I’ve just updated Keeping Score. If you’re on the blog, you can also just click the tab at the top of the page.
My intention is to publish each day from Sunday through Friday. I normally write my post the night before and set WordPress to publish automatically around 5am, New York time on the following day. Sometimes, though, I write the morning of and publish immediately.
That hasn’t happened over the past several weeks. Early one morning, a fire in a generator in our small town took down the internet for an entire day. Also, on two occasions I hit the Publish button and went on to other things–only to find the next day that my post was still a(n unpublished) draft. I’m not sure whether the problem was with WordPress or with me, but I now know I’ve got to double-check the publishing process.
Anyway, power failures, tornadoes or other disasters aside, I think I’ve got the issue under control. So be sure to keep reserving that special spot in your day for reading my blog. It’ll be there.
framing the issue
1. In round terms, the Federal government is taking in $2.5 trillion a year and spending $4 trillion. It borrows the $1.5 trillion difference by issuing Treasury securities.
The main areas of government outlay are:
–welfare payments 13%.
Interest payments on Treasuries amount to around $200 billion. That’s 5% of total outlays, or 8% of tax receipts. This isn’t a near-term concern, but imagine what would happen if fates started to rise.
2. Congress periodically passes laws setting a maximum allowable level of federal government borrowing. The current limit is $14.3 trillion (including things like government agency debt in addition to Treasuries). The Treasury Department estimates Washington hit that limit in mid-May. The Treasury can create wiggle room for a while–like keeping the proceeds of maturing Treasuries in federal government employee retirement funds under the mattress instead of reinvesting them. Such stalling tactics will probably run out within a couple of weeks.
what can happen
Let’s look at the rating agencies first.
S&P is saying that it wants to see some evidence that Washington will do something now to address the budget deficit and the accompanying buildup of federal debt rather than pushing action back until after the November 2012 election. In the latter case, S&P argues, legislation will be passed in 2013 at the earliest and probably won’t take effect for some time after that.
If it doesn’t see action, chances are it will downgrade Treasury debt from AAA. It has also said that if congress doesn’t act like grownups, it may downgrade for that reason alone.
Downgrade is unlikely to come as a shock to an institutional buyer of Treasuries, domestic or foreign, who will have seen US government finances steadily deteriorate over more than a decade, from surplus in 2000 to the current situation.
In theory, downgrade means that the US will have to offer higher interest rates to induce investors to continue holding Treasuries. Maybe, maybe not.
To my mind, there are two big practical issues with downgrade:
1. The more important is whether/how the role of Treasuries in the working of global financial markets will change. This is a question of the rules that financial players have to follow, either because of legislation in their countries or their contracts with customers.
Will institutional borrowers have to put up more Treasuries to collateralize a given transaction than before? Will investment companies be forced by their contracts with customers to hold fewer Treasuries than before? Will they have to sell, or just let their holdings mature and not reinvest? How will this affect the ability of corporations to get short-term finance?
At the very least there may be a period of adjustment that reduces the speed of financial transactions–and therefore economic growth.
2. The second is how domestic retail investors will feel about Treasuries after a downgrade. Will they withdraw money from money market funds that concentrate on government paper? As I mentioned in an earlier post, money market funds are already bracing for withdrawals by emphasizing the shortest-term securities. This is having a negative effect on the ability of some EU banks to tap short-term sources of funds.
This is a separate issue from downgrade. It’s much more serious.
Mr. Geithner has been careful to say that if the debt ceiling limit isn’t raised the government will default “on its obligations.” This is very different from saying that the government will default on its debt–either by failing to make interest payments or by not returning principal on maturity.
Without the ability to borrow, the federal government won’t be able to pay 40% of its bills, or about $130 billion worth a month. Given that failing to service existing debt would be disastrous–also, given the fact that interest payments on Treasuries are only a drop in the bucket at present–the Treasury Department would certainly have debt service as its number-one priority. So, as a practical matter, default on government debt is out of the question.
