Tuesday, November 10, 2015

MBA Recruiting, 2015-16: Ready, Set, Go

It's that time of the year at top business schools.  Recruiting season is about to be launched in full swing.

First- and second-year finance students must implement strategies they've devised to find the right job in the right sector at the right company. MBA graduates everywhere remember how recruiting is a full-time effort, a sixth course, an effort that requires massive amounts of time and worry.

The Consortium Finance Network, as part of its mission, hosted its fourth annual recruiting and interviewing webinar Nov. 5 for first-year Consortium students in finance.  Students from all 18 Consortium schools were invited to dial in to get advice from a panel of Consortium alumni in finance.

During the one-hour session, CFN hosts and panelists reviewed opportunities in several finance sectors (from investment banking to private equity) and provided step-by-step guidance on how students can sell themselves and convince prospective employees to extend an offer--for the summer or for full-time employment.

This year, in the webinar's second half-hour, CFN decided to focus on venture capital, private equity and financial entrepreneurship, partly because these sectors do not recruit formally on campus and because these sectors have abundant hurdles when MBA graduates try to get through the front doors.

CFN steering-committee members D-Lori Newsome-Pitts, Camilo Sandoval, and Tracy Williams organized and hosted the webinar.

Panelists included Consortium alumni Ed Torres of Lilly Ventures (Michigan MBA), Ben Pitts of MyFinancialAnswers (Virginia MBA), Eddie Galvan of Nomura (USC MBA), Mark Linao of Technicolor Ventures (Michigan MBA), Sinclair Ridley-Thomas of JMP Securities (USC MBA), and Enoch Karuiki of HIG (Dartmouth MBA).  (Karuiki and Galvan had participated in a previous CFN recruiting webinar and returned to volunteer their advice and experiences this year.) All panelists had thoughtful guidance and offered lessons learned from their own days in business school. They added special tips and encouragement, based too on their own few years inside the front doors and on the front lines.

Outlook, 2016

Webinar participants evaluated financial sectors and offered a rating outlook for employment in 2016 for interns and for long-term careers.  Opportunities are a function of many factors, including economic trends and cycles, companies' relationships with specific schools, companies' past success in hiring MBA graduates, and financial regulation.

Banks and other financial institutions' business opportunities are somewhat constrained or influenced by new regulation.  Limitations on balance sheet and leverage and new rules, for example, discourage banks from hiring in large numbers in sales and trading.

A "Positive" rating suggests major institutions in the sector project revenue growth and business opportunities that will likely require hiring ample numbers of MBA finance graduates to come on board in the next few years.

The following sectors were assigned "Positive" outlook ratings:

Financial technology (payments, processing, clearing, advisory)
Compliance and regulation
Risk management (credit, market and operations risks)
Asset management (all asset classes)
Private wealth management
Venture capital

Webinar hosts and panelists awarded a rating outlook of "Stable" for the following sectors:

Corporate treasury (financial management, non-financial institutions)
Investment banking (bulge-brackets and boutiques)
Corporate banking
Investment research (equity and credit)
Private equity
Community banking
Community development
Electronic markets (exchanges, market-makers)

Sectors receiving a "Negative" rating, based on constraints banks are experiencing and general performance over the past few years, include the following:

Hedge funds 
Sales and trading (at regulated institutions)

Galvan, an investment banker in the financial-sponsors group at Nomura, reminded students that within investment banking, certain industry groups are "hot."  There could be glowing opportunities in technology, health-care, energy and real-estate groups.

Torres of Lilly Ventures agreed that while the outlook in venture capital is as favorable as ever, the route to employment continues to be hard, unpredictable.  "Very few folks get hired by a VC firm right out of school," he said. The best way to land a good offer from a prestigious firm (like Kleiner Perkins or Sequoia), he suggested, is to have already racked up many years as a successful entrepreneur. "Been-there-done-that experience is what is attractive to VC firms."

Torres added, in venture capital, "It's not a recruiting process. It's a dating process."

Summer Goals

When an MBA student in finance wins an offer, another phase of hard work is about to begin. Student interns have less than 10 weeks to prove they can do the work, make contributions, and fit in. CFN panelists summarized the primary goals in an internship, which fall in many broad categories:

Technical skills
Industry knowledge
Work ethics
Firm culture

MBA interns and graduates on a new job should show they have expert technical skills and industry knowledge and demonstrate it everyday.  If they haven't mastered the skills, they should prove they can learn quickly.

The summer is also a chance for them to observe the culture around them and decide whether the company, the company's diversity commitment and the industry are right for them.  Work ethics count for much, too, and MBA students will need to show they will work hard, produce, show up, be eager, and contribute.

As they become more closely linked to the outcome of deals or transactions, MBA associates will want to show their comfort and rapport with clients.

Of course, the ultimate goal is to win a full-time offer, even if the intern has decided the fit at the company is not favorable or the culture is not ideal. It's ideal to at least have the offer in the pocket when the first days of second year arrive.

Interview Road Map

CFN co-founder Sandoval reviewed CFN's road map to interviewing successfully.  He reminded students they should have a strategy set for the season and asked, "What is your story?" New recruits should know their story, know what they want, and polish the story. "Think about why you want to work (at a financial institution)," he said. " Don't miss any opportunity to discuss who you are."

CFN's road map is based on the MBA interviewee being able to express clearly (a) background, (b) interest, (c) drive, (d) capability, and (e) insight.

Galvan from Nomura said, "There are two different routes to investment banking.  The non-core school route and the core-school route."  Galvan had gone to a non-core school (USC-Marshall), a school not necessarily on the primary recruiting lists at top investment banks when he pursued and eventually earned a job offer at JPMorgan.

"Show active interest and the 'want-to-be-there'," he added.  Coming from a non-core school, "I became the guy from USC that everybody liked.  I don't get the technical interview if I don't show interest."

Karuiki from the venture-capital firm HIG said that the interview process is sometimes summarized by the recruit answering a series of why's:  Why do you want to be a banker? Why do you prefer and enjoy finance? While he was at Dartmouth-Tuck, his strategy was to combine his science background with his interests in finance. (He worked at UBS before eventually joining HIG.)

Ridley-Thomas, a recent USC-Marshall graduate, was able to secure an internship after his first year with the private-equity firm Oaktree Capital.  He said he connected with the right people before the interview process started and he "benefited from referrals," getting to know people who could recommend other people.

Linao, who worked at Amazon during his MBA summer, explained how he pursued working for a start-up when he began to look for full-time opportunities, but ended up in venture capital in the process.

Pitts, while at Virginia-Darden, was able to gain offers from firms like Lehman Brothers (before its demise) and Goldman Sachs, where he worked after graduation before founding his own private-wealth firm. "Do what is genuine to you," he advised MBA students.  "Don't get easily distracted from your own goals. Be true to yourself."

Mentors matter a lot, panelists said.  "Seek out the most senior people you can," Pitts added. In school, "you have to be at all the corporate social events."

Torres advised students, "During the interview process, focus not just on the 'what,' but also on the 'how,' too."  Interviewers, he said, will want to know whether MBA graduates know how markets, finance, products and companies work or how to get a job or task done.

Galvan said, "The (recruiting) process starts really early, so be prepared."

Linao, an associate in venture capital, said, "A lot of it (the process, getting an offer) is being lucky. You'll want to force serendipity."

Pitts, the entrepreneur, encouraged graduates to consider the daring route he took after a few years at Goldman.  He started his own firm that offers wealth-management solutions.  "People think being an entrepreneur is this mystical thing," he said. "I think it's about just doing it. Motivation, relationships, and just do do it. The actual risk is less than the perceived risk."

Ridley-Thomas said, "Get focused as quickly as possible. Be relentless."

Focus on Venture Capital

Sandoval led a special discussion on venture capital, explaining major principles of how a VC firm is organized, how it raises funds, how it invests in companies, and what goals it has in the short- and long-term.

For the benefit of MBA finance students, Karuiki explained the primary difference between venture capital and investment banking.  Investment bankers have a transactional approach. Bankers work from deal to deal and seek to close them as quickly as possible. Venture capitalists, he demonstrated, have a long-term approach with clients (4-5 years typically).  They have a sustained, high level of involvement and get involved closely with people issues and senior-management hiring.

Torres, who has spent over two decades years leading Eli Lilly's venture-capital unit, said venture capitalists spend enormous amounts of time immersed in the operations of the companies they invest in.  There is a different pace and timeline when considering a deal, investing in a deal and monitoring it.  Unlike investment banking, where deals are birthed and consummated in short order, in venture capital, Torres said, "It may take three months just to decide whether to work on a deal and six months to complete a deal.  It may take four, five, six years before we exit."

