Friday, March 15, 2019

Easing Up on Stress Tests

Big banks operating in the U.S. might be able to stress out less over regulatory stress tests
The tide had already begun to turn in the past two years.  Bank regulators in the U.S. had begun to ease on the toughest aspects of bank regulation. 

And in Feb., 2019, the Federal Reserve in the U.S. amended some of the rules, requirements and expectations of stress tests administered to big banks after it had significantly changed requirements in May, 2018, with amendments to U.S. Dodd-Frank regulation.  

In just the past two years, there are likely a hundred or so banks around the country quietly applauding such changes in stress-test requirements.   In 2019, the Federal Reserve didn't abolish stress tests; it modified requirements by applying less pressure on banks to prove they will have substantial amounts of capital during prolonged periods of stress.  

The stress tests for big banks still exist. The 2018 amendments to Dodd-Frank granted relief to medium-size banks: They are no longer subject to regulatory stress testing, although they should conduct them on their own. 

The tests for the big banks (based on asset size) are administered and run by regulators using regulators' own models and scenarios.  And big banks must still seek to pass the tests. In the latest episode of changing bank regulations, regulators promised not to apply hard pass-fail rules to the "qualitative" phases of the stress tests, the rules that make judgment calls on how banks assess whether future capital levels will be sufficient as they growth their businesses. 

Stress tests of all kinds and conducted in any manner, based on assumptions and models to show how a bank would endure a period of systemic and economic stress, are still important.  Dodd-Frank II permitted fewer banks to be subject to the Federal Reserve-administered tests. But bank regulators still expect banks to run their own tests and submit results to supervisors.  Banks don't mind it when they manage their own tests, using their data and devising their own models.  They become concerned if they are subject to tests based on others' models, especially when the details of such models are not widely available. 

The Federal Reserve version of stress testing assumes big banks will be subject to a nine-quarter period of an macro-economic downturn (adverse case, severely adverse case, etc.). The regulator performs calculations of how each big bank will perform under the scenario.  In most cases, banks will amass big losses.  The regulator doesn't guess at the losses; it calculates them as precisely as possible. It determines whether the bank under review has sufficient capital to withstand the calculated losses and meet conventional capital requirements under Basel III and U.S. Dodd-Frank rules. 

In banking (whether for regulators or for ongoing internal risk management), there are numerous kinds of stress tests:  Stress tests for loan portfolios; stress tests for trading positions and investment portfolios; stress tests focusing on liquidity, funding and deposits; stress tests for operational risks (especially related to business continuity and cybersecurity), and stress tests related to country and political risks. 

There is scenario-testing, as well:  What happens to the loan book and deposits when interest rates rise or fall by 100 basis points? 200 basis points? What happens to trading positions when interest rates rise or equity markets fall by a certain percentage? What happens in trading activity when trading counterparties default or can't meet trading terms? What happens when the value of collateral in loan exposures or trading positions declines suddenly? The scenarios are countless in number. The bigger banks run models that look at thousands of variables and scenarios. 

Most banks are well-equipped to develop the required sophisticated models to quantify such risks--whether the risks are overnight or are prolonged over a two-year period. They also develop models with the understanding that bank supervisors will have chances to review model integrity and second-guess the results.  (Models are "back-tested" to evaluate whether they successfully predicted the amount of worst-case losses.)

Stress tests provide comfort for bank risk managers, bank investors and even regulators. They permit the bank to identify shortfalls in risk management, over-exposed business activities (in the loan book or in trading positions), and single out business units that aren't bringing in the rewards for the risks they absorb.  They also help banks determine how much capital is necessary for today's balance sheet and for balance sheets in the periods to come. Stress tests contribute to bank decisions about whether they can increase dividend payouts or buy back shares. 

Risk management in banking ultimately leads to the question of whether there are sufficient amounts of capital to absorb identifiable and unforeseen, hidden risks. Capital absorbs losses and prevents losses for creditors, depositors, trading counterparties, and ultimately central governments and deposit-insurance schemes that may feel the need to bail out failing banks.  

Regulators obsess over capital adequacy. Banks obsess over calculating optimal capital levels.  They want to make sure they have capital for today's operating environment and capital to pass tests. They embrace having excess amounts of capital, but they also don't want too much capital.  Too much capital, they reason, implies wasted amounts of capital.  They rationalize increased dividends or buy-back programs if there is excess beyond excess.  

Stress tests, therefore, help regulators and banks in these calculations of what is the right amount of capital on an ongoing basis.  

In the past year, the Federal Reserve reaffirmed the value of stress testing. But they provided relief for small banks (by not subjecting them to regulators' versions of the tests) and eased up on the pass-fail requirements for big banks. 

Ease up or not, the last thing bank supervisors want is for big banks to learn how to mastermind or "game" the regulatory stress-test model to permit them to pass stress tests without difficulty. 

Tracy Williams 

See also:




Wednesday, January 30, 2019

Big Banks' Big Year

Despite volatile stock prices, big banks have begun to report blockbuster 2018 earnings in early 2019.
Bank stocks, especially those of the big, familiar "too big to fail" banks, fluctuate in value too often.  They did for much of the last quarter. Whatever happens in economies and financial markets around the globe appear to have immediate impact on bank stocks. If the economy in Taiwan coughs, then it might have impact on Goldman Sachs' market value.  If oil prices capsize, then investors presume banks will suffer losses from oil-and-gas loans, and the stock shares plummet.

Hints of a global economic recession, uncertainty in China-U.S. trade talks, the agonizing shutdown in Washington, and fear of just about everything have caused markets to shake vigorously the past few months. Take the stock of Citi (now at about $62/share). A year ago, the price had approached $80. In December, it dipped into the low 50's. Bank of America share prices (at $29/share) had been comfortably above 30, but slid below 24 in December.

