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Absolute Return Podcast #31: The Activist Hedge Fund Playbook

By September 16, 2019 No Comments

September 16, 2019—Activist Hedge Fund Elliott Management Targets Conglomerate AT&T. What does the Activist Investor Want?

Business Legend T Boone Pickens Dies at 91. What Made Him so Notable?

Hong Kong Stock Exchange Goes Hostile for the London Stock Exchange. Why is this Potential Deal so Interesting?

ECB Cuts Rates and Restarts Quantitative Easing. Why did they do it?

It’s a Momentum World and You’re Just Living in it. A Discussion of August Factor Performance.

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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 investors to Episode 31 of The Absolute Return Podcast. I am your host, Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering.

Julian Klymochko: Today is Friday the 13th, of September. So if anyone’s superstitious out there hopefully you don’t suffer any bad luck. And on the markets, we had a pretty calm day today, but quite the week have a lot going on. Some interesting topics to discuss on the podcast this week off the top.

    • There is activist hedge fund Elliott Management. They targeted a conglomerate, AT&T with a new activist campaign. We are going to chat about what, Eliott wants here and the activist playbook.
    • Business legend T. Boone Pickens he passed away at 91 years of age. We are going to chat about what made him so notable.
    • Big news in the M&A space with the Hong Kong Stock Exchange going hostile for the London Stock Exchange. Why is this potential deal so interesting
    • And some macro stuff: We had big news out of the ECB as they cut rates further into negative territory and restarted quantitative easing. Why did they do it?
    • Lastly, we are going to talk about a factor performance for the month of August.

Feared activist hedge fund Elliott Management, they disclosed a three point two billion dollar stake in media conglomerate AT&T this week. What they did is they came out fast and criticized the company’s strategy and leadership. Now, this campaign is notable because Elliott, their stake is over three billion dollars. However, AT&T, its market cap, is nearly 300 billion. Elliott is coming out swinging with a stake of only about 1 percent, which typically an activist will take a stake of between 5 to 10 percent, such that they have pretty significant control or influence over a company. This campaign off the top is just notable due to such as a small portion of the company. We are going to get into specifically some of the criticisms that Elliott has with respect to AT&T.

Number one is just AT&T, its track record of M&A, some of their mergers or their acquisitions have been questionable. In addition to that, they question management as well. Elliott is urging AT&T to end its acquisition spree and focus on operational improvements. They had negative things to say about AT&T’s recent acquisition of Time Warner, which was an 85 billion dollar deal, and Direct TV, which was nearly a 50 billion dollar deal.

Elliott believes following its playbook would boost the stock nearly 60 percent by 2021. So that would be a pretty exceptional shareholder return if this comes true. I mean, this is all highly speculative, but Elliott’s playbook behind this activist play on AT&T is they should divest certain businesses, they should cut 5 billion of costs and they should cease their M&A spree. This is basically most of the initiatives in the standard activist playbook being, margin expansion through cost cutting. That is a big one. Debt pay down, a big one that activists really like are share repurchases. You reduce the float of shares, which boosts earnings per share. So you have earnings per share growth and you don’t even need revenue growth to attain that. The combination of margin expansion through cost cuts and share repurchases, this is like a double whammy, a double multiplication on earnings per share growth, which will ultimately grows the share price.

Their theory is that with these changes, they will drive nearly 10 percent annual earnings per share growth. That is one method to get to that 60 percent return over the next two years.

The other is they believe if investors start to see this earnings per share growth, that the market will ascribe a much higher multiple on AT&T stock, meaning investors are willing to pay more for a set amount of earnings per share. They believe that with its earnings per share growth and combined with AT&T is attractive dividend yield, that AT&T can immediately become a low to mid double-digit value compounder.

Investors on the news are pretty happy with it. I mean, the stock went up one point five percent and to drive a stock that’s nearly 300 billion dollars in market cap higher, that’s a pretty impressive feat. I mean, it is early days on this activist campaign and you can tell AT&T is likely already doing some of these activities that Elliott wants them to do. Ultimately, it is really, I admire their chutzpah behind this activist campaign to go over such a massive target is certainly new to them. What are your thoughts on this really interesting and stunning activist campaign that really has no lack of confidence from Elliot?

