June 19, 2019–Germany Sells 10-Year Bunds Yielding -0.24%. Is The Bond Market The Real Dumb Money?
Online Pet Supply Retailer Chewy Soars Nearly 90% In Its IPO. Does Its Valuation Make Sense?
China’s Industrial Output Growth Slows To 17-Year Low. Is China Losing The Trade War?
Investors Seek To Take Retailer Hudson’s Bay Co. Private. Are Shareholders Getting A Fair Price?
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 investors to Episode 18 of The Absolute Return Podcast. Today is Monday June 17; we are a few days late recording the podcast. That was because my co-host Mike here wrote the CFA Level 3 exam over the weekend, the Chartered Financial Analyst exam. Did mine a number of years ago so I’m sure it feels great for him to get that off his plate for now but this week we have a number of interesting topics to discuss, off the top:
- There is Germany selling 10-year bunds yielding negative 0.24 percent. We are going to talk about is the bond market really the dumb money here?
- Online pet supply retailer Chewy. They soared nearly 90 percent in its IPO last week. Does its valuation make sense here?
- China’s industrial output growth slows to 17-year low. Is China losing the trade war?
- Lastly, investors seek to take retailer Hudson’s Bay Co. Private. Are shareholders getting a fair price at this level?
Some interesting action in the bond markets this week, and one thing that we really touched upon a number of times over the last few months of the podcast, it is really been happening over the last number of years. Is the concept of negative yielding bonds globally, which I believe Deutsche Bank came out with a figure last week saying there’s 12 trillion dollars globally of sovereign debt yielding negative rates of return. This is one of the first times that government has capitalized on this and actually got paid to issue debt. What happened here was Germany sold 10-year bonds or boons as some people like to call them. Yielding negative 0.24 percent that is the lowest yield on record that they have ever sold debt at, what is interesting and shocking is that investors buying this are guaranteed a negative rate of return. It is a guaranteed loss if you hold these until maturity. You have investment with a guaranteed loss yet this 22 billion euro issue generated investor demand of more than 60 percent of the twenty two billion offered, which is pretty shocking in my opinion.
This yield was well below the minus .07 percent that previous 10-year auction yielded in late May. Germany the government is getting even better prices here. They’re getting paid even more by investors to take their money. A previous trough a minus 0.11 percent this, was recorded in 2016. Like we said, negative yields have been happening for a number of years but it just seems to be getting more and more negative. Highly rated bonds have rallied in recent weeks as concern over the global economy particularly this US-China trade war, which we have been discussing every single week on the podcast. This has sparked expectations that major central banks will assume a more dovish posture and pursue rate cuts. And so by a dovishness we just tend to mean rate cuts globally not just that but additional potentially quantitative easing measures or just halting any sort of quantitative tightening that they have been engaged with. We recently discussed how in the U.S. they recently stopped their bond roll off the balance sheet. You see the ECB the European Central Bank becoming increasingly dovishness, just last week the ECB promised to hold rates at historic lows until at least mid-2020. This is pushing out their guidance they previously indicated they would hold rates at record lows until late 2019.
The guy running the ECB Mario Draghi. He indicated he was prepared to use, quote “all instruments that are in the toolbox.” That just kind of indicates his level of dovishness. That reminds me of back a number of years ago when the Eurozone was really in crisis. You had Grexit to worry about, a number of sovereign bond yields going really high. Remember Italy yielded to 7 percent. Greece was about to default, he indicated he would do whatever it took to keep the euro together and that central bank actions seems to have calmed that market panic, a number of years ago. So never, underestimate the power of central bankers.
How this relates to U.S. rate cuts with yields declining globally. The implied odds of at least one quarter point reduction to the Fed’s benchmark rate now sits at a stunning 98 percent. The market believes it is a near certainty that the Fed will cut rates this year. With two or three quarter point cuts being the most likely scenarios. In the bond market, you have 12 trillion dollars globally sovereign bonds with negative yields. That means investors buying these are a guaranteed to lose money. In my opinion that is just a dumb trade right there. I am branding the bond market as a real dumb money. It is no longer retail investors. It is the bond market. What are your thoughts on this craziness going on in German fixed income?
Michael Kesslering: The first question that comes up is who is buying these bonds? And really there’s kind of two separate groups. You have institutions that have to own government bonds for liquidity requirements or to pledge as collateral when borrowing in money markets.
Julian Klymochko: They are effectively forced buyers.
