Tuesday, March 18, 2008
Non-GAAP OPEX: $300
Interest Inc: $6
Net Income: $38
And now my own estimates, using this announcement as guidance:
These are pro-forma estimates, which means they don't include one-time charges. Given the decline in business and the ongoing restructuring, I would not be surprised if actual GAAP earnings were to turn negative.
The important takeaway from this announcement is that we are finally starting to see the consequences of heavy investment in a business with declining growth. EBIT margins should decline by over half YoY. If this trend continues, as I expect it will, the affect on MNST's operating results, and share price, should be severe.
I also think this announcement speaks a lot to management credibility. If there was any doubt that management was withholding guidance on principle, those doubts should be put to rest. Their operating margin guidance (another form of guidance that apparently doesn't count) is now basically unattainable unless trends reverse themselves drastically in the back half of the year. Expect this to be the first of many "corrections" to come.
Author is short MNST. Above writing should not be construed as "guidance" of any kind. Do you own DD.
Saturday, March 15, 2008
GLG Incentive fees at risk
GLG is structured like a typical hedge fund, in that it earns revenue primarily based on a combination of incentive and incentive fees. Annual management fees equate to an average of about 1.9% of AUM. Incentive fees vary across funds, but typically average between 20-30% of all performance gains across most single manager products. Incentive fees accounted for 50% of revenue last year, but also tend to be higher margin, and so have a disproportionate impact on earnings.
As of the year end 2007, GLG managed approximately $24B in assets spread across over 40 funds. Though funds are widely spread, there are some concentration issues, particularly in regards to revenue:
Fund % of Gross AUM FY07E Rev % of rev Annualized net return*
GLG Emerging Markets Fund 17% 265 32% 70.6%
GLG European Long-Short Fund 13% 141 17% 13.6%
GLG Market Neutral Fund 10% 124 15% 20.0%
*Based on morningstar estimates
GLG's top three funds account for only 37% of AUM, but accounted last year for 64% of revenue. Most importantly, I think it's fair to say that the emerging markets performance is nowhere close to sustainable. This implies gross returns (returns before fees) of annualized 90% since inception in November of 2005, compared to ~35% for the emerging markets ETF. Given the tougher emerging market conditions (down about 13% YTD as of this write-up), and the high growth in AUM (which makes high performance more difficult), incentive fees are poised to come down substantially in 08'. Also, note that this one fund may have accounted for over 50% of GLG's performance fees in the 2nd half of the year. Many of GLG's funds were actually down in the 2nd half, so this fund in particular helped artificially keep the firm's profits afloat.
The Leverage Risk
The other two funds noted above (European L/S and market neutral) have components of hedging, making them less prone to market fluctuations. At the same time, these sorts of hedged funds are the most likely to use leverage. Leverage allows funds to amp of their performance, and was a particularly common practice over the last couple years, as low risk premiums and eager prime brokers would often loan funds capital at low interest rates. Over the last few months, and in particular over the last few weeks, prime brokers have begun reigning in this excess. The result varies from crippling to disastrous (see the Caryle Capital collapse). GLG is very hush hush on the extent of leverage it uses: I doubt it took on the sort of ratios that Caryle took, but analysts reports indicate that it has, in some documented cases, used leverage in excess of 4x. Also, anecdotally, there are two points worth mentioning:
1) GLG is part owned by LEH, which itself was an aggressive prime broker. You've got to think that at the height of the boom, there was a chance that LEH encouraged GLG to gorge itself with leverage to boost its prime brokerage business.
2) Freedom Acquisition, the SPAC that took GLG public, is run by the infamous CEO's of Jarden, who I have written about previously. If their own appetite for leverage and risk is any indication, the leverage in GLG's funds could be scary.
If the leverage at GLG is extreme, the downside is clear: funds could blow up, leading to mass redemptions, lawsuits, loss of key talent, and potential collapse. While possible, I have no reason to believe this outcome is likely.
