October 7, 2019—Broker Battle Breaks Out as Schwab Drops Commissions to Zero. How Are They Going to Make Money?

U.S. PMI Falls Below 50 in an Ominous Sign for the Global Economy. Is a Recession Imminent?

FanDuel Owner Pushes All-In with its $6 Billion Acquisition of PokerStars Parent. What’s the Strategic Rationale?

LBO Hot Potato Continues as Great Wolf Resorts Bought by a Third Leveraged Buyout Firm. Can Private Equity Still Add Value?

A Discussion on Why You Shouldn’t Invest in Money-Losing Companies

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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: Hey Investors, welcome to Episode 34 of the Absolute Return Podcast. I am your host, Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering

Julian Klymochko: Today is Friday, October 4th 2019. We had a pretty volatile week in the markets. A lot going on, but we are here to hold your hand through it all. A bunch of pretty exciting events on the street this week off the top.

    • We had a big broker battle breaking out as Schwab dropped its trading commissions for customers to zero. How are they going to make money doing this? And is it really free?
    • Some economic news as U.S. PMI finally falls below 50 in a pretty ominous sign for the global economy. Is a recession imminent?
    • Big deal in the gambling space with the FanDuel owner. They pushed all in with their six billion dollar acquisition of PokerStars Parent Company. What is the strategic rationale behind this deal?
    • Going to talk about a private equity deal in what we call LBO hot potato as Great Wolf Resorts got passed around to a third leveraged buyout firm in this case of Blackstone. Can the private equity firm still add value as the third player in line?
    • Lastly, we are going to talk about some recent money losing IPOs and if you should invest in stocks of money-losing companies.

Schwab Dropped Trading Commissions to Zero

Julian Klymochko: A big broker battle breaks out on the street as Schwab dropped trading commissions to zero. And shares of U.S. discount brokerage firms just plummeted on that news. Now, Charles Schwab, they announced a few days ago that they are totally eliminating commissions on stocks, ETFs and options on North American exchanges. So, New York, Toronto, free trades for all their clients. They are formerly between four ninety-five and six ninety five between them and their competitors, E-Trade and T.D. Ameritrade, who were effectively forced to follow suit. Those two companies came out and also announced that they’re dropping their commissions to zero dollars. The entire brokerage industry has really come under brutal competition from an upstart, specifically Robin Hood, which is a V.C. funded entity that offers trading services with no or low commissions via popular mobile app that they have. Robin Hood, it is a private company. It was last valued in a financing round at 7.6 billion and it is worth almost as much as E-Trade, which is 8.4 billion. So certainly, Robin Hood has been a hugely disruptive force in the discount brokerage firm industry. Obviously, commissions have been declining for a long time and it seemed natural with what Robin Hood was doing and the success they’re having that these large firms, the incumbents were going to be forced to drop their commissions down to zero.

Brutal price action Schwab was down 10 percent. T.D. Ameritrade, their stock dropped the biggest in two decades, down 26 percent. Now T.D. Ameritrade was itself specifically really vulnerable here. I mean, their commissions account for almost a quarter of their revenue. So really tough strategic pivot for them. E-Trade, it is another popular platform their stock dropped about sixteen and a half percent, which was its biggest stock hit since the financial crisis. There is a number of important implications here. Investors might be wondering how are they going to make money here? What are your thoughts on this recent broker battle with commissions going to zero?

Michael Kesslering: Yeah. So it’s really just a changing of a point of view, something that used to be a source of revenue being trading commissions. Now it is more so because of Robin Hood and some of these other Robo Advisors that they are now looking at this as more of a customer acquisition cost or an operating cost that they used to be able to flow through to investors, no longer able to do so. For some context, in the wealth management and Robo Advisor industry, the customer acquisition costs are thought to be as high as about a thousand dollars per account so those are pretty high customer acquisition costs relative to other industries. This is really just when you’re looking at the lifetime value of each of their customers, this is really just decreasing that which they are hoping to be able to increase their growth rates on the other side to be able to balance this out.

