Tesco moves to stage 2 of its 'recovery'

UK supermarkets are a bit like the beer they used to sell; bland and too many of them. Tesco however is working on that one as it culls its less profitable sites and brands (including the #4 UK brand, Carlsberg) to restore its growth and margin metrics, even it means from a lower base of revenues and margins. Tesco's interim results released yesterday therefore reflect this dynamic of what was a slight deterioration in actual UK sales growth in Q2 to -0.9% YoY vs the -0.4% posted for Q1, but having eliminated the weaker perfomers from the average meant that the Q2 like for like sales in the UK surged from -1.3% to -1.0%, to take the first half average to -1.1%. While a considerable improvement on the prior trajectory, it was not without cost, with UK & RoI operating profits collapsing by 69% (-£377m) to only £166m and a margin down -200bps to only 0.9%. Given the profit decline of -£377m substantially exceeded the underlying revenue decline of -£226m and that the group had taken around £6.8bn of provisions last year to help pad out the bottom line this is a pretty remarkable performance. Either management is keeping its powder dry for the great cost led margin rebound just ahead of their option vestings in 2-3 year time or the apparent stabilisation in top line sales was expensively purchased out of gross margins.  While this may keep some pressure off the new management, this is no substitute for a sustainable recovery, particularly when the share price is still reaching out to well above even where consensus forecasts are anticipating in FY17.

With underlying organic sales growth still negative and the shares trading on a current year prospective operating FCF yield of possibly under 3% markets are clearly reaching out into a future where a restoration in operating margins and possibly also near market average growth rating may also be in prospect. If one were to take a fairy upbeat assessment that the group ought to be able to justify an underlying growth rating of around +4% pa (and circa 7% Op FCF yield), then we estimate that the group needs to convince markets of its capacity to restore operating margins to near peak levels of around 5%, or to over +50% above where consensus estimates are currently for FY17. We may be through the trough, but is the pace of improvement currently being delivered by either Tesco or its competitors really enough to take us to these valuation highlands within a credible investment horizon? At this stage, the group needs to a capacity for some serious over-delivery rather than merely tracking existing expectations.

A serious over-delivery against current consensus out to 2017-18 will still be needed

du Pont - So bad its good!

Guidance slashed and CEO dumped. Shares bounce however on appointment of break-up artist and more layoffs.

Up until today (6 Oct 2015) the narrative of a weakening underlying performance from macro and fx headwinds (particularly around Brazil and Agriculture) was trumping the speculative aspirations of activist shareholders such as Peltz and an EPS guidance that was increasingly reliant on share buybacks and lower tax provisioning. With the sudden ‘retirement’ (firing) of CEO Ellen Kullman accompanying a further trimming of current year earnings expectations however the narrative is shifting. Now bad is good; a bit like the macro relationship markets have with the Fed. It is not so much due to the announcement of the acceleration and extension of the existing cost reduction programme, but the appointment of Edward Breen, an existing Du Pont board member, as interim Chairman and CEO, ahead of the proposed search and appointment of a full-time replacement. Mr Breen of course was the CEO of TYCO who oversaw its three way split back in 2012 and for those who managed to get out of the shares before 2014 will have very happy memories of the subsequent share price outperformance under his watch. TYCO’s more recent performance however also serves as a reminder that you that repackaging the pieces is not a real substitute for real organic growth any more than a series of debilitating layoffs (ask HP shareholders!).

Markets like the idea of Edward Breen's appoinment who was CEO at TYCO and over-saw its three way breakup at end 2012. The shares performed strongly, although only for a subsequent 18 months and the shares relative to the S&P are pretty much back where they started. Breakups are often better in the telling than the realisations!

Run with the breakup story but know when to cut and run!

Has MailOnline discovered irony or was it just a cock-up?

Perhaps the successful Mail Online should stick to celebrity gossip as its foray into serious issues seems prone to schlock.
While lacking the pithy wit of a News of the World headline, the Mail Online’s recent article on China’s alleged mistreatment of Falun Gong certainly pulled few punches with its title:
“Thousands of religious prisoners in China had their livers, kidneys and corneas ripped out while they were ALIVE to sell to ‘transplant tourists’, claims new film”
http://www.dailymail.co.uk/news/article-3257383/Thousands-religious-prisoners-China-livers-kidneys-corneas-ripped-ALIVE-sell-transplant-tourists-claims-new-film.html#ixzz3nUwZKrMT
On first reading, the article seemed be a one-side puff piece promoting and anti-Chinese film with its “most compelling testimony” coming from a doctor, who just happens to be a Uyghur. Was there no balance to be had? Are the Chinese authorities that evil and when is the computer game out?

But “STOP THE PRESS!”
….the article does have balance, although you have to be able to read Chinese to get it.
In one of its pictures (below) the articles shows the groundswell of support for Falun Gung in Hong Kong from some clearly hardened radicals – well mainly little old ladies. Read what is actually written on the banners however and you’ll see that they are saying quite the opposite to what the Mail Online’s caption purports. Far from them “appealing for recognition for the Falun Gong’s plight” as claimed by the article, the banners are actually urging people to distance themselves from the evil religion of Fallun Gong (the black script) with the scripts in red making various complaints against the sect including accusing it of attacking China and attempting to de-stabilise Hong Kong by aligning it with foreign powers.

It’s okay, Gwailo’s can’t read chinese!

