Warren Buffett on the US economy

On pages seven and eight of his thirty page-long annual letter to shareholders of Berkshire Hathaway, Warren Buffett takes issue with politicians who are emphasizing the supposed weakness of the US economy.

After arguing, reasonably, that even 2% real GDP growth (more than double the growth of the population) is something Americans should be happy about, he says:

“Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious. Just as is now the case, there will be struggles for the increased output of goods and services between those people in their productive years and retirees, between the healthy and the infirm, between the inheritors and the Horatio Algers, between investors and workers and, in particular, between those with talents that are valued highly by the marketplace and the equally decent hard-working Americans who lack the skills the market prizes…

The good news, however, is that even members of the “losing” sides will almost certainly enjoy – as they should – far more goods and services in the future than they have in the past. The quality of their increased bounty will also dramatically improve…My parents, when young, could not envision a television set, nor did I, in my 50s, think I needed a personal computer. Both products, once people saw what they could do, quickly revolutionized their lives. I now spend ten hours a week playing bridge online. And, as I write this letter, “search” is invaluable to me. (I’m not ready for Tinder, however.) For 240 years it’s been a terrible mistake to bet against America…”

I’m sure this is at least directionally true.  But it’s also a view from the sunny “winning” side of the struggles for a bigger slice of an expanding pie.  From the “losing” side, however, the picture is increasingly nineteenth century Dickens-ugly.  It’s also debatable whether a very poor family with a flat panel TV is that much better off than a generation-ago family with a radio.

The plight of people left behind by rapid structural change may present much more of a political and social problem than Mr. Buffett is able to see.  Whether such issues become stock and bond market problems as well remains to be seen.

More tomorrow.

Foxconn and Sharp Corp (6753), an update

A month ago, I wrote about the merger proposal for Japanese video screen maker Sharp Corp (6753) made by Taiwan-based Foxconn (aka Hon Hai Precision).  Foxconn had offered to acquire control of Sharp for roughly US$6 billion, or about twice the price that Japanese government-owned Innovation Corporate Network of Japan (ICNJ) was willing to pay for the chronic money-loser.  Nevertheless, before a public uproar over the traditional Japanese solution of hiding a problem in a government-orchestrated bailout rather than fixing it, it appeared that Sharp would opt for the ICNJ offer.  So much for Abenomics.

Three developments since then:

–it is now clear that neither proposal involved buying Sharp shares from existing shareholders.  Both Foxconn and ICNJ intended to purchase new stock from Sharp itself.  On the positive side, that would mean that Sharp would receive all the funds.  On the negative, existing shareholders–meaning the investing public in Japan–would be severely diluted.

–apparently feeling significant public pressure from the disparity between the two offers, the board of directors–surprisingly, to me–chose Foxconn over the ICNJ!

–yesterday, on the eve of the change of control, Foxconn announced it was suspending its offer.  According to Reuters, this was because in the final, official disclosure of financial documents by Sharp, Foxconn learned the company had US$2.7 billion in liabilities it had not known about previously.  

Sharp says the liabilities were properly disclosed in its financial statements.  I interpret as meaning that, yes, Sharp didn’t bring the subject up in negotiations, despite its importance, but that there was a least an oblique hint in its publicly disclosed financial reports that these liabilities might exist.  It also sounds to me as if Sharp had a higher legal disclosure requirement in the case of takeover, which it fulfilled at the last minute, hoping no one would notice.

 

My thoughts:

–Welcome to Japan.

–One Reuters report says the liabilities are “contingent” ones, meaning that in some way future events will determine whether Sharp is on the hook for the $2.7 billion.  These might be guarantees for the borrowings of other companies, like suppliers or customers.  They might be warranties, or guarantees of minimum purchases from suppliers, or guarantees that Sharp products in the hands of merchants can be returned for full refunds if not sold.  In any event, however, there are a whole lot of them.  Foxconn’s action implies it believes the contingencies are pretty likely.

–Foxconn says it still wants to go through with the deal, but presumably at a lower price.

 

latest news on oil

Three developments in the last week or so:

Saudi Arabia has clarified for reporters the significance of its recent agreement with Russia, Venezuela and Qatar to refrain from increasing oil production.  The Saudis have no intention of decreasing production, as the media had speculated, but will not pump out more than it is doing at present.

