Chart of the Day - S&P500 - Leverage and performance

"When you combine ignorance and leverage, you get some pretty interesting results." - Warren Buffett

This Exane BNP Paribas chart displaying the S&P 500 with the performance relative to the leverage summarizes clearly the current "releveraging" trend in the United States we think:

- Source Exane BNP Paribas

Some thoughts around the latest jumbo M&A deal of the day, namely the $37 billion Avago/Broadcom deal. Like in many recent deals in the cable industry or pharmaceutical industry, we note that the buyers who are Investment Grade/Low Investment Grade rated use current low rates/spreads to realize acquisitions which are financed by most part through significant debt issuance.

We have therefore the following "spicy" buybacks/M&A cocktail at the high of the cycle financed by debt. This is reminiscent of the M&A Telecommunications wave of 1999/2000 where buyers who had realized their acquisitions by paying mainly in shares (Vodafone) fared much better than those who used debt and leverage (France Telecom/Orange, Vivendi, etc.).

Our thoughts:

1. If this trend continues, US Investment Grade credit will become less and less attractive from current levels of rates/spreads
2. This might be a statement of the obvious but, this "releveraging" to finance buybacks/acquisitions is a "bullish" development from a "volatility" perspective at medium/long term. The correlation between credit spreads/equities is more likely to rise and "self-power" financial stress in a case of a "Macro" risk reversal.

"Fair play doesn't pertain in bargaining. What matters there is leverage." - Alan Rosenberg, American actor

Stay tuned! 

LBO? No problemo!

"No problemo" is a slang expression used in North American English to indicate that a given situation does not pose a problem. It has roughly the same meaning as the expression "no problem," but is rarely heard as a response to "I'm sorry." - source Wikipedia

While looking at the quick succession in LBOs (Dell, Heinz), a subject we have tackled with Dell recently in our conversation "The return of LBOs - For whom the Dell tolls", as a credit investor, the "sucker punch" capacity of inflicting serious pain to the investment grade bondholder is reminiscent of the hay days leading to the burst of the credit bubble in 2007.

In similar fashion to the Dell transaction, the Heinz effect was rather more sanguine than ketchup, and probably as spicy as tabasco when it comes to spicing things up a bit in the CDS space - source Bloomberg:

From 50 bps to 200 bps, given Buffett's new found love for the ketchup is transforming H.J. Heinz into the most leveraged food maker in America as reported by Mary Childs in her Bloomberg article on the 21st of February - Buffett’s Ketchup Fancy Plies Heinz With Junk:
"Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc.’s $23 billion acquisition of Heinz may double the company’s total debt to five times earnings before interest, taxes, depreciation and amortization, according to Fitch Ratings, the highest of any comparable food company. The cost to protect Heinz’s debt from losses soared to a record after the announcement. While Buffett has used takeovers to build Berkshire into a $249 billion company and burnish his reputation as the world’s most successful investor, financing the deal with $14.1 billion in debt threatens to strip Heinz of the investment-grade rating that it’s had for four decades. Fitch cut Heinz to junk on Feb. 15 and credit-default swaps imply a Ba1 rating, according to Moody’s Corp.’s capital markets research group. That’s two steps lower than its Baa2 rating from Moody’s Investors Service and three below its BBB+ grade from Standard & Poor’s. The trading “underscores the hazards of high-grade bonds in an active M&A environment,” said Martin Fridson, chief executive officer of research firm FridsonVision LLC. Investors should be aware of the “inherent danger now that leveraged buyouts as well as strategic acquisitions are once again prominent in the financial landscape,” he said." - source Bloomberg.

The cheap credit environment is indeed sufficiently friendly for shareholders in this on-going releveraging process and arguably very unfriendly and painful, to say the least, for the investment grade portfolio manager, given that the LBO story is clearly more favorable to equity investors than credit investors facing multiple downgrades and Profit and Loss hits.

In a recent note by CITI entitled "Ever Been a Better Time for a LBO?" published on the 22nd of February 2013, they argue that the current cheap credit environment makes the pursuit of shareholder-friendly activity quite compelling relative to historical norms:
"Question: If you could buy the exact same company for $75 today (sale price) or for $100 tomorrow (full price), which would you chose?

Answer: Depends. Paying full price may very well be better than paying the sale price if borrowing costs for the two are different. Price is one part of the “package.”

