Thoughts through the cycle: W1 July ’20

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Business as usual?

  • Most people are familiar with the Alan Turing story from the 2014 film The Imitation Game starring Benedict Cumberbatch. During World War II, Turing worked in Hut 8 of Bletchley Park deciphering German communications which had been encrypted using an enigma machine. Less well-known but arguably more important was the work done in Hut 6 at Bletchley, where Gordon Welchman pioneered the use of signal intelligence to outline axis battle plans and troop movements by the close monitoring of radio traffic. After the war, Welchman moved to the US where he became a key contributor to Cold War intelligence; his strategic conceptualisation of shared and coordinated information gathering arguably created the logical basis for the world wide web which was itself originally designed for military purposes.
  • What is signal intelligence? While not necessarily being party to all the facts, signal intelligence offers an elliptical approach to analysis which looks at who is talking to whom and with what intensity in order to build a shadow-picture of what is happening, especially if the actual facts are concealed. Another World War II film (Midway, 2019) contains an excellent explanation of the process as voiced by the character Joseph Rochefort (Welchman’s American code-breaking equivalent):

“Imagine you’re throwing a wedding and maybe I’ve never seen the invitation but I hear from the caterers they have an event on a certain day. The flower guy’s buying up all the roses on the island. The best band is booked. That’s what signal intelligence can give you… clues, not a definitive answer.”

  • As we head in to Q2 corporate earnings, over 80% of US S&P 500 companies have withdrawn earnings guidance. With multiple millions of workers in developed world economies on furlough, it is unclear where the true level of unemployment (permanent or otherwise) lies. With government fiscal deficits exploding and central banks flooding the market with liquidity, the actual economic damage from the pandemic lockdown is as yet unclear, as is the long-term outcome for the money system. Perhaps an exercise in signal intelligence might provide some clues.
  • Where to start? Given how the rebound of the service sector is a key element in the argument for a V-shaped recovery, a positive press article about the high-end members club Soho House seems as good a starting point as any. According to The Financial Times:

“Despite global lockdowns “nothing stopped” at the business, said Mr Jones [CEO of Soho House], looking up at a green ceiling in 180 Strand, a new Soho House that was due to open in London in April. The clubs, known as celebrity hang-outs frequented by the likes of Prince Harry and Kate Moss, closed in the pandemic and finishing touches at 180 were paused.”

  • This redevelopment is part of a new five-year strategy that includes, “an extensive refurbishment programme, five new sites a year, and a revamped app.” (‘Soho House to roll out global expansion despite pandemic crisis’, FT, 03/07/2020). With the UK’s ‘independence day’ from lockdown on the 4th July, this is an excellent time to be pushing a strong growth and recovery story.
  • The FT article continues, “Soho House has been able to continue its aggressive expansion through a mixture of cost cuts, fundraising and incoming membership fees.” What in fact has happened is there has been a large and thus presumably dilutive equity investment in the group, although this is skirted over. Details can be found elsewhere – for example in the article, ‘Soho House group lands $100m injection from Burkle-led investor consortium’ (Business Matters Magazine, 22/06/2020).
  • It turns out that the FT had another article about Soho House back in October 2019, coincidental to the company’s last cash-raising effort where $100m of equity was issued (‘Soho House raises $100mm to step up expansion”, FT, 28/10/2019). The conclusion one ought to draw is that Soho House employs an excellent financial PR company which is able to attain positive coverage of the growth story just at the time another cash call is being made.
  • In October’s FT article, CEO Jones is quoted as saying, “he expected the company to be profitable “within about two years”, adding that the latest investment meant that “we’re good for cash”. He added: “Opening new houses is not the cheapest thing to do, but if we stopped all of that we would be profitable very quickly.” Clearly the subsequent cash-call in 2020 meant the club was not ‘good for cash’. In October 2019, Jones said the group would be profitable in about two years. Ten months later in the FT article of 3rd July, Jones is quoted as saying net profitability is another two or three years away, and this despite an extension of debt covenants to reduce borrowing costs. Classic extend and pretend.
  • Membership has held up. July’s FT article says, “Only about 10,000 of its 110,000 members have frozen their memberships during the crisis, despite many working in the hard-hit creative industries. Those who have continued paying have been offered their fees back as vouchers to spend in the Houses and Soho Works, the company’s co-working sites.” Given the battering the creative sector is taking (note ad-spend at Facebook being pulled, UK Chancellor Sunak bailing-out the British arts sector to the tune of £1.5b in 2020 and so on), this is a great outcome.
  • The club will start to operate at 70% capacity, but Mr Jones reassures that, “on a house-level the business will break even this year. “Every house makes money. It’s just the continuous growth.” (FT, 03/07/2020). Miraculous indeed, especially if one considers this statement in the light of another FT article published just a day later (‘Can London’s high-end restaurants survive the pandemic?’, FT, 04/07/2020) in which we are told amongst other things,

“But beyond the weekend, with a dearth of tourists and corporate lunch trade, and with social distancing measures limiting the number of tables, the proprietors of London’s most iconic restaurants face a stark choice. “It’s a question of whether we lose money keeping [the restaurants] closed with the staff on furlough or lose money opening. The gamble is we think we will lose less money opening them up,” said Jeremy King, chief executive of Corbin and King, which runs landmark restaurants such as the Wolseley, the Delaunay and Brasserie Zedel.”

