August 4, 2020- Kodak Stock Surges as it Pivots to COVID Drug Initiative. Should Investors be Buying or is this a Stock Scam?

After Sitting Out the Entire Pandemic Bear Market, Leveraged Buyouts Finally Make a Comeback. Why is Private Equity Structurally Pro-Cyclical? 

Big Tech Defies Historic Recession with Blockbuster Q2 Results. Are They Recession Resistant?

MAEs, Horse-Trading and Deal Repricing: A Discussion on the Forescout Technologies Takeover

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Transcript:

Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by Accelerate Financial Technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.

Julian Klymochko: Welcome podcast listeners to episode 80 of The Absolute Return Podcast. I am Julian Klymochko. 

Michael Kesslering: And I’m Mike Kesslering. It is a lovely Friday, July 31, 2020 and we are back in the office, back in the podcast studio. So that feels great, I have been working from home for a number of months, so we are back officially in the Accelerate head office. Some craziness going on in the markets this week. 

    • And how could we not talk about what’s happening at Kodak? One of the most ridiculous situations I have ever seen in the markets. The stock of Kodak absolutely surged about tenfold this week, as it pivoted to COVID drug initiative. We ask should environs be buying this, or is this just a straight up stock scam? 
    • After sitting out the entire pandemic, bear market. Leveraged buyouts finally make a roaring comeback. Why is private equity structurally pro cyclical?
    • Some big tech results and most of them just, you know, blew the lid off. Beating expectations, handily they are defying this historic recession with just blockbuster Q2 results. We are talking about Facebook, Amazon, Google, and Apple. Are these companies recession resistant? 
    • Lastly, wanted to touch on a blog post to put out this week on Forescout Technologies, MAEs, Horse-Trading and Deal Repricing. 

Julian Klymochko: But Mike, let’s start things off with this Kodak situation, which is absolutely mind blowing. Ridiculous situation, but let’s get into it. Now Kodak, everyone knows Kodak that iconic camera company, at least they used to be. Have been going through a bit of a pivot. Everyone knows their camera business went away. The company went bankrupt in 2012 restructured in 2013 and their stock after that restructuring; I believe it started trading around $30 dollars in 2013. I took a look at it from an investment perspective. It was a post reorg equity, which is sometimes a good place to look for cheap stocks.

However, passed on that one and thank God I did, at least up until last week. Cause the stock slowly declined over the years from about 30 to have bottomed around a dollar fifty. So both down 95%. It did have a brief sort of scammy pivot to cryptocurrency in 2018. Where they had this insane idea to come up with a cryptocurrency called Kodak Coin and also launch a cryptocurrency mining hardware initiative called, what was it called? Coin Miner.

Michael Kesslering: I really just remember the Kodak Coin. 

Julian Klymochko: Anyway, it went nowhere, but it briefly was effective in pumping their share price about threefold during that brief cryptocurrency initiative that they did quickly abandoned. But now once again, I mean we’re seeing memories of that pivot as they’re now attempting to capitalize on this whole COVID pandemic. Announced a dramatic change in business model, this time pivoting to become a pharmaceuticals company.

So now, it is going to be Kodak Pharmaceuticals, and there is actually real money involved in this. Despite having zero experience in pharmaceutical manufacturing and no potential products, Kodak received a $765 million dollar loan. That is right, $765 million from the U.S. Government, to kick-start this pharmaceutical manufacturing initiative and what the government claimed to be an attempt to reshore industrial manufacturing back to the United States. Certainly the Government’s desire to reshore pharmaceutical production. I mean, that is a decent initiative because many of the world’s pharmaceutical ingredients come from China and India. And obviously the relationship with China isn’t too hot these days. However, that is a concern. Especially in recent years, over quality control issues and more importantly all the treatments coming out with respect to the Coronavirus and the various shortages that all these various treatments are experiencing. Now this $765 million dollar Government loan came under the defence production act, which was effectively the first of its kind.

Now let’s get to some stock market action here. Kodak stock absolutely gone crazy. Where was it before all this? Like around two bucks? 

Michael Kesslering: Two fifty. 

