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China's Ticking Time Bomb?

Are Bad loans buried in Chinese banks going to be the next blow up?


We recently received a question from one of our macro subscribers about the threat posed by non-performing loans (NPL) to the banking sector in China, and whether the there was sufficient transparency and regulation among financial institutions there to accurately gauge the risk.   The question struck a deep chord with us; from our perspective the development of the banking system has been a lingering Achilles heel in the explosive Chinese growth story of the past 15 years.


Our conclusion is, ultimately, that the full extent of the potential losses there is unknown, but that this does not undermine our overall thesis on China’s recovery potential. I wanted to share some of the bullet points that we are focused on:


The Bullish factors for Chinese financials seem clear enough: High savings rates, the strict restrictions of international capital transactions due to a closed capital account and the lack of alternatives in China have helped the banks to increase deposits at a rapid rate. Total capital, increased by the government capital injection, IPOs and the introduction of foreign strategic investors also provide opportunities for the banks to increase lending in a global environment where large internationals have seen their lending ability hobbled. What we are left to wrestle with are questions of asset quality and risk management.


Through accounting system reform and public listing, the transparency of the major commercial banks has improved in recent years, making some international comparisons of bank financial results possible, with the caveat that detailed differences do exist in accounting systems. While some Chinese banks have become competitive with the large internationals (state-owned commercial banks/SOCBs, and joint-stock commercial banks/JSCBs) in terms of assets and capital size, they still lag in terms of asset quality and profitability.


The reported average NPL ratio at the recapitalized SOCBs declined to 3.28% at the end of 2006 from 20.62 at the end of 2002. During the first two months of 2009 the level of bad loans in the Chinese banking system decreased by 17.5 billion Yuan, to 1.53 trillion Yuan, with commercial banks’ non-performing loans totaling 553.5 billion Yuan, a non-performing ratio of 2.2%, down from 2.44% at the start of 2009, according to the CBRC. It is assumed that the four-trillion Yuan stimulus plan, accompanied by credit extension of 1 trillion Yuan in new loans on average, each month, will drive the level- and ratio of non-performing loans higher with a long lag before the numbers reflect this increase accurately. The blind spot in these equations is the large number of “special mention” loans on the balance sheets of Chinese banks, a category that is not regarded nonperforming but that is deliciously defined as “the repayment of loans that might be adversely affected by some factors.” This definition leaves a very large carpet to sweep problems under.


The capital adequacy of the SOCBs improved, when measured by their amount of Tier 1 capital, after the CBRC established a regulation requiring commercial banks to keep their capital adequacy ratios above 8% after January 1, 2007, in accordance with the Basel Capital Accord. The central government subsequently committed to providing the Agricultural Bank of China with capital injections but took a harder stance with the JSCBs since most of their shareholders are local governments and state-owned enterprises (SOEs), reluctant to offer a direct bailout, pushing them to seek new money from local governments and the private sector.


In recent years the government has begun implementing a series of reforms to improve the efficiency and profitability of the state banks given the impending opening of the domestic financial sector to foreigners under the WTO. A large percentage of bad loans have been transformed from the wholly state banks to fully state-owned asset management corporations (AMCs) in return for bonds guaranteed by the Ministry of Finance.  Given the weak cash recovery rate of less than 25% reported on these bad loans, these transfers are effectively government recap transactions, in some cases with direct cash injections directly from the pool of foreign reserves.


Three of the SOCBs have been transformed from wholly state-owned to corporations owned by shareholders, although the state remains the largest shareholder, listed on Hong Kong. Now most commercial banks must dispose of NPLs out of their own provisions or profits, which could be problematic due to the banks’ low profitability. In the first quarter of 2006 it was estimated by Fitch that the deposit taking institutions had US$271 billion of NPLs, which were classified as “special mention,”  -the above mentioned purgatory category hovering between normal and nonperforming. Officially, the total amount of NPLs was US$206 billion, of which US$164 billion are held in commercial banks and US$42 billion in noncommercial banks. UBS Securities Asia estimated that Chinese commercial banks might have new NPLs as high as US$225billion of the loans extended during the boom period of 2002 to 2004, with a rapid increase in property loans, a focal point of the Chinese government. Large amounts of NPLs remain on the balance sheets of the AMCs, with the purchasing of US$330 billion NPLs from the four SOCBs and the Bank of Communications (BOCOM). The State Development Bank has also transferred NPLs to the AMCs. The four AMCs were originally designed to be closed within ten years but are now expected to continue under a market-oriented business model and transform their organizations into commercial entities resembling investment banks and establish securities companies with joint-venture asset management companies with foreign banks (The joint-venture AMCs were established, in part, to introduce market-oriented mechanisms into the NPL secondary market).


