thinking about 2013

looking ahead

Today is the last day of May.  In a normal stock market year (let’s define “normal” as a time when investors are neither euphoric nor ready to jump out windows on high floors in tall buildings), this is the time when equity investors begin to ponder what the following calendar year will bring.

Why so early?  No extremely compelling reason.  It’s just the way it typically works.  Equity markets are futures markets, after all.  And by this time participants will have already discounted much of what the current year is likely to bring and are asking “What’s next?”.

not normal everywhere, but definitely normal in the US

Conditions are by no means normal all around the world.  Europeans are scared out of their wits by the politics/economics of the EU.  Pacific Basin markets are keeping a close eye on China, while hoping the battering they’re taking from European selling will soon end.  In the US, in contrast, the economy is entering its fourth year of recovery.  Employment is stable-plus, compensation for regular employees (as opposed to CEOs, who always pay themselves well) is beginning to rise, and the housing market–a key source of wealth–is showing its first signs of life since 2007.  While daily price volatility may be high and the shrill noises from talking heads may be particularly bearish, I think 2012 is a normal year.

therefore, time for pondering 2013 to begin

(You may argue that pondering season has already started, and point to the 8% decline in the S&P since its intraday high on April 2nd as evidence.  I don’t interpret the data that way, but you may be right.  If so, you should be more bullish than I am, since you think Wall Street has been factoring bad news into prices for longer than I do.)

a few numbers

Let’s begin with a back-of-the-envelope (which is the best you’ll get from me) calculation.  According to Factset, Wall Street is estimating earnings of around $105 for 2012, up from $97 in 2011.

Let’s say S&P 500 eps will reach $110-$115 in 2013, which is roughly the consensus.

based on 2012 eps

If the market could trade at 14x earnings, a target for the S&P based on estimated earnings would be 1470.

The 1422 high of two months ago was about 3% below that, giving new money absolutely no motivation to buy stocks.  That also meant short-term traders had a reason to bet against a further rise.

Yesterday’s close was about 12% below 1470, suggesting the US stock market may be on more stable ground.

…and based on 2013 eps

The same calculation gives a target range of 1540-1610 for the S&P based on my guess about next year’s eps.  Potential appreciation from yesterday’s close would be +17% to +23%.

If you want to say that the US stock market continues to trade at the current multiple of 13x eps instead of 14x, then potential appreciation would be +9% to +14%.

In a world of 1.6%-yielding ten-year Treasuries, and 2.7% thirty-years, either case looks pretty good.

clouds on the horizon

I can see three, all of them the obvious ones:

1.  slowdown in China   For what it’s worth, as macroeconomics I think this is old news.  Policy is already beginning to move in a stimulative direction.  However, it will take some time for the new policy direction to take effect.  This probably means weaker prices for industrial commodities–and for commodity-dependent stocks–as well as for negative earnings surprises for firms whose profits are strongly linked to Chinese customers.  So China does have stock market implications.  But they’re stock selection ones rather than market-moving ones.

2.  “fiscal cliff” in the US    On January 1, 2013, the temporary federal payroll tax cut is set to expire.  So, too, is the extension of Bush-era income tax reductions.  Large mandatory cuts in federal government spending, triggered by Washington’s failure to come up with an overall plan for deficit reduction, are supposed to happen as well.

This combination is enough to send the domestic economy beck into recession.

The consensus view is that after the election, the lame-duck Congress will do something to soften the blow.  My guess is the consensus will prove correct, although an accident is always possible.

3.  implosion in the EU    This is the main concern of global stock markets.

To recap:

–The crisis has been going on for almost three years.

–Worries have been discounted in waves of selling over that time, the worst of which (I think) have been the one currently in progress and the previous one last summer.

–The general parameters of a solution have been well-understood for a long time.

–I think Greece being in the EU or out is a big deal for that country but for no one else.

–The end game is unlikely to be a Japan-like fading of the EU into irrelevance, which would be bad for Europeans but ok for world equity markets.  Unaddressed, an outcome more like the 1996-98 crisis in smaller Asian markets is more probable.

timing?

