January 24, 2020—Coronavirus Roils Markets as the Outbreak Spreads. Should Investors be Concerned?
Xerox Plans Proxy Battle to Take Control of Rival HP. What is Their Goal?
Tesla’s Market Capitalization Hits $100 Billion to Become the Second Most Valuable Auto Group. Why Has the Stock Tripled?
Bank of Canada Leaves Door Open for a Rate Cut. What Does the Market Think?
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 ladies and gents to episode 49 of The Absolute Return Podcast. I am your hosts Julian Klymochko.
Michael Kesslering: And I’m Mike Kesslering.
Julian Klymochko: Today is January 24, 2019. We have a number of really interesting topics to chat about this week off the top.
- Now, this is not a bad beer, but a potentially deadly virus that is going around. What happened? It really roiled markets this week as the outbreak spread throughout China and it is coming to North America. Should investors be concerned about this?
- Xerox plans a proxy battle to take control of rival HP. Looks like this takeover battle is heating up. What is their goal behind this proxy battle?
- Tesla, one of the big battleground stock between bulls and bears. Their market cap hits $100 billion to become the second most valuable auto group in the world. Why has the stock tripled over the past few months?
- Lastly, we will chat some macro stuff with the Bank of Canada leaving the door open for a rate cut. What does the market think?
Julian Klymochko: China went into unprecedented lockdown as a fast spreading coronavirus, this deadly pneumonia like virus, which seemingly came out of nowhere, started to wreak havoc in the country and it is slowly spreading worldwide. But China really took an unprecedented action here in basically shutting down 10 massive cities with a total population of 33 million put under lockdown, which is completely unprecedented, it is just crazy. What happened thus far is that at least 26 people have died from the virus, and over 800 cases have been confirmed in China. And there’s been reports that it has hit Japan and the U.S., but thus far. U.S. stock markets, global stock markets not really taking too much of a hit. I think this is probably most comparable to the SARS outbreak, which happened earlier last decade between 2002 and 2003, which in fact, seems to be a more deadly virus than this latest coronavirus. During the SARS epidemic, more than 8000 people were infected and around 800 people died in that crisis. So, you know, the death rate quite a bit higher and tenfold number of people got infected. And what happened there in terms of market action?
The MSCI Hong Kong underperformed by about 10 percent. And so that least kind of see that as more of a worst-case scenario here. But in terms of this outbreak, it seems not nearly as bad as SARS, does it?
Michael Kesslering: Yeah, absolutely. And in terms of to go a bit further in to the SARS comparable from November 2002 to April 2003, as you had mentioned, the Hong Kong stock market was down and that 10, 11 percent range and that was up from kind of from November 2002 to April 2003 and really by July. So just a few months later, all of those losses were recovered, so it was a downtick. Then by the time, the World Health Organization had cleared Hong Kong, that they had kind of revamped all these gains as well. When you look at the impact from a from a GDP perspective is it did impact China’s GDP by five percentage points back then, but then similar to the stock market, everything did snap back.
It will be interesting to follow how this works in the in terms the global markets. Now, right now, there has been one of the areas that there has been an impact is the luxury goods makers. So Chinese consumers, they account for about 33 percent of global luxury goods sales. So depending on their exposure to China, these goods makers will have gone down now. LVMH, they are down, whether they are makers of Louis Vuitton, down about 5 percent in the last week. Richemont, down 6.4 percent. The maker of Gucci is down 6 percent. But yeah, you’re really just seeing Chinese equities as well down so far, but as we mentioned, if it does play out like SARS, it’s more of a short term issue.
Julian Klymochko: Yeah. And thus far, really just impacting Asian markets, as we indicated, not much hit to North American and European stock markets. However, you know, there are certain segments of the market that have been affected in terms of the price action. You spoke about luxury goods producers. You are seeing oil, WTI, Brent crude oil trading down over 5 percent this week. Other commodities, such as copper as economists take down global growth estimates, Chinese growth estimates. Chinese stock market tumbled 2.8 percent on Thursday and the Yuan weakened. The other thing is we are seeing some effect in the airline stocks. We have seen some weakness there. But ultimately, you know, as the nerds would say, this is nothing but nothing-burger. But at the end of the day, it gives you time to sit back and reflect on your portfolio and just kind of make sure you’re fully diversified such that if this does turn out to be something more than a quote unquote, nothing burger, that you’re really prepared. But thus far, it’s not looking like you should look to make any massive changes within your investment portfolio.
