Why I disagree with Bill Gross about Carry Trades.

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Bill Gross

 

 

 

 

 

 

Bill Gross has issued a new message to investors in a letter entitled Bon Appetit! He is worried about yield spread compression and refers to the past forty years as a “Gray Swan” event. I disagree. The demise of the carry trade is greatly exaggerated.

I am going to go out on a limb here and offer a mild critique of Mr. Gross’ letter. Admittedly, I am on the thin limb – actually, its more like a leaf… I have never completed a “carry trade” myself, nor am I articulate in the fine points of duration. The one thing I do know is what a yield curve looks like, and I don’t think the shape of that curve will change for many years to come: Up and to the right… The demise of the carry trade is greatly exaggerated.

Bill Gross is a very wise man and a fixed income investor par excellence, but he has also been wrong from time to time.

A couple of general observations about the latest Bill Gross missive:

First, Mr. Gross doesn’t provide any Earth-shattering revelations here (pun intended). With the exception of life insurance and pension fund managers, I don’t think there is anyone left who doesn’t believe that a large measure of returns in the investment world have been the result of steadily declining interest rates post-Volcker.

Second, I don’t believe anyone disagrees that the low hanging fruit of a wide yield spread has been squeezed out due to the proliferation of liquidity. Therefore the probability of risk mis-pricing has risen significantly. Mr. Gross’ point about the danger of illiquid assets is very relevant. I am in the commercial real estate industry and the compression of yields has been breathtaking.

Third, I am very surprised to hear Bill Gross talk of the past 40 years as a one-off “Gray Swan” event. He usually has a fantastic sense of historical context which he seems to disregard in his letter. World capitalism has faced severe disruptions, panics, and most of all – deflation. The last decades of the 1800’s were marked by massive over-investment in railroads and steel (enabled by foreign capital) which caused multiple panics and a severe depression. The Great Depression itself was a period of deflation where the entire banking system ceased to operate because there was no ability to borrow short and lend long. The depositors simply refused to “lend” to the banks at all. The current period, in many ways, is not unprecedented.

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I’m really not that unusual! People confuse me and Alan Greenspan all the time.

Mr. Gross contradicts himself. He says that volatility is very likely in a market with compressed yield spreads, and yet he glosses over the disruptions of the past. He says you will rarely find a 12 month period where bonds had a negative performance. To make this statement assumes that the ebbs and flows of credit markets have been homogeneous. In fact, there have been pockets of massive volatility in credit markets: The 1974 IMF intervention in the UK bond market, the capitulation of New York City’s municipal bonds, the massive defaults of the central american debt crisis of the early 1980’s, Long-Term Capital Management, the Asian and Mexican currency crises, etc were all relatively recent events. Each one of them required highly coordinated international central bank intervention. Each one of them alone could have rendered the 40-year “Gray Swan” analogy useless. Indeed, if the past 40 years is a “Gray Swan”, it is one of artificial nature – entirely managed by central banking intervention. 2016 may be an extreme moment in time, but again, it is not unprecedented.

Here are some specific disagreements I have with Mr. Gross’ position:

1. The playing field of the post-Lehman era is littered with bond managers (including Bill Gross on occasion) who have bet against a reversal in yields, only to find themselves on the wrong side of the trade. Rates have continued to decline.

2. Gross has contradicted himself by recently recommending securities like Annaly Capital (NLY) and the Nuveen Preferred Income Opportunities Fund (JPC), both of which rely on short term leverage to juice long term yields. Are these not carry trades?

3. Three reasons for declining rates show little signs of reversal. Inflation has continued to decline. Indeed, we may well be on the cusp of a Japan-style 20-year+ deflation cycle. Next, the entire banking system relies on the ability to borrow short and lend long at higher rates. The Federal Reserve will do everything in its power to maintain this friendly arrangement for as long as it takes. Finally, the carry-trade referred to by Mr. Gross limits its perspective to the domestic environment. It ignores the other main trend of the past few decades – the demand for US Treasuries as a safe haven and/or the repatriation of export-based dollars. The argument also ignores the desire to borrow money in a currency that is depreciating to obtain stronger dollar yields.