Michael Kesslering: Absolutely, and Elliot is known for their confidence in their activist campaigns as we spoke about them last week. Just in terms of the capital allocation strategy that they want the company to follow. Now, it revolves around a few things. Number one is their dividend growth. So continuing to be a dividend grower, appeasing the market from that standpoint. But the rest of it is the allocation of the post dividend free cash flow amount, which they’re proposing to be a 50/50 split to buybacks and debt repayment as well as they would also recommend the sale of DirecTV and some of the Mexican wireless assets. But with regards to that 50/50 split of the post dividend free cash flow, they already are doing both of those things. They already are paying back debt and they already are buying back shares. Now, what this would be is more of like a strategy to codify that to be 50/50, where it would just give management less discretion in terms of, you know, whether they pay back debt or do share buybacks at any point in time. Making it easier for analysts to model, and with regards to as well, the M&A strategy, it is interesting and they brought up a couple of case studies, the aforementioned direct TV deal, which they didn’t speak fairly highly of, as well as the failed T-Mobile deal, which Julian you’re very familiar with. But just for our listeners, this is a good example of a failed acquisition where they ended up paying in this deal a four billion dollar break fee on a deal, That had not add in value, I believe 39 billion.

Julian Klymochko: Right. So what happened? There were regulators blocked a deal on antitrust grounds and T-Mobile had negotiated into the merger contract that they would be paid a break fee or a reverse break fee upon that. That reverse break fee also included a vast array of spectrum in addition to a ton of cash. Billions of dollars, which really set T-Mobile up for success, and they have really just crushed it in the mobile space since then. And Elliot, that was one of the main or one of the main points they criticized is, look, you gave a competitor all this firepower. That was a really idiotic move. And that certainly turned out to be the case.

Michael Kesslering: Absolutely, and a break fee that is 10 percent of deal value is quite a high break fee in and of itself. Then you mentioned the spectrum as well as a seven-year roaming deal where this break fee was significantly more valuable than 4 billion dollars. And just for context, at that point in time, T-Mobile, that was for a deal of 40 billion dollars. Right now, their enterprise value is one hundred and ten billion dollars. So you’ve seen massive growth from T-Mobile, which is now the third competitor.

Julian Klymochko: Really? Yeah. So really, what you are saying is that AT&T, Elliott is saying that there’s a track record of strategic blunders on their acquisitions that they’ve done over the past. There was the blunder on T-Mobile where the deal broke and stuck compensating a competitor very, very well. Then they did the DirecTV deal, 50 billion in DirecTV. That satellite TV and AT&T probably couldn’t have been worse with the timing. They top ticked the satellite TV market, and ever since they closed the deal, they have just faced a massive decline in subscribers as viewers cut the cord and go into streaming. Then on the recent Time Warner deal, Elliot’s criticism was that, look, you have owned this for over a year already and you don’t have a coherent plan. The other thing is and the main criticism that Elliot ultimately has on AT&T is they are saying, look, you have become this conglomerate, and you have diversified away from your best business, which is the mobile phone business. You need to stop trying to become a conglomerate, because that is really gone out of fashion basically 30 years ago. You need to become more like Verizon and focus on your strengths, divest all these businesses that you acquire solely for diversification purposes, but they really aren’t adding any value. In fact, they are creating a conglomerate discount in which investors really don’t like in this market.

Michael Kesslering: Absolutely, the last thing I would mention that in terms of market reaction, debt investors have reacted with a little bit of scepticism to the Elliott note. And their main concern is just that AT&T will be pressured by Elliott to pursue a buyback heavy capital allocation strategy that would prioritize the buybacks over the route repayment of debt. And as a creditor, they’re not really a fan of that. That is something to monitor, is how the debt investors do continue to analyse the situation here.