Julian Klymochko: Yeah and a lot of these discount brokerage firms are getting into the robo space. We saw Schwab a couple months back announcing that highly innovative and disruptive new subscription robo advisor service, which really caused a stir in that industry.

Michael Kesslering: Absolutely. Some of the industry analysts are also mentioning in their deal analysis is that this could revive some of the M&A market in this industry so that will be interesting, too, to watch moving forward. Why don’t you go into a little bit of how these brokerages make money on their cash balances as well as the flow.

Julian Klymochko: Right and so they knocked commissions down to zero, which obviously is not good for their revenue, not good for their business model but, is it really free? No and here is why, these firms still make money off their trades. So they went from a commission model to zero commissions but what they do is they actually sell customers flow their trades to high frequency trading firms. Now, what high frequency trading firms are, they are effectively a middleman. For example, say, you go to a store; you want to buy a chocolate bar for ninety five cents. You go to the till then someone comes in between you and the cashier, and they buy it for ninety five cents, mark-up the price five cents sell it to you for a dollar. That is effectively what high frequency trading firms are. They are effectively a tax on the system, kind of a middleman or some refer to them as somewhat of a parasite in the markets. They do bring some good to the markets. They claim that they bring liquidity, more volume, easier to buy and sell shares.

However, that industry is pretty profitable and they are profitable by exclusively being the middleman in between buyers and sellers. This really is not free because surely you could perhaps buy or sell shares for a zero commission. However, since your flow is being sold to high frequency trading firms, they are not in it to give you the best price ever. They are not in it to lose money. Those guys, you know for sure, are making money and so you pay for this commission through worse execution prices. Basically, you are going to be paying more on each share you buy and receiving less on each share you sell on average.

Michael Kesslering:  I would push back a little bit on the description of perhaps, you know, high frequency traders being parasitic in a sense that although, yes, they do, they are just really like a tax. They are in the middle. What you have seen is that spreads for the stocks that you are buying and selling have come down, bid-ask spread I am referring to have come down over the last number of years. That is not exclusively just because of these market makers. It is mostly the digitization of trading with electronic trading so there is some value in that. You also did mention that there is liquidity that these market makers do provide. However, some of the pushback there with the liquidity argument that they add is that there can be times when all of these algorithms act in tandem and when the market truly needs liquidity, it’s not to be found at that point in time.

Julian Klymochko: Right, certainly. Healthy environment requires biodiversity and in any sort of habitat, you have these organisms that feast off of others and they do add value and so that’s kind of how I see high frequency traders in the market. Yeah, they do add value tightening up bid- ask spreads, but like I said, somewhat parasitic in that, you know, they are just trying to insert themselves in between buyers and sellers within a transaction. Do these discount brokerage firms make money? Yes. The high frequency traders actually pay them to sell off your order flow.

For example, Schwab made almost $140 million in revenue last year by selling customers’ orders to high frequency traders. This was up 22 percent from the previous year. Obviously, that is pretty much Robin Hood’s only business model is to sell out your flow to high frequency trading firms. The thing that I wanted to discuss is do you think this will come to Canada, these $0 commission trades? I know I personally have a discount brokerage account with one of the big banks and I am still paying about 10 bucks per trade.

Michael Kesslering: Yeah, absolutely. Personally, I use Questrade, which for that I am able to buy by ETF is free but you do get charged the commission when you sell, so they get on one side of the transaction. So not exactly, free. I would view that the likelihood of this coming to Canada in the near term or even the mid-term is unlikely and that is just because of how the industry is set up in Canada, is that the market share is really dominated by the banks who act as an oligopoly. So they really don’t have any incentive to compete against each other and start offering zero commission. Now, if one of them did, that would be very interesting to see.

