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

Beware fake arbitrages on Yahoo - Alibaba!

For an arbitrage opportunity to exist, asset classes need to be fungible (deliverable against each other), so anyone selling you a scheme to "arbitrage" an apparent pricing disparity between related, but non-fungible, assets maybe selling you a dud.

When I see investor research by banks, who should know better, promoting "the Yahoo arbitrage trade" whereby the muppets are advised to short Yahoo Japan and Alibaba against a long Yahoo Inc (ie generating 3 trades and 3 commissions), alarm bells ring.  The logic may seem sound enough in that Yahoo Inc's shareholding in Yahoo Japan (35%) and Alibaba (16.3%) offer an indirect economic interest in these entities as well as a possible valuation implication on the rump Yahoo inc businesses if these assets are backed out. The problem however is this is a spurious argument if  Yahoo inc shareholders are unable to get direct access to the underlying assets or cash flows and is therefore sensitive to the assumed tax on disposal as well as conglomorate discount which the market would almost certainly also apply.

OK, so let's look at some numbers on this supposed arbitrage opportunity. At first sight, the Yahoo market cap of approx $40bn drops to nearer $36bn EV after backing out the approx $4bn of net cash (MV and cash assuming the 50% Alibaba IPO proceeds are returned to shareholders via a share buy-back). Against a current MV of its remaining interests in Alibaba (16.3%) and Yahoo Japan (35%) of almost $44bn this might suggest a negative EV is being priced in to the rump Yahoo operations. However, Yahoo's book values on these are marginal which implies a possible gains tax liability on disposal of over 30%, which would bring the net investment valuation down to nearer $31bn and therefore bring the implied EV of the Yahoo rump up to just over $5bn.  Against a prospective 2016 EBITA of $675m (consensus) and Op FCF of approx $473m, this would not be unreasonable; reflecting a prospective Op FCF yield of 9.0% and an implied growth rating of approx +3.0% CAGR.

But hang on, isn't Yahoo inc talking about splashing the Alibaba cash on other acquisitions? What this does is remind us that Yahoo management still stands between investors and the underlying Yahoo assets. Jerry Yang may have played a blinder with Yahoo Japan and Alibaba, but are investors as confident with new girl Marisa Mayer's ability to spot a bargain on investors behalf?  If AOL is the great new play, perhaps not, which just re-enforces the perception that a conglomorate discount will also be applied by markets as we've seen with the likes of Vivendi, Lagardere and countless other groups in the recent past.

If the implied valuation of the Yahoo rump is only just about OK when the post tax valuations of its investments are backed out, then applying a conglomorate discount of anywhere between 10-20% on these is going to make the whole 'arbitrage' deal a rather pointless and possibly expensive exercise, at least for the investor rather than the promoter, who stands to gain possibly 3 commissions and possibly also a spread or two!


Yahoo valuation (sum of parts)
 

See more here
wyt-i blog article

Post IPO: Market valuing Alibaba as if it were a normal US tech Co!

I am surprised! Having cleaned up the reported numbers a little (eg including stock comp and intangible amortisation - excl goodwill), and applied a broadly average growth discount trend, the Alibaba NPV on the WYT growth discount model comes within 5% of the post IPO price - nb this already adjusts for forward valuation horizon based on the rate of organic revenue delivery - for those with the growth rater service see the 'Horizons' tab.



So why the surprise?  - Because this suggests that markets in their hunt for growth are valuing Alibaba pretty much the same as they would an Amazon, LinkedIn, Ebay or Facebook. While the Alibaba that investors are buying may ape the business models of these, the instrument that is providing them with the exposure is entirely different.  In effect, what is being bought is a Caymans Island holding company (the "foreign owned enterprise") with the right to participate in a non-existent dividend from the Alibaba companies (the "variable interest entities"), but without a direct interest in these assets. Although a complex structure theoretically allows a conversion into many,but not all, the underlying economic entities, this is not actually legal at present under Chinese ownership rules unless by another PRC entity and indeed may never be permitted. In addition to that, there seems little to stop these options being re-assigned to other entities.

So what does the prospectus say about these "Exclusive call option agreements" that the foreign owned enterprise has over the variable interest entities

What is says on Exercise price: "Equal to the higher of  (i) the registered capital in the variable interest entity; and (ii) the minimum price as permitted by applicable PRC laws. Each relevant variable interest entity has further granted the relevant wholly-owned enterprise an exclusive call option to purchase its assets at an exercise price equal to the book value of the assets or the minimum price as permitted by PRC law, whichever is higher"
Interpretation: OK, so this seems to enable the foreign entity to buy some of the underlying Alibaba companies at book value, which is low and therefore attractive, or at some unknown "minimum" price that may be determined by PRC law. Perhaps a Gweilo pays more law!

What it says on conversion: "Each call option is exercisable subject to the condition that applicable PRC laws,rules and regulations do not prohibit completion of the transfer of the equity interest or assets pursuant to the call options."