Julian Klymochko: Yeah, typically that is what happens an activist comes in on the equity side, pushes for more leverage, more debt to fund buybacks. Obviously, that will make bondholders nervous and you will see the bond prices trade down.

Some sad news with the passing of business legend T. Boone Pickens, now T Boone, he has worn many hats in his lifetime, first as an oil wildcatter, then a corporate raider, then hedge fund manager and billionaire philanthropist. He died at 91 years old, and what were he is notable in the financial spaces? He was really a pioneer of the hostile takeover in the 70s and 80s, and he was known as a corporate raider in the 1980s. He even made the cover of Time magazine just due to all his pretty rabid deal making in the 1980s.

Other thing that is hugely, notable is he was very, very generous philanthropist who donated over a billion dollars to different organizations over the years. And we just wanted to chat about some of his accomplishments and what his career was like. He initially started at Phillips Petroleum after graduating from university. Only two to three years later, he founded his own oil company. Twenty five hundred bucks and one hundred thousand dollars in borrowed money, which really was characteristic of his whole life, was he was a tremendous risk taker. He had just a huge appetite for risk, which was, I think, his key to success over life. He founded this company initially just to drill wildcat wells, which is obviously super, super risky, just drilling wildcatter with borrowed money, but that was a successful strategy in Texas. This company later became known as Mesa Petroleum, which became one of the largest independent oil producers in the U.S. and five years after forming Mesa, he launched his first hostile takeover for an oil company called Hugoton Production. And this is what I thought was most interesting and it was actually really innovative back then is that he saw a big disconnect between the value of the companies oil reserves and its stock price. An interesting quote from Boone here. He said, “At the time it has become cheaper to look for oil on the floor of the New York Stock Exchange than in the ground,” which really gives you a sense of how innovative of a thinker he was.

And what he was indicating there is that, you know, instead of drilling oil wells trying to find new oil, you can just take over a company, get all their oil assets for much cheaper than it would be to do that organically. He really went on to monetize this hostile takeover strategy. For example, he made 30 million bucks personally by taking a 5 percent stake in a firm called Cities Service and launching a hostile bid for it. He got the cash out when they actually got a white knight through Occidental to take over Cities Service at a much higher price. He made similar but failed attempts with Phillips Petroleum, Unocal and Gulf oil. He was also criticized for what is was known as greenmail, where an activist would take a stake in a company and the management would utilize shareholder funds to buy them out at a large premium to the share price. That was really frowned upon because if you are a long-term investor in a company and they are greenmailing off an activist, then you are left with much more weakened company with significantly less cash in the Treasury. So that practice was ultimately banned, which is why we don’t see any greenmail anymore.

Michael Kesslering: It really just is not good for minority shareholders. They are the ones left holding the bag.

Julian Klymochko: Oh, certainly. But he was really, really big for shareholder value. He founded the United Shareholders Association in 1986 to pressure corporate leaders to give the companies back to the owners, which are the shareholders. Ultimately, he was a larger than life personality who is known for endless confidence and just a tremendous tolerance for risk.

Michael Kesslering: Absolutely, so in terms of his tolerance for risk, that is a really good display of that, is that when he was pushed out of his oil company, Mesa Petroleum, in the 1990s, he then founded his energy hedge fund, where he really just focused on playing macro commodities in terms of Nat gas and oil futures. And what was crazy about his hedge fund was, number one, the volatility, as you had mentioned, his confidence in his ability to take risk. I believe this was in the early 2000s where his fund was down 90 percent. There was some anecdotes about, you know, only a couple investors being left in the fund that had not redeemed. And then, you know, he went on to proceeded to go up, you know, either 100 x or a thousand acts from those points where it was just an unreal run that he went on that was based on obviously, he did take into account his own analysis, but it was very speculative. You did mention some of his green mailing tactics, which were looked upon very negatively in the 80s. It is believed that it is between him and Carl Icahn, who the Gordon Gecko character from the Wolf of Wall Street is based upon.