Evidence to date to the contrary, I tend to think that the worst won’t happen.  I’d feel better about markets if I thought I were in the minority.  But if I were, I think global equity prices would easily be 10% lower than they are now.

If I’m correct, the main imponderable is the timing of a solution.  What little I know (or think I know) about politics says that when resolving a difficult issue involves sacrifice, the problem must be seen as so bad that solving it–no matter what the cost–can be presented to voters as a victory.

Are we at that point yet with the EU?  I don’t know.  Martin Wolf, chief economist with the Financial Times, has a good summary of the state of play.

Were the EU to show it finally has the resolve needed to adequately address its financial woes, however, I’m confident that the higher S&P targets for 2013 mentioned above would quickly become Wall Street’s game plan.  And a mini-version of last year’s autumn rally would likely occur.

In the meantime, markets will likely drift.

Graff Diamonds yanks its proposed Hong Kong IPO

fuses blown

Bad day in New Jersey.  Yesterday was the first super-hot day of the late spring, with temperatures approaching 100 degrees Fahrenheit.  Creaking power infrastructure reacted in the way we’re unfortunately becoming accustomed to.  It collapsed.  No power for most of our neighbors, no internet or cable TV for us.  Hence the late post.

Graff

According to Bloomberg, the plug was pulled on the Graff Diamonds offering less than two days before the stock was supposed to debut.

I can’t say I was shocked, for several reasons:

–Hong Kong has been pummelled especially badly by selling emanating out of the EU, where another flight to safety by equity investors is in full flower.  It looks almost like last summer.  (Where did they get all the stock?)

–Chow Tai Fook Jewellery (HK: 1929) came public late last year and is now trading at about 2/3rds of the IPO price.  True, 1929 sells mainly chuk kam pure gold jewelry and knickknacks, not diamonds.  But the market is the same–China.

–TIF, whose main problems appear to me to be in the US, nevertheless also reported a deceleration in its China business last quarter.

–I suspect that retail investors in Hong Kong–always important in that market–were especially badly burned by the Facebook IPO.  IF US retail investors got 5x-10x what they expected, Hong Kongers could have gotten double that size.  Hong Kong is a market of veteran stock market participants, so they’ll shrug off their bad treatment by underwriters quickly.  But if I’m correct, they’re still licking their wounds.

–I haven’t tried to locate a copy of the Graff Diamonds prospectus.  My experience is that in Hong Kong these documents weigh a ton, but don’t contain anything like that amount of information.  Besides, they’re not supposed to be available in the US until after the offering.  Media reports do bring up two potentially worrying issues, however.

Apparently, a mere 20 customers make up 50% of revenues.

A large chunk of the IPO proceeds were said to be earmarked for buying diamond inventory from the company’s founding family.  I’d want to know how this inventory is being valued–and how many months’ (years?) sales this represents.  I’d also want to know how the acquisition of the gigantic gems Graff is famous for will proceed from now on.  Does the Graff family act as exclusive agent for the company?  …is the family paid a commission for acquisition?

a paucity of demand

When the IPO was pulled, the underwriters had orders for only half the shares intended to be offered by the company.  In a healthy offering the books would be, say, 5x covered.  A “hot” offering might have books 10x covered.  In Hong Kong, which operates under different rules than the US, 100x isn’t unknown.

my thoughts

In the current economic environment, Graff Diamonds was always going to be a tough sell, especially with the family wanting 25x earnings for its shares.  I think FB did much more to suck the life out of this offering than most brokers would be willing to admit, however.

“What Workers Lose by Staying Put,” Enrico Moretti in the Wall Street Journal

The New Geography of Jobs

“What Workers Lose…” is an article in the Weekend Edition of the WSJ, adapted from Dr. Moretti’s recent book (which I haven’t read) The New Geography of Jobs.  Dr. Moretti was born and grew up in Italy, but now teaches economics at Cal Berkeley.