This makes it resoundingly clear, as if it weren’t already, that Saudi Arabia is taking a page out of J D Rockefeller’s nineteenth-century playbook.  It intends to maintain oversupply until weaker, higher-cost competitors are driven out of business.

the International Energy Agency has revised up its estimate of how long it will take for steadily increasing world demand for petroleum to catch up to the current level of supply.  The breakeven date is being pushed back into 2017.

This breaking even consists of two separate elements:  the point when daily usage rises to/above the level of current oil production, and the subsequent–possible quite extended–period during which accumulated excess inventories will be run off.

My first guess is that the prices of oil equities will begin to readjust when the first of the two comes into sight.

J P Morgan announced with its latest earnings report that it is tripling the reserves it is providing on its balance sheet for potential oil company loan losses.

This is “old” news, in the sense that this is accounting recognition of economic damage that has already occurred.  Two reasons for the lag:

—bank loans are typically secured by the oil and gas reserves that the borrower owns.  Their value can change either because the selling price of output rises/falls, or because the quantity of output that can be brought to the surface at a profit changes with price.   It’s conceivable that a small firm that had a million barrels of reserves a year ago only has 500,000 today–because 100,000 have been produced and 400,000 are not economically viable at today’s selling price. Because of this, in an extreme case a halving of the oil price could conceivably wipe out 90% of the value of reserves.  Figuring this out depends on getting a report from petroleum engineers who “audit” reserves annually.  Many such reports have presumably been just rolling in since yearend.

—accounting theory and tax law both argue against a bank making a good-faith guess at what the potential liability will be.  The more prudent course is to wait for reserve reports (required in the loan covenants) from borrowers.

My bottom line:  the only surprise here is the IEA surmise that supply and demand won’t be back into balance before next year.  Otherwise, the oil market adjustment process appears to me to be playing out as one might have expected six or more months ago.  On the good news front, we’re passing the seasonal low point for oil demand.  On the bad news side of the ledger, there’s no evidence that the successful, if economically crazy, stock market trading linkage between equities and oil is being broken.  If I were a trader, though, I’d keep working the trade despite the lack of economic underpinnings until I stopped making money with it.

 

 

 

Toys R Us redux (ii)

memory lane…

I took an international banking course in business school, way back when.  A case study of a project loan made by an international bank consortium to New Zealand made a profound impression on me as I was beginning to understand how banks work.

The loan was to enable the government to develop an offshore oilfield.  Borrowings were secured by the assets of the project; repayment was required to come solely from project revenues.  The key aspect of the loan, however, was that the loan principal came due at the end of year five but the first revenue from the project was expected to come only in year six.  

In other words, it was obvious to anyone who read the loan documents in even a cursory fashion that the original loan could never be repaid.  Not to worry, however.  This was the beauty of the transaction.  It guaranteed that a lucrative (for the main underwriters) refinancing/restructuring had to take place in year three or four.  The borrower may–or may not–have understood.  But these were the best terms it could get.

Loans like this ultimately led to the 1970s emerging markets debt crisis.

…and Toys R Us (TOYS)

…which brings me back to TOYS.  According to the Wall Street Journal, TOYS is trying to refinance $1.6 billion in junk bonds that come due through between now and 2018.  The company is at the leading edge of $1.3 trillion in junk debt coming due in escalating yearly amounts between now and 2020.  As the WSJ points out, TOYS’ experience in getting its refinancing done over the next two months or so will give an indication of how bumpy the road will be that other junk-rated borrowers will have to travel in the near future.

Although I worked side by side with junk bond fund managers for years, I’m not an expert.  Nor are many financings as cut and dried as the New Zealand one I described above.  But I have learned a bit over the years about human nature and about how financial firms work.  I’m convinced that a hefty chunk of the $1.3 trillion in junk where principal repayment is coming due over the net three years was issued with the expectation that refinancing would be necessary.  (I’m also confident that the offering documents contained a boiler plate warning about this possibility  …and that many buyers skipped over these pages, either from laziness or because they knew that was the way these transactions worked. )

Unlike the emerging markets debt crisis of a generation ago, I don’t think a potentially serious problem with junk bonds today is the same kind of threat to world economic growth that the 1970s lending crisis was.  But it could be a nasty bump in the road for junk bond funds and for the private equity firms that control companies who have been big junk bond borrowers.