4. To the extent that inflation has the very strong possibility of turning into deflation, holding Treasuries sounds like a decent investment to me. Real yields improve in a deflationary environment. Meanwhile, pricing power at US corporations evaporates. What would you rather own? A piece of paper that can produce a 3% real yield (2% nominal yield) or stock in a commodity-based company that has falsely improved earnings per share through debt-binges for stock repurchases?

You may have to go to Mars to repeat the last 40 years, but the carry trade is going to continue for several more years right here on Earth.

The perils of student loans

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As high school seniors and their parents fill out those dreaded FAFSA forms, I thought it would be instructive to point out just how wacked out the world of student loan debt has become.

Since the 2008-09 recession, student loan debt has risen 665%. That is not a typographical error.

As always, the folks at Advisor Perspectives do a masterful job charting the ebbs and flows of markets and the economy.

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Microchip Technology Set To Acquire Atmel – Is It A Good Use Of Capital?

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  • MCHP announced a deal to acquire ATML on January 9th, 2016, for $3.5 billion or $8.15 per share.
  • ATML posted revenue declines of nearly 17% in 2015.
  • Both companies have exposure to Asia in excess of 40%.
  • The ATML acquisition will increase net sales by 55%, but represents a return on capital of less than 4%.
  • For clues, I take a look back at the Standard Microsystems acquisition of 2012.

 

I posted an article on Tuesday that cast my doubts on the merits of the Atmel (ATML) acquisition by Microchip Technology (MCHP). While the purchase absorbs a significant competitor and offers access to new product markets, it is an expensive and complex endeavor for MCHP that represents a radical departure from the incremental acquisition history that has proven successful.

The $3.5 billion acquisition of ATML is a risky proposition. It will increase MCHP’s sales by a substantial 54% from $2.2 billion to over $3.3 billion. Meanwhile the absorption of the purchase comes at a time when ATML is suffering serious declines in revenue – as much as 17% from 2014 to 2015. The purchase price of $8.15 per share is over 100 times TTM earnings.

China’s slowdown seems to be having a negative impact on the semiconductor industry.

For this reason, in my estimation, the ATML acquisition presents MCHP with a mediocre return on capital. GAAP earnings at ATML will be in the low $30 million range for 2015 – a return that is less than 1% on the $3.5 billion price. Free cash flow will be around $115 million – a 3.24% return on capital.

In defense of the optimism at MCHP, there is a lot of room to improve margins. ATML has consistently shown a GAAP operating margin below 10% while MCHP’s was as high as 41% in FY 2014 and 35% in FY 2015. MCHP believes that an additional $170 million can be generated from revenue growth and cost savings, which pushes the return above a more respectable 8%.

MCHP has $2.4 billion in cash

In the acquisition of ATML, it will be using its treasure chest of over $2.4 billion on hand, borrowing $765 million, and issuing 13 million shares. ATML holders get $7 per share in cash and $1.15 in MCHP stock. While the cash outlay is massive, MCHP has consistently shown positive cash flow of over $500 million annually, so the coffers should be replenished fairly quickly.

MCHP has successfully completed many acquisitions. They tout their record in a slideshow on their investor relations page. It shows organic net sales have expanded at an 8.3% compounded rate for the past six years, and 6.3% for the past three years. Meanwhile, including acquisitions, net sales expanded at 17.3% per year for the six-year period and 13.1% per year over three years.

But have the acquisitions really been that good?

I decided to look at the August 2012 acquisition of Standard Microsystems (SMSC) for $938 million in cash. It took place in fiscal year 2013, and was completely integrated in FY 2014 MCHP earnings.

Net sales increased from $838 million to $1.13 billion between 2013 and 2014. GAAP net income more than doubled to $327 million.

To investigate, I took the sum of MCHP’s numbers from FY 2013 and SMSC’s numbers from FY 2012 (roughly equivalent periods) – a hypothetical total as if the acquisition was merely accretive to earnings. These numbers are shown in the taupe column in the center below. Next, I compared the sum to the actual reported FY 2014 results (blue column). One can see that gross profit was about $74 million higher than the direct sum.

