Caesars Entertainment and private equity

I’ve been wanting to write about what might be called the private equity paradigm for some time. On the other hand, I don’t see any way for me as a portfolio investor to make money from research I might do–other than to keep as far away from private equity deals as possible–so I haven’t done as meticulous job of research on this post as I would if it involved a stock I might buy.  So regard this more of a preliminary drawing than as a finished picture.

When a private equity firm acquires a company, it seems to me it does five things:

–it cuts costs.  The experience of 3G Capital seems to show that typical mature companies are wildly overstaffed, with maybe a quarter of employees collecting a salary but doing no useful work.  Private equity also uses its negotiating power to get better input pricing, although it passes on little, if any, of the savings

–it levies fees to be paid to it for management and other services

–it increases financial leverage, either through taking on a lot of bank debt, or, more likely, issuing huge swathes of junk bonds.  An equity offering may happen, as well

–it dividends lots of available cash generated by operations and/or sales of securities to itself, thereby recovering much/all of its initial investment

–it then sits back and waits to see whether (mixing my metaphors) this leveraged cocktail to which it now has only limited financial exposure, sinks or swims.

 

Caesars Entertainment has added a new twist to this paradigm.  In 2013, its private equity masters seem to have decided that sink was the more likely outcome.  Rather than simply accept this fate, they began preparing a lifeboat for themselves by whisking away valuable assets from the subsidiary that is liable for the company debt into another one.  In January 2015, after this asset shuffling was done, they put the debt-laden subsidiary into bankruptcy.

Junk bond holders sued.  Litigation has been protracted and has reportedly cost $100 million so far.

Media reports indicate that the case is now approaching resolution–either through negotiation or court ruling.  My no-legal-background view (I was a prosecutor in my early days in the Army, but that says more about the Uniform Code of Military Justice back then than about me) is that:  these asset transfers can’t be legal; and the junk bond loan agreements should have had covenants that explicitly bar such action.  So I’m not sure what has taken this long.

Whatever the outcome of the case is, I think it will shape the nature of private equity from this point forward.

 

 

 

brokers, IRAs and the fiduciary standard

a fiduciary

Being a fiduciary basically means putting your client’s financial interest ahead of your own.

A practical example:  

…given the choice between two products, one with a checkered performance record and high costs, but which makes payments (cash or trips or dinners…) to a financial adviser for selling the product, and a second with stellar performance and lower costs, and which makes no such payments, a fiduciary is required to recommend the second over the first.  At the very least, the fiduciary is required to disclose the facts of the situation, including the payoff from product #1, and allow the client to choose.

A brokerage firm registered representative, on the other hand, is not a fiduciary.  So he’s not required to alert the customer in advance if he’s recommending an inferior product, which is ok, but not great for the client and which–oh, by the way–pays him more.

For a long time consumer advocates have been trying to get Congress to change the laws so that brokers are redefined as fiduciaries.  Their push has intensified since the financial crisis.  But, although the change seems to me to be just common sense, and is in line with the standard of service customers already assume they are receiving, the financial industry lobby is still strong enough to have stymied these efforts.

retirement funds

The Labor Department, however, has recently used its administrative authority to issue guidelines for retirement investments which require advisers to act as fiduciaries, that is, to give investment advice that is in the client’s best interest.

Today, I heard the first reaction to these guidelines–other than general disapproval–from the brokerage industry.  According to the Wall Street Journal, the Edward Jones brokerage firm is withdrawing its mutual funds from retirement products affected by the Labor Department rules.  I looked on the Edward Jones website for clarification, but there’s no press release I can find.

To me, this means one of two things:

–EJ thinks its business practices run afoul of DOL guidelines and it is choosing to withdraw from this market rather than change them, and/or

–it thinks that 401k/IRA providers that sell Edward Jones products have potential compliance issues and prefers not to be involved.

Either way, this all seems to me evidence of how reliant the traditional brokerage profit model must be to offering investment “advice” that can’t pass the fiduciary test.

 

 

Intel (INTC) and ARM Holdings (ARMH)

chipmaking rivalry

The big division in the chip-making industry over the past 15-20 years has been between giant vertically integrated makers like INTC, Texas Instruments … which manufacture chips designed in-house and smaller digitally-oriented design firms who rent structural intellectual property from ARMH, modify it and have chips made in third-party contract fabrication factories like those run by TSMC.

INTC’s advantages have been the raw power of its chips and its manufacturing superiority.  Users of the ARMH framework tout the elegance of their designs that enables output to be smaller, use less electricity and generate less heat.

disruption by iPhone

The balance of power began to shift away from INTC and toward the ARMH camp when INTC decided not to make chips for the iPhone.  It may be that INTC management thought smartphones were a flash in the pan, as urban legend has it, or it may simply have been that INTC knew its chips ran too hot and used too much power for Apple to be satisfied with them.  In any event, INTC has been trying to reinvent itself since then, by improving its chip design while maintaining its manufacturing edge.

On the latter front, INTC continues do well; on the former, not so much.  Despite a lot of design effort, its low-power, low-heat solutions for the smartphone world haven’t been good enough to gain much traction.

