01/2019 Market Commentary
Netflix (NFLX) has a new CFO and his first objective is to address the cash flow conundrum. The company’s cash flow is negative because it spends more than it takes in. Netflix is buying and building content at a rapid pace – while the payoff profile of the content occurs over an extended period (and often does not begin for at least two years). This means NFLX will not know if its strategy is successful until it is too far the wrong way. Most peers grow at a much slower pace and can rely on cash flows from existing content to fund content development. Investors in Netflix’s stock and bonds are risking their capital on the prospects of the returns on the content. Time will tell, but Ballast thinks its unwise to place high value on something that is unproven, unpredictable, does not cash flow, and whose outcome is several years into the future.
Netflix did notch one victory. The film Bird Box was a major success – at least based on viewership. It is important to note that the movie is not pay-per-view so its comparison to traditional film release via movie theaters is not possible. It may be a case study in how the future of movie release and promotion will look. The film’s success was the result of viral social media promotion among other things.
Also happening in January was Netflix’s announcement that it would raise subscription prices. NFLX stock price roared on the news. Then, the company’s earnings were released, and the stock price fell back to earth as analysts were disappointed by earnings. NFLX is growing revenue but it can’t seem to meaningfully grow earnings. Some conundrum…
Another month of headlines. We will stick with recent months’ format and list some top stories with minimal comments:
- Tesla to cut production hours of its higher margin models: S and X
- Battery talks with Chinese company to supply the company’s contemplated new factory in China
- Tesla announces CFO is leaving at the end of earnings call with no further comment
- Tesla plans cut for 7% of its workforce – A surprise move for a company ramping production
- SpaceX, Tesla’s sister company, cutting 10% of workforce
- Tesla requests tariff relief for ‘brain’ of Model 3
- Luxury car-peer (Porsche’s) Taycan could be a threat
As GE dismantled what was the financial operations of the company over the past few years, there were a few units that would always be retained. GE Capital Aviation Services, or GECAS, was one such unit. January brought the possibility that the unit would be sold, and it attracted a trove of private capital to bid. The unit’s fate is yet unknown, but it is expected to fetch as much as $40 billion. GECAS is the largest aircraft leasing company in the world – bigger than Air Lease Corp and AerCap – leasing to the world’s major airlines. It appears nothing is sacred to the new CEO, Culp, as he works to deleverage the company. GE’s challenges remain, nevertheless.
Pacific Gas & Electric (PCG), California’s largest utility company, filed for bankruptcy after careful consideration of its liabilities. It was a volatile month for PCG. As required by California law, PCG announced 15 days in advance of filing for bankruptcy that it intended to file towards the end of January. By the end of the month it did so, despite state investigators finding PCG not at fault for the wildfire that caused significant damage to Napa Valley and surrounding communities in 2017 (Tubbs Fire). What remains, though, is the liability from the 2018 wildfire, Camp Fire, which is estimated to be as much as $30 billion (an amount less than the implied equity value of PCG before the fire). So many equity investors are left wondering why PCG has filed for bankruptcy. Our thoughts are many but here are a couple primary thoughts:
1) Liquidity – Although PCG appears to be solvent, it is short on liquidity and would be in that position for a prolonged period (whereas bankruptcy will allow the company to recapitalize to a structure where liquidity is built-in).
2) Efficiency – The process of litigating and settling $30 billion in claims would be time consuming, cumbersome, and lead to volatility (whereas filing for bankruptcy brings more order).
Jack Bogle passed away in January. Jack was one of the fathers of passive investing, having founded Vanguard, the investment manager eponymous with low cost index funds. At the helm of Vanguard, Jack set off a revolution (and an industry-wide trend of cutting investment fees) as more investors came around to Jack’s passive investing. No one has perhaps done more for investors than Jack – through Vanguard. Jack, we salute you.
January was a tough month for the Brazilian miner, Vale. A tailings dam it was working on decommissioning failed, killing nearly 100 people and requiring substantial environmental cleanup. This isn’t the first dam failure for the company. Three years ago, a joint venture of Vale (called Samarco) experienced a dam failure that led to 19 deaths and several billion dollars in damages. To compound matters for Vale, the company has numerous other mines with potentially problematic tailings dams. Vale has taken the bold step of significantly reducing production at those mines and will decommission the dams over the next three years. The initiative will cost as much as $5 billion, and although all dams are characterized as inactive, Vale will have to cut back on production. The combined costs of cleanup and decommissioning acutely shifted Vale’s credit profile. Vale has suspended its dividend, and its credit ratings are under review for downgrade. Ballast is monitoring the situation for investment opportunities.
Abbvie (ABBV), a major pharmaceutical company that was spun out of Abbott a few years ago has suffered a few setbacks in recent years as it tries to shift away from a concentrated revenue stream (the majority of which come from sales of blockbuster drug Humira). Pushing its drug development pipeline to growth and shifting away from Humira, AbbVie has made several acquisitions lately. One such acquisition was Stemcentrx for $10.2 billion($5.8 billion cash and stock with the rest in milestone payments). Fast forward two years and ABBV announced it would take a $4 billion charge when the key drug that they acquired failed in clinical trials. Several peers have had similar experiences lately.
Bristol-Myers Squibb (BMY) announced that it would acquire Celgene (CELG) for approximately $74 billion. By comparison, BMY had a market capitalization of $81 billion. This is a large acquisition. The break-up fee for the acquisition was set at $2.2 billion. Ballast has discussed CELG in the past and highlighted its tough path forward. This transaction is a major bailout for Celgene, whose share price fell from $145 in late 2017 to a recent low of $59. Because the challenges of Celgene’s drug portfolio remain, this transaction could spell disaster for BMY if completed. BMY will increase leverage to complete the deal, which will compound any problems. BMY equity investors seemed to agree with our take as the stock price fell immediately on the news, dropping from $52 to $44.
As if January was not busy enough for pharmaceuticals, Eli Lilly (LLY) announced it would acquire Loxo Oncology for $8 billion. This comes after long focusing its efforts internally through R&D. LLY recently shed its animal health unit (Elanco in September 2018). The Loxo acquisition marks a major shift in strategy for LLY as it joins peers in scooping up smaller companies – whose primary asset is intellectual property of unproven drugs. The industry has been busy scooping up drugs through business acquisition, and as of lately, it seems many acquirors have charged off the acquired assets (AbbVie as example). Unlike BMY, at least LLY equity investors were lukewarm and the share price did not budge. The $8 billion will be easier to digest than what BMY is doing.
It’s tough out there, but using debt to acquire unproven or troubled drug portfolios is not prudent.