When considering re-leveraging activity, our sense is that many market participants tend to overlook the “package effect,” and as a result under-appreciate the extent to which corporate managers could favor shareholders. In fact, in a sum-of-the-parts context the argument for LBOs may look as compelling as it ever has." - source CITI

As we have also argued in our conversation "Bold Banking", when one looks at the return of Cov-lite loans to the fore front, no doubt to us we are entering, once again bubble territory in the credit space. In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."

"Low borrowing costs: Current borrowing costs are hovering near all-time lows. For example, a typical LBOed company is likely to carry a single-B rating, and Figure 2 (previous page) shows that the yield for the average single-B issuer is almost 4% below the historical norm (5.9% vs. 9.8%). Also noteworthy is that moving from single-A — the typical rating of an “un- LBOed” company — to single-B (likely post-LBO rating) is fairly cheap as well. Figure 3 (previous page) shows that the yield difference between the two is now only 3.4%, vs. the long-term average of 4.7%. And there are other lending features in the current environment that in practice cheapen borrowing costs as well, such as the relative lack of covenants (Figure 4). It really doesn’t seem to cost that much to move down the quality now." - source CITI

The "unintended" consequences of ZIRP courtesy of the Fed is favoring releveraging of corporates' balance sheets:

"Reasonable valuations: So an LBOed company in the current environment can be expected to provide a high income stream due to low interest expense, and equity stakeholders may now have an above average chance of collecting this income stream. But in addition, one also doesn’t have to pay all that much for these advantages; the PE ratio for the typical IG name is currently 12.8 (based on our sample universe as explained below), compared to the historical norm of 16.4 (Figure 6)." - source CITI

CITI goes further in their note displaying a real world example for the sake of the demonstration:

"Based on our sample universe, the typical “un-LBOed” company currently has $3.8 bn in total debt outstanding, current market cap of $13.8 bn, and earnings before interest of $1.8 bn (Figure 7). Given our assumptions, after an LBO this company’s equity value will decline by $9.6 bn and total debt will increase by the same amount." - source CITI

"Impact of low borrowing costs: If we consider an LBO scenario in a historical context borrowing cost rises from 5.1% (long-term average yield of the typical single-A issuer) to 9.8% (average single-B). Higher borrowing cost means that net income would fall from $1.58 bn to $0.45 bn for the typical name (albeit divided among fewer shareholders, of course; Figure 8). But currently all-in yields are low and the yield difference between the average single-A and single-B is only 3.4%, which means that interest expense rises by a fairly small amount (Figure 8, previous page). As a result, net income is not pressured by higher borrowing costs anywhere close to normal, and post-LBO net income is far higher than usual ($0.98 bn)." - source CITI

Given the pressure on CEOs to increase ROEs, the LBO can indeed justify the recourse in leveraging the balance sheet as indicated by the below table from CITI's note indicative of the potential increase of ROE that can be achieved via a typical LBO for an investment grade company:

"Pay less for more! One could normally expect the ROE for a typical company to be more or less flat post LBO (Figure 10). This is not all that surprising, as sponsors get paid to shift through the details. The multiple one has to pay for flat performance is normally 16.4x. But now the increase in ROE is over 11% in a post-LBO scenario (from 12.2% to 23.4%). And to get the relatively high ROE the multiple one must pay is lower than normal, not higher (12.8x vs. 16.4x)." - source CITI

As a reminder, in 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, but , as CreditSights put it in in their 29th of July 2008 report entitled LBO Analysis - It is more than Just Financial Metrics:

"Creating value by adding leverage is, in essence, an arbitrage strategy. And, like any arbitrage return, it will ultimately be arbitraged away as participants increase. 

Despite the favorable lending terms during 2005-2006 credit bubble, it stands that there is even less ability to create value simply from leverage.

LBO management can enhance value by exploiting knowledge of a competitor's play book when on the offense and by taking more financially productive responses when on defense." - source CreditSights

We could not agree more.

"What counts is what you do with your money, not where it came from" - Merton Miller 

Stay tuned!

US share buy-backs and dividends increases in two charts

"If you ask a firm's management, they'll likely tell you that a buyback is the best use of capital at a particular time. After all, the goal of a firm's management is to maximize return for shareholders and a buyback generally increases shareholder value. The prototypical line in a buyback press release is "we don't see any better investment than in ourselves." Although this can sometimes be the case, this statement is not always true." - source www.investopedia.com 

- Source - Societe Generale US Credit Research.