Somehow, I don’t see the Mail Online as being big on irony so either this was a simple cock-up by the picture editor who can’t read Chinese and the editor who didn’t think to check ( – come on Chinese is not exactly a minority language) or was selected by someone who knew exactly what is being said on the banners in the picture and maybe disagreed with the political narrative of the article.

Either way it’s all rather reminiscent of when the media was showing us fake pictures of Russian tanks supposedly invading Ukraine when in fact they were stock photos taken in Chechnya a few years before.
Well done guys, best stick to articles about the size of Kardashian’s booty.

Making the evidence fit the narrative

Yellen - "Who are you calling chicken?"

Yellen - "Who are you calling chicken?  cluck, cluck, cluck"

LoL - Yellen chickens out of hike interest rate as expected. Indeed, one FOMC member appears to be expecting negative rates.  Just confirms that the Fed has no idea how to get the patient off the hopium. This party is going to have to carry on until we finally get a currency collapse. With the Yen a prospective basket case, the Euro sumberged in under a migrant invasion and the Renminbi with a credibility problem however, the US dollar remains the only game in town, at least for the moment. Good news for gold and silver for those wanting to avoid the impending train wreck.
http://wyt-i.com/wp/wp-admin/post.php?post=904&action=edit

Economists predict 2018 for the next recession – LOL

Well that's okay, according to a recent survey by Bloomberg, most economists don't think the next recession will be until 2018. As most of these are employed by banks with a vested interest to pump shares, this is most convenient, at least on two fronts. Firstly, the very low risk of an early recession is supportive of market buy recommendations. Also, the date where a recession is seen as most likely, is so far out as to pitch it beyond the normal three year forecasting horizon of the stock analysts. The means fewer embarrassing inconsistencies between the two groups to explain to compliance.

Of course for a group that couldn't forecast its way out of a paper bag, such long range forecasts are little more than PR; indeed on past performance it probably means the next recession will be anytime except for 2018.  Any quick search on the subject will provide ample evidence to the accuracy of past forecasts.

Well now we know when it won't be!

One such analysis was conducted last year by a couple of IMF researchers titled:

"Can economists forecast recessions? Some evidence from the Great Recession"

The authors are senior research officer and advisor, respectively, in the IMF's Research Department.
http://forecasters.org/wp/wp-content/uploads/PLoungani_OracleMar2014.pdf

In their study, they looked at recession predictions for the 2009 downturn at different points, with the initial date being the September prior to the year ahead. For 2009 therefore, this would have looked at forecasts that were being made as at September 2008. As one can see from the below chart, a glorious ZERO number of economists were predicting the 2009 recession at this point. While one might wish to be charitable and claim that this is a long way out, this is considerably less than the forward reach of thecurrent Bloomberg forecasts. It is also a howler in that there was very clear evidence by the end of 2008 that the wheels were already falling off the US economy. Amazingly something completely missed by these economists, although not by the market, which had been pricing the collapse in from at least a year previously.


Number of Recessions Predicted by September of the Previous Year

100% miss rate for 2009 recession just 1 year out

So what was this evidence?
No less than the US non-farm payrolls which is a very reliable indicator of corporate confidence. Reliable in that in thirty years there had never been a false negative. When month on month payrolls had contracted by over 200k, it always preceded a recession. In February of 2008 private sector payrolls had fallen by around -114k MoM and by April the monthly decline was running at over -200k per month. By September of 2008, when the economists forecasts for 2009 were taken, the monthly private sector payroll decline was over -480k! So while the data from what companies were actually doing was screaming recession, the official line as parrotted by the economists was "don't panic".

US industry had been sacking staff aggressively since Feb 2008

Expect Yellen to chicken out again on any meaningful rate rise for September

Will she or won’t she? It seems with Fed interest rate policy remaining the only game in town, strategists are stuck with trying to second guess Yellen’s next move at the forthcoming FOMC on 16-17 September. Of course we’ve been here before and we can look at all the evidence and data under the sun showing that rates should have gone up years ago and that the current ZIRP regime is counter-productive. Once again, we don’t think Yellen will raise rates, or at least not materially. Not because of the data, because most of that from the upward revision in Q2 US GDP (from +4.4% to +5.9% YoY – at nominal prices) to the fairly steady progress in employment and incomes would be supportive of an increase. Nor do we think because of slowdown scare stories out of China. Official China GDP data has been looking increasingly suspect for years and the blow-off in domestic equity prices was in large part a correction to credit fuelled speculative bubble which the Fed ought to be attempting to unwind itself. No, we don’t think she’ll raise because she doesn’t need to. Barring a brief wobble on one recent bond auction, the Fed doesn’t need to offer higher coupons to get its debt away, at least not yet. With ECB NIRP and a suitable level of political chaos being maintained globally, the US dollar remains well bid as do Treasuries, with yields easier across the maturity range. With sign that manufacturing competitiveness is already under pressure from the stronger dollar, why would Yellen want to compound the pain with an even stronger dollar while also risking snuffing out the credit fuelled consumption that is still keeping the US party going. Like Carney, she’ll talk the talk on rates, but push out the point when these are likely to impact into the year-end or beyond, if currency markets permit.