Which bills don’t get paid? The Treasury Department decides. One open question is how sophisticated its computers are. Can they, say, pay every government employee below a certain pay grade and no one above? Can they sent out checks to Social Security recipients for 60% of their entitlements? Can they do the same with all defense contractors?
The choices Treasury might have to make would all be intensely political. …don’t pay Congress, but pay the administration and the courts?
From an investor’s point of view, however, no matter where the cuts come, they would represent an immense fiscal contraction. Whether cuts happened by accident or design, the damage to the economy would be substantial.
I don’t think that stock prices, either in the US or the rest of the world, contain even the slightest discount for the possibility that this could actually occur.
Why the current weakness in stocks?
I think it’s mostly uncertainty. Worries about a possible economic contraction are causing companies and state and local governments to put spending plans on hold. Citizens who rely on Social Security or unemployment benefits are also likely conserving, to the extent they can.
I also think that some investors are looking back to the TARP debate, when it took a plunge in the stock market to persuade congress to vote to prevent the domestic financial system from failing. So they’re raising funds on the idea that the same pattern will recur. I suspect, however, that in the convoluted way that Wall Street minds work, other investors are taking the contrary position. They’re saying to themselves that the obvious pattern is the TARP episode; therefore, that’s the least likely outcome in the present situation.
Who knows what will actually happen? The only thing I’m confident of is that congress would come under intense pressure to act if the flow of money from Washington were cut dramatically. A partial government shutdown might also lead to substantial turnover in congress in the 2012 election. Therefore, I think a possible period of shutdown would be very short.
In 2Q11, LVS had unusually bad luck in its gambling operations in Singapore and in Las Vegas. That happens occasionally. Give a properly run casino enough time, however, and the odds even out. 2Q11 was a more normal quarter for the company from an odds point of view. Combine that with stunning growth in Singapore, and the result was revenue for LVS during 2Q11 of $2.35 billion, up 47% year on year. Eps of $.54 weere more than triple the net during the comparable period of 2010, and 25% ahead of the Wall Street consensus.
To my mind, the biggest story is Singapore, where EBITDA (earnings before interest, taxes, depreciation and amortization–I’m not a fan of this metric, but it’s the one this industry uses) was $405.4 million, up 42% quarter on quarter (up “only” 30% if you adjust 1Q11 results up to reflect normal “luck”). July may turn out to be the best month ever for the Marina Bay complex–which, strictly speaking, isn’t even finished. Singapore is now by far the most valuable part of LVS.
I wasn’t floored by the Macau results, which–at EBITDA of $391.6 million–were up 27.5% year on year and about 4% quarter on quarter (market growth rates were 40%+ and 12%+, respectively, during those periods). The issues are new capacity that opened recently right next to some of LVS’s operations, and the time it tales to recover from the actions of an inept CEO (since fired; he’s suing). The Hong Kong stock market, however, regards the earnings report as very good news. Sands China was up 10% in overnight in a flat market.
Las Vegas continues its slow recovery. LVS posted EBITDA of $92 million in 2Q11 for Nevada operations. The lion’s share of the $30+ million quarter on quarter gain is a return of casino “luck” to normal.
$10 billion in debt no longer looks like such a big problem
Roughly speaking, $4 billion of that amount is borrowed against Singapore operations, $3 billion against Macau and $3 billion against the US. LVS has just renegotiated the Macau debt to extend maturities and lower interest expense by close to $100 million yearly. LVS will likely refinance Singapore soon, as well.
My back-of-the-envelope guess is that the LVS empire will generate $2.5 billion-$3 billion in cash flow over the coming 12 months. Call it $2.8 billion. Assume calls on that cash of $1 billion for capital expenditure plus $300 million for interest expense and $200 million for extra working capital. That leaves $1.3 billion to go to debt repayment. If LVS could manage twelve months without major capital outlays, borrowings would be more than cut in half in under three years.
Also, were LVS to sell 15% of Marina Bay in an IPO, I think it would raise enough to wipe out all its US debt. I doubt this will happen until the property is more mature, but the possibility has to make lenders–and investors–feel more comfortable about LVS’ debt level.
And, of course, LVS has $3 billion or so in cash on its balance sheet.