Increasing buy-backs in conjunction with rising dividends:

- Source - Societe Generale US Credit Research.

"The Bottom Line: Are share buybacks good or bad? As is so often the case in finance, the question may not have a definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback - and its effects - can be viewed as a positive sign for shareholders. Watch out, however, if a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution."  - source www.investopedia.com 

For us, buy-backs are credit negative if it means buying-back using leverage and more debt, particularly for banks given it reduces the equity buffer needed in case of trouble. 

Increasing debt to fund share buy-back is a trend we have seen lately. It might be more efficient from a tax point of view given interest on debt is deductible, but, remember, a debt has to be repaid at some point...

Share buy-backs do eat into FCF (Free Cash Flow). While we recently touched on the return of LBOs with the example of DELL inc ("The return of LBOs - For whom the Dell tolls"), from a credit perspective, in similar fashion to LBOs, the rising trend in share-buybacks using debt finance warrants close monitoring in this "Yield Famine" induced environment of "Financial Repression", where the "credit mouse-trap" has been set up by Central Banks.

"If you do not change direction, you may end up where you are heading." - Lao Tzu 

Stay tuned!

Credit - The Donk bet

"There are three roads to ruin; women, gambling and technicians. The most pleasant is with women, the quickest is with gambling, but the surest is with technicians." - Georges Pompidou, former French president (1969-1974)

While watching the much anticipated LTROs refund on Friday, as well as the economic data during the week  with the rebound of the European PMI which we had anticipated (France being an outlier, but, our readers  know it doesn't come to us as a surprise), Spain's Economy Minister Luis de Guindos took center stage for us on Friday by declaring on Bloomberg TV: "Spain doesn't need any sort of bailout", adding that the target for the budget shortfall this year is "achievable" and concluding his remarks by "The perception of the Spanish economy has improved and will continue to do so over the next weeks and months". 

Given last week's title analogy referred to poker games in general and the art of bluffing in particular, we thought we had to use yet another poker game reference in our title namely the "Donk bet".

 The "Donk bet" being:

1. A bet made by a donk, i.e. one that is generally considered weak or to demonstrate inexperience or lack of understanding of strategy.
2. A bet made in early position by a player who didn't take initiative in the previous betting round. It was named because this move is often considered indicative of a weak player (since it is more often reasonable to expect a continuation bet). - source Wikipedia

It seems to us that Spain's Economy Minister has not fully demonstrated his understanding of the "Fabian Strategy" of Mario Draghi. Our "Generous Gambler" has been trying to "call the clock" (using another poker game reference) on Spain  namely trying to discourage them to take a long time to act.

We would therefore "agree to disagree" with Mr de Guindos given Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index has beaten Greece as the crisis bites and unemployment has reached 26.60% as indicated by Bloomberg:

The European Commission prediction for Spain’s budget shortfall last year is already wider than the EU’s goal of 6.3 % of gross domestic product. The target for 2013 is 4.5 %...

We quoted in our conversation "Agree to Disagree" Henry Queuille. Henri Queuille was the epitome for "professional politician": he served three times as Prime Minister and was 21 times minister in a French government under the IIIrd and IVth French Republic. He was the symbol of the inefficiency and the failure of the French IVth Republic:

"Politics is not the art of solving problems, but to silence those who ask." - Henri Queuille

It appears to us that Mr de Guindos is indeed a true disciple of Henri Queuille when we listened to his latest Bloomberg interview. As a matter of Spanish "quote" comparison, BBVA's Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be "stable from now on". Looking how "stable nonperforming loans have in been in Spain, one can wonder whether or not a Henri Queuille award should be set up in Europe for the best delusional political quote, but, we ramble again...

So in true poker fashion, one can posit "there's indeed plenty of action in this game". In this week's conversation we will therefore look at what lies ahead for the Spanish banking sector in general and Spain's real economy in particular in conjunction with the LTRO impact of the early refund. But first a quick credit overview.

US PMI versus Europe PMI - source Bloomberg

"Short term, we do expect a minor reduction in the divergence as reflected in credit prices such as the US leveraged loan cash price index versus its European peer." - Macronomics, The Fabian Strategy, 5th of January 2013

We explained the divergence in our conversation "Growth divergence between the USA and Europe" and we indicated early January that this divergence should persist in 2013. 

