April 29, 2019– Microsoft Market Cap Touches $1 Trillion As Q1 Results Beat Expectations. What Drove the Increase In Value?
Occidental Announces Hostile Bid For Anadarko, Setting Stage For Bidding War With Chevron. What Happens Next?
Bank of Canada Holds Rates Steady. What Is Their Next Move?
US Q1 GDP Beats Estimates. What do the Numbers Mean?
The Private Equity Mirage: How to Replicate Private Equity With Liquid Public Securities
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: Welcome investors to Episode 11 of the Absolute Return Podcast. I’m your host Julian Klymochko.
Mike: And I’m Mike Kesslering.
Julian: Today is April 26, 2019, we got a lot of cool things to chat about today on the podcast. Starting off Microsoft market cap touches one trillion dollars as Q1 results beat expectations. What drove the increase in value? Occidental announces a hostile bid for Anadarko, setting the stage for a bidding war with Chevron. What happens next? The Bank of Canada holds rate steady, what’s the next move? US Q1 GDP figures beat estimates. What do the numbers mean? And finally, the private equity mirage, how to replicate private equity with liquid public securities.
Starting things off Microsoft market cap touches one trillion dollars off of strong first quarter results. Now Microsoft is the third company after Apple and Amazon to reach the one trillion dollar milestone. Talking about Microsoft’s Q1 results, the profits climbed 19 percent, which handily topped analysts’ estimates. The stock was up as much as 5% on the release of the results. I wanted to drill down on some specific numbers out of their quarter. It shows you even as a trillion dollar market cap company, it can still grow like crazy. Microsoft has a number of divisions that I wanted to highlight. The first one being as their cloud computing platform. Year-over-year revenue growth of seventy five percent is just astounding. Incredibly good numbers out of that division, office 365 commercial did 31 percent. LinkedIn, a recent acquisition, did 29 percent year-over-year sales growth. Windows commercial doing 20 percent, surface during 25 percent. So, when people talk about the large numbers, it really doesn’t seem to apply. You got Microsoft that just keeps growing like a weed, not just that but incredibly profitable too. What are your thoughts on the stock?
Mike: Yeah I just wanted to touch on the thesis which is, so part of the thesis is that we’re in the early stages of a global enterprise transformation as companies move to the cloud. Where Microsoft and Amazon are the dominant players and Google a distant third. And really what this touch on is their hybrid cloud business. Meaning that they have the combination of on-premise and then the public cloud of its structure and this is kind of the, this combination is the key differentiator between Google and themselves. Where AWS is also able to compete on this basis through the partnership with VMware.
Julian: By AWS you mean Amazon Web Services?
Mike: Yes, yes so really like this business model is just Azure renting out computing power to business clients. So, this is what the majority of the thesis has rested on and the main rationale for such a high multiple re-rating for Microsoft over the last number of years.
Julian: Yeah and I wanted to get into that. Because back in 2011 Microsoft was really beaten down. It was trading at I believe 8.3 times earnings is where the valuation troughed and even by 2013 it was still around 10 times earnings. Which was a big discount to the S&P 500. Ging back to 2013, activist hedge fund Value Act Capital took a two billion dollar stake which at the time was about 1% of Microsoft. The stock was $31 at the time. Which is I believe it’s around a hundred and thirty dollars since. Like I said roughly ten times earnings in 2013 and what Value Act did is they were instrumental in getting Satya Nadella, Microsoft’s current CEO in that position from longtime CEO Steve Ballmer who had been there for 13 years at the time and the stock had been, was lower than where it was 11 years ago and ever since such Nadella came in, the stocks has taken off. Not only has it gone from $30 to $130, that wasn’t all on earnings growth. Although quite a bit of was. But the multiple re-rated i.e. sentiment changed on the stock such that the valuation went from 10 times earnings to 30 times earnings, where it sits now. So, discount to the market, to a fairly sizable premium. Which is a very interesting dynamic in my opinion.
Mike: Absolutely and it just goes to show that yes like execution is the most important aspect of running a company. But one of the other things that you can’t really necessarily control is the sentiment that the market has and that is big effect on what multiple they’ll give you.
Julian: Yeah and what the market was really most impressed with and why it led to that rerating was Nadella’s focus on cloud computing and a subscription-based business instead of selling individual copy of windows for a fee. Now with the cloud computing in the subscription-based software services they get that recurring revenue, which investors clearly value at a much higher multiple.