Julian Klymochko: Some corporate activism news. Xerox indicated that it plans to nominate 11 directors to HP board in a bid to take control of its competitor after several snubbed buyout offers. Now, this takeover battle is really heating up here with the prospect of a proxy battle. And this is really just straight out of the 1980s style hostile takeover playbook. Now, a hostile takeover, if successful, would merge two American technology giants and they have both really just seen better days. So it really seems like a cost-cutting play. A synergy is play where they are both really experiencing kind of a slow, steady decline, certainly not growth companies here. The other interesting aspect that we have touched on in previous podcasts is the Minnow swallowing the whale dynamics such that Xerox as a market value of about $8 billion, while HP is nearly $32 billion, so the target nearly fourfold the acquire. And this deal is largely being driven by activist investor Carl Icahn. No stranger to these hostile takeover tactics, certainly no stranger to proxy battles. I mean, he has been through dozens and dozens throughout his career.
HP not having any of it. Obviously, they rejected this, saying it continues to undervalue the company, but shareholders continue to like it. HP stock continues to trade around 22 bucks per share. Xerox has all the debt financing lined up and the underlying goal, what Xerox is trying to accomplish here is to replace HP board of directors because they don’t seem keen on engaging in a deal. So they want to replace the board such that they can make a smooth path to a merger between the company. So certainly really interesting dynamic here, which we actually don’t see very often at all. While the proxy battle is a common tactic utilized by activist investors, we see dozens and dozens per year from a corporation’s perspective. You rarely see a company utilize a proxy battle to takeover another company by replacing the reporter directors. In fact, since 2013, we have only seen it five times in terms of a company; nominating directors at another company. A really unique situation, a takeover battle that is heating up here and just a really interesting situation. What do you think about it?
Michael Kesslering: Yes. So typically, I am quite sympathetic to the external party in a proxy battle, as you know, in most situations. It is an entrenched management team and they make a pretty compelling argument. Now, in this situation, the one little bit of sympathy I do have for HP position is that in the original bid, as we had discussed previously, they had come up with this debt financing to basically carry this deal over the finish line and come up with financing needed, but that really wasn’t the issue. Like the issue was that HP thought that the bid undervalued them, so they really still haven’t addressed this core complaint that HP had with their original bid. I guess the other aspect is that, you know, you have Carl Icahn involved. He is invested in both companies, and as you had mentioned, both of these companies are in secular decline. And so what they’re really trying to do is just realize some cost synergies and keep the keep the cash flows coming for as long as possible.
Julian Klymochko: Really, and that is what you see in mature industries. As consolidation, where they can really harvest those synergies, create value. And just it’s more of a free cash flow play and sort of a growth story
Michael Kesslering: Absolutely, and so in terms of the synergies, they are estimated to be about 2 billion in cost synergies. But on the other side, there is believed, analysts do believe that there is a little bit of issue with regards to how they would integrate the two companies, as they do, have different product offerings and different pricing models. With a two billion dollar number, it makes it seem like it is just incredibly easy.
It may be a little bit more involved than just, you know, mashing these two companies together. And one other aspect that this reminds me of is one of the things that’s mentioned is that, you know, HP and Xerox, their business model is in secular decline because e-mail is being used more, you know, e-mail being disruptor.
Julian Klymochko: Instead of printers.
Michael Kesslering: Absolutely, and this has been something that has been happening for the last 20 years or so. And what’s also interesting with that is that at this point in time now there’s a disruptor of email. So messaging services such as Slack are actually disrupting their disruptor. And so my only take away from that is really that, you know, when you look at the stock market, there’s plenty of different disruptors that are coming in to completely revamp a whole business line, but in reality, this typically will move a lot slower than one expects. One would expect that a disruptor will come in and the incumbent companies will just be completely wiped out. HP and Xerox are still multi-billion dollar companies and will continue to be for a number of years, not into the future to infinity. But they still are an ongoing entity.
