Eurobonds? No, Thanks. Debt Isn’t Solved With More Debt

Global Economy, On the cover, Sin categoría,

(Published in Cotizalia on Nov 26th 2011)The image of Merkel as an evil monster because she rejects Eurobonds increases by the hour.The collapse ofthe Eurostoxx and the markets in general, shows why. Investors have positioned themselves long in risky assets waiting for a rally that is not justified by fundamentals, after the poor results of the third quarter, or by macroeconomic expectations, with three banks slashing global GDP estimates again.

In this environment, why are 65% of investors overweight in European equities in their portfolios? Easy. Waiting for a shot of adrenalin, a glass of whisky to the alcoholic, a new vial of crack to the addict. We demand more debt, Eurobonds, or a massive stimulus plan, now. And who are the strongest supporters of these Eurobonds, demanding that the ECB infects its balance sheet with more peripheral euro-debt and to expand the EFSF, the stabilization fund? Surprise, the French, Italian, Spanish banks and so on. Entities”so cheap” that only have an average of 25 times debt to assets, and need €250 billion to stay afloat in the “running to stand still” race of exponential debt.

Why are Eurobonds a bad idea?

Imagine if all the companies in the Ibex 35 or the CAC or the Mibtel, with different managers, different businesses and different balance sheets, decided to issue a common bond to meet their refinancing needs. The interventionists and their media messengers would tell you that it is a great idea because the most indebted companies would benefit from the credit rating of the strongest, right? Well, no. It is the opposite.

We learned nothing from 2008, the sub-prime mortgage crisis, the mega mergers of savings banks or the tech bubble. Risk is not dissipated by accumulation, it spreads and it is contagious.


Those who are rubbing their hands waiting for a transfer of wealth from Germany and Central Europe to the peripheral countries of €134 billion euro (the difference in cost of financing if we use the average spread between the bonds) do not realize that the transfer would be the reverse. Negative for all.

In the same way that a solid and attractive stock collapses if the company acquires a poor quality asset even if it is “small”, the implied yield of Eurobonds would rise between 35% and 40% compared to the current underlying asset (the German bund). Furthermore, the risk premium of these Eurobonds would increase to match most of the default risk of the weaker economies.

The Eurobond not only does not protect in bad times, but in times of economic prosperity it does not allow emerging economies to benefit. Are we confident that when Spain or Greece or Portugal recover, Italy or Ireland are going to follow? And do these see a benefit of merging growth prospects with Greece or Spain risk? Imagine if the United States and Mexico launched a joint bond. In a recession, the bond would discount a very significant Mexican risk, and in economic growth times, it would discount part of the relative unattractiveness of a mature country.

I wonder why in Spain the local politicians feel so happy to accept the perspective of a Eurobond, when they know and can quantify the risk and opportunity that the Latin American crisis gave, which today saves the balance sheet, growth, and risk premium of Spanish companies.

It’s even worse. If one country accepts the Eurobond and the economy starts to take off, as it happened in Spain between 1990 and 2005, the cost of funding will be negatively impacted by the economies that now seem very solid and that weigh in times of growth. Do we forget when Germany and France were in technical recession and peripherals grew 3% pa?From the standpoint of the stock market and the refinancing of corporates, Eurobonds are extremely negative. European companies have 1.1 trillion euro to refinance between 2012 and 2013. Most of them have a much lower risk premium compared to their home countries, thanks to a policy of internationalization, debt reduction, cost saving and active management of cash flows. Well, a Eurobond would not only mean an increase in sovereign risk of the underlying higher quality asset (German risk in this case), but the cost of refinancing of companies would also rise proportionally all over Europe, regardless of the country, losing all the advantages of the policy of corporate austerity applied since 2007.

In addition, the route to Eurobonds, perfectly planned from Brussels, is a route that uses the years 2012 and 2013, in which the peripheral countries have more debt maturities, to curtail economic sovereignty in favour of three entities, the IMF, the ECB and the EU, which have shown no ability or track-record of doing things better than the disastrous individual governments . Changing a bad manager for three bad ones is not only to lose sovereignty, but to become an “experimental” economic province. From Islamabad to Islamaworse.Eurobonds would be the ” big short ” of 2012

Read Michael Lewis’s book “The Big Short”. Packaging and disguising risky assets into a conglomerate sold artificially as low-risk is creating an enormous short opportunity. Specially when they would “rate” them as Top Quality probably on their own, as Europe doesn’t want “foreign” rating agencies meddling in its pretend-and-extend scheme. Nothing better than over-priced over-valued assets with huge hidden risk to put some shorts of spectacular magnitude. I assure you that if Eurobonds were approved I would try to launch a Short Only fund the next day. Oh, and if the interventionists ban shorts, there will be a stampede of capital outflow out of Europe again. And goodbye Eurostoxx.

Let me give an example, courtesy of the great John Hussman. Almost all European media and analysts tell us that the ECB does a great job and must infect its balance sheet more and more with debt from countries at risk. We have to print money and borrow more. Of course, they do not tell us that all that money will be paid by European citizens through taxes. But what they definitely never tell us is that if we inject risk, the weakness of the stabilization fund bond grows, becoming even less attractive for investors. Look at the graph below, which shows the differential of stability fund bond with the German bund, which has been rising enormously despite the positive messages from the friends of interventionism. Debt cannot be solved with more debt.

The solution

I repeat. A debt problem is not solved with more debt. A problem of liquidity, not solvency, as the present one is, will not be resolved in any other way than increasing revenue and reducing costs and through saving, which has plummeted by 11 points of GDP in Europe. But above all, by reducing costs, after the orgy of public spending of the past decade, shown in the graph below (courtesy http://blog.american.com and kpcb.com).

The solution is to maintain Europe focused on budgetary control, something that already exists in the treaties approved. No need to change anything, all that has to be done do is to comply with the treaties. Therefore, to cede fiscal and economic sovereignty to a European Union that has never reduced its budget and has no track-record of success in managing costs is ridiculous. I do not doubt at all that the peripheral countries, which have solved dozens of bigger problems, will be able to put their accounts in order, stop spending on stupid subsidies 3% of GDP per year, reduce bureaucracy and duplicated administrations and attract foreign capital.

The solution is that Europe learns once and for all that it’s more attractive to invest in countries that grow less but manage expenses according to their income than to finance a silly soup of subsidies that destroy jobs, GDP and competitiveness in the hope that markets forget, Eurobonds are issued and in a typical “greater fool theory” move, they can place the package of sub-prime debt to someone new.

The solution is to attract non-bank financing, private funding, which will be delighted to support the reconstruction process, and also to generate a legal, administrative and regulatory framework that is stable and efficient to make Europe a commercial partner not only between the EU countries, but for the rest of the world. Borrowing massively from each other to sell to each other is simply unsustainable.

From an economic and investment standpoint, it is suicidal for peripheral countries to cede sovereignty in their weakest moment just because they don’t want to make the necessary cuts. It is a “devil’s pact” that ties them to an organism with no better track-record than their own governments for decades just to keep, maybe for a few years, not more, the Roman Empire “bread and circus” policy of the lost decade we have lived.

Further:

Here is a link to my analysis of the Euro crisis and Spanish elections on CNBC http://video.cnbc.com/gallery/?video=3000058799

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.