Verizon (VZ) and Disney (DIS)

A short while ago, rumors began circulating on Wall Street that VZ is interested in acquiring DIS.

Yesterday, the CEO of VZ said the company has no interest.

some sense…

The rumors made a little sense, in my view, for two reasons:

–the cellphone market in the US is maturing.  The main competitors to VZ all appear to be acquiring content producers to make that the next battleground for attracting and keeping customers, and

–the Japanese firm Softbank, which controls Sprint, seems intent on disrupting the current service price structure in the same way is did years ago in its home country.

…but really?

On the other hand, it seems to me that DIS is too big a mouthful for VZ to swallow.

How so?

–DIS and VZ are both about the same size, each with total equity value of around $175 billion.  If we figure that VZ would have to offer (at least) a 20% premium to the current DIS stock price, the total bill would be north of $200 billion.

How would VZ finance a large deal like this?  VZ’s first instinct would be to use debt.  But it already has $115 billion in borrowings on the balance sheet, so an additional $200 billion might be hard to manage, even though DIS is relatively debt-free.

Equity?  …a combination of debt and equity?

An open question is whether shareholders in an entertainment company like DIS would be content to hold shares in a quasi-utility.  If not, VZ shares might come under enough pressure for both parties to want to tear up a potential agreement.

dismember DIS?

VZ might also think of selling off the pieces of DIS–like the theme parks–that it doesn’t want.  The issue here is that all the parts of DIS, except maybe ESPN, are increasingly closely interwoven through cross-promotion, theme park attractions and merchandise marketing.  So it’s not clear the company can be neatly sectioned off.

Also, as the history of DIS’s film efforts illustrates, the company is not only a repository of intellectual property.  It’s the product of the work of a cadre of highly creative entertainers.  Retaining key people after a takeover–particularly if it were an unfriendly one–would be a significant worry.

From what might be considered an office politics point of view, VZ’s top management must have to consider the possibility that after a short amount of time, they would be ushered out the door and the DIS management would take their place running the combined firm.  Would key DIS decision makers want to work for a communications utility?

my bottom line

All in all, an interesting rumor in the sense that it highlights the weakness of VZ’s competitive position, but otherwise hard to believe.

 

 

 

bonds …a threat to stocks?

I read an odd article in the Wall Street Journal yesterday, an opinion piece that in the US bonds are a current threat to stocks.  Although not explicitly stated, the idea seems to be that the US is in the grip of cult-like devotion to stocks.  One day, however, after a series of Fed monetary policy tightening steps, the blinders we’re wearing will drop off.  We’ll suddenly see that higher yields have made bonds an attractive alternative to equities   …and there’ll be a severe correction in the stock market as we all reallocate our portfolios.

What I find odd about this picture:

–the dividend yield on the S&P 500 is just about 2%, which compares with the yield of 2.3% on a 10-year Treasury bond.  So Treasuries aren’t significantly more attractive than stocks today, especially since we know that rates are headed up–meaning bond prices are headed down.  Actually, bonds have been seriously overvalued against stocks for years, although they are less so today than in years past

–from 2009 onward, individual investors have steadily reallocated away from stocks to the perceived safety of bonds, thereby missing out on the bull market in stocks.  If anything there’s cult-like devotion to bonds, not stocks

–past periods of Fed interest rate hikes have been marked by falling bond prices and stock prices moving sideways.  So stocks have been the better bet while rates are moving upward.  Maybe this time will be different, but those last five words are among the scariest an investor can utter.

 

Still, there’s the kernel of an important idea in the article.

At some point, through some combination of stock market rises and bond market falls, bonds will no longer be heavily overvalued vs. stocks and become serious competition for investor savings.

Where is that point?  What is the yield level where holders of stocks will seriously consider reallocating to bonds?

I’m not sure.

Two thoughts, though:

–I think the typical total return on holding stocks will continue be around 8% annually.  For me, the return on bonds has got to be at least 4% before they have any appeal.  So the Fed has a lot of interest-rate boosting work to do before I’d feel any urge to reallocate

–movement in yield for the 10-year Treasury from 2.3% to 4.0% means that the price of today’s bonds will go down.  So, while there is a clear argument for holding cash during a period of interest rate hikes, I don’t see any for holding bonds–and particularly none for holding bonds on the idea that stocks might fall in price as rates rise

Of course, I’m an inveterate holder of stocks.  And this is an interesting question to ask yourself.  What yield on bonds would make them attractive to you?

 

 

my $260 price target for Tesla (TSLA)

A regular reader recently asked how I arrived at $260 as a price target for selling TSLA, which many of you will know I have been trading alongside my younger son for a while.

 

To some degree, I’ve regarded TSLA in the way I would look at any growth stock.  That is to say, I look for signs that the company can grow faster than the market expects and/or would sustain an above-average expansion pace for longer than the market believes.

I then try to use the company’s financial information, plus government, trade association and individual competitors’ data to project an income statement and flow of funds statement for several years into the future.

In TSLA’s case, reliable data are scanty.  In addition, the company’s own projections of its production capacity and sales have not been anything to hang your hat on.