No doubt big banks touch market and economic activity everywhere. They influence it, but they are influenced by it.  A change in interest rates, shifts in yield curves, or deteriorating perspectives about technology companies sometimes lead to risks and losses at financial institutions. Quickly.

Yet despite worries among investors and doomsday projections from economists who enjoy the attention they get after they predict the end of the financial world, as big banks have begun to report  2018 performance, many of them have done quite well.  Bank of America, JPMorgan Chase, and Citigroup, for example, reported annual net earnings of over $18 billion each, levels of performance they have never achieved and with returns on capital they haven't reached in a financial generation.

Granted, they are benefitting from a generous tax code, new tax legislation enacted a year ago.  JPMorgan, for example, paid 31% of pre-tax income in taxes in 2013; in 2018, it paid 20%. In 2018, it paid about $4 billion less in taxes than what it would have paid in 2013 (at a 31% effective rate).  That alone explains a 1% increase in its after-tax ROE in 2018.

But JPMorgan and other big banks have benefitted from steady increases in operating earnings--as they continue to spread their wings in many geographic and product directions (while quietly whispering about how financial regulation still keeps their hands tied). They leaped aboard the momentum of the last decade's improved economy; they have responded to threats of competition from financial technology upstarts. They have survived the ongoing threats (so far, as they cross their fingers) of cybersecurity.

So from year to year, they inch upward. They have grown their consumer and corporate loan books, have been prudential about loan-loss reserves, have retained and even increased deposits, have ensured they have more-than-excess amounts of capital and have stuck to their guns in finding ways to make money from trading (despite the handcuffs of Volcker regulation).

They get frustrated they can't grow their favorite businesses (fees from asset management and fees from investment banking) by double-digit percentages. But they embrace the minimal impact these businesses have on their balance sheets and capital requirements.

The big banks addressed bad loans. Bad loans and bad assets (especially in the mortgage categories) suffocated banks--legally and in performance.  It took almost a decade.  By 2018, loan portfolios on the balance sheet look more pristine. Non-performing loans and assets (impaired loans) have steadily declined (below 2% of total loans in most cases).  Loan-loss provisions (in expectation of future losses) have declined, suggesting that new loans booked are of better quality or have better protection (collateral, guarantees).

Such "success" (including not just operating results, but vastly restructured and improved balance sheets) have come with an expected consequence.  The same banks have comfortably passed Federal Reserve stress tests in the past year; hence, bank regulators have permitted them to reward shareholders with higher dividends and share buybacks.  The same banks blamed for contributing to the financial crisis have reached a success point where regulators have approved decreases in capital on the balance sheet and are tolerating a wee bit more leverage (while still, of course, ensuring they meet all the Basel and Dodd-Frank capital requirements handily).

CITIGROUP

By historical standards, Citi had a blockbuster year, reporting $18 billion in earnings and stepping up to a 10% ROE plateau after years in the single digits.  The bank spent much of a decade cleaning up its balance sheet ("good bank" separated from "bad bank"), reducing credit risks and ensuring it had sufficient liquidity to reach tough Basel liquidity standards.

It felt strapped in boosting the loan book while its peers did so eagerly. In 2018, it finally increased the corporate loan book and increased overall loan net-interest earned after years of outright flatness.

Trading securities, currencies and commodities around the globe is still important at Citi. Performance in 2018 ($9 billion trading income) was flat. The bank might accept that--given the volatile markets in the last quarter. (Banks look for customer-flow volume to achieve trading gains. Often volatile markets spark customers to buy and sell assets, which can lead to trading gains at dealer banks.)

What might be overlooked at Citi is how earnings improvements have resulted, too, from cost management. Profit margins and operating efficiencies have gotten better and rank admirably among peers, even if it is hard to imagine where else the bank can cut costs to improve margins in the years to come.

Nonetheless, watch out.  The bank has felt comfortable reducing capital and increasing leverage (okay, to keep shareholders interested and happy for now).

JPMORGAN CHASE

"Too big to fail?" JPMorgan Chase continues to get bigger and bigger.  Its balance sheet now tops $2.6 trillion in assets. On the same balance sheet, its loan portfolio will likely eclipse the $1 trillion mark later this year. Loans are booked in all possible borrower categories--credit cards, mortgages, small-business loans, bridge loans, and large corporate financings. Deposits continue to pour in from domestic and foreign branches (mostly deposits that pay interest) and could reach $1.5 trillion this year. Cheap deposits around the world support the loan portfolio.

But this is a trading behemoth, as well.  Trading-related revenues topped $12 billion in 2018 (Compare with Goldman's $8-9 billion annually).  Trading assets amount to over $400 billion (or about 15% of the balance sheet.) (That includes its big derivatives-dealing role, which, some argue, might be understated on the bank's balance sheet.)

There are substantial (and growing) trading risks at JPMorgan (as measured by the industry's "value at risk" metric). JPMorgan's "VaR" metric ($51 million maximum one-day loss) suggests a marked increase in trading risks the past year--likely due as much to exceptional volatility in 2018 on the same level of trading exposures.

The bank reported handsome upturns in most business lines--even in asset management (11% increase) and investment banking.  The increase in that loan book (with some help with increases in interest rates that contribute to increases in interest income) contributed to the $5 billion increase in net-interest earned.

Increases at JPMorgan at just about every important business area in all parts of the globe led to $33 billion in net income. Yes, the $4 billion tax gift helps, too.  The 2018 performance resulted in the 13% ROE the bank reached for the first time since the combined big bank consisted of separate existences of old Chase, old Chemical, old JPMorgan and even old Manufacturers Hanover.

Like Citi, it has benefitted from cost management and efficiencies.  Operating costs have increased across the board, but as JPMorgan's leaders often specify: "It's not about cost reduction; it's about cost control" (arguing that some costs are necessary to grow and get big around the world).