Julian Klymochko: Yeah, and so the stock peaked around $60 dollars. Finished the week up about tenfold, on this crazy news, adding more than 1 billion to its market cap. And if you think about it, all that happened was they received a loan from the government. They pivoted to an area that they have zero expertise in. Zero products and it is just a pie in the sky, dream effectively. Does that justify a billion dollars gain in market gap? Well, certainly it does for a large contingent of Robinhood stock market traders, speculators. They were the biggest purchasers of Kodak with over 117,000 accounts owning the stock by the end of Wednesday of this week, that is up from less than 10,000 accounts owning the company on Monday. So a massive surge from these Robinhood speculators and we talk about this time and time again on the podcast and that the millennial traders using these free trading apps, they’re perhaps the most unsophisticated investors out there, basically no fundamental due diligence. I mean, fundamentally Kodak has not changed at all, except they do have cash and they do have a loan.

Michael Kesslering: They have changed in the sense that their business model is declined. I mean nobody is using actual cameras for pictures and what have you.

Julian Klymochko: Yeah, exactly. But I mean, they’re a melting ice cube a long time ago and that ice cube has completely melted in their legitimate business. But now, you know, my hot take on this: investors should not be buying this clearly, if I was not obvious enough with that. And if you do own Kodak stock, you know, it’s probably a good idea to sell as quickly as possible before the stock goes down to $2 dollars or lower. It could be a great time to get out of it at an inflated valuation. So clearly some sort of stock scheme happening here, they are attempting to enter a low margin commodity market with zero expertise, no particular competitive advantage. In fact, they would be at a massive disadvantage to the thousands of companies that actually know this space and operate in this space. So a real head scratcher here, and my heart goes out to anyone who is short the stock before, because it looked like a good call. Like it is slowly melting or a quickly melting ice cube on its way to zero. And then, man, imagine being short and then it going up 20X. So certainly, that is one of the challenges of being a short seller. Obviously we are not short the stock because if we were, that would be very painful, but nonetheless. Yeah, thankful to not be sure, feeling real bad for short sellers on this one and the speculators bidding up the stock. I mean, you are in for a world of hurt and clearly, this one is going to end in tears, isn’t it?

Michael Kesslering: Yeah, absolutely. Like this honestly has all the different levels of scumbagerie. You have insider enrichment in kind of a grey area. It is not really clear whether it’s illegal and what I’m meaning by that is. There was actually some really good reporting on this done by a blog focused on accounting and corporate governance, the Non-GAAP thoughts blog which described how the company had issued their normal director equity grants in January of 2020, where they issued RSU, so restricted stock units. And in addition to that, then the directors then issued themselves special options. So outside of the typical RSU package in May of 2020, and the thesis on the Non-GAAP Thoughts Blog, is that obviously that the directors likely had some knowledge of this loan coming through the pipe at that point in time. Especially since they did ladder the strike prices quite aggressively for a two dollar and fifty cents sock, I believe strikes were like laddered into the double digits.

So looking at a Forex return before getting some return on your options and then as well, there’s enrichment for the executives where the day before the announcement, which is completely shameless. 

Julian Klymochko: Just egregious 

Michael Kesslering: Also because they don’t have to report that for two days. The hope would be that people would not notice the option grant after the fact but they then issued executive options one day before, so you have the insider enrichment. You had what looked to be potentially insider trading, but on second look, the day before the announcement, you did have 1.6 million shares of Kodak trade where the trading on average, it was around a 100K per day prior to that. And you will see that in mergers, well you’ll get some leakage, whether it’s loose lips with the investment bankers or the management team.

But in this case, it was actually a report published by Rochester TV Station, which was then deleted right after, but that news still was disseminated. But really the final piece is just crony capitalism in terms of this fund, this Government fund that is being used to develop drugs, which as you had mentioned, Julian. This is a very good goal of the U.S. the goal in and of itself to develop drugs onshore makes a ton of sense, but giving, you know, three quarters of a billion dollars to Kodak who has no experience in this. Like just destroyed value in every way, shape or form. You look at biotech and pharma companies; they will always have doctors involved. There will be a few MDs. That will be on the executive team. There CEOs, or a marketing exec like this is just absolutely insane. 

