A Hard Rain’s A-Gonna Fall



The lesson that too much debt is dangerous has sunk in. But for many companies, the corollary proposition, that too little cash is a killer, seemingly hasn’t. If there’s one thing investors ought to remember heading into the eighth year since the financial crisis, it’s that without healthy cash flows, balance sheets won’t stay balanced for long.

Trading house Glencore is a prime example. As commodity prices continued to plunge in 2015, its net debt of $27 billion, which investors had previously tolerated, started to look scary. The shares went into freefall. As cash flows dwindled, so did the amount of debt investors would stomach, forcing boss Ivan Glasenberg to hack the dividend, sell assets, cut production and reduce borrowings to $18 billion.

Weak commodities will wreak more havoc, but rising U.S. interest rates could make matters worse. That’s especially true for emerging markets, which have loaded up on U.S. dollar debt. A currency mismatch is one factor weighing on Brazilian oil major Petrobras. Non-bank borrowings in U.S. dollars had reached $2.3 trillion in developing countries by the end of June, according to the Bank for International Settlements. Mexican, Indonesian and South African borrowers have all doubled their dollar debts since 2009.

Europe has its own toxic cocktail, of stubbornly low inflation and poor consumer demand. Yet some companies are still casual about cash. One in four companies in the Euro Stoxx 600 index outside of banking and energy spent more on operations, capital expenditure and dividends than they made in the past 12 months, according to Eikon data. British grocers Tesco and J Sainsbury, telecoms group Vodafone and carmaker Daimler have all spent beyond their means for three consecutive years, as have numerous oil and energy groups. For some, dividends and investment will be vulnerable.

Who, if anyone, has learned their lessons? That would be the United States. Outside of resources and finance, the ratio of U.S. corporate net debt to EBITDA is now only slightly above the 20-year average of 1.6 times, according to Credit Suisse. Brazil, by contrast is 4.5 times. Only about 17 percent of these U.S. companies are spending more cash than they make. For once, America has something to teach the world about leverage.

When the reckoning comes, cash-rich companies and private equity firms will be in a position to sweep in and acquire assets on the cheap. More likely than not, they’ll come with American accents.

Published December 2015

(Image: REUTERS/Aly Song)



Quarterly capitalists should gird themselves for disappointment. With post-tax earnings running around 10 percent of national income, according to the Bureau of Economic Analysis, U.S. companies are close to a peak of profitability not seen since at least the late 1960s. High levels of corporate profit are a global phenomenon, too. Competition, disruption and tax policy – not to mention weaker growth – are set to change all that.

Worldwide, net income after interest and taxes increased fivefold between 1980 and 2013, according to a study published in September by the McKinsey Global Institute, not far short of doubling as a share of global GDP to 7.6 percent.

The consultancy’s think tank foresees competitive pressure on margins from emerging markets like China. Fast-growing companies are starting to go global, and their tendency to be controlled by government or family interests may mean they can accept lower profitability in the short term than Western multinationals whose investors watch quarterly earnings closely.

new2-US corporate profit as percentage of national income

(Source: Bureau of Economic Analysis, Breakingviews. REUTERS/Richard Beales)

Meanwhile, though the profit pie has grown, gains have gone disproportionately to technology and other idea-driven sectors at the expense of traditional industry. That trend could continue, with even today’s biggest tech firms – the likes of Apple and Alphabet (formerly Google) – themselves potentially vulnerable to upstarts wielding new ideas. The MGI also notes that the scope to cut costs, for example the outsourcing of production to China by Apple and others, could be bottoming out. Borrowing costs, which have lingered at historic lows thanks to the world’s central bankers, also look set to rise.

Slackening economic expansion is another factor. One consequence, the collapse in oil prices, is largely responsible for a plunge in the U.S. energy sector’s profit. As a result, analysts predict that overall S&P 500 Index earnings for 2015 will be a hair lower than in 2014, according to S&P Capital IQ’s tally on Dec. 16. They remain relatively optimistic, though, forecasting 8 percent growth in S&P 500 profit for 2016.

That sounds bullish. Companies face other headwinds, including tax policy. The recent furor over tax-reducing mergers by U.S. companies – notably drugmaker Pfizer’s $160 billion deal with Allergan – is just one instance of authorities questioning whether businesses pay enough to governments. Investors who have gotten used to earnings ratcheting higher every quarter may want to reset their expectations.

Published December 2015

(Image: Laszlo Balogh)



Volkswagen’s chairman and chief executive are both new to their roles. But in the coming months the German carmaker faces both multibillion-euro fines as a result of cheating on its diesel emissions as well as a scathing external report on its governance. These will shine a spotlight on leaving long-term insiders in charge.