And speaking of Carl Icahn in the past week. This is one of the few fellow investors that Carl Icahn actually speaks favourably about; he actually had really kind words to say about him, despite them being on the opposite ends of many leveraged buyout deals that they’re competing over back in the 80s. The other thing that I would like to mention is that despite, you know, is his passing away at the age of 91, even in his 80s; he was quite active on social media. He has attributed to one of the funniest tweets I have ever seen with, he had a little run in with the rapper Drake, who had tweeted out this was in May 2012. And Drake had tweeted out the Canadian rapper Drake tweet out, The first million is the hardest to which T. Boone Pickens replied. The first billion is a hell of a lot harder, which is really putting something in place for bragging about making a million dollars when you have a legitimate billionaire.

Julian Klymochko: T. Boone stunting on Drake was perhaps the greatest tweet of all time and the first billion being the hardest, that is one of his books, which happens to be a personal favourite of mine. And so it’s sad to see such a larger than life character pass away. I mean, he provided such a rich contribution to not only the energy industry, but the financial industry as well, and so he will certainly go down in the Hall of Fame.

Really interesting hostile takeover bid from the Hong Kong Stock Exchange, who made a bold play for the London Stock Exchange. So what happened was the Hong Kong Stock Exchange the HKEX announced a thirty nine billion unsolicited offer to acquire its London based competitor, and they offered a consideration at about eighty three pounds per share, which equates to about a 23 percent premium over London Stock Exchange unaffected price. One of the aspects that makes it so interesting is it would be contingent on the LSE dropping its previously announced friendly 27 billion dollar acquisition of financial data provider Refinitiv. Now, we spoke about this on a podcast last month. How LSE shareholders really love this Refinitiv deal. Number one is as a massive deal, nearly 30 billion, but it is highly creative and LSE shares rallied significantly off that acquisition, which was notable in itself because one of the things that we’ve been seeing in this environment were the acquirers stock price dropping precipitously on the announcement of large deals. But LSE shareholders really liked the Refinitiv deal. And this Hong Kong hostile takeover proposal is contingent on LSC dropping that refinished a deal. Number one, I don’t know how keen shareholders will be on that as the strategic rationale between behind HKEX is hostile proposal, their merger combination that the combination would create a global market juggernaut with tons of synergies. You would have trading between Hong Kong and London 18 hours a day.

It would be the second largest exchange operator globally next to the CME. However, we don’t see this deal really having any sort of probability of success. Number one, it was quickly rejected by LSE directors. And number two, I mean, this would face intense not only regulatory scrutiny, but political scrutiny as well. Got a quote from the LSE in a letter sent to the HKEX. They stated, “There is no doubt that your unusual board structure and your leadership with the Hong Kong government will complicate matters. Accordingly, your assertion that implementation of a transaction would be swift and certain is simply not credible.”

So this HKEX bid comes amid a deepening political crisis in Hong Kong, where the government’s grappling with months of protests that have turned increasingly violent as many of the citizens are really wary about China and Beijing’s influence on Hong Kong. Not just that, but with respect to the corporate governance of the HKEX, now the largest and controlling shareholder is the Hong Kong government, which is ultimately controlled by Beijing. The HKEX list vast amount of Chinese state owned enterprises on its exchange. In addition, their board of directors has 13 board members who were all directly or indirectly appointed by the Hong Kong government. So they are effectively nearly a state owned entity, you know, controlled effectively by Beijing, which really is not palatable in the current environment.

Nonetheless, I mean, Hong Kong did acquire the London Metal Exchange seven years ago, which was a much smaller deal, much less of a political issue. But this massive 39 billion dollar of really, a storied stock exchange. That has been around for a hundreds of years, and has tremendous political implications, it just seems like quite the non-starter, because ultimately regulators are going to view this as a Chinese takeover, basically like Britain would have to cede an institution that has been around since 1571, at least it can trace its roots back over five hundred years. At a time when London century’s long status as a leading financial capital is really in doubt due to the ongoing consultations with Brexit and the implications that a Brexit would bring. Not just that, but I mean, regulatory scrutiny would not only be limited to London because LSE also owns the Italian stock exchange. They would really be facing pushback throughout Europe. I have some interesting background on the LSE. What makes it so interesting? It has been a target of perhaps the most takeover proposals that I have ever seen. Over the past 20 years, competitor Deutsche Bourse has tried to take them over three times, first in 2000, then 2005, and then their last try in 2017 was struck down by the regulators.