Net income shows a much wider difference than expected. MCHP’s operating margin leaps to 40%. This is impressive, particularly in light of the 13% operating margin absorbed from SMSC.

Interestingly, if one takes a look below the income statement, the results are not quite as strong as they seem.

MCHP moved about $96 million from the income statement to the balance sheet. It is very apparent that MCHP capitalized about $50.5 million of R&D expenses after the merger. It is also evident that operating expenses improved by $45 million after SMSC’s depreciation was reduced.

The final column (dark beige) shows the capital expenditures added back to R&D and the depreciation restored to SG&A. If those actions are taken, GAAP earnings are closer to $300 million than $395 million.

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The acquisition of SMSC still looks good after the adjustments, but not quite as good as MCHP claims. Using operating cash flow, the return on the $938 million purchase is 20.33%. However, the GAAP earnings return on capital drops from 28.56% to 18.33% reflecting the higher adjusted operating expenses.

Finally, I think the operating margin improvement is slightly suspect. Someone with much more time (and accounting skills), can probably sort out the large increase in inventories that were booked in FY 2013. It may be possible that MCHP took the SMSC inventories on the balance sheet at the end of 2013 and recognized them as sales during FY 2014. This is merely a hunch.

I have produced a similar comparison of the pending ATML acquisition that I will share in a subsequent article.

I’m not sure MCHP knows what they are getting into.

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Yesterday’s conference call with analysts dissected the FY 2016 3Q earnings results for Microchip Technology, Inc. (MCHP). It offered a few insights on the purchase of Atmel (ATML) for $3.5 B.

MCHP stands behind its confidence that “synergies” from the deal will reap $170 million of profits. Yesterday, I questioned the merits of a deal that only yields a 4.86% return on capital, depletes the cash on MCHP’s balance sheet and raises leverage.

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A comment by the CEO Steve Sanghi stood out to me:

Steve Sanghi

“Well, we’re not learning much about the business at this point in time. Atmel is essentially not shedding anything about the business. We still see that Antitrust hasn’t cleared and we still see the businesses as competitive. We’re largely getting through the people, we tour the facility, we’re learning where people are located, we’re starting to formulate some initial thoughts about how we will go about the integration. We have done enough of these that we know what burdens we have to push and what we have to do so we can get there quite quickly. But in the two weeks that have passed, they are not letting us into the business yet.”

I don’t find it surprising that Atmel is holding their cards close to the vest, but I do find the confidence in perceived “synergies” to be wildly optimistic for a CEO that has barely scratched the surface of the ATML integration.

ATML has seen revenue decline from over $1.4 B in 2014 to $1.2 B in 2015. It will likely see its free cash flow from operations nearly cut in half – from $150 million in 2014 to between $75 and $85 billion in 2015.

MCHP has been through the acquisition game many times, but ATML is different. It enlarges the business by 47% and takes on a company facing serious headwinds in Asia. It also increases debt from about $2 B to $2.7 B at a time when leverage appears to be a growing problem for companies exposed to Asia.

Feedlots lost an average of about $500 per head of cattle sold in October

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Continuing Feedlot Losses Will Add Pressure on Cattle Prices

Feedlots look likely to extend into 2016 losses which began in 2014 – putting “even more downward pressure” on feeder cattle prices, and undermining the revival in the US herd. Feedlots lost an average of about $500 per head of cattle sold in October, taking nearly to a year their spell in the red, with cattle marketed in November 2014 the last to show a profit.  And this spell in the red could easily continue until at least January 2016, spelling fresh troubles for feeder cattle prices which last week hit an 18-month low of 170.375 cents per pound in Chicago’s futures market, extending to 22% their decline so far in 2015.

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This fellow appears to be quite virile. Alas, the prices for his offspring are not.

These negative margins will likely exert even more downward pressure on feeder cattle prices, as well as on cow prices and these price drops could in turn temper enthusiasm for what has appeared to be a rapid build-up in cow inventories” from their lowest in more than 70 years.