Matthias Mueller, who took over as CEO after the emissions scandal cost Martin Winterkorn his seat at the wheel, is a VW lifer and former Porsche boss. Hans Dieter Poetsch, meanwhile, spent 12 years as finance chief before becoming chairman.

There’s some justification for appointing one of them: steering the overly complex vehicle that is Volkswagen through an existential crisis arguably requires detailed knowledge of its inner workings. Installing both of them, though, seems tin eared. Of the two, Poetsch looks the more exposed.

First, he’s a confidant of Ferdinand Piech, the towering patriarch of the Porsche family, VW’s controlling shareholder. Piech spent 22 years as boss and then as chairman of Volkswagen until being forced out in a power struggle in April 2015. He started the empire building and created the internal fiefdoms and sclerotic culture that worsened under Winterkorn.

Poetsch is also, thanks to having held a seat on the executive board as finance director, one of those who can be held legally responsible for any company misconduct in the emissions scandal. And he is central to a key legal issue: whether the 17-day delay in September in informing investors about its emission woes after admitting cheating to U.S regulators can be justified.

All this puts Poetsch in a difficult position to start with for many of the tasks he will have to carry out as chairman. These include assuaging the anger of American regulators, lawmakers and VW shareholders.

His role is likely to get even trickier as scandal-related costs mount: the 8.7 billion euros the company has so far set aside do not cover any fines; and the U.S. Environmental Protection Agency alone could impose a penalty of up to $18 billion. Meanwhile, U.S. law firm Jones Day’s investigation into the inner workings of the scandal will probably unmask the carmaker’s rotten internal culture as well as whatever role Poetsch played. Appointing an independent chairman in 2015 would have been a smart move. In 2016, it will become a necessity.

Published December 2015

(Image: REUTERS/Ina Fassbender)



Less is more. But apparently luxury companies don’t feel that applies to their swollen store networks. Labels like Prada and LVMH have spent a decade expanding rapidly to meet emerging market demand. Slowing sales and overexposure suggest it’s time to go the other way. While cutting back will be painful, it could spur higher luxury valuations.

The global market for luxury has ballooned in 10 years, mainly because of China’s rise. Storefronts have blossomed accordingly. Consider the tripling of Burberry’s retail locations over that time. Prada has more than doubled in size since 2009 – with 629 locations by 2014. Hermes is one of the few that has been conservative. It opened 65 shops since 2005 – or 26 percent growth over a decade.

That has helped create new sales – but the numbers aren’t that impressive. Revenue growth at Burberry has been 226 percent, suggesting average annual growth of 14 percent, where store numbers have grown an average 13 percent. Prada’s sales have also kept pace with new openings, suggesting both relied heavily on additional shops to beef up their top line.

Hermes snubbed the easy money and focused on organic growth. It’s the harder route but has made its store network far more efficient. A quarter increase in its retail footprint led to a near-tripling of sales from 1.4 billion euros in 2005 to 4.1 billion euros in 2014.

Now that luxury sales are slowing, and falling in China, the maths work against the likes of Burberry and Prada. With their store networks at saturation, their old growth story is over. Hermes, though, is still forecasting 8 percent annual growth, even when the global market for personal luxury has slowed to 1 percent to 2 percent.

The pace of expansion has also overexposed many luxury brands. Burberry has 17 stores in Hong Kong alone – that’s more than cheap fast-fashion Spanish label Zara. There is a glut of stores in China. Yet Chinese shoppers are now buying 70 percent of their luxury trinkets abroad, according to consultant Bain. It would be a brave move to abandon a decade-long habit of growth, but then as Coco Chanel once reputedly advised, “elegance is refusal.”

Published December 2015

(Image: REUTERS/Alessandro Bianchi)



The news from Brazil will get worse before it gets better. The arrest of billionaire banker André Esteves suggests room for further nasty surprises from the Petrobras corruption probe. The roughly $2 trillion economy, Latin America’s biggest, is tanking. President Dilma Rousseff could get impeached. But feisty independent courts and stronger institutions point to a brighter future.

The arrest of Esteves and Delcidio do Amaral, the ruling Workers’ Party leader in the Brazilian Senate, is the latest salvo in a massive investigation into bribes and kickbacks at state oil giant Petroleo Brasileiro. It has rippled through the economy, affecting construction and power companies and even threatening to tarnish the upcoming Olympic Games in Rio de Janeiro. Fiercely independent judges are spearheading the probe, and Rousseff is in no position to try to influence them. Some 50 politicians are being investigated for bribery.

