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The Market Doesn’t Attack, It Defends Itself. Spain, Short Positions And The Lost Decade

Global Economy, On the cover, Sin categoría

Here is a link to my analysis of the Spanish elections on CNBC http://video.cnbc.com/gallery/?video=3000058799(The following article was published in Cotizalia on November 19th)If there is a chilling fact of this past week is the result of last week’s Spanish Treasury auction. There was no institutional demand. The market is scared seeing again how on Tuesday the government revised downwards the expectations of GDP growth for 2011, no less than about 40% less from +1.3% to +0.8%. € 180 million less of GDP every time they revise it, and there have been six times, while expenditures are not trimmed. So one can understand the reaction of the markets in a country which shall spend 3% of GDP in financial expenses, issues debt to pay interests and each year spends between 1 and 2% of GDP in subsidies. How is Spain going to pay that debt?

Amid all this, the media in Spain constantly mentions “attacks against the country debt” without realizing that the only thing the country has done has been to introduce risk and uncertainty for investors.Regulatory uncertainty, planning and legislation swings and turns. There is no attack. Because no one wants to invest. The market is closed. Imagine that the management of any listed company that has breached its own estimates for years demanded more funding and more support, and think how much its shares would fall. That’s the situation.

The elections have been a first step towards the solution. At least the new government has absolute majority not only at the State level, but also in 95% of the regional communities, which have been responsible for a very large part of the spending binge of 2004-2010, multiplying their budget by 3x.

Part of the solution is the famous “confidence” that the popular party advocates, and that is nothing more than credibility. Give the real figures of expenditure, deficit and exceed targets. Stop the ostrich policy of “pretend and extend”, which has been the country’s economic policy since 2008, hoping that people forget the announced estimates and forgive the mistakes.

A serious problem is the brutal installed overcapacity generated in the orgy of stimulus plans and expenditure. Ghost-airports in every region, ghost towns, a giant real estate bubble, billions in energy infrastructure and renewable subsidies optimistically estimating annual growth of 2-3% … In Spain there is little to do in the field of infrastructure for a few years. The scissor on civil works is unavoidable. Spain has invested in infrastructure like an emerging country, but with the demand of a mature country. Now it has massive spare capacity and the country has to digest, and pay, the debt created by the construction of unnecessary assets.

The good news: some companies are doing their homework and, as always, the private sector will rescue the economy. We’ve spent too much time attacking the capital markets and investors, scaring them with constant revisions of the legal framework, changing regulations in the middle of the period and looking for patch solutions to long-term problems. And while public saving has fallen by 12 percentage points of GDP, private savings reached 11 points. This saving is essential, added to a policy to attract investment capital, to boost the economy.

Well, now that the Ibex has lost all its gains in the “lost decade”, in part because many companies have spent the last ten years looking away, it is worth focusing on companies that can benefit from a situation that on one side will be incredibly complex, without growth, but in which the country and investment risk is lower.

The table below shows the companies in Spain with the largest short positions.

The first surprise is that, contrary to what people in Spain think, short positions in the IBEX are nothing special compared to other global indices. Not much of an “attack” then, even if we look by sectors. But the interesting thing is to look at the ones with the highest short interest and understand why it remains so high.

When media and banks say that stocks are cheap, the key to understand this table lies in something that no one is looking at. Namely, the outstandingly high short interest (look in the table at the ones with more than 1-1.5% of market cap) is due to a massive deterioration of working capital. The reason why hedge funds increase their short positions in some of these companies even when the stocks go up is because the cost of “survival” of these companies is rising as working capital deterioration accelerates. With a ratio of annual working capital to sales that in cases exceeds 20%, those stocks ​​are called “living dead” (it costs more to maintain the activity than to stop it).