Having said all this, the immediate conclusion is hardly satisfying:  Considering the questionable reliability of existing data, the recent rapid increase of lending and the remaining huge NPL pools held by AMCs, is still difficult if not impossible to judge whether the NPL problem in China has actually moved toward a significant resolution.


Our bullish thesis on China does not ignore these concerns, we just think that the sustainability of the national budget must also be considered within the context of the NPL issue.


We are betting that massive foreign exchange reserves and a relatively modest fiscal deficit (111billion Yuan in 2008 although with the current contraction in economic activity and the level of stimulus the fiscal deficit will expand rapidly in 2009) leave the Chinese government with the capacity to manage the issue in the short-term while progressing with banking sector reforms (another critical focus for us), capital market development and opening the capital account.


Please keep the questions coming.


Andrew Barber

China's Ticking Time Bomb? - fu12

Tech Spec: Screening for Tech M&A Candidates

On March 9th, we sent a note to our clients a note entitled, “Eye on Value: Companies Trading at Discount to Cash”.  Since that time the screen in aggregate has returned ~34%, with Eastman Kodak being the top performer at +~94%. 


Not surprisingly given the move in the market over that period, every stock in the screen registered a positive return.  To quote Keith indirectly, our screen was either good, or lucky, as it outperformed the market by over 1,000 basis points.


We ran a new screen today, which we have called, “Tech Spec”.  Our Head of Technology research, Rebecca Runkle, wrote today in her morning piece, “M&A is what matters now.”  In effect, she is looking at the IBM / Sun deal as an early indicator of the re-emergence of tech M&A.  While Rebecca would obviously offer a more nuanced view of what company is next to be taken out, probably focusing on the franchise value of the company and such; we macro guys are simple folk.


As a result, I put together a tech spec screen based on the following parameters: cheap, good balance sheet, and market capitalization south of $1.0BN.  Since tech is working and M&A in tech is likely to pick up on a y-o-y basis, especially since, as Rebecca also wrote, “bid-ask spreads have already collapsed (0.9 TTM sales versus 1.9 a year ago, according to The 451 Group)”, this seems like the good area to look for some beta and to play the potential thematic increase in technology M&A.


According to Capital IQ, the group on average trades at less than 4.0x EV/EBITDA, less than 1.0 FV / Sales, and all the companies have net cash balance sheets.  Value investor’s values, to be sure. Incidentally, all of these companies fell under Capital IQ’s technology classification. 


Happy hunting!


Daryl G. Jones
Managing Director


Tech Spec: Screening for Tech M&A Candidates - tech29

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Switzerland: What A Mess!

Swiss National Bank intervenes to prevent appreciation of the Franc yet the negative economic fundamentals and weighting of the ETF will outstrip the positives of currency devaluation…


Position: Short Switzerland via the etf EWL


SNB started buying foreign currencies on March 12th to encourage devaluation of the Franc versus the Euro and Pound and reduced its benchmark interest rate to 0.25% to improve liquidity by lowering borrowing costs.  The SNB is now continuing to devalue the Franc by buying foreign currencies and corporate bonds.


On the margin, Swiss monetary policy is positive. A weaker Swiss Franc will benefit exports to its largest trading partner, the Euro zone, and better match deflating prices and waning demand that are pushing down GDP. Since 3/09 the Franc has depreciated 3.7% versus the Euro and Pound.


The Swiss Market Index is down -9.7% YTD, but up +6.9% in the last four weeks.  We shorted the Swiss etf EWL on 3/25 at an intermediate top.


Yet our negative outlook on the country is confirmed by Switzerland’s fundamentals. Despite the positive “spirit” coming from G20 along with the $1Tillion increase to the IMF’s balance sheet, Western Europe has a ways to go before it recovers from its recession, especially Switzerland, which is levered to European financials.


From a monetary standpoint the SNB has run out of room to cut interest rates, and deflationary pressure is a real concern. Swiss CPI declined 0.4% in March Y/Y, the biggest decline since 1959. Economists predicted a drop of 0.1% after a 0.2% gain in February.