Julian Klymochko: Yes, certainly if any one of those banks feels like competing, which seems as a customer to be quite rare, you typically see them all follow on and pile on to the exact same rate, whether it be prime rates, mortgage rates. Nonetheless, they earn very high return on equities just because the competitive environment is so friendly. They do not really compete with each other. They are just happy earning excess profits and no one is really willing to make the move. So for consumers, obviously, we hope that it comes to Canada, but we don’t really see any of the big banks going out on a limb and Robin hooding the space as has happened in the US. So fingers crossed, but not looking like a high chance of probability in the near term.

U.S. PMI fell below 50

Julian Klymochko: I wanted to touch on some negative economic data this week as U.S. PMI fell below 50 in a pretty negative sign for the global economy. What we referred to as PMI is the Institute for Supply Management. The ISM puts out their Purchasing Managers Index PMI. This monthly figure represents manufacturing activity – anything above 50 represents growth and anything below 50 represents a contraction. While the PMI last month in the US dropped to forty-seven point eight, which was a huge miss, massively below expectations of fifty point two. The Street expecting slight growth at fifty point two, but the number coming in at forty seven point eight, which was its lowest level in over 10 years since June 2009, which was really just coming out of the credit crisis. That is a pretty negative number and this is really just representative of what we’ve been discussing ad nauseum for the past six, nine months, which is the trade war is really starting to take its toll.

Previous U.S. economic figures have proven that economy to be fairly resilient. We had seen in the past pretty much most major global economies coming in with poor PMI figures, sub 50 signalling contraction. The US was really sailing through that, but no longer. I believe they’re really the only hold out until this month with this really negative PMI print Canada coming out today with their Ivey PMI just a different provider of the same sort of purchasing managers index economic data point. That one came in for Canada forty eight point seven, which was a four year low. We have all these PMIs globally, sub 50, just a warning sign signalling global slowdown, potential recession.

This is a really key leading indicator that we like to keep an eye on which is obviously something important if you are constantly on a recession watch. Got a quote here from the chair of ISM manufacturing business survey committee he indicated that, global trade remains the most significant issue, as demonstrated by the contraction in new export orders that began in July 2019. Overall sentiment this month remains cautious regarding near-term growth. Basically, we are seeing a big global slowdown due to the US-China trade war and its effect on global flows. What are your thoughts on this negative economic data point that you saw?

Michael Kesslering: Yeah. So first, I would like to point out that another interesting data point from this is that just three out of 18 manufacturing industries actually reported growth in September. So, you know, it is kind of wide spread across the different sectors within manufacturing but when looking at this, the question is, why does it matter? Right. Like, how does this flow through into GDP well the weak demand numbers can lead to a slowdown in job creation, which then will have impacts on obviously the employment rates as well as this weak demand will flow through into weaker GDP growth. On its own, you know, isn’t the biggest of deals but really, when looking at both this and yield curve inversion, you know, you’re getting multiple red flags and so, you know, investors really need to take a look at this. It provides a good opportunity, as we have said before, when looking at any of this economic data it should be a reminder to look at your portfolio and see how your portfolio will react to different economic scenarios. You know, really looking to hedge out some of that volatility on the downside, perhaps.

Julian Klymochko: Certainly. If you cannot handle a big bear market drawdown, then perhaps you are too overly exposed to equities. There are obviously strategies, whether they be government bonds or alternative strategies that are uncorrelated to the markets that could have positive performance in that sort of cycle drawdown. So that’s something for investors to consider, is to have an asset allocation plan that you have implemented that you’re comfortable with that can help you maintain your investments through that negative scenario in which the global markets, S&P 500, have a pretty significant drawdown. I always call risk management something that you want to have before it happens, not scrambling and panicking as the markets are really tanking. That is not something you want to do. You also don’t want to dance around between being fully invested and being in cash. I think that is kind of a fool’s errand. It never works. No one ever times it right. So don’t think about doing that just craft out a well-balanced, highly diversified capital allocation plan and this includes more than just stocks to be diversified.

