organic growth, notwithstanding the high cash costs of maintaining and upgrading the portfolio and the approx. £300m pa of EBITA, but nearer £250m pa on a cash basis (post capital expenditure rather than depreciation).   With an EV of approx. £2.85bn, ETI is therefore currently priced at approx. 11x cash EBITA and a normalised Op FCF yield of around 6%; the latter implying an annual discounted growth rate of around +4.5% pa. Against organic growth struggling to get to even half this level and no dividend support, this would seem ambitious. In summary a potential asset play on presently undefined alternative residential use as long as financial repression can sustain absurdly low current buy-to-let yields in the South of England, otherwise a ‘value’ trap.

In the meantime, the enthusiasm of the NAV is obscuring the growth rating being afforded the business. After several years of heavy investment in sprucing up the portfolio, organic revenues are beginning to stabilise, but still to well under the implied growth rating of the overall group.



Perhaps, markets are missing the future growth potential and scope for over-delivery? While always possible, this however is not reflected by consensus expectations where earnings moment remains broadly flat to down across 2014 (see below chart).



So, what we have is a business that may or may not have a potential asset backing which may or may not ever get distributed to shareholders, which is carrying a heavy financial leverage that is being serviced from flat to falling cash flow from an ex-growth business model but has still managed to command a premium growth discount.  Given the financial leverage, small reductions in growth discount have an amplified effect on the equity, so take the growth rating down by even 20% from the current +4.5% to even +3.6% and the equity component would face wipe-out!

November non-farm payrolls – Bah Humbug!

I can hardly contain myself with excitement. US non-farm payroll data for November is out and the headlines are that the +321k MoM additions (+314k for the more relevant Private sector jobs) “smashes forecasts” (Guardian) and that “The dollar has gone through the roof” (City AM). With another month of unemployment at only 5.8% (try to ignore the participation rate), this should get the President hot-footing it from the golf course to make another speech on how well his policies are working!

So what’s all the excitement about?   Yes, November has broken above the +300k level which nowadays is a pretty rare occurrence and on a MoM basis, the pickup in what should be higher added value areas such as Professional & Business Services, Construction and Goods Producing should auger well for incomes, albeit the evidence for that is unfortunately still rather tenuous with average weekly hours of 34.6hrs up by only +0.3% both MoM and YoY from October’s and last November's 34.5hrs and with average hourly earnings of $24.66 per hour up +0.37% from October's $24.57 and up by +2.1% YoY from last November's $24.15 per hr.



Notwithstanding the brouhaha, the year on year performance remains disappointing given the $80bn pm of QE ‘goosing’ for most of the period. Over 12 months, private sector employment growth of +2.3% has only just exceeded overall population on a percentage basis, but has struggled to match the absolute increase. From the below table, one can also see a mixed profile by industry. Normally high value added areas such as Prof & Bus Serv have done well at +3.7%, but the normal premium end of this in Financial (at +1.4%) and Legal (not disclosed but flat), have been struggling, so it looks like recruitment has probably been at the lower end of the scale. Temporary Help meanwhile leads to pack with an +8.5% YoY increase, with Leisure, retail and Service industries providing the main absolute drivers to YoY growth – more burger flipping and check-out jobs!



Where’s the growth driver?
With around two-thirds of economic growth coming from personal consumption, one has to wonder where this is going to come from. The 99% still look fairly maxed-out on their student loans, mortgages, auto loans etc and with property prices settling back the prospects for equity withdrawals and other forms of debt fuelled spending can’t be that good. Recent oil price falls and lower ‘gas’ (petrol/diesel) prices have been used to talk up consumption stories, although the offsetting inflation from food and health seem to have been borne out in the grim ‘Black Friday’ sales data (down over 10% YoY and not a function of online which seems to be flat).