Michael Kesslering: Exactly, as well as within that I would probably group the overall like government bond ETF once again they are forced buyers. These bonds or are going to be a part of government bond indices. If you are passive, ETF you have to hold these there is no real credit decision there.
Julian Klymochko: But counter to that. You do have investors, I guess active investors.
Michael Kesslering: Yes.
Julian Klymochko: Allocating to that ETF. Those guys must be the dumb [Laughing].
Michael Kesslering: Yes. What you should see in an ideal scenario is that there is outflows from those ETF providers. I don’t have any data to support that. Then the second group would just be speculators that believe that they can profit from the price appreciation on these bonds. Their rationale would be yes these are negative shielding right now, but that they are going to yield even more negatively in the future.
Julian Klymochko: Right, that is a speculative trade where you are buying an overvalued asset. Betting on the greater fool theory that someone else is going to come along and pay an even higher or more overvalued price for that asset. It is just a straight speculation not an investment.
Michael Kesslering: Absolutely, and the other thing that I just want to point out that just generally that this kind of puts the whole finance and valuation on its head. When you are typically using discount rates to value assets. Having a negative discount rate really throws a wrench into that machine evaluation.
Julian Klymochko: Certainly and there’s a couple of things I wanted to touch on that you discussed. The first one being who is buying these? And you mentioned those two parties, but the third one. I think a major reason why we have so much debt globally; sovereign debt trading at negative yields is just the central banks. The ECB is buying up as many bonds as they can in their quantitative easing measures. They are trying to get interest rates low to spur the economy. The euro, euro zone really has not been growing at all since pretty much 2009. You have had a number of countries there go through multiple recessions whether it be Greece or Italy. Some of the major economies in the Eurozone, then moving on to Japan. I mean the Bank of Japan has had you could call it MMT or Modern Monetary Theory, which is pretty extreme monetization in which the central banks are buying all the government debt. The government is effectively funding massive deficits just by issuing more and more bonds in which their own central bank goes ahead and purchases. I think that is one of the main reasons, why we have such an incredible amount. As I said 12 trillion of negative yielding debt worldwide and that is negative on a nominal basis. If you take inflation into account assume inflation is 2 percent then you’re going to be losing north of 2 percent of your purchasing power each year. In my opinion, pretty dumb trade and investment.
Another thing you talked about was the negative discount rates in terms of valuation. I really think we have seen that manifest in markets over the past 10 years. Where you have had tremendous outperformance on growth stocks, highly speculative story stocks or as I call them glamour stocks that are perhaps burning a ton of money just to show revenue growth whether it be Netflix or some of these story stocks IPO these days at tremendous valuations. Uber, Lyft all burning a ton of dough, investors typically invest for profit but these companies are burning a lot of cash just to get revenue growth current year to perhaps earn a profit sometime in the far distant future.
The thing with zero or negative interest rates is, you don’t discount those future positive cash flows that are way in the future. Meanwhile if interest rates normalize to 4-6 percent then those future profits of these speculative entities the discounted value of those would come down pretty remarkably. I believe a rise in interest rates would really hurt the present value of these glamour stocks and these more so tech related companies / growth entities. I think that is a big deal having negative interest rates it is really thrown investors for a loop where you have had a massive underperformance of value stocks and tremendous outperformance of these growth or glamour stocks. I think in my opinion is that this has largely been caused by these zero or negative discount rates negative interest rates worldwide.
Michael Kesslering: Absolutely and you look at the U.S. you have the equity markets have been on an absolute tear. In Europe they have not been as much so. When you are looking at the favour ability between bonds and just losing you know 25-26 basis points on these bonds vs. equity markets that have been a lot more volatile than, perhaps it is just that decision to lose a little as opposed to having the risk involved more volatility.
Julian Klymochko: Right, and as an individual investor you probably don’t think about it because you can put your money in a checking account, savings account earn a little bit of interest but when you have 10 billion dollars it’s not so simple just to open up a checking or savings account at your local bank. Unfortunately, a lot of these fixed income buyers are forced buyers. You obviously see pensions and endowments moving up the risk scale allocating to more alternative investments moving out of fixed income especially on the sovereign bond side moving more so into hedge funds, private equity, real estate. Things of that nature in order to seek higher yielding returns.
We had a big IPO last week with online pet supply retailer Chewy soaring nearly 90 percent in its IPO. Some price action – it rallied as high as 41 bucks per share and stock market debut after selling the shares in the IPO at 22 bucks per share and raising one billion of equity capital. This was increased from the initial IPO range of 19 to 21 bucks a share. Chewy using the ticker C.H.W.Y was valued at 14 billion dollars once its shares chart started trading.
