Saturday, 8 March 2014

Credit - The Thin Red Line

"If we take the generally accepted definition of bravery as a quality which knows no fear, I have never seen a brave man. All men are frightened. The more intelligent they are, the more they are frightened." - George S. Patton

Watching with interest the events in Crimea, after having spent some time wondering about the raft of "good" economic data (PMIs, nonfarm payrolls,...), and the recent geopolitical events we thought we ought to use a reference to a military action, given we quoted the maverick George S. Patton earlier on. 

This time around we decided to pick a military action by the red-coated Sutherland 93rd Regiment of Highlanders at the battle of Balaclava on the 25th of October 1854 during the Crimean War. In this event the 93rd backed back a small force of Royal Marines and some Turkish soldiers routed the Russian cavalry charge, earning the fiery Scots more Victoria Crosses than at any other time:
"The Times correspondent, William H. Russell, wrote that he could see nothing between the charging Russians and the British regiment's base of operations at Balaclava but the "thin red streak tipped with a line of steel" of the 93rd. Popularly condensed into "the thin red line", the phrase became a symbol of British sangfroid in battle." - source Wikipedia

The Thin Red Line became an English language figure of speech for any thinly spread military unit holding firm against attack. The phrase has also taken on the metaphorical meaning of the barrier which the relatively limited armed forces of a country present to potential attackers. 

You must therefore be already wondering where we are going with our chosen analogy. Colin Campbell, 1st Baron Clyde, the commanding officer of the "Thin Red Line" had such a low opinion of the Russian cavalry that he did not bother to form four lines but two lines, although military convention dictated that the line should be four deep. 

When ones look at the growing sense of "impunity", in both the equity space with the S&P breaking records after records and in the credit space with the Markit CDX North American Investment Grade Index touching the lowest intraday point of 61.6 basis point, the lowest level since the 1st of November 2007, we are left wondering in this replay of "Balaclava" if investors are not too "complacent" by not bothering to protect their portfolio, preferring, like Colin Campbell, to hold two lines of defense, rather than the conventional four (volatility being currently very cheap).

Credit wise, we reminded ourselves that dealers' books have shrunk from $256 billion in 2007 to $56 billion today. So, when and not if, the market turns, mind the gap because, as goes one of our favorite quote which we have used repeatedly:
"Liquidity is a backward-looking yardstick. If anything, its an indicator of potential risk, because in liquid markets traders forego trying to determine an assets underlying worth  - they trust, instead, on their supposed ability to exit." - Roger Lowenstein, author of When Genius Failed: The Rise and Fall of Long-Term Capital Management. - "Corzine Forgot Lessons of Long-Term Capital"

So dwindling dealers' books and rising bond offerings might make DCM bankers put on a huge smile but if the market turns, everybody will cry, much more than in 2008.

In this week's conversation, the metaphorical meaning in our title is that of the relative "limited" protection offered in terms of "liquidity" due to the relatively limited dealers book present to potential "redemptions" on the downside for credit investors. But we ramble again...

For us "The Thin Red Line" is how thinly liquid credit markets are today relative to 2007. Valuations wise in segments of the technology space are akin, we think to 1999, and credit markets looks more eerily familiar to 2007. We could indeed be looking at 1999+2007 for both equities and credit. 

In this week's conversation, we wanted to convey our thoughts and some of the "Red Flags" we have seen as of late, not justifying the on-going complacency when it comes to assessing the replay of "Balaclava". We are not too sure the "Scots" (USA and Europe) can hold the line this time around versus Russia but we digress slightly.

More and more, investors are not getting compensated for the credit risk they expose themselves to in the High Yield space. For instance, a recent example of the complacency we think is illustrated by the new HeidelbergCement 2019 new issue in Euro, offering 2.40% of yield, for an annual coupon of 2.25%. It isn't much being paid out for a BB+ 5 year bond when you think that the Iboxx Euro Corporate All benchmark index commonly used in investment grade mutual funds is offering a yield of 2.12% for a modified duration of around 4.5 years.