US private sector jobs +2.5%, average income +1.4% therefore total US private sector income +3.8%

So what of August’s NFP numbers? At +173k MoM overall and +140k for private sector jobs, the numbers were a little less than the >+200k estimates preceding them, although the August holidays can sometimes make the numbers a bit lumpy. On a YoY basis this represented an increase of +2.2% overall and +2.5% for private sector jobs, which after a +1.4% rise in average wages implies an approx. +3.8% YoY overall increase in US private sector gross incomes. Not a particularly rampant performance, but nor was it something out of line with what was being delivered over the previous cycle and certainly not something that would suggest the need for endless Fed life-support.

Average hours -0.5% vs Av hourly wage +1.9%

In terms of the components of this +1.4% YoY average wage increase, this included a +1.9% increase in average hourly wage which was slightly down from the approx. +2.5% being achieved earlier in the year, but a -0.5% contraction in average hours being worked. As reductions in overtime and hours worked can sometimes precede a more general contraction this will no doubt be kept under review by the Fed, although as one can see from the below chart this can also produce a number of false negatives.

Interest sensitive industries of Auto & Construction still hiring

By industry segment, the collapse in commodity prices has had an immediate and heavy impact on the associated ‘mining and logging’ employment segment (including oil) which should come as no surprise. A high US dollar has been slow to impact manufacturing employment, which is only just starting to tail off, while continued credit availability seems to continue to underpin construction and Auto related areas; notwithstanding the increasing erosion in share at the latter from international competitors. With both these areas sensitive to credit availability and rates, we would expect Yellen to be reticent in adversely impacting these.

So what does this mean for Wall Street? - More of the same, albeit perhaps with more emphasis on acquisitions and mergers than just share buybacks. For example, for the 5 year period 2010-15, the US quoted groups under our coverage converted approx. 71% of net income into FCF (vs 89% equivalent for 2002-07) and spent approx. 17% on acquisitions while returning 75% back to shareholders, with the remaining c.8% used to reduce debt.

71% of US FCF returned to shareholders in last 5 years

FCF generation and capital allocation 2002-07

For GfK, another guidance miss could make it the next target

For more see:  www.growthrater.com

While organic growth lags the growth rating the shares underperform - surprised?

Having adopted a “shape for growth motto” for 2015, GfK is struggling to deliver, with its core syndicated electronic research business hit hard in Q2 from the backwash from weakening Chinese demand. While the group is doggedly maintaining its full year 2015 guidance to deliver growth in organic revenues and its adjusted operating margins, these (again) look increasingly ambitious without some creative allocation of yet more costs into excluded “highlighted items”. With its projected FY15 sales only 78.5% covered by its order book as at end June (down from previous year’s 81.6%) and considerable reliance being placed on a couple of TV audience measurement contracts due to kick in at Q4 (Saudi Arabia and Brazil: usually low margin initially), the most positive spin one might be able to extract from the current performance is whether a second potential guidance miss now acts as a catalyst for a long overdue corporate merger with another player, such as Ipsos.

Zoopla stabilises agency membership which sugar coats 'Value Creation Plan'

For more see - https://www.growthrater.com/growthrater/#/summary

Stabilising agency membership underpins revenue delivery above growth rating

Last trading report – IMS to end July 2015: The pill investors are being asked to swallow is a new incentive scheme that could reward the CEO with up to 7.5m new shares (via nil priced options) over the next 3 years dependent on a TSR exceeding +8% pa.
More details here - (www.zpg.co.uk/sites/default/files/trading-update-aug-2015.pdf)
The sugar coating however, is the confirmation that after the mauling from AM at the beginning of the year, agency membership numbers have stabilised, rising by 213 since March to 12,556 at the end of July with churn rates also reported to have returned to more normal historic levels. New home developer members however seems to have slipped back a little with July at 2,672 members vs March’s 2,781. Overseas member though have hardened (from 664 in March to 684 in July) as have commercial members (from 182 in March to 219 in July) to increase the group’s overall membership at end July to 16,131, an increase of +55 (+0.3%!) since end March. Overall listings meanwhile are reported to be up +7%, from 828k to 882k, uSwitch is “trading well” following the acquisition and the management is “confident of delivering FY15 results in line with expectations”.

Pearson CEO buys more time by selling FT Group and Economist stake

Pearson is pricing in a +3.9% CAGR growth rating but has delivered only +1% organic revenue growth in H1 FY15. Deferred revenues however were up +3% organic at end H1, which if translated into similar improvements in H2 organic revenue growth would put the group on course to perhaps delivering +4-5% for FY16 and therefore comfortably exceed the growth currently being discounted by the shares. A strategically sound corporate disposal at an attractive price, while expected, is nevertheless a crowd pleaser to buy some time for management to deliver on its investment plans.
(For more register at www.growthrater.com)




"Over my dead body" was the alleged retort that the previous Pearson CEO, Marjorie Scardino made when asked whether she intended to sell the FT Group. Of course, Marjorie had been CEO of the Economist before taking the top job at Pearson, so may have held a personal attachment to financial publishing. Not so her successor, John Fallon who, while chief spin-meister for Marjorie, was getting it in the neck from both the buy and sell side for not dumping the businesses at the top of the market at the time when Murdoch was paying nose-bleed prices (not a Trump/Kelly analogy!) for the WSJ.