We’ll know more in a month or two.

 

Toys R Us redux

Toys R Us (TOYS (not a ticker symbol today)) has been an iconic name in retailing over the past forty years.

–In the 1970s urban department stores came under attack by upstart specialty retailers who extracted the most profitable “departments” from the older merchant conglomerates and opened stand-alone locations focused on a single line of goods in direct competition with their older rivals.  More nimble, with a wider selection, often lower-priced, more willing/able to follow customers to the suburbs, specialty retailers ate the department stores’ lunch for years.  Many still do.

Toys were at the top of the extraction list.

TOYS was the first of the three contenders (the others were Child World and Lionels Kiddie City) to complete a nationwide retail network yielding the economies of scale that eventually won out against the other two.  As such, TOYS is a textbook case of the successful 1980s retailer.

It took market share both from department stores and mom-and-pop toy retailers.

–The 1990s saw the rise of Wal-Mart (WMT) and Target (TGT), who, more modern versions of the department store, used their floor space in a flexible way than their predecessors.  Their toy departments were relatively small for most of the year, but expanded dramatically during the holiday season–meaning, in contrast to TOY, they had toy overhead expenses for only a small part of the year.  Because they had other lines of merchandise to sell, they could (and did) use the hottest toys as loss leaders, as well.

For the first half of the decade, TOYS steadily lost market share to WMT and TGT but made it up by taking share from mom and pops.  Then there were no more m&ps   …and TOYS’ underlying competitive issues became more evident (there are a lot more wrinkles to the story–like store locations–but I think WMT and TGT were the main plot line).

–In 2005, TOYS was taken private in the first of a series of attempts to reorganize or restructure the firm to restore its past glory.

 

today TOYS is back in the news as markets worry about the firm’s ability to refinance its substantial junk bond borrowings.  It’s now being looked at as a possible canary in the coal mine for future troubles in sub-prime debt.

More tomorrow.

 

 

4Q15 earnings for the S&P 500

A few days ago, Factset published a note analyzing 4Q2105 earnings for the two-thirds of the S&P 500 that had reported as of that time.  It wanted to find out two things:

–how the sharp decline in the price of energy, especially oil and gas, had affected revenue and earnings of the S&P, and

–how the strength of the dollar affected the results of companies with substantial overseas revenues, earnings and assets.

Three observations (from me):

–the oil and gas figures, which show a general collapse in earnings, are a mix of operating results and writedowns of long-term investments in what are now no longer viable exploration/development projects (in plainer words, the balance sheet cost of finding the hydrocarbons exceeds their market value).  Factset doesn’t separate operating earnings declines from writedowns—which would be a pain in the neck to do—even though the distinction is important

–companies may have hedged either currency or oil/gas price fluctuations.  If successful, these hedges would have meant the reported results were better than unhedged would have been.  If unsuccessful, the opposite would be the case.  (Even farther afield, companies typically disclose unsuccessful hedges, thinking investors will focus on the unhedged results; no one calls attention to successful hedges, for the same reason.)

–products and services sold abroad are typically priced in local currency.  When that currency falls against the dollar, the dollar-denominated results for a US-based company fall as well.  As a matter of course, the US company can raise its local currency prices.  But the general rule of thumb is that they can be boosted by, at most, the local inflation rate—and with a time lag, as well.  In the case of the euro, which is the currency of most concern to the S&P 500, there is no inflation at present.  So (ex hedging, if any) current results show the full brunt of the euro’s decline against the greenback.

 

The Factset numbers:

–for all S&P companies, revenues fell by 3.7% during the quarter.  Earnings fell by 3.6%.  For companies with more than half their sales in the US, revenues were up by 0.8% and earnings by 2.7%.  For firms with more than half their business abroad, revenues were down by 13.0%; earnings were off by 11.2%.

–for the S&P 500 ex Energy, sales were up by 0.5%; earnings for non-energy firms rose by 2.5%.  Domestically oriented companies ex Energy, had revenue gains of 3.9% and an earnings increase of 6.9%.  Sales for foreign-oriented firms fell in dollar terms by 7.4% and earnings by 3.2%.

