Sunday, October 20, 2013

With Debt Ceiling Debate Out of Way..What's Next For the Market? (An Investment Strategy Update)

Perhaps I was too pessimistic in my prior post to expect a market correction. Stocks hardly experienced a correction at all! The S&P500 and TSX both reached new 52-week highs of 1745 and 13,150 respectively. Investors are cheering over the fact there was a temporary kick the can down the road solution that avoided a U.S. default. Yes, a disastrous default was avoided, but the fight will come up again. Let's all hope Santa gives politicians a merry Christmas so they all can maintain their rationality in the new budget/debt ceiling negotiations in the new year. 

A 11th Deal...Again:

The Reid-McConnell dual did it again. Once again, it was up to the Senate to break the stalemate given the House cannot formulate any reasonable bill.  The deal was extremely favourable for the Democrats given the bipartisan bill re-open the government and provides funding until January 15th without any large changes to the Affordable Care Act (Obamacare) that conservative GOP lawmakers demanded. Also the bill suspends the nation's debt ceiling to February 7th, giving lawmakers a small breathing room of 4 month to come up with a credible deficit reduction plan.  A bipartisan committee is set up to negotiate over the budget, trying to bridge the differences between the House budget and the Senate budget. The deadline is to present a proposal to congress by December 13. 

Damage of Political Bickering:

The GOP's strategy of combining the Obamacare debate into the debt ceiling negotiation backfired. Even senior GOP members like McConnell admitted the strategy was "flawed" in the beginning. Unfortunately, the biggest losers are not those adamant conservative GOP lawmakers. The real losers of the 16-day government shutdown are actually the ordinary Americans that depended on the government. Most economists estimate that there was a direct 0.2% GDP hit because the loss wage income of the 400,000 furloughed government workers. There could be another 0.3-0.4% GDP hit in the fourth quarter because of indirect impacts, i.e. tourism/travel businesses saw a huge decline in customers due to the shutdown of many national parks and government sites. Adding both the direct and indirect impacts, there could be a 0.5-0.6% drag on the fourth quarter GDP. Prior to the government shutdown, the U.S. economy was expected to grow at 2.6% in Q4 (Q1 growth of 1.1% and Q2 growth of 2.5%). Therefore, the 16-day government shutdown would reduce Q4 GDP to approximately 2%. 

Here is a million dollar question: If the economy just experienced a slowdown, why is the equity market rallying to new highs? The simply answer is the Fed. Given a 0.5-0.6% cut in GDP in Q4 and the fact that the Fed policymakers are literally flying blind (important data such as non-farm payrolls, inflation, industrial production, housing reports were all suspended due to the government shutdown), it is likely there may not be any further tapering talks for the remainder of the year. According to a Bloomberg survey of Wall Street economists, the Fed is not expected to taper until March next year, a complete change in opinion since August when the Fed was expected to taper last month but did not. The expected path of QE3 is completed altered and additional stimulus is likely to provide further boost prices of risky assets. As former Citigroup CEO Chuck Prince used to say, "as long as the music is playing, you gotta get up and dance"

Equity Outlook:

The outlook for equities is positive for the next few months (up to New Years Day), although the author is still slightly cautious given current valuation. The S&P500 is valued at 16.6X trailing earnings and 14.5X forward earnings. The long term average for trailing earnings is 16.4X (50 year) and 14X (20 year) for forward earnings according to Bloomberg data.  Although valuation may look high, there is no doubt that the current least path of resistance for equities is up, meaning further gains ahead. Moreover, equities tend to gain from late-October to December based on historical seasonal trends with December being the best month for stocks. Finally, stocks current have positive price momentum and that will trigger further buying to support the current advance.  A combination of seasonality, positive momentum, and monetary stimulus all point to a positive outlook for equities for the remainder of the year. 

In my July Investment outlook report, I expected the S&P500 to finish 2013 at ~1625. Because tapering is delayed and the debt ceiling problem is avoided, I now expect the index to finish around 1720-1770, a valuation based on expected earnings of $122 in 2014 and a 14-14.5X forward multiple. Although the multiple is slightly higher than the average 14X, I expect the positive investor sentiment and the high level of monetary stimulus to justify recent multiple expansion. The index rally this year was 70% attributable to multiple expansion and only 30% to actual earnings growth. Given earnings is expected to grow only 8% while revenue is only expected to grow 5% this year, a 24% rally (YTD) in the index is not justified purely on fundamentals alone. The search for yield  has force many investors, small or large, to invest in riskier assets like equities in order to fulfill their expected returns requirements. 