But there are three important points to argue:

a) In spite of strategic errors, especially those damn “acquisitions to diversify” that have destroyed so much value, several of these companies are demonstrating that their core business is being managed very well. Therefore, if they manage to stop working capital deterioration and focus on the areas where they have real competitive advantage, the market will reward them.

b) Companies should not fall back into the mistake of “diversifying” and growth for growth sake. Reducing size and being a cash machine is more attractive in the medium term, leaving the balance sheet breathing. The small, focused and efficient companies are worth more than the inoperative conglomerates.

c) No one appreciates debt reductions if they are due to financial engineering, changing of accounting parameters and other tricks.So do not try. The short covering will happen only when margins, cash and balance sheet is restored. Not because of changes in accounting.

There is nothing I like more as an investor than a stock where there is a large short interest, recommendations of analysts are neutral or negative but the company is in the process of recovering quickly and efficiently. These are treasures stocks. And nothing I like more as a short than stocks where the working capital is soaring, returns plummet but have many Buy recommendations. These diamonds are the “short on strength” stocks that gave us so much joy in 2009 and 2010.

While many executives and directors are blinded by accumulating many Buy recommendations from sellside and are pleased with themselves adding revenues purchased in acquisitions at massive multiples, they should realize that the market values ​​organic cash generation, margins, and balance sheet. Not imperialistic adventures. I was head of investor relations for several years in public companies. There is nothing better than to win the interest of bears on your stock and to prove the company is delivering and exceeding expectations of ROCE (return on capital employed) and balance sheet strength. Companies should focus their communication efforts on those investors that currently do not want to buy their shares or are short, not those who already have them, as these are the first to sell in this market. They will learn a lot.

Companies can continue blaming their share price on attacks and justifying themselves, depending on subsidies and grants, or revive. “Shrink to Earn”. It is in their hands.

Oil-Gas Spreads Rocketing Again. Careful with the European Gas Majors

Global Economy, On the cover, Sin categoría

Most analysts keep in their numbers for 2012 and 2013 a massive improvement in profitability for those companies that buy long term contracted gas from Russia and Norway. The thesis on ENI, E.On, GDF-Suez and others is simple. These companies have been losing money on their long term contracts due to an agressive take-or-pay obligation. Basically these groups, in a strive to maintain giant market share and profit from their exposure to retail, reached agreements with the major suppliers of gas in conditions that looked very attractive ONLY if gas prices rose and demand continued to soar. As such, major suppliers locked in large take-or-pay contracts with oil-price-linked formulas based on the “conservative” bet that gas demand in Europe would rise by 2-2.3% pa from 2007-2020 and that gas prices would retain their historical link to oil prices.None of those things happened, and greed turned into loss. The accumulation of market share was part of the problem (most of these companies control c60% of market share in their countries), making them very exposed to GDP and demand growth.

… And demand growth vanished. European gas demand peaked in 2007 and is c9% below that level four years later.

The other problem was the bet on oil-gas link remaining, driving spot gas prices higher as demand soared. What happened is that spot gas prices collapsed by 15%, oil prices soared and the long-term contracts were overpriced versus flexible spot levels. This meant losses that reached levels of €1-1.5bn in 2010 for some companies. These losses are expected to turn to profit by 2013 through a combination of re-negotiation of contracts (mainly with Gazprom) and improvement of demand. Errrr…. not likely.

The bet was wrong on both sides (demand and price), and is likely to get worse mid-term, as demand growth estimates in Europe are overstated given the downward GDP revisions. Furthermore, Gazprom and Russia are in active discussions to build a 30BCM per annum pipeline to China, and the Yamal LNG project (where Total and Qatar are likely to be major players) will create a new export route for Russian gas. Therefore, Gazprom’s “urgency” to renegotiate the take-or-pay contracts is diminishing by the day. And their policy is now to preserve wealth (reserves) not to maximize volumes exported to Europe. Gazprom’s decline rates (4% pa, some see 6%) don’t justify a policy of “maximizing volumes at any cost”.