Mike: Absolutely and when you talk to people in the its services industry, it is very clear that Microsoft is the best option just because of the ability to have the legacy model for companies with their current infrastructure and combine that with the cloud. It’s not just moving say with google moving all the way to the cloud. It’s that kind of combination that is a lot easier to sell.
Julian: Anadarko shareholders got to be happy as Occidental unexpectedly launches a 55 billion hostile bid for Anadarko, setting the stage for bidding war with Chevron. As we previously discussed on this podcast, Chevron had struck a friendly deal to acquire Anadarko and in only a couple of weeks Occidental came in and I note here that Occidental has a fifty three billion dollar enterprise value.
They launched a fifty five billion dollar hostile takeover for Anadarko and so they’re trying to take over a company that is slightly larger than them. Which is, it doesn’t happen too often. Net result Anadarko shares were up 12% on the news. And if you look at the competitive dynamics here, Occidental is going up against an absolute giant in Chevron. Chevron’s worth almost two hundred fifty billion dollars in enterprise value. So, the market is really expecting a pretty heated takeover battle here.
Getting into some details here, the Occidental bid is at 76 bucks per share; fifty percent cash. And as far as I know they have committed financing on the cash portion of that bid through a bridge loan in addition to other strategies that they’re using versus Chevron’s bid at $65 per share. So, it’s 76 versus 65 and Chevron’s bid is only 25% cash. As we have previously talked about in terms of takeover dynamics cash is always king and typically you want to put up as much cash as possible and as little as possible in terms of share consideration. One thing that came clear out of this bid is that Occidental made it clear that Anadarko is highly attractive for its US shale assets, that’s really the key thing that both parties are looking for here. I believe Occidental is the number one producer in the Permian and Anadarko is the second largest producer in the Permian basin. The Permian basin is perhaps one of the hottest shale oil plays in the world today. Certainly, the hottest play in North America. Comparing the bids, Occidental’s bid is at a 22 percent premium to Chevron’s, fairly sizable and what happened prior to them going public with a letter and this public offer to Anadarko shareholders is, Anadarko actually spurned two offers from Occidental earlier this month and just went for Chevron’s lower bid. And they blamed it on thinking that the Chevron bid was much more likely to succeed. Got a quote here from occidental CEO Viki Holub saying, “We are the best performer in the Permian basin and we have the ability to execute on this development better than anyone else.” so there you have it that’s kind of what Occidental is thinking, that’s their strategy here. It’s really to get their hands on Anadarko’s Permian basin assets. I believe they want to sell ten to fifteen billion in assets once they close this deal and that’s their strategy. What are your thoughts on this one?
Mike: Yeah first off Anadarko did say that they would prefer the Chevron bid because of their ability to absorb the company in its full form. Whereas with Occidental they are likely to have a substantial amount of asset sales as this new combined entity would be quite leveraged. Perhaps a little bit more than what they would like, the capital structure may be a little bit different. But yeah moving to, there would be a 1 billion, so I guess at its base there would be a 1 billion dollar breakup fee payable to Chevron if Anadarko chose Occidental, if they renege on the agreement that they had. But as well there’s some interesting dynamics in terms of corporate governance with Anadarko, their CEO he’s actually set to receive 43 million dollars as kind of a golden parachute of sorts following the acquisition by Chevron and this number was actually increased the day before the merger with Chevron was announced and so I find that kind of interesting that they typically wouldn’t do that right before a merger announcement. That would be you know months or years ahead. But the other interesting aspect is that their CEO was actually made about 130 million dollars since becoming CEO in 2012. Where Anadarko’s’ total return in that timeframe has been 3 percent, that’s including dividends. Which is much lower in comparison to their peers’ comps including EOG, ConocoPhillips, Occidental Petroleum itself, where they have returned about 62 percent that timeframe.
Julian: Certainly not paid for performance on that one.
Mike: Absolutely not.
Julian: And I wanted to touch on the leverage issue that you discussed. So, by leverage you you’re indicating that the market fears that Occidental is taking on too much debt in swallowing a fifty five billion dollar Anadarko in which they’re paying for half the equity consideration in cash.