Nonetheless, there are slight positives that can at least maintain the current price momentum to year-end. First, according to Factset, out of the 97 S&P500 companies that reported Q3/2013 earnings, 53% reported  sales above consensus estimates. That is slightly better than 40-50% rate in prior earnings seasons. Top line sales growth is paramount to further earnings growth. In addition, profit margins is near 2007 highs.

Sector-wise, I still favour cyclical sectors like financials (banks benefit from steeper yield curve and insurers can benefit from higher interest environment. Author likes MFC and IAG), industrials (GM, F, UNP), energy (downstream refiners like VLO looks attractive given the low crack spreads), and technology (look for the cash cows and good ROIC like CSCO). Despite putting a underweight outlook on materials in July, the author feels many names in this space are becoming undervalued such as AGU and YRI/AUY. 

FICC Asset Outlook: 

The outlook FICC (Fixed Income, Currencies and Commodities) remains relatively unchanged since my July Investment Outlook Report. I am keeping most of the expected price targeted unchanged such as the year-end target for 10-year treasuries at 2.8%-3.0% (despite a huge change in tapering expectation!).  A slight change would be a less favourable outlook for the U.S. dollar given delayed tapering,  which is positive for commodity currencies like the CAD and AUD.

This piece is for information purposes only. The list of stocks suggestions provided only serve to provide readers with ideas that they can further conduct research on. The author is not responsible for any losses readers incur by buying any names suggested. 

Out of the names suggested, the author owns a large stake in MFC

Monday, October 7, 2013

The Debt Ceiling Debate: A Possible Repeat of 2011?

In this piece, I will update everyone on the current situation in Washington regarding the government shutdown and the debt ceiling debate. Given both parties are publicly attacking each other and negotiations to re-open the government failed to yield any results, investors should not be expecting a smooth negotiation to raise the $16.7 trillion debt ceiling. Treasury Secretary Jack Lew already stated that by October 17th, the Treasury would only have $30 billion to pay claims including interests on debt.   

One party Zigs, other Zags:

Because of political differences, the U.S. government had to shutdown last Tuesday because of the U.S. congress's inability to pass a funding bill to fund the government for the new fiscal 2014 year. (U.S. government has fiscal year ending September 30). Republicans insisted on delaying the implementation of Obama's Affordable Health Care Act (Obamacare) as a condition to pass a funding bill. Democrats did not yield to Republican's demands and merely blamed Republicans for the cause of the shutdown. It is clear that each party is using this opportunity (government shutdown & debt ceiling debate) to try to lay blame on the other party and to seize some political gains for the upcoming election (mid-year election next year for the house/senate and 2016 Presidential election). Furthermore, Republicans already conceded too much in the last budget debate on New Year's eve that led to the sequester. Therefore, Republicans wanted to act tougher this time to force the Democrats to concede more during this round of budget debate. 

Given the hard stance taken by the two parties publicly, it is difficult to reconcile the two parities and form an agreement to open the government. Also, the vote to increase the debt ceiling appears more difficult given politicians can't even agree to end the government shutdown. The political game of chicken is starting to look awfully similar to 2011 and may have similar consequences. 

U.S. Won't Default, But That is Not What Investors Should Worry About: 

Yes, I can safely assure investors that U.S. won't default on its debt. Given U.S. treasury yields are used as benchmark yields for almost every financial instrument and the U.S. dollar is also the reserve currency, politicians know they can't risk a default, no matter how small it is. The effects of such a default would be unimaginable. For those who are curious, yields on treasuries would soar (not a safe haven anymore!), stocks prices would tumble and foreign investors may attempt to exit their U.S. investments. The consequences of these actions will trigger a long recession or even depression if policymakers do not act quickly. 

Let's move away from the doomsday scenario to a more realistic scenario.  The U.S. will not default, but politicians will continue to avoid making progress on discussions until the last minute regarding the debt ceiling. As the October 17th deadline date approaches, investor confidence will slowly erode to reflect a rising probability that politicians may fail to reach an agreement by the 11th hour. The erosion of confidence will be detrimental to the financial markets. Stocks will face some short term headwinds and bonds yields will decline due to the safe haven trade. 