On the heels of one of its best years ever, the bank has seen its stock bounce way up and then way down.  In September, share prices had touched $120; by December, they had sunk below $95 and have recently hovered about $102.

BANK OF AMERICA

Bank of America raises the earnings flag to boast, "We, too." The bank's net income leap-frogged up to $28 billion, sufficient for a 11% ROE, a return that tops 10% for the first time in memory. It, too, was blessed by generous tax relief, paying about $5 billion less in taxes than it would have had to do so in 2016.

The bank replicates JPMorgan in many ways--in size, scope, business lines. They certainly compete head-on--in consumer, corporate and investment banking. Like JPMorgan, Bank of America has similar sizes in loan portfolios, deposits and total balance sheet.  Bank of America, a storied, big investment bank in its own way (thanks to the Merrill Lynch lineage), trails JPMorgan in trading assets, trading income, and investment-banking revenues.

Still, like JPMorgan, Bank of America has "contained" and "controlled" costs (steady improvement in operating-efficiency ratios) and has felt satisfied enough to do what its peers have done:  Reduce capital by giving some of it back to shareholders in the way of dividends and buybacks.

Leverage has increased and is as high as it has been since 2013. The bank will be the first to assert that 2013's balance sheet was still stockpiled with market and credit risks, bad loans, illiquid mortgage-related assets and who knows what else.

So in sum, they quietly toot their horns and pat their backs and thank legislators and regulators who have permitted than to boost dividends and buy back stock.

Now if only if stock prices can proceed at a more predictable, tolerable pace.

Tracy Williams

See also:

CFN:  Dodd-Frank Tossing and Turning, 2018
CFN:  A Spike in Bank Stocks? 2017
CFN:  What is CECL to Banks? 2017
CFN:  Wells Fargo's Woes, 2016

Wednesday, December 12, 2018

What Will Be the Trigger?

As financial markets behave erratically, what could be the trigger to push the system into some form of a crisis?

In the financial crisis of a decade ago, economists and historians tend to agree that America's over-dosage on mortgages, mortgage products and securitizations proved to be a trigger that caused global havoc in 2008.

From 2006 into 2007-08, there might have been signals for what was to occur. What eventually occurred was the collapse of Bear Stearns and Lehman Brothers and the disappearance of familiar mortgage banks like Countrywide and Washington Mutual, followed by a debilitating recession.  Scattered mortgage defaults across the country (especially in the sub-prime sectors) led to defaults in mortgage bonds, mortgage securitizations and mortgage structures. Defaults led to losses, not just in the millions, but in billions.

Back then, products (highly rated bonds, securities, and loans) that were popular just a few years before couldn't be traded, sold or touched. What had been modestly liquid turned out to be unbearably illiquid. As the crisis appeared and evolved, risks some financial institutions thought were tolerable or negligible suddenly became overwhelming and insufferable. Losses mounted.  Over time, but firms and banks, one by one, began to fall like a "house of cards," as it so often was later described.

Ten years later, market-watchers and market-forecasters are trying to project the next crisis by trying to identify what might cause it.  What might be the one phenomenon that leads to another that leads to outsize losses that spread like a wildfire around the globe?

Despite low unemployment statistics, increasing job growth, and heretofore glowing prospects for global businesses and the global economy, market players have begun to react as if it's inevitably time for another recession. They speculate whether a slowdown or crisis is imminent, although not in the proportions we endured in 2008-09. 

Check the equity markets the past few months. Or check it one hour and then glance back an hour later. Watch the emotions of the market. Watch how one announcement, one trend, or one hint of how interest rates might behave moves markets by whole-integer percentage points.  

Everybody attempts to figure out the trigger: The Trump presidency, Trump's whims and misguided pronouncements, or a credit and debt bubble (after corporate borrowers have begun to amass almost too much debt). Will it be a economic pause that leads to an aggressive slowdown? Will it be a sudden turnaround in consumer confidence? How about recent-years' mania over crypto-currencies? What about (what we see this month) the bickering over trade policy between China and the White House? 

Economists study inverted yield curves and try to make sense of the implications of short-term interest rates rising above long-term interest rates.

Can market events and uncertain economies in India, Argentina and Turkey lead to mini-crises in Europe and the U.S.? Will a plateau in growth in Silicon Valley result in a collapse of economic activity in Latin America? Will corporates later be haunted by the billions in debt when they struggle to generate cash flow just to meet quarterly interest payments? Or what will happen if a major corporate entity can't roll over what's due within the next six months?

Where are the hotbeds of political and country risk that could seep into financial markets and affect a global economy?

Ten years ago, the crisis was chaotic and evoked angst, stress and widespread concern about the financial system. Some point out the build-up to it was steady, almost methodical, occurring step by step: the euphoria of home ownership, the overflow of mortgage origination, the excess in innovation with newly created mortgage products (CMO's, CDO's, ABX CDS's, synthetic CDO's, re-securitizations, etc.), the mortgage-making and mortgage-securitizing machinery (led by the likes of Lehman and Bear Stearns), the acute demand for more mortgage product, the over-rated AAA ratings on mortgage bonds, the inability to value mortgage securities properly, the collapse of short-term debt markets, and the panic among short-term lenders to financial institutions.

Ten years later, as a rocky, misbehaving stock market suggests something bad is about to happen, what could be the factor, the variable, the phenomenon or the event that sends us back to harsh memories of 2008?

Crude, irrational experts say they know and offer weak conclusions and incomplete warnings. Real experts don't try to predict as much as they remind all that economic downturn and volatile markets are facts of life in finance and market activity. 

Real experts are, too, aware that with interdependent financial markets, one thing can lead to a negative bad thing, which can have detrimental impact on many other things and lead to financial losses of some kind---which leads to diminished confidence and standstills in the marketplace.  Lenders and investors stop lending and investing to other financial institutions and companies.  Traders become hesitant to trade and make markets--at least until confidence turns upward again. And that would be followed by corporations reluctant to spend, hire and invest, followed by consumers too afraid to consume. 