Strategically, the sale of the FT Group and now its 50% stake in the Economist was always a no-brainer given the Pearson focus on educational publishing. The reason for its current timing may seem to reflect the differing priorities and background of a new CEO, but the reality is far more mundane; John needed to sugar the pill of stalling growth and falling earnings as he reinvested into online remedial learning tools at a time when the rug was being pulled from under the College market.  Under Marjorie's watch, school enrollments were booming and with it, investment in educational materials and testing. With two of Pearson's big rivals weighed down with debt following some particularly aggressive buy-ins by private equity, the group was able to outspend on new online products without impacting margins while also taking market share.

By the time John Fallon arrived however, the wheels were beginning to fall off the old educational publishing model. Improvements in State funding were not permeating down to K12 textbook publishing, where digital penetration was slow, while the growth in College publishing that had been sustaining the HiEd publishing markets was rapidly heading in reverse. This was not the normal cyclical fall in enrollments as improving employment opportunities intercept potential students however. This was a crisis in funding as outstanding US student loans doubled to nearly $1.3tn in just five years, yet was not matched by educational attainment or improved employability. Students were sold the American dream by the profit hungry universities, but often with little useful qualification to help pay for a student loan debt that Debt.org estimate that in 2014 averaged $33,000 for 70% of college graduates.

The issue was not the educational materials suppliers such as Pearson, as expenditures on these account for under 1.5% of overall educational expenditures; indeed much of Pearson's online services centre around remedial learning tools with a quantifiable return and record of fixing the massive problem of falling attainment and college drop-outs. It has been a tide though, that has raised and now lowered all boats, notwithstanding whether they are part of the problem or potential solution, such as Pearson.  The time between investment and return in a market where the teachers often feel threatened and can be resistant to change makes this a tricky time for the new Pearson CEO. Last year, investors had to swallow a bitter pill of increased development charges accentuating an already soft top line performance. For FY15, lower charges and savings on these were to add almost £90m (before tax) to the bottom line, or around +13% to earnings. By the third year however, FY17, growth would be dependent on these new services delivering incremental revenue and margin growth. The trajectory in organic revenues through this year and into next therefore will be seen a crucial test on this strategy and with H1 organic revenues still languishing at only +1%, investors would need appeasing, so hence the need for a crowd pleaser divestment.

With the low hanging corporate fruit now picked, there will be few places for managment to hide from now. The encouraging data released with the H1 results was a a +3% rise in organic deferred revenues which, as can be seen from the initial chart analysis (also go to www.growthrater.com), would put the rate of organic revenue growth to within spitting distance of the current +3.9% CAGR growth rating currently being priced into the shares. More importantly though it would encourage markets into anticipating a rate nearer +4-4.5% perhaps for FY16 which, if achieved would leave the growth rating trailing.  Markets are impatient, so CEO's occasionally need to throw in a bone to buy some time to get to the point where rising revenues can vindicate the strategy.

Amazon through the growth prism

Markets often distinguish growth from value, but for an equity, growth defines value. For most stocks, this can be seen by the close relationship between the organic revenue growth being delivered by a company and the implied growth rating being discounted by the share's operating FCF yield. A problem however arises when trying to price in an above market growth rate in perpetuity or worse, a growth rate higher than the cost of equity. Markets understand the impossibility of sustaining both scenarios so will inevitably reach out to some sort of horizon point where the valuation will revert back to discount a market average, or below, rate of growth. The question for investors therefore is whether there is a systematic relationship between this mean reversion point and a group's trading performance over a realistic forecasting horizon.

The encouraging news for the investor is that markets do seem to behave rationally in the way they reach out to a valuation horizon and in a way that can also be incorporated into a predictive tool. Markets value stocks on a near term horizon of <18 months unless organic revenue growth exceeds double the market average, from which point the horizon point is progressively extended in direct relationship to relative organic revenue growth. Instead of scratching your head over whether a PE ratio of 150x or 200x is cheap or dear, view your 'super-growther' from a growth prism and one can start to see how markets have really been discounting their growth prospects. This can only be seen at www.growthrater.com and is included in our valuation algorithms.
An example can be seen with Amazon.com and a chart that is available for registered users at:
https://www.growthrater.com/growthrater/#/horizons
 The chart looks at the mean reversion profile of how far out the markets are reaching in their valuation horizons to bring the company's growth rating back to a market average. The orange line is the company's organic revenue growth rate with the green bars being the number of months that the markets are effectively reaching out to revert the growth rating to a market average. A correlation and Rsq is also included in the chart on these two series - currently approx 0.75/0.56 on the period selected, which is not too shabby. The blue bars denote the forward reach that is calculated automatically within my valuation algorithm. As you can see, I have a max horizon of 50 months as a cut-off which is less gung ho than obviously the market at present is reaching out by, although I have been through too many bubbles to be comfortable in pushing the envelope.

Mean reversion horozon is determined by relative rate of organic revenue growth

Google – markets chasing stories arrive late to the party

Markets love a good story. They’re so much easier to digest than actual analysis and usually provide a catalyst for action that brokers and journalists need to stimulate a transaction. Take for example Google’s Q2 results last Thursday. The results themselves were solid, but were neither significantly ahead of street estimates nor provided anything particularly new of note to harden forward expectations. Revenues excl TAC at $14.35bn (+13.3% YoY; c.+20% at =fx) were a touch over the street estimates of $14.27bn as were the funny money non-GAAP EPS of $6.99 vs street estimates of $6.70, which were struck after a -160bps drop in tax rate and excluded a +28% YoY increase in stock compensation charges. The stock however rallied 16.3% on the announcement to close at $699.6 after “soaring” as high as $703.