Got a quote here from Zoe Sutherland an analyst at Wood Mackenzie saying, “Financially the deal would be a big stretch for Occidental. A potential transaction would be materially increasing the company’s leverage ratios and stretch its balance sheet.” Another analyst here from Mizuho wrote, “We think the bid is a very bad idea. So does pretty much absolutely everyone we talked to.” So Occidental shareholders aren’t too keen on it that result. Anadarko’s trading at seventy three bucks a share, Occidental’s bid is seventy six, Chevron’s sixty five and these move around because a large portion of these considerations are in stock. But clearly the market pricing in a quite a bit above Chevron’s price. Will see what Chevron does here and we’ll monitor that situation. But certainly, an interesting takeover battle brewing and could be quite exciting for Anadarko shareholders specifically.
Mike: Yeah in terms of those Anadarko shareholders one shareholder that is in favor of the occidental bid is actually D.E Shaw. Which is quite interesting. But as well just some other notes on Chevron is that insiders are saying that they’re unlikely to raise their offer. But you can’t really take that quite at face value, that could just be part of negotiation.
Julian: Yeah the key thing in a hostile takeover battle is the value of the assets. If they’re very marquee and rare assets that won’t come up for sale again. Which I kind of see the Permian assets that Anadarko owns being in this situation. Then you could see both companies pretty keen to get their hands on it. So, I don’t necessarily see Chevron backing down. The other thing is if they do choose to back down, they do it quickly and there have been a number of days since Occidental released its proposal and touching on D.E Shaw, now D.E Shaw is a very large hedge fund established a stake in Anadarko and they’re pushing for a sale process there to attract the highest bid possible. So, we’ll see how that one plays out.
Bank of Canada holds rate steady this week at 1.75 percent in line with what the market expected. What was unexpected is that they downgraded their forecast of GDP growth for the year from one point seven percent to one point two percent. In the first quarter they believed GDP grew by only 0.3 percent. Which is not very good especially in the face of U.S GDP numbers, which we will get to. U.S grew at 3.2 percent annualized. So, Canada’s 0.3% in Q1 is not looking impressive versus the U.S.
As a reminder what the Bank of Canada has done since mid-2017 they have hiked their benchmark rate five times and it lies at 1.75 percent. A couple things, number one is in the oil and gas sector that has really affected the economy and the path of interest rates at the Bank of Canada. Wanted to mention that investment in the oil and gas sector in 2019 will be 20 percent lower than it was just two years ago and looking at the investment two years ago, that had already dropped 50 percent from 2014. So, a significant decrease in oil and gas sector investment which is the largest portion of the Canadian economy effectively. Another comment on housing, it’s showing early signs that it may be stabilizing particularly around Toronto. However, the Bank of Canada did acknowledge that there could be more downside in the Vancouver area and Alberta.
Another interesting tidbit within their monetary policy report is the BOC lowered its estimate of the neutral rate from 2.5 to 3.5 percent to 2.25 to 3.25%. So, we had we discussed the neutral rate and that is a rate in which the Bank of Canada, their benchmark rate they believe is not simulative to the economy. Clearly we are lower than that. But the lower that they take their neutral rate, the less likely they are to conduct future rate hikes. Talking about the Canadian dollar on the back of this news, which was obviously negative with the downgrade in GDP. The loonie fell to a four-month low as the market priced an increasing chance of a rate cut and rate cuts have been a thing that we’ve really been on the past couple of months here really thinking that, that is the path that the Bank of Canada increasingly looks like it’s going to take. What are your thoughts on this?
Mike: Yeah so one thing that I did want to point out is that as we all know that Canada is an export dependent country. We rely on our exports to provide a lot of our growth and so trade uncertainty is actually having an outsized impact on these export dependent countries. So not only is Canada struggling with this, but actually South Korea, another export dependent country, saw its largest GDP contraction in a decade of 0.3 percent. So, this isn’t just specific to Canada. But specific to Canada is that one of the points that Poloz in his notes mentioned for the slowdown in growth rate was the Ontario Premier Doug Ford’s budget austerity. This seems like a little bit of a political response by the by the Bank of Canada. Do you see this as common for the BOC governor to talk fiscal policy?