The alternative and more likely scenario, while not as bleak, is still damaging to GLG's earnings prospects. Let's assume that GLG's market neutral fund conservatively used 4x leverage in 2007 and earned 13.7% net fees (according to morningstar), and charges typical hedge fund fees. Using those assumptions, you'd get an un-levered performance gross performance of only 8.2%, vs. the estimated 18.5% levered gross performance that was implied to get to a net performance of 13.7%. By borrowing 4x its money at 5% and earning 8.2%, GLG was able to return more than double on a net basis what it would have been able to do if no leverage was available. If it does continue to use leverage, and rates go up and/or gross returns go down, leverage could magnify the losses. Also, due to the nature of leverage (typically short term lending), these agreements must be negotiated often. Depending on GLG's terms, it's possible that de-leveraging could force a liquidity crisis and force GLG to liquidate positions and rapidly reduce its leverage, resulting in a sharp decline in the value of the stocks it holds. This is somewhat unlikely, but always a risk.
The High watermark and hurdle risk:
Relationships between performance and incentive fees are not linear. It's impossible to know without reviewing the incentive structure of each fund, but we do know that certain of GLG's funds are subject to high watermarks, which means a fund that declines in one period must reach its prior highs before incentive fees can be charged again. Some funds are also subject to hurdle rates, meaning a certain performance benchmark must be exceeded before incentive fees can be charged. These measures should hurt GLG in tougher stock market times.
The bulk of GLG's funds had an abysmal January. The flagship European L/S fund was down over 4% in January and the Market Nuetral fund was down 3%. The emerging markets fund was flat, which is impressive on a relative basis, but will not be particularly helpful in repeating GLG's outstanding emerging markets performance last year. If GLG's performance in a tough January is any indication of its ability to weather a tough 2008, flat YoY performance (and, consequentially, little/no performance fees) is not out of the question.
What does this all mean financially?
Barring stellar out-performance by GLG in these tough economic markets, GLG should experience somewhere between a rough and devastating 2008, cases that are not currently reflected in the stock price. If GLG does not keep up it's rabid performance, and, worse, if performance turns flat or even negative, much of GLG's revenue and profitability will dry up. Performance turning flat or negative is not out of the question, and has occurred before. Let's take a look at GLG's historic performance:
The image quality isn't great (blogger is giving me trouble), but you can see that performance in 2000-mid 2002 remained relatively flat. Also, before the incredible launch of GLG's emerging market fund in late 2005, GLG's overall performance was not very impressive. GLG returned 10.4% and 8.2% net fees in 2005 and 2004, well below its most recent performance, driven primarily by its emerging market returns.
Best Case Scenario:
In my best case scenario, GLG sees half of its AUM rise an average of 20% gross, and the other half of its fund experience losses. This could be possible if Emerging markets and a few other big funds do exceptionally well, despite losses in most other funds. In this scenario, GLG earns about $1/share, at the high end of estimates.
Base Case Scenario:
A more likely outcome given the market turmoil is a scenario under which 65% of assets perform negatively or otherwise do not hit the rate required to charge performance fees. The other 35% of assets return 15% gross of fees. In this case, GLG earns $.65, well below estimates.
Bear Case Scenario:
In another likely outcome, if January is indicative of how the year will turn out, it's entirely possible that about 75% of assets end up negative or below the rate at which performance fees can be charged. The other 25% return 12% gross returns, meaning earnings around $.40.
I believe the best case scenario for GLG is that they meet or slightly exceed expectations, while the likely scenario leaves them under performing by a wide margin. Slap a 10-15x P/E on the base and bear case scenario and we can see downside between 25-55% to the stock price, or 50-80% to the warrants.
Note: Author is short GLG common and warrants.
Friday, March 7, 2008
MNST serves as a broad proxy for the larger employment market. It is not surprising, then, that current weakness in the employment market in the US (and, increasingly, abroad) has and will continue to erode its business. KFY and HSII, however, focus on a very small niche of the job market: that of executives, and higher level management. The market for executives and high level management is driven primarily by the creation of new management jobs and increased turnover in management. Factors that influence these two drivers are tighter markets for talent, increases in poaching from other companies, reductions in promotion from within, business creation, and general economic conditions.
My original thesis was that all the aforementioned factors would be negatively influenced in deteriorating economic conditions. I believe I misjudged a couple key elements which have delayed but not prevented an eventual drop. These develops include:
1) Continued robust growth abroad, which should begin to slow noticeably as the US drags down international economies with it. Also, keep in mind that most of HSII & KFY's business is from multi-nationals, not country domiciled businesses, which means that many of these businesses country growth plans could be harmed by issues in the US.