In venture capital, there are winners and loses, home runs and duds, whopping gains and occasionally embarrassing losses.  "You've got to have perspective," Torres said. Venture-capital firms look at countless possible investment opportunities before they invest. "You're looking for reasons to say no. We look at 100, 150 deals for every one we do."

He summed up, "In venture capital, we're looking for the jockey, the horse, and a large unmet need." Strong management, efficient operations, and an interesting, novel product.

Tracy Williams

See also:

CFN:  Recruiting Webinar, 2013
CFN:  Recruiting Webinar, 2012
CFN:  Recruiting Webinar, 2011
CFN:  MBA Job-Hunting:  No Need to Panic Yet, 2012
CFN:  MBAs:  Second-Year Dilemma, 2010
CFN:  Opportunities, 2015
CFN:  The Finance Resume' and Recruiters, 2014
CFN:  Summertime, Summer Internships, 2010

Wednesday, October 21, 2015

Corporate Debt: Elephant in the Room

How much is too much debt?  In its announced acquisition of EMC, Dell will borrow over $40 billion to complete the deal

Financial analysts, including equity-research analysts, asset managers, and investment bankers, spend gobs of time assessing the equity of a company.  They value the stock, they assess market and book values, and they project performance and tie that to the company's overall value.  

MBA students in finance take courses in analyzing stock values of companies. They learn theories of valuation, portfolio analysis, and the factors that influence market values.  In business school, however, they seldom immerse themselves in subject matter that addresses the intricacies and complexities of companies taking on debt. 

Unless they are credit analysts and risk managers at banks, even experienced analysts sometimes overlook the burden of debt. Or they don't address it properly. Or they take it for granted (take for granted that companies can borrow when they need financing to support growth and take for granted that companies can make payments in timely fashion).  Some analysts prefer companies avoid debt altogether or dismiss how debt can be a vehicle that leads to higher returns on equity.

(Corporate debt includes an array of funding sources:  bank loans, corporate bonds, private-placement notes, structured notes, subordinated debt, convertible debt, etc.)

Debt:  A Burden or a Spark?

Debt can be a burden; it be can be hurdle, a conundrum, or the elephant in the room. This month, Dell announced it will acquire EMC, the cloud-computing and data-storage company, in a major deal that will acquire that it assume over $40 billion in new debt to consummate it.  Will that debt load eventually haunt the combined companies? Or will it be the spark to promote revenue growth and surging earnings?

If shrewdly deployed, debt can lead to higher stock prices or company valuations.  Some companies could be better off if they borrowed more.  Other companies have no more room to borrow another dime.  

It's up to financial analysts (including bankers, fixed-income researchers, and arguably equity analysts) to determine what's the right amount--what's too much and what might be too little. How is the analyst assured that the company under review can generate cash flow to meet all debt requirements due in the next quarter?

Apple avoided debt by all means during the Steve Jobs era, but now embraces it (if only to pay dividends, buy back stock, and get accustomed to the discipline required to run a company with higher leverage).  Other companies (Dell and Verizon, e.g.) resort to debt to finance large acquisitions.

Others use a combination of new debt and new equity to spearhead growth and expansion.  Financial institutions, with blessing from regulators, pile on long-term debt to avert the possibility of an occasional "run on the bank." 

All companies (and the analysts who follow them), nonetheless, wrestle with the right amount.  When does debt become too much of a burden?  When do once-manageable debt loads evolve into a mad scramble by companies to find cash in its operations to make interest and principal payments?

Financial analysts have tools, models, and ratios--even for debt--to help them draw conclusions.  Yet analysts also use intuition and experience to determine how much is too much.

Debt-to-equity ratios are often analyzed. Cash-flow coverage models are deployed.  Analysts sample many capital structures to determine the right debt load.  Past experience and history (previous defaults, bankruptcies, and companies that deteriorated in the past, e.g.) and current statistics (probabilities of defaults, e.g.) are useful, as well.

Grappling with "Ebitda"

To determine what might be too much of a burden, a favorite, traditional ratio for analysts is a Debt-to-Ebitda (“E-bit-dah”). Earnings, of course, are an obvious source to manage the burden and pay down debt when it's due. Debt/Ebitda is a useful tool to measure what's too much, but the ratio alone is a flawed approach.

First things first. Let’s agree on what “Ebitda” is, why it is a popular reference to a company’s performance, and why it might lead to a flawed approach.

Credit and equity analysts like to use this common pre-tax earnings line item as a proxy for operating cash flow, a “back-of-the-napkin” estimate of actual cash generated from operations before they derive it more precisely.

Picture two bankers in a discussion of a client’s performance. They want to size up operating cash flow without the benefit of spreadsheets, calculators or detailed financial information. Ebitda is a start.

Ebitda is the first glance at whether operating cash flow is positive, negative or trending one way or the other. It is what it can be—a cash-flow proxy. Analysts, nonetheless, must be mindful it disregards working-capital adjustments, capital expenditures, and a list of other required pay-outs (e.g., lease and tax payments).

Sometimes Ebitda is a fairly close approximation to actual derivations; often, it over-states actual cash flow or disregards how a company may generate cash from non-operating activities (e.g., the sale of an investment or manufacturing facility). (Last year, Pepsico reported Ebitda of about $14 billion. An analyst might compute gross operating cash flow at about $12 billion.)

But all analysis must start from somewhere.

Debt-to-Ebitda as a Debt-Burden Tool

Now Debt-to-Ebitda. This ratio is used frequently to measure debt burden. To assess whether debt is too high or has become a financial challenge, analysts look at an array of debt ratios (Debt/Equity, Debt/Tangible Equity, LT Debt/Equity, Cash/ST Debt, e.g.).

Or they examine Debt/Ebitda. 

The ratio is popular among bankers, credit analysts, and deal-doers. It is widely used in loan agreements as a financial covenant (borrower requirement) or in comparing debt levels for peer companies in an industry. Ebitda is much easier to confirm than actual cash flow, which may require bankers from different institutions to agree on the derivation.

Analysts interpret the ratio in many ways. For example, it can be an approximation for how long (in years) it might take for a company’s business operations to pay down a set level of debt. 

For any analysis to be complete, analysts will still eventually go through the painstaking exercise to compute and project actual cash flows, but Debt/Ebitda gets the analysis off the starting blocks. 

Debt/Ebitda < 3, for example, as a financing benchmark, implies debt on the current balance sheet will likely take about three years to amortize, three years to expunge if the company opted to do so.

Indeed many strong companies with stable, predictable cash flows will exhibit Debt/Ebitda < 3. However, in the realm of “leveraged finance” (financing structures for less creditworthy, but established borrowers), those negotiating big debt deals will argue analysts should find a way to get comfortable with Debt/Ebitda > 5, based on an argument Ebitda (or actual cash flows) for the borrower is stable, sustainable, and predictable. 

Some analysts use the ratio as another way to put leverage in perspective. A borrower might have a high Debt/Equity ratio (> 3?), but with relatively strong earnings, could have a low Debt/Ebitda ratio (< 2?). Debt, therefore, may appear high on the balance sheet, but earnings are strong enough to amortize it quickly. 

Take a look at recent calculations of the ratio: Microsoft 1.6, Yahoo 5.5, Pepsico 1.6, Goodyear 8.8, and Merck 1.0. 

The ratios imply Microsoft, Pepsico and Merck have earnings that result in healthy cash flows that can amortize debt in less than 2-3 years. They suggest that Goodyear and Yahoo might have earnings and cash-flow woes, where debt will take years to amortize and could be a burden, especially if earnings prove to be volatile in the future.

In leveraged-finance transactions, analysts determine the maximum amount of debt that creditors will tolerate for an earnings stream (maximum Debt/Ebitda). The more confident they are that the borrower can achieve a stream of earnings, the more comfortable they are with debt, which will be amortized by the same, predictable flow of earnings. That explains the possibility of getting a debt deal done at Debt/Ebitda ratios < 5. 

When Verizon acquired all of Verizon Wireless from Vodafone in 2013 and took on $49 billion in new debt to do so, Debt/Ebitda calculations pushed toward eye-popping 9.0--very little room for error in operating performance to pay this all down.)

No matter how much the ratio is discussed or used, analysts should recognize its flaws, because 
  1. Ebitda, as mentioned, is still an approximation of cash flows,
  2. The ratio assumes cash from operations is available only for debt-related payments,
  3. The ratio disregards interest rates and related fluctuations,
  4. The ratio neglects that tax obligations are real, required, and must be tended to, and
  5. The ratio presumes earnings are not necessarily available for dividends, new investments and capital expenditures—an unrealistic scenario for many companies.
A thorough analysis, of course, requires the analyst to use Ebitda to derive actual cash flow from operations and to consider a variety of factors, including investment requirements, working-capital requirements and adjustments, and perhaps other cash sources. 