What happens in markets in America surely has impact on markets in Singapore, Brazil, Japan and throughout Europe.  A global bank's loan losses to medium-size enterprises in the Midwest will influence how much risk it's willing to take in Japan or its willingness to make markets in German corporate securities. 

At least this time around, regulators have done their best to ensure that banks big and small can weather the worst cases.  Losses will occur (even big losses), but banks, they project, should be able to absorb them without having to hope the U.S. Treasury will step in and save the day. 

Regulators and supervisors understand how markets and financial institutions are closely interconnected and interdependent.  They have obsessed over how best to manage risks in the financial system, even choosing to implementing stricter capital requirements for financial institutions that appear too powerful or "too important." 

And they, too, perform scenario stress tests on big banks to see how they would fare if, say, equity markets zoomed downward by 30-50%, if real estate values crash, if unemployment surges above 10%, and if the U.S.'s GDP growth rate sags below 2%.

What we do know is that financial markets act in desperate ways and assume the worst when they are engulfed in uncertainty. They calm down when uncertainty is contained. 

Tracy Williams

See also:


Thursday, November 1, 2018

Big-Company Woes: Sears, GE and Tesla

Some well-known companies have had significant operating challenges the past year or two
Stock markets are in an unsatisfactory swirl in the middle of fall, 2018. Markets flirt at being at a turning point or precipice, not sure whether to go up or prepare investors for correction or prolonged downturn.

Some familiar corporate names themselves, one by one, have dominated recent news. They blast onto the top of financial-media headlines and then go away and then return, when the issues that plague them don't disappear or don't get resolved with finality.

Sears

Sears announced a bankruptcy, and that's a surprise to few people. For some, it's a wonder it stayed away from courts until now.  The company has not made money in years and has had huge cash-flow deficits from old, fading business models and unappealing and unspectacular physical storefronts.

The company generated nearly $40 billion in sales in 2012, but could barely reach $16 billion last year. Sears didn't survive the onslaught of the Amazon generation and was ill-prepared to transition to online retail commerce.  Or it did so and stumbled out of the box.

It restructured, reorganized, tweaked the brand, bought other brands, sold other brands, sold real estate and store properties, restructured some more, and scrambled to find new ideas.  Not much worked, beyond its ability to sell off properties, fixed assets and brands to manage what under ordinary circumstances is a reasonable amount of debt on the balance sheet ($2-3 billion for much of the past five years).  

When you are suffering from billion-dollar cash-flow deficits year after year from operations, any amount of debt can become a threat to your existence.  (The company lost between $380 million-$2.2 billion in each of the past six years.) Sears continued to bleed cash until not much remained on the balance sheet to get it through this winter and onward into spring. With about $250 million in cash reserves, the inevitable (or what could have happened years ago) occurred: A bankruptcy filing.

Sears now becomes relegated to business-school history books. Some MBA schools might decide to write a teaching case about how an illustrious retail brand plunges toward insolvency after it is purchased by a hedge-fund investor not as astute and effective in running a storied retail organization as he thought.  ESL, the hedge fund, had ideas, took risks, hired outsiders, and tampered and tweak the business model in ways that didn't work.  Company management was guilty, nonetheless, in not being able upgrade stores and make them (including those at  subsidiary Kmart).  They aimed to bring excitement and energy to the Sears shopping experience, but didn't succeed.

He (Eddie Lampert) tried and devoted much time and attention to reviving the company and making it profitable, although his detractors disliked his running the company as an absent CEO. His experiments didn't work. The marketplace continues to watch, however, because he shrewdly restructured the funding side of the balance sheet such that if there are crumbs to be paid out from liquidating more Sears assets, they will accrue to him. (The hedge fund is an investor and is also a big debt lender.)

General Electric

For decades, General Electric had long been considered one of the world's best managed global companies. It groomed some of the best general managers of industrial operations. Those who didn't reach the top were tapped to run businesses and companies elsewhere.

Not it has reached a fork in the road.   In the post-Jack Welch (former CEO) GE, the company has tripped as a conglomerate and contemplates what to do with its bundles of unrelated businesses.

A company that easily glided and remained near the top quartiles of Fortune 500 lists and was firmly settled into Dow Jones trading indices now has market value ($88 billion) that is about half that of a company like Uber, which is still in the late years of being a start-up and plans its own public offering of equity with almost joyous fanfare.

GE has been a mixture of many businesses, some of which are unrelated and some of which have questionably rationalized.  There have been jet turbines, appliances, and financial services.  It once included a securities broker/dealer and a television network.  And the company has parked its business plans around the world.

Revenues still top $120 billion a year, but profits are still hard to come by.  Some of the earnings sluggishness is its steady restructuring and selling bits and pieces of businesses.  The financial crisis hurt its previous commitment to financial service and dreams of becoming a financial powerhouse, but many of the old GE Capital assets remain.

The fluctuating and unpredictable performance from quarter to quarter for a company where operating flows used to be clockwork predictable has led to the departure of two CEOs (Jeffrey Immelt and John Flannery) in less than two years.  In the annals of U.S. corporate history, GE leaders were supposed to stick around and produce stable, growing bottom lines for at least a decade.  In an un-GE-like fashion, it went outside to find a new CEO (Larry Culp) in September.

GE has enormous debt loads (over $130 billion), but it can manage that and that's not its most plaguing issue.  There is still sufficient operating cash flow (although more erratic than before) to keep debt investors calm.  Stock investors aren't happy. Shares valued over $18 in January are now headed toward $10, and the year is not over.