Julian: It happens rarely, and I don’t think he’s taking a political shot here. He’s just trying to add color and perhaps make excuses for their poor forecasting ability. Which can be expected because they really aren’t generally too accurate and if I were to put stock in someone’s forecast, either the Bank of Canada’s or the market’s, I choose the market’s forecast every time. It’s just more accurate, more up-to-date and it’s the collective insights of thousands of economists, analysts and traders pricing these in the market intraday every day and so I believe that collective wisdom generally forecasts much better than the economists at the Bank of Canada do or any central bank for that matter.
Contrasting those Canadian GDP numbers, we have us Q1 GDP. Which actually beat expectations. 3.2 percent annualized versus I believe 2.2 percent as expected by analysts on a consensus basis. But digging into this 3.2 percent number, the burst of growth was really driven by a smaller trade deficit and the largest accumulation of unsold merchandise since 2015. Which are viewed as temporary boosters to the GDP figure. Now if we exclude trade inventories and government spending, which are seen as temporary, the economy actually grew at only 1.3 percent in the first quarter. So, it’s important to make that distinction.
The headline number seems really good, it’s above Donald trump’s 3% growth target. But it just seems pretty unsustainable. Because growth isn’t coming from the right areas. That being said clearly no recession as the market was pricing in in Q4, so that’s very positive news. Economists expect GDP growth to slow this year, forecasting about 2.5 percent of this is below Trump’s 3 percent annual target.
Got a couple quotes here one from a bear one firm a bull. Our first bearish quote from David Rosenberg he says, “This was a low quality GDP report, all one op. Lower imports, higher inventories and pentagon’s spending real final private sales, a puny 1.3 percent, removing more lipstick from the pig, cyclically adjusted GDP contracting at a 2 percent annual rate. Deepest decline in nearly decade.” so Rosenberg the bear views GDP on an adjusted basis as actually contracting. Which is pretty significant. It’s a pretty big call from him. Now on the bullish side we have the national economic council director Larry Kudlow calling the Q1 report a “blowout number”. “President Trump’s policies are rebuilding the economy and actually the prosperity cycle we’re in is gaining momentum not losing it”, he said. Bottom line the US economy has been on a roll. This marks 10 years of expansion in July, which will be the longest on record. What are your thoughts on these numbers?
Mike: Yes, so I mentioned that the Canadian economy is largely driven by exports whereas the US economy is largely, the largest part of the US economy is consumer spending, and this actually rose above consensus forecasts at one point two percent, grow by one point two percent growth rate, which is interesting. But similar to Rosenberg’s comments on the quality of the forecast. This quarter also has a quirk where because of the government shutdown analysts actually didn’t have access to some of the consumer spending data that they normally would factor into their estimates. Which would give question to the overall quality of the data that they were using to make their estimates. So that’s another interesting aspect of this read.
Julian: Yeah another dynamic to keep in mind as there is an ongoing trade war, specifically between the US and China. So that will negatively affect some of these GDP growth numbers and speaking of which, they do have further future upside if those two countries can seem to settle their differences. Which hopefully they can over the next number of months. But it’s certainly been something we’ve been watching and something we’ve been waiting for.
Put out a blog post this week entitled Replicating Private Equity with Liquid Public Securities. Now what we talked about in this blog post was private equity and how to create an investment strategy using publicly traded stocks to effectively give you the same returns that you can get in private equity. I’m touching on private equity what it is, it’s a very large multi trillion dollar industry of largely something called leveraged buyouts. Where a private equity firm will buyout company, a lot of the times it’s a public company taken private. Utilizing a significant amount of debt. When I mentioned significant I believe private equity leveraged buyouts tend to happen north of 6.2 times net debt to EBITDA. So, a significant leverage ratio that is over three times higher than the average of the S&P 500 company. But use utilizing that leverage and we get into what drives private equity returns in this piece is that they have had substantial returns, market beating returns over its history and so from that performance they have raised three trillion dollars from investors since 2012. Contrast this to the active mutual fund space. Now active mutual funds have lost one trillion in investors over the past four years. So, you see this divergence between active mutual funds and active private equity where investors are taking money out of mutual funds and allocating more to private equity and demand for private equity is so insatiable such that private equity firms now have 1.2 trillion of dry powder, that is excess capital that hasn’t found its way into investments at this point.
We highlighted a study that Harvard Business School did in a methodology to replicate private equity returns utilizing public securities. On a quote they say, “A passive portfolio of small low EBITDA” (and by an EBITDA I mean earnings before interest taxes, depreciation and amortization. It’s commonly used measure of cash flow). So low EBITDA multiple stocks with modest amounts of leverage and hold to maturity counting of net asset value produces an unconditional return distribution that is highly consistent with that of the Preqin private equity index”.