The uncanning similarity of the US leveraged loan cash price index versus its European peer with the above PMI graph - source Bloomberg:

"Loan prices have risen to 97.72 cents on the dollar, the highest since July 2007, from 59 cents in December 2008, as concern eases that the world’s largest economy will slide back into recession. Leveraged loans and high-yield, high-risk bonds are rated below Baa3 at Moody’s Investors Service and lower than BBB- at S&P." - source Bloomberg.

The current European bond picture with the continuing fall in Spanish and Italian yields with rising Core European yields - source Bloomberg:

In relation to our "Flight to quality" picture, Germany's 10 year Government bond yields have been recently rising above 1.60% and the 5 year CDS spread for Germany has been rising in tandem in the process - source Bloomberg:

2 year German bond yields versus 2 year Japanese yields, yet another "sucker punch" courtesy of the LTRO's refund anticipations. From 0% yield to 0.23% in January 2013 - source Bloomberg:

Credit and volatility wise, the Itraxx Crossover index (representing the credit risk gauge for 50 European high yield entities) have as well falling in tandem but with volatility (a subject we recently touched on) breaking through important levels similar to the regime of 2004-2007 - source Bloomberg.

Credit wise, what really caught our attention was not only the "new regime" in volatility (or should we say Central Banks' dictatorship via "financial repression"), but, the US High Yield space, where Tenet Healthcare has issued a 7 year bond with a single "B" rating with a coupon of 4.25%, which is an "all time low" level for a primary yield level on a single "B" credit on a 7 year bond.  

As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks. Well done...

We also recently reflexionate around the return of mega leveraged buyout transactions such as DELL inc  in our recent conversation "The return of LBOs - For whom the Dell tolls".  Record low borrowing costs in the market for junk bonds (high yield) where LBOs are financed is creating the ideal set up for a leverage buyout   buying spree: "There will be about $135 billion in LBO volume this year, compared with an average of $100 billion during the past two years, and below the $600 billion annual peak of 2006 and 2007, he said. Credit-default swaps typically surge on LBO speculation because the debt added to a company’s balance sheet to fund the takeover erodes its credit quality and leads to ratings downgrades. 
“As the recent experience with Dell illustrates, the risk of LBOs has a particularly large impact” on Markit’s investment-grade benchmark, pushing it a net 2 basis points wider, Bank of America’s Mikkelsen and Yuriy Shchuchinov wrote in a Jan. 23 note. Their model shows 14 percent of the index’s underlying credits are feasible LBO candidates. 
 Credit-default swaps on Quest Diagnostics have climbed 38.5 basis points to a mid-price of 123 basis points since Bloomberg News first reported Dell’s buyout discussions with private- equity firms, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. 
Buying Protection:   
That was “precipitated by investors’ buying protection on names that have traditionally been considered LBO candidates,” following the Dell news, according to a note dated Jan. 23 from Barclays Plc analysts led by Shubhomoy Mukherjee. Credit-default swaps tied to Nabors surged 42 basis points to 191, the highest since July, and contracts on Avnet Inc.’s debt climbed as high as 254 basis points on Jan. 14 before falling to 178 basis points yesterday, CMA data show. Those on Falls Church, Virginia-based Computer Sciences Corp. added 40.5 basis points since Jan. 11 to 193 yesterday. Buyout firms announced a record $1.6 trillion of acquisitions from 2005 to 2007. The end of that era was “quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains,” CreditSights Inc. analysts Glenn Reynolds and Ping Zhao wrote in a note."  - source Bloomberg - Dell Lifts Default Risk on Next Buyout Targets: Credit Markets.

Could that be another indication of a "Donk bet" taking place in the credit space? We wonder...

As we have argued last week's Dell LBO conversation:
"One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...)."

Moving on to the Spanish "Donk bet", no disrespect to Mr de Guindos and Mr Cano but we will have to agree with Citi's recent note on Spanish Banks - Iberoamerican Big Picture from the 21st of January:
"A change in the latest asset quality deterioration trend is needed for the sustainability of the banking system. If at a system level we maintain the loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would increase to 29.1% in 4Q13E from 16.6% in 3Q12. As expected the key drivers of the NPL growth will be the construction and the real estate sectors" - source Citi

"Just as an example, if we maintain the yoy loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would go from 16.6% in 3Q12 to 29.1% in 4Q13E. Just keeping the contraction deleverage pace stable pace with the stock of NPLs, the NPL ratio would increase to 18%." - source CITI

So much for "stability Mr Cano. So much for "improvement Mr de Guindos.