One other thing on what we have been seeing, you mentioned the yield curve inversion. Now we are seeing PMI signalling contraction. These all point to the China trade war. I want to note to investors that this whole thing could ultimately get resolved overnight if Trump and Xi can come to an agreement to resolve this trade war, obviously we have seemed to be close many times thus far. It has been going on for about a year already with no resolution. However, there is nothing to say that they cannot ultimately come to some sort of agreement here. I believe with that, all of these issues with respect to a global economic slowdown, recession fears, I believe all those will kind of go away in that sort of scenario and so investors should be pricing in some sort of odds of that. It is not like a global recession and big bear market is guaranteed here. I mean, there are plenty of different scenarios that could play out. So that’s something to keep in mind but nonetheless, investors not liking this. S&P 500 was down 1.2 percent on the news as these ominous indicators for economic growth keep they just keep coming here.


Julian Klymochko: We are seeing some consolidation in the gambling space with a FanDuel owner, Flutter Entertainment PLC, it also owns online betting sites Paddy Power and Betfair and these are big in Europe. They made a play to enter the North American market with their acquisition of the Stars Group, which owns PokerStars, one of the largest online poker sites out there in a U.S. 6 billion dollar transaction. This was an all share deal, strategic rationale – so the acquiror Flutter, which is based in Ireland, they are seeking to increase their exposure into the budding U.S. online gambling market, which is really coming to fruition. There is a lot going on, the government regulation and players trying to get into that new market. Now, Stars Group, the target of this friendly deal, they have a pretty coloured and interesting past. Now, it used to be known as Amaya, which a number of years was embroiled in a big insider trading scandal behind their acquisition of PokerStars.

I remember watching the stock back then, which was perhaps half dozen years ago and you saw it skyrocket from kind of in the $4 range to up to $20 on these rumours and speculation. Ultimately, the previous founder and CEO, David Baazov he ended up leaving the company as he got investigated for insider trading. The other thing is that Stars Group formerly known as Amaya it was pretty acquisitive in addition to buying PokerStars. They did a bunch of other deals, such as buying William Sky Australia in 2018 for 234 million. They also bought Sky Betting and Gaming in Britain for nearly five billion dollars recently. Other interesting factoid is that they are minority owned by big entertainment conglomerate Fox. Nonetheless, talk about the merger arbitrage spread here. You can buy Stars Group shares and short Flutter Entertainment shares they acquire because it is an all share deal that spread offers a 9 percent annualized return, which is pretty attractive and the market is currently pricing in a 75 percent chance, implied chance of success of this deal closing.

One major potential issue is that of anti-trust, some major potential market regulatory scrutiny specifically in the UK where the combined groups would have roughly 40 percent market share, which you know, any sort of market share above 30 percent typically gets the regulators concerned. I am sure they are going to look closely into that market there again. The betting market in the UK between these two companies is quite high at about 40 percent some price action Stars Group; they have a nice premium shareholder has to be a happy, stock was up 31 percent. Contrary to what we have seen in recent M&A news, the acquirers stock was actually up 7 percent so their shareholders liking this deal as well. What do you think about it?

Michael Kesslering: Yeah. So just to touch on some of the strategic rationale, you mentioned that this was the move into the U.S. market for Flutter Entertainment for FanDuel. Why they are interest in the U.S. market and we touched on this a little bit, but in our previous podcast discussing the valuation of pro sports teams. Some U.S. states have made legalized sports betting. They have made that legal in the last number of months. This is going to be an ongoing trend where some of these players really try to get into this massive U.S. market and that will draw some M&A as well. You had mentioned the Arb-spread as well. Just another to add on to the valuation that Stars Group got was a 14 times EBITDA pre synergies and that would be eleven point nine times with synergies.

Julian Klymochko: So synergies were about two hundred million bucks.

Michael Kesslering: Yes, in that range. Synergies in this situation, since there is quite a bit of overlap, there is obviously overlap in terms of some of the back end that they use but the other the other synergies would just be layoffs in terms of cutting G&A.