This growing disconnect is clearly illustrated we think with the evolution of the Itraxx Crossover 5 year CDS index (European High Yield risk gauge based on 50 European entities) and Eurostoxx volatility (1 year 100% Moneyness Implied Volatility) - graph source Bloomberg:
"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

The evolution of the US Vix index and its European counterpart the V2X tells as well a similar story of volatility being contained by the sea of liquidity. Evolution of VIX versus its European counterpart V2X since 18th of April 2011 - graph source Bloomberg:

As we already posited in our conversation "All that glitters ain't gold" in December 2013, 2014 is indeed the year of the "Carry Canary" in particular in the convertibles space given M&A and buyback activity are always a catalyst for issuance as illustrated by the below chart from Bank of America Merrill Lynch displaying the proportion of high yield issuance used for acquisitions:
Another point which indicates a "Thin Red Line" has been in the loan space with the significant rise in high loans without covenants as indicated by Caroline Salas Gage and Kristen Haunss in their Bloomberg article from the 6th of March entitled "Banks Enriched by Junk Resist U.S. Regulatos Standards for Loans":
"For the first time, more than half of the junk-rated loans made in the U.S. during the fourth quarter and so far this year lacked standard protections for lenders such as limits on debt relative to cash flow, Bloomberg data show. Such so-called covenant-light loans amounted to a record $84 billion in the fourth quarter. That was followed by another $57 billion since December.
The exclusion of “meaningful maintenance covenants” is a sign that “prudent underwriting practices have deteriorated,” the Fed, OCC and Federal Deposit Insurance Corp. said in a March 21 statement accompanying the release of their underwriting guidelines.
The advisory said debt levels of more than six times earnings before interest, taxes, depreciation and amortization, or Ebitda, “raises concerns.” Underwriting standards should also consider a borrower’s ability to repay and “delever to a sustainable level within a reasonable period,” the regulators said." - source Bloomberg

It reminds us of the buyout of TXU in 2007 for $48 billion which came at the peak of the private-equity boom which ended up in tears. Energy Future will probably end up  being the biggest failure of a private equity-backed company since Chrysler Group LLC in 2009.

Another "Thin Red Line" we have been looking at has been in the convertible space with the gigantic Tesla convertibles issue upsized from $1.6 billion to $2.3 billion has also made us revisit the hay days of 2007, given most the latest issues in the convertibles are offering a zero coupon with an "ambitious" premium, such as Akamai which in February announced a $500 million Senior Convertible Note with 0% coupon and 45% premium, giving you an interesting negative yield of -0.2% / -0.3% and 50% premium:
"Akamai intends to use the remaining net proceeds of the offering for working capital and general corporate purposes, including potential acquisitions and other strategic transactions. Repurchases of common stock from purchasers of notes in the offering, as well as any additional repurchases of common stock by Akamai, could increase, or prevent a decline in, the market price of Akamai's common stock or the notes." - source Akamai offering.

In relation to that 1999 feeling for equities, we noted the following as reported by Bloomberg by Leslie Picker and Ari Levy on the 6th of March from their article "IPO Dot-Com Bubble Echo Seen Muted as Older Companies Go Public":
"Last year, 208 companies went public, raising more than $56 billion in the U.S., the most since 2007, data compiled by Bloomberg show. Companies seeking more than $100 million in their U.S. IPOs surged an average of 21 percent on their first day of trading, the biggest annual increase since 2000.
People who argue that this time is different “have a vested interest to ensure the investing trend continues,” said Ian D’Souza, an adjunct professor of behavioral finance at New York University who co-founded a technology-focused equity fund." - source Bloomberg

When it comes to stretched "valuations" and echos from the 1999-2000 era, we have been monitoring a specific stock which appears to us strongly reminiscent of the 2000, namely, which displays many prior accounting similarities with Microstrategy.  had a Q4 EPS of $0.07 beat by $0.01. Q4 GAAP loss per share was ($0.19), yes GAAP (all that matter for us). Salesforce previously introduced in 2012 a new metric called “unbilled deferred revenue,” a "non-GAAP" measure of the value of contracts. For us, more than a "Thin Red Line", a "Big Red Flag". Unbilled deferred revenue rose 29% Y/Y to $4.5B after growing 40% in FQ3.