But all deals, discussions of new financings and negotiations must have a starting point, and why not Debt/Ebitda?

Debt Capacity: 
What's the Most a Company Can Tolerate?

For any company under review by an analyst, what about the approach of computing the maximum amount of debt the company's operating cash flows can handle?

When they project operating cash flows in the periods to come, whether 5- or 7-years out, analysts measure whether a company can pay down existing debt and interest expense and any new debt that’s necessary to generate those projected cash flows. 

Analysts, too, if they wish, can compute an imprecise, but useful number: a maximum “debt capacity,” the highest amount of debt the operations can tolerate over a certain time frame. (Five-year debt capacity would be the sum of discounted projected cash flows over five years, discounted at the interest cost of debt and assuming all cash flow is used for debt-service only.)

“Debt capacity” can be a marketing tool for bankers in discussions with clients who contemplate new debt to finance growth, new investments or planned expansion. Knowing what might be maximum debt capacity, bankers can respond immediately to a client to confirm whether new debt is worth considering. 

Pepsico, for example, has about $23 billion in debt. A rough debt-capacity exercise might show its extremely reliable cash flows will tolerate as much as $20 billion more in debt (or $45 billion in total capacity). It won’t need this much in new debt, but it proves what its operating cash flows can handle despite debt-equity ratios that continue to rise.

Debt-capacity calculations come with red flags. Does the calculation reflect all the capital expenditures necessary to keep the company growing? Does it allow for cash to be set aside for unplanned or emergency purposes? 

Does it permit companies to pay dividends to shareholders who expect predictable quarterly payouts (as a company like Pepsico would surely want to do)? Does it capture no-growth and worst-case scenarios? 

Just like the Debt/Ebitda, “debt capacity” is merely one tool among many. Analysts must probe and still take steps beyond. 

At least companies (and the analysts who assess them) have ways to get more comfortable with that elephant in the room, tame it and use it to gain advantages to shareholders. 

Tracy Williams

Friday, October 2, 2015

Financial Models, Ratios: Updating Them

Analysts and researchers should understand when it's time to adapt and update their financial models when they analyze companies
Working Capital/Sales, 
Market Value/Book Value

Financial ratios. Financial models.

MBA's, who have labored in finance courses and are headed into long careers in corporate finance, know all about them. Analysts, associates, researchers, and deal-doers at investment banks, corporate banks, private-equity firms, and asset-management companies are smothered by them.

Are the same financial ratios and calculations financial analysts have used for generations still useful? With new businesses and new industries sprouting all over the business landscape and with companies expanding desperately into new markets and countries, are the same techniques still relevant?

Financial ratios drive home the conclusions financial analysts make. They use popular ratios and calculations to describe the financial health of the companies they analyze. They use them to confirm the values of companies.  They use them to help decide whether to lend or not lend, invest or not invest, merger or not merge.

Ratios tell a financial story of what’s going on or what will or could happen to a company’s ability to make money, pay down debt, and reward investors with stable dividends. Sometimes analysts use them carelessly or in rote fashion, not always understanding thoroughly what they mean. Some ratios are self-explanatory. Some are tricky, misunderstood, or misinterpreted. Others convey different messages at once.

Shrewd analysts go beyond the definitions to grasp what they mean: What do they convey? How do they help in assessments of profitability, liquidity or leverage? How might they be flawed? What factors do they neglect? When should they be revised or adjusted? For what industries are they most relevant?

Analysts (credit analysts and equity analysts) nowadays analyze large, complex companies in global industries or in businesses that didn’t exist a generation ago. What ratios, therefore, should analysts use to describe activities for Internet and telecommunications businesses or for financial institutions that trade exotic financial instruments?

Old Companies, New Companies, New Industries

What special ratios are applicable for companies like Google, Facebook and Twitter, all companies not even two decades old? What ratios might explain the business models of companies like Groupon, Zygna, Uber, and Yahoo? How do companies like Amazon, eBay, PayPal, AT&T and NetFlix translate business activity into real cash flow?

The companies under review could be old stand-outs like Coca-Cola, IBM, Boeing, General Mills or Exxon. Or they can be new companies like Twitter or struggling ones like J.C. Penney or Sears. What ratios or financial techniques explain best whether these companies have adequate cash to make debt payments and deliver handsome returns to investors—now and in the years to come?

What ratios, financial models and analytical methods show how some companies have resources to meet debt payments, pay dividends, repurchase stock, and commit to capital expenditures to ensure long-term growth?

For example, is cost of goods sold (relative to total sales, CGS/Sales) applicable to Internet companies like Yahoo, Google and Twitter? Are there raw-material purchases and inventory for these kinds of companies?

What does the popular ratio, Debt/Ebitda, used to assess many syndicated loans and debt transactions really mean or imply? Is it a fair, realistic assessment of a company’s leverage? Why is it a sometimes preferred a benchmark when comparing debt levels with peer companies?

What does the analyst do when valuing all those Silicon Valley start-ups with no history of earnings, no cash flows to speak of, but all with great promise, engineering marvels, and innovative products>

How useful is the customary quick ratio (Cash/Current Liabilities) in measuring a company’s liquidity? What if some of that cash resides in foreign countries, subject to high repatriation taxes, or is cash “encumbered,” set aside or pledged for other purposes (e.g., collateral or required capital expenditures)?

Or what does it matter if a company has cash to meet all short-term debt, but shows few signs of revenue growth to meet long-term obligations and to help boost market valuation?

How does an analyst grapple with a hedge fund with unregulated amounts of leverage, derivatives exposures, and “short” trading positions?

When faced with complex, evolving, and growing companies in new industries, what approach should the analyst take? What if the company is old and stumbles to generate any sufficient amount of cash, still convinced that obsolete ways and old products can still lead to sales growth?

Time to Update Models and Ratios

Whether the company is old or new, struggling or surging, those who are responsible must be willing update their models. They should:

(a) know what financial ratios mean or how they can be useful or relevant,

(b) understand what financial messages or signals they convey,

(c) understand how they apply to a particular industry,

(d) revise them, when necessary, based on the industry or the company’s business model,

(e) understand how ratios are occasionally incomplete, flawed, or not meaningful,

(f) avoid drawing bad conclusions or making false inferences,

(g) create new ratios or approaches if they explain a company’s business better

As companies (borrowers) grow globally, expand and become more complex, analysts must be willing to adapt and change their ratios and financial models to find the best way to capture the essence of financial performance. That might mean discarding some familiar ratios and techniques or revising the analytical framework as necessary.

They should do the same when they encounter a new company in a new industry, delivering the product (likely a technology gem) or service that didn’t exist a few years ago. Uber, for example, only few years old, might require different ratios and techniques to explain how it manages costs, generates cash flow, and reinvest earnings. Airbnb, another new company, may require different approaches to explain its financing needs and explosive growth.

In an analysis of a company like Facebook, who are the real “customers”—those who use the service or those who place ads and contribute advertising revenues? For companies like Coca-Cola or Pepsico, what ratios explain whether their operating models of franchised bottling companies are working efficiently?

For pharmaceutical companies like Pfizer or Eli Lily, are there R&D-related ratios that prove that related expenses will eventually yield soaring revenues, high profit margins, and high returns to shareholders?

For companies with operations around the world, what ratios or approaches prove their business activities are properly hedged or show that their cash reserves are trapped abroad because they hesitate to repatriate them homeward?

As borrowers grow, tap into new markets and customer bases, take advantage of revolutions in technology and as debt deals get larger and more complex, analysts must keep up, too. As new companies are formed in new industries, analysts must be prepared.

Always be willing to adapt, revise, change or take a novel approach.

Tracy Williams

See also:

Wednesday, September 23, 2015

Alibaba a Year Later

Over the past few months, Alibaba's stock price has taken a wild, bumpy ride
A year ago, last fall, Alibaba and its colorful CEO Jack Ma marched into the U.S. capital markets with its well-promoted, highly publicized IPO.  China's version of eBay, PayPal, and Amazon wrapped into one touched down on American soil with a big splash of a public offering, $22 billion of new stock listed on the New York Stock Exchange.

A year later, China's stock market is in turmoil, and its flaming, booming economy is waddling in uncertainty.  Alibaba's stock has since taken a wild, tumultuous ride, and some have doubts about the once-glowing prospects for the company.  But what do the fundamentals say--Alibaba's bottom line, its earnings, its business activity, and its prospects to sustain Amazon-like growth in revenues and customers?

Alibaba share prices in the U.S. are on a roller coaster with swirls, bumps, and tumbles sometimes unbearable.  At the IPO, the stock was priced at $68/share, the company raised over $21 billion, and it had an aggregate market value that quickly climbed toward $200 billion--planting it in the market-value league of Apple, Google, and Facebook.