Bah Humbug!
While it may seem unseasonal, it is worth taking a quick look at the numbers. With the public sector ultimately funded by the private sector, private sector income growth is a crucial component to overall GDP prospects. A +2.3% YoY increase in private sector employment with an average earnings up only a miserable +2.1% pa (annualised, less on a rolling 12 month basis), means total private sector incomes must be up by under +4.8% or by +$0.238 tn to $5.24tn. Against the approx. +4.0%/+$0.683tn increase in overall US GDP to $17.56tn over the same period, private sector income growth only provided 35% of this increase. How much of the remaining growth (of $0.445tn) can be directly attributed to the near $1tn of QE during the period will no doubt be cause for debate, but with sub-inflation income growth, more wars and more deficits a few more disappointing retail announcements and markets will be clamouring for “moar,moar moar”.

Airlines and oil prices

With fuel costs representing 45-50% of an airline’s operating costs and 35% of its revenues, it would seem self-evident that a significant movement in oil, and therefore fuel prices, would have an equally dramatic effect on margins; in particular when the industry’s margins are often the wrong side of 5%. The oil price however is a tide that raises or lowers all boats equally, albeit the same rate of price change will have a much more pronounced percentage impact on the less competitive and therefore lower margin players. As such, this might suggest a strategy of “buy the dogs” in the current falling oil price environment, although this would be a mistake. The problem is that margins are determined by the relative operating efficiency of the carriers and that ultimately any change in fuel as a cost component will be competed away. This is why there is such a poor correlation between the transport industry’s historic operating margin performance and its principal cost item, fuel (see below chart). Chasing the low margin airline stocks on the basis of a quick margin boost from low oil prices therefore is the wrong play. Instead, use the oil fueled rally to dump the dogs.

No negative correlation as one might have expected!

If you need to see what really drives airline margins, look no further than the macro environment. US private sector employment provides an accurate proxy for US corporate investment and US economic cycles and also for airline margins, as can be seen in the below chart. Oil prices provide a useful broker story for the muppets, but it is the bigger picture of the broader economy that really drives the industry. In this context however, the oil price movement cuts both ways. Is the recent collapse in oil prices a lead indicator of slowing demand and therefore a precursor for a negative headwind which will impact cyclicals such as airlines or something else? Certainly the involvement of Saudi Arabia in pulling the rug from under the oil price after meeting with Romney suggests an element of “get Putin” behind this, although this would not have been possible if the underlying growth out of the BRICs had not been softening and Europe not been sinking back into recession.

Transport industry driven by the top line not the cost line

P&G swaps Duracell at 7x EBITDA for shares in itself at 13x. Buffet wins again!

When a company such as P&G can sell 10 year debt at little more than a 3% coupon, then we should not be surprised at some of the pricing decisions being taken. With regards its subsidiary Duracell, it has a business in slow structural decline, which provides a drag to its own organic growth figures, but with good cash flow. With an adjusted EBITDA of approx. $670m and we estimate approx. $400m of underlying operating FCF, the $4.7bn imputed valuation being paid by Berkshire Hathaway for Duracell is 7x EBITDA, an EBITA yield of 12% and more importantly a 8.5% Op FCF yield. As a carry trade against even BH’s funding costs, this is obviously highly accretive to its short term earnings even without some clever accounting slight-of-hand to exploit tax shields etc. The high initial exit return however is a reflection of potentially diminishing longer term returns as demand for disposable batteries are displaced by rechargeables and against the still relatively high market cost of equity of around 10.5%, the exit FCF yield of approx. 8.5% is still discounting growth at around +2% pa. So from P&G’s perspective, it has sold an ex-growth asset at a small growth premium, although in the current environment this would raise the problem of what to do with the cash and the prospective earnings dilution. For a business struggling with only +3% pa organic revenue growth, one might have thought that the great P&G would have no shortage of projects where it could allocate the capital efficiently, as clearly it needs to raise its value proposition to customers.

Think again. As with most other large groups that can borrow at sub real longer term interest rates, money is being returned to shareholders and particularly via share buybacks rather than being re-invested back into their businesses. While this may often be value destructive, in that they are over-paying for growth, the low rate environment ensures significant short term earning accretion on which so much of board variable compensation seems still to be exposed to. P&G’s decision to effectively swap Duracell for BH’s shareholding in P&G therefore makes perfect sense from the distorted perspective of financial repression, but may prove less attractive if reviewed in hindsight should markets ever recovery from central banks the role of pricing capital. Accepting its own shares at 13x EBITDA for payment of a subsidiary sold for 7x, or selling a -2/0% growth business on a +2% growth rating for a +3/4% growth business priced at a +6/7% CAGR is no more than a short term game in relative returns and ought not to mistaken for a real value proposition. BH may well be overpaying for Duracell, but this is more than compensated by the premium received on its P&G stake. P&G however has merely recycled its Duracell premium into paying an even bigger premium for itself while doing nothing to address the real problems of restoring its own organic growth.