 "Those who cannot remember the past are condemned to repeat it" - George Santayana

Fortunately for us, we do remember the past.

When it comes to the accounting similarities, the previous case of MicroStrategy Inc in 2000, was a case of Revenue Recognition Fraud or Error, as explained by Sudha Krishnan, assistant professor Loyola Marymount University:
"On March 20, 2000, MicroStrategy announced that it planned to restate its financial results for the fiscal years 1998 and 1999. MicroStrategy stock, which had achieved a high of $333 per share, dropped over 60% of its value in one day, dropping from $260 per share to close at $86 per share on March 20th. The stock price continued to decline in the following weeks. Soon after, MicroStrategy announced that it would also restate its fiscal 1997 financial results, and by April 13, 2000 the company’s stock closed at $33 per share." 

Basically, MicroStrategy stock tanked in 2000 because it had materially overstated its revenues and earnings contrary to GAAP not complying with SOP 97-2. So when we read that tells the SEC it cannot quantify the revenue impact between new customers and additional subscriptions as indicated by Michael Blair in Seeking Alpha, we do indeed chuckle. Particularly when we know that in 2012, Salesforce introduced a new metric called “unbilled deferred revenue,” a non-GAAP measure of the value of contracts not yet booked as sales.

So we really do feel sorry but, in our world, sales growth without profit is pointless. From an equity valuation point of view is overstretched. We do not know when this stock will crater in similar fashion MicroStrategy did, but eventually it will.

Another illustration of this 1999 feeling comes from the recent surge in China's Tencent Holdings Ltd, as displayed by Bloomberg's Chart of the Day:
"China’s Tencent Holdings Ltd., the best-performing major technology stock worldwide in the past five years, is mirroring gains by the biggest U.S. computer companies at the height of the dot-com bubble.
The CHART OF THE DAY compares Tencent’s 1,246 percent advance in Hong Kong trading since March 2009 against the rallies in Microsoft Corp., Cisco Systems Inc. and Intel Corp. before the stocks peaked about 14 years ago. The lower panel shows Tencent shares trade 10 percent higher than the average 12-month price target of 27 analysts tracked by Bloomberg.
Surging demand for Tencent’s online games, e-commerce platform and WeChat social-networking app in the world’s most-populous nation has helped the company boost earnings at a 48 percent annual rate since 2009 to become Asia’s largest Internet business. While ABCI Securities Co. says the advance is built on stronger profits than many U.S. stocks during the 1990s bubble, Shenyin & Wanguo Securities Co. says Tencent is becoming a riskier bet after its valuation reached an almost six-year high.
“A rally like this cannot go on forever,” said Gerry Alfonso, a trader at Shenyin & Wanguo in Shanghai. “There is upside on this stock, but it is clearly a more risky stock to buy than a few months ago.”
Shares of Microsoft, Cisco and Intel climbed between 1,078 percent and 3,432 percent in the five years through March 10, 2000 -- when the Nasdaq Composite Index peaked -- to become the world’s most valuable technology companies. The trio plunged between 55 percent and 81 percent over the next three years on concern valuations in the technology industry overshot the potential for earnings growth.
The gain in Tencent, the best performing technology company with a market value of at least $20 billion, left it trading at the biggest premium over analysts’ price targets among large-capitalization peers. The stock is valued at 60 times reported profits, the most among Asia’s top 100 companies. Cisco’s price-to-earnings ratio was 196 on March 10, 2000, versus 63 for Microsoft and 52 for Intel.
Jerry Huang, a director of investor relations at Tencent, declined to comment, citing restrictions before the company reports earnings on March 19." - source Bloomberg.

