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


Wednesday, June 13, 2018

Dodd-Frank: Tossing and Turning

Once it touched down in Washington in 2017, the Trump administration promised to rip apart portions of Dodd-Frank bank rules and present gifts to banks that would ease up regulatory requirements.

In its first year, the administration, addressing other issues and matters, didn't get around to it.

In spring, 2018, the administration and certain Congressional leaders have decided to push Dodd-Frank higher up the political agenda and have begun to thrust bills through Congress to make some initial tweaks.

First, it decided to ease a burdensome criteria of banks not considered in the special category of "too big to fail."  Regulators and supervisors avoid this phrase, "too big too fail," but there is a special category of banks that are deemed so mammoth in size, they could deal blows to the global financial system if they got into trouble too quickly. 

They prefer the term "Globally Systemically Important Banks" or "Significantly Important Financial Institutions." Those banks require extra capital cushion,  non-stop observation of their activities from examiners, full-scale stress tests and more involved scrutiny. The latest Dodd-Frank tweaks will decide which banks (with assets < $250 billion) will not be subject to the annual anxiety-filled stress tests, administered by the Federal Reserve.

Second, this spring, Congress dared to consider revamping the Volcker Rule, Dodd-Frank's prohibition of proprietary trading among big banks. Not quite eliminate it, but ease the taxing burden banks have had in complying with it. 

The rule, as written today, presumes all securities and derivatives trading at banks is proprietary (speculative and hedge-fund-like) unless the banks painstakingly prove the same trading is for the benefit of clients. To prove to regulators they bought a portfolio of equity stocks for the eventual resale to institutional clients is one of the most difficult tasks in banking today, so say compliance officers at big banks.

Small banks (those of the community kind) aren't likely to participate in the whirlwind of derivatives and securities trading.  So Dodd-Frank revisions will consider not even applying the rule to them.

Dodd-Frank, formally, is the title of U.S. banking laws that were enacted on the heels of the financial crisis.  Dodd-Frank is legislation that requires U.S. banks and U.S. subsidiaries of foreign banks to follow Basel III global-banking standards. Dodd-Frank, the 2010-11 version, however, tightened up global standards and enacted a bundle of other requirements--enough to fill over a thousand pages of rules with wiggle room to add even more.

From Dodd-Frank, banks have capital requirements, but there are also rules related to leverage, balance sheets, liquidity, and managing operational risks.  There are rules that require stress tests, prohibit hedge-fund-like trading, and require banks to present liquidation plans, even if they are not likely to liquidate anytime soon.

Even if they don't voice their disagreement and difficulties with Dodd-Frank with public outcries, many banks will privately enjoy this springtime hint of relief, if only because of the burden of compliance.  Most U.S. banks can and do comply with the detailed rules of Dodd-Frank, but they do so by investing millions in people, processes, systems, and compliance.  Ensuring compliance with rules has not been a significant chore.  The task of complying has.

In many ways, Dodd-Frank, the first edition over the past eight years, did its job.  Banks, big and small, are healthy, financially sound, and well-capitalized.  Risks of all kinds--from market risks to operational risks--are identified, measured, quantified, disclosed, and analyzed.  Tests under various worst-case scenarios are conducted, and no bank wants a headline exclaiming it has failed a Federal Reserve stress test. No bank wants pundits from CNBC to declare they don't have sufficient capital or liquidity.

Part 1 of Dodd-Frank revisions have commenced. In May, legislators introduced bills to (a) exempt smaller banks from having to go through regular stress tests,  (b) to re-examine the Volcker Rule and (c) reconsider how it defines "globally systemically important banks" (GSIB's).

In many respects, the current Dodd-Frank revision strategy focuses on making changes in simple ways:

a) Grant relief to smaller, less-complex institutions in their attempts to comply with Dodd-Frank rules. 

b) Don't force smaller banks to perform complex calculations to determine capital for market, credit and operational risks.  Don't force them to conduct arduous stress tests for all of their business operations. 

c) Don't force them to show compliance with Volcker restrictions, mostly because they never engaged in exotic trading that involved equities and derivatives around the globe in the first place.

d) For the rest, tinker with the Volcker Rule; don't over-haul it yet. Revise it in stages.

That dividing line between big and small is $50 billion or $250 billion or $750 billion in assets and depends on whether the topic is stress testing, liquidity requirements, or capital calculations.

Pros and cons about Volcker keep the debate alive.  With big banks reporting record-breaking profits in 2018's first quarter, banks won't be able to argue Volcker must be abolished to permit them to improve earnings from trading and provide more liquidity in capital markets. In late 2018, the SEC distributed a study showing the Volcker rule has not reduced liquidity in bond and equity markets, as banks predicted.

After years of living with Dodd-Frank and the Volcker Rule, banks have adapted, although they welcome compliance relief and the opportunity to focus a more on clients, capital markets, and new regions.  Banks that retreated from sales, trading, securities and derivatives have already funneled related capital and resources elsewhere.  Banks, big and small, have implemented systems and data aggregation to ensure they know what amount of capital (and in various forms) is necessary to support any business they breathe on--mortgages, corporate loans, investment banking, securitization, interest-rate-swaps dealing, currency trading, custody, credit cards, payments and cash management, etc.

While some banks occasionally slip in earnings performance or struggle to meet Return-on-equity (ROE) targets, most banks (at least those above $50 billion in assets) have shaken up balance sheets and risk-management processes to make sure they have excess capital for market, credit and operational risks and for the types of businesses they choose to emphasize. 

Big mega-banks such as JPMorgan Chase, Bank of America, Citi and Wells Fargo manage themselves to ensure they have excess capital. Big regional banks such as PNC and Regions do the same.  And so do banks that specialize in transactions and processing (and not much on corporate and investment banking) like State Street, BNY Mellon and Northern Trust, too.

Yet while Dodd-Frank gets wrung about, twisted and tweaked (but not abolished), all of the above will silently applaud some relief from compliance-process headaches.

