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 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:
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.
"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 Salesforce.com, which displays many prior accounting similarities with Microstrategy.
Salesforce.com 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 Salesforce.com 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 Salesforce.com 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:
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":
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:
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:
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.
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