The thrust of the article is that Americans are unusually mobile in search of work, in contrast with Continental Europeans, who seldom stray from their birthplace.  Dr. Moretti believes that this flexibility is an economic virtue–not necessarily a surprise, given his own career.

His observation is interesting because it runs so counter to the views of prominent 20th century European literary and social critics, who look on American willingness to move as evidence that we’re rootless, soulless wanderers who have no sense of belonging.  Even worse, we eat at McDonalds, vacation at Disneyland and use disposable pens!  That’s all evidence, in their minds, that we’re an inferior brand of humanity–which, by the way, finds its highest and purest expression in the stay-at-home residents of whatever their native country is (read: themselves).

More important from a stock market point of view, the article sheds some light on the problem of the current high level of unemployment in the US.  And it offers a policy prescription for helping to alleviate it.

cyclical or structural?

The key unemployment issue, to my mind, is whether the current high level is

–a cyclical phenomenon, that is, a function of the slow economic rebound from the Great Recession, or

–a structural onemeaning that the unemployed don’t have the skills needed to qualify for jobs in today’s world.  If so, unemployment won’t just go away.

White House and Capitol Hill vs. the Fed

Politicians in Washington seem to adhere to the former view, which, conveniently for them, means that no legislative action is needed.  Time, patience and continuing low interest rates will solve the problem.  The Fed is in the latter camp (where, for what it’s worth, I am, too).  Structural unemployment requires retraining programs, plus continuing unemployment benefits until workers gain skills needed to compete successfully in the job market.

JOLT
The Fed points to the Labor Department’s Job Openings and Labor Turnover (JOLT) studies.  The latest report, from the end of March, shows the private sector has 3.7 million+ unfilled job openings.  Washington replies that workers are trapped in their home towns by houses the can’t sell because the mortgage exceeds the house value.

What does Dr. Moretti bring to the discussion?

He says:

–“willingness to relocate is a large factor in American prosperity”

–“the financial return for geographical mobility keeps increasing”

–the willingness to move is very strongly related to education level.  45% of college graduates will likely move to find better jobs before they’re 30 years old, vs. 17% of high school dropouts.  Dr. Moretti cites research by Prof. Abigail Wozniak of Notre Dame who says education explains most of the willingness to move.

Why the huge difference?

The less educated:

–have less information about the possibility of good work elsewhere

–may lack the skills needed in high-paying jobs

–don’t have the savings needed to finance the trip and support themselves while they look for a job.

Example:  the Motor City, 2009

Dr. Moretti cites the example of Detroit in 2009. Unemployment there was 18%.  Unemployment in Iowa City, 500 miles away, was 4.5%–basically meaning Iowa City firms were crying for workers of all stripes.  But high school dropouts in Detroit didn’t budge.

a policy recommendation

Dr. Moretti suggests that in high unemployment areas government unemployment benefits include vouchers that cover part of the expense of moving to find work.  This doesn’t address the lack-of-marketable-skills problem, but it does address the lack-of-cash one.  Such a program–already being implemented in a small way for workers whose firms have been hurt by foreign competition–would have two benefits.

It would help shift workers who were willing to move to places where they could find work.  And, by starting to drain the pool of unemployed in high unemployment areas, it would make the job search there somewhat easier.

two kinds of structural

All of the commentary–at least all that I’ve seen–about structural unemployment is concentrated on the long-term issue that many young men leave the US school system unequipped to compete for the best-paying jobs.  They’re prime candidates to be chronically unemployed.

Dr. Moretti’s insight is that while we can’t educate these men overnight, we can make them more mobile with the stroke of a pen.  We may also find that removing the structural rigidity of no-money/no-information does much more to relieve unemployment than we might imagine.

TIF’s 1Q12: surprising slowdown by US customers

the report

TIF reported 1Q12 (ended April 30th) results prior to the opening of equity trading in New York yesterday morning.

Revenues were up 8% year on year, at $819.2 million.  The company earned $.64 a share for the three months, down a bit less than 5% from  results–but substantially below the Wall Street consensus of $.69.