The issue that was getting markets and commentators so excited about, was the new CFO from Morgan Stanley, Ruth Porat who had arrived in May. “New Google CFO promises more discipline” proclaimed the headline in the FT the next morning, which was the theme taken up by many other commentators. As with Amazon, Google shareholders have had to accept that the founding and controlling shareholders may fritter away margins on occasionally hair-brained blue sky projects and not to expect much in the way of disclosure on costs in a business that is presented as little more than a block box; somewhat ironic for the world’s largest commercial information group. Markets know that a flick of a pen could substantially increase reported margins and the near term earnings performance, so this is an easy narrative to sell, particularly as this is attached to a new personality onto which investors can place their trust. The slight problem with this however, is that the story is running way ahead of the reality. The reality is that all this is mainly a presentational issue to manage investor sentiment and insulate Sergei and Larry from us hoi polloi. After last year’s 2:1 split and issue of non-voting ‘C’ class shares, the founders have effectively locked in their continued voting control of Google and a CFO or any other executive will need to jump to their tune. Ms Porat has managed to successfully present a more market friendly face, but very little has actually changed; a case of form over substance. No new metrics have been disclosed or financial projections of targets were offered. Indeed, the central investment meme of 70-20-10 (70% on core, 20 on adjacent areas and 10 on big new ideas) is unchanged with Ms Porat informing markets that the phasing of the spend on ‘big new ideas’ can be lumpy due to the very nature of these types of opportunities; ie don’t misinterpret a margin spike on a lower spend as this may be temporary. At the end of the day, investors are still largely disenfranchised spectators at the Sergei & Larry show and are along for the ride. A new CFO with good street credentials is a bonus and one might hope would provide valuable advice on managing expectations and returns for markets, but ultimately shareholders are buying into the founders continued vision and ability to pick and back winners. The Q2 numbers out last week were by no means shabby, with organic revenue growth at about +18% (nearer +20% excl TAC), paid clicks up +18% and an aggregate cost per click, although reported down -11%, may have been nearer -4% adjusting for the -7ppts fx headwind in the period. The near +20% organic growth in gross margins however translated into a mere +50bps advance in operating margins, which again highlights that this group remains as opaque as ever.

If markets are chasing a possible momentum story, our valuation position remains embedded in the group’s operating FCF and capacity for growth, with the bounce in the shares taking them from the lower end of our NPV range to the upper range. This is delineated by a normalised growth rating range of +4.0-5.5% on an 18 months forward reach (to Jan 2017) to the valuation horizon which is determined by the pace of organic revenue growth delivery.

Bounce takes Google from lower to upper end of the Growth Rater NPV range

Incorporating a growth sensitive component in the Growth Rater algorithm can offer greater insight into the share price drivers for the stock. A management story can provide the headlines, but it is only when one looks at the relationship between organic top line growth and the growth rating. A good example of this was from about 2012, when the stock was looking cheap on the Growth Rater model, but was still unloved by markets. The reason for this disparity is easy to identify when one looks at our mean reversion analysis on the ‘Horizons’ tab. While markets were de-rating Google due to its increased investment activity, the growth rater’s sensitivity to organic revenue growth was more than compensating for this. As a consequence, those using the Growth Rater model would have been well ahead of all the tail end Charlie’s now piling into the stock at the top!

Growth Rater identified that the big buy opportunity on Google was from 2012

Get the oil price right and make the right call on oil stocks

Invest in an oil major such as Exxon or Chevron and there are two over-riding factors to consider. The first and probably obvious one for Groups which traditionally make over three quarters of their income from pumping oil and gas out of the ground is the price of oil. While an occasional oil spill and >$40bn of fines and penalties can occasionally introduce an extraneous component to the investment equation, the price of oil still provides the principal determinant to company value added. A high correlation of these companies share prices to the price of oil therefore ought not to come as a particular surprise, with the ratio for groups such as Exxon and Chevron exceeding 0.86, with an Rsq of >0.73. In other words, get the oil price right and you’re 9/10ths on the way to getting your investment position on these stocks right.

 Share price to Oil price correlations

Get the oil price right and you're 9/10ths on the way to getting the stock right

The dilemna for investors however is the second investment factor; the apalling inaccuracy of markets in predicting the price of oil even 12 months out which makes sector valuations a volatile play on an uncertain premise. The respected US Energy Information Administration (EIA) for instance has revised its 2015 average Brent price down by 43%/-45/b (from $105/b to $60/b) in the 12 months between its July 2014 and July 2015 “Short-Term Energy Outlook” reports and many bank forecasts have proved even more wildly inaccurate. Indeed, with the forecast revision exceeding the original estimated maximum lower range (+/-$30/b) on last year’s guesstimates, the EIA has increased the absolute margin of error on its forward guidance for oil prices over the next 12 months to nearer +/-$40/b, which on a lower central price estimate (of $67/b for 2016) actually represents an even higher percentage margin of error of almost +/-60%; and this on a 95% confidence interval!

Margin of error is at 60% +/- the projected price forecast!

What becomes painfully obvious from these projections, along with those of preceding years, is that forward estimates will be dressed up with voluminous analysis of estimated production and demand, but still looks suspiciously like a tangent drawn from the last few data points on the chart. A projected oil price is needed, but the historic record of forecasting suggests investors will need to adapt to directional changes in price forecasts and central to this are sensitivity tools, such as those to be found at www.growthrater.com where one can model the valuation impact of changes in marginal revenues.