Julian Klymochko: The other really interesting thing to keep an eye on as we indicated Xerox $8 billion market cap. HP $32 billion market cap, and so if Xerox were to actually be able to acquire HP under the current structure, it would leave a highly levered pro forma entity. We are talking about four to five times EBITDA. However, if the tables were to turn. HP acquiring Xerox i.e. the $32 billion company acquiring the $8 billion company that would certainly alleviate a lot of this balance sheet pressure such that the pro forma entity would be levered less than two times EBITDA. I think that’s a potential option here, but thus far really tight-lipped from HP, they just sort of snub the bid and say it is insufficient. They really have not made a play to utilize the so-called Pac-Man defence when you turn the tables and the target turns into the acquire, but that is something to watch for here, and I would not be surprised, frankly, if that happened.
Julian Klymochko: In a battle for the ages between the bulls and the bears, long investors have come out on top as a controversial electric car maker, Tesla. Its stock market value has rallied threefold over the past few months to reach a stunning hundred billion dollars. That is right, Tesla at one hundred billion dollar market cap. Now, the surge in valuation has made Tesla the most valuable U.S. automaker, and second, globally next to Toyota. Believe it or not it’s actually more valuable than Volkswagen, and basically more than GM and Ford combined, which obviously manufacture many multiples of vehicles more than Tesla does.
And what the battle is here between the bulls and the bears longs and the shorts is basically on valuation is a big one. I mean, hundred $100 billion dollar, real tough to justify when it has never recorded an annual profit and produces a small fraction of the profits of its competitors. I looked at, you know, fundamental analysis based on whether it is sales, EBITDA. I believe most auto manufacturers trade between two to four times EBITDA, extremely low valuations, and Tesla’s is in the triple digits like north hundreds of times or something crazy like that. Then fundamentally, I mean, it has a lot of debt as well, but nonetheless, the stock has rallied its face off up over 20 percent year to date. Short sellers, get this, have lost almost three billion dollars in the first two weeks of the year. Just on this face ripping rally. What are your thoughts on this stunning one hundred-billion-dollar valuation on everyone’s favourite electric carmaker, that Tesla, or TSLAQ?
Michael Kesslering: And so I have been on the podcast here before discussing my overall negative view of the business model, which I still would agree with. I mean, when you look at the actual fundamentals, the issue for short sellers is that the actual business fundamentals are not what is actually driving the stock here. I mean, it is not a high growth company. You know, it’s kind of expected with revenue year over year here. It will grow at 13 percent, so it is not a high growth company anymore. But for shorts there main thesis has really been that insolvency. So moving into 2019, that was really the main focus. The story was supply constraints as well as insolvency from the company that basically their losses were going to catch up to them and they had a dwindling cash balance, but the difference now is that they’ve raised a ton of external capital. And so that really has negated…obviously losses do matter over the long term, but in the short term, if they’re able to sustain those losses by introducing new capital into their cap structure, that really pushes out the timeline that they can have to execute.
Julian Klymochko: Right and shorts were on to something because, you know, Elon Musk have admitted in the past that it has been a very close to bankruptcy just due to its losses and access to capital, which appears to not be an issue at this point.
Michael Kesslering: Absolutely, and so when you are looking at, you know, the whole short thesis is what I’m seeing on kind of the Tesla Q’s side. To be a little bit critical is that they are now experiencing a lot of a thesis draft where now the thesis has changed for their short position. You know, if you look at short interest, it peaked in, you know, over 30 percent in twenty nineteen, but it is still around 18 percent. So still, a lot of people short this name and really getting their faces ripped off right now.
Julian Klymochko: Yeah, the other thing to note is that there are converts outstanding. So some of that short interest is related just on that convertible bond arbitrage trade where they are long the converts short the stock.
Michael Kesslering: Yeah, that is a great point. And really all I intending to say here is that when your thesis isn’t playing out. Now, this was not a position of Accelerate nor my own. But when your thesis isn’t playing out, it’s time to take a look at what your underlying thesis is and not just jumping to something else that aligns with your world view. You really have to take an unemotional look at the situation, and when I look at Tesla as a company, I see the bulls and bears as both being very emotional about this about this topic.
Julian Klymochko: Right, it is a big no, no. You never want to be emotional about a stock.
Michael Kesslering: No, and that’s a situation that you really don’t want to be involved in from either side, in my opinion, when both sides are somewhat irrational, not letting fundamentals move the stock.