Some shareholder dynamics. PetSmart a private company, I believe it is private equity owned. It remains a majority owner of Chew with a 70 percent stake in the company and a 77 percent controlling interest. We have the dynamics here of a fairly low float IPO which tends to be somewhat manipulative where they offer only a limited amount of shares. They know that demand is going to overwhelm supply and they seek to get that very high valuation and that typical IPO pop.
Some background PetSmart acquired chewy.com for three point three five billion in 2017. At that time, Chewy had 900 million in revenue and 107 million dollar operating loss. They are losing a lot of money here. Two years later, currently the market is valuing Chewy at 14 billion so nearly fourfold increase in valuation. Now that as two point one billion in revenue, sales went up threefold and a three hundred and thirty eight million dollar operating loss. They managed to lose almost four x the amount of money and got pretty massive valuation bump. I believe five x valuation bump just had a massive increase in losses but also growth in revenue as we recently discussed. The market really seems to be rewarding companies growing their top line at any cost even if it comes with massively spiralling losses greater and greater every year. The market seems to be looking past that. Perhaps that is correlated to the negative interest rates.
This really goes with the trend that we have seen in IPOs. We have been commenting on a lot of different IPOs. Whether it be Beyond Meat, video videoconferencing company Zoom, software company PagerDuty, they have all surged since going public. Pretty tremendous IPO pops on that one even though the broader market has kind of been a bit choppy. You have had a couple of high profile struggles such as Uber and Lyft. Nonetheless, my opinion the IPO window here is wide open especially if you are a high growth company that is effectively selling dollars for 95 cents. With that business model, you can certainly take market share. You can show tremendous revenue growth. But will they ever show profits? That ultimately lead to sustainable business and a good share price performance over the long term.
I would be remiss if I did not comment back on pets.com, which was pretty much the exact same business model as Chewy although it happened 20 years ago. When the tech boom was really going wild in the late 90’s up to the year 2000, pets.com they had their infamous sock puppet and Super Bowl commercial. They went public, wild IPO pop and went bankrupt less than a year later just because investors really soured on funding these loss making Internet companies. It will be interesting to see just keep that in mind if you do plan on trading the stock. Word of caution there, we have a good precedent for a company with the exact same business model that was heavily hyped but ultimately went bankrupt quite quickly in the midst of spiralling losses. What are your thoughts on just these crazy IPO as we have been seeing lately?
Michael Kesslering: I mean you mentioned some of the IPO that have done well but we did see last month the Uber IPO which was somewhat of a disaster and looking back after that. Some of the investors in IPO shows they were kind of concerned about how this next one was going to go. You are seeing a lot of strength within Beyond Meat and now with Chewy but really looking at Chewy specifically they’re capitalizing on a recent trend of increasing average spend per pet among U.S. households which has been trending upwards over the last 10 years. That is an interesting thing that they are they are really kind of dialling into. The other aspect when looking at them as opposed to a company like zoom that has a lot higher gross margins is that Chewy really only has I believe it’s 22 percent gross margins. There are just a lot less benefits to scaling, the traditional mind-set with these companies that are growing revenue at a massive rate but have large losses. Is that eventually they’ll kick the critical scale where they will be able to realize all these benefits of operating leverage where they have a high fixed cost base but they’re able to dwindle that down on a per unit basis. This is not a business model that is structurally suited towards that. I mean In terms of that the valuation it is quite crazy. The other interesting aspect is that their revenue growth is actually been slowing. Last year they did grow at about 68 percent but in their most recent quarter, that growth had slowed to about 40 percent. Still substantial growth rates but those growth rates are coming down a bit.
Julian Klymochko: That is interesting you brought up the topic of operating leverage and it’s really important when evaluating the business models to determine what sort of operating leverage the businesses have. You mentioned Zoom, which as it scales you see a nice growth in operating profits, but a company like Chewy who seems to have negative operating leverage. That means as they grow more and more, the more they sell the more money they lose. At some point, they hope to turn that around but a lot of the times that doesn’t happen. It just kind of gets overwhelmed and the other thing with companies with negative operating leverage is they are highly sensitive to market conditions because they rely on capital markets to fund these increasing and seemingly infinite never-ending losses. If the market, the window for equity or debt financings for these companies with negative operating leverage and rising losses if that window ever closes, then it is effectively lights out for the business and these things can go bankrupt which did happen to effectively you could call it a predecessor type company pets.com in the tech boom of the late 90s early 2000s.