Our central modelling assumptions for Brent oil include what is probably a broadly market consensus one in that the price could recover to around $90/b by 2020. In the short term however, the bounce in price after the initial collapse to nearly $40/b may start to wilt in the face of record output from Iraq, potential Iranian supply and continued output from Saudi and of course fracking supply and we are happy to sit on a sub-consensus short term price estimate.

Recovery maybe, but still scope for short-term reversal

Modelling these assumptions through our growthrater matrix and the target NPV on most of the oil majors start to recover ahead of current share prices by 2016, and in some cases considerably so into 2017 and 2018, as can be seen from the Royal Dutch Shell analysis below. To get to these future highlands however, markets may need still to negotiate tough terrain where a possible reversal in oil prices will challenge the current consensus expectations.

Royal Dutch Shell example

NPV upside from 2016 on central oil price assumption

Modelling a Brent price stuck at around $55-60/b for the next three years would equate to lopping around -10% pa from our revenue forecasts in our revenue sensitivity model. As one can see from the below example, the result would not be pretty and therefore suggests that with little confidence in the longer term oil price forecasts dished up by banks and ‘experts’, one should take care not to try and catch this knife too early.

Eliminate oil price recovery with a -10% pa cut in marginal revenues and no share price recovery

Impact of flat oil price at $60/b (=-10% pa impact to central revenue assumption)

More on this and much more can be found at www.growthrater.com

Tsipras makes Merkel an offer she can't refuse

How should we interpret this week’s volte-face by Tsipras and the Syriza government in approving austerity concessions to the Troika that had been specifically rejected by Greek voters in a referendum less than a week before? Short term, this would seem to provide an opportunity for celebration for creditors and financial markets in that the Greeks will have to repay all their debts and perhaps more importantly will not offer a precedent to other indebted nations to demand debt relief and therefore open the floodgates to unlimited QE and debt monetisation so feared by the northern block.

This reprieve however would be both temporary and illusory as it fails to address the political or economic reality of the situation. The most obvious of these is that Greece is bust and chasing it into the grave for the last sou will make it less, rather than more likely to be able to pay what it owes, let alone become a functioning and contributing member of the EU. Politically, it is also counter-productive for the EU to be shown as a rapacious creditor in league with a politicised and conflicted ECB to use weapons of mass financial destruction to terrorise the Greeks into submission. Without a debt relief, how long do you think Tsipras and his Syriza party will last and if not them who – Golden Dawn or some other extreme fringe, and then what?

At face value, the concessions approved last night by the Greek legislature is at best another attempt to kick the can down the road. While agreeing to cut government expenditures, including pensions and defence along with improving tax collection rates are fairly uncontentious, the current plans also include a number of counter-productive proposals including heavy increases in consumption taxes (eg 23% VAT on restaurants and increased ‘luxury’ taxes on recreational boats on anything longer than a dinghy) as well as increases in corporate and tonnage taxes along with the removal of Island tax breaks. How this is expected to get more tourists to want to go on holiday to Greece or more ships to locate there is a mystery to me and seems to be blind to the simple fact that these industries are mobile and will just go elsewhere and thus further compound the revenue erosion. Does anyone in their right mind actually believe the current commitment to stick to a primary surplus target of 1% for this year rising to over 3% from 2017 is achievable? Look at some of the other proposals and things get even more ominous. Consider the proposed amendments on insolvency laws to get debtors to pay up loans or ‘consultants’ on how to deal with bad loans or the opening up of restricted professions such as court bailiffs. Throw in the asset privatisations of the electricity grid company, regional airports and shipping ports and the Greeks will be little more than rayahs in their own land. https://www.youtube.com/watch?v=rRBPS3o_IvU . Germany may be obsessed with its hyper-inflation history, but it seems to have also forgotten the dangers of leaving a nation without hope or self-respect.

The problem with the above scenario however, is that it doesn’t explain why Tsipras would commit political suicide agreeing to concessions that would not work anyway. It also fails to recognise the wider geopolitical issues at stake which need Greece to stay in the western sphere of influence and would happily sacrifice Germany’s aversion to sovereign debt monetisation to achieve it. Greece has long existed on a number of fault lines (geological, ethnic, cultural, political and religious) and this has been reflected in its complex politics. Add in gas politics of Gazprom cancelling South Stream in favour or a new route through Turkey and Greece and the EU’s domestic spat over debt relief has acquired a more serious geo-political dimension. Tsipras has obviously been playing this card with his meeting with fellow orthodox Putin and the US are concerned enough to put pressure on Europe.