Tif also lowered its full-year guidance by $.25 a share, to a range of $3.70-$3.80.  Worldwide sales are now expected to grow at a 7%-8% rate, down from the prior expectation of +10%.  Eps comparisons will likely be negative in 2Q12 and 3Q12.

The stock dropped sharply on the news.

As I’m writing this on Friday morning, TIF shares are somewhat lower again, in a choppy but flattish market.

the details

sales

Americas           up 3% at $386 million

Asia Pacific         up 17% at $195 million

Japan          up 15% at $142 million

Europe     up 3% at $88 million.

Business was much better than I had expected in Japan.  Analysis is complicated by the fact of the Fukushima nuclear disaster in mid-March 2011.  Still, same store sales growth is up more than 10% from two years ago, in a land that had been turning decidedly cool toward luxury goods.

I think any gain in Europe, now the epicenter of world economic woes, is just short of miraculous.

Asia Pacific performed as expected–no better, no worse.  The company says Chinese business has cooled a bit from the torrid pace of last year.  I don’t consider this a worry.  But it does suggest that Asia won’t be a source of significant upside surprise for a while.

It’s the Americas, and specifically the US, where the falloff versus expectations lies.  Sales to foreign tourists are up, with weakness in European buying more than offset by a step-up in purchases by Asian visitors.  So it looks like the problem is with sales in the US to Americans.

TIF pointed out in its conference call that the softness:

–occurred in April

–is not focussed in any one region of the country (so it isn’t just laid-off NY bankers), and

–is consistent with MasterCard data for high-end jewelry in general (so it isn’t a Tiffany-specific issue).

my thoughts

Some portion of the poor US performance may be attributed to a later date for Mother’s Day this year.  But everyone who has access to a calendar already knew that.  Certainly management had factored this into its earlier guidance.

The downward revision comes after TIF has seen Mother’s Day sales.  I think this means that–unlike the case with more mass-market jewelers like Signet–Mother’s Day didn’t counteract April weakness for TIF.  It confirmed the slowdown.

Elsa Peretti

TIF has an exclusive license to sell Elsa Peretti jewelry, which makes up about 10% of company revenues.

The company filed an 8-K with the SEC on May 23rd in which it says that Ms. Peretti, 72, wants to retire and to sell her brand name and designs.  Negotiations between her and TIF are now in progress.  The Peretti intellectual property should have more value to TIF than to anyone else, so in a completely rational world TIF would end up obtaining it.  Earnings would be affected by, say, +/- 7%-8%, depending on whether negotiations result in purchase or not.

the stock

A short while ago, I sold the last of the TIF I held while I was doing a portfolio housecleaning.  My position was small and–as I’ve written elsewhere–I think the stock market is moving toward playing recovery of the average American rather than the continuing prosperity of the affluent.

I don’t feel a huge urge to buy back the stock I sold.

On the other hand, the stock looks cheap to me at 15x earnings.

15x was the place where I became interested in the stock–which I had owned in my portfolios, off and on, for many years–during the bounceback from Great Recession lows.  There’s always the possibility that the company could be acquired by a luxury goods conglomerate or a sovereign wealth fund.  We also know TIF management, which should know the value of the firm better than anyone else, has been buying the stock at above $60 a share.

I guess I’d like to watch the price for a while-and possibly get a better understanding of the current dynamics of the US customer.

 

 

 

 

IPO arcana: underwriting vs. sales, and the over-allotment. Who knew?

As I mentioned in an earlier post about FB, it’s surprising to see how little the financial media understand about how IPOs work–whether it be newspaper reporters and their firms’ related blogs, or the talking heads on cable.

Two aspects:

the over-allotment

In the case of FB, it was 63.2 million shares (the number is on the front cover of FB’s registration statement).   As noted in the sentence that gives the over-allotment number, this amount of stock is not included in the 421.3 million share figure listed in bold.

What is it, then?

