May 21, 2019–Airline Consolidation Heats Up as Onex Acquires Westjet For $5 billion. What Makes This Deal Interesting?
Air Canada Bids For Air Transat And Puts The Company In Play. Hows Does The Quebec Government Play a Role In The Deal?
Chinese Economic Data Slows in April. What’s Behind The Numbers?
Trump Moves to Isolate Huawei as he Bans it From U.S. 5G Networks. How Does This Fit Into the US-China Tradewar?
A Discussion of AlphaRank, Which Represents Accelerate’s Equity Ranking According To Its Proprietary Multi-factor Model
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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: Welcome investors to Episode 14 of the Absolute Return Podcast. Today is Friday May 17th, 2019. I’m your host Julian Klymochko.
Mike: And I am Mike Keslering.
Julian: A number of really interesting news events, deals to talk about. Specifically, there were two airline deals now in Canada this week. Number one, we had Onex acquiring WestJet for five billion. We’re going to talk about what makes this specific deal unique. The second deal is Air Canada, they bid for Air Transat and put the company in play. We’re going to talk about how the Quebec government comes into play on this transaction also wanted to chat about some of the economic data coming out of China for April. Then lastly, we’re going to chat about Trump’s move on Chinese networking equipment maker Huawei, how he banned it from U.S. 5G networks, how that fits with the current U.S.-China trade war. I don’t want to forget we also want to chat about this new research that we’re putting up called AlphaRank. We’re going to explain what AlphaRank is all about at the end of the show.
Some airline consolidation in Canada with Onex, the private equity firm moving to by WestJet striking a deal for five billion dollars inclusive of debt. This deal was done at $31 per WestJet share representing a pretty massive premium of a 67%. Now that premium could be a bit illusory in terms of valuation, because it was actually only done at five point nine times EBITDA, that’s based on 2019 estimates. So, the valuation is relatively low, yet the premium is high which shows you how down in the dumps WestJet shares were over the past while. The share price is quite a bit lower, even with this massive premium, it is lower than I believe Westjet hit in 2014. So, WestJet shares haven’t been doing well so far and perhaps Onex is trying to make a cyclical play here to catch it at the bottom of the cycle.
Some deal dynamics – it’s expected to close late 2019 or early 2020 subject to a shareholder vote, court approval and regulatory approvals.
Some background behind the deal, Onex made its first takeover approach just in March this deal came together relatively quickly less than two months. Which to me shows that it likely wasn’t shopped, I.e., either was no auction process and with no auction process onyx coming in with a fairly strong thirty-, $31 per share bid, 67% premium. I mean shareholders got to be happy with the price they’re getting there and lastly, I want to talk about how this is a leveraged buyout. Onex is a private equity firm. Meaning that they do use a lot of leverage or debt to take WestJet private and some of the numbers behind that to keep in mind is, it is a pretty unorthodox deal and given that private equity firms typically don’t play in businesses such as WestJet. Which I classify as being capital intensive, highly cyclical and pretty dangerous those two characteristics to load a bunch of debt onto this company. What are your thoughts on this deal here?
Mike: Yeah so you mentioned the leveraged nature and although Onex hasn’t announced how they’ll be financing the deal, it’ll likely be with a substantial portion of debt. So, their current net debt to EBITDA ratio is about 1.2 times, but they can bring that leverage ratio probably to two or three times. Which would result in financing it with about 850, 1.7 billion dollars worth of debt and the remainder being financed with equity from the Onex partners 5 PE fund. Which is about 7.2 billion dollars, U.S. As well as this isn’t Onex’s first foray into the aerospace sector they actually have a current investment as well as a few other investments exits from the sector. But yeah in terms of the merger arb spread, currently at about a three percent gross assuming an end of year close with two dividends. That’s about six-point three percent annualized, assuming an end of Q1 close, that’s about three quarterly dividends and about a five percent annualized.