2) Increased mandatory turnover as companies (especially financial companies) clear house, firing scapegoats and bringing in fresh blood. This has the effect of increasing demand for HSII & KFY's services. I believe this affect is temporary. Once house is cleared, the impact of decreased turnover should be revealed. In tough economic times, employment opportunities tighten, leading to less voluntary turnover as people are presented with less opportunities to move elsewhere.
3) HSII alluded to strong demand in financial services for risk managers that offset much of its weakness elsewhere. The financial markets turmoil has, it appears, at least temporarily created demand for new management positions. I believe this shock is one time in nature and that, eventually, we should see new job growth at the management level slow noticeably, both domestically and abroad.
MNST should continue to experience pressure to its earnings and stock price nicely mirroring declines in US and abroad job growth. Whether or not these same pressures will eventually hit KFY and HSII remains to be seen, but I for one believe they will.
Author is short MNST, KFY, and HSII.
Tuesday, February 5, 2008
The M&A Cycle
Mergers and Acquisitions activity fluctuates in tandem with the equity markets and general economic activity. M&A activity tends to peak in economic boom times, as optimism, easy credit, and fluffy growth prospects rule the day. As economic times head south, companies tend to slam the brakes on M&A furies: credit dries up, attractive growth stories become harder to find, and CEOs have enough to fix in their own companies that they can't bother to be distracted by integrating acquisitions. There are other factors at play at well, but for simplicities sake, lets leave it at that. Lets take a look at total global M&A volumes from 1997-2006 (estimates from dealogic):
Total RoW US
1997 $1,512.82 $632.2 $880.6
1998 $2,307.69 $307.7 $2,000.0
1999 $3,073.77 $1,637.0 $1,436.8
2000 $3,459.02 $916.8 $2,542.2
2001 $1,764.71 $953.9 $810.8
2002 $1,400.00 $933.3 $466.7
2003 $1,411.76 $878.4 $533.3
2004 $2,037.67 $1,190.1 $847.6
2005 $2,875.86 $1,582.8 $1,293.0
2006 $3,891.72 $2,096.4 $1,795.3
In the tough economic years of 2001-2003, M&A fell off a cliff. The results look particularly awful when we take a look at the US only (look at the US drop from 2000-2002!), despite falling interest rates. Several bulls have come out on M&A because of the falling interest rates, but they are not taking into account rising corporate yields (the real cost to buyers), nor stricter credit standards, which were basically non-existent in 2006 and early 2007. Similar trends repeat themselves to varying degrees in nearly every recession of the last 30 years. This time truly may be a little different. Most notably, M&A activity abroad has picked up substantially in recent years, and the trends are even more pronounced in 2007. Though not pictured here, M&A activity has slowed down substantially since the credit crunch, as easy credit has dried up and economic prospects outlooks have turned downward. Things will likely get even worse as private equity firms, currently flush with cash, run out of money and have trouble raising new funds.
How the M&A cycle affects Evercore
Evercore was one of the prime beneficiaries of the latest M&A boom, and is also likely to be one of the greatest victims when this current cycle turns. EVR derives ~90% of their revenue from M&A advisory (helping companies sell themselves or buy other companies), with over 80% of that revenue coming from the US. EVR also tends to focus on mega deals ($5b+ acquisitions), that have been all the rage the last two years due to the LBO craze, which has officially come to an end. Going forward, we are likely to see declining overall M&A volumes, increasing volumes in the rest of the world compared to the US, and sharp declines in both the number and size of megadeals. These trends, which I will discuss in detail, do not bode well for EVR.
EVR provides a financial advisory services, including M&A advisory, recapitalizations, and restructuring, but the biggest chunk of that is M&A. Unfortunately, the company--probably for good reasons--does not break-out advisory revenue into its different segments. They are often hired by the acquiror or the seller to advise on a prospective deal. They are typically paid a % of the total deal size upon the deal's closing, ranging to an average of about .06% of the deal size for sub $1B deals, .224% for $1B-5B deals, and .545% for <$1B deals. These numbers are estimates, but they should be relatively accurate. If the deal does not close (if EVR cannot find a buyer to match with a seller, or find a deal for a buyer), then the company makes no money.