ITV - Onus on content delivering the goods as NAR growth slows and audience share erodes

New management with a new veneer to the content strategy and a cyclical recovery in UK TV advertising have all encouraged markets to give ITV the benefit of the doubt that this time it can manage the transition from distribution monopolist to a more balanced content origination and distribution business, albeit in a considerably more fragmented and competitive environment.  As advertising comes off its QE and World Cup highs and content acquisitions bed down markets will need to review whether there is scope for structurally raising an already competitive operating margin of around 30% or whether the growth in demand for its originated content will be great enough to offset the prospective erosion in free to air audiences (NB 9 mth SOCI -6% YoY)and share of future advertising to support the current approx. GDP average growth rate implied by the operating free cash flow yield.  Acquisitions of content originators, such as Pawn Stars producer “Leftfield”, usually sound beguiling initially, but these are invariably bought at their peak and only justify the prices if they can continue to originate new hit series. Anyone remember “MTM”, “Reeves and Allen”, “All American” or “Grundy”? Nuff said!

Trading 9 month IMS:  Revenues reported up +8% including +6% for NAR (implies Q3 at +4% vs +4/5% target and +7% for H1) and +24% for online and +10% for Studios (all acquisition led). Notwithstanding the World Cup in the summer, viewing share remains disappointing with overall share (SOV) for all ITV channels down -5% from 23.0% to 21.8% and Share of Commercial Impacts (SOCI) -6% from 38.4% to 36.1%. Total ITV adult impacts declined by -9%, although long form video requests increased by 24%. Costs: Co reporting it is on track to deliver the planned FY14 savings of £15m.

Trading H1 FY14:  Revenues +7%/+£81m to £1,225m including NAR +7%/+£54m to £795m, online +20%/+£11m to £65m and Studios +6%/+14m to £240m (-10%/-£23m organic however).  EBITA advanced by +11%/+£31m to £322m, including +10%/+£22m to £250m for Broadcast & Online (o/w gross margin for broadcast increased by +14%/+£14m) and +14%/+£6m to £78m for Studios.  Including reductions in funding charges, adjusted PBT increased by +16% to £312m with EPS +15% to 6.1p and DPS +27% to 0.3p.

OUTLOOK:  FY14 NAR growth is forecast at +5% with Studios up by approx. £100m after absorbing around £30m of fx drag. For FY15 the group is predicting improved revenues based on a positive economic outlook, an additional 2 new channels and a return to organic growth for Studios and a focus on improving SOV from investments in new scripted content.  Well, that’s the plan! It does however suggest additional investment in origination (and deficit financing) which may provide a margin penalty. In itself that ought not to worry markets, but only if balanced by viewing improvements, otherwise we are back to where we were a few years ago, albeit with a less stressed balance sheet if one turns a blind eye to the increased pension deficit (from -£362m in June to  -£456m in September following reductions in discount rates).

ITV growthrater tab

Digital plonkers

WPP’s annual digital investor day provided Sir Martin Sorrell another opportunity to show off his digital wares as well as take some entertaining swings at rivals; particularly the “plonkers” who had recently been over-paying (ie out-bidding WPP) for digital assets and particularly those in Brazil. Comment est-ce qu'on dit ça en Francaise Maurice?

At some point ‘digital’ media and interaction will become so ubiquitous, it will become obsolete to try and split it out as a discrete area of activity for marketing agencies. In the meantime it will provide a rich seam to be mined for corporate finance and purveyors of charts showing the exciting growth opportunities in most things digital that can be displayed to starry-eyed investors.

A digital presentation needs a chart showing digital growth, so here it is!