Current investor sentiment is high because of the Fed's commitment to keep rates low (accommodative monetary policy) and the continuation of its asset purchase program (QE3). Nonetheless, history has provided many evidences where confidence can erode quickly. As investors saw in 2011, the debt ceiling debate suddenly went sour 2 days before the deadline and investors quickly dumped all risky assets (such as stocks) to avoid a potential U.S. default. When investors are nervous, emotions will take over. This means that anxious investors will sell everything because they only care about the return OF their capital rather than return ON their capital. Investors must realize that they are creatures of emotion, not creatures of logic especially in times of uncertainty. T-bill investors are already anxious enough to push the yield on T-bills due in late October from 0% to 0.13%. The CDS market is also showing some signs of stress with the cost of U.S. CDS rose to 64 bps from 30 bps. 

Investment Strategy:

In times of uncertainty, cash is king. Keeping some cash on hand is wise especially if markets will react negatively if negotiations continue up to the 11th hour of the debt ceiling deadline. Markets are not worried now because they assumed the debt ceiling will be raised and the agreement would be amicable. However, the final agreement on the debt ceiling would be far from amicable and investors' anxiety will increase with each passing day. More anxiety will likely lead to a market correction in the short term despite the U.S. congress will eventually raise the debt ceiling.

While it is possible for a debt ceiling agreement without creating too much investor anxiety, markets would hardly respond at all to a positive outcome because it has already been "priced in". However, markets will decline if negotiations become too hostile. Hence caution is warranted for now. 

Going back to the question I proposed in my title, it is quite possible for a repeat of 2011. However, equity market declines are likely to be much smaller than the 19% experienced in 2011 because of the Fed's stimulus and better economic conditions. Nevertheless, if the U.S. congress fail to raise the ceiling by the deadline, a 5-10% equity decline is definitely possible. Market declines are actually good for investors because they allow prudent long term investors to add to their positions when prices are down. Unlike most investors, I welcome market declines -especially large ones like 50%- so I can buy additional shares of the companies I own. If everyone likes big discounts when they go shopping, they should learn to appreciate market declines the same way. 

Wednesday, October 2, 2013

BlackBerry Q2 MD&A: More Bad News But Not All Negative

Quietly on a Tuesday afternoon, BlackBerry released its full Q2 report on EDGAR. I had the opportunity to skim through the filing and found some interesting data points. Readers are welcome to read my analysis, but could skip to the conclusion if they want to a quick read on what is the outlook for BlackBerry's shares. The financial media quickly pointed at all the negatives in the report without painting a full picture of the company. That being said, the Q2 report was more negative so I'll start of with the negatives. 

The Negatives:

(1) Hardware Fiasco:

According to, the word fiasco is defined as "A Complete and Ignominious Failure" and those words describe perfectly the performance of BlackBerry's hardware division in Q2/2014. We already knew from the pre-announcement on September 20th that hardware had a 50% decline year-over-year but new details are also very disappointing (see chart below). Quarter-over-quarter, the region that saw the hardest decline was Latam and EMEA (Europe, Middle East, Africa).  Weakness was wide-spread in all of the regions, even in emerging markets such as EMEA and Latam where the BlackBerry brand was favoured . 

$ in millions
North America
Asia Pac

Another confusion in the quarter was the accounting for BB10 devices. According to the quarterly report, the company did NOT change its revenue recognition policy. However, BB10 devices did not meet the company's revenue recognition criteria. Under U.S. GAAP (BlackBerry reports under U.S. GAAP), one of the revenue criteria is for the price to be fixed and measurable. Given BlackBerry must deduct estimated return returns and sales incentives (marketing, rebates) to estimate net revenue, the final price is not fixed if return rates or sales incentives cannot be measured reasonably. BlackBerry had trouble selling its BB10 devices and cannot accurately forecast the return rates/sales incentives in order to book the BB10 revenue. Due to the low sell-through rates and additional sales incentives needed, the company decided to not book revenue on BB10 devices until they are sold in the channel as described below: 

"Where a right of return cannot be reasonably and reliably estimated, the Company recognizes revenue when the product sells through to an end user or the return period lapses.For shipments where the Company recognizes revenue when the product is sold through to an end user, the Company determines the point at which that happens based upon internally generated reporting indicating when the devices are activated on the Company’s relay infrastructure."