After the IPO, its price surged toward $100/share, eventually reaching $120.  In early September, the price had fallen to $65 (Sept. 15) and $62 (Sept. 22) with total market value below $165 billion.  The stock has traded within a range of $58-120/share the past year.

Do current prices reflect a more realistic value of Alibaba? Were peak market values overblown because of fanfare, popularity, and over-promotion?  Or is Alibaba's current value influenced by grave concerns and negative long-term prospects in China?

Market metrics suggest the company's stock values might still be attempting to find that right trading range after the initial hoopla--a correction atop a correction. Recent PE (price-to-earnings) ratios show valuation is likely in a realistic range, while some of its U.S. Internet peers may be trading at values that continue to rely on (and hope for) astounding growth.

Alibaba's PE has declined from about 40 to 23 in recent weeks, partly because of the decline in growth expectation, despite the company continuing to report stunning earnings in the midst of Chinese woes and negative outlook.  Market values and PE's are also influenced by (a) investors now requiring a higher return to compensate for greater risks (therefore, increasing "equity cost of capital") and (b) a conservative assessment of growth, which might have exceeded 10% last year, but may have dwindled into single digits.

By comparison, PE's at Google and Facebook are 31 and 98, respectively.  Expectations of growth explain much of those PE ratios and swings. (Apple's latest PE has dipped below 15. Investors aren't sure Apple has another trick in its bag of magic.)  The more investors forecast significant growth in a company's business (and its revenues and earnings), the more they are willing to pay for value and for current earnings.

Investors don't like uncertainty, too.  So while it's likely Alibaba will grow and spread its business around the globe among an assortment of activities, turmoil in China means uncertainty, which lends doubt to whether Alibaba can achieve what it has set out to do.  Hence, expect a few more wild rides in its stock price.

Does Alibaba belong in a league of Google, Facebook, Amazon and Apple in discussions of Internet and technology companies and their market values?  Alibaba generates revenues of about $12 billion (and climbing), which puts it on par with Facebook, but is dwarfed by the behemoths Google, Amazon and Apple (which range from 4-10-times larger).  Despite the stock-price swirls in recent weeks, Alibaba's $160 billion market value still keeps it in the same value hemisphere and secures it as the world's fourth largest "Internet" company:  Google, $437 billion; Facebook, $264 billion; Amazon, $251 billion.

Recent performance statistics show the company riding a remarkable upswing. Revenues (about $12 billion) grew 45% last year and are headed toward $13 billion or more this year, although not at a similarly stellar rate.  Earnings ($4 billion) are expected to grow this year, as well.

This translates into returns on equity above 25% (28% last year).  Returns are high because revenues are growing steadily, profit margins are high, and the company has been comfortable exploiting debt to keep financing costs low.

Alibaba's sales growth matches that of Amazon. (Alibaba makes gobs of money, while Amazon is indifferent to its bottom line and reports earnings every now and then.) The business models of the two firms differ, nevertheless.  Alibaba is Amazon without the warehouse facilities dotting the country--more like eBay, but with Amazon's eye toward expanding into new businesses and new markets with the flick of a finger.

The company, similar to Apple, has become, at least for now, a mega-cash-flow machine, generating about $6 billion in annual cash flow from operations and attracting bundles more from the IPO and new borrowings.  About $20 billion of cash sits on its balance sheet, ready to be funneled into whatever new business, new investment or new operation that suits the whims (or visions) of its CEO.

In recent years, the company has plowed billions in new investments, which will likely support continued growth, but which also makes for a complex, difficult-to-unravel organization (in the eyes of many analysts).  Alibaba is a challenge to analyze because of complex ownership arrangements, labyrinthine organization charts, vague minority interests, cloud-computing businesses, e-commerce businesses, a payments business and a search engine.

Bottom-line results, impressive to date, are why it could step into the U.S. and sell equity to those who know little about Chinese commerce.  What could keep the company from continuing to perform and keep its stock price stuck below $70/share for months to come?

1. The entire globe wonders about or is worried about the prospects of Chinese economics, which would have direct impact on Alibaba's immediate results.  But as the economy there transforms from over-emphasis on infrastructure investments and real estate to one of service and consumerism, Alibaba is poised and will pounce on the transition.

2.  Just as Amazon has Bezos, Facebook has Zuckerberg, and Apple had Jobs, Alibaba has Ma, who like the others sets the agenda, articulates the vision, knows precisely from where growth will come, and convinces the world to buy the products or use the service. He, like the rest, sticks to his convictions.  He also attracts the talent, selects the right people to run operations, and keeps the company on a proper course.  Ma doesn't seem distracted, disappointed or too concerned yet.

3. The company will continue to be a giant jigsaw puzzle of organizations and activities.  Equity analysts will be pleased by earnings and growth (especially during a China downturn), but will continue to be stumped by unwieldy, maze-like organization structures.  As Ma and corps continue to make new investments, the structure will get more complex.  Simplicity in structure could raise market values a few billion, just as it did when Google reorganized this summer. Google analysts can can define more precisely where operations cash flow is derived and where true value lies.

4. Unlike Apple, but like Amazon and Facebook, Alibaba is comfortable with debt and its burden. Debt offers cheap funding and an added source of cash to support growth, expansion and new investments. At some point, debt becomes too much of a burden.  Alibaba, with about $8 billion in debt on the balance sheet (and room to take on a few billion more), can manage the current debt load with no difficulty and may not likely tap into debt markets as much, because it won't need to.  It is piling on cash from business operations.

5.  Yahoo holds a significant portion of Alibaba stock (over $20 billion) and is entitled to a prominent voice at the board table.  Yahoo wants to spin off this investment, focus on its own challenges and had planned to do so this year. Alibaba stock gyrations have spurred Yahoo to postpone this sale. Yahoo still sits at the table, but has been passive about its investment, exerting silent influence in how Ma runs the company.  Yahoo, over the next year, will be around, but with negligible impact or say-so, as Alibaba encounters this momentarily rough patch in China's economy.

Alibaba, jostled and shaken while taking the summer-time rocky ride, will survive in tact. Revenues may not likely surge as before, and stock values will continue to rattle and roll until year-end, but high profit margins and an economy that is encouraging consumer spending will keep it in the big leagues among Internet powerhouses.

Tracy Williams

See also:

CFN:  Alibaba and Its U.S. IPO, 2014
CFN:  Facebook IPO: The Lucky Underwriters, 2012
CFN:  Google Reorganizes, 2015
CFN:  Twitter and Its IPO, 2013
CFN:  China, Greece and a Stressful Summer, 2015

Monday, August 24, 2015

Is This 2008 All Over Again?

All of a sudden, it feels like 2008, but with different trigger events
The big summer market-sell-off of 2015.  Uh-oh, is this 2008 all over again?  Does it feel the same as it did in late summer, early fall 2008, as Labor Day approached? 

Is there another financial crisis looming over the horizon, a crisis that could wreak economic havoc and cause us to sink into a debilitating recession? Is this the same? Or different? Yes and no.  

Yes, it feels like 2008.  When market indices for every equity market around the world sink into a cellar in a matter of days (and hours), 2008 comes to mind.  Investors get confused, and they scramble to make rash decisions about their investment portfolios, no matter how much the old-time asset managers admonish all to take a long-term perspective. Investors seek comfort and solace from financial advisers.  Uncertainty abounds.  

Financial institutions all over summon their risk-management units to the board room to gather data to determine where the big risks are and to devise a swift game plan to manage risks that seem uncontrollable. 

But no, it's not 2008.  It's different this time.  There is a different set of trigger events.  In 2008, the whole mess was ignited by rumblings in mortgage markets, which triggered losses in mortgage-backed securities, which led to losses in hedge funds and financial institutions, who had been forced to sell assets in fire-sales to generate cash to pay off panicking lenders. And on and on, until the Great Recession swarmed in. 

This time there is a different trigger event from markets a half-globe away:  China.  Earlier this summer, we watched from a distance as its stock markets crumbled.  The earlier declines over there had not yet had much impact over here, while our markets continued to engage in Fed-watching, trying to figure out precisely when interest rates will turn upward.  But after the Chinese decided to devalue its currency, global markets began to swirl and descend, slowly, then quickly.  The devaluation proved to be the signal that the dampening or shrinking of its economy was no longer a conjecture.  It was perhaps real. 

Equity markets don't wait for economists to figure out the global impact of China's struggling economy.  And they don't wait for government officials to provide guidance (or issue out blame). Stock markets react, and they watch each other to determine how to behave and react. If they over-react, well, they'll correct that in ensuing sessions. 