The Mega-deal decline:
Even if the only thing to decline is the number of mega-deals, EVR will be in serious trouble. Megadeals have accounted for the majority of their revenue the past few years, and are likely to decrease in both number and size. Below is the estimated dollar value megadeals ($5B+ deals) that EVR has closed since 1997:
Note megadeals have generally peaked as the market has peaked, and can even dissapear entirely from EVRs pipeline in more mild economic times. This trend has continued in 2007, though we've already seen the completed mega-deal number for EVR come down substantially as megadeals are increasingly being done in non-US markets, or by foreign companies in US markets (neither of which EVR is particularly strong in). Megadeals have accounted for an estimated 78%, 55%, 94%, and 84% of EVR's deals in 2004, 2005, 2006, and 2007 respectively. The numbers are a bit lower as a % of revenue (since the % fee per deal dollar is lower), but it is stil substaintial: likely 50%+ in each of the last 4 years). EVR has only one mega-deal in its pipeline (the ADS deal, which has blown up and likely won't happen), and odds are seemingly increasingly likely that even if they do nab one or two of these deals in 08', the average value of these deals is likely to be smaller than the average mega-deal size in 07' and 06'. This development alone could cut revenue in half (or more) in 2008, even if small to medium size deals increase slightly.
The vanishing pipeline:
US M&A activity has grind to a halt since August, but because deals take time to close after they are announced, EVR's revenues have held up deceptively well. In the most recent quarter (Q3) they closed on two megadeals they'd announced moths early (KKR and CVS acquisitions), as well as a variety of smaller deals done before the credit crunch. They are estimated to have closed only $15B in Q4, and go into 2008 with a relatively tiny backlog of $18B. The company only announced $5B in new deals in Q4 according to dealogic. If production continues at these levels, EVR will come nowhere close to equaling the amount of deals they completed in 2005-2007. Yet, analysts somehow are projecting continued revenue growth, mostly due to newly hired MDs. Even if the new MD hires allow them to grab some market share, I expect this will be more than offset by declining macro trends.
EVR set up to disappoint in 2008
I estimate that EVR may earn between $.42-$.62 in 2008, well below the $1.70 consensus. EVR has almost no tangible book value (~2.50 v. $19 share price), so there is little in the way of a margin of safety if earnings drop as I expect they will.
To get to my revenue estimates, I assume that completed M&A deals below $5B/deal will revert to 2005 levels, which seems like a reasonable assumption given that much of the M&A growth of the last 3 years was unsustainable. I assume Mega deals ($5B+) will revert to 2004 levels for simmilar reasons. I also add in the fees from the current estimated backlog going into 2008 (~$18B), as well as some amount for non-M&A advisory revenue (~$20M). I assume a 25% pre-tax margin, vs. the 30-35% experienced the last couple years, due to lower revenues on a partially fixed cost base.
The earnings range comes by assuming different market share numbers for EVR. Even under the most optimistic of share scenarios, I estimate revenue should fall between 40-70% if the M&A market (particularly the US market) contracts as much as history would suggest.
Note: Author is short EVR.
Thursday, January 31, 2008
US Monster Employment Index (MEI) turns negative
Monster generates the majority of their revenue from job listings. The MEI index allows us to get a very good sense of how job listings are trending; the data is released monthly, and is an excellent indicator of where revenue is headed. For the first time, the MEI index dropped year over year in January, which increases the likelihood of negative revenue growth in North America in Q1. Even small revenue declines should impact margins negatively as costs remain relatively stable and as pricing is pressured. Because this data is released every month, I expect future announcements to continue to pressure the stock. As of December, international MEI numbers remain positive and impressive, though this should change at some point.
To support this belief, I plotted Year over Year changes in the MNST MEI vs. revenues in the North America Careers segment. Here's what that gets you:
As you can see from the chart, YoY revenue growth is highly correlated to YoY changes in the MEI (for math geeks, the rsquared is a convincing .93!). One other point worth pointing out is the intersection it he graph that occurring in Q2 of 07'. For the first time since 2005, revenue growth dipped below the MEI, which suggests either that MNST is discounting, or that their mix has shifted such that they get less money per listing. I believe its the later: small businesses (who purchase one off listings at higher prices) have, according to MNST, been reducing listings at a faster clip than corporate clients (who buy listings in bulk). Continuation of this trend should continue to pressure margins. Assuming January MEI trends mirror those in February and March, MNST could see NA revenue fall 6-8% in Q1, and should likely see further margin contraction, too.