Julian Klymochko: It is a head scratcher for sure and like, you indicated really, really poor corporate governance, if not fraudulent, we’re not sure about that. However, you know, completely ridiculous situation and it can largely be ignored from an investment standpoint. However, it is extremely entertaining just to observe what is happening here and a good lessons learned, so certainly don’t buy the stock. And if you are along then, I’d probably be looking to sell as quickly as possible. It really reminds me of say, if you go back to when Tilray IPOed and the stock prices rallied like crazy, and now it is down what, 95%. So you have these crazy stories that don’t amount to anything fundamental and more often than not, or nearly all the time they crash and burn and it ends in tears. So another interesting study to look at on the story stock side.

AFTER SITTING OUT THE ENTIRE BEAR MARKET, LEVERAGED BUYOUTS FINALLY MAKE COMBACK 

Julian Klymochko: Let’s move on to some M&A news and leveraged buyouts. I mean, over the past four-five months, ever since this pandemic bear market started, where have leveraged buyout firms being? They have been nowhere to be found. Typically as an acquirer, you want to be counter cyclical, i.e. buying when things are cheap, but nope. Not for private equity firms, however, as the market has bounced back, so have they. It has been a busy couple of weeks for private equity firms. They have announced four leveraged buyouts of public companies in the U.S. and Canada since July 20. Now that amount that we have seen in the past two weeks far exceeds anything announced since mid-February. It was just crazy how the private equity firms, when acquisitions, where their cheapest, they did absolutely nothing. Now, I want to touch on why. 

There is a number of reasons why, but I wanted to note who was active here. We had Oak Hill Capital, Thoma Bravo and HGGC, all with leveraged buyouts below 600 million in July. And we actually had Madison Dearborn stepping up to the plate for two leveraged buyouts in July, including the 1 billion buyout of Canadian-listed IPL Plastics. Now I wanted to touch on why we didn’t see private equity firms come do leveraged buyouts, M&A when stocks were at their cheapest, I mean, we saw the S&P dropped nearly 40%, but they were nowhere to be found. Well, one issue is that targets don’t want to sell when their stocks down 50%, they always want to wait for things to bounce back. So there is this thing called the bid-ask spread where a acquire will want to buy cheap, say the stock dropped from 20 to 10. A private equity firm comes in and says, oh, hey, we will give you a 30% premium. Buy you out at 13, but the Target is looking at well, our stock was just at 20.

We don’t want to sell now when things are bad, we want to wait until the market improves and we can kind of climb back to those highs that we were at, so that’s one factor. Another factor is debt financing. Through the depths of the bear market, debt markets and capital markets in general, basically closed. They are very shaky, so in order to conduct a leverage buyout, you need to have debt financing. And it was highly unlikely that a large amount of debt financing would be available when everyone’s pulling back on risk, so that’s another thing to consider. The point being is that private equity is pro-cyclical. You see the biggest deals at the peak of the market, and really, that is kind of, what we are seeing here. Deals start to pick up as valuations, get higher and higher, and confidence comes back. But to me, I don’t think, or I don’t consider this a true bull market until we start seeing those massive leveraged buyouts like LBO north of 5 billion, then we’ll know. Private equity firms have their mojo back.

Michael Kesslering: Absolutely, one caveat is that our focus typically is just looking at the LBO market for public equities, public companies, which is the largest in terms of deal size. That will be the larger part, but there is a large number of volume or a large volume of deals that do get done with private co’s. One other thing, you know, similar to what you had mentioned with the bid ask-spread during a bear market, you also just get plain old adverse selection where to do an LBO. The best candidates are cash flow positive, and I have an underutilized capital structure. In the sense that you could add, comfortably add debt to that capital structure and be able to realize these great returns, which is kind of the fundamental thesis of private equity but in a down market, the only companies that are willing to sell and not just ride it out are companies that either are not profitable. So they wouldn’t be able to service debt or are just already over leveraged and so aren’t very suitable candidates anyway, so that is one fair reason why there wouldn’t be as many deals being done right now. As well, one other thing that we have talked about on the podcast before was Silver Lake involvement. They have been doing a ton of deals, but they have been very flexible and quite creative with their deals investing across the capital structure. 

Julian Klymochko: Yeah, not traditional private equity leveraged buyout. 

Michael Kesslering: Exactly. 