Tracy Williams

See also:
CFN: Dodd-Frank Dismantled? 2017
CFN:  Volcker Rule: SEC Weighs Impact, 2017

Saturday, March 31, 2018

Understanding VIX

This so-called "fear index": Are investors interpreting it correctly?
When markets are calm and stable and investors are beating their chests happily as stock indices creep upward and upward, there is a market metric, an index, that often gets less attention. It exists on the fringes of market-data updates and reports. Meanwhile, finance purists and market watchers study it.  Hedge funds and "innovators" in structured finance look for ways to make money trading it or selling it.

Like other metrics and indices in finance, it was born to be a convenient measure to understand what is going in capital markets.  This convenient measure is supposed to quantify market fluctuations--a quick way to size up volatility in equity markets.

It's the VIX index, which in recent weeks has hovered about 19-20.

With equity markets swirling and swooning upward and downward in early 2018, the VIX index comes to the forefront. Until recently, the index might have been perceived as moth-balled.

When markets seem "violent," VIX numbers, because markets are more volatile, rise sharply.  The media will then decide to headline the rise of the index.

Because it's an approved market index, the inevitable will have happened. Financial engineers would have found crafty ways to structure an investment vehicle where performance is tied to movement of the index. Thus, we hear about hedge funds or daring traders who either made much money trading the index or lost gobs of it because they bet markets would continue to be stable.

The media, also, like to call it "the fear index."

Technically, the index, administered and computed by the CBOE and launched about 25 years ago, tries to compute expectations of oncoming volatility, not necessarily calculations of volatility just past. Therein exists apparent confusion about what the index intends to convey.  Past volatility or expected, upcoming volatility?

Most traders, brokers, and analysts understand concepts of volatility and certainly know it when they observe or experience it.  Volatility is watching the S&P stock index rise 3 percent one day, fall 7-10% the next, another 2-3% the following day, and finally rise again 1-2% days later.  Stomach-churning volatility, some will say.

Some investors and market commenters mistakenly consider the index as a computation or reflection of recent market volatility.  The index, more precisely, is a reflection of anticipated or expected volatility, based on the volatility captured in options prices. 

A technicality, but an important nuance.  While the intent is to measure expected stock-market volatility, the approach is to compute that expected volatility by observing current options prices. Let's allow options markets to suggest what oncoming volatility will be in stock markets.

Options prices (whether they are options on single names or options on a basket of stocks) are determined to be a function of several factors:  (a) the underlying stock price, (b) interest rates, (c) the time to expiration, and (d) volatility of the underlying stock. 

The four factors are not difficult to rationalize and understand. The value of a "call" option should rise if the underlying or referenced stock increases.  The value of the option might rise if given more time between now and expiration date. And the value of the option could rise if there is movement in the underlying stock, especially positive, upward movement.

If the stock has fluctuations and is subject to volatility, then there is an increased probability that such movement could head in an upward direction. Hence, an increased probability that the stock might increase in value. That, of course, suggests increasing value in the option.

Finance graduates everywhere are familiar with Black-Scholes options-pricing models, which account for these factors and present ways to compute precisely the value of an option. If I own an option to purchase a stock at price 25, and the price is 25 today, I might conclude quickly the value of the option is zero. However, if the option expires in five years and the stock price is expected to fluctuate, then time might permit the stock price to rise, say, to 30. The option, therefore, will have value because of what the stock price might be in five years.

How high could that underlying stock rise--within a certain degree of probability, over a certain time frame? Stocks that have histories of movement and fluctuations are likely stocks that can reach certain levels with higher probabilities than stocks that sit still in price for long periods. Similarly, stocks that have expectations of volatility in ensuing periods might be more valuable than the stocks that have expectations of minimum movement. 

Options prices, therefore, reflect expected volatility, as much as they reflect historical volatility, although history can certainly influence expectations. 

Options prices on active markets and exchanges account for underlying prices, time to expiration, and interest rates (thanks to the pricing models), and they account for expectations of volatility.  Based on current options prices, we can derive the market's perceptions of forward-looking volatility.

VIX calculators "extract" expected volatility from current options prices to determine how the market perceives upcoming fluctuations.  More specifically, it examines S&P options (or options on a basket of S&P stocks).  That makes sense, if the index strives to capture market volatility and not specific single stocks. 

Volatility measurements are as straightforward as calculations of variance and standard deviation from a statistics class.  In this case, volatility is inferred from options prices and then interpreted in terms of standard deviations.  Or the current price of an S&P option will imply that volatility is, say, 10% (or one standard deviation equal to 10%).

The VIX measure infers standard-deviation measurements from S&P options (over 30 days) and then quotes it based on one year.  In sum, VIX provides market perception on expected movement (up or down) over the next year one year (with about 68 percent confidence). 

So what does it mean when VIX jumps to 20, as it has in recent weeks? Or 19.8 as of March 29? What does it mean if VIX hovers in single digits as it had been in recent years?

At 20, it suggests options (and options market-makers and traders) are priced with 68% confidence that equity markets could rise 20% or fall 20% within a year.  (Or there exists a 16% chance equity markets will fall more than 20% in the year.) 

A lot of volatility.  A lot of stock-market bumbling up and down in the year to come.

Will the market decline by 20%? Not necessarily.  VIX suggests market participants see it as something plausible.

But keep in mind a VIX measurement, in theory, suggests markets can rise by 20% over the next year, a phenomenon many participants say is not plausible. 

As with much of finance, the tool (VIX, in this case) should guide, not dictate or foretell.

Tracy Williams

See also:

CFN:  High-frequency Traders and Flash Boys, 2014
CFN: High-Frequency Trading: What's Next? 2012

Tuesday, January 16, 2018

Bitcoin Mania, Again

Activity and values of Bitcoins and cryptocurrencies continues to rise in unexplained ways. In 2018, where do we go from here?
To invest or not to invest. To buy or not to buy. Is it for real? Is it here to stay?

Bitcoin. Cryptocurrencies.

The mania reached peaks in 2017.  An "investment" in Bitcoin a few years ago of about $1,000 reached values exceeding $18,000 as we approached the Christmas holidays, 2017. Swoons of volatility and uncertainty pushed that back to $13,000-plus and sparked greater discussion about digital currencies, blockchains, and the distributed-ledger technology that runs Bitcoin (and other digital currencies like Ethereum and Ripple).