In last week's conversation "Cool Hand" we discussed the Bank of Spain's recent willingness in stemming the  war for deposits taking place in Spain:
"By trying to put an end to the deposit wars, the Bank of Spain ambitions to reduce the pressure on banks' earnings and profitability which would reduce the capital shortfall for some Spanish banks and the level of capital injunctions needed. It is once again a "Fabian strategy", buying time that is."

Citi's recent note on that matter is as follows:
"On 8 January 2012, the Spanish press reported that the Bank of Spain had “recommended” the largest banks in Spain to limit the yield of saving products. Other banks followed shortly. The measure apparently would also affect guaranteed funds and commercial paper products. The penalty for high yield deposits would consist of higher capital requirements, which would not affect foreign banks operating in the country (ie Banco Espirito Santo, ING). 

The press sources differ in the way the penalty is going to work, given the lack of official statements from Bank of Spain, the interpretation of the law can vary significantly. We expect a law to regulate this “recommendation” shortly. The Bank of Spain has taken this measure in order to reduce the cost of funding for the banks, which are expected to transfer part of this reduction to lower lending rates. We have to take into account that, according to the 3Q12 results, banks are already reducing the yield of loans after the repricing cycle during 2012. 

How do we understand the new recommendation? It will apply to the new savings production from banks — 85% of the new production of the banks won’t be able to exceed the yield limits set in the table below (Figure 4). The banks exceeding this limit will need to comply with higher core capital requirements, according to the press up to 125bps more from the current 9.0% requirement. The latest reports point out that the deposits above €10 million won’t be affected by the new requirement, supporting big corporate and public deposit accounts." - source CITI

The larger than expected EUR 137.2 billion initial repayment from the first three year LTRO (consensus was for 84 billion), we will have to wait until mid-march to get the geographical breakdown from National Central Banks in order to assess the complete picture for European countries.

But some Spanish banks such as Banco Sabadell indicated on the 11th of January, that the bank was planning to repay EUR 4.8 billion of LTRO funding (20% of the total requested) according to Citi's note.

As far as profitability for Spanish banks is concerned, as indicated by Citi's note:
"Given that the last LTRO was already announced in February 2012, it should be fully included in analysts’ estimates, reducing revenues expectations for 2015. Below we can find the revenue consensus estimates of our coverage universe. It is not only that revenues seem high, in our view, it is also that consensus seems to be missing the LTRO effect in 2015 revenue estimates, as they are expected to grow by 7% on average (ex Santander and BBVA)." - source Citi

An interesting analysis from Citi, while there are not missing out on the LTRO impact on earnings, we think they are lacking some essential points in relation to Spanish banks.

-First missing point - the issue of puttable bonds which we discussed in our conversation "When causation implies correlation":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg
Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag." - source Macronomics, When causation implies correlation, 27th of October 2012

-Second missing point - the issue of the dwindling capacity in absorbing potential losses at the parent bank due to partial IPOs discussed in the same October conversation:
Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs(the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights" 

-Third missing point being one of Macronomics's favourite namely the importance of "Goodwill" (see our conversation from November 2011 - "Goodwill Hunting Redux"):
"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."

Goodwill:
"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."

In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:

"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.

As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."

We also indicated at the time:

"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."

When one looks at European banks, Spanish bank Santander, Credit Agricole and Italian bank Intesa are carrying the most "Goodwill" as indicated in the table below from Bloomberg:

"A mere 5% of the 800 billion euros of outstanding goodwill was impaired in 2011, with about 19.2 billion (2.4%) relating to financial services, according to an analysis of 235 public European companies by the European Securities and Markets Authority. The top 24 European banks' combined goodwill fell to 173 billion euros at FY07, from a 2007 peak of 233 billion euros, with further impairments likely." - source Bloomberg.

In relation to the "real economy" in Spain and the on-going "Donk bet", Spanish recession has deepened in the last quarter of 2012 with GDP contracting 0.6% from the previous 6 months when it slipped 0.3%. So while Spanish Economy Minister Mr de Guindos is seeing an improvement in the perception of the Spanish economy, there is a difference between perception and reality. Even the European Commission on the 22nd of January indicated Spain would miss its 2012 deficit target. with a GDP contraction forecast of 1.4%, taking the deficit to 6% for 2013, not the "ambitious" 4.5% Mr de Guindos seems so sure of.