Interpretation:  This is of course a big 'IF'. Investors may hope that either the future bar on direct overseas investment will be lifted or that the entities can be parked into another vehicle that might hoodwink the PRC that it was still PRC owned. Many states however have long-standing 'look-through' legislation (such as the HMRC in the UK after 'Dawson v Furness') and one might also expect the PRC to exercise similar action. Indeed, the Alibaba prospectus warns
"However, we have been further advised by our PRC legal counsel, Fangda Partners, that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, rules and regulations. Accordingly, the PRC regulatory authorities may in the future take a view that is contrary to the opinion of our PRC counsel. We have been further advised by our PRC counsel that if the PRC government finds that the agreements that establish the structure for operating our internet-based business do not comply with PRC government restrictions on foreign investment in the aforesaid business we engage in, we could be subject to severe penalties including being prohibited from continuing operations"

This however, may be the least of ones worries. Check the small print of the options and you find
"The wholly-foreign owned enterprise may nominate another entity or individual to purchase the equity interest or assets, if applicable, under the call options".

Naturally, one might have thought that this is part of the wheeze that would enable the Gweilo investors to park the assets into a PRC friendly vehicle and no doubt this was its intention, but wait a moment and think about this. The foreign owned entity will still be substantially controlled by Jack Ma and Simon Xie, who are also the 'owners of the variable interest entities and as such they will also be able to "nominate" the "entity or individual" to exercise these options. As a shareholder in a Cayman Island holding company which has a right to a dividend for which there is no intention to pay and an option to buy the underlying assets at perhaps book value, that might be all it gets should someone else be "nominated" to exercise it, do you feel lucky? Well do ya?
   

Finally, a memorable and relevant financial services advert

With marketing infatuated with big data, social media, mobile and any other nerdy technology where they can bamboozle the client with techno-babble, it is a pleasure to see a good creative advert. I may have been 'exposed' to a thousand marketing messages from the financial services industry, and for which someone has paid good money, but there is only one I not only recall, but actually enjoyed watching. This is the new advert for Direct Line by Saatchi & Saatchi who recently won the account from their namesake, M&C Saatchi. In it Harvey Keitel reprises his role as Wolf from Pulp Fiction, but in this instance as a fixer for a couple who have been burgled rather than for a couple of hoodlums.

Well done Saatchi & Saatchi



https://www.youtube.com/watch?v=ir791xwvOP4

Correlation <> causation, but sometimes maybe!

When I was but a nipper, a wise old Chairman of a large and successful financial information business gave me a valuable piece of advice:  That mediators extract better margins in poor information environments and when price discovery is obscured. As his business, amongst others, picked off and commoditised market after market with real-time pricing, newsflow and data, spreads narrowed and the mediators were increasingly forced in the opaque areas of finance where clients could still be bamboozled into chasing a higher return without appreciating the often killer tail end risk.  While plain vanilla equity broking was being crushed, derivative margins soared as any old sows ears were packaged together and sold as silk purses, with a whole industry supporting the illusion.  The key of course, as the Chairman knew, was the ability to withhold the relevant data from those on the other side of the trade; yes, the muppets.  Raw data however without insight is not a solution. The 'casino' owners are not dumb and know how to bury the truth under a ton of information; hidden in plain sight. To better democtratize the investment process therefore needs insight and context to be applied to the content.

At WYT, our aim is to provide insight to what drives valuations and includes a search for systematic relationships, both internal (relating a company's ability to grow with its 'growth rating') and external.

A feature we have recently added to our 'growth rater' analysis suite includes an auto-correlator which searches for the best correlation fit for a wide range of external macro factors against 5 company related factors to test for relationships in the way the shares perform (actual and relative), the possible impact to trading (organic revenues and margins) and the possible effects on valuation (via growth rating).  Yes, we appreciate that correlation does not necessarily imply causation, but without such a perspective an investor is truly blind.

Often a correlation analysis confirms an obvious relationship, sometimes it reveals an absence of one that was expected and very occasionally offers that much desired WTF experience.

The obvious ones:
Yes, Royal Dutch Shell's share price is tightly correlated to oil/energy prices

The interesting with hind-sight
Perhaps its more a reflection of a broader economic sensitively, but for an oil major to make better margins when there are more vehicles about is not totally without merit!

 



The yes, of course, but only if you already know that gas is the largest cost component for a chemicals group such as LyondellBassell.
Yes, its margins are negatively correlated with the gas price.

Another obvious one? A consumer staple with a share price that correlates with real personal income.
More income = more spending = higher share price?

Another consumer major with a high share price to consumption correlation
Wow, this investing business is getting easier!

Err, hang-on. A cyclical sensitivity to consumption ought not to imply a structural re-rating to a higher growth rating into the cyclical up-swing.
Perhaps, PepsiCo is just doing better in exploiting new and higher growth areas?

Er, nope. Actually this company's organic revenue growth is negatively correlated to actual real retail & food sales.

So what have we got here?  A share price that follows personal income, but this is not reflected in its sales and trading and therefore as a consequence its valuation (as measured by the growth rate that the shares are discounting - the 'growth rating') has to rise. Indeed, rise to well above its ability to grow its revenues.

My conclusion? Markets are clearly being inefficient and possibly lazy by using PepsiCo as a proxy for broader consumption. The principal culprit of poor pricing in current markets however is not too difficult to find - financial repression. In these dull days of command economics and crushed yields, a big mature business that can borrow cheap and payout big (85-90% of net income into share buy-backs and dividends over the last 5 years) is going to appeal to the muppets these days.  Will it last? No, of course it won't and if you think you'll be the smart one to get out before the rush, then that's what they all think!

Are there more such stocks out there?  You bet! you just need to know how to find them. Good hunting.