Nevertheless, the company expected the change in BB10 revenue recognition did not "materially" impact revenue and they merely deferred the BB10 revenue. As I stated in my prior post, the big $500 million jump in deferred revenue could account for some of the deferred BB10 revenue. 

The future outlook for the hardware division is not encouraging. Device sales may continue to decline and BB10 sales are not picking up. Based on the company's provided BB10 sell-through rates, I estimate around 3 million BB10 devices have sold through to end-users vs. company's old expectation for "tens of million" units. The company needs to re-position its devices to attack specific markets it wants to target. The decision to make Z10 a low-cost devices could boost near-term sales as the high selling price on Z10 was main factor why many consumers decided to buy Android phones or iPhones. The Q5 also needs further price reduction in order for the company to remain competitive in emerging markets.  

(2) Services Businesses Still in Decline:

Service revenue declined 8.8% quarter-over-quarter from $794 million last quarter to $724 million this quarter. However, both quarter included service revenue deferrals due to the currency crisis in Venezuela ($72 million last quarter and $67 million this quarter). Without the Venezuela currency impact, service revenue actually declined 11.5%. Going forward, the company project a 12% quarter-over-quarter decline in Q3/2014, which is much higher than the single-digit decline projected in prior quarters. The faster than expected decline in service revenue is attributable to lower device sales and the migration to BB10 devices which receive lower service revenue than older BB7 devices. 

(3) The Restructuring Process is Costly:

The company already announced a planed reduction of 4500 employees. In the Q2 report, the company further elaborated that this plan will cost $400 million ($0.76/share) over the next three quarters.  To help alleviate the financial strain, the company is putting up $122 million ($0.23/share) of assets up for sale immediately. 

The Positives: 

(1) Ample of Liquidity:

The company burned $500 million cash in the quarter;  however, the cash burn rate should decrease after the company cut expenses and cash is received from selling its massive inventory. Z10 devices are now worthless on the company's books (thanks to the $934 million inventory charge) and could be sold at very low prices to protect its market share and increase BlackBerry's cash flow. With nearly $2.5 billion of cash on hand and a $500 million tax refund in Q1/2015, BlackBerry does not face a liquidity problem and could survive for the next few quarters. However, if it does quickly restructure its businesses, the long-term survival of the company could be at risk. 

(2) Purchase Obligation Less of a Drag on Valuation: 

BlackBerry bears like to point at the $5.3 billion purchase obligation stated in the Q1/2014 report as drag on the company's valuation. In its new Q2 report, purchase obligation decreased significantly to only $3.1 billion and could be reduced further as the company further re-align its purchase obligation with expected demand for its products. 

(3) Lost Service Revenue can partially recover:

The company deferred $72 million of service revenues in Q1 and $67 million in Q2. Of the $72 million deferred last quarter, $25 million has now been collected and the company expect further payments. Therefore, the lost service revenue could partially recover although it may be difficult to recovery the full amount. 

(4) Channel Inventory is Reduced: 

Sell through this quarter was 5.9 million units vs. shipment of 3.7 million units, which decreased channel inventory by 2.2 million units. Usually shipments increase after channel inventory is decreased significantly, a slight positive for the next quarter. 


Overall, the Q2 report revealed a more negative picture but there are also some positives as well. The $9 preliminary offer from Fairfax is discounted by the market because Prem Watsa is still seeking financing. Nonetheless, investors should not doubt his 28-year track record at closing deals and making good on his promises despite negative developments. He will keep his word and the $9 offer will be finalized. Other bidders may emerged but the $9 offer price still represents a 16% gain from today's market price of $7.75. The headlines may not be friendly to BlackBerry and the future prospects of the company is not 100% positive, but it looks like the maximum point of pessimism has been reached on the stock.

UPDATE( 1:00pm EST), Dow Jones reported that there are "other parties" interested in BlackBerry including Cerberus Capital Management. It is more likely than not that maximum point of pessimism has been reached.

Source: BlackBerry Q2 Report