Michael Kesslering: Absolutely and in terms of the capital markets window is, you typically do see a strong demand for IPO but secondary offerings of shares are a different beast. That is a kind of a word of caution for some of these IPO investors when the company does look to tap markets in the future.
Julian Klymochko: For sure, so focus on sustainability of the business and keep in mind that things are getting pretty crazy in IPO land and this could be a tech bubble 2.0 or IPO bubble 2.0, something to keep an eye out.
Touching on the US-China trade war here. Interesting numbers out of China. We have been discussing it for the past number of months just increasingly negative data points coming out of China’s economy. We had another one just like last week, which industrial output growth is slowed to a 17-year low. Came in at five point zero percent compared to analysts’ expectations of 5.5 percent, so pretty substantial miss on the industrial output growth in China. Another interesting aspect is that after this data was released China’s central bank announced another 300 billion yuan stimulus to smaller domestic banks. Certainly Chinese central bank is really getting heavily involved in the economy with pretty significant stimulus but at the end of the day this is just another negative economic data point and a warning signal and a clear sign that China is ultimately losing the trade war with the US. It’s not only in their stock market showing this which has had a relatively rough ride versus the U.S. markets which are within 2 percent of all time highs you really seeing it come through the economic data numbers which are coming in worse and worse seemingly each month. We believe that trend is going to continue. Quote here from Capital Economics research firm they indicated, “The weakness in May and April’s activity data suggest that economic growth is likely to slow this quarter and increase the likelihood of additional monetary easing in the coming months.”
My thoughts are that instead of China reforming its economic policies to settle trade tensions as it should it continues to turn to fiscal stimulus which is continuing to lose effective at least not just that but I mean it seems like they’re just pushing on a string here with respect to stimulus. It gets less and less effective each time. What are your thoughts on what is happening in China with respect to the growth numbers and the stimulus that they seemingly have an unlimited amount?
Michael Kesslering: Yeah, with the stimulus package that they announced as well as they are likely to further cut the banks’ reserve requirements to encourage additional credit support. This was something that we brought up about a month ago on the podcast as a possibility and especially with regards to the reserve requirements, is they’ve actually cut these six times since the beginning of 2018. It was not a novel prediction of any sorts, but it is just going to show how much they are as you mentioned China push on a string and it is just becoming less and less effective. The interesting metric that I noticed was that power generation grew just zero point two percent over the past month which is traditionally been used as a proxy for growth in China.
Julian Klymochko: Yeah.
Michael Kesslering: It is a little bit more accurate.
Julian Klymochko: And that was the slowest rate since 2016.
Michael Kesslering: In terms of other economic drivers, you are seeing a slowing in real estate, construction starts and these are all areas in addition to infrastructure that the Chinese Government has used to, indirectly provide stimulus especially with infrastructure spending.
Julian Klymochko: Right and stimulus is no panacea. Certainly, it helps combat some economic weakness temporarily but ultimately China clearly needs structural changes. Large structural changes and not just that but effectively legal changes in their legal system to effectively change their economies such that it’s more sustainable not just for their own sake but on a trade sake they need to tighten up relationships with the U.S. and other large trading partners. Just to be more balanced, because it is really starting to bite them here. We are seeing it not just in the stock market, but it is really coming out in their economic data figures. They can really only hold out for so long until they realize that something needs to be done or else they can start talking about the R word recession which they haven’t seen in a while but I think ultimately at some point all these stimulus measures really will cease effectiveness in combating this pervasive economic weakness.
Moving on to some M&A. Investors seek to take retailer Hudson’s Bay Co private. Are shareholders getting a fair price here? Well what happened was a group of investors including HBC Hudson’s Bay executive chairman Richard Baker along with co-working company Wework and private equity firm Rhone Capital. They offered to take HBC private effectively buy out the minority shareholders at nine dollars and forty-five cents cash per share. This represented a takeover premium of 48 percent which is a fairly sizable takeover premium but I mean HBC was down in the six dollar and change range being basically an all-time low. This investor group already owns about 57 percent of the company so they are looking to acquire the remaining 43 percent of the equity.