Financial institutions, this time, should be in much better shape--thanks in part to regulatory reform that (a) requires that they have more capital cushion for times like this, (b) requires that have more liquidity if lenders and depositors flee en masse, (c) requires they pass stress tests to prepare for these awful scenarios, and (d) requires they maintain balance sheets with limited (if any) amounts of risky trading assets.  

In 2008, the financial system was in danger, at least for a few weeks in late fall.  In 2015, the financial system, at least in the U.S., should be sturdier, more sound.  

We knew it, and we've seen it, but global turmoil, circa 2015, proves once again how interconnected the economies of large economic powerhouses are and how interconnected their financial markets have become and will be. What happens over there seeps into the equation variables that explain what happens over here.  

This also becomes the time to pinch ourselves to peek at market history for guidance and a little bit of comfort. History and technical analysis show that eventually equity markets eventually bounce back, sometimes after a little bit of tweaking, sometimes when hysteria recedes. They may not be useful now to tell us when. 

Now could also be the time to reach for the security blankets of wisdom from the consistent perspectives of  the best long-term investors (the world in which Warren Buffett resides). During market strife, they cling even harder to their Graham-Dodd investing principles and refuse to lose sleep when market indices suggest that days of doom lie ahead. 

Tracy Williams

See also:

Wednesday, August 19, 2015

Google and Its New Alphabet

From out of the blue, Google reorganized itself into "Alphabet" 
Google caused heads to turn, right in the middle of summer when corporate managers, business leaders, bankers, traders and investors had their minds on Chinese currencies, Republican presidential candidates and a possible beach vacation.

The company announced a reorganization and a name change at the holding-company level, explained its strategy in terse press releases and then left it to equity markets to figure out what all this implies.

The market responded favorably with a large spike in share price, as bits of details unfurled from Google's Mountainview headquarters. The most notable reaction has been analysts wondering out loud whether Google reorganized itself into a West Coast version of Warren Buffett's Berkshire Hathaway, a holding company with a large portfolio of large, diverse companies.

Others have ventured that Google is replicating an organization model similar to General Electric, a holding company with several operating companies within similar industries. The eldest analysts and observers contend Google decided to bring back the popular conglomerate models of the 1960's and 1970's (ITT being the best example of that era). Finance professors, theorists, and historians have debated for decades about the pluses and minuses of conglomerates. Are investors better off, they argue, bearing the responsibility to diversify a portfolio themselves?

At Google, a lot is happening structurally. And a lot isn't. The name change at the top surprised many. (Did anyone outside the board room and Google's cadre of lawyers and advisers see it coming? Could anyone have speculated the new name would be "Alphabet"?) Few, if anybody, had projected that Google would "downstream" its untouchable brand name into a main operating subsidiary and then adopt the unforeseen "Alphabet" title at the top. Some might have recommended all along that  a reorganization of some kind would occur eventually.

Alphabet Raises Eyebrows

If anything, a new title at the holding company lets analysts and the public know this reorganization was more than a rearranging of organization chairs. It got people's attention. If there had not been a name change or if the new name had been a variation on "Google," then many might have dismissed the announcement as nothing more than a late-summer business press release.

While not much has changed in operations and people, the reorganization unleashed value (the upward bump in the stock price is evidence) because it permits investors to understand the company's businesses, its new investments, and even its long-term dreams more quantitatively and, in the main Google unit, with more certainty. The reorganization will help analysts understand the financials and appreciate, too, how sturdy and sound the search-engine side of the company has been and will continue to be.

Analysts and investors won't need to guess at the contributions from the search-engine operation (Google in the new organization) and fathom how much all the experimental businesses (drones, driver-less cars, thermostats, etc.) might be a financial drain. They can determine better when in the future the dream businesses will begin to reap returns. There is a basic tenet in corporate valuation. When investors and analysts don't on guesses or are not befuddled or strangled by uncertainty, intrinsic value rises (and so do stock prices).

Buffett's Inspiration?

As much as the media invoke Buffett, the reorganization doesn't replicate a Berkshire Hathaway model, although Google's founders Larry Page and Sergey Brin acknowledge having been inspired by Buffett's approach. Buffett pounds the pavement looking for the next value investment (which he found in the aerospace industry in a blockbuster deal in the past month). Investments range from railroads to insurance, from financial institutions to beverages.

Google isn't evolving into a similar conglomerate with passive investments in a dozen or more established companies, many with hundred-year-old products.  It is realigning into the proven and the unproven, separating out the research laboratories and generally remaining in a broad technology-oriented sphere.

Google, until the announcement, is a $66-billion-revenue company, growing lockstep each year, generating earnings exceeding $13 billion (good enough for ROE's that climb above 14%). Company investors enjoy the predictable growth and seem satisfied that dividends and stock repurchases aren't promised or don't seem to be on the horizon.  Hence, the company's $18 billion cash flow (last year) permits it to use over $10 billion to reinvest in new projects, as it did in 2014, and hoard the rest until the next new idea comes along.  (The company hardly relies on debt.)

The company, after the announcement, will continue to reap billions in cash from the Google unit, some of which can be siphoned off to support the ideas of its sibling units.  The restructuring allows investors to see precisely where the cash comes from and where it is going. It may also keep shareholder activists from barging in to demand hefty dividend payouts, if they see the analytics of where cash is being reinvested.

Investment bankers, nonetheless, wait in the wings, always looking for other ways to unleash more value for the company (valued at $465 billion this week). Somehow some will eventually tap the Page-Brin  duo on their shoulders--not now, but perhaps a few years from now--to convince them that shareholders would be better off if the new Google unit (the search-engine unit, which includes YouTube) were spun out. Watch.

Tracy Williams

See also:

CFN:  Twitter's Turn for an IPO, 2013
CFN:  Alibaba's IPO, 2014
CFN:  Yahoo:  Will It Rebound? 2015
CFN:  Verizon and AOL, 2015
CFN:  Dell Goes Private, 2013

Monday, August 10, 2015

Pepsico's CEO: On the "Hot Seat"

Despite excellent results and strong cash flows, Pepsico's CEO Indra Nooyi faces a big agenda.
If you follow the stock of Pepsico, you notice the price bouncing around like a rubber ball in a box--up and down and around and sideways.

Investors sometimes don't know what to make of it, beyond the fact that it pays a  comfortable dividend, and the company board is committed to keep paying it indefinitely. (A most recent share price hovered just below $99/share, but prices over the past year have roamed about $95/share like a sine curve.)

The company performs well, produces lofty returns for shareholders, and generates predictable, stable operating cash flow above $12 billion/year. And to its credit, it competes fiercely and often successfully against its competitors (Coca-Cola, most notably, and Dr. Pepper).  Yet CEO Indra Nooyi, who launched herself into a  prominent business career after receiving her MBA training from Yale, a Consortium school, is still and seems always to be on the "hot seat."

The company gives gifts to shareholders every year in the way of high ROE's (over 25% consistently) and cash set aside to pay attractive and reliable dividends (over $3.5 billion each year). Yet shareholder activists and other critics haunt Nooyi and Pepsico's management team with a barrage of questions:  How will management grow the company? How will it boost flat revenues? From where will growth come? How will it be achieved? And how must it confront the biggest risk of all--the health concerns tied to its major products (high-sugar cola beverages and salty snacks)? Will these concerns and risks eventually knock the company flat and result in depressed earnings and declining sales?

Pepsico's returns are outstanding (the gifts it gives to shareholders every year). And the company, for a long time, has responded to consumers' growing concerns about health by diversifying its operations, introducing new products, and addressing health questions with a sense of urgency. Some activists and market watchers say it hasn't done so fast enough. The company generates total sales of $66 billion year after year in robotic fashion.  They want revenue growth, want it immediately, and pound on the CEO's door looking for quick solutions regarding growth and health risks.

Despite the whining from outsiders and demands for answers, Pepsico does what it can to keep shareholders happy.  The company has paid an average of $3.3 billion in dividends the last four years (almost $13 billion in total) and repurchased almost $10 billion in stock--financial maneuvering that causes ROE to surge and leads to short-term bursts in the stock price. That totals about $23 billion in cash. That's cash that could have been used to reinvest in new businesses and new products, but cash that Pepsico is compelled to distribute out, not retain.

The company has also increased debt (by about $5 billion net the past four years) to add to the cash pool to pay out shareholders.  As a result, despite strong performance and billions in cash flow, debt-to-equity ratios have increased.  Book equity has declined.

Why would activists and others still want more? The inherent DNA of activists, however, is to push for more, ask for more, and demand more to ensure a long-term, secular increase in the market value? How does the company get the stock price to $110/share and get it to stay there indefinitely?

If the company has a clear path and defined plan to boost annual revenues toward, say, $80 billion, then perhaps shareholder voices would dissipate.  Some market analysts are aware, too, that the annual high ROE's have been achieved in part from modest financial engineering (more debt, less equity) and not from organic growth.