Rousseff herself has not been implicated, though she chaired the Petrobras board when much of the alleged improbity occurred. But she is hugely unpopular, blamed for sending the economy into its worst recession in 25 years and the austerity she espouses to fix it. Demonstrators have called for her impeachment.

Brazil’s institutions have been growing stronger since democracy was restored in the 1980s, however, and can act as a bulwark against the populism Rousseff has compared to coup-mongering. If she is impeached, it would probably be for dodgy government accounting practices rather than incompetence and would only happen after a long process in Congress. She could also be in trouble if the Petrobras probe, known as Car Wash, finds illicit contributions to her 2014 re-election campaign.

Plea bargains and other legal measures have made it easier to investigate companies since a huge vote-buying scandal known as the mensalão broke a decade ago. Though the court system has pockets of corruption and bogs down in red tape, a well-functioning judiciary can offer more security for investors and eventually help the economy recover.

The nation stands out from regional laggards like Venezuela, where the Bolivarian revolution of Hugo Chavez and his hapless successor, Nicolas Maduro, has seriously compromised the independence of government institutions. Facing crises of their own, such countries would do well to watch for the silver lining in Brazil’s: the rule of law.

Published November 2015

(Image: REUTERS/Ueslei Marcelino)



Low rates have forced investors into a dangerous search for yield. Just look at the surge in junk-bond and emerging-market corporate debt sales over recent years. Cheap money has also driven record levels of stock buybacks in the United States and fuelled a boom in corporate mergers.

This is evidence of what the Japanese call “zaitech” – the use of cheap capital to boost reported profitability. Like all grand experiments in financial engineering, though, this one too will come unstuck.

Japan’s infatuation with zaitech arose in the late 1980s, at a time when economic growth was slowing and the rising yen threatened corporate profits. Many companies responded to those headwinds by issuing warrant bonds in the eurodollar market, swapping the proceeds back into the domestic currency and investing in Japanese shares, which were held in special trust accounts.

While the Tokyo stock market soared, these companies enjoyed rising earnings and a negative cost of debt funding. However, after interest rates rose and stocks plummeted in the early 1990s, it was game over. Many enthusiastic zaitech players, such as Hanwa, reported large losses.

The mid-1960s witnessed an earlier experiment with financial engineering in America. This was the era of the conglomerate boom. Companies such as ITT, Gulf + Western, Saul Steinberg’s Leasco and Ling-Temco-Vought (LTV) expanded rapidly through acquisitions. Between 1966 and 1968, conglomerates accounted for more than 80 percent of U.S. takeovers. These conglomerates often adopted dubious accounting techniques to boost profits.

Take LTV, cobbled together by the ambitious Oklahoman James Ling. The company expanded from a core electronics business into meat packing, sporting goods, airlines, insurance and eventually steel manufacturing. Ling understood that investors – in particular, the “gunslinger” fund managers of the “go-go” era – were focused on earnings per share.

To deliver EPS growth, Ling issued convertible bonds and bank debt to finance his acquisitions. He also enticed shareholders to exchange stock for convertible securities, which further boosted EPS. Ling would often float shares in acquired companies (like today’s tracking stocks) and use the proceeds to retire debt.

As long as the stock market continued rising, these feats of financial engineering worked wonders for LTV’s shares, which climbed 17-fold between 1964 and 1967. After interest rates rose towards the end of the decade and the stock market turned down, the conglomerate bubble burst. LTV was forced to divest companies to pay down debt, Ling was fired, and his company ended up as a second-tier steel concern, eventually going bankrupt in the mid 1980s.

In a presentation at the Grant’s Conference in New York in October, Chicago-based hedge-fund manager James Litinsky drew an intriguing parallel between the 1960s conglomerates and today’s so-called platform companies, businesses which have grown rapidly through M&A.

Unlike the conglomerates, they are not diversified but focused on a single industry. Like the conglomerates, however, they have thrived in an era of financial repression, when interest rates have been kept below the rate of inflation. Like their predecessors, platform companies have been using debt to generate EPS growth. Similarly, they have been egged on by investors, with activist hedge funds replacing the gunslinger generation.

Litinsky highlighted companies from various sectors, including brewing (Anheuser-Busch InBev) and consumer staples (Kraft Heinz). But pharmaceutical companies dominate. One of them, Valeant, resembles a modern-day LTV. The firm has grown rapidly through acquisitions, such as of Bausch & Lomb, and slashing costs to meet cost-cutting targets.