A sum of the parts calculation is probably the most reasonable.
At yesterday’s closing price, LVS had a market capitalization of $33.8 billion. The company’s share of publicly traded Sands China is worth $17 billion. If we assume that Marina Bay would trade on the same valuation as Sands China–which could prove much too low–then that 100%-owned property is worth $24 billion.
This means Wall Street is valuing LVS’ US operations at -$7 billion. This compares with a +$7 billion implied valuation for WYNN’s US operations and +$3.3 billion for those of heavily indebted MGM.
LVS shares (which I own–I may sell some today, though) would have to rise by about 30%, just for the implied valuation of its US properties to match those of MGM. It would take a 20% rise just to get the value up to zero.
Why the disconnect? I don’t know. The former CEO of Sands China is suing, and claiming all sorts of improprieties by LVS management. It’s also possible that some investors are uncomfortable with LVS’s debt–I know I have been–or don’t understand that the earnings disappointment in 1Q11 is just one of those things that happen in the gambling business.
a small boat out on the ocean
At the moment, the hardest investment task for me, as an American, is to distinguish between emotional involvement in the political struggle now going on in Washington, on the one hand, and the stock market consequences of apparent gridlock in Washington, on the other.
An equity portfolio manager, amateur or professional, is like a sailor in a small sailboat out in the middle of the ocean. If you see a storm coming, you can spend your time cursing the wind and railing against the lightning–and achieve some emotional satisfaction. But you’re better off taking in some sail, tying stuff down, putting on a raincoat, and doing whatever else prudent sailors do in circumstances you have basically no control over.
Two factors make the deficit situation hard for me to handicap. The first is that, like most equity investors in the US, throughout my career I’ve regarded politics as a mild negative for stocks, but basically irrelevant. So I don’t know much about the world inside the Beltway. Also, today’s argument isn’t about who gets a larger relative share of an expanding pie to distribute as patronage to the people who voted for him. It’s about everyone giving up something. That’s a much harder discussion. Nevertheless, you have to assume something. For me,
1. If S&P’s word is good, and I think it is, US Treasuries lose their AAA credit rating sometime soon. This has two consequences that I can see:
–the US will have to offer a slightly higher interest rate to sell new debt, and
–depending on how their contracts are written, some bond managers will be unable to buy new Treasury debt, or to hold as much of it as they’ve done in the past.
2. Washington may have to be forced into compromise. This could happen in one (or both) of two ways:
–In early 2009, it took a large stock market drop immediately after Republicans voted against countercyclical fiscal stimulus to get them to change their minds. That may happen again. Maybe the Treasury refinancing scheduled for August 4th won’t go well. Or maybe the stock market will drop.
–The government may stop sending out transfer payments, like Social Security, or checks to government employees. The resulting tons of angry phone calls and emails to congressmen would likely focus their minds.
By the way, there’s been some discussion in the press as to whether government computers are flexible enough to make some payments, like Social Security or salary checks, but not others, say, payments to defense contractors. It’s not clear that they can. So the choice may be either to pay everyone or no one. Federal government offices may have to shut down. Not great for a sputtering economy.
In addition, money market funds are becoming more liquid–and withdrawing repo financing from EU banks–in preparation for possible redemptions of their own on a government debt downgrade.
–events will force Washington to raise the debt ceiling in short order;
–there could be a temporary, but possibly sharp, stock market selloff before that happens.
what I’m doing
Worries about domestic politics can play out in three ways, I think:
1. through a weaker US dollar. This is already starting to happen; look at the ¥/$ rate. My guess dollar weakness continues. My US holdings are selected to benefit from dollar weakness, however, so I don’t have to defend myself here. In fact, I may even gain something. A secondary concern is that investors in foreign markets will orient their holdings away from dollar earners, but I don’t have enough exposure to worry.
2. through higher interest rates. Since bonds are substitute investments for stocks, higher rates will likely put some downward pressure on stocks. But US stocks already seem priced for much higher interest rates than we have at present, so I’m not too concerned. Other than avoiding financials–and I own almost none–I don’t see anything I can do.