Management pulls FY08 guidance and dodges tough questions on the CC:
Management sounded very uncomfortable speaking about what happens to MNST in an economic downturn, and conveniently decided that now was a good time to stop giving forward looking guidance. No matter what management says, this is highly suspect, especially in light of their reticence to discuss how they would be impacted by an economic downturn. Management guided to 25% operating margins, despite NA margins dropping. International margins showed strong growth.
Management vows to continue to invest in the business:
This is the right decision long-term, but by having this focus MNST is likely to see a sharp margin down tick if revenue declines, as expenses stay relatively flat and revenue falls.
This remains my highest conviction short. If MNST is ascribed a cyclical multiple rather than a growth multiple, the stock should come under further pressure.
Author is short MNST. Not a recommendation to buy and sell shares. Please do your own due dilligence.
Friday, January 25, 2008
Today, President Bush and congress announced that they have tentatively reached an agreement to borrow $150 billion dollars from foreign countries to prop up the ailing
This is not the headline that has been reported elsewhere, but it should be. US consumers have spent beyond their means. They took on too much debt, got used to lifestyles they could not afford. Eventually, the credit spigot ran out, and they pleaded to their government for help.
Now here comes our government to save us, suffering from a similar ailment. Like many consumers, our government spends more money that it takes it. Passing tax increases (revenue generating measures for the government) is political suicide. Decreasing spending (decreasing expenditure) is political suicide.
Let’s look at the
Entities that spend more money than they take in eventually face a day of reckoning. We have once again chosen a short term solution that will exacerbate the inevitable day when we must balance our budget. When the
How long will people take that investment for? What happens if the interest rate rises (note: mortgage rates are tied to treasury rates, not fed fund rates)? What happens when people no longer buy the worthless paper our government is issuing?
We have made a choice as a society. Rather than face the consequences of our poor choices, we continue to make more poor choices that raise the stakes on the eventual pain higher and higher. This is insanity, and it will not last.
Monday, January 21, 2008
With that in mind, let's take a look at a broad swath of companies that you should avoid to protect your portfolio in a bear market.
1) Avoid story stocks: Story stocks are stocks whose valuation is based soley on lofty future expectations. Examples today include Solar stocks, CRM, emerging market companies, and basically any company with a P/E in excess of 100x, or a P/S ratio great than 5-10. These stocks are already pricing in tremendous growth that may or may not come. Even if the story does work out eventually, these stocks are unlikely to see their multiples contract heavilly in bear markets as people discount the future, and in general grow more pessimistic. These stocks are also havens for retail investors who tend to panic more in bear markets, exacerbating downward moves. Story stocks always carry these risks, but negative market sentiment is always more likely to be the catalyst.
2) Avoid Wall Street Darlings with cyclical exposure: Stocks in this category would include internet stocks like MNST and AMZN, and even a company like APPL. All these companies are sensitive to economic conditions. If their revenue or margins fall, which often happens to economically sensitive companies in tough economic times, these stocks could get slammed even more than they have already.
3) Avoid Value Traps: trailing P/E multiples in an environment like this are highly misleading. Many companies that look cheap on an environment that no longer exists. The staffing stocks (KFY, HSII, and MNST), which I hae been short for several months now, are great examples of stocks that look deceptively cheap looking backwards, but expensive looking forward. Other examples would include retail companies, financial companies, bond insurers, and a variety of other companies whose future results are likely to look far worse than the results they have experienced in the recent past.
4) Avoid over-levered companies: Bankruptcies are not pretty and, rest assured, they will come. Companies with poor balance sheets are susceptible to going to zero if their businesses hiccup and they cannot pay off their debt. JAH, one of my favorite shorts, is an example of this kind of company: deceptively cheap, but if they run into issues the creditors will own them and the common shareholders will be left with nothing.
Stock corrections are painful for all investors, but especially amateur investors, who tend to be invested in exactly the wrong kind of stocks to be invested in in bear markets. If you have been going it on your own, or aggressively chasing the latest hot thing, strongly consider looking into time-tested mutual funds like HSFGX or FAIRX, which both have an excellent track-record in consistent, positive returns in all market environments.
The road ahead is fraught with perils. Many who did not learn their lesson from the internet boom, or the real estate bubble, are once again in harms way. Cautious investing to all.