Operating cash flows have been choppy the past few years and must be high enough to accommodate about $7 billion in annual capital expenditures and $8 billion in annual dividends.  To keep that going (in the way shareholders hope), it must continue to sell off assets and consider more debt. In late October, it took an alarming, but necessary step by announcing it would slice much of the dividend payouts.

Like Sears, GE has adopted strategy, reviewed strategy, abandoned some of it, and continues to search for ways to determine what GE is supposed to be and do.  In September, it decided to continue a campaign to clean up the balance sheet by charging off huge amounts of "goodwill" that arose from purchasing some industrial businesses for amounts far more than what they were worth. It continues a long-term exercise of filtering and reviewing business lines to decide what should stay and what should go.  On the table this month:  Should it sell its healthcare-related businesses?

Unlike Sears, GE will likely stick around for a long time; it may just resolve to become a shell of itself.

Tesla

Tesla's Elon Musk always finds ways to remain in the news.  His headline splashes across financial pages often describing new projects, new risks, new challenges, and new emotions.

There is his company, Tesla, where not surprisingly revenues have soared in recent years.  There has been and will be demand for his product--slick, electric cars bought by consumers generally happy with their purchasing decision.  Tesla's story nowadays is more an operational tale of woe.

Revenues have grown in Amazon-like fashion (from $4-11 billion between 2015-217). But costs have surged even more.  Tesla and Musk don't hide behind the cost numbers.  Costs for growing in an specialized segment of the auto industry are inevitable and necessary. Costs, they argue, will eventually be managed and pushed to reasonable levels.  But not now. The combination of operating costs and required capital expenditures topped $16 billion last year. Real cash outflow.

So Tesla and Musk beg for patience.  In the meantime, surging operating costs are accompanied by surging amounts of debt (now over $9 billion at Tesla), as the company had to construct infrastructure to support the product.  Because of costs, earnings and operating cash flows are non-existent.

Hence, we have a rapidly growing company--led by a sometimes distracted CEO--that has explainable, but uncontrollable costs and mounting amounts of debt. Tesla must convince its stakeholders (debt holders and shareholders) that that costs will eventually be contained and the red line of losses will turn into bulging positive cash flow.

Debt investors might be comfortable company meets regular interest payments.  (It has, believe it or not, about $3 billion cash reserves to get it through any short-term emergency or hurdle.) But can it pay down some of the debt when necessary and can it, if it needs to, refinance some of that debt?

If debt investors and lenders are uncomfortable and impatient, the company will have life-threatening problems.

For all three, stay tuned.  The stories are far from over.




Sunday, September 2, 2018

Netflix: Managing a Mighty Debt Load


Netflix's stock values have surged, but debt investors assess its growing debt burden
In debt and equity markets, there's a love-hate relationship going on with Netflix, the Internet-streaming content provider. 

Equity investors, depending on snippets of information they find about Netflix content plans or Netflix's competitors, love the stock. Occasionally they dump the stock, then buy it, reminded that Netflix is at the pivotal center for how entertainment programming will be created and channeled to consumers for the long haul.

Equity investors, enticed by the company’s strategy, revenue growth, and market leadership, have pushed the company’s market value to over $150 billion (vs. $3.5 billion book value). Business journalists include the company in their special "FAANG" category--the technology movers and shakers that include Facebook, Apple, Amazon and Google. 

Debt investors get uncomfortable now and then, as they are also reminded of ominous non-investment-grade ratings from ratings agencies. The agencies provide alerts that Netflix faces daunting competition from the HBOs, Disneys, and Hulus and reports cash-flow deficits while confronting a big debt burden. (Moody's rates Netflix as non-investment grade, B1.)

It's a debt burden that will continue to rise--a chicken-and-egg conundrum. The company's revenues are indeed growing rapidly. To ensure they grow at that pace, the company promises new, more alluring content.  To develop that content, it chooses to fund it from new debt.  New debt requires even more cash-flow pressures to meet principal and interest payments.  The business model has evolved toward continuing promises of more content, the development of which requires mounting amounts of long-term debt.

Growing revenues have been accompanied by debt levels that now top $9 billion. The company has avoided tapping equity markets to fund these fixed assets.

Netflix, as many know, was originally founded as a service to deliver DVD content (movies, documentaries, etc.) via postal service. DVDs in red envelopes were literally mailed to subscribers, who watched the movies and returned them in pre-sent packages. Many are not aware this continues to be a small part of its business, but the core business now generates revenues from the tens of millions of subscribers who pay monthly fees to access entertainment content on Netflix’s Internet portal. 

In recent years, the Netflix strategy can be summarized:

(a) Grow revenues by expanding into various regions around the world (and introduce content appealing to those from different cultures) and

(b) Evolve gradually from licensing (or “renting”) content from other content providers toward developing new content because contents Netflix creates will likely be more attractive and of higher quality than content it finds elsewhere.

Give Reed Hastings, its CEO, and the company credit.  If it had stubbornly stuck to a DVDs-in-the-mail business, the company would have disappeared or been bought out a long time ago.
Revenues have grown at a compounded-annual growth rate of 28% the past five years and now exceed $11 billion annually; the company is profitable, although income has fluctuated. In 2018, it is on a pace to reach $13 billion in revenues. Equity investors trade the stock as if it will top $20 billion over the next five years.

The company generates positive cash flow from ordinary business operations, but must rely on new debt to fund the significant investments in new content, over $8 billion in new assets the past five years. Hence, until now, if the company didn't bother with creating content and relied only on its Phase 2 strategy of licensing or renting content from content providers (the movie studios, e.g.), it might continue to show positive operating cash flow.

But the same cash flows and revenues might dwindle over time, as subscribers would become turned off by old, familiar, unappealing content on the portal. Once-eager subscribers would cancel accounts and move on to other steamers with more interesting offerings.