3. through a stock market selloff–a mini-panic. For an institutional equity manager, instructions from clients will likely not allow holding more than very small levels of cash. So he just grits his teeth and rides out the storm. A taxable private investor has to balance the certainty of triggering a capital gains tax vs. the possibility of selling today and buying back, say, 15% cheaper in a month.
I’m looking through what I own to try to identify the clunkers hiding there so that I can get rid of them. I’m also eyeing my biggest positions–both individual names and industry groups–to see what I should trim. This is what I usually end up doing in times of stress–cleaning up my portfolio with the long term in mind. I try to do this every day, but I find storm clouds on the horizon make me a more critical observer.
In my post from yesterday, I titled this reason “making dumb mistakes.” I’m not sure what else to call it. Let me illustrate with two examples of recent huge misses by analysts who should have known better. They’re the June quarter results from two high-profile companies with plenty of Wall Street coverage, WYNN and AAPL.
Let’s take WYNN first.
In 1Q2011, WYNN earned $173.8 million, or $1.39 per fully-diluted share. Look one line higher on the income statement, and you see that the $173.8 million figure is after deducting $52.5 million in “income attributable to non-controlling interests.” That’s minority interest. It’s income that belongs to the 27.7% of Wynn Macau that WYNN doesn’t own. (Wynn prepares its financials as if it owned 100% of Wynn Macau, and then subtracts out the minority interest at the end.)
From the minority interest figure and the magic of long division, you can calculate ($52.5 /.277) that Wynn Macau’s total net income was $190 million. WYNN’s share was $137 million. Therefore, WYNN, ex its interest in Wynn Macau, earned $36.8 million for the quarter.
One unusual feature of 1Q11: gamblers at the WYNN tables in Las Vegas had bad luck by historic standards during the quarter. They lost a bit over 30% of what they wagered vs. historical loss experience of 21%-24%.
Any analyst who follows the company could have found all this out in five minutes of studying the 1Q11 income statement. Given that the analysts’ consensus for 1Q11 was wildly low at $.73, you’d assume they’d do so to try to figure out where they went so wrong.
turning to 2Q11
In 1Q11, 80% of WYNN’s income came from fast-growing Macau, 20% from slowly-recovering Las Vegas.
From figures the Macau government posts monthly on its Gambling Coordination and Inspection Bureau website, we knew on July 1st that gambling revenue for the market as a whole was 12% higher in 2Q11 than in 1Q11. If we assume that Wynn Macau grew in line with the market, and that a 12% increase in revenues produced an 18% jump in income (basically, adjusting for normal operating leverage and the fact that Wynn Macau “adds” gambling capacity by raising table stakes), then Wynn Macau would have earned about $225 million in 2Q11. Of that, WYNN’s share would be about $165 million. That translates into around $1.35 a share for WYNN in eps during the quarter.
What about Las Vegas? It chipped in $.25 a share to first quarter earnings. “Luck” at table games returning to historical norms would probably push that figure back to zero. On the other hand, room rates at both Wynn and the Encore are gradually rising, so zero might be too low. But let’s stick with zero from Las Vegas is the most reasonable guess.
In other words, a sensible back-of-the-envelope guess for WYNN’s eps in 2Q11 would be $1.35 + $.00 = $1.35. This isn’t necessarily the most conservative forecast, but it is one based on factual data about the Macau gambling market and the assumption that nothing much goes wrong (or right) in Las Vegas.
What did the professional analysts say?
The median estimate was $1.01. The highest was $1.25; one analyst had the dubious distinction of saying eps would be $.69. For this last estimate to have come true, WYNN would have had to break even in Las Vegas (it earned about $.25/share) and to have revenues in Macau drop by 25% quarter on quarter, while the market was growing at 12%.
Given that WYNN’s results are so strongly influenced by Macau, even the median was predicting a relative disaster for the company there. What were they thinking?