 

My thoughts:

–I think the euro has already bottomed against the dollar.  If so, ex hedges, 2016 results may be surprisingly good for S&P firms with significant EU exposure.

will an oil cartel cut production and raise prices?

As I argued yesterday, the oil cartel can cut oil production to a degree that will raise prices significantly, because the gap between supply and demand is relatively narrow.  Whether it will, however, is another matter.

The announcement on Tuesday of an agreement among Saudi Arabia, Russia, Venezuela and Qatar is a case in point.  The Saudis and Russians together account for about a quarter of world oil production.  Venezuela and Qatar each account for about 2%.  The four declared three days ago, after what was widely rumored to be a meeting to discuss production cuts, that they had agreed not to raise production further.  Given that the Saudis, Russians and Venezuelans are all running flat out–Qatar may be, too, I just don’t know–this was an incredibly weak statement.

Of course, consuming nations don’t want prices to rise.  Sunni countries don’t want Shiite countries to have more money and vice versa.  The rest of the world would worry that extra funds in the Middle East will find its way into jihadist hands.

There are also important economic considerations, concerning the character of OPEC and the differing motivations of Saudi Arabia and the rest of the cartel.

First, OPEC as a cartel:

Economic theory and practical experience both conclude that economic cartels never work.  That’s because members always violate any production reduction agreements they come to.  At one time, OPEC, founded in 1960, was an exception.  That’s because, in my view, in the early days OPEC was a political organization–formed to combat colonial exploitation of resource-rich third world countries.  During that period, the organization displayed remarkable cohesion.  OPEC’s nationalization of the oil companies’ interests in the 1970s, however, transformed the organization from a political detente to a garden-variety economic cartel, subject to the same garden-variety cheating problem that other commodity producers suffer from.

On top of that:

Saudi Arabia possesses vast oil reserves, enough to continue production at current rates for, say, 100 years.  Since the oil shocks of the 1970s,  Saudi Arabia’s biggest economic concern has been to maximize the value of this asset   …that is, to make sure the world is still using oil and has not substituted other forms of energy for the next century.  The main threat to accomplishing this goal is very high prices.

By and large, the reserves of other OPEC countries are much smaller–enough to last, say, 20 years.  These nations couldn’t care less about long-term substitution of other fuels, because they will have run dry before that can happen.  Having the highest possible oil price in the here and now is the most important objective.  So they have a strong incentive to cheat rather than adhere to production cuts OPEC agrees to.

Also, for the past several years, the Saudis have had to worry about the emergence of large amounts of oil extracted from shale.  That has been enough to tip the oil market into oversupply.  The expansion of shale oil output undermines the ability of the Saudis to stabilize prices, too.

In practical terms, what do these factor imply?

–although the rest of OPEC would be willing to agree that Saudi Arabia should cut oil production to stabilize/increase prices, other members are unlikely to reduce output themselves.  They’re much more likely to boost it.  We saw this clearly during the oversupply years of 1982-86.  During that time, Saudi Arabia reduced its oil production in steps by about seven million barrels a day without putting a dent into oversupply.  That’s because other OPEC nations, which had promised to cut back their output, upped it instead, barrel for barrel with Saudi Arabia’s cuts.    All the cutbacks did for Saudi Arabia was to lose it market share–which the kingdom found very hard to win back when supply and demand came back into balance.  There’s every reason to expect the same outcome would happen again.

–at a $30 a barrel market price, shale oil production in the US is gradually starting to shrink.  If oil prices remain at the current level for another year or two, shale oil firms will start to go out of business.  This means that skilled workers and technical knowhow will be lost–making it more difficult and time-consuming for shale oil production to start up again.  Arguably, this is Saudi Arabia’s main objective.  After all, if the Saudis had not increased its oil output over the past year or two, world oil supply and demand would be roughly in balance today–and prices would, I think, be significantly higher.

 

What does “significantly” mean?  When oil prices were at $100+ per barrel, shale oil producers had no need to be efficient.  They made a profit almost no matter what their costs were.  So they concentrated on maximizing production.  Estimates at the the time were that shale needed a price of $60 a barrel to be economic.  In today’s world, where shale oil drillers have got to concentrate on keeping costs in line, I think the breakeven price is closer to $40.  So even in the unlikely event that OPEC agrees on production cuts–and nobody cheats (fat chance!)–$40 a barrel is probably a price ceiling.