Hastings and team are right that they had to figure out what subscribers want to see and what will appeal to a broad number of viewers from around the world.  And they couldn't rely on outside sources to provide it.  They had to arrange to develop it themselves.  Development, of course, means funding.  Long-term debt would be its strategy.

In the world of debt analysis--a world including lending banks, insurance companies, institutional investors and other asset managers--cash flow counts.  Can the company sustain ongoing operations to be able to meet cash interest payments regularly?

Can the company also make principal payments on the debt regularly and, as necessary,  encourage investors to refinance debt when it matures.  The company wouldn't necessarily have to pay down what's due; it would refinance it.

In the realm of debt analysis, the word "risk" arises often. Cash flows that should be available to pay principal and interest on debt are vulnerable to bundles of risks, and cash flow existing in early years can disappear in later periods, threatened by expected or unforeseen risks. What risks does Netflix encounter?
Increasing competition from other streaming services and from other companies launching their own services (Hulu, HBO, Disney, Amazon, etc.): A number of players, agreeing that cable TV cord-cutting will continue briskly, have joined Netflix in streaming. Some already have financial and business advantages. Some entered the streaming business out of desperation. Together, the competition will influence Netflix pricing and expansion strategies.

High costs and time commitment involved in developing own content: There is risks of escalating costs and risks of quality of new content after investing substantial amounts. 

Content piracy and illegal streaming: Regardless of developing or licensing content, Netflix encounters this regularly.  Some potential subscribers will privately vow not to become customers when they can get access to content without paying--legally or illegally.

Pricing strategy (variable monthly fees, depending on markets and geographies):  Netflix subscribers, especially with new competitors launching their own strategies, will likely be sensitive to Netflix plans to increase monthly subscription fees. But the company will consider fee increases if it is strapped for cash or if it wants to minimize cash-flow deficits.

Decreasing growth rate of new subscribers. There is risk its greatest growth rates in subscribers occurred in the past.  Growth rates can fall or flatten, because of competition and because subscribers' sensitivity to price increases and because subscribers indeed share accounts with others.

Global strategy for different cultures. As the company expands across the world, the company may not be attuned to different viewing tastes and cultural patterns in other countries. Netflix may guess and plan and be wrong. As it expands across borders, country, political, currency and legal risks exist.

Technology risks. Netflix is an entertainment company, but it is also a technology company, relying heavily on subscribers' access to Internet services. In the U.S., issues related to diminished "net neutrality" could pose a risk. (Subscribers don't have equal, uninhibited access to the site.)

Management risks: CEO succession. Longtime CEO Hastings presents himself as spokesman, heartbeat and pulse of the company. He, for the most part, devised, promoted and pushed the strategy to evolve from DVDs and develop content. But has he prepared for the next generation of leadership and strategy execution? Is there bench strength?

In most cases above, the impact of the risk is a threat to revenues. In some cases, the impact of the risk is a possible rise in costs or potential liability (litigation, e.g.). The risk review, in total, helps market and debt analysts project the performance of the company.

So what's Netflix's track record and true financial condition to date, and what do we expect going forward? Why have equity investors had such a favorable outlook on the company?

Profitability

The company is consistently profitable, although profit margins and returns on capital are not high and not improving steadily. Revenues continue to grow significantly, while costs are growing just as quickly. The company, however, has shown it can keep most operating costs (administrative and overhead costs, e.g.) under control. As the company continues to grow and expand, some costs will be necessary to support growth.

Asset quality and productivity

The company doesn’t rely on substantial amounts of fixed assets to generate revenue, but it does rely on content (licensed content and owned content, both of which appear as assets on the balance sheet). High-quality content assets are important to attract and keep subscribers. However, to grow revenues, the company is aware it must add to existing content (and, therefore, must finance new content). It acknowledges it cannot increase revenues with old content or "borrowed" content.

Asset efficiency

The business model permits the company to match subscriber fees received to amounts paid to content providers, from which it licenses the right to use and stream. The business model also doesn’t require accounts receivables or efforts to collect monthly fees. (Subscribers pay immediately via credit-card charges.)

The model, therefore, doesn’t require funding for working capital purposes. As the company develops more content it owns, subscriber fees will be used more to service long-term debt, less to pay down payables to other content providers.

Liquidity

Ratios show the company has sound levels of cash or access to cash for short-term purposes. It can pay down short-term obligations with little difficulty. Some of the $2 billion-plus in cash reserves results from recent debt proceeds and may be earmarked for future content development.

Liquidity could be affected as current portion of long-term debt comes due and if the company is not in a position to refinance maturing debt.

Leverage and capital structure

The company today is committed to a strategy of debt financing.  It has vowed to continue to do so, even as interest rates might increase and balance-sheet leverage continues to increase. An already highly leveraged balance sheet will likely become more highly leveraged.

The debt levels are rising faster than capital on the balance sheet. The company does not pay dividends, which permits it to retain earnings, but earnings alone cannot finance the aggressive goals of new content.

Capital adequacy

The book-value capital base is growing moderately, but is offset by larger increases in long-term debt. Capital will likely continue to grow, as it maintains profitability and resists paying dividends and buying back stock.

Equity market values fluctuate occasionally, but the overall trend is pushing upward, as investors value the long-term revenue growth. High market values of equity suggest the company could issue new equity if necessary—an unlikely step in the short term.

Cash flow

Cash flow from business operations has been positive the past five years (between $200-500 mil/year), fluctuating from year to year. The company benefitted from tax credits in 2018, which bolstered cash flow (It didn't have to pay out taxes). The tax credits were a one-time event (and the company will have tax payments going forward).

The levels of cash flow, although increasing at modest amounts, however, are not sufficient to finance the combination of capital expenditures and new content, the latter of which approximated $3 billion-plus in each of the last two years and is likely to continue at that pace or above in years to come.

Cash flow after operations and after capital expenditures and investments in new content, therefore, is negative—and requires debt funding.