Yesterday’s digital investor day by WPP therefore pretty much delivered to cue; lots of charts with lines rising diagonally from bottom left to top right together with accompanying suits from often recently acquired digital properties to explain why their piece of the pie was going to grow faster than everyone else’s. This was clearly not the forum for discussing falling gross margins, sub-GDP net sales growth or the reliance on acquired digital skills and the extent to which these acquired intangibles are consumed and therefore ought to be recognised as a real P&L and cash flow expense.

Amongst all of the digital brouhaha however was a chart that was so incongruous as to represent a sort of Banquo’s ghost.  This was the rather worn analysis of comparing time spent on various media with the proportion of advertising expenditure.  The premise of course is that the two should ultimately converge and therefore digital budgets (especially mobile) should continue to rise.  Forget the billions spent on marketing effectiveness studies and research to measure and improve advertising effectiveness and accountability, let’s just assume a linear relationship of time to effectiveness regardless of media and type of interaction and plan budgets accordingly.

Time = Value? really?!!!

I am not too sure what place a chart such as the one above still has in a presentation of digital businesses whose main value proposition is that they can improve marketing effectiveness and therefore de-commoditise the time/spend relationship and better identify which “half of the advertising budget is wasted” as allegedly quoted by John Wanamaker.  Perhaps WPP was trying to keep it simple for the audience, although perhaps there remains an element of truth in it as well. Despite all the spend on research and data, perhaps a large section of the advertising customers really are so unsophisticated as to run with such a simple an unrepresentative metric. Heck, it’s not as if financial markets are any better. How many investors still value stocks on a price to earnings ratio (PER) and usually against an earnings denominator that has been adjusted by the company to exclude all the bad stuff (EBBS  - earnings before the bad stuff) and also may have little connection with the real cash flow or profitability of the business?

In the real World, it may be that little has really changed over the past decade when I trawled through a number of planning and buying agencies to try and understand whether there was an objective basis to determine the relative effectiveness of various media.  I remember the shock of discovering how little hard data to measure marketing cause and effect there actually was and the extent to which budgets were allocated on soft metrics including share of voice, competitor media mix, unaided brand recall and a whole host of other factors that were divorced from any type of ROI analysis. In yesterday’s WPP presentation, it’s market research head, Eric Salama presented his strategy of connecting audience measurement with retail measurement, as Nielsen tried with Apollo about a decade ago (without success), and in another attempt to get closer to that holy grail of market research, measuring cause and effect.  Unfortunately theory and execution can be strangers in this field. As other panel members were pressed to back-up their value proposition claims or discuss forecasts of changing media mix in budgets they often appealed for Eric to step in with some data to support their position, but to no avail. If Eric’s division has been able to measure relative effectiveness of marketing spend by media platform, then he was keeping it to himself!

Recency bias – the curse of financial markets!

We are all guilty of it, but it is probably the single most dangerous investment sin. Perhaps it is part of our social evolution to conform. A sort of “Eat shit 17 quadrillion flies can’t be wrong”. With regards to financial markets you may have seen the same shit, but given a pseudo- intellectual spin such as “perfect market theory” or its ilk which implicitly suggest that markets are right and you are wrong, albeit an imperfect market theory would be just as valid. Human capacity for self-delusion based on information and normative conformity bias is well documented and includes Asch’s classic Conformity experiment which is well worth watching, if only for the appalling 1970’s hairstyles.
http://www.youtube.com/watch?v=sno1TpCLj6A
Ok, so over the past five years we have been taught that bad news is good news as market liquidity is dominated by central bank policy and that all dips should be bought (see http://www.youtube.com/watch?v=0akBdQa55b4) and that yield is good, almost regardless of risk. If it’s gone up in price, find a justification, however spurious and then flex the assumptions to add at least 10% to the price to keep compliance happy with the endless buy recommendation. This self-reinforcing consensus however is little more than a mass goal-seek. Sell side careers do better during the longer periods of cyclical upswing and if it all goes pear-shaped, then the flawed recommendation can be buried along with the general debris. For buyside, the pressure on short term returns is also intense and bucking the trend can also be expensive to careers, ergo momentum investing rules and in turn merely reinforces the conformity bias until the big reset. A particularly interesting feature of the Asch experiment was also the effect of introducing an additional potential dissenting voice to the group and the speed at which it could puncture the group delusion. Quite what will represent that ‘additional voice’ in today’s markets will have to be seen, but take care because when it happens, as it always does, it will be quick.