The over-allotment is a kind of insurance or safety precaution that the company issuing stock and the underwriters build into the offering.  The company agrees to sell a specified amount of extra stock to the underwriters at the IPO price if the underwriters ask for it.  In the FB case, it was 62.3 million shares.

When the underwriters divide the stock up and sell it to clients, they distribute the larger amount.  So the FB stock sold to the public amounted to a total of 483.6 million shares (421.3 + 62.3).

If the issue goes well and the stock stays at a price higher than the IPO level, the underwriters purchase the extra stock from the company and deliver it to clients.  That’s the usual case.  For FB, that would have meant an additional $2.4 billion from the IPO.

If, on the other hand, the issue goes badly, the underwriters can buy stock in the open market at the IPO price up to the amount of the over-allotment, without taking any financial risk themselves.  Don’t ask me why, but underwriters are legally allowed to do this for a short period after the IPO is launched.

The underwriters did this kind of intervention with FB just before noon and again during the final hour of trading on its first day.

How do we know?

The underwriters make no attempt to hide their identity or their intentions.  They want other traders to know they have a huge amount of buying power and intend to defend the IPO price.

How did I find out?  I looked at a chart of FB on my cellphone.  I saw the stock stopped its normal minute-to-minute gyrations just after 11:30 and flatlined–just like when someone dies on a TV medical drama.  That’s not natural.  Someone was making a statement about the $38 level.

In listening to hundreds and hundreds of IPO roadshows, I’ve never heard the over-allotment mentioned–ever.  Professionals know it’s there.  For the underwriters, it would be like a restaurant saying it had a great food-poisoning doctor on call.

underwriting group vs. sales syndicate

This is really arcane.  There’s no reason to read any further, except that this distinction may explain the bad treatment of some retail investors in the FB IPO.

The money that brokers charge in an IPO is for two slightly different functions.

–They have a percentage interest in an underwriting group.  Although I use underwriter and broker as synonyms in everything I write, that’s not precisely correct.  The underwriting group buys the stock from the company and then resells it. It’s paid a small amount for taking the “risk” that the members will be unable to resell the stock.  Remember, though, that the brokerage companies have firm–though not legally binding–commitments to buy the stock from clients who know they’ll never see another IPO allocation if they renege (legally, any client can return the stock and get his money back up until shortly after the final prospectus is issued.  See my post on preliminary and final prospectuses).

–the underwriting group employs a selling syndicate to distribute the shares it buys from the company.  It’s made up of the same firms that comprise the underwriting group, but possibly in different proportions, based on the size and strength of institutional and retail distribution networks.  Normally, the selling commissions are much higher than the underwriting fees.

Why write about this?  The accounts I’ve read mention only Morgan Stanley as a broker whose retail clients received much larger allocations of FB stock than they anticipated.  My guess is that Morgan Stanley carved out for itself an especially large piece of the selling syndicate pie.

Facebook (FB), looking back after three days of ugly trading

a failed IPO

The long-awaited IPO of FB has come and gone.

The stock opened late, due to a NASDAQ computer snafu.  It almost immediately gave up its initial gains.  It closed a mere 25¢ a share above its $38 offering price–and that only due to “stabilization” (read: price-fixing) efforts by the underwriters in the final hour of trading.

It’s been falling since.

a successful offering??

One interesting aspect of the fiasco is that many commentators–as well as many retail participants in the offering, and apparently also the CFO of Facebook–are basically clueless about how the IPO process is supposed to work.

In particular, I’ve heard media proponents of the tooth-and-claw school of capital markets trying to burnish their Darwinian credentials by claiming that Morgan Stanley actually did a good job with the offering.  Explicitly or implicitly, they point to the poor trading performance of FB as evidence that the bankers achieved the highest possible price for FB.

I think this is crazy talk.  When FB conjures up in investors minds words like “overpriced,” “disaster,” and “huge losses,” that’s not good.  Nor is it when retail investors feel they were tricked into buying more stock than they wanted   …or when the lead underwriter is being investigated for disclosing negative opinions about FB only to a few customers.  And, of course, none of the money from sales of extra shares went to FB itself.