What matters is loan growth for economic growth to resume in Spain. We do not see it happening in 2013 for the "real economy" - graph below source Citi:

As indicated in the article from Charles Penty in Bloomberg from the 21st of January 2013 entitled - "Spain Banks selling debt still won't cut loan costs:
"The prospect of diminishing competition for retail deposits may boost lending margins. Reports that the Bank of Spain wants lenders to cap the yields they offer on deposits are positive for banks because it would provide relief for their funding costs and bolster margins, Sergio Gamez, an analyst at Bank of America Merrill Lynch, wrote in a Jan. 10 note to clients. Bank behavior may make it hard for Spain to rejuvenate an economy mired in a five-year slump and headed for a further contraction this year, said Tobias Blattner, an economist at Daiwa Capital Markets in London. Spain’s economy will shrink 1.5 percent this year after contracting 1.4 percent in 2012, according to the median forecast of 38 analysts surveyed by Bloomberg. “The interest rates that banks are charging to lend to companies aren’t going down and that’s a big worry,” Blattner said. “There are no signs yet of a pass-through by banks of their lower funding costs to the real economy.”" - source Bloomberg

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

From the same Bloomberg article: 
“If they’re using wholesale debt that costs 3 to 4 percent to replace ECB funding that costs 0.75 percent, that means substantial pressure on margins,” Creelan-Sandford said. Banks are trying to wring more revenue from loan books as they seek to absorb the rising cost of a clean-up of 180 billion euros of real estate assets ordered by the government last year, he said. Banks in other nations have dropped their lending rates, ECB data show. German rates declined to 2.9 percent from 3.9 percent a year earlier, while French companies pay 2.2 percent, down from 3.2 percent. In Portugal, the cost of a loan for as much as 1 million euros fell to 6.7 percent from 7.6 percent, while Irish banks charge 4.6 percent, compared with 5.3 percent. Spanish companies are petitioning Prime Minister Mariano Rajoy, who says one of his priorities in government is to create conditions for credit to recover in Spain. The Spanish Confederation of Small and Medium-Sized Companies said in a Jan. 17 statement that it didn’t see “normal” financing conditions returning until 2016 at the earliest and that the lack of funding put firms in a “situation of extreme weakness.” - source Bloomberg

It is deflation in Europe and Spain is still mired in a deflationary spiral. 

On a final note the VIX volatility index passed the 5 year level as Bank CDS fall further as indicated in the Bloomberg chart from the 21st of January:

"The VIX Index, a widely-used measure of market risk often called the investor fear gauge, fell to its lowest level in more than five years as macroeconomic concerns, including those regarding the U.S. fiscal cliff, recede. Certain bank revenue streams remain correlated to volatility, with lower volatility increasing demand for risky assets, pressuring prices higher, and vice versa." - source Bloomberg

"There is no gambling like politics." -   Benjamin Disraeli, British statesman

Stay tuned!

The return of LBOs - For whom the Dell tolls

"It was easier to live under a regime than fight it." - Ernest Hemingway, For Whom the Bell Tolls, Chapter 34.

"A leveraged buyout (LBO) is an acquisition (usually of a company but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explains the origin of the term LBO." - source Wikipedia

In the run-up to the financial crisis of 2008, 2006 and 2007 where the years where "cheap credit" fuelled the housing bubble, but it was the years as well of the mega-buyouts. In 2006, private equity firms bought 654 US companies for 375 billion USD, 18 times the level of 2003 and raising 215.4 billion USD in investor commitments to 322 funds. 2007 saw yet another record with 302 billion USD of investor commitments to 415 funds. 

The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  

Energy Future Holdings is loaded with 37.4 billion USD worth of obligations whereas Texas Competitive is saddled with 32.2 billion USD in debt, 700 million USD of which is due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 

KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp is moving towards bankruptcy and restructuring according to Bloomberg article by Richard Bravo and Mark Chediak - TXU Teeters as Firms Reap $528 million fees: 

"Energy Future’s long-term debt has soared to $42 billion since the buyout and the company is poised for its seventh straight quarterly loss as it struggles with natural gas prices 73 percent below their 2008 peak. Moody’s Investors Service says the company may need to restructure next year and derivatives traders are pricing in a 95 percent chance of default within five years for its deregulated unit." - source Bloomberg.