So what should Nooyi do?

1) Draft a credible strategy and game plan regarding health risks.

The long-term, harmful effects of certain beverages are a looming concern and risk at Pepsico and Coca-Cola.  How does Pepsico management perform the near impossible: Boost revenues and stock prices, while finding a long-term solution to the risks of the product. And do so without jeopardizing earnings, risking a sudden sinking in revenues, and altering the tastes and enjoyment consumers have for the product. And don't risk a downgrade in credit ratings, the same high ratings that permit the company to borrow whenever it wants and needs to. (Ratings agencies rate Pepsico single-A.)

Nooyi and team know the challenges they confront and have tweaked business lines and introduced new products. Yet the same cola products that are embedded with the greatest risks are the same products that help generate $12 billion in annual cash flow in predictable fashion. Year after year.

(Coca-Cola, in August, announced a strategy that will encourage consumers to devote more time to exercise to off-set health risks from drinking its products.)

2) Ensure shareholders are happy with their dividends.

Shareholders, as mentioned, clamor for more, despite the 25%-plus ROE's, the stock buybacks and the dividends.

Pepsico, therefore, must retreat into laboratories and invest cash in new products and new ideas, yet still appease its owners by siphoning some cash flow to pay $3 billion-plus in dividends and do occasional buybacks.  In order to do all of that and more, it must be prepared to use incrementally more debt.  The marginal increases in its debt burden contribute to cash stockpiles to do all things at once (reinvest, make acquisitions and pay shareholders).  Leverage and the recent reductions in equity explain why book ROE's at least look superb, too.

The billions in cash flow also rationalize why it can handle greater levels of debt. If it didn't pay dividends or repurchase stock, cash from operations could pay down all debt in less than three years. Or differently interpreted, cash from operations could still handle a debt load of over $40 billion without too much ado.

In recent years, borrowing was a cheap option, an easy decision. Who wouldn't be enticed to borrow at record-low interest rates to pay down more costly equity capital?  In the few years ahead, borrowing will be conducted cautiously with all the expectations that rates will rise.

3) Keep costs under control and tweak the bottling-company model. 

Management at any level worries about costs.  Pepsico has managed costs consistently and sufficiently. It does so, too, to squeeze out expenses and achieve income growth in a company where revenues have hardly budged the past half-decade.

Beverage companies like Pepsico and Coca-Cola often improve cost efficiencies by tampering with the bottling-company business model.  As many have said before, they have a "love-hate" relationship with their independent bottlers, franchisees who distribute the final packaged product that most of us drink. If Pepsico presumes it can distribute the product better and reduce related costs, then they will likely repurchase some bottling companies that exist under their auspices.  If Pepsico presumes bottlers can do it better or will have more success in designated markets, then they permit bottlers to operate independently.

The back-and-forth ties to bottlers help Pepsico maintain strong, consistent profit margins. The business model hasn't been replaced and likely won't. It just evolves or fluctuates from time to time.

4) Diversify the business in novel ways.

Expand and diversify is always an important business strategy for a global company. The seniors at Pepsico know that and are obsessed with trying to do it the right way.  Do Nooyi and staff diversify within beverage products? Do they diversify among consumer snacks? Do they diversify among market geographies?  Pepsico, in many ways, has done all of that.

Do they diversify by leaping aggressively into other ventures? What will that entail? Tough calls, big risks, a likely mega-acquisition, and the long timeline it would take to decide, acquire, finance, invest, and execute. Should Pepsico expand into businesses for which it has minimal expertise and experience and which could result in consumers becoming confused about the brand?  (Decades ago, its rival Coca-Cola dared to experiment with diversification by acquiring a movie studio, Columbia Pictures.)

Or should it remain committed to the success it has had for generations and retreat to labs to invent a health-risk solution for its beloved products, while accumulating mounds of cash, parts of it to be shared with anxious shareholders.

It may be able to do just that, as long as shareholder factions give Nooyi time.

Tracy Williams

See also:

CFN:  Will Yahoo Ever Rebound? 2015
CFN:  Is Shake Shack Worth a Half-Billion? 2015
CFN:  Radio Shack's Doomsday:  No Surprise, 2014
CFN:  Who's Betting on Blackberry? 2013
CFN:  Alibaba's IPO, 2014
CFN:  Verizon Rescues AOL, 2015
CFN:  Twitter's IPO, 2013
CFN:  Will HP's Split Help Stock Values? 2014
CFN:  Why Did Dell Go Private? 2013

Thursday, July 23, 2015

Bank ROE's: Stuck at 10%

Morgan Stanley reported a 10% ROE last quarter and is giddy about it
Large global banks continue to waft through a maze of ways to achieve long-term earnings growth, even while they splash headlines of billions in profits and rebounding stock prices.  ROE is the way shareholders, bank boards and bank managers assess performance, and big banks can't get their returns-on-equity (ROE) to budge a bit.

There was once a time when big banks like Goldman Sachs and Morgan Stanley (when they were pure investment banks and broker/dealers) and the historically commercial banks like Bank of America and Citibank could generate returns above 13-15% or push returns toward 20% quarter after quarter. Those were the days when banks could do it all--lend money to small businesses, arrange mortgages, trade commodities, invent new derivatives, and operate like quasi-hedge funds. They took big risks (paying for those risks later during the financial crisis), but they could strive for high returns, ROE's that eclipsed 15% now and then.

Times have changed.  Laws have changed.  And regulators have been persistent in forcing banks to reduce the risks on their balance sheets and eliminate risk they take in hedge-fund-like trading and ensuring banks dare not use customer deposits to fund questionable balance-sheet positions or exotic activity.  Their biggest tools:  (a) Require banks to hold more and more (and more) capital and follow thousand-page rule books regulators devised (via Dodd-Frank legislation). (b) Take advantage of the discretion they have as rule-makers to increase the capital requirements when necessary.

The capital rules are tough, challenging, detailed, and sometimes hard to comprehend.  Give the big banks credit.  They whine, and they fret. Their CEO's and presidents craft long essays in financial reports explaining the difficulties in meeting requirements. But for the most part, they cooperate and comply.

More capital and less risk, however, mean lower ROE's and make it nearly impossible for senior bank managers to push ROE's toward, say, 12%.

Take the most recent quarter.  Big banks announced large amounts of earnings in the second quarter. JPMorgan Chase and Wells Fargo, for example, topped $5 billion each.  A better economic environment helps.  More confidence among their risk managers boosts loan volume and gets the loan machine churning again.  Investment-banking and asset-management fees have increased.  Bank administrators have squeezed out costs in just about every function, activity or process that exists.

In many cases, net revenues among banks are growing, but not in leaps and bounds. The increases are slight bumps upward--from net-interest income to fees.  Banks have become creative and obsessive about finding new fees to offset revenue declines from the trading they won't be permitted to do. Services they once performed for customers at their pleasure are now subject to lengthy fee lists.

Yet ROE's are merely satisfactory.  Bank managers and bank boards are realistic.  They hope to reach 12-13%, they dream of 15-17%, but they settle for 10-11%. Examine bank ROE's in the second quarter, 2015:

Wells Fargo, 12% (12% in 2014)
JPMorgan Chase, 11% (9% in 2014)
Morgan Stanley, 10%
Citigroup, 9%
Bank of America, 9% (including Merrill Lynch)
Goldman Sachs, 5% (after special legal charges, 11% otherwise)

They head into the second half of 2015 wishing they could have done better, but happy and giddy they generated percentages that hover about 10% because any number around and above 10% results from managing effectively dozens of factors--including regulators' persistent requests to add more capital to the ROE denominator.

They know they are fortunate, too, because much of the ROE they report resulted not from surges in revenue, but from successful cost-cutting campaigns.  JPMorgan Chase and Wells Fargo, for example, are banks of similar size; they have different strategies, scopes and businesses.  They overlap in some areas (credit cards, small-business banking, and mortgages, e.g.). Wells Fargo stays within U.S. boundaries and long ago elected not to immerse itself in derivatives and trading in the way JPMorgan does.

Both banks, however, have experienced respectable, but slow growth in net-interest income and overall fee income the past few years.  Both, especially JPMorgan Chase, won't be able rely on substantial income from trading bonds, equities and derivatives in the way they prefer.  For both, business is better, and it's growing, but in inches, not miles.

To boost profits in the way they have done in the past year or so, they have conducted rigorous, aggressive cost-cutting campaigns on top of being clever about where they can charge fees.  Cutting costs, rationalizing businesses, and improving efficiencies in processing, operations, and product delivery across the board have had a favorable impact on the bottom line. (Some of those cost reductions have been offset by substantial increases in expenses for risk management, legal and compliance, but not enough to cause earnings to suffer too much.)