Some background on HBC along with its namesake Canadian chain Hudson’s Bay. They also own Saks Fifth Ave and Lord & Taylor. Some stock price performance was down nearly 50 percent over the past year. Prior to this one point seventy four billion takeover offer being made but prior to unveiling this go private offer the stock had lost almost two thirds of its value since its IPO in 2012. Certainly extremely poor share price performance negative business performance since it went public seven years ago. A quote here from the executive chairman Richard Baker he stated quote, “We believe that improving HBC is performance will require significant time and patient long term capital that is better suited in a private company context without the emphasis on short term results and returns. While we continue to believe in HBC long term potential, it has become clear that the significant challenges risks and uncertainties facing HBC and the rapidly evolving retail environment are best addressed in a private market setting.”
That is the quote from HBC executive chairman and large shareholder Richard Baker. This transaction would be subject to approval of the majority of the remaining shareholders so they got to vote it through to get it done. The deal’s timing was sparked by investor’s frustration that the public markets have not recognized the steps that Hudson’s Bay has taken over the past year and a half to improve shareholder value. It did a number of things such as selling Gilt, which they really just acquired it, was one of these online flash sales companies, which was pretty much a disaster. They shut down Home Outfitters, home décor chain as well and they have been selling a number of real estate assets. What I find problematic with this bid, obviously the share price has been extremely poor. I believe the IPO at 17 bucks per share in 2012. Seven years ago and the stock was recently at six bucks and now they are trying to take it out for nine forty five. Well I remember a number of years ago HBC was telling investors how valuable their asset base was. They have a substantial amount of prime real estate.
Saks Fifth Avenue in Manhattan you have all these flagship stores. Hudson’s Bay has been around for nearly 500 years. Over time, they have really gotten some flagship real estate developments and in many major cities. HBC indicated that their net asset value was as high as forty-five dollars per share and not just that but their new CEO recently bragged to investors only in September. Just last year less than a year ago that HBC is real estate alone was worth 28 bucks per share, and now you are management trying to buy it out at nine dollars and 45 cents per share or a two thirds discount on that recent value peg by the CEO. It really seems like just really poor performance by management and the board here, not recognizing any of that net asset value for public shareholders or effectively trying to steal it for pennies on the dollar from public shareholders and effectively take all those profits for themselves. Being the spread between the takeout price 9.45 per share and the resulting net asset value if they’re able to monetize these real estate assets that could be worth seeing at all over the map. At least 28 to forty five dollars per share is some material upside from management here. In my opinion, it seems public shareholders really getting a raw deal. What are your thoughts on this deal?
Michael Kesslering: Yeah I guess. The question, is where it goes from here? Because right now just looking at the current trading of HBC it is trading at nine dollars, it is around nine dollars and 75 cents.
Julian Klymochko: Through the terms.
Michael Kesslering: Yes, so that is indicating that the market believes there will be a bump in terms of the price offered. When you mention what the estimated net asset value is, that is just a small percentage. They can bump it very substantially and still be in a good position to realize great value for themselves in this situation. The other interesting aspect in this deal to watch will be the involvement of Land and Buildings so they are a U.S. based activist investor. I believe they took their stake in early 2018.
Julian Klymochko: They are a pretty major HBC shareholder.
Michael Kesslering: Yes and they have been pushing management to realize value for shareholders since that involvement.
Julian Klymochko: When you are talking about Land & buildings there a real estate expert.
Michael Kesslering: Yes, so they are known as experts in the space. The basis of their thesis is based on the value of real estate and spinning off those realizing the value of those. They have not made any official comments but there is some news reports that have indicated that they believe that the offer undervalues the company, which is not surprising. What will be interesting to watch is what action they take.
Julian Klymochko: Exactly. Interesting article today in the Toronto Star and you see media starting to pick up on the fact that HBC does have tremendous unlocked value in their real estate. You have a group of insiders really looking to capitalize on the low share price caused by effectively their own poor performance in operating the company. You have had years of back-to-back losses continuing decline in same store sales growth negative growth there. The Toronto Star and today put out an article and it said quote, “Hold out for 15 bucks.” End quote. Even the media are recognizing this tremendous delta difference between this nine forty five offer and the real estate value which could be at least 30 bucks and perhaps even higher than 30 bucks a share. I think public shareholders should recognize some of that value and the market starting to catch on. I mean like you said it’s now trading through the terms meaning it’s above the nine forty five cash pressure operating its 9.70 probably close to 9.80. What does that tell you? Well it tells you that the market is saying we want a better price.
That wraps it up for this week’s podcast episode 18 of The Absolute Return Podcast. Hope you enjoyed it, if you did you can check out more episodes at absolutereturnpodcast.com. You guys have a good week and we will chat with you soon, cheers.
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