For now, it has avoided paying dividends to shareholders, who buy the stock based on long-term growth expectations and price appreciation. Despite non-investment-grade credit ratings, it feels confident it can continue to access debt markets, when it chooses.

Projecting Performance and Cash Flow

Projections of future Netflix performance and cash flows should be based on and consistent with the financial analysis and business-risk analysis above. As a matter of practice, projections in debt and credit analysis should be realistic and conservative.

Debt analysts project a base-case, no-growth case and peek at worst-case scenarios, although equity investors and management boast about the expected growth to come.

The challenge in projecting cash flows for the company is projecting annual expenditures for new-content development. New-content development in 2017 exceeded $3 billion in cash outflow, reaffirming this will be the company’s ongoing operating model in the future.

But new content expenditures could decline if operating cash flows decrease and if the company can no longer borrow new funds. Note the tie-in.  The company wants to grow via new content, but it can only do so--at least now--if it can access new debt.  If it can't access new debt (because of the declines in credit ratings and because debt investors are concerned), then new content won't happen and growth expectations from equity investors will dim.

While equity investors are eyeing revenues leaping from $14-20 billion over the next five years, ratings agencies and concerned debt investors might expect a short-term jump in revenues to about $15-16 billion, but much uncertainty looms in the long term.

A plausible future case of operating cash flows of about $650-700 million of year, while seemingly strong numbers, will still be insufficient to handle debt loads of $10 billion or more. But how else does it plan to finance new-content levels of $3 billion/year--except for even more debt?

Maximum debt capacity (assuming all debt is serviced from cash flows and not refinanced), based on a 10-year realistic-case horizon, at best is about $4 billion. Issuing new equity to meet funding requirements is an option, but one the company is resisting.  For now, the company’s current financing strategy presumes that as long as it can meet interest payments (which it can), then it will successfully refinance debt obligations when due.

Netflix’s financial condition will likely remain stable over the next 2-3 years. There is uncertainty in the long term, and there is no assurance the company can continue to tap debt markets to support new content—although new content is critical to maintain revenues at epected growth rates.


Friday, July 20, 2018

Uber: Ready for an IPO?


Now valued at over $60 billion, Uber has several issues to address before it decides to do an IPO.
In the industry that is called ride-sharing services, Uber, despite having to address reputation risks the past year, is the preeminent brand name. In the industry of investment banking, Uber is the cherished prospect, the next big blockbuster IPO on deck.

As an established "unicorn," a venture-capital-supported enterprise with a billion-dollar-plus valuation, Uber is "next up."  Recent computations, based on the company offering new stock to investor groups and employees this year, value the company at about $60-62 billion.

Market watchers, analysts, and hungry bankers await its decision to go public.  But don't hold your breath. While the company is next up or next in line, it has a long list of thorns to address. 

On paper, Uber looks ripe for an IPO. The business model is familiar, and competitors have jumped in, if only to reaffirm the growth and establishment of an industry. The brand is globally known.  Revenues have grown at a steady pace.

The company is old enough now to contemplate investments into other allied services (Uber Eats). Annual earnings and cash flows continue at deficits, but the IPO world acknowledges that losses by the millions (or tens and hundreds of millions) don't thwart IPO planning.

Like many IPO candidates, losses and cash-flow deficits are explained by required expenditures and costs to support marketing and expansion.  New companies aspire to get to where they need to be and go far as fast as possible, before competitors and copy-cats catch up. Like dozens of other IPO-aspirants in the last generation, Uber promises costs will eventually be contained. Or costs will eventually handily covered by towering levels of revenues.

Uber's path to an IPO is progressing in slow motion.  Too much needs to be addressed , including a renewed polishing of the brand.  Last year's forced ouster of its founder, Travis Kalanick, was step one. Step two was to hire a strong, credible, market-facing CEO who could assure potential investors (and Uber customers) the company was committed to cultural shifts in its ranks.

While the new CEO, Dara Khosrowshahi, whose transportation-services experiences go back to his Expedia days, has addressed the culture problem, continuing reports of isolauted problems surface now and then.

So what about the IPO? Now or later? Is it ready? What are deciding factors?  One major investor, the Japanese firm Softbank, making a statement of confidence in new leadership, upped its stake to $9 billion.

The revenues.

In IPO analysis, while initial years of high costs and investments drown revenues, the long-term story is about growth:  Is it possible? From where will it come? How will it come? And will early experiences of growth lead to even larger growth percentages in the years ahead?

The oft-told story projects one of scale, expansion and growth. Get large, get out there, get bigger, and make a mark before competitors imitate. But is it just that--a story of wishes, dreams and luck, or one of disciplined, rationalized expansion?

Can the company and its cadre of bankers project revenue growth accurately and propose a realistic plan to control costs?

Uber acknowledges losses and negative cash flows, but argues (as most young companies do) that costs are necessary to support a strategy of global expansion and its contemplation of expansion into different, but necessary businesses. 

Expansion also means broadening its mission from being a basic ride-sharing service to one of providing other products and services (not just rides) to a larger customer base that will--in the blink of an eye--dart off to competing services or other innovative companies if Uber doesn't respond to or care for them.

The company has no obligation to broadcast financial performance to the public, but it provides quarterly highlights, if only to prove performance and perhaps prepare for the time when it must disclose greater amounts of financial details as a public company.  Revenues are growing; the bottom line indicates big annual losses (about $4 billion in 2017) and occasional quarterly gains (as in early 2018). 

The ongoing issues.

Uber knows it needs to respond to them definitively and aggressively--without delay. They include management and culture issues. 

They include regulatory and governmental issues in jurisdictions around the world (London, Japan, China, e.g.). They include relationships with and fairness to its drivers (labor relations, fair compensation, driver support, etc.). They include the company's vain efforts to penetrate in certain regions. (Asia has been notably difficult.)