Julian: Its a decent spread. I’d be wary on the fact that it is a leveraged buyout, those typically come with higher risks if you are going to arbitrage the share price, the difference between where it’s trading at and the $31.00 takeover price can be a good strategy. But you certainly need to know a lot of the details behind it from a regulatory perspective, I don’t see a lot of pushback given that onyx doesn’t really compete. It’s more of a financial transaction and the thing with financial transactions if the market heads south, it’s not a strategic deal, financial buyers can walk away if they no longer deem it attractive. So, you’d face some market risk as an arb on this trade in addition to financing risk. Which always comes with a leveraged buyout, typically it’s nothing but you know if we hit a rough market with turbulence pardon the pun, then you know it could have some shaky trading in the arbitrage spread up to close as expected later this year or early next year.
Mike: So I did want to mention that this isn’t Onex’s’ first foray into aerospace sector in terms of Air Canada and Westjet is that in 1999 they actually attempted to merge Canadian Air Lines, then Canadian Air Lines with Air Canada in a 1.8 billion dollar hostile bid, that it was eventually dropped after a long legal battle in Quebec and so the background there is that Air Canada’s current CEO, Calvin Rovinescu was then a lawyer at Stikeman Elliot and brought in by Air Canada to create a legal defense against Onex’s bid. Ultimately the Quebec Court ruled that Onex’s bid violated a 10% ownership limit on Air Canada’s shares, so they had to back down from the bid. There was a good summary of this in this week’s Globe and Mail by Conrad Yacobucci. But in terms of that in terms of the bid violating the 10% ownership is there’s another regulatory hurdle that would reduce the opportunity for other bidders, foreign bidders especially as the 49% bid where the Canada Transportation Act doesn’t allow for over 49% from a foreign bidder.
Julian: Bottom line, here attractive price for West shareholders. Got to be happy with that big 67% premium. There still is a spread between the current price and the $31 takeover price. So decent arbitrage opportunity there, just be wary the fact that it is a leveraged buyout. So, take that into account when setting the risk and the spread that you desire on this trade.
Speaking of airline deals and Quebec, you have a Quebec based a deal with Air Canada bidding for Air Transat. This puts the company in play. Because Air Transat and Air Canada, they don’t have a definitive agreement, but they do have an exclusivity agreement. They have disclosed the price, which is $13 per share for Air Transat. This represents a deal value of five hundred and twenty million dollars. One major issue that I see potentially in this deal is, Air Canada is the country’s number one carrier and Air Transat is number three. So major potential competitive issues there if they do strike a definitive agreement, this will require antitrust approval through the Competition Bureau.
Getting into some marketshares, I have some numbers in front of me her. Between the two, the airlines would have about 60% of transatlantic tickets and 46% of winter holiday seats to Mexico and the Caribbean. Given these numbers, in my experience you see the Competition Bureau express serious concerns with respect to a merger. If market share goes above 30% and some of these business lines they’re as high as 60%. So, you better believe that the Competition Bureau will look very closely at this takeover and could demand pretty major concessions out of Air Canada if it wants to close the deal to get the Competition Bureau onside and reduce the market share of these combined airlines.
Just some background on Air Transat, what they do is they sell vacation packages and air travel to 60 destinations in the Americas and Europe. Its fleet includes Airbus, A330s and Boeing S737 and 800. It’s kind of been a self-help case struggling over the past number of years and that’s where the share price was so low quite a bit below an all-time high set a number of years ago. It actually had a net loss of twenty-four point five million in 2018. Basically, caused by increased competition from Air Canada’s low-cost carrier Rouge, WestJet vacations and also Sunwing. It had a plan to invest 750 million to build hotels in destinations, such as Mexico. But this was really panned by analysts as being too risky and also taking too long to materialize. Clearly Air Canada saw an opportunity here from the press we read, there were some other bidders interested. But there’s an interesting dynamic here on the Quebec angle. So, Quebec is very very interested in being involved in corporations’ business. By this I mean they don’t want to lose head offices. They really value that. So, there’s a lot of political interference in M&A activity on any Quebec based company. Not just that, but Québec’s current premier François Legault, he’s actually a co-founder of Air Transat, which is really interesting.