Valeant promised to take $900 million from Bausch’s $1.2 billion of operating expenses. Valeant’s takeovers have been funded by cheap debt – interest expenses relative to long-term debt have averaged below 6 percent in recent years. Cost-cutting, takeovers and low-cost loans have boosted Valeant’s EPS, which climbed from 29 cents (on a diluted GAAP basis) in the fourth quarter of 2012 to $1.56 in 2015’s third quarter.

Like LTV, Valeant has adopted complex financial structures. Its ownership stake in specialist pharmacy Philidor, which distributed some of its drugs, was held through what’s called a variable interest entity. Critics claim this structure, which Valeant is now unraveling, kept contingent liabilities off the balance sheet. What’s clear is that Valeant has borrowed a lot – long term debt has grown from around $10 billion in late 2012 to over $30 billion today.

Corporate rollups, from LTV to Tyco International, have tended to come unstuck when they stop growing. Valeant’s stock is down more than 70 percent since its peak earlier this year. Its high-yield bonds are now trading below par. Valeant’s days of acquisitive growth would appear to be over.

The Valeant story is not an isolated case of aggressive financial engineering. At a time of ultra-low debt costs, announced global M&A activity in 2015 has reached a record $3.9 trillion, according to Thomson Reuters. Global non-financial investment-grade debt issuance has climbed to $1.3 trillion so far this year. Acquisition-related debt reached a record $365 billion, says Thomson Reuters.

Even more debt has been issued by U.S. corporations for share buybacks. Over the past five years, the top 100 share repurchasers have grown their EPS by 93 percent. Their return on equity has climbed to 19 percent from 13 percent during this period, according to Thomson Reuters Worldscope, and their shares have handily outperformed the broader market.

This may look impressive. But the buyback leaders have also seen their sales growth slip and leverage rise. Their median capital spending (relative to cash flow) is below the S&P 500 average. To deliver EPS growth, these companies have been leveraging up and eating their seed corn.

Valeant’s fall from grace is just another example of how debt-fuelled growth creates only an illusion of value. Real worth comes from companies investing wisely for the future and acquiring shares – whether their own or in other companies – at low valuations. While corporate revenue is declining and debt is cheap, financial engineering is an easy way out – until it all falls apart.

Published November 2015

(Image: REUTERS/Issei Kato)



A glut of funds will send Asia’s buyout barons off-piste. Asia-focused private equity managers are flush with a record $162 billion of unspent capital, Preqin data shows. In the coming year firms will be tempted to overpay for assets, buy businesses that rivals have already spruced up and drift into unfamiliar kinds of deal-making.

In some ways, having plenty of “dry powder” is a nice predicament. Keen institutional interest in the higher returns promised by private equity means that buyout firms around the world have more money than they can easily spend.

But the issue is particularly acute in Asia, where the industry is relatively immature: 2014 was the first year that Asian-focused firms returned more cash to investors than they sucked up in fresh commitments, according to Bain. The region also has fewer big takeover targets, since most Asian companies are controlled by rich families or governments.

True, the picture looks slightly better close up. Strip out venture, infrastructure and property funds, and dry powder available for pure buyouts actually shrunk by $3.8 billion, to $36.9 billion, in the year to November 2015. But that is not enough to ease the overcapacity, especially as corporate buyers, sovereign wealth funds and pension giants are also jockeying for assets.

Three things are likely to happen in 2016. First, private equity firms may end up paying top dollar to win those assets that do come to market. That will squeeze returns, and raises the risk of financial distress.

Second, expect more “secondary” trades of businesses between rival PE firms. Sometimes these pass-the-parcel deals can be a good idea: for example, a new owner may be better able to help a company expand globally. But often they just look like fee-heavy asset-shuffling.

Third, watch out for style drift. Firms may venture further from the countries and sectors they know best in search of deals. Or they might compromise in other ways – taking minority stakes alongside powerful founders where it would be better to wield majority control, for example. Though doing nothing is hard, buyout specialists would do better on well-signposted routes rather than straying onto unfamiliar terrain.

Published December 2015

(Image: REUTERS/Emmanuel Foudrot)



Move over, shale: climate change will supplant the U.S. oil revolution as the energy industry’s No. 1 disruptor in 2016. The world’s politicians have gotten serious about cutting greenhouse gases at the United Nations climate summit in Paris. The consequences for the industry will be longer lasting than the recent revolution in oil production.

The growth of shale, largely thanks to hydraulic fracturing technology, shook up the sector over the past few years. It allowed the United States to flirt with becoming energy self-sufficient and thus reduce the political sway of OPEC. Increasing supplies also led to a drop in prices that accelerated last year as China’s economic growth began to slow.