Julian Klymochko: More so, growth equity

Michael Kesslering: Yes. Yeah, and so they’ve been flexible in that sense being opportunistic, but that being said, you know, despite us praising Silver Lake for that, not every PE Manager has the flexibility in their mandate to do that. Typically, when you have a mandate with a private equity fund, you are likely to be restricted to just the equity tranche of the capital structure. So there are institutional impediments to being able to do that. One her thing is, you know, both of us have a background in investment banking and the constant thing that you would be pitching in a down market is dry powder. And in a lot of cases, what it is pitched as, you know, in the worst moments of the market. All this dry powder will come in. Boil everything up, and that is just not the case.

Julian Klymochko: No, not at all. And I think a lot of private equity shops were more so focused on rescuing some of their portfolio companies. You got to realize that their portfolio companies are highly leveraged, so when you get into an environment where revenues dropping precipitously. They are probably, you know, looking at their portfolio and not sleeping at night. So likely zero appetite with respect to more leveraged buyouts when their entire portfolio is getting smoked. However, you did mention Silver Lake that is a good point. They were very active. They will go down as basically the Berkshire Hathaway of this cycle and really, we didn’t see much at all from Warren, but we did see Silver Lake step up to the plate and to give some other private equity firms, some credit. We did see some of them acquiring some distress debt situations, so that is something to consider as well.

 

BIG TECH DEFIES HISTORIC RECESSION WITH BLOCKBUSTER Q2 RESULTS 

Julian Klymochko: But certainly, they are not crushing it yet, but you know who is crushing it? What I call the four horsemen of tech: that is Apple, Google, Facebook, and Amazon, they all announce Q2 results on Thursday. Across the board topping expectations, however I looked at analyst estimates and they were taken down significantly. For example, Apple, I think like they’d beat on EPS, huge, but that’s after analysts. Sell-side analysts brought down their estimates about 30%. If it sell-side, just left their EPS estimates where they were at the start of the year. Like they would have nailed it. They would have nailed the Apple EPS perfectly. 

Michael Kesslering: That is the company being smart as. Because the company would have came out to introduce their guidance and then analysts reduce their estimate, so there was a little bit of massaging there.

Julian Klymochko: Yeah, so you will see in the media. They just smoked expectations, beat consensus by double digits. But you know, it’s all a game where analysts are dramatically reducing expectations, such that these companies can beat. However, my point here being these large cap growth companies showed remarkable resiliency. They released results that were phenomenal for the economic environment that we are in, if you look at Q2, GDP declined 10%, which is north of 30% on an annualized basis, so horrible economic conditions. However, the four horsemen of tech held up beautifully. All of them showed year over year revenue growth, Apple, even at double digits. I believe Amazon as well, except for Google. Google was down about 2% on ad spending, took a hit amidst the pandemic

The other interesting thing about this is these blockbuster results from these tech leaders came at a super awkward time. As we, all saw on TV and all over the internet. The companies’ CEOs of these four companies were grilled on their market dominance in front of congress. Just one day prior to announcing these absolutely huge economic results. That is kind of another awkward situation because telling congress, look there is tons of competition. We are not dominant at all, yet the next day release financial results that effectively prove their dominance in the market. This small company is going bankrupt, getting crushed, revenue down significantly and these tech giants just absolutely crushed Q2 with stellar results. 

Get into some price action off the back of these quarterly results. Apple stock up 6.4%, Facebook up 7.5%, Amazon up almost 4%. The only outlier Google down about 5% and that is a notable because we look at index performance. Everyone follows the equity indices and S&P 500 has been crushing it. Now back into the green or the black year to date after being down, what 35%. These four companies represent, I believe around 16% of the S&P 500, so on an equal weighted basis, I believe the index would still be down dramatically. It has given the up performance of these top four companies.

Michael Kesslering: Absolutely and just looking a little bit closer into the three of the four. At least is when you look at Apple; they were actually really Boyd by their hardware sales. So they are Boyd by the common sales of iPads and Macs while people were in quarantine. Which is a really interesting because the thesis with Apple lately has been very focused on the services revenue side and not only is the investment thesis, but just the company’s focus itself. So that’s quite interesting to notice that good old fashioned hardware is what really helped them this past quarter. With Amazon, they are really an e-commerce in general, as we are seeing this in north of the border with Shopify but Amazon and e-commerce just capturing a lot more of the economy. As Jeff Bezos will be very quick to point out is they are still a very small portion of overall GDP.

