#sharebuybacks

Why didn’t GE use the $45bn in buybacks to take care of the $31bn negative equity?

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After GE’s monster $22bn goodwill impairment charge, the company remains in negative equity to the tune of $31.3bn. $79.2bn in goodwill remains on the balance sheet with $31.5bn in shareholders equity and $16.4bn in non-controlling interests. To think GE spent $45bn on buy backs over 2015 & 2016. Imagine if the company had used those funds to shore up the balance sheet and go back to positive equity?

While the kitchen sinking of GE Power should be deemed a positive (although somewhat expected) it is interesting to see the reaction to the shares (-9%) which flirted with April 2009 lows. Cutting the 1 cent dividend from 12 cents in the grand scheme of things was optics.

Although the goodwill charge is a non cash item on the balance sheet, she is clearly not in a position to deal with the rest of the goodwill just yet.

The brand new CEO has done the right thing to restructure the former largest company in the world but he has drawn attention to the most gangrenous wound that needs to be cauterized.

It is still a rough ride from here for an industrial stock at the top of the megacycle to have such a dreadful balance sheet.

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Harley – the Milwaukee Anvil

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Harley can blame tariffs for ruining margin but the rot set in well before. 2Q motorcycle shipments came in at 72,593 (-11.3%). The other luxury brands continue to climb. Its long time American arch rival Indian continues to grow. Indian’s parent Polaris Reports Q2 tonight. Indian sales were up double digit in Q1. The limited edition Indian Jack Daniels Scout Bobber sold out in 10 minutes. Product anyone?

Harley is losing share in America, it’s largest market, and Australia and Japan remain soft. Harley used to sell 16,000 units in Japan. In 2018 it will be lucky to ship 9,500. Ironically Europe is its most encouraging growth area yet tariffs will impact it.

Luxury motorbike brands BMW Motorrad, KTM, Ducati, Triumph etc are ALL growing.  Just Harley is flailing – the best motorcycle brand in the business (one where customers are prepared to tattoo the brand to their bodies) is chasing dreams from some consultant inspired long term plan which misses one core ingredient – listening to customers.

Expect the Harley management to keep the excuses rolling. It suffers from the divine franchise and its leadership seem more willing to point to external factors for its issues when internal complacency and resting on the laurels of the glory days seem the biggest factor. It is so obvious.

So Harley met its Luke warm 2Q EPS guidance. Maybe shareholders should reflect on the $103mn (1.3% of outstanding) of the $700mn in planned share buybacks which flatters EPS. E is not rising, S is falling. 10% of the stock is being shorted.

Why discontinue?

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This is a chart of the change in the US Fed balance sheet, a series that has just been discontinued. Is this because the Fed is about to step up its activity and offering wider disclosure on tapering activity might spook markets? Given that 72% of the growth in S&P earnings has been driven by buybacks since 2012, it stands to reason the market is not exactly providing the type of confidence inducing organic lift the index reflects. Bank of America revealed that “net buying of Tech sector in the 1H was entirely buyback-driven.” 

Kind of reminds CM of the day Bernanke’s Fed announced it would no longer report M3 money supply a year before the financial markets headed into the GFC. CM estimated on p.4 of a report several years ago that M3 money supply by 2018 on constant long-term growth rates would turn into around $35 trillion from the $10 trillion at the time it was discontinued.

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Nothing to see here? Throw a deteriorating fixed income market with fewer buyers and corporates that have binged on cheap credit to fuel buybacks, it doesn’t look like the stuff dreams are made of. The chart below shows that quarterly pre-tax US profitability is struggling since 2011. Earnings (E) are not doing so well. It is by the grace of falling number of traded shares (S) that makes the EPS look flattering.

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We took the liberty of comparing corporate profitability since 1980 and correlating it to what Moody’s Baa rated corporate bond effective 10yr yields. An R-squared of almost 90% was returned.

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Why not use the Aaa spread instead? Well we could do that but looking over the last decade the average corporate debt rating profile looks like this. We have seen a massive deterioration in credit ratings. If we look at the corporate profitability with Baa interest rates over the past decade, correlation climbs even higher.

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We shouldn’t forget that the US Government is also drunk on debt, much of it arriving at a store near you. $1.5 trillion in US Treasuries needs refinancing this year and $8.4tn over the next 3.5 years. Couple that with a Japan & China pulling back on UST purchases and the Fed itself promising to taper (but now hide the results of) its balance sheet. So as an investor, would you prefer the relative safety of government debt or take a punt on paper next to junk heading into a tightening cycle?

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Discontinuation of series always carries a sense of deep cynicism for its true intention. It is not an onerous data set to cull. Sure we can fossick around and try to find it hidden in the archives of the Fed website but the idea is that they probably don’t want to publicise how much more they intend to flog.