 

Typically, and for a stock I would consider as a core part of my portfolio, I would try to make a projection that I believe to be reasonable, or perhaps mildly aggressive, and would reassess as/when the stock reaches the future target price that projection would lead me to.

In the case of TSLA, however, I did something different.  I decided to make an extremely optimistic projection, one I thought would leave the shares at least temporarily overvalued–and which would serve as a sell signal.

 

This is what I did:

–I decided to make my projection based on 2018 earnings, since I don’t think anyone has the faintest idea of what earnings for years farther in the future will be

–I took the TSLA production forecast, which has proved consistently too optimistic, of 500,000 cars during 2018 as a given

–I decided that most of these cars would be Model 3s, where the average selling price indicated in preorders is about $42,000, as another given.  To account for a small portion of more expensive models, I rounded the average selling price up to $50,000

–I examined other publicly traded auto companies worldwide.  The highest pre-tax margin I found (yes, although this is a dangerous shortcut, I did use margins) was Porsche, at 15%.  I assumed that TSLA would achieve that margin in 2018, even though I think the figure is substantially too high

–I assigned a financial reporting tax rate of 25%, which is probably too low.  That gave me net financial reporting profits of $2.8 billion, and earnings per share of $17.10

–I decided to apply a price earnings multiple of 15x to the earnings number, even though auto companies typically trade at single digit valuations.  I don’t think TSLA should trade at the 20x+ multiple that an IT stock would merit, so 15x seemed about right.  That gave me a valuation, based on 2018 earnings of $257–which I rounded up to $260.

 

As we can clearly see from a TSLA chart, the stock blew through my $260 target in March-April as if it weren’t there.  It peaked, for now, at least, at $386–leaving an embarrassingly large gap between me and it.

 

Where did I go wrong?

The obvious place is in the PE multiple.  The prevailing market view would seem to be that 2019 earnings will be, say, $25/share, and that it’s safe to be factoring anticipated earnings for two years from now into today’s stock price.  Another way of saying the same thing, one which I think must be TSLA bulls’ belief, is that TSLA is this decade’s Amazon (AMZN)

That may well be correct.  Personally, I’m uncomfortable making the bet, though.  One thing experience does tell me, however, is that, barring a total corporate collapse, the stock is highly unlikely to get back to the $180 – $200 range that has marked the lows over the past couple of years.

the Fed’s next move

The highest economic policy objective of the US is achieving maximum sustainable growth in the economy consistent with annual inflation around 2%.

If growth deviates from this desired path, either through overheating or recession, the government has two tools it can use to nudge the economy back toward trend:

monetary policy, controlled by the Federal Reserve, which can relatively quickly alter the rate of growth of the money supply and thereby either energize or cool down activity

fiscal policy–government taxing and spending–controlled by the administration and Congress, and which may be thought of as more strategic than tactical, since there are typically long lags between need and any legislative action.

As a matter of fact, the Fed has been calling for fiscal stimulus from Congress and the administration for several years–worrying that continuing monetary stimulus is increasingly less effective and even potentially harmful to the economy.  Its pleas have fallen on deaf ears.

The Fed has been using two methods to keep rates low:

–it has kept the Federal Funds rate, the interest rate it sets for overnight bank deposits, at/near zero, and

–it has taken the unconventional step of putting downward pressure on rates of long-maturity instruments by buying a total of $4 trillion+ of government securities in the open market.  This is called quantitative easing.

Donald Trump was the only candidate to address the problem of fiscal policy inaction, by promising giant fiscal stimulus through lower corporate tax rates plus a massive spending program to repair/improve infrastructure.

After Mr. Trump’s surprise win last November, the Fed seems to have breathed a sigh of relief and aanounced a series of interest rate hikes that would begin to return monetary policy closer to a normal amount of stimulus–based on the idea that Washington would also provide serious fiscal policy stimlus in 2017.

We’re now in month nine since the election, without the slightest sign of any action on the fiscal front, despite the fact that the Republicans hold the Oval Office and both houses of Congress.  Senator Pat Toomey (R-Pa) remarked last week that this is because no one expected Mr. Trump to win, so Congress made no plans to implement his platform.   It hasn’t helped that, despite his campaign rhetoric, Mr. Trump has shown little grasp of, or interest in, the issue.

This leaves the Fed in an awkward position.

I think its solution will be to shift from raising the Fed funds rate to slowing down or stopping its purchases of securities farther along the yield curve.  Although in a sense the Fed is already no longer buying new government bonds, it is taking the money it receives in interest payments and principal return from its current holdings and reinvesting that in new securities.

Its first step will be to reduce or eliminate such reinvestment–which will presumably nudge longer-term interest rates upward.  Since the process is being so well advertised in advance by the Fed, it’s likely that most of the upward movement in rates will have occurred before the Fed begins to act.  The most likely date for the Fed to more is in September.

 

Employment Situation, June 2017

The Bureau of Labor Statistics released its Employment Situation report for June this morning at 8:30 edt.  The report was a strong one, indicating that the economy added +222,000 new jobs during the month.