Banks still must wrestle with ongoing challenges.  Bank of America clocked in at 9%, a solid output after it struggled with capital requirements, stress tests, and balance-sheet restructuring the past year. It pat itself on the back, yet still felt it necessary to shake up top management as it marched to the 2015's second half.

Managing a complex, globally entrenched financial institution is as tough as ever. Their balance sheets are constrained.  They must maintain billions  more in capital, atop the hundreds of billions in capital they already show on balance sheets. They must now prove to regulators they are liquid, showing substantial amounts of calculated cash or cash-like assets that can't be used to make loans.

They have restrictions on leverage, so onerous that some banks like JPMorgan Chase are turning away large corporate deposits--those same funding sources that banks since the beginning of time have salivated over.  (Many banks will accept the deposits, but will charge fees or penalties for doing so. Some hedge funds, for example, may be required to pay fees to deposit excess cash at some banks.)

For now, they confront questions like those that follow:

1)  How much more in costs can they wrench from large, complex organizations without jeopardizing service, risking operations and technology glitches, and losing employee talent in big numbers?

2)  From where will revenue growth come, if they can no longer rely on the occasional spikes like that from trading income, sometimes a result of trading in new, exotic products, often a result from proprietary activity?

3)  What will the bottom lines amount to once interest rates start to rise? What impact will rising rates have on earnings?

4) Is it worth the hassle and compliance complexity to maintain a trading business of any kind to gain incremental revenue?

These are mere snapshots of challenges just to get ROE to a 10% threshold.  And that might be why some banks, like Morgan Stanley, didn't lament reporting a 10% ROE.  They tooted their horns.

Tracy Williams

See also:

CFN:  Credit Suisse Makes a Big Move, 2015
CFN:  Banks and Stress Tests, 2015
CFN:  Wells Fargo Sticks to What It Does Best, 2014
CFN:  Citi:  Why Did Its CEO Resign? 2012
CFN: UBS Throws in the IB Flag, 2012
CFN:  JPMorgan's Regulatory Rant, 2012 
CFN:  Banks and Their Dreadful Downgrades, 2012
CFN:  Morgan Stanley:  Can It Please Analysts? 2012

Sunday, July 12, 2015

Greece, China and a Stressful Summer

Events in Greece and China have led to summertime uncertainty and worries
Just when we thought it was safe to settle in for a stress-free, event-free summer, we encounter unwanted turmoil corralling us from around the globe.  Summer should have afforded easy moments to let traders, investors, and bankers glide toward Labor Day.

But now here come forces from Greece, China and even from within U.S. markets that make us wonder whether the rest of summer will be disrupted by events oceans away.  What we fear most is whether what happens over there can have impact on what exists here. What over there will affect market performance, investor behavior, and overall economic outlook on these grounds?

Many observers argue that Greece defaulting on its debt obligations and China's stock markets entering into a quarter-length nose-dive are contained events that won't cause too much of a dent in U.S. capital markets.  We don't know for sure.  But most of us know how a tipping of a giant mortgage iceberg led to the financial crisis and Great Recession of the late 2000's.

Out of the blue in early July, an unexpected technology glitch caused a nearly four-hour shutdown at the New York Stock Exchange. That stressed markets for an afternoon, but spawned greater worries about who or what was responsible and when will that occur again. Market analysts reminded us that because brokers and traders can go elsewhere to conduct trading (thanks to updates in trading rules in the past decade), the shutdown didn't cause calamity or panic. Yet everybody now knows this can happen again, will likely recur, and will happen more frequently than we want to acknowledge.

So instead of taking it easy in the precious weeks up to Labor Day, we are obliged to keep an eye on world events and wonder how they much damage they will inflict on trading positions and investment portfolios. For bankers and corporate finance officers, we wonder what impact all this will have on deal flow, corporate transactions, and companies' willingness to invest in new projects and business growth over the next six months.

The financial turmoil in Greece is often explained and has been intricately analyzed.  A complex, befuddling scenario can be summarized:

a) Greece, a member of the Eurozone, didn't meet a recent required debt obligation (billion-dollar payments that were due) and wants to renegotiate terms with a creditors (which include the IMF and Europe's central bank) that are already fatigued from years of patience, fumbled negotiations, and little improvement in the country's economy or its willingness to take seriously a hefty debt burden.

b) Greece, meanwhile, also has other obligations, including substantial pension-related debt, accumulated after years of outlandish spending and effusive promises to government workers.

c)  While the country's economy stumbles and appears to have dim hopes of an impending recovery, Greece must fend off creditors, make choices about who should get paid or who won't, decide if it wants to continue to be a Eurozone team player, and employ expert negotiating tactics to get irritated creditors to back off and agree to a restructured debt arrangement.

No side in any multi-player game of debt-restructuring chess wants the worst outcome.  Hence, the mountain of debt must be restructured, payment schedules extended, terms redrawn, and tenors extended.  But how does this get done to the satisfaction of all?

Meanwhile, nobody definitively can show how the country's economy will rebound soon or define how a series of  defaults and continuing non-payments will affect the rest of the world.  Daunting uncertainty prevails.

In China, an equity marketplace still in adolescence is going through growing pains. The Chinese stock market has grown enormously and quickly, so much so that it is now second only to the U.S. in aggregate market valuation.  But unlike U.S. markets, Chinese institutions and investors, including individuals have helped spark the country's consumer boomm don't have the advantage of a history of precedents from which lessons can be learned about crises, rampant volatility, trends, and exuberant behavior. They are learning on the fly.

Stock investing in China had become a new, popular pastime. Individuals and institutions just becoming accustomed to buying shares in private companies and hoping for favorable windfalls had hopped onto the bandwagon of stock ownership.  Chinese markets welcomed the surge in new activity and new investors in the midst of a rocketing economy.

The inevitable equity bubble many projected has come to be.  Equity markets had soared above 75% in value in the last year or two. P/E ratios, the benchmarks that indicate what's a bubble or not, climbed to outrageously high levels, even soaring past P/E ratios of the irrational days of the 1990's Internet bubble here.  In the past month in China, markets have imploded by percentage points (30-40% and more) that would cause investing nightmares in the U.S.

Yet Chinese government bodies have assumed a curious, perhaps expected role in trying to prop up markets, reignite confidence and assuring all that things will be all right.  They have purchased shares or have arranged for loans to others to purchase shares to boost indices.  They, including Communist officials, have changed rules on the spot and show no restraints in intervening to keep a capitalistic-bred machine humming briskly. Anything possible, short of inviting invite foreign investors to come over and partake in trading in its markets. (For example, they have prohibited short-selling.)

The rest of the world is getting acquainted with Chinese equities, how they trade, who buys them, what explains volatility, and the meddlesome role of government entities that keep stock markets buoyant.

It's hard to compare U.S. and China equity markets. They operate by different rules and histories, although Chinese exchanges have observed U.S. markets and replicated some best practices (including triggers that halt trading when something seems awry).  U.S. companies have layers of ways to issue new equity (private placements, venture capital, private equity, small-business and large-company offerings, etc.). China continues to study what works and what it might adopt.

U.S. markets have strict laws for registering new securities, reporting requirements of issuing companies, and insider-trading prohibition. U.S. markets have a vast array of players from clearing firms to high-frequency traders and an assortment of hybrids and derivatives:  options, convertibles, equity swaps, e.g.  It's just a matter of time before China catches up and introduces its version of the same.

For now, Chinese players can work to straighten out the summer angst without the complexities of exotics.  The current woes are likely due to something U.S. players know well: irrational exuberance--market values that can't be explained by the underlying economics.

In the U.S., we watch both Greece and China, analyze, wonder and try to gauge impact.  In some ways, we are actually rooting for both to overcome their issues and solve their problems.  That results in stability for all and continued optimism in all world corners, because what's good over there keeps the markets humming over here, too. Like it or not, what happens in Shanghai can influence what happens on Wall Street or seep inside the computer servers that keep trading activity in the U.S. whizzing.

Yet back on these shore., the New York Stock Exchange's systems glitch reminds us that (a) we need to prepare for and brace for more frequent outages and technology mishaps, (b) it was a good idea after all to have changed rules in the early 2000's to permit more exchanges to exist to arrange trades for any or all stocks, and (c) now and then, there is still a benefit to stick with apparently antiquated trading models that require humans in trading robes to stand at Wall Street posts to ensure orderly markets will continue throughout a trading day.