I was reminded of the pervading power of recency bias in a meeting with an investment manager who was interested that my growthrater system did not share his upbeat view of the value of a stock; in this case Nestle, a solid consumer group with a good record of historic growth but with current revenue growth falling short of the expectations that rising Asian demand were expected to deliver. Notwithstanding, the investor was probably referring a post interest cost of capital (WACC) rather than a more robust pre-interest one, his position was that the market (aka big sell-side) were pushing the stock on the basis of a seriously sub-market cost of capital. If growth is slowing and volatility increasing however, this looked more like a goal seek to justify where the stock, or they would like it be, rather than a serious revaluation argument. In the ‘growth-rater’, the equity risk premiums used are those for the market average, with the flex in target operating free cash flow yield determined by variances in discount growth rating. Unlike the above flexing of specific risk premium, this is not a function of a subjective discount plucked out of the air to goal-seek a share price, but directly related to what the company is actually achieving and is expected to deliver in terms of organic revenue growth. As a consequence it is considerably more immune from the group goal-seek. It may provide uncomfortable results, but this should be expected from any rigorous structured approach. My response to the cost of capital issue on Nestle is simple and demonstrated with two charts. First, the chart of the group’s organic revenue growth vs the growth rating being priced in by markets against the backdrop of the share price. From 2004 to end 2011, Nestle’s organic revenue growth was consistently above the growth rate that was being priced into the shares. In other words you could buy growth at a discount, ie Cheap. After that point, the relationship inverted and markets were pricing growth at a premium to that being delivered, a feature that has become more pronounced as organic revenue growth rates erode, ie Expensive. As the Growt-rater automatically provides target price ranges (second chart) one can see that the time to buy Nestle was before the shares outperformed and the to sell it before it went down. Now how about that for a revolutionary investment strategy!

Cheap growth for the price up to end 2011, then expensive

Back-test analysis of target price ranges

Publicis bids $3.7bn for Sapient Inc. - how to buy 'organic growth'

Finding a marriage of 'equals' with Omnicom was not to its tastes, Publicis is back to what it does best; hoovering up smaller digital marketing operations. When you are not a Wonga client and can borrow at only 2.6%, then buying in a business on an operating profit yield of approx 5.5% before synergies and 7.0% proforma post synergies also makes a lot short term sense in terms of short term EPS accretion, particularly when it enhances your own flagging organic revenue growth and you can step-up the proportion of claimed digital component from 40% to 50%.  EPS accretion however does not equate to value enhance in these QE distorted markets

So what is Publicis buying here? Sapient is essentially a consultancy business focusing on digital marketing solution for range of both commercial and government clients. Revenues are substantially generated from fees (usually time +costs) and as with all consultancies, compensation is the major cost. At almost 72% of revenues however it is considerably higher than the approx 60% ratio for most larger marketing agencies, notwithstanding that 66% of Sapient's staff are located in India. In terms of historic revenue growth, Sapient's performance  has been good at >+10% pa, albeit with limited operational leverage to margins that remain at under 11%.

  The valuation
Historically, Sapient has traded in a growth rating range of +3.8%/+6.8% and a mean average of +5.2% against an average revenue growth rate range between +5%/+25% and +14% average.  Applying a growth rating range of +5.6/+5.8% on prospective operating FCF, the valuation for the stand alone enterprise comes in at approx. $19/$21 per share vs the $25.0 ps cash offer being made this morning by Publicis

Sapient worth $19-21 ps pre-synergies

Mapping the WYT npv calculator into a chart (below) suggests that the shares had not been running ahead of their growth delivery in the run up to this offer



Post acquisition synergies take the valuation range to $25-$26 per share

Publicis is a past master in eking out cost savings from its acquisitions without imploding  the acquired growth.  For Sapient, Publicis expects to extract cost synergies of $50m/$60m pa which is probably an under-estimate on past performance. Adjust Sapient's earnings for this to derive a proforma operating FCF and see what happens to the valuation in the table and chart below.

proforma incl €50m savings

Include an adjusted chart history and presto!