Legal issues abound everywhere and consume a substantial amount of expenses--today and likely regularly in the future.

The brand.

It exists; it's there. But could it be irreversibly tarnished? Uber is a familiar name and term--like Google, Apple, and Facebook.  Almost like Coca-Cola. A proper noun that could become a common verb.  ("We  'Ubered' over to the other side of town.")

Just as brands are built to legendary, storied levels, they can slip overnight--because of smoldering reputations unrelated to finances and business models, a result of mishaps behind closed doors or mis-statements in the board room.  Uber's brand sits on such a precarious perch.

The long term.

Over time, Uber and its banking corps must decide whether a new, different ride-sharing business model could supplant it.  It must face off against competition. Lyft, most notably. Competition surfaces as taxi systems around the world arrive to the 21st century or as populations decide commuting and walking are better and environmentally friendly.

Could regional services (companies choosing to operate only in smaller locales) become its biggest long-term competitive threat?

Competition will push the company to consider "reinventing" itself now and then. Change, reinvent, or die. Uber (with UberEats and its audacious dreams to make self-driving and flying cars) has already charged down that path. Its formal name, moreover, is not Uber Ride-Sharing Services, but Uber Technologies, Inc., indicating in Google- and Apple-like fashion, that it plans to evolve as necessary, while offering a basic, ride-sharing core product.

Uber, arguably, is in the legal business, as it confronts regulatory bodies and lawsuits from every corner of the globe and as it pays gobs in legal fees to address these issues.  It is also likely aware that regulation (unforeseen new laws, new rules, new restrictions) can sprout from nowhere to crush its business in certain regions.

As it prepares itself to be a public company, the drive to generate stable, sustainable cash flow from period to period will define its existence. In 2018, the company might generate positive cash flow from time to time. That positive flow, however, might be due from a sale of investment or a sale of an operation as it retreats from a certain region (China). Positive, but not yet predictably stable.

As a young company funding itself predominantly from equity investments, shareholders understand dividend payouts are not on the horizon.  As a public company, shareholders in years to come will later begin to require dividend handouts and require the company to have "turned the corner" toward a predictable flow of operating cash.

Investment banks are paid to advise the company issuing public shares on the proper valuation of the business, including total market value (market capitalization) and share price.  If Uber is worth about $60-62 billion today, what will it be worth when it launches its IPO, and to what extent will investor interest and stock supply-demand dynamics influence the issuing price?

Bankers, traders and market analysts attempt to determine the right timing. Uber might decide the best time is next year.  Market forces and trends often have the final say-so.

The balance sheet.

Following the business model of a sharing economy (one where the business requires minimal investment in fixed assets, because it piggy-backs off the collective fixed assets of tens of thousands of individuals), the company should operate with a somewhat simple balance sheet.  Minimal amounts of infrastructure and fixed assets imply the company in its youthful years can grow without amassing piles of debt.  Debt burdens force the company to hurry up to generate cash flow to pay interest and principal on the debt.

As a company, it has little reason to have inventory and accounts receivable.  It doesn't sell cars. Riders pay up front.  It doesn't have to collect revenues from users over time. It shouldn't have mounting amounts of payables, obligations to raw-material suppliers.  (Down the line, the company may consider a financial-services reserby providing loans to drivers to purchase cars and other financial services.)

Ongoing accrued expenses (legal expenses, promotional expenses, research expenses, etc.) will continue to be a significant balance-sheet liability. 

Plant, property and equipment should be nominal and includes business offices (if the company doesn't lease) and technology systems.  Long-term debt is not necessary to finance warehouses, branches, and structures (beyond technology support). Debt, however, might be necessary to fund annual cash-flow deficits, if equity-investor cash hasn't done so sufficiently.

Debt also might be sourced to finance small, intermittent acquisitions.  For companies riding a surge in growth, acquisitions become part of the business model. Acquisitions will also be done at prices above book values of the target company and will add to increasing amounts of intangibles on the balance sheet.

IPO proceeds, hence, could deliver billions in cash reserves at levels permitting the company to endure the few years ahead when operations will continue to yield losses.

After the IPO.

While it contemplates a public offering, its bankers and board have already contemplated what business life will be when there is a stock trading everyday. Everyday becomes a new scorecard day, where the market provides an opinion of the company every hour every trading day.

As for financial disclosure and earnings projections, public-company status vaults Uber into another league.  Revenues, costs, earnings and cash flows will be analyzed, scrutinized, and dissected.  Management, strategic decisions and the company's response to public opinion will be second-guessed. 

The company will be expected to explain and rationalize costs and investment spending. Activists will squeeze themselves onto the agenda and insist on participating in strategy or even boldly require the company move in different directions.  Venture-capital investors and early-round supporters may likely have reduced their holdings to insignificant portions and may no longer provide a supporting voice.

What happens from here? In sum:

1.  The business model has worked. It has required tweaks and attracted competitors. Consumers understand it and have flocked to it.

2.  Competition all around the world is evident and is capable of undermining growth and its path to profitability.

3.  Long-term stagnant growth (always possible) is why the company is investing in different, but related businesses. The company should be applauded for exploring other products.

4.  The company is learning and will continue to understand that certain geographies will never be penetrated. At least right now.

5.  Continuing issues related to management and culture must be addressed vigorously.

6.  Sustainable, healthy, positive operating cash flow is still probably about 2-3 years away.

7. With investor support in private-equity markets, the company might not be in a rush to go public. If it needs cash, it can access it in private markets.  That IPO celebration party may still be at least 12-18 months away.

Tracy Williams

See also:

CFN: Snap Goes Public, 2017
CFN:  Twitter Goes Public, 2013
CFN:  Shake Shack Goes Public, 2015
CFN: Facebook Goes Public, 2012