Few Canadians would remember back in 2011, LSE made a play for the Toronto Stock Exchange, which ultimately failed because a bunch of Canadian banks got together and in fact gave a superior proposal to the Toronto Stock Exchange. Not only that, but you see in these exchange deals, there is always political pushback from the nation in which their stock exchange is getting acquired. LSE also rejected a bid from NASDAQ in 2006. In addition to the Stockholm Stock Exchange in 2000. So a really storied history, not just trading for 500 years, but takeover attempts over the past 20. What are your thoughts on this? Really interesting, but what I think to be ultimately an unsuccessful hostile takeover attempt.

Michael Kesslering: I would agree with your thoughts on it being unlikely to be successful. But with that being said, I do understand the rationale for the Hong Kong exchange to acquire the LSE as this would reduce their dependence on Chinese company listings, as currently they represent 78 percent of their equity listings since 1998. But where I don’t understand the strategic rationale would be from the LSE standpoint. Now, you had mentioned the Refinitiv deal and what was interesting was when we discussed the LSE Refinitiv deal. There strategic rationale was that it would take them away from as much exposure to trading as well as the listing revenue that exchanges have typically relied upon and place them more in the position where they would still have that revenue. What was really driving the business model was the data and analytics being provided, and really being an all in one platform. Thinking of, say, Bloomberg or something like that, where if you did drop that deal now and did a deal with the Hong Kong exchange, it would just be more of the status quo where your key revenue sources are the listings and the trading revenue. Where I really don’t think that fits into how the industry is moving in the long term.

Julian Klymochko: Right. Because trading revenue is really, there is not a lot of growth in that. It is a highly commoditization business. There is a ton of competition there. Meanwhile, data is obviously very important and some view it as the new oil where it’s highly valuable and they have pricing power behind that data.

Michael Kesslering: Absolutely. Pricing power, so more of an offensive move as to a deal with the Hong Kong exchange would really just be a defensive move in a commodities industry where your only goal is to cut costs and compete on that side.

Julian Klymochko: Right. Nonetheless, British takeover rules. They say that the Hong Kong exchange now has 28 days to either make a firm acquisition offer or walk away. Either way, shareholders liking it. You look at the long-term stock chart of LSE. It is pretty tremendous – up and to the right. But off this news, LSE stock was up six point six percent on the news. So shareholders certainly like it. Hong Kong Stock Exchange shareholders not digging it too much. Their stock down 3 percent and those moves are kind of strange given how low a probability we think this has of happening. So ultimately, we could see Hong Kong come back with a higher bid, but I think ultimately that it will be futile. And this will ultimately be kind of a waste of time because I don’t see it being successful.

Wanted to touch on a little bit of macro here as the European Central Bank cut its benchmark interest rate by 10 basis points, putting it further into negative territory at negative 50 basis points or negative half a percent. In addition, they relaunched their bond-buying program, all in a bid to stimulate Europe’s sputtering economy.

So what they what they did here is they pledged to buy 20 billion euros of Eurozone debt per month in this new quantitative easing program, also known as QE. May indicated that this new QE programme is expected to run as long as necessary, so that ECB and President Mario Draghi really coming up with the bazooka here, and this is really their largest dose of monetary stimulus in three and a half years. And it’s really a bold finale for their departing president Draghi, because he will be leaving his position shortly. Nonetheless, there was some controversy here.

Some ECB officials really divided on the relaunch, a reviving of quantitative easing. Number one, like my criticism is that negative interest rates and QE really has not been effective in Europe. You can tell by the economic figures, you can tell by the stock price or the stock market. I mean, look at the stock prices of their banks. They’re just getting crushed here by the negative rates. And it’s really not spurring much economic activity at all. Not helping out Inflation, inflation is still below target, but ultimately it’s like a geographic divide in the European Union.