Confusion still abounds. What explains 2017's surge in Bitcoin? What explains value? How should it be quantified? What is its purpose? Why are investors and traders willing to take such risks?

Regulators, bank supervisors, and government officials are huddling in conferences trying to determine what their roles should be.  They watch, share views, analyze public data, observe the euphoria among some traders, but haven't taken action (beyond some overseers in a few countries)--partly because they aren't sure how they are empowered to do so.

Questions continue--in the media, in academic discussions, in financial columns and among traders, investors, technologists, politicians, regulators, and bank leaders. What does it actually mean to own Bitcoin?  Is this flippant speculation? Does it represent real value? Does a catastrophe of some kind lie on the horizon? Could mishaps on a Bitcoin exchange trigger defaults and extreme events in the larger, global financial system? Will Bitcoin volatility trigger global systemic risks?

Rational traders approach the market as if value is based on not Bitcoin's purpose or usefulness today, but on prospects that it may have significant purpose and usefulness tomorrow--in periods to come.  That purpose would be tied to the value of Bitcoin as

(a) a way of making payments (consumer and corporate, anywhere in the world),
(b) a storage of economic or investment value,
(b) a safe haven from unstable global currencies (a "flight to quality"), and
(c) a way of operating within a transparent system without intermediation or intervention by a central government or central bank.

Hence, Bitcoin's value (or the value of any meaningful cryptocurrency) is a function of those factors and the probability the coin or the system will achieve those goals.

But some traders aren't interested in such factors and merely want to speculate and take advantage of what ultimately is a speculative trading game.

In reality, combinations of both types of traders are involved in the market. The two factions have influence on the daily fluctuations in Bitcoin prices.  Speculators are risk-seeking and will gamble to achieve high returns. Investor-traders who perceive there is a long-term purpose for Bitcoin and other digital currencies assess long-term value.  They acknowledge uncertainty in achieving those long-term objectives in the way there are uncertainties in any risky investment.

In the current marketplace, however, speculators might be out-numbering rational investor-traders.

Instances of fraud abound and have been reported, and institutions and entrepreneurs devise ways to open up markets to new participants to invest directly (via a Bitcoin wallet) or invest indirectly (via exchanges). In the U.S., the Bitcoin ETF (exchange-traded fun) doesn't exist. At least not yet. An ETF offering must win approval of securities regulators, who will certainly take their time to determine whether it's a suitable investment from all classes of investors.

In a recent step toward legitimacy, in late 2017, commodity and futures exchanges announced they would unveil a new Bitcoin futures contract, an instrument that permits investors and traders to maintain a leveraged stake in Bitcoin values--a way to trade (or speculate in?) Bitcoin without having to enter into the blockchain system and owning the digital coin directly. A trader comfortable with uncertainty and volatility now has an opportunity to speculate with financial leverage. The trader doesn't have to buy the entire Bitcoin amount, but merely put up a margin deposit (financial leverage).

The Chicago Mercantile Exchange launched its product in December. To do so, it had to do preliminary value analysis and assess worst-case scenarios. (Exchanges and clearinghouses do this on an ongoing basis for each of the trading products they offer.)  It had to measure and quantify price volatility and set up rules.

In doing so, it also had to establish and quantify "initial margin" (an amount the investor must put up in cash-equivalent margin to account for the maximum (short-term) loss the investor will experience within a defined time period). Unfortunately the CME has had to establish these margin requirements based on a limited number of years of trading data and without experience or scenarios of what could happen to Bitcoin values in extreme cases or "black swan" events. (It likely increased its worst-case calculations to account for the limited years of trading data.)

The CME is aware it is facilitating trading of all kinds in Bitcoin values and prices (investing, betting, gambling, speculating). It's also aware it will attract the most speculative of Bitcoin speculators because of the advantages of "leverage" in purchasing financial futures. And it will lure traders who will try to profit from the disparities in Bitcoin market prices and Bitcoin futures prices (arbitrage or basis trading).

The exchange/clearinghouse has established an initial margin of about 40-50% of the face value of a Bitcoin contract.  Hence, to purchase a Bitcoin contract (for March settlement) at $13,000, the investor must deposit, say, $6,500.

If the price doubles, the investor makes $26,000- $6,500 (=19,500, or 300% of the deposit amount). If the price declines by half (as it likely could in this market), the investor loses everything (or 100%). Speculators might consider this trading opportunity a trade from heaven, notwithstanding the real possibility of losing all of the up-front deposit.

The exchange, of course, will have done significant due diligence to determine if the investor (operating through a registered broker/dealer) is financially qualified and capable of taking such risks. In reality, it's likely the trader would have also have other trading positions and assets (where gains elsewhere can offset Bitcoin-futures losses) (cross-product margining).

In the past year, government supervisors have begun to weigh in and render opinions. It's about time. Except in some places (like South Korea recently), no specific law or ruling has been enforced in the U.S., but they have begun to suggest where there could be problems or how they might act in certain circumstances. They have identified flaws in cryptocurrency systems and exchanges. They have called for protections for uninformed consumers or under-capitalized investors, and they have diagnosed whether cryptocurrencies are currencies or financial instruments and securities.

And there is the ICO.

On other fronts, government regulators are addressing this Bitcoin offshoot--initial coin offerings, where companies seek to raise funds by issuing new digital coins, specific to the company, similar to the way young companies issue new shares to the public to finance operations.  Several ICO's have been done.

Now regulators are catching up. A primary questions looms over this activity: Is this a way for companies to finance the business without approval by securities regulators and without having to be subject to the same scrutiny and due diligence the SEC in the U.S. requires?

In early 2017 and in December, the SEC issued statements acknowledging that, to date, it has not approved any cryptocurrency or any ICO.  Period.

It has reminded investors that if any person or institution who invests in a digital coin via an ICO and if there is expectation of a share of ownership or economic value from the earnings from the issuing company, the ICO offering might be deemed to be security under U.S. securities laws.

The SEC stated summarily:  "(While) there are cryptocurrencies that do not appear to be securities, simply calling something a currency or a currency-based product does not mean that it is not a security."