He said the deal would be good for the province since both companies are based in Montreal. He really didn’t want to see it neither did any other Quebec politician go to, not just a foreign company. But even a company outside of Quebec such as WestJet, which is Calgary based. Some quotes here from co-founder François Legault, he says it’s a lot of emotion for me. Because of course I was there for the first flight of Transat with all the employees crying with joy. Of course, being bought by our competitor of the time is not easy to accept. But the good news is that Air Canada has a headquarters in Montreal. So, I’m happy to see the headquarters will stay in Montreal if the transaction is closed between Air Canada and Air Transat.
Some comments from provincial officials, they said that they prefer that transit is not stripped down by any new owner, that its head office remains in Montreal and that it continued to grow as a corporate entity in the province. Now behind these comments they do have some teeth. Because they control their pension funds and the government said its mandate, its investment arm to prepare to support a local buyer if needed and you have heard rumblings of a few other Quebec-based people discuss a potential bid for Air Transat. But with respect to a versing or going head to head with Air Canada, a much better capitalized entity and a company that would have significant synergies, it’s really going to be difficult to top Air Canada here, what are your thoughts on this one?
Mike: Yeah and it’s interesting that you mentioned some of the regulatory side. Because the break fees, in terms of the structure of this deal, the break fees do kind of represent some of that difficulty where there’s a break fee of 15 million dollars payable by Air Transat, if they terminate because of a higher bid. I believe if it’s more one dollar per share higher and then a reverse break fee of actually forty million dollars payable by Air Canada if the agreement is terminated. Because those regulatory approvals aren’t obtained. So, it does provide them with a lot more incentive to come to terms with the Quebec government. In terms of yeah some of those previously rumored interested parties where Quebec or and then Onex itself. So, this view can, in terms of the Air Canada rationale for this deal. It can be viewed as a little bit of a defensive move to ensure that WestJet with Onex is backing, doesn’t go after transit. However, since Air Canada has more experience flying in Transat’s markets, they are likely to realize more synergies enabling them to pay a higher price than WestJet slash Onex. But in an end as well Transat is in like in terms of their routes, they’re in many of the same markets as Air Canada currently. So, in the winter the Caribbean routes and then in the summer some of those transatlantic routes.
Julian: Yes, some of the strategic initiative behind this, this deal offers Air Canada new seat capacity and in-place Airbus orders at a time when some of, I guess all of Air Canada’s 24 Boeing 737 max planes have been grounded just given those two previous crashes happened globally and basically all the 737 max planes are currently grounded until Boeing is able to figure that problem out. You touched on the reverse breaking at forty million, which I think is really interesting on a 540-million-dollar deal. Because this would be classified is a very large break fee, eight to ten percent. Almost ten percent of the deal value and this shows that perhaps Air Transat Board of Directors was fairly you know, they knew it was a high-risk deal from a competitive perspective. So, they do want some cushion in case it is rejected by the regulators. Perhaps this signals that they don’t have high confidence in the closing. Because that reverse break fee of 40 million dollars would be pretty significant compensation for a block from the regulators and clearly Air Canada seems like they are willing to take on that risk. So, it must be a fairly strategic deal for them.
Mike: Yeah and one other thing that I’d like to mention as a disclosure is that, one of Accelerate’s funds does hold a position in Air Transat.
Julian: Just wanted to touch quickly on a few economic data points coming out of China this week. For the month of April, Chinese data came in pretty negative as April numbers for factory activity, investment and retail sales all trended downward. April retail sales growth came in at 7.2 percent. This is a pretty big reduction from the eight-point seven percent one year ago and a substantial miss of street consensus of an eight-point eight percent average analyst’s expectation for April retail sales. Industrial output gained a 5.4 percent in April from year earlier and this slowed markedly from an eight-point five percent year-over-year increase in March. Well investment in fixed assets such as infrastructure, during the first four months of the year rose 6.1 percent year-over-year. This is slower than the six-point three percent pace this March. So, all three Chinese economic data figures heading downward, coming in below expectations. Not the best data coming out of China as we’ve kind of seen year-to-date, what are your thoughts on these numbers and China in general?