Of course of the main culprit for the "meteoric" rise of some stocks in the technology space, has been the generosity of the Fed and its QE as displayed by the below graph from Bank of America Merrill Lynch form their 18th of February note entitled "Pig in the Python - the EM carry trade unwind":
"Could the party go on? Yes, if for some reason – a significant deterioration in the US labor market, or a deflationary shock from China, or any other surprise that could lead to a cessation of the US tapering could prolong this carry trade. This is not the house base case. We believe it is better to start preparing for a post-QE world. As one of our smartest clients told us: “the main theme in the past five years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” We agree."- source Bank of America Merrill Lynch.

When it comes to the deflationary forces at play, they should not be underestimated we think, no matter how "rosy" the latest data appears to be. From our point of view, we have a hard time believing the US economic recovery is genuine and that US has finally reached "escape velocity" when we look at the trend for shipping as our favorite deflationary indicator. Container shipping rates continue to fall, highlighting no doubt the fragile state of global growth as displayed in the following Bloomberg table:
"Shipping rates for 40-foot containers fell 7% to $1,843 for the week ended March 6, marking the sixth-straight weekly decline and the lowest rate since mid-December when prices dipped below $1,700, according to World Container Index data. All major trade lanes declined, except Rotterdam to Shanghai, which rose 3.4%. Rates from Shanghai to Rotterdam declined the most, falling 15% for the seventh-straight decrease, to $2,166, the lowest price in 11 weeks." - source Bloomberg

As we indicated on numerous occasions, any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic.

But, when it comes to the housing market revival, we would have to agree with Bloomberg, namely that the housing-market prospects in the US seems shaky:
"Housing may slow the pace of U.S. economic growth this year even though home prices and sales of new single-family dwellings would indicate otherwise, according to Pavilion Global Markets Ltd.
The CHART OF THE DAY displays one reason for the firm’s conclusion, presented in a report yesterday. As the top panel shows, the annual rate of home resales fell 15 percent for the six months ended in January, according to data compiled by the National Association of Realtors. The decline contrasted with a 25 percent increase in new-home sales during the same period, according to data from the Commerce Department.
There were 8.7 existing homes sold in January for every new dwelling, the fewest since August 2008, as illustrated in the chart’s bottom panel. Yet about 90 percent of transactions for the month were resales, based on a sales-rate comparison.
“Housing is on a shaky pillar, and perhaps more than recognized,” Pierre Lapointe, head of global strategy and research at Montreal-based Pavilion, and two colleagues wrote.
The market presents “one of the largest real economic risks to U.S. growth in 2014.”
Smaller gains in home prices are another reason for concern, the report said. The Standard & Poor’s/Case-Shiller price index for 20 U.S. cities rose 13.4 percent in December, down from 13.7 percent in November. The change in the growth rate, called the second derivative, slowed earlier last year. The potential for reduced investment buying of homes, the lingering effect of foreclosures, and a reluctance among many banks to provide mortgage loans may also weigh on the housing market, the report said." -source Bloomberg.

In similar fashion, container shipping rates fell another 5% recently as shown by the latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 for the week ended March 5, declining to the lowest rate since early January and marking the fifth week below $2,000 in 2014. Slack capacity continues to pressure prices, with rates 17.9% lower yoy and 25.1% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase on containers from Asia to the U.S., effective March 15." - source Bloomberg

So investors might indeed think that "The Thin Red Line" is enough to keep the deflationary forces at bay, but, given volatility remains cheap, we think investors would be wise to follow military convention  which dictates that the line  of "defense" should be four deep.

"Courage is what it takes to stand up and speak; courage is also what it takes to sit down and listen." - Winston Churchill

Stay tuned!

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