The SEC's detailed notices suggest it acknowledges Bitcoins and the growing number of cryptocurrencies are here to stay. It joins a growing number of financial leaders and organizations that admit crypto-currencies, blockchains, and distributed-ledger technologies could refashion the global financial system in the way derivatives and securitizations vaulted into the middle of the financial world in the 1990's.

Acknowledging "We can't beat this, so let's wrap ourselves around the risks and do so quickly," the SEC, to its credit, offered a handy list of questions investors should to ask themselves when they decide to join this marketplace. They include such questions related to proper due diligence of the sponsor, use of proceeds, financial statements of sponsors, timely trading data, openness of the blockchain, threats of cybersecurity, and legal rights of investors.

Blockchains and distributed-ledger technology, no doubt, are here to stay. Many industry participants see the best value in Bitcoins from the underlying technology and system--a record-keeping system free of a central moderator or intermediary and transparent to all players, and one that crosses borders easily.  Hence, many institutions are supporting enterprises to exploit the technology for purposes of securities clearance and settlement and other conventional financial transactions.

On the other hand, crypocurrencies are here to stay unless some catastrophic collapse in values or some blatant fraud leads to a debilitating financial crisis. Industry leaders cringe about systemic risk: The risk that unexplained, unexpected volatility would lead to mammoth market losses, which could lead to credit risks, credit losses and the bankruptcy of significant participants, which could lead to losses among financial institutions and banks that interacted with or funded the bankrupt players, which could lead to a global standstill, which could lead to....

Such extreme events would likely halt popularity and expansion, but for a short time. Remember, derivatives, securitizations, mortgage securities and junk bonds spawned financial crises of various kinds years ago, but after periods of inactivity (and after new rules), they all reappeared.

See also:

CFN: Bitcoins: Embrace or Beware? 2014
CFN:  Flash Boys: Slowing Down High-frequency Traders, 2014
CFN: MiFid 2: Do We Know the Real Impact? 2017
CFN:  Making Sense of Derivatives, 2013
CFN:  High-frequency Trading, 2012

Wednesday, January 10, 2018

U.S. Stocks: Winners and Losers

U.S. stock indices rose 20% and higher in 2017. Who were some of the winners and losers?What will happen in 2018?
A year ago, just on the heels of a glowing year in equity markets, investors and traders were optimistic, but geared up for volatility and possible corrections in 2017.

A year later, equity market players (investors, analysts, traders, and bankers) are patting themselves on the back and feeling fortunate.  The markets survived and even thrived during Trump-triggered political volatility. It was a good year. Most stock indices were up around 20%, some higher.  Arguably, the biggest winners are investors who parked funds in mutual-fund indices and ETF's, avoiding higher management fees to reach such lofty returns.

With the Dow eclipsing 25,000 in early January and some momentum carrying over, will 2018 be even better?

A year later, pundits and columnists do what they always do. They contemplate whether a correction is ahead and a long-run bull market will be derailed. They assess the short-term favorable impact of the latest U.S. tax legislation.  They ponder the impact of large companies with billions in cash residing in foreign balance sheets repatriated back into U.S. operations.  They decipher patterns in consumer spending, consumer and corporate debt levels, and hidden messages from Federal Reserve Board governors.

And then they dare to predict boldly where we might go from here.  The market, meanwhile, follows its own course.

A quick look back.

What companies and sectors were winners and losers? What explains a momentous surge or an inexplicable decline when the market in general is trending upward? Let's examine a sample.

Among S&P 500 sectors, tech, healthcare, pharmaceutical, banking and industrial stock portfolios all exceeded 20% returns.  Consumer, retail and real estate sectors lagged, although they experienced gains.  Energy stocks, as a sector, had losing returns, even as oil and commodity prices bounced back from 2015-16 lows. (All, of course, depends on how a sector is defined and what stocks are included in a vast array of energy-related companies.)

Across all industries, there were some real winners, where gains exceeded 40% and share prices vaulted to new highs because of new corporate strategies, new markets, and well-planned expansion and because of the continuing phenomenon of "the internet of things" and plain ole luck.

The computer-chip maker Nvidia saw its shares increase by 85% in 2017 (and the rise continues in 2018). It benefits from growing markets in gaming and artificial intelligence.  With P-E ratios above 50, investors have expectations of continued growth in sales and earnings.  The $8 billion-revenues company is expanding quarter after quarter and generating over a billion in annual cash flow to add to a balance sheet with mounds of cash (over $5 billion) and a modest amount of debt.

PayPal is a fin-tech stock that also surged in 2018 (88% increase).  It has gone through transitions and iterations (mergers, spin-offs, etc.) and now stands alone.  Like Nvidia, investors are paying for grand expectations of growth. At PayPal, investors perceive monetary payments will become more digital, and such electronic wallet payments will no longer be an experiment or a technology fashion.

Like Nvidia, PayPay's P-E (price-earnings) ratios exceed 50 and reflect educated guesses the company will continue to grow. Income in recent years has fluctuated and in 2017 was flat from quarter to quarter (generating satisfactory 10-11% returns on book equity).  The company appears to have adopted an Amazon corporate strategy of focusing on revenue growth, managing costs reasonably, but not allowing rigorous cost control to keep it from growing as rapidly as it wants to. 

Revenues are approaching $13 billion annually.  The company operates with almost no debt, lots of invested cash, and a strong equity cushion. Some observe PayPal is a financial institution; others classify it as a technology company. Many see it as a combination-- a major participant in financial technology with years of a track record and a realistic strategy.

For those who endured tough times with the company, Freeport McMoRan, the global copper-mining company, was a 2017 winner. Its shares increased 46%.  Just a year or two ago, with commodity and copper prices imploding, the company was a financial mess.  Losses were rampant, revenues plummeted (with declining copper prices), and a mountain of debt couldn't be managed. Ratings agencies and creditors worried. And it had to confront political turmoil and labor strife in its mines in Indonesia.

The company went through significant restructuring. It redefined its businesses, shed some operations, sold assets to raise cash, and has managed to get the debt burden under control ($20 billion in debt has declined to less than $13 billion).  It helps, too, prices for copper and gold (two of its mined products) have rebounded. 