Julian Klymochko: Right. Interesting. Yes. So we’ll keep an eye on this deal, but more consolidation in the gambling space. I think we are going to see that trend continue and ultimately, I think this deal is going to be a success. Shareholders of both companies really liking it here. As you say, a pretty high valuation for Stars Group, nice premium for shareholders and I think for merger-arbs here, a pretty attractive M&A spread.

LBO Blackstone owner of Great Wolf Resorts

Julian Klymochko: More M&A news, this time in the private equity side with private equity firm Blackstone, they are doing a leveraged buyout of Great Wolf Resorts. The way this is working, they are acquiring a 65 percent stake in waterpark owner Great Wolf Resorts in the 2.9 billion dollar joint venture, with its current private equity owner, Centerbridge Partners. Great Wolf it is the largest operator of indoor water parks in North America. It has about 18 resorts and six thousand employees and interestingly, long history of ownership by different leveraged buyout firms. For example, here Blackstone is actually the third LBO shop coming into play in owning Great Wolf. Initially, fellow private equity firm, Apollo Global. They bought Great Wolf a number of years ago, I believe in 2012, in May 2012. They bought Great Wolf in a leveraged buyout of a public company when Great Wolf was public. I remember it was a pretty heated bidding war with a back and forth between another firm, I believe KSL, this deal went for seven hundred forty million in 2012 and then they flipped it. Apollo flipped Great Wolf to Centerbridge for one point three five billion in 2015. So they only held onto it for three years. Apollo made 2.5 times its equity investment.

Now Centerbridge has held it for about four years. Now they are flipping a majority stake to Blackstone. Now, this is known when firms get passed, companies get passed between LBO shops it’s known as a secondary deal. Now there has been $54 billion worth of secondary deals so far in 2019. Last year there is one hundred and eight billion the year before in 2017, they are one hundred thirty six billion. None of those have yet to top the hundred sixty five billion we saw in 2007. However, Private Equity Limited partners do not like secondary deals. Say you are invested, for example, in this transaction in both Centerbridge and Blackstone LBO funds. Well, typically when an LBO shop sells a portfolio company, they will make a distribution to their limited partners, their LPs. On the other end, when LBO shop buys a portfolio company, they will have a capital call from their LPs to pay for it. So if you’re an LP in both Centerbridge and Blackstone, you’re getting a distribution from one minus a bunch of fees and then Blackstone is calling that same capital to buy the same asset. So you’re as an LP owning the same asset, minus a ton of fees that are going to both these private equity firms. So clearly, they are not happy about that but I wanted to talk about these so-called second the secondary deals specifically. I refer to this as LBO hot potato, as different private equity firms are selling their portfolio companies amongst each other at consistently higher prices, recognizing and crystallising performance fees. And it really just you know, it kills the two main theses on which private equity claims to add value.

The first one being operational improvements. A lot of private equity firms say we will buy this company, we will fix it up, we will improve margins, improve revenue and not so much lipstick on a pig, but make true operational improvements. And perhaps this is arguable for the first one and all the data we’ve seen, it certainly isn’t the case. Typically, they cut capital expenditures, they cut costs, they fire employees, shrink revenue and try to cut to the bone like that. But in this scenario, when you’re the third firm that’s own private equity portfolio company, what operational changes, what improvements are you going to make that the first two missed? You know, if there are still those opportunities, then that really just shows the first two private equity firms really suck at that and they can’t do that at all.

The second misconception on private equity that they claim they earn their market beating returns from is the notion of an illiquidity premium. But the way they earn that illiquidity premium, if they did, which I’m arguing against, is buying an asset at a discount and then selling it at a market multiple. But in this case, in a secondary deal, so-called LBO hot potato, where an asset is trading between LBO firms, if one is selling it or if one is buying it at a discount to recognize and earn that illiquidity premium, then the other one would lose it because they’re selling the asset on the cheap. So you can’t have it both ways if one gets to earn this illiquidity premium then the other PE firms certainly can’t. What are your thoughts on this interesting secondary LBO deal here?