This itself threatens the manufacturing operation.  As INTC steadily shrinks the size of its chips, each silicon wafer processed becomes capable of yielding more output.  At some point, INTC’s factories are potentially going to be capable of churning out more chips than the company can reasonably expect to sell to its PC and server customers.  The capital equipment used in chip making is so expensive–$3 billion+ today, maybe $10 billion+ for the fabs of a few years from now–that the factories have to run at high utilization rates to be profitable.  INTC has already said that next-generation (extreme ultraviolet lithography) technology is too expensive for even INTC to invest in by itself.

Hence the deal with ARMH.

three other points:

–presumably working with ARMH-based firms will help INTC fine-tune its manufacturing processes for mobile and the Internet of Things

–this may be the first step in closer cooperation between the two companies

–the arrangement has been announced very quickly after Softbank agreed to acquire ARMH.  Are the two connected?  If so, Masayoshi Son may have plans for much greater integration of the two rival firms.

 

 

 

 

Intel (INTC) and ARM Holdings (ARMH)

At its Developer Forum yesterday, INTC announced that it is opening its cutting-edge fabs to manufacture chips that employ ARMH designs created by third parties.  So, as at least part of its business, INTC intends to become a foundry like TSMC.

(An aside: despite its glitzy style, it’s much harder to find information about the move on INTC’s website than on ARMH’s.  I don’t know whether this has any significance, but it’s the sort of odd fact that rattles around in a security analyst’s head until an answer can be found.  Is it me?  Is INTC more interested in sizzle than steak?  Is INTC’s IR effort still mired in the mindset of the former regime?…)

I’m not sure what the total significance of this move is, but at the very least:

–TSMC, the premier foundry, a Taiwanese company, trades at about a 17x price earnings multiple.  INTC now trades at about the same PE, although it has typically traded at a lower rating than TSMC in the past.  In contrast, ARMH trades at about 70x, a PE that I think must be unsustainably high, even though ARMH has managed to do so for years.

For my money, INTC’s fabs are better than TSMC’s.  Making loads of ARM chips for others will likely not lower INTC’s pe ratio.  Arguably, as the foundry business expands, INTC’s pe will rise.

–in every generation, the size of chips shrinks while the cost of a next generation fab rises. As a result, the amount of output that a fab must have to be able to operate profitably increases, while the penalty for having too little output goes up as well.

The ARMH partnership signals, I think, that INTC believes that to maintain its manufacturing edge, it must accept manufacturing orders from outside parties.

 

More tomorrow.

 

 

 

 

thinking about Big Oil

I’m starting to feel I should be interested in oil stocks again.  That’s mostly because I think that we’ve already seen the lows for the oil price earlier in this year, when quotes were flirting with $25 a barrel.  I continue to think that crude will trade in a range between $40 and $60.

Under normal circumstances, I’d figure that the big multinational integrated oils would be the safest bet and that one could add some oilfield services shares to provide speculative upside potential.

For today, however, I don’t think the traditional formula is right.  Instead, I think the main thing to come to grips with is the technological change that hydraulic fracturing has brought to the industry.  I think this is similar to what happened in the steel industry when mini-mills began to compete with blast furnaces  …or to semiconductor manufacturing when third-party fabrication plants opened in Taiwan, enabling the separation of thought-intensive design from capital-intensive plant ownership  …or to the computer industry when the minicomputer and the PC replaced the mainframe.

If I’m right about this, then anything that has to do with the older order is out.  This means multi-year mega projects in remote or hostile environments (physically or politically) are substantially more risky than they have been.  It also means that the builders of giant offshore drilling equipment to find, lift or transport this kind of output aren’t coming back any time soon.  Nor are the service companies that own this sort of equipment and specialize in this kind of drilling.

The Big Oil majors, who have been the leading proponents of exotic mega projects, must also come into question, as well.   How quickly can/will they mentally adjust to a new era of abundant oil rather than perpetual shortage?  What will they do about projects that are now under way?

What other industries undergoing radical transformation have shown in the past is that the incumbents take a surprisingly long time to adjust to the new circumstances.  If that proves true again, then the best way to make money will be to undertake the tedious task of examining smaller fracking-related drillers and service companies to see how they will benefit.

 

more on productivity

Last Friday, Jim Paulsen, a strategist from Wells Fargo whose work I like, gave an interview with CNBC about productivity.  His take: US productivity is being substantially understated.

The interview contains an interesting chart–one well worth checking out–in which Mr. Paulsen tracks a measure of wage growth with one of productivity.  Historically, the two have moved in tandem  …until 2012.  At that time wage growth begins to accelerate …and productivity starts to drop like a stone.

His argument is that if the productivity figures are as bad as they look, employers would never be raising wages at anything like the rate they are.

To get his results, Mr. Paulsen has had to do two things:  he uses real (meaning after inflation is subtracted) wage growth and productivity; and he uses deviation from trend (sort of like a rate of change) rather than the wage and productivity figures themselves.

As a general rule, I don’t like charts (because you can manipulate the axes to add or subtract drama), and I worry when the key relationships are in derivative data.  Still, I think the Paulsen argument is right.  Wages are rising in a way that strongly suggests there’s something wrong with the official productivity calculations.