Proforma

Markets find it tough to break the BTFD conditioning

Was the Friday rebound in equity markets another BTFD opportunity, or a possible suckers rally? Certainly, the wall of central bank liquidity over the past five years have reduced the market’s pricing mechanism to little more than a pavlovian response to the next turn of the central tap and where bad news can be good news for prices if it raises expectations of a bigger flow.  News however, whether good or bad that does stimulate more liquidity may just be bad news.  

Last week had a lot of ‘bad’ news. This however was not new bad news. The US continues to goad Russia, albeit now through bombing its ally Syria and getting its own ally Saudi Arabia to cut oil prices on which Russia also depends. Ebola continues to spread, which is bad for airlines, but good for pharma and security. Japan continues to struggle with radiation, a collapsing economy, rising real inflation and what should be an utterly discredited and failed QE policy.  Europe meanwhile continues to grind back into recession, but having approached the moment of truth may be shying away from the full QE programme that advocates were predicting after Draghi’s recent Jackson Hole speech.  Notwithstanding a partial attempt with an ABS programme, this fell short of expectations and so bad news was just bad news and markets reacted accordingly.

Unfortunately, market volatility is an inevitable consequence of the deliberate confusion about the nature of the ECB and Euro that has been sponsored by politicians and central bankers. At the centre of this has been Merkel who has been trying to ‘hunt with the hounds and run with the hares’.  EC treaties are clear and indeed have been paid lip service to by Draghi when he re-iterates that the EC is “not a transfer union”.  His actions however belie this, including advancing ECB liquidity to domestic banks who have used this to buy local sovereign debt in the secondary market to circumvent the ECB’s prohibition to fund primary debt. Notwithstanding the German constitutional court’s ruling in February (which had been sat on for around 9 months) that the ECB’s OMT plan “manifestly violates” the EU treaties, Merkel seems happy just to turn a blind eye while playing a ‘good cop, bad cop’ game with Bundesbank president Jens Weidmann.  This, together with Draghi’s “whatever it takes” and subsequent utterances have goosed the market into believing peripheral EU sovereign debt is now backstopped by the ECB and therefore German tax-payers. German tax-payers however have not been consulted and seem to be in no mood to comply, as today’s comments from a key Merkel ally, Hans Michelbach of the Christian Social Union (CSU) might suggest. Not only is Draghi accused of “endangering the stability of financial markets”, but more pertinently Herr Michelbach reminds us of the now largely ignored constitutional court ruling and that “The ECB needs to change its policies so that they come back within the terms of the treaties”

http://uk.reuters.com/article/2014/10/04/germany-ecb-draghi-idUKL6N0RZ07N20141004

So bad news in Europe may not be the ‘good’ bad news that markets have run with during the US QE programme, but ‘bad’ bad news for markets if the ECB is approaching that crisis point where it has to reveal whether it has any real bullets in its monetary pistol or has just been fooling us with blanks. Perhaps by taking Europe to the cliff, Draghi feels he can present the German tax-payers with a fait-accomplie from which they dare not refuse, as such a refusal would have devastating consequences to peripheral bond markets and banks. Germany’s decision however, will not be telegraphed to us muppets ahead of time. With peripheral Euros now invested back into peripheral bonds and banks, the creation of a hard currency Northern block at this stage would not be saddled with a mountain of peripheral euros in Germany which might have to be converted at par into the new Deutschmark. While the ‘soft’ Euro areas would then be free to monetise debt and devalue, yields would rise significantly and there would be no shortage of burnt positions amongst bond investors.