  • Soho House is not a listed company whose accounts are easily accessible. Yet a cursory examination of a few newspaper articles suggests it is a highly-indebted, cash-consuming growth business whose break-even horizon has again been extended, whose ongoing operations will struggle to maintain profitability given social-distancing rules and changing consumer habits, and whose vaunted membership retention appears to be being maintained by Groupon-like give-aways. Having a top PR company to spin the story will only work so long as fresh funds can be provided to keep the enterprise afloat. The story is so feeble that the cracks in the logic can be seen even now – the FT article dated 3rd July says, “Mr Jones has vowed that job cuts will be “in the single digits” but less travel and more Zoom meetings will be encouraged.” If this is true of Soho House, why would those who used the facilities for business or leisure not do exactly the same sort of cost-cutting, given the recession and stuff?
  • So much for signal intelligence. The real question for those concerned about the credit cycle is how severe and extended will the defaults be, and if and how anything can be done to mitigate the process should it prove severe. Hats off to Soho House for raising equity rather than debt – this is clearly an example of balance-sheet repair, but the logic of reducing the ratio debt to equity is normally applied to companies which are going concerns not ones which are loss-making. The wisdom of the equity investors has to be called into question in this instance, especially as they have invested during the 2020 recession at the same valuation as those who invested in October 2019.
  • Much has been made of the US Federal Reserve entering the corporate credit market in a move whose legality has been questioned in some quarters. Notwithstanding this, the de facto Fed backstop due to secondary-market purchases has kept credit markets open, putting US corporates on track for a potentially record-breaking year of issuance at investment grade level. Raising cash is one thing, paying it back with falling revenues and profitability is another altogether. Cost-cutting has been a feature of the post-global financial crisis world so there are questions about how much fat there is left to trim. A focus on issuing debt to buy equity for many corporates has resulted in capital projects and R&D investment being overlooked, meaning organic growth will likely be lower.
  • Companies go into insolvency if their revenues fail to cover their expenses and if no one is willing to lend to them to make up the difference. The current recession is one which US corporates have entered with record levels of debt. The graph below (Fed Data courtesy of Bloomberg) shows the extent to which US corporate debt has ballooned.

Source: Bloomberg, Federal Reserve, as at 6th July 2020.

  • High levels of debt provide the potential for a sharp pick-up in corporate defaults and insolvencies. There is nothing the Fed can do about this – as Jay Powell has repeatedly said, the Fed can only lend money and not provide grants. In any case, the negligible take-up rate of the Fed’s new Main Street Lending Programme suggests many smaller firms are unwilling to borrow in a recession. This is entirely to be expected – recessions are period of balance-sheet repair not of re-leveraging. This is what Keynes meant by the idea of pushing on a string – the collapse in the demand for credit leading to a deflationary spiral of ever-lower growth.
  • Wendy’s and Pizza Hut occupy a different world to Soho House, although it would seem that the challenges of the current recession are the same for all these businesses, regardless of the quality of the PR company employed. NPC International Inc, Pizza Hut’s largest franchisee (1,225 restaurants, with an additional 385 Wendy’s) has filed for Chapter 11 citing rising food and employment costs (‘Pizza Hut and Wendy’s Operator NPC files for Bankruptcy’, Bloomberg, 01/07/2020). It had $903m of debt. While Soho House found a wealthy benefactor, NPC was unable to.
  • During Wendy’s Q1 company earnings report press conference (06/05/2020), the Q&A revealed that a number of franchise fees has been suspended during the Covid-19 pandemic. It is interesting to consider NPC’s bankruptcy filing in the context of fees being suspended, Federal taxes being delayed, and the Federal Paycheck Protection Program (PPP) helping with wages amongst other things. A major franchisee going bust is one thing, but does this create stress further up the corporate chain?
  • Wendy’s (WEN.US) is itself a highly levered company. According to Bloomberg, it finished 2019 with a net debt to EBITDA ratio of 7.2x. It’s Q1 results showed free cash flow having fallen 91% YoY from $48.0b to $4.3b. It does have a new breakfast offering though. This being 2020, the stock has rallied c.100% from a low $10.94 in March to close on the 2nd July at $21.89. The stock’s market capitalisation is $4.9b, while its tangible net asset value (assets less goodwill, other intangible assets, and liabilities) was negative $1.54b according to its 10-Q for quarter ending March 2020. One doesn’t need signal intelligence to see this is the sort of structure which might be vulnerable to a change in financial circumstances.
  • Ostensibly, NPC filed due to rising raw material and employment costs which some might call the burgeoning symptoms of inflation. But it was these costs on top of a large stock of debt which made the company so vulnerable. Wendy’s itself looks little different, even if it did have $294m of cash on its balance sheet at the end of Q1. Wendy’s, like Soho House, is a growth model – asset light, heavily-indebted, focused on revenue growth rather than bottom-line profits.
  • This is fine during a period of low inflation. The question is now whether the extraordinary increase in M2 money supply by central banks in response to the pandemic along with massive fiscal stimulus from governments to stimulate demand will start to feed through into inflation, especially if unemployment remains stubbornly high. If it does, then corporate models based on revenue growth on an asset-light model will start to look very vulnerable. It will be interesting to see how the next instalment of the FT’s Soho House cash-call saga unfolds

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Thoughts through the cycle: W1 August ’20

The New York Federal Reserve seems to have a habit of using the Wall Street Journal to ‘float’ policy changes or at least give hints about the direction of Fed policy…

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