Morning in Arizona

Morning in Arizona
Rainbows over Canyonlands - Dave Stoker

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Wednesday, February 17, 2016

Breaking Up Is Hard To Do

Financial Review

Breaking Up Is Hard To Do

DOW + 222 = 16,196
SPX + 30 = 1895
NAS + 98 = 4435
10 Y + .03 = 1.78%
OIL – .36 = 29.08
GOLD – 8.50 = 1201.30

Top oil officials from Russia, Saudi Arabia, Qatar, and Venezuela met in Doha and have agreed to freeze crude output at January levels, targeting a supply glut that’s sent prices to 13-year-lows. According to the International Energy Agency, Saudi Arabia produced 10.2 million barrels per day last month, below its most recent peak of 10.5 million barrels per day set in June 2015. Russia produced nearly 10.9 million barrels per day in January, a post-Soviet record.

To be clear, the idea is to freeze production at those levels, not cut production. January levels of oil output would most likely keep global supplies running faster than demand for months to come, if not longer. There really wasn’t much incremental production expected from Russia, Qatar and Venezuela for the rest of this year, given these countries are already stretching their production limits.

Iran was absent from the Doha meeting, and no surprise why: The Islamic Republic is planning to ramp up shipments as it looks to regain market share lost after years of international sanctions. Over the weekend, Tehran sent its first cargo of oil to Europe since the end of sanctions last month, and announced plans to boost production and exports by 1 million barrels per day in 2016.

Oil prices jumped up at news of the meeting, which was seen as an effort to stem the oversupply that has been driving down crude oil prices and shaking world commodity and stock markets. But those gains were largely erased later after word that the four nations had agreed only to freeze output rather than cut it.

While the U.S. was on holiday yesterday stock markets across the globe rallied, with Japan’s Topix index soaring 8 percent and shares in Europe capping their biggest two-day gain in more than four years.

The Bank of Japan’s negative interest rates take effect today. The Bank of Japan, which announced the decision on Jan. 29, will now charge lenders 0.1% to park additional reserves, prompting banks to lend and businesses to spend and invest.

Bad loans at Chinese banks are at their highest level in nearly a decade. Nonperforming loans at Chinese banks surged 51% year-over-year to $1.2 trillion, hitting their highest level since June 2006. McKinsey Global Institute reports half of all loans are linked, directly or indirectly, to China’s overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable.

The Bank of Korea kept policy on hold. South Korea’s central bank held its key interest rate at 1.50%, as expected. The Bank of Korea said the economies of both the US and the Eurozone appeared to have “weakened somewhat” and the Chinese economy continued to slow.

This was one of those days when bad news was good news. The thinking goes as follows. If the Japanese economy shrank by 0.4% in the final three months of 2015 and Chinese exports fell by more than 11%, policymakers will sit up and take notice. Central banks will stimulate activity by cutting interest rates, even when they are already negative, and by expanding their quantitative easing (QE) programs.

Right on cue, Mario Draghi popped up before the European parliament to administer a bit of his own soothing balm. ECB President Mario Draghi says the European Central Bank “will not hesitate to act” to boost its stimulus in March if it believes recent financial-market turmoil or lower oil prices could weigh further on consumer prices.

Most analysts now expect the ECB to cut its already-negative deposit rate — charged to banks for storing funds at the central bank — by at least another 0.1 percentage points in March, to minus 0.4%, and to accelerate its bond-purchase program, which is currently running at €60 billion a month.

The National Association of Home Builders reports homebuilder sentiment fell in February; the index was down 3 points to 58, from an upwardly-revised 61 in January. The sub-gauge that tracks current sales conditions also dropped three points, settling at 65 in February.

Royal Dutch Shell has surpassed Chevron as the world’s second-largest non-state oil company after completing its acquisition of the BG Group. Exxon Mobil remains the globe’s most valuable oil company with a market value of $337B, almost twice as big as Shell.

Moody’s Investors Service says Deutsche Bank will be able to make interest payments on its riskiest debt this year and in 2017, stating that the bank can make payments due in April and only “a major, unforeseen event” would prevent those due a year later.