Julian Klymochko: Right, exactly and it is all about fundamentals and what I caution both bulls and bears on Tesla is that this is a story stock, in fact it’s the definition of a story stock and by story stock, this refers to the fact that the stock is completely isolated from the underlying business. They are completely different things. Tesla, the stock and Tesla, the company, aren’t related at all. There is no correlation between the two. Obviously, the business faces its issues. It has product issues, potential demand and production issues, fundamental capitalization issues, etc. However, the stock has been on fire because, as you indicated, it has turned cultish. There is these, you know, radical longs who buy at any price. Right, and then to make it worse. You have this sort of short squeeze dynamics such that the higher it goes, the more that the short sellers need to buy back because they’re facing these punishing losses, which creates just really this feedback loop of the stock just going up and up and up irrespective of underlying business performance. So I always caution when people are looking to short stocks, never short a story stock that is unrelated to underlying business principles. And then valuation in addition, is never solely the only thing you should be shorting on because of a valuation is 10x too high. Is nothing preventing it from going up another two to three to four to five x, which we have seen on Tesla. I read a very good short report when it first IPOd and the stock was at thirty dollars and look it’s gone up 20x since then. So I really caution investors ongoing short story stock. That is kind of one of our rules here. We like to short stocks that are sort of circling the drain on their way to zero. And so a skyrocketing stock is nothing that you want to be putting in a short book, because in my opinion, that’s playing with fire.
Bank of Canada
Julian Klymochko: We will finish off with some macro stuff with the Bank of Canada leaving the door open for a potential interest rate cut this year. Now, they had a meeting this year in which they chose to keep their policy rate steady at one point seventy five percent, which has been the status quo for a while now. But Governor Stephen Poloz he turned a bit dovish this week as he indicated that weaker economic growth in Q4 could lead to a rate cut in 2020, should this sluggishness continue into this year. What is interesting is we looked at the market expectations that is priced in. The futures market actually rose for a rate cut in 2020. Expectations of a rate cut by December 2020 went up from 50 percent to 80 percent. So the market thinking that a rate cut this year went from a coin flip to highly probable. Got a quote here from Governor Poloz, as he indicated. “I am not saying that the door’s not open to an interest rate cut. Obviously, it is. It is open, but it hinges on how the data evolve from here. We have a strong belief that this will prove temporary, but temporary could be longer or shorter. And to the extent that it’s longer, we would have to come back to that decision to decide then whether or not the interest rate as it is today remains appropriate.” So there you have it, a quote from Governor Poloz, but the thing is, he is kind of kicking the can down the road here because he is actually retiring and out as Bank of Canada governor this summer. So perhaps he is putting this big decision on his successor.
Michael Kesslering: Yes, absolutely and with that being on his successor, it is not official. There is some grumblings about who it will be, but it is not official. Who got individual will be at this point in time. So it’s really difficult to handicap what’s going to happen in the future with an entire regime change. The Poloz’ Bank of Canada is very data dependent, and, you know looking at the data as it comes in. And there really is no reassurance if his successor will engage with their policy decisions in the exact same manner. So it is a really tough coin flip here, like whether there will be any sort of cut in the in this year.
Julian Klymochko: Right. And what is the goal of a rate cut? Well lowering interest rates. Number one weakens the Canadian dollar, which Poloz as does not like to see go up. And perhaps that’s why he had some dovish language because that did cause the Canadian dollar to trade down.
Ultimately a weaker currency gives, you know, domestic economy, domestic producers quite the boost. And so on this news, we saw the Loonie traded down about a half a percent on this dovishness from Governor Poloz and basically the Bank of Canada looking like a rate cut is in the cards for later this year, and we shall see.
And that’s it. Ladies and gents, for episode 49 of The Absolute Return Podcast, if you want to check out more, you can visit absolutereturnpodcasts.com. And please give us a follow on. Check us out on social media on Twitter. I am the people’s hedge fund manager that is at @Jklymochko, J-K-L-Y-M-O-C-H-K-O, and you are?
Michael Kesslering: And my handle is @M_kesslering that is K-E-S-S-L-E-R-I-N-G
Julian Klymochko: And we wish you the best of luck in your trading, speculating and investing this week, 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.