The price of crude is now mired around $45 a barrel, 60 percent off its 2014 high. That hit shares: the S&P Global Oil Index, which tracks the stock prices of 120 petroleum producers, had fallen 30 percent between mid-2014 and September 2015. It has since rallied nearly 12 percent as hopes grow that the oil price will stabilize as both shale and OPEC producers finally adjust production properly to reflect recent turmoil.

The Paris talks could upend this relief. Skeptics may find it easy to dismiss the event. Little has ever been established at these jaw-jaws in the past. The Paris U.N. summit, though – officially known as the 21st session of the Conference of the Parties – already has a good deal of momentum. The idea is to reach an accord that will reduce emissions by a large enough amount that the temperature of the earth’s atmosphere will not be more than 2 degrees Celsius higher by 2100 than before the Industrial Revolution.

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The United States and China, which between them account for some two-fifths of all CO2 emissions, in September detailed a series of accords to start limiting these pollutants over the next 10 to 15 years. In all, nearly 180 countries responsible for some 90 percent of global greenhouse gas emissions announced reduction targets ahead of the summit.

If all their various proposals are fully implemented, it may still not be enough to meet the 2 degree goal. That’s the threshold that many scientists regard as the starting point for dangerous climate change – though a growing number are putting the tipping point at 1.5 degrees Celsius. At that stage, yields from crops as currently grown may fall by roughly 15 percent, water flow in some river basins may drop as much as 10 percent while elsewhere rain falling during heaviest precipitation may jump by the same amount, causing floods.

Hitting a weaker target would still represent progress, though, especially if countries agreed to revisit it periodically with an eye to introducing more ambitious policies later.

Either way, the talks increase the focus on how exposed the energy industry is to changing environmental policy. The main concern among investors is how many so-called stranded assets companies may end up with – in other words, how much of their oil, gas and other energy reserves would no longer be viable – and what impact these will have on performance.

In 2011, researchers at the Carbon Tracker think tank calculated that companies and governments around the world own five times as much coal, oil and gas than can be safely burned without an unacceptable risk of exceeding the 2 degree limit. In a recent report, the group calculates that fuel companies risk squandering over $2 trillion of capital expenditure over the next decade – around a quarter of oil majors’ potential investment – pursuing projects that may ultimately end up uneconomic due to tighter carbon policy and advances in renewable technologies. Exxon Mobil and Royal Dutch Shell would be most at risk in dollar terms.

Both companies largely dismiss talk of a carbon bubble. They argue that fossil fuels, especially oil and gas, will still be needed if policymakers want to supply a growing, more affluent global population with reliable energy. The industry appears willing to bet that the high cost of keeping global temperatures below 2 degrees Celsius will make the target untenable. Better, in that case, to keep pumping, invest in technologies to make fossil fuels burn cleaner and invest to offset the worst effects of climate change.

For the first time, though, the industry is facing a combination of both political and financial pressure. So they are unlikely to be let off the hook.

Bank of England Governor Mark Carney, for example, revealed in September that as chair of the Financial Stability Board he is considering recommending to the G20 that “more be done to develop consistent, comparable, reliable and clear disclosure around the carbon intensity of different assets.” Such information could make “climate policy a bit more like monetary policy.”

The International Energy Agency and several Wall Street firms have published studies supporting the carbon bubble logic. Earlier in November, New York Attorney General Eric Schneiderman issued a subpoena demanding documents related to Exxon Mobil’s communication about climate risks.

Shareholders are taking a more active role, too. At times, that’s simply a case of publicly committing to sell fossil fuel holdings. Big institutions and individuals responsible for $2.6 trillion in assets have done so, according to a September report by philanthropy consultants Arabella Advisors. That’s a 50-fold increase in assets under management over last year.

Others have used companies’ annual proxy voting process to push for more disclosure on climate risks at Exxon and Shell, for example. And research and lobby groups are corralling investors to take action, too. CDP, for example, gathers data from at least 4,500 firms – not just energy companies – on behalf of more than 800 investors responsible for some $95 trillion of assets.

All in, it puts energy companies in a bind. Those that ignore climate risk – and the willingness of politicians and financial markets to deal with it – could eventually see billions of dollars of investment go up in smoke. Those that forgo investing in fossil fuel altogether, though, may struggle to grow as the rising global population demands a better lifestyle that, currently, only more traditional energy methods can help provide. Whatever happens in Paris, climate will prove more vexing than shale in 2016.

Published November 2015

(Image: REUTERS/Francois Lenoir)