How much did VW managers know about the company’s emissions scandal and when did they know it? Reuters reports that a high-ranking employee warned senior Volkswagen managers in May 2014 that U.S. regulators might examine car engine software as part of an investigation into pollution levels. The notice came in the form of a letter, which was sent more than a year before the German automaker’s public admission that its cars had been equipped with software to manipulate emission test results.

Freeport-McMoRan has agreed to sell an additional 13% stake in its Morenci mine to Sumitomo Metal Mining, Japan’s second-biggest copper producer, for $1 billion in cash. The deal will take Sumitomo’s share in the Arizona based open-pit copper mining complex to 28% from 15%.

Freeport expects to record a gain of about $550 million on the transaction and expects it to close in mid-2016. Morenci is Freeport’s biggest mine by production and the largest copper mine in North America. In short, Morenci is Freeport’s crown jewel asset with the biggest copper reserves and the longest mine life.

Mining companies have had a hard time lately, and copper prices have taken a big hit, but if you are trying to figure out what went wrong at Freeport McMoRan, look no further than the oil market. It wasn’t too long ago that Freeport was a miner. But in 2013, when oil prices were high, it bought McMoRan Exploration Co. and Plains Exploration for roughly $9 billion. In the end, the deal led to an explosion in Freeport’s debt, which stood at nearly $20 billion at the end of 2015.

Before the big oil deal, debt was only about $3.5 billion. Putting some perspective on those two numbers, debt as a percentage of the capital structure was 15% before the acquisitions and over 60% at the end last year.  The stock is down over 80% since the start of 2013. Rounding, to keep the math easy, Freeport went from a $40 billion-market-cap company to around a $7 billion cap. That’s more than $30 billion lost.

In the press release, Freeport-McMoRan stated: “This transaction represents an important initial step toward our objective to accelerate debt reduction and restore our balance sheet”. So, while most investors were thinking about whether Freeport-McMoRan will be able to sell its oil and gas assets, the company came up with a deal to sell a part of its key copper asset.

Freeport-McMoRan itself stated multiple times that good copper assets are very hard to find, but now the company is selling its copper assets to get rid of the debt created by the oil asset purchase. And what happens to Freeport McMoran if oil prices stay low for longer than expected? Will they end up selling off all of their valuable copper assets to pay for their bets on oil?

A slowdown in the Chinese economy has hit the mining industry hard. On Monday, ratings agency Moody’s cut Anglo American’s debt rating to junk, citing a deterioration in commodities market conditions; that follows a fourth quarter earnings report that showed a loss of $5.6 billion. Anglo outlined plans in December last year to restructure its portfolio to between 20 and 25 assets, down from 55 and cutting its workforce to about 50,000 people, an 85,000 reduction. Anglo American will streamline its asset portfolio to De Beers, platinum and copper, holding just 16 assets down from 55

Home security services company ADT Corp. has agreed to be purchased by affiliates of Apollo Global Management for about $6.9 billion. ADT shareholders are to receive $42 a share. That’s a 56% increase from Friday’s closing price of $26.87. The companies said ADT would be merged with Protection 1, which is also owned by Apollo, to create a business with nearly a third of North America’s electronic security products market. Apollo Global Management, which agreed last week to buy Apollo Education Group with other investors, acquired Protection 1 last year.

Apollo Global Management is part of a consortium of private equity investors who have bid on Apollo Education Group, the parent company of University of Phoenix, but it might not be a done deal. Schroders Plc, Apollo Education Group’s largest shareholder, plans to vote against a $1.1 billion takeover.

The U.K. firm, which spoke to Apollo Education’s management last week, said that based on the limited information it has access to, a price tag of $9.50 per share “significantly undervalued” the company’s assets. First Pacific Advisors LLC, the second-biggest investor in Apollo Education, with a holding of about 7 percent, told its clients that a deal valued at $1 billion “would be unquestionably rejected” by the firm.

According to a new 13F filing, Alibaba owned 33 million shares of Groupon at the end of the fourth quarter, a stake valued at $95 million. While the disclosure fuels speculation that Alibaba could try to acquire Groupon, it should be noted the company has taken stakes in many American firms without fully acquiring them.