So, there you have it. What we did in our blog post is we created a multi-factor model to replicate private equity returns using some of the data from the Harvard study. What we found and what our simulations showed is that you can replicate private equity with liquid public securities by building three factor model. Number one is size, the first factor. So, you select a universe of small and mid-cap stocks. Why? Well because small and mid-cap stocks have historically outperformed the market. Number two, value. You want to select top decile value stocks on EBITDA to EV. Now this is a valuation measure. Effectively it’s the cheapest 10% of stocks in the market. Why do you do this? Well because historically low valuation stocks have outperformed the market. And lastly the private equity secret sauce really is leverage. So, you want to apply a modest amount of leverage to the portfolio, because leverage amplifies returns.
Going through some of the simulations we ran on our North American basket of stock since 2007, so over the past dozen years, our private equity replication portfolio unlevered returned one hundred forty-four percent or eight point eight percent annualized. Now the Preqin buyout index, which aggregates private equity fund returns on a quarterly basis, it returned a hundred sixty-six percent, or nine point five percent annualized. However, one thing that I wanted to note the difference between our simulated private equity replication portfolio and the Preqin index is that, LBO or leveraged buyout companies typically have six-fold the amount of debt or leverage that our private equity replication portfolio has. So, a significantly higher risk portfolio.
Now we ran another simulation in which we leveraged our private equity replication portfolio one hundred and thirty percent and had hedged 30% by shorting 30% in S&P 500 futures. This resulted in a two hundred and twenty percent returned for the leveraged private equity replication portfolio and this is eleven point four percent annualized, which beat the Preqin buyout index by nearly two percent per year.
So, there you have it. We’ve created a pretty cool model to replicate private equity. But this is with securities that offer you intraday liquidity, not just that but you can do this at a significantly lower fee than private equity.
Another thing I chat about in the blog post is many like to point towards either operational improvements or the so-called illiquidity premium as to where private equity results and outperformance comes from. But we clearly show that that is not the case and the results come from those three factors that we discussed, that being size, value and leverage. Do you have any comments on this post?
Mike: Yeah absolutely and so in terms of the rationale for those side for size leverage and value, is that these factors actually make a lot of economic sense as well. Since private equity funds historically such as KKR and Bain, some of the most popular PE funds had their best years in the 1970s and 80s when it was relatively less competitive, and they were doing mid-market deals. So, they are doing smaller deals, less competition. So, valuation that was typically lower.
Julian: By valuation you’re talking four to six times EBITDA in terms of enterprise value or takeover value of the business where you’re buying at four to six times its cash flow and you look at the average leveraged buyout these days, I believe the multiple is at an all-time high at roughly eleven times EBITDA. So, you’ve seen valuations double and obviously the amount of the equity increase much more than that just given the leverage on these deals.
Mike: Absolutely and doing a deal you know 11 times is very different from doing a deal at five or six times.
Julian: Yeah exactly with the amount of leverage you’re seeing a large number of leveraged buyouts being done at six to seven times debt to EBITDA, inclusive of a number of adjustments. So, after adjustments many could be north of seven times. But you look in the heyday of private equity and in the 80s and 90s and they’re getting total deals done far less than six times EBITDA. So, it’s a pretty significant difference and perhaps the best days of private equity are behind them, what do you think?
Mike: Yeah that’s a definite possibility. I mean to counter that perhaps it is just cyclical where the next recession that comes across. Perhaps deal sizes and multiples will refer to more of a historical norm.
Julian: Yeah there’s just so much capital chasing these opportunities, pension funds really desperate for higher returns than the market. I should note that one of the largest PE shops out there is in the midst of raising the largest leveraged buyout fund ever and their CEO said the raising of the money was so easy. It was akin to a quote “out-of-body experience”. And so there you have it, when things like that happen it typically doesn’t end well. That’s all I got to say about that.
So, there you have it folks Episode 11 of the Absolute Return Podcast. You can hear more at www.Absolutereturnpodcast.Com. We will chat to you again in another week. Feel free to leave us some questions, leave us some ratings on iTunes and we’ll talk to you soon. Cheers.
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