So what was the cause of Friday’s market euphoria, a cure for Ebola, peace on Earth? No, it seems a slightly better than expected monthly job growth figure in the US non-farm statistics for September.  To qualify as a ‘good’ figure for markets however would either be a really ‘bad’ number that would raise the prospect that Yellen would defer the QE tapering and keep the liquidity tap and low rate environment going indefinitely or a figure that was so good as to signal a serious acceleration in US GDP growth prospects. Unfortunately neither of these would apply to the September numbers. At +248k net new jobs (+236k private), US job growth was around +30k ahead of consensus and the trailing 12 month rolling average of approx. +213k, albeit in large part reflecting a +40k MoM swing in retail (from -4.7k in August to +35.3k in Sept).  While the numbers are ‘so..so’, they do not deserve the praise heaped on them by political spin doctors who focussed on the flawed unemployment ratio (-0.2ppts to 5.9%). 

Perhaps a little perspective is needed for this political hot potato. First, the context. For the year to end September, US private sector employment increased by +2,588k/+2.25% to 117.524m versus a total civil non-institutional population that increased by +2,278k/+0.93% to 248.446m.  This is hardly spectacular given the government and central bank largesse over the period with private sector job growth only just exceeding population growth. But what about incomes?  Average hours have barely changed at 34.6 pw (vs 34.5 pw) while average hourly earnings are struggling to keep pace with inflation with a +2.0% YoY increase to $24.53 p hr (from $24.04 p hr) to take average weekly earnings from $830.07 pw to $848.74 pw, an increase of +2.2% YoY.  Multiply this by the increase in employment and this implies that private sector wages increased by +4.6%/+$225.8bn to approx. $5.2tn. Although this may seem ok, there are a couple of points one may need to consider. Firstly, don’t forget that the private sector ultimately has to support the entire working population and that these figures are nominal. Also, remember that the US economy is worth approx. $17bn pa, which means that the $225.8bn increase in private sector wages is equivalent to only +1.3% of GDP.  If consumption accounts for around two thirds of GDP in the US, clearly private sector wage growth alone will not be offering much of a boost this year!

So back to Friday’s market bounce. As the dog might utter, “Woof, Woof”

Budget airlines soar in September, but war of the handbags still being fought

Ryanair is still packing in the passengers (Sept +5% with load +5ppts to 90%  vs +7.5%/+2.5ppts respectively for EasyJet), although with the Air France strike settled and the end of the summer holiday season I would expect the Oct traffic figures to be a little less supportive.  The stock is still my preferred one in the sector (Valuation -growing faster than is being priced in,  momentum - weak Eur & oil price benefits persisting into year end, strategy - extending into the lower premium market, volatility - regional vs global carrier & balance sheet), although whether the sector is that safe is another matter! 

Oil/fuel is lower, but that partially reflected weak GDP expectations as well as US/Saudi price manipulation to get at Russia. Geo-political? Rhetoric on Ukraine seems to be easing, but US bombing of Syria is reckless - one bomb or Buk missile and ....! Terrorism?  More bombs seems to produce more domestic jihadists which doesn't exactly help airlines.


A handbagging?

An obvious alternative to Ryanair is its smaller rival EasyJet (Sept passenger numbers of 6.13m vs Ryanair's 8.5m). While EasyJet is not currently loaded on to the WYT growthrater yet, there are two areas of divergence I see. One is the obvious one of currency in that Ryanair reports in Euro and carries a higher proportion of Euro costs, so will be a beneficiary of the current weak Euro policy being pursued by the ECB. The other is the perhaps shock change in Ryanair's approach to passengers. Travel on an EasyJet flight and you will see the thunderous faces of women forced to stuff their handbags into their hand luggage to avoid being fined by the bag gestapo for breaching the one hand-luggage policy. Most airlines used to take relatively relaxed approach to hand luggage. A woman could take her handbag while a bloke would be allowed through with a laptop bag. Not anymore for EasyJet however, and I was not surprised at the ferocity of the grumblings by the ladies on the last EasyJet flight I was on. Get between a woman and her handbag is not a wise move!
Since the end of last year Ryanair has been allowing passengers to carry on a second small bag (35 x 20 x 20). Although a small step, I would not underestimate the impact on particularly women passengers and their future flight preferences when choosing a budget carrier.

"It's okay Ma'am, it's not EasyJet"

Ryanair (WYT npv)

 

 See also WYT blog
http://wyt-i.com/wp/?p=771