Well, see below a very interesting chart sent by Citigroup updating on the weakening environment for utilities as the oil-gas spread widens.

oil gas spread

According to Citi “the spread is now back up to €7/MWh as you can see from the attached chart mostly driven from the appreciation of the US$ on which the oil basket that drives long-term gas prices is based. Midstream gas players should now be nearly 100% locked in through October 2012 and ~50% locked in through October 2013 at what they estimate to be a ~€5-5.5/MWh spread. So any incremental volumes sold from now on would actually be at a higher cost given today’s prices, exacerbating loss-making positions”.

The issue, as highlighted above, comes mainly for the giant market-share owners. European demand is unlikely to recover to 2007 levels until 2015, the flexibility of LNG and Asian demand is keeping the gas market in better conditions, but still oversupplied, and the strategic decision of revising take-or-pays goes radically against the political role of these giant companies as “security of supply” providers.

Expect earnings revisions to go…down.

ENI

Consensus expects a return to profitability from demand recovery and re-negotiation of contracts generating an uplift in EBITDA of between €1.5bn and €2bn. However, with Italian gas demand down by 4% in 9M 11 and new gas volumes coming from Libya (16mcm/day, or 1.5bcm in 2012 due to the opening of Greenstream) prices are falling further while ENI may be required to assume some Russian take-or-pay obligations, equivalent to an additional 2 bcm in 2012e, unless we see a favorable outcome from renegotiation with Gazprom on both flexibility and price, something that seems unlikely.

E.ON

Consensus expecting gas midstream business to come back to profit in 2013 with approximately 50/60% contracts renegotiated by end of 2012 Bull case: +€1bn in Ebitda 2012 and +€2bn Ebitda 2013. In a no-renegotiation bear case -€850m in Ebitda 2012 and -€1.7bn in Ebitda 2013

GDF-SUEZ

Concerning GDF-Suez, new negotiations are starting now on contractual clauses (renegotiation every 3 years). Normalization is expected by 2013 with still a wide range in the consensus: (+€1bn – +€2bn) €1bn delta on 2012e Ebitda of Gas division from one broker to another.

Why Italian and Spanish CDS can rise 40%… and Greece is not to blame

Global Economy, On the cover, Sin categoría, ,

(Published in Cotizalia on 5th Nov 2011)The peripheral European sovereign risk premium and the role of CDS (credit default swaps) have focused the debate this week with my Twitter followers. Despite the enormous stimulus measures and bailout packages, the CDS of the peripheral countries remains at historic highs. It falls one day and rises quickly the next. That is because, despite all the stimulus plans,  the risk increases.

On the issue of credit default swaps there are many myths that often hide the desire of governments to mask reality. We’re used to hear that every time the premium rises they say that it is because of Greece, the Fed, or any other excuse.

The CDS market is about $ 24.1 billion gross. Insignificant compared with the impact of the ECB and public institutions. The European Union itself in 2010 analyzed the potential impact of CDS positions on the cost of debt and concluded that there was no effect. Nevertheless, the EU has banned CDS without collateral, a cosmetic measure as not even 0.3% of the CDS market transactions are negotiated without coverage.

The main positions in CDS are in Italy ($ 22.8 billion), Germany ($ 13.1), Spain ($ 13.1), Brazil ($10.6) and Greece ($ 8.7), but for those who support the the theory of an “attack from Anglo-Saxon institutions” against Europe, the figures don’t even compare remotely with the U.S. CDS positions, or, more tellingly, General Electric, Bank of America, JPMorgan and Goldman Sachs that, combined, surpass the CDS exposure to Italy and Spain together. The biggest exposure to corporate CDS is … Berkshire Hathaway with $ 4.8 billion, far more than Deutsche Telekom, Telefonica, and France Telecom, all below $ 4.0 billion.

. Those buying CDS do not expect that countries or companies go bankrupt because in that case the “credit event” would make these CDS worthless. What they expect is to cushion the impact of default risk. In fact, when one buys a CDS, one seeks to mitigate the probability of bankruptcy when it is between 20 and 65% (Spain is now at 29%, Italy 35%). From 65% chance of default, the CDS does not protect.