Revisions to the so-so reports of the prior two months (made as fuller information comes in to government statisticians from participating employers) were also strong, adding a total of +47,000 positions to the previously estimated gains of +174,000 new jobs for April and +138,000 for May.

The ES is having a positive impact on stock trading in New York today, partly because the numbers are good.  It’s also partly–maybe mostly–because the monthly employment report released by ADT a couple of days in advance of the ES, and which is designed to mimic the ES, reported +158,000 job additions, which was the weakest in that series for a considerable time.

If anything, the June ES gives more encouragement to the Fed to begin in the next month or two its unwinding of unconventional measures to keep long-term interest rates low.

More on this Monday.

 

a bad day for Tesla (TSLA) shares

First, let’s put yesterday’s negative price action for TSLA–down by 7%+–in context.  Prior to yesterday, the stock had risen by 75%+ since the opening bell in January.  So a down day–or even a down few weeks–shouldn’t come as a shock.

What happened yesterday:

–TSLA reported 2Q17 results.  Profits were hurt by another production foulup–a shortage of batteries this time–that prevented the company from churning out cars at a higher rate.  The good news is that the problem was solved intra-quarter and shouldn’t affect results for the second half

–TSLA also said it intends to be churning out 20,000 Model 3s a month by the end of the year and 500,000 in total during 2018

–two negative analyst reports were released, arguing that TSLA is substantially overvalued.  Reasons:  plateauing demand for older models, increasing competition from other auto companies and TSLA’s less-than-perfect production experience.  Goldman Sachs says it now thinks the stock is worth $180 a share (down from $190 previously)

–Volvo announced it intends to become a exclusively a hybrid/electric car company in 2019; Baidu announced it will give its autonomous-driving car technology away for free in return for usage data.  Takers include a bunch of other Chinese carmakers + Ford and Daimler

my take

–I sold my last shares of TSLA at $260, based on the idea that this is the highest price I can reasonably conceive of TSLA trading at during 2018, assuming the company does indeed make and sell 500,000 cars.  I guess that’s my bottom line

–the negative reports are good news in the limited sense that they imply the authors’ firms see no possibility of future investment banking business from TSLA.  Maybe their negative analyst stance in the past has already ruled them out.  But emphatically underlining the fact suggests to me they think TSLA needs no further funding to carry out its production plans

–the possible turn to significant profits being earned in 2018 is a mixed blessing.  On the one hand, say, $5 a share in earnings for the company, with the promise of more to come in 2019 is better than the current situation.  On the other, the emergence of earnings–and of a more easily predictable future–means an end to the “dream” of unparalleled riches that many early-stage-company investors routinely harbor with any of their stocks.  For a certain percentage of “dream” stocks, the minute the earnings begin to arrive marks the peak in the stock price.  A minerals exploration company that owns a single orebody peaking the day the mine opens is the stock example.  Euro Disneyland is another.

UK investigation of the investment management industry

The UK Financial Conduct Authority is wrapping up a two year investigation of the money management industry in this important global financial center.

Despite heavy industry lobbying which has squelched similar inquiries in the US, the FCA’s just-released preliminary report is an indictment of many traditional industry practices.  Excessive fees, lack of disclosure and conflicts of interest among asset managers and pension consultants are recurring themes.  The Financial Times, which seems to me to be in the best position to know, thinks that the “good” news for the industry is that the FCA has not recommended a government investigation of its practices for potential breach of UK law.

Although the investigation began before Brexit became a reality, it occurs to me that the FCA’s conclusions are being shaped by the idea that UK investment services no longer need simply meet the (very) low bar of being better than what’s available in the rest of the EU.  Without a built-in clientele, services must also be good in an absolute sense.  A regulatory regime that gives investors a fair shake is a sine qua non–as well as miles better than what is generally the case elsewhere, including in the US, the current market leader.

The FCA investigation has two implications I can see for US-based money management:

–increased disclosure of fees/performance in the UK will increase pressure for similar disclosure in the US.  One particular bone of contention is the use of “soft dollars” or “research commissions,” meaning a management company pays a broker, say, 2x the going rate for a portion of its trading.   In return it receives goods/services that the manager would otherwise have to pay for from management fees.  The kinds of stuff a manager can receive is already regulated in the US, but disclosure of the amount of money in extra commissions ultimately being paid by clients is not.  The FCA will require such disclosure in the UK.  My sense is that the amounts will be surprisingly large.

–during the years prior to the financial meltdown, US banks opened London branches to process transactions–often involving US buyers and US sellers of US products–that were allowed in the UK but illegal domestically (think:  sub-prime mortgage derivatives).  This was a result of the UK’s decision to build up its financial services industry using a “regulation lite” approach to governance.

In the absence of any changes to US laws, why wouldn’t large US institutional investors demand that their investment managers similarly conduct business out of London.  In this case, however, it would be to obtain lower fees, greater transparency and better legal recourse in the case of disputes.

Yes, this sounds a little crazy, but the legacy investment management industry–both managers and consultants–are so powerful that I think favorable change for investors is unlikely to happen otherwise.