At Freeport, investors and traders aren't necessarily buying long-term sustainable growth, as much as they are rewarding a company for having solved operating problems, dealt with debt, and, of course, taking advantage in upswings in mineral prices.

Even in a winning year in equity markets, there are losers--companies and industry sectors that are struggling, where products and prospects are dim, cash is disappearing and corporate strategy is confusing or questionable.  That applies to much of the retail industry (think Sears, JCPenney, Macy's, The Gap, etc.), where companies coast to coast are near panic trying to respond to online-shopping trends.

Sears and JCPenney are attempting every trick in the retailing book to stuff the flow of losses, although both will likely report 2017 fiscal losses. Share prices have declined in the last few years, but occasionally bounce up and down as investors evaluate whether company managers have restructured adequately or have adopted the miracle strategy that will turn their fortunes around.

Macy's encounters the same, but it still makes money. In 2017, Macy's shares declined 30%. The company continued to address falling revenues, dwindling cash flow, and debt.  Shutting down stores is a short-term solution. New marketing strategies, supposedly a long-term solution, haven't worked as well as hoped.  Investors and traders aren't sure what's next for the company or any old brick-and-mortar retail company.  At least Macy's is reporting earnings (barely) (about $300 million in 2017 (estimated) on a precipitous drop in revenues (about 6% return on book equity).

Macy's management is fortunate it's not confronting what Sear's and JCPenney are facing today:  another year of high-probability losses in 2018, cash disappearing from the balance sheet, and futures even more uncertain than that at Macy's.

Under Armour, the upstart sneaker and athletic-apparel company, suffered a 50% decline in stock value and might have been a victim of excess enthusiasm in a company thought to be able to gnaw at Nike's market share.

Until this year, the company had been performing well--double-digit percentage revenue growth, steady earnings improvement, and good returns.  In 2017, growth was stunted, and quarterly earnings were erratic.  Had the company reached a peak? Had it run out of clever ways to attack Nike's stranglehold of the marketplace?  And has the industry saturated? 

In recent days, Under Armour's share values have recovered in small amounts. Traders may have soured on the company during the year, but may have corrected their pessimism.

It's January, and observations about equity portfolios are as varied as the industries that comprise the S&P 500.  Optimists point to economic metrics, employment figures, companies' optimism and companies with billions of cash searching for creative ways to invest in the long term. Pessimists remind all that bubbles burst and we've been down these euphoric paths many times before.

Tracy Williams

See also:

CFN:  The Recent Spike in Bank Stocks, 2017
CFN: Shareholder Activism at P&G, 2017
CFN:  Amazon and Whole Foods, 2017
CFN:  What Happened at JCPenney? 2013
CFN: Second-Guessing Snap, 2017

Friday, December 15, 2017

Glancing Back Ten Years

Columbia University hosted a conference in Dec., 2017, to assess financial markets 10 years after the crisis
Ten years ago, rumblings of a financial crisis had begun to boil.  The darkest days were still ahead.  Bear Stearns, AIG Financial Products, Lehman Brothers, Countrywide, and Washington Mutual continued to stoke the mortgage-products machinery of mortgages, mortgage securities, and mortgage derivatives.  Although erratically, many were still making money.

There were hints of the nightmare that would overtake 2008-09.  In 2007, there had been unexplained standstills in certain credit markets. Short-term debt almost ground to a halt. Financial institutions, all of a sudden, couldn't roll over short-term funding or commercial paper.  Many thought markets would eventually correct themselves, one-time losses would revert to profits, and small, insignificant players would disappear quietly without impact. The financial system in 2007 would resolve these uncertainties and tolerable mortgage losses as 2008 approached. After a mid-2007 collapse of an obscure Bear Stearns mortgage fund, market players would get over it.

Ten years later, we know what happened in 2008. And in 2009-10.

We know who disappeared, who collapsed, who was forced to be acquired, and who threatened to put the global financial system on its knees. And today we recoil over the memory of a Great Recession, billions in losses, mortgage penalties and fines, and the avalanche of regulation that followed. New regulation was supposed to present solutions to avert or soften the blow of the next crisis.

Columbia University, in early Dec., 2017, held a "Ten Years After" banking and finance conference on campus and invited industry leaders, bankers, academics, regulators, and long-ago participants to review what happened and decide whether industry solutions are appropriate. Conference participants were tasked to try to predict when the next crisis along similar scales will occur and what will be the financial product or circumstance that triggers it.

The guest list of panelists and speakers included Nobel laureate economics professor Joseph Stiglitz and former U.S. Congressman Barney Frank--yes, the Frank, as in Dodd-Frank legislation, for whom vast amounts of post-crisis bank regulation is named. 

Former U.S. Treasury Secretary Jacob Lew appeared, as well as Columbia Law professor John Coffee, Jr., Columbia Business School dean Glenn Hubbard, and Stephen Cutler, JPMorgan Chase's chief legal officer during the years of the crisis and thereafter. Standard Chartered Bank CEO Bill Winters, who spent the crisis years as an Investment Bank head at JPMorgan, piped in via teleconference and proved his in-depth familiarity with the minutiae of bank regulation and its impact on banks like the one he runs.

Other academics (in business, economics, and law) also weighed in, sharing summaries of research they've conducted and papers they've written that explain what went wrong, why it went wrong, and why things may go wrong again.

Because the format permitted panel discussion and audience participation, the banter was formal and informal, lively and freeform.  Congressman Frank sparred with JPMorgan's Cutler, as they debated heartily on whether bank regulation today is suffocating, complex, and stifling or is inadequate and insufficient.

There were other highlights from two-day sequence of presentations of analysis of what happened and speculation of what market phenomenon around the corner will start the next crisis.

The Volcker Rule, the prohibition of proprietary trading at U.S. banks, was vetted often. Will it be tweaked, changed, updated, or simply reaffirmed?  U.S. banks say they are disadvantaged.  Winters in London said European banks suffer in some ways, too, because they are on the "receiving end" in not being able to trade reliably with U.S. banks, who can only rationalize some trading activity if it's tied to customer flow.