The stimulus program, it is contentious and parts of northern Europe. Due to concerns that it subsidizes the free spending governments in the south of the region. It is basically Germany, which is very fiscally conservative I’d say. They don’t want to subsidize or support in other freewheeling ways of some of the Mediterranean nations, whether it be Italy, Portugal, Spain, those countries with basically massive deficits.

The other thing that I wanted to chat about, the ECB is new easing measures is this. The QE really faces challenges because they have a self-implemented buying limit of one third of each government’s debt. So some speculate that there is only so much there to support nine to 12 months of this, 20 billion euro per month buying unless they change that limit. But the ECB is hesitant to do that because they don’t want voting control if a country were to default, which opens up a whole new quagmire of potential problems for the central bank. Nonetheless, obviously interesting comments from Trump because as you know, he very much enjoys criticizing the Federal Reserve and Fed Chairman Jay Powell. He came out with a tweet accusing the ECB of trying to weaken the euro and basically bashing the Fed for not matching the decline in rates, saying that it’s not fair how Europe can pay negative rates. Meanwhile, the US pays actual interest on its debt. But I mean, it leaves you scratching your head here. Well, QE ultimately have any positive effect to me. It seems like it is just pushing on a string here. What are your thoughts?

Michael Kesslering: I would very much agree with that. And with regards to your comments on Draghi leaving office soon and the self-imposed limits where they have basically 9 to 12 months of runway before they converge on that limit. Is it is effectively him kicking the can down the road. So he’s implemented something that the next governor will have to make changes to that. So whether they increase that limit or start buying different securities, it will be really interesting. It puts the new governor in a very interesting position once they come in as well as you’d mentioned, Trump, where he had the ability to both praise and critique the move by the ECB. You know, his comments about currency manipulation are valid. It will devalue the euro against the dollar because of the lower interest rates. Whether or not that is their stated goal is to devalue the currency. But it is a very happy after effect for Europe in general.

Julian Klymochko: Yes, certainly that makes sense. As we have seen over the past number of months, we have seen China utilize the tool of devaluing its currency to cushion any sort of negative economic impacts and try to spur growth by having a weakening currency. And, you know, clearly, although it’s not a stated goal and they, in fact came out with a statement to go against that they were looking to devalue the euro. Ultimately, I think that could be part of their plan as to spur growth through a weaker currency.

Michael Kesslering: Absolutely, and just with regards to the timeframe, how they didn’t give any sort of timeframe for how long this will last. The only thing that they did mention is that it would end shortly before the bank started raising interest rates. And with that, they also promised not to increase interest rates until their inflation converges to their 2 percent target. So very loose terms in terms of how long it will last.

Julian Klymochko: Right, there you have it. QE to Infinity.

Put out a blog post this week entitled it is a Momentum World and you are just living in it. Wanted to do a quick discussion of August factor performance. Now we focus on the factors of value, quality, price, momentum, operating momentum and trend. And what we’ve seen thus far up until the end of August was really value and quality, just struggling. You know, cheap stocks not doing well. Highly overvalued stocks doing well, and then high quality stocks not doing all that well either. And where you’ve seen strength is stocks with price momentum, i.e. shares that have been going up continue to go up or stocks with operating momentum, companies beating expectations, et cetera, and then companies with a really good share price trend. Those have been doing very, very well up until August. But in the future, especially this month, and you’ll have to tune in to the subsequent podcast next week as we discuss a complete reversal of this in September, which has been super interesting news, some claiming it as a quant quake or just the equity earthquake because you had massive moves in factor performance this week, which we would like to touch on next week and perhaps a blog post, too. So keep your eyes open for that one.

And that’s it for episode 31 of the Absolute Return podcast, I hope your week goes well. We will chat with you soon if you want to check out more podcasts, feel free to go to absolutereturnpodcast.com. Leave us a review if you would like, and we will chat with you soon. 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.