You know, that tech companies, things are going really well for them when on their earnings called all of them are just talking about, instead of boasting about their record numbers, they’re focusing on how small portion of GDP they are and just how tiny and insignificant these behemoths are. I found that quite to entertaining, but then as well. Lastly, with Facebook, they are really proving out their advertising model. Despite having some pretty large and public advisor boycotts. They still have robust growth; it really just speaks to the long tail nature of their customer base, where they are not really reliant on just a few big advertisers. Their scale really just comes from the sheer number of small advertisers. So small businesses, independent contractors, and things of that nature that are advertising on their platform are really the engine of their ad machines growth, which is, you know, just quite interesting to follow as that’s played out. I believe there was a number of people talking about the impacts of say, you know, a Nike not choosing not to advertise on Facebook and Facebook base, basically just shrugs that off. They don’t even care, which is very interesting. It is just another aspect of those social networks that they built, really.

Julian Klymochko: Yeah, much of it is local in terms of the advertising that they do, and that’s really shining through in their second quarter results. And the last thing I wanted to note is that with the stock rally. Apple to an all-time high briefly overtook Saudi Aramco as the world’s largest public company, so fun fact for listeners there before concluding the podcast. 

Blog Post

Julian Klymochko: I did want to touch on a blog post; I put out this week on MAEs. Those are Material Adverse effects, horse-trading, and deal repricing, a discussion on the Forescout technologies takeover. Now we have been talking about Forescout quite a bit on the podcast, brief recap, they had a friendly acquisition by private equity firm, Advent. Struck just prior to the pandemic led recession and bear market. Given the market was down so much, Advent got cold feet, tried to wriggle out of the deal, claiming a material adverse effect had occurred because Forescout had a poor Q1, however, their results did pounce bounce back in Q2.

And this MAE litigation argument looked extremely shaky. We believe that Advent had little chance in court to be successful in litigating their way out of this deal. So ultimately, our thesis was that they would try to re-cut the price, which they in fact they did. And the way we got this insight was by analysing our alpha rank merger monitor database. And we basically have been following M&A for over a decade now. Have a database of alternative data that tracks, you know, thousands upon thousands of precedent M&A situations. We analysed precedent deals in which these deals were repriced downwards, and looking at the range. They had been repriced down as little as 5% with respect to BorgWarner recent deal for Delphi technologies. All the way to nearly 15% in last year, Callon Petroleum on their deal for Carrizo Oil & Gas, and looking at all the deal repricing was downward between the ranges of 5 to 15% with an average of about nine and a half percent.

And that was the ultimate piece is on a of Forescout was it would come kind of in line with that range and sure enough, it did. They did strike a new deal, down to 12.1%. So it fits nicely within that range and really just showcases the usefulness of alternative data when analysing a specific security and who knows, perhaps it could be applicable to the current Taubman Simon Litigation. The Forescout, Advent deal didn’t get struck until the day prior to litigation was about to commend. So I think on the Taubman situation, we do have a few months for it to see that play out, but ultimately that’s the thesis there is that Simon is trying to get a cheaper deal. And if they do it likely be in that 5 to 15% price cut, so it’s an interesting situation. Got to disclose, we are long both of Forescout and Taubman in these M&A situations.

And that basically concludes this analysis being, you know, look at the data. The answer typically lies in that data set and the merger monitor dataset is super, super useful and effective and running a merger arbitrage on the strategy, but that about wraps it up for this week on The Absolute Return Podcast, if you enjoyed it, always check out more at absolutereturnpodcast.com. Leave us a review if you want and definitely follow us on Twitter. Mike, where can they find you? 

Michael Kesslering: I am at M_Kesslering

Julian Klymochko: And you can find mine at @JulianKlymochko, K-L-Y-M-O-C-H-K-O and I hope everyone has a great week and obviously our Canadian friends getting a long weekend. TSX is closed on Monday, so this podcast should be coming out on the Tuesday, such that everyone can enjoy it as the market opens. All right, everybody hope you have a good one. Cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.

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