Many who are now accustomed to the rule's restrictions on trading say they just wish it were less complex, more simplified. Proving to the Federal Reserve that a securities or derivatives trade was done for the benefit of an institutional client is one of the most difficult tasks big banks face today.

Basel III is the governing regulation by which financial systems and governments around the world choose to abide. Dodd-Frank legislation in the U.S. legitimizes Basel III in the U.S. and then, of course, tightens up many of the requirements and offers an array of other rules (like Volcker and periodic stress tests). 

Has Basel III worked, does it continue to work, and where do we go from here?  Panelists pondered next steps, discussed, debated and offered data and research. A Basel IV is inevitable, the next step in bank supervisors trying to fend off the unforeseeable or trying desperately to ensure banks are prepared for the next round of financial turmoil.  Basel IV might also be, as Winters suggested, efforts to "roll back" to more consistent methods of calculating capital requirements or simplify the models big banks must use.

While the conference was going on, Bitcoin prices were soaring, providing a backdrop and a suggestion the next crisis could be triggered by boundless enthusiasm over cryptocurrencies.  During the same week, the Chicago Mercantile Exchange was about to introduce a new futures contract tied to Bitcoin prices. Investors (or speculators) can now leverage themselves in betting on the direction of Bitcoin. (They only need to put up a calculated margin on a total notional bet.)

Panelists preferred to focus instead on Bitcoin technology, Blockchain distributed ledger technology.  Many banks, while dismissing the euphoria of surging Bitcoin prices, have embraced the technology--its transparency, its record-keeping, its ability to process and confirm transaction without days of delay by a central intermediary. Over time, it can and will work in securities processing, trade settlement, funds settlement, and other bank operations activity.

In his point-counterpoint with Frank, JPMorgan's Cutler highlighted the complexities of big banks seeking to comply with a thousand pages of Dodd-Frank rules, some in place, some still to come.  He said JPMorgan responds to seven different regulators in operating a mortgage business.  In the aftermath of its "London Whale" trading loss (where its investment office lost over $4 billion trading credit-default swaps), Cutler said JPMorgan had to respond to five or six different regulatory enforcement arms, each independent from the other.

However, big banks themselves are frustratingly complicated, too.  Their organization charts are large, wieldy, interconnected, and difficult to comprehend--a messy maze. A panelist showed that  the "GSIBs" (Globally systemically important banks, as identified by central banks) average over $1.6 trillion in assets and each manage over 1,400 subsidiaries.  Dodd-Frank's "Living Wills Rule" (Recovery and Resolution Plan) requires banks must show how those countless subsidiaries would unwind net assets and businesses in a stress scenario or liquidation.  JPMorgan's Cutler admitted the exercise pushes banks to rationalize some of those subsidiaries. At JPMorgan, there are only about 50 subsidiaries "that matter," he said.

Frank agreed in the U.S., there ought to be some consolidation of regulatory bodies.  Why do both the SEC and CFTC exist? Why are they separate? Why can't they consolidate?   Understanding how inertia overtakes the U.S. Congress, Frank explained how East Coast-West Coast Congressional interests are wedded to the SEC, while "fly over" agricultural interests are tied to the CFTC.  A bill to merge the two is not likely in the works.

Panelists agreed the SEC's expertise is financial disclosure and consumer protection--less so around quantifying and managing market and systemic risks. They also pondered what would have been the outcome if the Federal Reserve had been the primary supervisor behind Bear Stearns and Lehman.  How would the Federal Reserve have managed the demise of these two institutions? (Frank and Cutler couldn't agree on whether the Dept. of Treasury in 2008 "forced" JPMorgan or "pressured" JPMorgan to acquire Bear Stearns, even as both had a ring-side seat of the monumental transaction.)

Across the board, with Frank in the room, the consensus was Dodd-Frank in the U.S. won't be abolished. It will likely be smoothed over a bit.  For example, rules will likely be relaxed for smaller banks, who shouldn't be subject to convoluted rules related to stress testing, liquidity coverage, and financial modeling. And perhaps there will be an easing of rules for regional banks and custody banks. Mid-size banks already have enough on their hands in managing anti-money laundering, "Know Your Customer" rules, and the Patriot Act.

Law professor Coffee was insistent the next blind side could be related to incentive compensation, the giant bonuses big banks paid top bankers during the crisis and in the 10 years since.  He presented data, trends and arguments to show that banks, for the most part, have dismissed what Dodd-Frank attempted to regulate in bonus payouts.

Coffee worries about systemic risk and banks and supervisors' capability of managing this risk.  He said the interests and objectives of bank shareholders are not in sync with supervisors' objectives to manage systemic risks.

Coffee's Law School colleague Mark Roe presented an analysis of the current U.S. tax-law proposal. What impact will a planned reduction in corporate tax rates (from 35% to 20%) have on banks?  Roe's study estimates banks will have 3% more equity capital, suggesting banks will be that much better capitalized to absorb risks (if a new crisis unfurls).  He didn't address the likelihood, however, that banks would just as eagerly pay that "extra capital" out in higher dividends or stock buybacks (catering to stockholders' interests).

New tax legislation could limit the amount of interest expense that's deductible from taxable income. Roe says that could increase the cost of debt and, therefore, decrease the appetite to issue debt. A higher cost of debt might encourage banks to issue or retain more equity. (The Federal Reserve's new "TLAC" rules for large banks will still require them to issue a minimum amount of long-term debt.)

Roe contemplates financial engineers will step in to introduce ways to respond to new tax rates and tax rules in the way of new derivatives or securitizations. Count on it.

While the crisis of 10 years back has been sliced, diced, reinterpreted, and analyzed to points of exhaustion, no panelist pinpoints when, where and why the next crisis will occur. Not many bothered to guess. 

But most agree bank regulation, as complex and difficult as it is, might help banks be better prepared.

Tracy Williams

See also:

CFN: A Spike in Bank Stocks? 2017
CFN:  Is Volcker Hurting Market Liquidity? 2017
CFN:  Will Dodd-Frank Be Dismantled? 2017
CFN:  The Impact of MiFID 2, 2017


Tuesday, December 5, 2017

A Spike in Bank Stocks?