(True, they might have been assuming a disaster in Las Vegas, not Macau. And, I’ll admit, I thought WYNN has done surprisingly well in Las Vegas so far this year. But Las Vegas isn’t big enough to move the eps needle down to $1. And the situation is a little more complicated than I sketched out above: Wynn Macau pays a large management and royalty fee to the parent, almost $40 million in 2Q, so the better Macau does, the better ex Macau looks.)
AAPL’s 2Q11 (ended in March)
During 2Q11, AAPL earned a profit of $6.40 a share. Its business broke out as follows:
Macs 3.76 million units $4.98 billion in revenue
iPod 9.02 million units $3.23 billion (includes iTunes)
iPhone 18.6 million units $12.3 billion
iPad 4.7 million units $2.84 billion
Other $1.3 billion
Total $24.7 billion
turning to 3Q11
Let’s try a back-of-the-envelope forecast for AAPL’s 3Q11. To make things ultra-simple, we’ll ignore operating leverage, which will bias our estimate to the low side.
Macs growing, but slowly in a developing world where overall PC sales are flattish. Let’s say $5 billion in sales.
iPod flat, $3.2 billion in sales
iPhone industrywide smartphone unit sales are growing at 80% year on year. All the growth is coming from half the market, Android and iPhone, with Android growing faster; Nokia and RIM are taking on water and sinking fast. Let’s pencil in 19 million units at $660 each = $12.5 billion.
iPad this is the tricky one. We know that AAPL is capacity constrained, is adding manufacturing capacity as fast as it can, and sold 4.7 million units in 2Q11. Let’s put in 6 million units at $600 each, the average price from 2Q11. That’s $3.6 billion.
Other Leave it flat at $1.3 billion.
Add all these numbers up, and we get $25.6 billion. If we assume constant margins–i.e., no operating leverage (which a really terrible example to set–working with margins instead of unit costs, but I’ll do it anyway), then earnings will come in at $6.60-$6.75 a share for the quarter.
As events turned out, my guess is way too low. …oh well! AAPL reported eps of $7.79. The big difference? The iPad sold 9.2 million units and brought in $6 billion in revenue. That alone adds more than $.60 a share in earnings. The rest is bits and pieces.
So I missed badly. That’s not really the point. The real question is how my ten-minute approach stacks up against the work of the 45 professional analysts who follow the company for a living–and for whom AAPL is probably their most important stock. Check them out and I’m starting to look pretty good.
The median estimate of the 45 was $5.82 a share. The low was $5.10, the high $6.58.
How could they consensus be projecting an almost 10% quarter on quarter drop in earnings?
APPL’s main business, smartphones, which accounts for 50% of total company revenue, and a higher proportion of profit, is exploding. The category is growing by 80%. Rivals NOK and RIMM are not only going nowhere, they’re getting worse by the day. In fact, NOK’s smartphone sales in the June quarter fell year on year–probably by a third. So AAPL’s continually taking market share from them. Quarter on quarter sales were likely up.
We don’t know what 2Q11 iPad revenues could have been, only that they flew off the shelves as fast as AAPL put them on. So product sales had to be up, maybe substantially, in 3Q11.
If both iPhone and iPad were flat, quarter on quarter, the only way to get company results to be down 10% would be if Mac sales, which represent about a fifth of the company’s business, were cut in half. Hard to fathom, given that the PC industry is growing, if only slightly, and Macs have been gaining significant market share from Windows-based PCs.
what did I do differently?
I think everybody ignored AAPL’s “guidance” of $5.03. WYNN doesn’t give guidance.
I did five things:
I gathered industry information from the internet.
I read the prior-quarter results carefully.
I used a line of business table to make (very primitive) quarter on quarter projections.
I ignored macroeconomic forecasts of slow growth for the US, since both firms target the affluent here–AAPL more so than WYNN, I think.
I didn’t worry about missing on the high side. I didn’t want an estimate that was deliberately too conservative.
What didn’t the analysts do?
I only have guesses.
It’s possible that they were influenced by downbeat general economic news. Even so, I don’t see how you could have gotten to the consensus figures for either APPL or WYNN if you did a line of business table. But that’s one of the first lessons in Security Analysis 101. Maybe the analysts in question were out that day.