Feedlots’ woes reflect a vicious circle of increasing weights in slaughter cattle undermining beef prices and animal values, in turn encouraging feeders to hang on to livestock and fatten them more in the hope of a recovery in values ahead.  Cattle are spending longer periods on feed primarily because feed costs are relatively low, and the current market does not provide much incentive to sell fed cattle, resulting animals spending longer time in feedlots.

The trend of elevated fed cattle weights – exacerbated by the heavy weight of feeder cattle bought into feedlots, as southern US ranchers attempt to exploit to the maximum pasture condition improved by decent rains – have been evident in slaughter data.

Cattle carcass weights are at record levels and continue to increase counter-seasonally, flagging steer weights which, at 920 pounds in September, exceeded bull weights for the first time, and increased to an average of 927 pounds as of the week ending October 24.

Bid to force the market lower

However, the effort by feedlots to feed their way out of difficulty has met with limited success in part because of the inability of a beef market, suffering a hangover from high prices, to absorb the extra supplies. The USDA termed as “fragile” US beef demand, noting “weak interest in the ground beef complex and sharp drops in the value of byproducts such as hide and offal”.  Furthermore, beef packers, themselves facing deteriorating profitability, have increased the discounts on very heavy cattle.  Packers are attempting to support their margins by constraining front-end supplies to force the live cattle market lower.

Seasonal trends

Packers at least have the calendar on their side, with the run up to year-end typically provoking an improvement in wholesale beef prices.  Seasonal trends suggest that beef cut-out values should start to move higher post-Thanksgiving, potentially improving beef processing margins.  However, for feedlots, no such imminent relief is not in the cards, with the backlog of heavy cattle on feed likely to provide large numbers of market-ready cattle, disproportionately steers, through at least the first quarter of 2016.

Source: The Cattle Range

 

 

Omaha Apartment Market, Pockets of Oversupply but No Worries

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We continue to have positive views on apartment demand going forward. Occupancy has exceeded 95% for over two years. However, we view 2016 with some trepidation as a surplus of 500 units reaches the market in 2016. 

Market Breakdown

We believe the Omaha Metropolitan Area apartment market is heading towards an over-supply level of 500 apartments. However, this amount is fairly insignificant in light of the pace of job creation, population growth, and the overall amount of units in the market.

Three reasons support this idea.

  1. Supply is roughly in line with demand, but has slightly outpaced typical homeownership percentages.
  2. Multifamily supply has been in line with job growth, but has recently exhibited a ratio that signals some caution.
  3. The perceived amount of oversupply is not only a function of job growth. It is also a function of income growth. Construction costs have pushed rents to levels that many new entrants to the housing market will lack the means of stretching for rental payments in new projects.

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Supply and Demand Equilibrium Levels

The Omaha metropolitan area has grown beyond a population of 905,000 and has a consistent level of household formation around 4,000 per year. With about 70% of new housing demand typically attracted to homeownership, rental housing stays at rough equilibrium between supply and demand at 1,200 units per year. That number is roughly line with current supply numbers, but there are signs that new apartments have begun to outpace growth.

As a percentage of total housing supply, multifamily units have, in aggregate over the past three years, exceeded the typical homeownership ratio by 2%. There were 3,041 single family permits issued in 2013, 2,639 permits in 2014, and 2,830 for the trailing 12 months ending September 2015. Multifamily housing hit 1,370 units in 2013, 1,533 in 2014 and 1,114 through September 2015. The sum of the three years shows that multifamily has been approximately 32% of new housing. Meanwhile, historical averages for homeownership in the Omaha MSA have hovered at 70%. In this instance, the oversupply of 2% translates in 250 excess apartments.

As an aside, the peak single family construction occurred in 2005, when 5,877 units were permitted.