While deflated prices (led by a y/y drop in oil costs) will benefit consumers in the short term, unemployment is rising and a weaker Franc will put downward pressure on wages and increase the price of imports. Cooling prices may have the opposite intended effect and prolong the recession, especially if consumers pull back spending and increase personal savings or wait for lower prices, a trend we’re seeing throughout Europe. The economy is forecast to contract as much as 3.5% this year and the SNB expects inflation to remain close to zero in 2010 and 2011. This is a bearish forecast for recovery in the intermediate term.


See the chart below - the Swiss eft EWL is heavily concentrated in healthcare (36.33%), consumer staples (22.47%), and financials (17.18%), sectors we’re bearish on. Our Healthcare analyst Tom Tobin is decidedly bearish on Swiss healthcare companies (Roche and Novartis each make up 13.5% of the etf) because they sell primary to the Europe, where profit margins are heavily reduced due to fixed pricing. Nestle makes up 20.2% of consumer staples. We’re bearish US Financials and believe European Financials will lag the US’s recovery by at least 3 Months. Again, Switzerland is heavily levered to financials and EWL’s financial composition includes: Credit Suisse 4.9%; UBS 4.4%; and Zurich Financial 4.2%. 


The country’s negative fundamentals coupled with the weighting of the etf in underperforming sectors leaves us confident in our bearish thesis despite the intermediate gains that might result from the central bank’s devaluation of the Franc.


Matthew Hedrick

Switzerland: What A Mess! - swis1

Switzerland: What A Mess! - swis2


I recently commented on EAT’s CFO Chuck Sonsteby’s bullish view on margins following his presentation at an investor meeting in mid March.  Specifically, he said he was optimistic about margins because EAT is benefiting from slower unit growth, improved labor productivity, lower employee turnover and better food cost control.  At the same time, commodity costs are coming down.  EAT’s controlling what it can combined with the fact that it consistently outperforms the industry on a same-store sales growth basis as measured by Malcolm Knapp, particularly at Chili’s, causes me to maintain that the company is one of the better positioned casual dining companies.  That being said, despite Mr. Sonsteby’s more bullish sentiment, I continued to question how much fat could still be cut out of the system.  The company reported better than expected 2Q09 earnings as a result of better cost control and better margins, but I remained concerned about the company’s ability to maintain its margins without a lift in top-line results.


After taking a more in depth look at EAT’s recently announced organizational changes, which it says will “create additional synergies across its portfolio of brands,” I am only more convinced that the company’s margins will not only withstand the current sales environment but also improve significantly once sales growth returns.  The most important organizational change, in my view, was the announcement that the current president of the Chili’s concept, Todd Diener, will now also serve as president of On the Border, overseeing operations for both concepts.  CEO Doug Brooks said, “These changes will help us to streamline organizational efficiencies and elevate the guest experience across all brands.”  Although I agree with the first part of that statement in that by increasing Mr. Diener’s span of control, the company will be able to streamline its costs, this type of organizational change or cutting of brand-specific management  does not typically bode well for a concept’s operations and/or guest experience.   The company’s franchisees have had success with this dual brand management approach, but I think increasing management’s span of control could possible hurt the company’s ability to operate efficiently at both Chili’s and On the Border.  Time will tell!

The next obvious move would be for the company to reduce its number of area directors across the two concepts, particularly where there is some overlap of brands on a geographic basis.  Again, although I don’t necessarily agree with this change to the company’s business model, this could be where the real bulk of fat remains in the system.  The company could easily cut people and costs out of the system across these two concepts.  These reduced costs along with the company’s continued focus on labor and food costs, which are already rolling over, will provide a big cushion to margins despite sales performance.  Of course, growing same-store sales would help! 


It is this margin cushion that leads me to the paradigm shift…I have been talking a lot recently about the market share shifts between QSR and casual dining.  Here is what we all know:  The QSR players upped their quality, which helped them to become more competitive with casual dining restaurants.  The restaurant industry is a zero sum game so the QSR companies grew their market share at the expense of the casual dining industry as a whole.  The challenging economic environment then perpetuated this market share shift to QSR as more people sought lower priced, value menu offerings.  The casual dining operators began playing the discounting game in order to try to drive traffic regardless of the impact to margins.  

Now, selective QSR players are continuing to drive value (at times giving away food) but also offering more premium-priced menu items to try to compete with casual dining.  So the question is, will casual dining restaurants have to maintain its current low prices in order to compete with QSR?    Are lower priced casual dining offerings just a sign of the times or are they here to stay?  Brinker is making structural, lasting changes to its business model.  The company cannot easily or quickly reverse these recently announced organizational changes once sales improve, which leads me to believe that Brinker is permanently resetting its cost and margin structure to adjust to these lower prices and maintain the current, reduced price gap with QSR. 