EU tariffs the least of Harley’s worries

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Two weeks ago CM wrote, “Harley-Davidson (HOG) is the classic case of a divine franchise. While still the world’s largest maker of cruiser motorcycles, it is being swamped by new competition. HOG’s EBIT performance has slid for the last 4 years and is even below the level of 2012…Sadly for HOG, 1Q 2018 has revealed even worse numbers. Global unit sales were 7.2% down on the previous year and 12% down at home.  Japan and Australia were soft. Looking at the strategy it looks like throwing spaghetti at a wall and hoping it sticks.

There is a touch of irony in that Harley was starting to do better in EMEA markets in Q1 2018 (+6.8%). Now EU tariffs are likely to sting the maker some $2,200 a unit average on motorcycles sold there. The company is seeking to bypass this in the short term by sucking up the cost of the tariff to help dealers before arranging (one imagines) for final knock down kit assembly outside the USA. A downturn in EMEA is a nightmare that exacerbates the weakness elsewhere around the globe. H-D Japan shifted 16,000 units at the peak. It will be lucky to do 9,500 this year. The business has lost its compass.

At the moment it seems the brand is stuck in an echo chamber. Harley announced at the start of the year it was closing a Kansas City plant for a net loss of 350 jobs. The rot has been in since before the tariffs. Trump lambasted Harley Davidson on Twitter for waving the white flag too soon but it is probably more evidence of the scatterbrain negative spiral approach to dealing with the predicament it finds itself in. Harley may want half of sales to come from overseas markets but it may not come through growth outside of America, rather a decline from within.

In closing Harley’s are a cult. There aren’t many brands where customers are prepared tattoo it to their bodies. Sadly this mentality means that Harley is still committed to conduct $700mn in buybacks which smacks of denial for a company seeing EBIT dwindle at 40% below peak. Then again, we shouldn’t be surprised when buybacks have made up 72% of all S&P500 earnings growth since 2012!! A recent survey that showed 75% of asset managers have not experienced the tech bubble collapse in 2000. Sure it is nothing to be worried about! Experience is a hard teacher. You get the test first and the lesson afterwards!

GE’s Angolan Kwanza exposure

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Sell-side analysts rarely read through the fine print of an annual report. Hidden away in the prose, one can find some pretty eye-opening paragraphs. From GE’s 2017 Annual Report,

“As of December 31, 2017, we held the U.S. dollar equivalent of $0.6 billion of cash in Angolan kwanza. As there is no liquid derivatives market for this currency, we have used Angolan kwanza to purchase $0.4 billion equivalent bonds issued by the central bank in Angola (Banco Nacional de Angola) with various maturities through 2020 to mitigate the related currency devaluation exposure risk. The bonds are denominated in Angolan kwanza as U.S. dollar equivalents, so that, upon payment of periodic interest and principal upon maturity, payment is made in Angolan kwanza, equivalent to the respective U.S. dollars at the then-current exchange rate.”

On that basis the marked to market figure is actually another $250mn hole in 2017. One wonders what the exchange rate will be in 2020? Furthermore at what level will Travelex or Thomas Cook exchange that for? It would be safe to assume the ‘bid/offer’ spread will be horrendous. GE might find it more useful to run a Nigerian mail scam to hedge the expected losses. For a company as large as GE, potentially losing $850mn should look like a rounding error unless the company is bleeding as the monster is. GE took a pretax charge of $201mn on its Venezuela operations.

We shouldn’t forget that “GE provides implicit and explicit support to GE Capital through commitments, capital contributions and operating support. As previously discussed, GE debt assumed from GE Capital in connection with the merger of GE Capital into GE was $47.1 billion and GE guaranteed $44.0 billion of GE Capital debt at December 31, 2017. See Note 23 to the consolidated financial statements for additional information about the eliminations of intercompany transactions between GE and GE Capital.

As 13D Research noted, “GE spent roughly $45 billion on share buybacks over 2015 & 2016  despite the shares trading well above today’s levels all the while ignoring the $30 billion+ shortfall in its pensions. Management disclosed in a recent analyst meeting that it would have to borrow to fund a $6 billion contribution to its pension plans next year, as well as chopping capex by 26% in 2018.

As mentioned yesterday, there are some who have faith in the sustained turnaround in medical. Indeed it has seen some top line and margin improvement but management seems more concerned with focusing on cutting costs than pushing innovation. Efficiency drives should be part and parcel of all businesses but one must hope CEO John Flannery has far bigger hopes for its market share leading product line (which GE admits facing pricing pressure in some segments) than trimming the staff canteen cookie tin.

GE remains a risky investment. Flannery has it all to prove and to date his performances have been anything but inspiring. GE feels like a business suffering from the divine franchise syndrome synonymous with former CEO Jack Welch. That dog eat dog culture seems to be biting its own tail.