. While Euro governments persist in the mirage metric of debt to GDP, false because what matters is free cash flow generation, bond investors looks at the percentage of income to interest expense, the acceleration of debt and deterioration of the accounts, calculating the difference between the actual cost of it, artificially manipulated by the ECB buying, and the real one if it was traded in the open market, given the fundamentals of the economy and the type of interest that institutions would demand.

By that calculation, unless things change, the Spanish CDS, for example, could rise 40% in the next twelve months (519 basis points if the deficit reaches 12.5% ​​and the financial costs exceed 35% of income). Since it is very likely that the next government sees a real deficit of 8% instead of 6% due to lower income than expected (uncollectible bills of autonomous regions) and see higher non-computed costs, the probability is not small. in Italy, the deterioration of the accounts has made the 10 year government bold yield 6.595%, its highest since 1997. And the deterioration of the accounts is visible while refinancing needs take 20% of all Euro supply. Italian CDS rising by 35-40% is also likely as spending cuts are proving less and less evident.

. 96% of the sovereign CDS market is absorbed by the financial institutions (many semi-state owned) that accumulate billions of European sovereign debt (€275bn) and know they have to “pitch-in” and buy more when countries need to refinance € 5.9 billion from 2011-2015.

. Many of the new CDS are “quant CDS”, a simple long-short strategy in which the investor buys protection against sovereign risk using CDS, buying in dollars and selling in euros, which “insulates” the sovereign risk and covers the two parts with no “speculative” impact to the country risk premium.To understand the rise of risk premium spreads we must analyze the lack of institutional demand, as the demand-supply analysis explains perfectly why the CDS up despite aid packages to Greece, bailouts and injections of debt.

The first major problem for peripheral debt is institutional investors do not demand it because the price and interest does not match the risk .

If we look at official figures, Spanish debt seems well placed between residents and non-residents (62% -38%). The Treasury boasts that 38% of sovereign debt is placed “between non-resident investors”, however this figure conceals the fact that the vast majority are European central banks, which support each other in the orgy of public debt, EU institutions and underwriters. In Italy it’s the same. Institutional demand is all but nonexistent. Very active buyers are the European central banks, government agencies and the Social Security, which can go to the primary market and is filling its reserve fund, up to 80%, with sovereign bonds . In other words, almost 45% of the debt is bought by the issuing country and the rest by the EU entities.

On Thursday’s Spanish auction there was not a single final customer order, I have been told by several banks. The same since July 2011. And in 2012, Spain has €150 billion more to refinance. Italy has €361 billion maturities in 2012. Therefore it is essential to attract capital and to stop placing the debt in a false cocoon market buddied between the ECB, public entities, social security and underwriters. Countries have to show that this investment is attractive for foreign capital. And that can only be achieved regaining confidence in public accounting, commitment to re-pay, providing transparency and allowing the investor to receive an interest on that debt that is right, not manipulated.

The fundamental reason for the rise of the CDS is not the absolute debt level, religiously repeated by politicians, but the acceleration of expenses and the deterioration of cash flow.

The other reason why CDS are not down is the huge refinancing needs. Between 2011 and 2015, European governments must refinance € 5.9 billion and European companies another €1.1 billion, all while GDP and stagnates and spending does not drop substantially. Italy, especially the Czech Republic and Spain are the biggest risks.

It seems normal that bond investors will continue to demand a premium over the German bund of at least 150 basis points rising to 400 if the deterioration of the income statement of Europe SA continues. The sovereign debt risk premium of peripheral countries is at risk of rising in a scenario in which the supply of debt in the market far exceeds the possibilities of investors to buy it. Spain can not expect to reduce their risk premium when their refinancing needs account for 8% of European supply in 2012, because it is simply impossible to bear weight by investors. The same with Italy, which accounts for a staggering 20% of European refinancing requirements in 2012.