In the past casual dining companies operated on the basis that more is better.  To drive incremental revenues restaurant companies would add more food to the plate and take prices up.  This strategy works in good times but does not work when nearly every consumer is looking for ways to save money.  This strategy also works when you don’t care what you are eating.  As the industry is faced with the need to tell consumers how many calories they are eating, adjustments to the menu are required. 

The result is a further evolution of the new paradigm in casual dining - less is more.  New menu items are being introduced, with less food on the plate (fewer calories), at lower price points that are designed to maintain margins and improve traffic.  Given the decline in commodity costs, it’s a great time to be reinvesting in driving new occasions.  


We continue to see more price points on the menus at casual dining restaurants in the $7-$8 range.   I see these price points as a big challenge for QSR operators, especially for those concepts with average checks near $6 and for those with new products geared toward trying to capture the casual dining customer.   In our March 26 post titled “Is Market Share Shifting?”, we highlighted new menu items from EAT that are being introduced at $7 (• Chili's.  On April 6, the chain will offer a "10 meals for under $7" deal).  Regardless of the potential industry paradigm shift, EAT’s changes to its business model will definitely boost margins in the near-term.






This Is BIG: US Employment Is Turning...

There are a lot of ways that the pundits are going to try to skin the cat on this morning’s US employment report for March – but I have yet to see anyone on the tape with the call that I am about to make. Like US Housing, US Employment is now turning to the positive.

Positive? Yes – very much so. On a nominal basis, this morning’s report was obviously better from a claims perspective than both January and February, but the more important point is the sequential deceleration in the acceleration of the monthly US unemployment rate.

Everything that matters to my macro model occurs on the margin. This month’s sequential acceleration in US unemployment was only +.40% (from 8.1% FEB to 8.5% MAR). That’s a significant deceleration of the acceleration, and one that should start to TREND in Q2 – Why? Obama has 4 plus million jobs to bring into the base, and that ball is finally in motion.

For the math on this (and for Transparency/Accountability purposes), below is the call I made on March 6th, 2009 on employment titled “The Great Recession: Why I'm Not Depressed”:

Why I’m Not Depressed: It’s all about the delta. The revisionists are straight-lining the record setting acceleration in unemployment into becoming a repeatable rate of growth – mathematically speaking at least, that’s silly. Whether you want to look at this relative to the mid 1970’s when year-over-year trough to peak unemployment last ramped this quickly (up 300-400 basis points year over year), or in terms of percentage accelerations across different durations, my conclusions are the same – the rate of growth in the US unemployment rate is setting up to SLOW… right as the manic media worries people about it most.

This Is How a Depressionista Can Get To His/Her Numbers: the February 2008 to February 2009 acceleration in the unemployment rate was 330 basis points (from 4.8% to 8.1%, see charts below) – that’s a 69% acceleration of the nominal level of unemployment in this country. If we were to straight line that steep curve (chart) and project the same rate of growth in unemployment to February 2010, you’re looking at a 13.7% US unemployment rate. That would err on the side of a Great Depression type number. Using a shorter duration model, maintaining the current pace of growth in monthly unemployment gets you a 8.6% unemployment rate by the end of March – that too would be depressing, but I don’t think we see that number – if we don’t, the growth rate of unemployment will have SLOWED sequentially.

Back to today, April 3rd, 2009 and updated for this March report, the steepness in the chart below incorporates the peaking slope of this curve.

Was this steep? You bet your Madoff it was – but at +340 basis points year over year, the expansion of the US unemployment rate is not as bad as we saw in the 1973-75 recession, and it also coincides within earshot of both US stock market bottom and a bottoming in the y/y price declines in US housing.

The February employment report marked the peak of the acceleration in US unemployment. March just gave us one more critical economic data point that supports the recent +23% squeeze in the US stock market. While the Bears of 2008 are still writing books, I feel that I am one of the few bears who has made the bullish turn here with hard cold mathematical facts behind my reasoning.

Stock prices remain leading indicators. The fundamentals of the US economy have turned positive, on the margin, and materially so. Trailing economic data just reminds most economists why they are revisionist historians.


Keith R. McCullough
CEO & Chief Investment Officer

This Is BIG: US Employment Is Turning...  - kmch

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