U.S. bank stocks have enjoyed a smooth, upward ride in recent weeks. What explains the rise?
Take a look at how bank stocks have soared in recent weeks:  Share prices at JPMorgan have climbed 10% since early November, 8% at PNC Financial, 8% at Regions, 9% at Citi, and even 8% at Wells Fargo, the big bank that has had its share of reputational and off-balance-sheet issues the past year and a half. Bank of America shares have inched up almost 2%. 

What spurs such a spike in share prices? And is this spike subject to a later freefall after the market has deciphered and digested the bundle of financial news that has caused the spike in the first place? Or have market values risen to a new plateau?

Equity analysts often compare market values to book values (MV/BV) and try to determine how much a bank's market value (from share prices) exceed book value (net assets on the balance sheet).  The more confident investors feel about the strength of the bank's balance sheet, the way the bank manages an array of credit and market risks, and the "sustainability" and "predictability" of earnings, the higher the market value (relative to book value).

The same group of banks above (except for Citi) now show MV/BV ratio in a 1.2-1.4 range.  Investors appear comfortable that banks are measuring and managing risks and will be able to generate a predictable level of satisfactory earnings. (Citi continues to lag in this metric, but it, too, has seen upturns in overall market value in the past year.)

Consider how just a short time ago (a year ago? two years ago?) banks barely reached beyond MV/BV=1, and many showed MV/BV less than 1.  When the ratio falls shy of 1, equity analysts will rationalize shareholders are better off if banks break themselves up and sell of divisions, sectors, and subsidiaries.  (Buy the shares at 80; sell the various assets at book value at 100, and reap gains.)

What explains the rise?


<1 a="" ago="" analysts="" and="" at="" bank="" banks="" better="" book="" broken="" but="" chorus="" consolidated.="" cried="" discount="" divisions="" equity="" feed="" in="" into="" is="" it="" less="" might="" more="" nbsp="" of="" off="" or="" outcry="" p="" pieces.="" separated="" shareholders="" shares="" so.="" sold="" some="" spurred="" still="" suggesting="" than="" that="" the="" this="" to="" trading="" two="" up="" value="" was="" way="" were="" who="" worth="" years="">Some say favorable tax treatment (under the proposed U.S. legislation) explains rises in value.  If banks pay less in taxes, then they certainly will have more cash available to increase dividend payouts and buy back stock.  Citi and Bank of America reported over $6 billion in tax provisions last year; JPMorgan, over $9 billion. Bank stock investors lust after the predictable flow of bank dividends, and any hints that dividends will continue to rise will certainly boost share prices today.

This undermines some of the purpose of updated tax legislation, where politicians contend companies will use tax savings to reinvest in company operations.  At banks, the presumption is that banks will retain the extra earnings to boost capital that will permit banks to increase loan portfolios.  There is no guarantee.  Banks may just as likely use the extra earnings to deliver gifts to shareholders (dividends, stock buy-backs).

Projected easing of tough bank regulation is also speculated. Bank industry leaders continue to argue that regulation straps them. (Some say new regulation strangles them, curtailing growth and discouraging innovation and expansion.)  Dodd-Frank won't disappear, but it could be tweaked in ways that permit banks to boost loan growth and engage more comfortably in certain types of securities and derivatives trading.  If so, share investors contemplate this might boost returns on capital and, therefore, share prices.

Achieving ideal returns on capital continue to be a challenge for banks. Regulation imposes capital requirements on most bank activities and operations. Reaching a 12-13% is challenge. Few banks have returns that eclipse that mark.  Even fewer have returns that exceed 15%.  (And this includes all banks--big and small, global and community). 

Bank investors appear to understand returns will likely hover in the 10-12% range and are comfortable with that as long as returns are stable and predictable (while risks are managed) and as long as returns are sufficient enough to pay dividends and conduct occasional stock buy-backs.  No rational, reasonable investor can expect bank performance to result in ROE> 20% year after year.

U.S. banks, in the aftermath of the financial crisis and complex bank regulation, seem by now to have adjusted to the new normal.  Making sure they are comfortably above all requirements, benchmarks and standards is a regular operating activity at banks.  Share investors may have acknowledged that by 2017, banks have adjusted well to compliance, requirements, and stress tests, even if they wish some of the rules could be loosened or would just go away. 

In 2017, U.S. banks fared well in the Federal Reserve's stress tests, a regulatory-administered examination that assesses whether a bank can survive a prolonged period of downtown and macro-economic stress.  Banks subject to the test geared up, invested in people and systems, and reorganized their balance sheets to ensure enough capital anchored balance sheets to pass these tests--despite their complaints they didn't get to see the Federal Reserve's inhouse models used to conduct the tests.

Stock investors would likely be concerned about unexpected risks in banks.  Much of that is borne in trading and investment banking.  Related revenues and earnings are volatile.  But many big banks have offset these activities with revenue generators (asset management, consumer banking, service businesses, e.g.) with predictable streams of income.  Some big banks (JPMorgan Chase, Bank of America, e.g.) still look for trading and investment-banking home runs, but they won't be saddled too much if those activities are dormant in certain periods.

Banks also continue to do a better job simplifying the disclosure of complex activities in earnings and on the balance sheet (including loan portfolios, trading risks, hedging programs, etc.).  Some investors might actually understand most pages in 200 pages of 10-K disclosure.  Risks--including credit, market, liquidity and operational risks--are thoroughly explained. Even risks related to collateral, reputation, and documentation are addressed. 

Banks, as well, have been better about loss reserves on the loan portfolio.  Loss reserves should equal to expected losses from a range of loans--consumer to corporate, secured and unsecured, domestic and abroad. If the bank observes signs of vulnerability or weakness in the portfolio, they appear to plan and reserve for losses more quickly and more conservatively. Where could there be weaknesses in current portfolios?  Perhaps some banks have excess concentrations in energy loans, real estate loans, or loans originated in vulnerable countries.  Perhaps banks are reconsidering loans extended to companies in other sectors (retail companies, technology companies, etc.). 