Mike: Yeah one thing that I found interesting in addition to some of the industrial output was specifically in auto production as it dropped 16 percent with demand weak while auto sales dropped 14.6%. Which was the tenth consecutive month of decline and so in terms of the consumer sentiment in China, it’s really showing negative consumer sentiment as you’re not going to be buying these durable goods. Like a car, you know dishwasher things like that, those larger capital items, if you’re not very confident about the future and the Fed is kind of assumed that this would be the stabilizer. But if they’re going to want the consumer to be their stabilizer, it does appear that they’re going to have to enact future policies to keep consumption as that stabilizer. Which could be you know rolling out further targeted tax cuts and subsidies to own middle income groups.
Julian: So, from the perspective of this ongoing trade war between China and the U.S, what China has been saying is in their country they’re saying that the U.S tariffs, they’re not going to be damaging on the economy. Because the Chinese consumer is going to be there as a replacement to drive economic growth. But what these figures are saying, specifically the retail sales figures which came in significantly below estimates, they’re saying that that’s just not happening. China continues to be an export-driven economy. They’re not going to be rescued by the consumer. I mean these numbers were, they were pretty bad, far below expectations and to me as I’ve been saying adnauseam in the podcast the last few months is that, the U.S is winning this trade war. Clearly the stock market of the two countries show this. Not just that, but all the economic data coming through also shows this.
The data come in from China just consistently below expectations and the data from the U.S consistently above expectations. The bottom line for me is I think at some point China cracks, comes to the table and gets a deal done with the U.S just because they need it more than U.S does.
Interesting move by Trump potentially stirring further drama in the Chinese trade war is he banned Chinese technology and networking company Huawei from the U.S 5G networks. So what Huawei does is they are one of the market leaders globally in cell phones and they also make networking technology specifically for the next generation of cell phone networks, that being 5G. Huawei is the lowest cost producer of 5G networking equipment. What the Trump administration has done, they moved to ban Chinese networking company Huawei from the U.S market. This not only bans them from effectively the largest market in the world, but there’s also pressures other nations to take a look at banning Huawei as well. I know Australia has done the same. I believe the UK is in the same boat as well.
Mike: New Zealand as well.
Julian: Yeah New Zealand there. So, in moving to cut off this Chinese corporate champion, because Huawei is rumored to have very close ties with the Chinese government. So, in doing this, the U.S really risks spurring increased trade war tensions. Interesting to note there’s also a bill sitting in the Senate Judiciary Committee called the China Technology Transfer Control Act. What this would do if put into law, it would put all core technologies develop to China’s quote “made in China 2025” technology push on the Commerce Department’s expert control list along with Huawei. Now getting into this China has a made in China 2025 initiative. Where they’re really trying to take leadership position in industries such as electronics, semiconductors, chips and they really want to become a technology leader. But what this bill does is the U.S is really trying to cut China off at the knees here with respect to their drive to become a technology leader and by putting them on the export control list that’s effectively banning all Chinese technology developed under this made in China 2025 technology push. So that is a pretty big shot there from the U.S.
Getting more into it, what China, made in China 2025 is meant to be, it’s meant to be the next phase in China’s plan to evolve its economy into a major player in the global technology market. For the past number of years, they’ve been trying to buy semiconductor companies overseas. But the U.S and other countries I believe specifically Germany have really put a stop to that. Because there’s increasing concerns that China is utilizing the Chinese corporations such as Huawei to conduct covert spying surveillance operations in foreign countries and I know Canada is perhaps looking to ban Huawei as well. Certainly, interesting implications for 5G tech and even wider implications for this potential trade war and Huawei’s relationship with the Chinese government. What are your thoughts on this situation here?
Mike: Yeah and so back to your earlier point is that in disrupting the global supply chain, this really has far-reaching impacts on many different companies, as under these rules foreign companies wouldn’t be able to sell any products containing or any products containing U.S parts and components to Huawei either and so just to put that into perspective, Huawei spent, I believe it was 70 billion dollars globally on components and within that there was 11 billion dollars spent on U.S components and so many of those components are bought from U.S. chip makers, such as Broadcom, Qualcomm, Intel, components as well from Microsoft and Android as well and so these are, this is going to have a big impact on a lot of these chip makers as you’ve seen over the past week, the chip makers, their share prices come under quite a bit of pressure.