HSBC has decided to keep its headquarters in Britain, rejecting the option of moving back to its main profit-generating hub in Hong Kong following a 10-month review. The unanimous decision by the bank’s board gives a boost to London’s status as a global financial center, which has faced challenges from tougher regulation since the financial crisis. Analysts had estimated the cost of moving out of London at up to $2.5 billion.

Stock repurchase plans have exploded over the last few years, thanks to cheap money following the Fed’s zero interest rate policy of the last few years. According to data from FactSet, over the 12-month period ending last September, $566 billion was spent on share repurchases, nearly 65% of net income.

In the trailing 12 months ending in the third quarter of 2015, 130 companies had a buyback to net income ratio that exceeded 100%. And that begs the question of how those companies are investing for future growth. It also begs the question of how individual investors can value earnings per share growth.

Buybacks can paint a deceptive picture of corporate growth because it shrinks share count and makes earnings per share look stronger than they really are. For example, if a company’s net income is $10 million and shrinks its outstanding shares by 5 percent to 19 million from 20 million shares, its reported EPS jumps to $0.53 from what would have been $0.50, yielding EPS that is 6 percent higher even though net income hasn’t changed at all.

Narayana Kocherlakota has resigned as President of the Minneapolis Federal Reserve Bank, and his successor is Neel Kashkari. Kashkari joined the Minneapolis Fed in January. Prior to joining the central bank, he was an executive at bond giant PIMCO and then lost a bid to become the governor of California. Kashkari worked at the Treasury Department under Henry Paulson before and during the financial crisis. Kashkari oversaw the Treasury’s Troubled Asset Relief Program; and before that he worked for Goldman Sachs.

Today, Kashkari made his debut speech as Minneapolis Fed President and he said: “While significant progress has been made to strengthen our financial system, I believe the [Dodd-Frank] Act did not go far enough,” adding that the nation’s biggest banks remain too big to fail and pose significant risk to the economy. Kashkari said that policymakers must give serious consideration to breaking up banks. Another idea is to turn large banks into public utilities “by forcing them to hold so much capital that they virtually can’t fail.”

Another idea is to tax leverage throughout the financial system “to reduce systemic risks wherever they lie,” he said. “Large banks must…be able to make mistakes —even very big mistakes— without requiring taxpayer bailouts and without triggering widespread economic damage.” Kashkari says the Minneapolis Fed will develop a plan to end too-big-to-fail banks and make it public by the end of the year.

Goldman Sachs Asset Management says the worst of the credit-market selloff is probably over and it’s now waiting for a sign that the situation has stabilized so it can plow cash back into U.S. junk bonds and other corporate debt. Credit went into meltdown this year as questions mounted around the efficacy of central bank policies and the ability of China’s government to stem capital outflows while maintaining economic growth.

The selloff pushed spreads on high-grade and junk-rated company bonds in the U.S. to levels unseen in at least 3 1/2 years. Goldman’s research suggests that once sentiment becomes less negative, the “magnetism” of the yields on offer will draw investors back. We’ve been through the worst of the adjustment and you should start looking for things to buy.

They’re not quite sure when you should start buying, maybe a month, maybe a little longer. Given that they’ve gotten 5 of their 6 beginning of year calls wrong so far, Goldman‘s credibility isn’t great. But in 2007, there was a bounce in subprime from March to May, and in 2008, the self-congratulatory “Mission Accomplished” post-Bear phase, which lasted till about July. So near-term moves are anyone’s guess. What we do know is that Goldman is happy to sell, so their message is buy.

The fourth-quarter earnings reporting season is winding down and it is shaping up as the worst quarter for earnings growth since the financial crisis. With 87% of companies in the S&P 500 having reported results for the last three months of 2015, overall earnings per share are slated to show a drop of 4% from a year earlier, making it the worst quarter for growth since the third quarter of 2009.

Per-share earnings have now fallen for three straight quarters; and even though estimates had been ratcheted lower, total per-share earnings beat expectations by the smallest amount since the second quarter of 2011.

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