The issue with TCEH was that their breakeven cash flows needed in 2011 was based on 6.40 USD/mcf sustainable gas prices to cover all interest expenses and 450 million USD of maintenance CAPEX according to CreditSights calculations in April 2011. Of course it went horribly wrong for natural gas in 2012 and the "assumptions".

- source TradingEconomics.com

When too much leverage and when assumed breakeven on natural gas prices are so far out from reality, it does not end well for the TXU/TCEH bondholders and could get even uglier if natural gas price falls again towards the April 2012 lows...but that's another story and we ramble again...

Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with 1.5 trillion USD in assets that they intended to sell at a profit. For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council.

While we already delved into the insidious returns of cov-lite financing in our September conversation "The World of Yesterday":

"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance."

In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."

Back in February 2011, we also discussed the dangerous return of Cov-lite loans financing and we referred to what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, said in her article - Corporate Subprime - The default crisis that never happened:

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.

After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."

But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Old habits die hard:

"Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard and Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006."

The latest news surrounding the possibility for Dell to go private via the use of a LBO, have made us want to look into more details about the return of the LBOs, which was previously linked to the previous credit bubble. It was fuelled, in similar fashion by "cheap credit". 

Following a comment from Dave Merkel, writer of the Aleph Blog in relation to our post "Chart of the Day - S&P 500 pension equity allocation" ("Private equity is replacing public equity in many DB pensions. The "Chart of the Day" may not mean what you think."  - David Merkel), 

Here comes the time for us to go into the Dell case, and the unsurprising come-back of the mega-LBOs. So yes David, you are right, private equity and large LBOs are coming back with a vengeance.

During the run-up to the credit crisis of 2008, the impact of LBOs where not only a nightmare for investment grade credit portfolio managers given a LBO is by definition a negative credit event (more leverage with more debt on the balance sheet meaning an obvious fall in the rating spectrum), it was as well a nightmare for market makers in the credit space, natural sellers of CDS protection to their clients, given the "sucker punch" capacity and P&L pain infliction caused by widening CDS spread on LBO news such as the one relating to DELL. 

For instance, the latest news surrounding DELL have cause a serious "denting P&L" kind of spike in the CDS price - source Bloomberg:

This kind of "sucker LBO punch" significantly hurts your P&L if you have been a net seller of CDS protection on DELL in this tightening spread environment (+200 bps on 5 year...).

Sector wise, the result is similar, DELL has indeed widened significantly relative to some peers on the LBO news as displayed by the below graph of CMA, part of S&P Capital IQ:

The latest news surrounding DELL is that it has hired Evercore to seek higher bids should a buyout be formalised according to Bloomberg:

"Silver Lake and its partners are close to lining up about $15 billion in funds for a buyout of Dell, the third-biggest maker of personal computers, people familiar with the situation said last week. The deal would likely value Dell between $23 billion and $24 billion, said one of these people." - source Bloomberg.

A similar Texan company that went through a similar buyout than DELL, was Freescale Semiconductor Inc back in 2006 which was bought for 17.6 billion USD by Blackstone and loaded with 8.1 billion USD worth of debt.

Following the 2008 crisis, the ability for the DB pensions mentioned by David Merkel to monetise their investment was shut down because the IPO market went down by 70%. Endowments and pension funds which poured into private equity pools during the "credit" binge, did not receive the return they thought they would get on their investments.

So why DELL is looking at a LBO? It stock price fell 29% in 2012 due to increased competition from the likes of LENOVO.

DELL Share price 1 year evolution (18th of January 2012 to 17th of January 2013) - source Bloomberg:

DELL reported weak results in its Q3 with revenue below its prior guidance range (down 10.7% YoY) and EPS below expectations. DELL's is facing increasing headwinds in the PC space and has seen its business fall sharply in the third quarter in both consumer and commercial markets.

In this "deflationary environment" (falling prices) in the PC space, both DELL and HP have been losing market shares to Lenovo in both end-user segments. As we posited before, whether it is for the car industry, or the shipping industry, it is, end of the day, a game of survival of the fittest which entails serious strategic adaptations for some.