Total Units

Units         Single Family    Multifamily    Total      % Multifamily

2013             3,041              1,370            4,411              31%

2014             2,639              1,533            4,172              37%

2015 ttm       2,830              1,114            3,944              28%

Total             8,510              4,017            12,527            32%

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Job creation and Housing Demand

Apartment demand follows job creation levels in a fairly lock-step pattern. The Omaha employment market has been robust since 2012. Between the 2008 nadir of 437,000 jobs and the recent 2014 figure of 462,500 jobs, Omaha has created over 25,000 jobs. This level far outstrips the supply of housing by more than double. By comparison, the stock of housing increased increased by an astonishing 56,700 between 1999 and 2008, but jobs only grew by 26,200!

Typically market research firms such as Axiometrics use a ratio of 5 jobs per unit as a demand equilibrium ratio. In an ideal equilibrium, the 25,000 jobs created in Omaha since 2008 implies a maximum apartment supply of 5,000 units. In fact, over 6,000 multifamily units have been permitted between 2008 and the end of 2014. This implies a ratio of 4 jobs per unit. If one assumes a job growth rate for 2015 of just over 1%, it can be figured that 5,000 jobs have been added during the past year. The ratio for 2015 is, therefore, slightly better at 4.50.

The ratio of jobs to units at a sub-5 level implies an oversupply of about 750-1000 apartments in the metro area.

Year Employment Population Jobs/Population
1999 411,240 761,603 54%
2008 437,478 845,119 52%
2014 462,515 904,421 51%

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Income Concerns

So far, we’ve established that an oversupply of between 250 and 1000 apartments exists in the metro Omaha area. While this number is statistically insignificant out of Omaha’s 100,000 rental units, the direct peer group for new construction is much smaller. The peer group for these units really amounts to about 10,700 units built over the past ten years. These apartments have been built at the top end of rental rates. In this case, a 5-10% oversupply is a number that deserves watching.

Why do we say this? The new apartment math requires an annual income of $38,800 per year. This is towards the high range for single person households who have recently entered the workforce. With young people graduating with significant amounts of student debt, the ability to afford rents approaching $2 per square foot per month may be under pressure.

In Conclusion

Apartment supply as a percentage of homebuilding implies a 2% level of oversupply – about 250 units. When a job ratio is applied as a benchmark, the oversupply level rises to between 750-1,000 apartments. Our best estimate is that the Omaha MSA is heading towards a 500 apartment surplus in 2016 that will cool the occupancy levels from the peaks enjoyed the past several quarters. Additionally, units being delivered to market must be cautious about the pressure of income levels. While employment growth has been robust, student debt is high and many new jobs are below $35,000 per year.

Are we concerned? Not yet. We believe that many of the areas receiving supply have been absorbed at a rate that has exceeded our own expectations. Meanwhile, some experts believe that the Midtown Omaha area is going to be pushing the limits of absorption by late 2016. Also, while supply may have been running ahead of demand recently, the level of occupancy has been in excess of 96% for a few years now. Anything above 95% implies a very tight market. In this regard, there is proof of continued high demand.

One final caveat: We are not in the camp that there has been a paradigm shift in home-buying attitudes. Millenials will eventually get married and have kids. This process may have been retarded by the recession, but it will continue.

Omaha 2015 Multifamily Permits Below Trend… For Now

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Through September 2015, there have been 667 multifamily housing units permitted in the Omaha-Council Bluffs metropolitan area. This is well below the 2014 level of 1,533.

When asked about housing supply in Omaha, Def Leppard responded through their agent

When asked about housing supply in Omaha, Def Leppard responded through their agent “We played two bloody nights at the Civic back in 1983. It was brilliant.”

The equilibrium level which keeps supply and demand in balance is roughly 1,000 to 1,200 units per year.

If you track the previous 12 months and include the last three months of 2014, permits totaled 1,164.

I suspect that 2015 permits will come in at roughly 1,200 as a few projects sneak in at year-end. Despite this fairly moderate number, experienced lenders have expressed concerns of over-supply.

Affordability will be a much bigger issue as rising costs force developers to ask for rents that are pushing the outer limits of income levels.

Recently, lumber prices have started stirring again.

Lumber_Composite October 2015