The fin-tech sector, including new-venture companies that for the past few years have threatened to blow up traditional banking, still poses as a challenge to conventional banks.  They operate slightly beyond the supervisory eye of regulators. (They don't take deposits. At least not yet.) Many banks have begun to respond to the challenge, rather than dismiss or neglect the important role of that sector.  Some banks have decided to establish partnerships, providing capital and access to customers (something fin-tech companies crave and need). 

Stock investors are likely comfortable that banks are developing reasonable strategies to whatever goes on at or whatever will come from fin-tech companies. 

With any sector of stocks, there's always something that looms that could threatened to cause values to plummet.  The great unknown. The uncertain, unplanned-for event. The threat that appears from the darkness.  Analysts try to predict what could be the firestorm that tears apart a bank's sturdy, sound balance sheet.

What could that be?  Insufficient cybersecurity risks? A global recession that sets upon the global economy from yet another house of cards (one incident leading to another to another until the economy is wrecked)?

For now, at least until yearend, some bank shareholders will say, let's enjoy this bundle of riches for the moment.

Tracy Williams

Friday, October 13, 2017

What's the Fuss at P&G?


Shareholder activist Nelson Peltz made P&G his next move.  Round one has ended.
Old reliable blue-chipper, Procter & Gamble, is seldom in the financial headlines--unless it's being praised for being a good corporate citizen in its Ohio home state or unless it announces expansion into a new region in the world or names a new CEO.

P&G has grabbed headlines in recent days.  A shareholder activist has made moves to "shake up the company."  Nelson Peltz, the activist acting on behalf of his Trian fund, wants to reorganize the company to improve results and shareholder returns and made bids to try to get a spot on the board.  He and his fund own about $3.5 billion of the stock and launched formal proxy efforts.

The activist says he doesn't want to oust current management and replace with his own appointees, nor he does he claim to have devised revolutionary strategies and product ideas.  He wants to reorganize in a way to permit outsiders to understand performance better and hold managers accountable. 

Although not the same, it appears similar to how Google reorganized itself into the Alphabet holding company and separated out the search-engine business from other innovative or different activities, at least to permit investors to dissect each business activity carefully. Business activities are not bundled into single operations, and managers and investors know for sure what's growing, what's profitable, and what's worth investing in for the long haul.

P&G hasn't ignored Peltz's pressure and responded with vigor, reaching early-round triumph in the recent proxy move.

But what is it about P&G's performance the past decade that irks him and stirs such activism? Sometimes it's not about specific performance, but specific performance compared to others in the industry. Sometimes it's about a reorganization to figure out what's profitable and what's not, and what should, therefore, be sold off or shut down.

In the consumer-goods industry, that will likely mean they measuring P&G's share performance against the likes of Colgate-Palmolive and Kimberly Clark.

Needless to say, with all the commotion about business reorganization and board seats, the stock price has jerked around a bit the past several days. By most measures, share price (now hovering about $91-92/share) has increased steadily since it experienced brief dark moments in late 2015 (when the broader market was in a downswing).  The stock's price-earnings (P/E) ratio ranges between 24-25 range. In some circles, investors might suggest it's over-valued. Activists will contend it's not where it could be.

The company, like others in consumer goods and products, has reached levels of stagnation.  Revenues haven't grown over the past several years; in fact, they have declined. Profits, therefore, have remained flat.

What had been a $74 billion-revenues company will not likely eclipse $65 billion in revenues this year.  Facing markets in very mature product lines and encountering tough competition wherever it turns, the company has worked to cut costs to maintain profits and to generate returns investors want to see in a bustling economy. The company appears to have done well to reduce costs across the board, which explains why operating profits are flat when revenues are down.

Returns on capital deployed (book capital) have climbed above 20%. The company is resorting to financial maneuvering like other mature companies in a similar scenario.  Revenues are flat, because product offerings are mature and global expansion has peaked. Hence, to achieve reasonable returns on capital, companies like P&G focus on (a) cost control or cost curtailment and (b) rewarding shareholders with big dividends and share repurchases. They also resort to reducing overall funding costs by substituting cheap debt for expensive equity. 

Returns on capital rise, and share prices could actually climb (because of dividends and the certainty of cash flow generated from old products year after year after year).  Share prices inch upward, but they may not soar.  Activists take big stakes and then insist they have the right strategies to help the share price surge.

Debt at P&G now totals a manageable $31 billion (including short- and long-term debt).  Operating cash flow of about $9-10 billion annually (even after accounting for capital expenditures), as well as cash reserves of about $10 billion on the balance sheet, can handle the debt burden. Ratings agencies award it a AA- rating, stellar by most standards.

Now compare with Colgate-Palmolive, a peer, where shares trade at a higher multiple (28 P/E) and which might have benefitted from recent market "concerns" about P&G, as its own stock has climbed almost 5% in the last week.

The numbers show CP wrestles with similar issues. The company is about a quarter the size of P&G and has also experienced steady declines in revenues. Like P& G, it has boosted profits from aggressive cost-cutting.  It, too, keeps shareholders happy with consistent dividends and share buybacks, but hasn't had to increase debt to supplement operating cash flow (about $3 billion annually).

(CP has a market value at 10/13/17 of $66 billion, based entirely from predictable cash flows and the value of many brands. It has less-than-zero book equity.)

P&G, by comparison, is an elephant, a healthy one, but perhaps one that is walking uphill. Peltz might have launched his haunting of P&G by habit.  He, his fund and other investment vehicles have habitually invested in large, mature consumer-products or consumer-goods  companies.  In past years, they have had stakes (and pursued activist strategies) at PepsiCo, Mondelez, Kraft Foods, and Wendy's.  (He might best be known for stir-ups at DuPont two years ago.)

After an unsuccessful proxy effort, Peltz was shoved back to the sidelines.  But the ball is in P&G's court, as it had announced it has its own well-crafted plan to determine a way grow an old, graying enterprise.

Tracy Williams

See also:

CFN: PepsiCo's CEO on the Hot Seat? 2015
CFN: Is Shake Shack Worth a Half-Billion? 2015
CFN: Radio Shack's Doomsday, 2015
CFN:  What Happened at JCPenney? 2013
CFN: Why Is Dell Going Private? 2013
CFN:  Alibaba's U.S. IPO, 2014
CFN:  Twitter's Turn to Go Public, 2013