"Lenovo shipments gain 24% in industry beset by falling prices" - source Bloomberg

"PC shipments should increase while prices decline as value markets such as China and India grow to become larger portions of the market. Intel-branded Ultrabooks are spurring innovation in PC technology that appeals to mass-market buyers, and has been largely absent in recent years, apart from the laptop. Lenovo's shipments grew 24% in 2Q." - source Bloomberg

As reported by Bloomberg, Dell's "PC Competitiveness" is a much in focus as its financial metrics - DELL, HP and LENOVO, market shares evolution:

Although DELL has been losing PC Market Share, it has managed to increase its market share in the Global Server Market.

The Global Server Market Share was impacted by the macroeconomic weakness of 2012 which drove, according to Bloomberg a 4% YoY decline in 3Q server revenue. DELL was the only top five server vendor  to increase revenue, with 8% growth. HP saw its revenue in that space fall 12% while IBM declined 8% ahead of new products being introduced in the fourth quarter. Oracle fell 23% as it moves away from low-end servers - source Bloomberg:

While Dell's current 9 billion USD debt pile isn't insurmountable at 89% of total equity as of the end of 3Q, the serious threat posed by Lenovo warrants caution in relation to its future under a new owner via a LBO, because Lenovo has leapfrogged HP to become the top global notebook maker with 15.9% market share:
"The overall portable market fell 7%, led by declines at Hewlett-Packard (19%), Dell (18%) and Acer (7%). Apple grew 10% and Asustek 8%. Tablets and smartphones appear to be increasingly hurting portable sales." - source Bloomberg

"Dell's debt is 89% of total equity as of the end of 3Q, with a total of $9 billion on its balance sheet. With cash and equivalents of $11 billion and a trailing free cash flow of $3.1 billion during the last four quarters, this debt burden is not insurmountable, especially with low rates and an A- S&P credit quality rating." - source Bloomberg

From a pure deal point of view, we agree with Bloomberg in the sense that Dell's cash flow and valuation makes the private equity option looks rational - source Bloomberg:

"Dell's free cash flow generation of $3.1 billion, $2.2 billion net cash position and valuation metrics (7.6x ex-cash P/E and 6.9x price-to-free cash flow) may appeal to a buyer. Dell is discussing going private with TPG Capital and Silver Lake, Bloomberg News reported. An assumed 30% premium to Dell's Jan. 14 price would create the industry's first $28 billion deal, topping HP's $25 billion 2001 acquisition of Compaq." - source Bloomberg

But from a strategic point of view, it all depends on the strategic orientation DELL will embrace under its new ownership. The intensity in the competition for PC from the likes of Lenovo, makes it increasingly difficult for DELL to protect its own turf as PC have become more commoditised and are facing as well a change in consumer spending patterns with the increased developments of smartphones and tablets.

If DELL is to survive, even under a new "leveraged" ownership, it will have to adapt fast, given that across most of its product lines (storage, software, peripheral, mobility and desktop) have seen important declines as per their recent 3Q results (PC business declined 19% YoY with desktop down 8% YoY and mobility down 26% YoY).

For DELL, the only way is up, up the value chain that it is (entreprise solutions and services) for the LBO to increase its probability of success and to avoid being saddled by debt like its Texan neighbor Freescale Semiconductor Inc.

Moving back on the private equity deal flow and in relation to David Merkel astute comment, relating to pension funds allocation to private equity, a recent note by independent credit research house CreditSights entitled "LBO Risk Revisited for HG Bonds" from the 20th of January 2013 explains clearly the rationale behind private equity allocation:
"The correlation between strength in the high yield origination cycle and private equity deal volume is hardly a new one since the HY market exploded onto the scene in the 1980s. The problem with high yield origination booms is that they have had a habit of quite literally exploding as they did after the LBO binge of the mid-to-late 1980s and after the TMT cycle. In the LBO boom of 2005-2007, the end was also quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains. The reality is that a wide range of LBO deals are still in limbo from the 2006-2007 period and it will take more time to get those deals off the books via an IPO or strategic buyers. That does not prevent new funds from being set up by new investors or to see higher allocations from pension funds raising their commitments to private equity. These funds need to plan on meeting their return shortfalls in future years, and their allocations in high quality fixed income make for very difficult math." - source CreditSights

One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...).

As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks:
"So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."

For us, mega-LBOs, such as DELL, are another "smart way" in snaring in "yield starving investors" in the "credit mouse-trap".

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

Stay tuned!