Our inimitable, in-house cartoonist Bob Rich is on a much-deserved summer vacation. While he kicks back and relaxes, we're going into the Hedgeye Vault and highlighting some of his best work. On that note, and given the resurgence of Europe’s ongoing, multifaceted issues, we bring you this audience favorite. Originally published in June 2015, it's just as fitting today as investors fret over Italian bank solvency and a host of other issues in Europe.
Takeaway: Call Summary & Replay
On Friday we hosted a call with the Brexit Task Force team from the international law firm of Squire Patton Boggs. The team discussed the events following the UK’s exit vote and what the outcome of the vote spells for the UK and the rest of the world.
Along with the audio replay, below is a summary highlighting key discussion points and takeaways
- While the expectation is for the U.K. to issue article 50 which is required for Brexit, Theresa May has said she won’t trigger the article 50 mechanism until year-end. Invoking article 50 is a three-part procedure:
- Article 50 (1): To issue, U.K. must do within constitutional laws
- Article 50 (2) and 50 (3): Negotiation of Details of Withdrawal Agreement taking into account a potential framework for future relationship. Withdrawal agreement has a two-year sunset period and requires a qualified majority with consent of European Parliament. Any extension to sunset period must come by way of a unanimous vote
- Freedoms that came with E.U. membership such as movement of goods, services, persons, and capital would cease to exist:
- For a US company that currently enters the European market through the UK, that form of access would be closed
- Mutual recognition and passports will not be applicable any longer
- Banks, insurance companies, airliners, etc. will not be able to conduct business as usual (will need to develop new licenses and branches within the 27 member states)
- EU Jurisdiction and Enforcement Regulation: core judgements applied by a European-based court will cease to apply to UK-based court
- EU Insolvency Regulation: currently provides protection of European-based companies. Insolvency proceedings being prevented against other EU based companies would not apply. Insolvency cases would yield to the domestic laws of the 27 EU countries to decide how UK-based companies will be treated
- Future Contracts: The implications of company contracts with the UK with reference to EU rules or EU trade will depend on the governing law on those contracts
- Existing Contracts: Be prepared to expect the triggering of explicit and implicit termination rights, frustration, increased costs, market disruptions
Potential Exit Scenarios for the U.K.:
- Customs Union (Turkey)
- No say in EU trade deals with third parties but must abide by their rules (i.e. Turkey is not sitting at the negotiation table between EU and US on TTIP discussion but will need to comply with all the rules that come about)
- No free-movement
- EEA – e.g. Norway
- Outside the Customs Union – not mentioned much in the press; being outside means more customs paperwork and hassle
- They pay reduced dues to the EU but no vote at European level
- Accept free movement from EU and EEA – was very sensitive topic during campaign; making EEA not a very likely model for the UK
- No say in EU rules
- Bilateral Agreement – e.g. Switzerland
- More than 120 bilateral agreements since 1956 on various specific sectors and matters
- It took 20 years to negotiate and talks are still ongoing
- No access to financial services (Swiss) / insurance dealt with separately (i.e. Passport Rights)
- Accept free movement of persons
- Outside the Customs Union
- No say in shaping of EU rules
Labor, Employment, and Immigration:
- An agreement will have to be made for 3 million EU born UK residents and some 1.8 million British passport holders in EU countries
- Post-Brexit UK immigration policy without free movement would look very different to current UK policy
Is it realistic that exit negotiations can be completed in 2 years?
- No, we’ve never seen a deal close within a 2 year period in the history of negotiations
Does the U.K. have any bargaining leverage with the EU after invoking Article 50? Is a good deal for them possible?
- The strong message coming out of Germany and France are that you don’t get the right of access to a single market unless you agree to freedom of movement of people; does not seem to be a point that the UK people are keen on
Takeaway: As central banks push interest rates further into negative territory, the market value of negative yielding debt hits $387 billion.
That's no misprint. The value of negative yielding investment grade corporate debt is up +1,322% this year, hitting $387 billion. That's according to data in the Bloomberg Global Investment Grade Corporate Bond index, which tracks 9,976 investment grade bonds.
The index now includes 621 negative yielding bonds, versus just 59 at the start of the year, issued by companies such as General Electric, Siemens, Total, Unilever, Daimler, and Roche.
Meanwhile, on the sovereign bond front, there is $9.1 trillion in negative yielding bonds globally, according to the Bloomberg Global Developed Sovereign Bond index. That's up from $2.8 trillion at the start of the year. (Note: The yield on the Bloomberg Global Developed Sovereign Bond index is currently 0.49%, versus 1.14% in November.)
Don't expect this trend to reverse any time soon. With central banks globally desperately trying to reverse the general economic malaise expect yet more bonds to test negative territory.
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In this excerpt from The Macro Show earlier today, Hedgeye Financials analyst Jonathan Casteleyn reiterates his short call on Lazard ahead of its earnings report on Thursday.