The US therefore needs a deal to keep Greece inside the tent, but knows that Germany is resistant to debt monetisation. As befitting the EU and in the best tradition of the Godfather, they need an ally on the inside that can propose the deal to both parties while furthering its own interests http://youtu.be/fuWkcKbBQkg and this is where the French come in. At the last moment, the French have sponsored the Tsipras’s apparently generous concessions which will form the basis of discussions at tomorrow’s broader EU meetings. Debt relief is not explicitly included, but the IMF ‘leak’ that Greece debt is unsustainable and needs restructuring (ie relief) was incidentally released and not accidently. Tsipras must know that his concessions in isolation would destroy Syriza and resolve nothing, so his participation must therefore have included broader assurances also on debt relief. Germany no doubt suspects that its red line on sovereign debt monetisation may be assassinated at this meeting arranged by its ally and hence some of the rumoured hostility to the plan even though at face value Tsipra has conceded on virtually everything barring a tribute of children. In many ways, Merkel is being manoeuvred into an impossible position. Reject IMF evidence of the need for debt relief and drive Greece into default and her dream of European unity starts to look pretty shabby. Agree to it however, and a principal will have been conceded which will inevitably turn the Eurozone into a transfer union, but without political responsibility or restraint which may hasten calls for a northern block.

Greek referendum - all part of the Varoufakis game

Greece votes a resounding 61% “No” to the Troika debt proposals, yet financial markets remain largely unfazed, with European equity markets declining initially by less than 2% and 10 year bond yields for Italy, Spain and Portugal harden by less than 10bps. With traders having been weaned on a succession of last minute resolutions to avert a crisis (US sub-prime, US debt caps, PIIG’s, to name a few) markets seem to be clutching at the conciliatory comments by Alexis Tsipras and resignation of Yanis Varoufakis together with Angela Merkel’s comments that the Greeks’ decision must “be respected”, whatever that is supposed to mean. But is this a move towards conciliation that is being assumed by markets or an attempt by wily politicians to distance themselves from the impending train-wreck? Should one follow the market conditioning of the past five years and ‘buy the dip’ (http://www.youtube.com/watch?v=0akBdQa55b4) or take note of that the economists at both JP Morgan and Barclays working models now assumes ‘Grexit’?

It is looking increasingly obvious that the Troika negotiations have been set up to fail. Greece is bust and has been for years. EU bureaucrats want to hide it, but Tsipras knows this, so does Merkel, the IMF and even my mother. Another so called bailout that merely adds more debt to pay the interest back to the bankers on the last lot and keep the Greek people in debt bondage for another two generations is now no longer a politically viable option. The terms of that last bailout, which saw over 90% of the €240bn package go back to financial institutions rather than the Greeks, has done the Troika no favours in selling its latest ‘deal’. Politically, Merkel cannot concede the principal of debt forgiveness to Greece given the long line of other EU petitioners who will demand the same, particularly now that the ECB has ECJ clearance for QE. Tsipras however can demand now less given his original election mandate and now the referendum. The referendum was less about giving him better legitimacy to negotiate a better deal from Merkel, but a mandate to reject the Troika. Up until a couple of weeks ago, markets were expecting Tsipras to submit to theTroika’s proposals notwithstanding his election mandate. Now, the mandate is explicit in that he is unable to concede. Burning ones ships to ensure no turning back, may not have been an Athenian tactic, but they seem to have learnt from Cortes. With suitable goading from his finance minister and game theoretician, Yanis Varoufakis, the Troika have adopted a hard line in negotiations and a proposal that Tsipras could take back to Athens to get squashed, but from which it will be nigh impossible for either side to substantively retreat from. Varoufakis’s resignation at his moment of victory therefore is not about securing concessions that cannot be made, but to remove himself as factor from the inevitable collapse in negotiations. This has been set up not just to fail, but to leave the Troika taking most of the responsibility for it.

Over the next few days, markets will urge investors to buy the dip, but may have a rude awakening. Some ‘leading’ investment houses were even recommending investors rotate into financials last week and ahead of the referendum, no doubt hoping for a ‘Yes’ vote and citing that the ECB has now relieved most of the banks of their direct Greek bond exposure, although not the unknown derivative tail risk. We are not aware of whether their recommendation has now been revised following the result or whether they are compounding the error by attempting to brazen out the newsflow with hopes that a last minute debt resolution. Either way, these remain dangerous waters to be exposed to financials, particularly amongst the EU peripherals. The first test meanwhile may come as early as next week when a small Japanese (Samurai) bond of approx Yen 20bn matures. Will this be the first credit event and domino?

Shrink EPS while reporting rapid EPS growth

As with every reporting season one can play the game of “spot dodgy”. Unfortunately, the deluge of quarterly results with their more limited disclosure can make it tough to identify some of the more sophisticated scams. As always these can include the myriad of acquisition accounting tricks (fair value adjustments, acquisition timings, accounting policy adjustments, off-balance sheet manipulations etc) as well as the more obvious ones that simply park the inconvenient expenses into a bucket called “one-off” or “non-recurring” which are all too ongoing. Playing around with tax provisioning and using low funding costs to re-purchase shares to bump-up EPS growth in attempt to have this mistaken as value creation are now old hat; everyone seems to be in on this one.

While updating my models for the quarterly results I was reminded of another ploy, ‘scoping’. Although hardly novel or sophisticated, it involves simply changing the scope of the operations that you want investors to focus on and to obscure those that may not suit. A business that under-performed can be classified as non-core and “to be discontinued” which under IFRS and also seemingly US GAAP can from then be reported ‘below’ the line with the revenues and other operating numbers excluded from the main body of the P&L. Having excluded the bad stuff into what becomes little more than a footnote in the accounts, companies can then impress the markets with how well they are managing all the remaining good stuff – genius! Of course, this trick is also great to use as a way of restating down previous results where the lowered comparatives are used to show the upward only progress in “continuing” earnings and EPS, even when the exact opposite is occurring. As memories are short and there are simply too many quarterly announcements for investors and commentators to take to time to do the proper leg work, the narrative that invariably appears in the financial newswires and markets is the one that has been crafted by the company.