Julian: Yes, significant knock-on effects here. Not just on Huawei and its competitors, suppliers, customers and 5G networks globally specifically in developed nations. But pretty big implications on a potential trade war between U.S and China and implications on Canada too as well. Because what happened in Canada was with the founder of Huawei, his daughter’s actually the CFO and she got arrested in Vancouver for to be extradited to the U.S and China has struck back at Canada arresting a bunch of citizens, Canadian citizens in China, stopping imports of canola from Canada into China. I think they’re having issues with soybeans now. So very very far-reaching implications, clearly Huawei has close relations with the government even though they claim not to. So, it’ll be really interesting to watch how this situation develops.
Put out some research this week and it’s called AlphaRank. Now what AlphaRank is, it’s our monthly publication of our data platform, our alternative data that we produce here at Accelerate. It represents Accelerate’s equity ranking according to our proprietary multi-factor model. What it does is AlphaRank assigns a numeric value to each stock in North America. The scores go from zero, which are bottom rank to 100, which are the top ranked stops. Based on selected predictive factors which I’ll get into. All Canadian and U.S stocks priced above buck 50 per share and a hundred million market capitalization are evaluated.
Looking at the report here, what we do is we put together the entire universe we rank at the end of each month all the equities in Canada and U.S. So, we have a top and bottom Canadian and U.S stock list and what we rank these stocks on, basically a five-factor model and each factor is a composite of what I call sub factors. So, on to the top-ranked AlphaRanked list, what we’re looking at here are stocks with an attractive valuation that are of high quality with good price momentum, positive operating momentum and a great share price trend. On the opposite end for bottom ranking, what we are looking at our low-quality companies with a high valuation, bad share price momentum, negative operating momentum and a poor share price trend. So, some of the implications of this or things for investors to look out for, obviously we believe the top-ranked Canadian stocks, top ranked U.S stocks are attractive buys, attractive to be owned and on the other hand bottom ranked AlphaRank stocks we feel the opposite. You know perhaps to sell or a short position. Although none of this constitutes investment advice of course and these are just our AlphaRrank proprietary system, which in fact some of our hedge fund strategies are based off of.
Mike: So, Julian you mentioned some of the use cases on the positive side for the AlphaRank. How wouldn’t you use the AlphaRank list?
Julian: So, tell you how we use it within our fund strategies, we don’t straight go long all the top ones and short, the bottom ones specifically short selling. There’s a number of things that you need to keep in mind. You want to have a diversified short book and sometimes an AlphaRank, like for example AlphaRrank in U.S we have a lot of, I call a low quality speculative pharmaceutical companies. We don’t want too much sector concentration in any one sector, especially on the short side is the thing with respect to short selling. You have to take into account short borrow rates and availability. Which AlphaRrank does not. But that does not affect a sell decision if you’re long a bottom ranked stock. You could certainly look into selling it. But short selling it securities are something different. So, when utilizing this, we definitely take it into account running a risk model and utilizing a bunch of different constraints. Whether it be liquidity, sector exposure, factor exposure etc. But we do believe that it’s something that’s really worthwhile looking at. Running any names, your whole long and short in your portfolio against the AlphaRank to see where it in fact stacks up in the universe and also, it’s probably a good list to take a look at if you’re looking for investment ideas either long or short.
Mike: Just to clarify with when you’d mentioned a risk model, it is really just a way of insuring that you’re taking the types of exposures that you’re wanting to and what I mean by that for example if you are looking to be long value stocks, let’s say you’re wanting to be long short value stocks and all that would mean is that you’re not just ending up with some sort of sector tilt, because of this choice. For example, long financials / short technology, the risk model helps you become more sector neutral and ensure that you’re taking the only the risks that you’re wanting to be taking.
Julian: Yeah basically you do want a diversified portfolio and you see some portfolios that are perhaps forty oil and gas stocks, but they are highly correlated and what a risk model does is help you establish you know a better portfolio. That minimizes correlations between securities. So, it eliminates that sector bias or highly correlated securities that act very similar. Take that out and basically establish a portfolio of stocks that move independently of each other or as much as possible.
And that’s it ladies and gents for Episode 14 of the Absolute Return Podcast. As always you can check out more episodes on www.absolutereturnpodcast.com. We will be gone for this week. But we’ll chat with you next week, have a good weekend. 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.