Takeaway: Wabtec (WAB) has fallen over 30% since Jay Van Sciver made it a Best Idea Short.
Editor's Note: Our Industrials analyst Jay Van Sciver added Wabtec (WAB) as a Best Idea Short on February 20, 2015. Shares are down over 30% since he laid out his bear case. Here's an excerpt from his original note. For information on how you can subscribe to our institutional research email email@example.com.
While we might be a bit early, we believe that a short WAB position offers excellent exposure to the downcycle in resources-related capital spending. Stating the obvious, railroads provide transport for bulk commodities. The rapid growth in output for iron ore, shale oil, and many other commodities drove a boom in capital investment in rail transport infrastructure. The gradual stagnation in bulk commodity output growth amid lower prices should drive global rail investment back toward long-run norms. This one may not be quick, but the return opportunity appears significant, as we currently see a normalized valuation range for WAB between $40 and $60 per share.
We believe the valuation of WAB shares reflect a premium ‘growth industrial’ story, which we see as analogous to the mining equipment companies (JOY, CAT) in early 2012. Back then, similar rationalizations based on population growth and aftermarket opportunities were employed to justify overvalued equity. We view both rail capital equipment and mining capital equipment as GDP-ish growth deep cyclicals, not industries experiencing secular growth.
There are several risks to our view including a huge commodity price rebound, S&P index addition, and the potential for WAB to be acquired. We would look to be long a cheaper industry player, or hedge appropriately, as discussed in last week's note.
For more information on how you can subscribe to our institutional research email firstname.lastname@example.org.
Should we be worried about the rise of pro forma?
Editor's Note: In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses the growing use of "pro forma" accounting and explains the broader implications for investors.
There’s been a lot of hoopla so far this year about corporate America’s growing use of “pro forma” accounting—or its growing aversion to U.S. generally accepted accounting principles (GAAP), depending on how you think of it.
Sure, all public companies still have to comply with GAAP, the New Deal-era accounting playbook that ensures consistent tracking and reporting of vital financials. But firms are free to supplement their GAAP numbers with figures that aren’t required by SEC regulators.
These customized earnings reports go by many names—“pro forma,” “adjusted,” or simply “non-GAAP.”
Whatever nomenclature you prefer, these terms are a catch-all for the myriad ways companies may present a different picture than the one portrayed by their GAAP statements. Maybe a company wants to exclude taxes or regulatory fees that are not likely to reoccur again soon. Maybe they want to eliminate the effects of a currency shift. Perhaps they want to draw attention to an alternative metric not required under GAAP—such as operating earnings, EBITDA, or cash flow.
Undeniably, over the past two decades, more and more companies have flocked toward pro forma reporting. Back in 1996, nearly half (42%) of current S&P 500 constituents handed in only GAAP numbers. By 2006, that share had dwindled to just a quarter, and by last year, just 6% of S&P companies used GAAP exclusively.
Certain types of companies have long been in love with pro forma—especially young high-growth companies that have just gone public or financial companies with unusual valuation issues. That pattern still shows up today. According to one comprehensive sample of listed companies, tech companies continue to show the most pro forma adjustments by number (an average of eight per company in 2015) and financial companies show the most by dollar amount (roughly $40 billion in 2015).
WHAT PRO FORMA CRITICS SAY
What’s the problem with this shift toward pro forma accounting? Critics have no shortage of complaints.
Companies use pro forma to artificially boost earnings. Bloomberg analysis finds that 80 percent of S&P 500 tech firms used pro forma figures in order to revise their earnings higher in the most recent fiscal year. It’s not just Silicon Valley: More than half of the Dow Industrials did the same.
Herein lies the problem: Research has found that pro forma inflates net income by an average of 44% among profitable firms—and by a whopping 70% among companies reporting net losses. Funny how a more “accurate” non-GAAP view so often looks so much better than a GAAP view. Many analysts refer to pro forma earnings as “EBBS,” or “earnings before the bad stuff.”
Firms are “leaving out” more and more types of costs. When pro forma first became popular, most companies only removed costs that were clearly extraneous to the basic business proposition—because they were either a one-time hit (like a licensing fee) or a well-understood “external” item (like taxes). Today, virtually any charge—from restructuring costs to depreciation charges to pension expenses—can be removed as long as the CFO can make a plausible case for it. Accounting firm Sanford C. Bernstein finds that the average dollar amount of recurring charges held out of pro forma statements has never been higher.
Inevitably, the practice is spreading even among those who don’t care for it. If your hi-tech competitor sweeps stock options and IP amortization off the table when computing earnings, can you afford not to show a similar perspective to your own investors?