A good example of this was with PPG’s Q1 results that were released last Thursday (16 April). Having sold its Optical’s JV last year for a short $2bn and re-invested most of this back into a Mexican coatings business (Comex), there were obviously a few moving parts to take into account when analysing the ongoing performance. It would seem understandable therefore that the group might wish to present a review of the underlying business performance. Unfortunately, by excluding the operating results of the disposed optical activity while including the acquired business fails to do this and creates a fictional scenario where the results of part of the group are excluded into the prior and comparative period, yet the contributions from the business acquired by applying the disposal proceeds are included in the following periods; a classic case of having ones cake and eating it.

Looking good on a "continuing" basis

Although, the net contribution from the entire group is recognised within the P&L, only the “continuing” operations are represented above the net income line. As the “discontinued” contributions net off the operating contributions of these businesses with any impairment write-down or gains, these often do not provide a representative picture of their underlying performance unless you want to route around in the notes to the accounts. Unsurprisingly, not many investors will bother to do this, preferring to rely on the group’s analysis of “continuing” activities instead. As PPG booked a gross disposal gain of $1.5bn in its Q1 FY14 (approx. $915m net), the US GAAP EPS figure for this period of $8.97, including $7.00 for discontinued, was not particularly meaningful. The only alternative metric provided investors meanwhile are the “continuing” figures. On these, the Q1 FY15 results reveal a relatively steady revenue line considering the dollar appreciation in the period, but an increasingly impressive performance as you drop down through the P&L. Revenues +1%, EBIT +9%, Margins +96bps, PBT +16% and EPS +18%. Clearly some great cost management at work and assisted by debt refinancing and share buybacks? Wrong, think again! Although the contribution from acquisitions has not been broken out from these figures we can see what has been excluded from the comparatives, and re-stating these alters substantially the perceived performances of the “continuing” results.

When one disaggregates the Q1 FY14 “discontinued” results into their component parts we can see that these included a non-operating disposal gain of approx. $913m within the $985m of net income. Excluding this, operating results included EBIT of $104m and net income of $72m, which would have added $0.51 per share if included in an overall operating EPS metric for the group. Sales of $247m meanwhile were completely excluded from the group P&L.

$0.51 per share of operating EPS was excluded from Q1 FY14

Presenting PPG’s Q1 FY15 adjusted results for the businesses as owned by the shareholders, but to exclude the non-operating book gain therefore offers a somewhat different perspective on events. Revenues are lower, although that should not in itself be a concern. Indeed, under a more relaxed recognition to include proforma sales from Comex, the Group might have been able to announce a slightly better organic sales growth than the +1% reported for the “continuing” activities. EBIT, PBT and net income however are all down heavily on what would have been a more accurate analysis of actual performance and notwithstanding the refinancing and share buybacks, Q1 FY15 EPS of $2.33 ps was in fact down by -6% YoY; somewhat less impressive that the +18% highlighted by the company.

How to turn a -6% YoY EPS decline into a +18% rise!

Market complacency may be its undoing

Welcome to the Q1 reporting season. If you hadn’t noticed yet, Easter came early this year (good for retailers, airlines etc) and there is a minefield of shifting currencies and commodity prices to adjust for as well as some decidedly mixed macro data coming out from the major trading economies.  If you’re selling out of a Euro manufacturing base or consuming a lot of energy, then chances are that Q1 2015 is proving a relatively benign results season. For those outside of this magic circle, then perhaps one should think beyond the share buybacks and start applying cheap capital to leverage cost synergies through acquisitions. Fedex buying TNT, Heinz buying Kraft Foods and Shell buying BG are all manifestations of this process.

In a World dominated by QE and its accompanying financial repression and currency wars however, none of this really matters. As long as governments and central banks can sustain the illusion of endless liquidity without flipping their currencies into free-fall and hyperinflation, real price discovery will continue to be crowded out by the carry-trade junkies in what is increasingly a zero sum game of beggar-thy-neighbour. Unfortunately, as with any hard drug addiction, this is a habit that is going to prove difficult, if not impossible for politicians to kick.  The consequence of US tapering of QE has been a rise in US dollar and fall in commodity prices as liquidity supporting these asset classes dried up. While the latter has been supportive of domestic consumption, the former has monkey-hammered US GDP growth expectations and with it China, as recent March trade data highlights. In our new world order where good news is bad and the reverse also applies, then falling growth can only mean one thing, the spice must flow again. Forget an early US interest rate increase and indeed brace yourselves for the taps to be opened again. With record oil stocks and the prospects for yet more excess supply to arrive following a possible rapprochement with Iran, why else have oil prices rebounded against this backdrop of falling GDP expectations?

Perhaps perversely, the market’s attempt to discount such an eventuality may be its very undoing. If asset prices remain elevated in the anticipation that the falling GDP expectations will necessitate QE4ever-wherever, then what is going is going to provide the catalyst and political cover for the Fed and PBOC to defer its rate increases and possibly engage in a little surreptitious pumping? Clearly a market dump will need to be engineered first which may well also explain the self-interested warnings from some leading Wall Street banks that a correction may on its way.  As the instructions say, “Rinse, repeat”.   

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…