Tracy Williams

See also:

CFN:  Alibaba and Its U.S. IPO, 2014
CFN:  Michael Lewis' Back-Door Move, 2014
CFN:  High-Frequency Trading:  What's Next? 2012
CFN:  Dark Days at Knight Trading, 2012
CFN:  Derivatives:  Making Sense of Where We Are, 2013

Monday, June 22, 2015

The Mid-Year Review in Finance

Time for a mid-year review in finance. Any surprises?
July is about to roll in, and that means, besides the start of a hot summer, a time to figure out how the year has fared at its half-way point.  In finance, have things turned out as expected, or have there been surprises, both pleasant and unsatisfying?

Much of early 2015 has been an ongoing and sometimes agonizing mulling over interest rates. Every analyst in all corners contends they will rise, but when, how soon, and what will be the immediate impact?   Market watchers, traders, banks, and economists have looked for clues from the Federal Reserve and speculated on how to be prepared.  Interest rates will rise, they argue, but, in fact, an upturn has been anticipated and discussed for years (since the early 2010's) and is now expected any day.

Now in late 2015, the probability seems certain. As a result, markets are occasionally jittery, corporations are winding up their rush to refinance long-term debt while there is an opportunity to tap cheap funding, and investment managers ponder what to do about massive portfolios with large bond positions (Reallocate and sell off now? Later? Be patient or act now?)  Others sense that misbehavior in markets and panic striking bankers, traders and corporate treasurers could lead to a mini-crisis of sorts. A rise in rates will increase borrowing costs to companies that want to grow, expand and/or invest. A rise could cause a sudden slowdown in the multi-year recovery.

The Federal Reserve is policing it all, and most market participants are ready to act.

Equity markets, to date in 2015, aren't soaring as they have done the past two years.  They haven't, however, collapsed. There are good days followed by sour days, much of the latter explained by interest-rate uncertainty, varying perspectives of a recovering economy, and interpretations of geo-political events.  Most indices are up for the year (just a little bit), and financial advisers continue to be confident in the long-term. They counsel keeping most assets in equities.  But it hasn't been unusual this year for 100-point drops in the Dow to be followed days later by 100-point rises, only to be followed by a similar drop the next week.

Even with some topsy-turvy market behavior, IPO's haven't evaporated. (Fitbit was the most recent highly touted offering.) With liberal new regulation permitting small companies to raise equity funding without cumbersome registration, new companies or old, small private companies have many options to go about doing it.

For many new ventures, the question these days is less about market timing (the best time to go public, based on equity-market behavior and demand for shares), but more about whether the new venture is willing to tolerate the unrelenting demands (reporting, shareholder expectations, growth projections, etc.) on a public company.

Think Uber. An IPO of Uber in the second half of 2015 would be popular, well-promoted, extensively analyzed, and likely successful. A 2015 Uber IPO would attract the same fanfare Alibaba's IPO did in 2014.  But Uber IPO this year is not in any bank's deal pipeline. Not yet. Uber management is steadfastly focused on strategy and exponential early-stage growth, instead of SEC registrations, road shows, quiet periods, and unstable earnings reported to new shareholders. Uber still has a few more countries to penetrate.

Bond markets are feeling some pain.  Investors and traders who maintain positions do so courageously. The expected increase in rates will reduce bond prices suddenly and could lead to earnings stumbles among traders and funds, even if they say they are prepared and hedged. New bank regulation has spurred banks, one by one, to reduce emphasis on fixed-income trading and market-making. The profit margins had become too slim, and the balance-sheet burden too great. The unintended consequence of bond-market restructuring is that these markets are now less liquid.  And what happens when rates rise and funds, dealers and traders want to sell? Big banks won't be accessible or helpful.

The year has featured a handful of notable M&A deals and corporate restructurings:  Charter Communications is acquiring TimeWarner and Verizon grabbed AOL, among others. GE caught may off guard by announcing it will sell off  GE Capital, even while the finance unit contributed substantial amounts of revenues and earnings to the consolidated GE organization.  This one was a decision based on long-term corporate strategy and long-term concerns about GE's balance sheet.  GE Capital is overwhelmingly profitable, but it also overwhelms GE's balance sheet and makes it subject to meddlesome surveillance and oversight by financial regulators. GE made the earth-shaking decision. It had to push a favorite child out the door. And in doing so, few have criticized its move.

Financial institutions (banks, asset managers, hedge funds, insurance companies, and broker/dealers) continue to cry for relief from the onslaught of what they contend is burdensome regulation.  In 2015, large non-bank financial institutions have done most of the crying, especially those that could be tapped with a label "SIFI"--strategically important financial institutions, a designation by regulators that subject non-bank organizations  (including insurance companies, finance companies, and investment funds) to bank-like regulation of balance sheets and capital requirements.  More than a few institutions (AIG and GE Capital come to mind) have hustled to craft rebuttals for why they shouldn't qualify.

Meanwhile, from quarter to quarter, the large, familiar global banks reorganize, restructure, consolidate, and rationalize everything under the institutional umbrella.  And in doing so, even some CEO's have been hustled out, as bank boards struggle to pinpoint the right overall strategy.  Deutsche, HSBC and Credit Suisse are big banks in 2015 that have replaced CEO's or announced a series of corporate overhauls. Other banks have endured stand-offs with equity analysts and politicians who argue the biggest banks are better valued and less risk if they broke themselves up into their natural parts. (JPMorgan Chase seems to be the bank defending most of the break-the-bank arguments.)

Every year, global banks contend with the scandal du jour.  Following years of litigation, write-offs and fines related to mortgage securities and LIBOR (interest-rate pegging), in 2015, the club of banks that dominated foreign-currency dealing for decades agreed to admit to wrongdoing in FX trading and pay big fines to regulators.  In the process, they had to open up closed doors about how this enormous marketplace has worked and how banks colluded to make it unfair to other participants (smaller counter-parties and dealers, corporate and institutional clients, etc.).  The big banks paid up hundreds of millions in fines, but their dominance in the trillion-dollar market continues.

In mid-June, JPMorgan Chase's heralded and consummate deal-maker Jimmy Lee died suddenly, and bankers and corporate clients around the country paid tribute to him. Some attribute the birth of the syndicated-loan market to him.  He didn't invent this financing market, but he is likely responsible for its boom in the 1990's. He was instrumental in turning it into a major financing machine, a viable, reliable funding vehicle for large companies that all of a sudden became just as important to the corporate treasurer and CFO as the corporate bond, high-yield and equity markets.

When companies needed billions and wanted it quickly, a bank syndicate could step up more quickly, more efficiently and more assuredly than if companies wanted to finance themselves via equities or bonds. At JPMorgan, the syndication machine was big, visible, effective, responsive, and successful. In due course, it became efficient, aggressive and comfortable with stomach-turning deal sizes. If a corporate CEO in the midst of an acquisition wanted confidence over a weekend that it could finance a bid in the billions, Lee's syndication army could arrange the financing by Sunday evening.

In turn, Lee made syndicate lending the centerpiece of investment banking activity and, in many ways, turned the organization of an investment bank upside down. At traditional investment banks, M&A and equity and bond underwriting are core activities.  At JPMorgan Chase (and later at other big banks), the syndication unit was the heart and core, around which competence in M&A, equities and bonds was built.

He was so successful in the machine he built that by the early 2000's,  investment banks that were once indifferent to corporate lending (Goldman Sachs, Morgan Stanley, e.g.) quickly developed lending operations to compete for and retain traditional investment-banking business (M&A, equities and bonds).

Mid-year always means a flood of new graduates, including MBA's, many of which continue to march into lucrative positions in finance, trading, investing and research.  In 2015, some big banks, knowing they now compete for talent that is distracted by more interesting or less-taxing opportunities in other industries, decided to raise base salaries for new analysts and some associates. This is an industry, remember, where if Goldman Sachs makes a human-resource move (hiring numbers, compensation levels, incentive payments, etc.), the rest of the industry watches and tries to follow, even if sometimes they lack the financial resources to do so. Hence, a bump-up base for many in entry positions.

Work-life issues, however, continue to surface.  Banks don't manage them well, even after they announce serially new initiatives and new rules to ease the physical toil of working on Wall Street. (Underneath the finance headlines this year, two analysts jumped to their deaths in apparent suicides after having reported to others how they suffered from working long hours.)

Is a crisis around the corner? That's the question that must be asked. Some will say the probability is low.  Some pinpoint signals (over-valued markets, under-capitalized banks, too much exuberance in new ventures, e.g.) and swear that a doomsday is on the horizon.

Others will say, despite probabilities, the more important question is whether the financial system (with new structures and new regulation and oversight) can exploit the millions of data points to detect tell-tale signs of the next crisis better and whether the system is better prepared for anything that can happen.

Tracy Williams

See also:

CFN:  Banks and the FX Scandal, 2014
CFN:  Banks and the Libor Crisis, 2012
CFN:  Verizon Rescues AOL, 2015
CFN:  Do Banks Have Enough Capital? 2015