Adjusted earnings undermine the purpose of GAAP. Generally accepted accounting principles were adopted to ensure consistency; a manufacturing company would use the same measures and standards as a telecom provider, a trucking company, and everyone else. But pro forma earnings reports, by their very design, are inconsistent across companies and industries.
WHAT PRO FORMA SUPPORTERS SAY
Pro forma is not all bad. Plenty of analysts and executives feel that non-GAAP reports serve a vital purpose for investors and companies.
All information is good information. Remember: Pro forma isn’t replacing GAAP figures, but merely supplementing them. These adjusted reports add a layer of context to traditional earnings statements, giving investors a picture stripped of expenses (and earnings, mind you) that obscure the underlying business outlook.
Pro forma is a boon to young businesses. Start-ups routinely use “pro forma” assumptions to demonstrate their ability to generate a profit. Even after these firms go public, their valuations are so weighted on future profitability that current GAAP earnings say little or nothing about how investors should value them.
Any GAAP alternative is fine by me. The strongest support for pro forma accounting comes from those who believe that GAAP is an archaic, outdated tool that needs replacing. Authors Baruch Lev and Feng Gu fall in this camp. They contend that GAAP prioritizes backward-looking indicators and all but ignores future growth potential.
Just think of a company like Amazon, which regularly falls short of earnings estimates and openly eschews profitability yet sees its share price skyrocket. Are all of those investors wrong, or does Amazon’s true value lie outside of what GAAP measures?
The pro forma camp holds that GAAP is rooted fundamentally in a 1930s materials-oriented economy that is passing away. GAAP was an appropriate way to assess company value back when goods producers like U.S. Steel were the tentpoles of American industry. But today? What’s the use of an accounting method that hinges so heavily on inventory and COGS (cost of goods sold) when a growing share of today’s star performers—from Facebook to Google—don’t sell goods at all?
Remember that the “earnings gap” widens during economic downturns. The gap between pro forma and GAAP earnings reached 23% in 2015, a yearly figure not seen since the Great Recession. In the first two quarters of 2016, however, this gap has started to close again.
In hindsight, it looks like select troubled sectors sent the gap soaring last year: S&P 500 energy companies had an estimated GAAP loss of $48 billion in 2015—but a gain of $45 billion in pro forma terms. Health care companies boosted their earnings by more than $50 billion using pro forma.
One interesting pattern we can observe since 1999 is that the gap seems to widen very late in the boom cycle and grow to maximum size during the following bust. In 2001 the gap peaked at just over 1.9 x GAAP earnings. And in 2008 it peaked at 5.6 x GAAP earnings. Explanation? Late in a cycle, firms are tempted to downplay the earnings deceleration. And in a recession, they will do anything to stop the appearance of bleeding—including writing off their losses as a one-time catastrophe.
Late in 2015, the gap seemed to point to an impending repeat bust. The closing of the gap in 2016 may be taking us a step back from the brink. The next two quarters are worth careful watching.
Expect regulators to turn up the heat on pro forma abusers. The SEC is making accounting consistency one of its top priorities. In May, the SEC issued interpretive “guidance” on Regulation G (which allows publicizing pro forma numbers) warning firms against a variety of possibly noncompliant practices.
The guidelines are very explicit about what companies can and cannot do regarding pro forma presentation. Whether in press releases, earnings calls, or official SEC documents, GAAP figures must always be listed before any comparable pro forma figures. A company cannot refer to pro forma figures without disclosing that they are not GAAP numbers—for example, listing pro forma EPS as simply “EPS.” Pro forma metrics cannot even be listed in a more prominent font (larger, bolder) than GAAP numbers.
Nevertheless, there are companies that stretch these rules—and the SEC is going after them. Regulators have questioned at least 80 companies in recent months (with growing frequency of late) about their pro forma usage. Tighter oversight may be contributing to the closing of the pro forma earnings gap in 2016.
Get ready for growing support for a move to international accounting standards. The U.S. Financial Accounting Standards Board and the International Accounting Standards Board have been working since 2002 to find a way to merge U.S. GAAP with International Financial Reporting Standards (IFRS).
While the United States currently has no plans to switch over, such a move would enable companies to better convey underlying growth than GAAP allows. (IFRS is a principles-based system that gives firms more flexibility to include or exclude items than does the rules-based GAAP.)
To be sure, IFRS seems a tough sell for SEC regulators who want explicit rules in place for every contingency. But it’s an attractive and flexible alternative to the unstandardized world of pro forma accounting.
- More and more companies are issuing adjusted earnings reports that have been proven to inflate income. While critics say that companies are using pro forma to paint a falsely positive picture, supporters believe that anything would be better than our outdated GAAP system.
- There is growing tension between the SEC and listed firms over how earnings may be defined and publicized. The apparent impossibility of pushing earnings back into the GAAP bottle means that some non-punitive solution—whether it’s a loosening of pro forma rules or a move to international accounting standards—will eventually be needed.
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