Michael Kesslering: Absolutely. You brought up a good point there. At the end, especially with regards to the hot potato, you know, typically, you know, I guess historically when the LBOs were first being done, some of these transactions were being done with less sophisticated sellers. And so you would come in, you know, being a private equity firm, having good valuation knowledge, and you would buy something at a discount like you’d mentioned on this scenario. You have a very sophisticated seller. So there’s really no chance for a year or less of a chance to get a good deal on it. And as well, you kind of highlighted something. Another critique, which is really in all these transactions, what was done was a recap essentially.

So when it is passed to each to each different private equity firm, they just add more debt to their capital structure and then to increase their ROE. And really, you know, looking at this as well, I guess in this specific scenario, you do have to give the private equity firms a little bit of credit just because back in 2012, when Apollo had first taken a private I believe they had eleven locations now in 2019 they have I think you’d mentioned 18 locations. So there has been some growth in this scenario where they actually did invest into capital expenditures that I think on the deal call, they did make mention they looked forward to investing more into the business. But I would say that this would be more of an outlier transaction where they are investing into the business. The typical is, as you had mentioned, focusing more just on operational improvements, really cutting those costs.

Julian Klymochko: Really not your traditional leveraged buyout in terms of a quick strip and flip. They are looking to grow this company. So we’ll see how that one turns out.

Losing IPOs

Julian Klymochko: Put out a blog post this week that is really fitting for today’s environment. It’s called Losers Average Losers: Why you should not invest in money losing companies. And I say that it’s fitting for this environment because we’ve been discussing a lot of IPOs in the podcast lately. And if you look at the data now north of 80 percent of new initial public offerings, companies, private companies coming to the market, going public, over 80 percent are not profitable. Over 80 percent of these, new companies are losing money and we wanted to examine is investing in these money-losing companies a good idea since so many IPOs these days are of money losing companies. Now, where I got this idea from for the title Losers Average Losers was one of the greatest hedge fund managers of all time in the 80s and 90s, Paul Tudor Jones. He made a ton of money, especially on Black Monday 1987 when the markets crashed about 20 percent their largest one-day drop in short, the market. And he made a killing. Nonetheless, he had a sign over his screen that said losers average losers. So he was what I call a trader’s trader. He likes to, you know, buy stocks going up and short stocks going down. So if he bought a stock and it went against him. This would be a losing stock. He would never average down. And this is how he came up with a slogan that losers, average losers. With that in mind, I posit a new rule for this day and age losers, average losers 2.0.

I call this one losers buy money-losers. Contrary the other side being winners by profitable companies. We ran the numbers here. And if we look at the current American environment in North America, we look at liquid securities. So pretty much anything with a market cap above 100 million. On average, there are about 450 money-losing stocks per year in the market. This is roughly 15 percent of all publicly traded companies in the market with negative EBITDA, which is representative of cash flow. We’re basically saying those are our money losing entities if they have negative cash flow over the past twelve months and we ran a simulation that would rebalance a portfolio, basically you would own all the money losing companies over the past 12 months and rebalance each quarter. And what we realized over the past 20 years, the S&P 500 compounded at 6.4 percent annualized pretty good returns since 1999, whereas the negative EBITDA portfolio, the portfolio of all the money losing stocks in the market actually lost 2.1 percent per year. And so over 20 years, you would’ve lost 35 percent of your investment if you only invested in money losing entities like most of these new IPOs coming to the market are not profitable. And so I just wanted to caution investors about getting too excited about those stocks because historically unprofitable companies do very poorly in the stock market and we just don’t see great returns on average for all these unprofitable companies coming to the market.

And that’s all about we have to say this week on the Absolute Return Podcast, episode 34. Hope you liked it. If you did, you can always check out more episodes on absolutereturnpodcast.com if you really enjoyed it, leave us a review or just give us a shout on Twitter. Tell your friends about it, family members, co-workers whatever it is but until next week, 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.

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