An IPO is supposed to go up!  

Not necessarily by 100%, but maybe 20% or so.  Why?

Psychologically the company is associated with success when its stock rises.  Retail investors, who will buy/use the company’s products and loyally support management, feel good about themselves and the stock they own.  This positive association lays the groundwork for the market to absorb more stock when lockups expire and when employees want to cash in more of the stock that’s a key part of their compensation.

A failed IPO, in contrast, generates questions–well-founded or not–about the stability of the company and about the trustworthiness and competence of its management.

what went wrong?

As I see it, there were two separate problems:

1.  The main one is that FB issued too much stock all at once.  Up until a week ago, the plan had been to sell 388 million shares at a maximum price of $34 each.  That’s $13.2 billion.   Which is enough money to buy all of the stock of Sony or Omnicom or Applied Materials or Ralph Lauren or Limited Brands, at yesterday’s closing prices.

Last Wednesday the amount of stock was increased by 25% to 485 million shares and the offering price was upped to $38.  So the total take from the IPO went up by 40% to $18.4 billion.  That would be enough to buy Marathon Oil or Kellogg or Yahoo–or to pick up Whole Foods or Charles Schwab and have a couple of billion left over.

This decision had two negative effects:

–it took $5.2 billion out of investors’ pockets that might have gone into buying FB in the open market after the launch.

–worse, the underwriters were unable to find happy homes for all that extra stock.

In any “hot” IPO, institutions routinely place orders for many times the amount of stock they actually want, in the hope that this will influence the underwriters to give them larger allocations than they’d get otherwise.  You want 250,000 shares so you ask for a million.

I don’t think this tactic works, since the parties know one another very well.  But people do it anyway.  Maybe it makes them feel good.  Occasionally the move backfires and the institution gets more stock than it wants.  Maybe it gets 500,000 shares.

When this happens, the message is clear–the issue is in trouble.  The institution probably decides to stay on the sidelines rather than buy more.  Or it turns into a seller.

Lots of retail investors seem to have been playing the same game with FB.  Institutions have battle scars and regard being burned like this as a cost of doing business.  But for a retail investor, finding 5,000 share of FB in you account last Friday when you expected 500 must have come as an incredible shock.   That’s enough to turn you from a greedy buyer into a panicky seller.

2.  NASDAQ had a computer meltdown.  The details aren’t clear.  My broker, Fidelity says it still doesn’t have complete execution information on buy and sell orders it placed for clients during the first few hours of FB trading last Friday.  This doubtless raised the level of panic individuals have been feeling.

Just as important, I think the NASDAQ mess also had the effect of transferring some selling from last week into this–prolonging the period of trading turmoil.

who decided to up the offering size?

Normally it’s the underwriter, who, after all, is the one in continual contact with potential buyers.  If so, Morgan Stanley and the others had exceptionally tin ears.

In this case, my reading of stray media comments says that the Facebook CFO made the final decision.  At the very least, he seems to be the one being thrown under the bus.  I’ve never seen comments like this before.  My inclination is to say this means they’re true–and that the underwriters don’t like David Ebersman very much.  Let me amend that–they don’t think they’ll need to be doing business with him again.

who benefits from the pricing decision?

The underwriters, of course, whose fees are determined by the size of the offering.

Company officers other than Mark Zuckerberg are still listed as making no sales.  Mr. Zuckerberg remains as seller of 30 million chares, which he notes will go to pay taxes.

The largest chunk of extra stock, 54 million out of the 97 million added, is listed in a catch-all category of people who have given voting rights to Zuckerberg.  Their sales go from 71 million shares to 125 million.  The rest of the shares come from venture capital investors.

To me, this says the company FB had nothing to gain by raising the offering size.

what to do

This is still the same company, with the same prospects, as before.  If you liked it at $38, you’ve got to like it more at $32.  I don’t know the company well enough to have an investment opinion.  The stock does seem to be starting to trade more normally today, though.