The Age of Deleveraging Part 1

Gary Shilling is an economist with a spectacular 40 year track record of predicting macro-events. He called the fall of inflation in the early 80s, the US housing bubble and the subsequent financial crisis. The book focuses on explaining the deleveraging phenomenon and its impact on investing strategies.

Over the past 60 years (since 1952), every single sector of the economy has levered up. The financial services sector went from cumulative sector debt of under 20% to in excess of 120%. The story is similar for non-financial corporations (abet not as extreme). It's repeated across households to state & municipal governments and the Federal government.

The increase in leverage among households is mirrored by the decrease in savings. The savings rate of the American consumer fell from 12% in early 1980s to 1% in Jan 2008. Not surprising the decline in savings rate coincided with the beginning of the bull market in stocks in Aug 1982.

Shilling predicts an era of slow growth ahead. Driven by 2 key trends - increase in the savings rate and business cost cutting. He estimates that a 1% rise in savings rate will knock off 1% of real GDP growth. Businesses have been cost cutting by not hiring more employees and increasing employee productivity. These two trends suffer from the fallacy of composition. If everyone saves, who will buy stuff and generate demand? Overall the economy suffers. Similarly for business cost cutting.


The above 9 causes will take some time to work through the system, leading to slow growth ahead.

Dreamworks - Value in the Works

Dreamworks - Value in the Works

Thesis

DWA is cheap (Forward consensus PE 13.6x, currently $16.96 near its 52 week low of 16.34). Given that they have just released a hit movie (Puss in Boots), this is highly unusual. When we invest in DWA, we are buying 1 thing – the creative team (Jeffery Katzenberg and William Damaschke).

Company Overview

• Short Company History

Dreamworks SKG was formed by Steven Spielberg, Jeffery Katzenberg and David Geffen. In 2004 Oct, Dreamworks Animation was spun off from the parent company.

• Management/ Ownership Structure

Currently, DWA is being run by Jeffery Katzenberg. Jeffrey Katzenberg, David Geffen and entities controlled by them own 100% of DWA’s Class B common stock, representing approximately 13% of the company’s common equity and approximately 69% of the total voting power of its common stock. Katzenberg has 269,796 options (from compensation plan) with a weighted average exercise price of $35.30. At least, Katzenberg has some incentive to raise the share price.

Bill Damaschke is head of Creative Production and Development. Bill has been with the company for 10 years. Bill has worked on Prince of Egypt, Shrek, Shrek 2 & Madagascar. He owns 332,301 shares. Kristine Belson is head of Development. She just joined the firm. Ann Daly is the Chief Operating Officer. Lewis Coleman is the CFO.

John Batter who was co-president of production has recently left to become CEO of MediaNavi.

In total, the Directors and executives own 69% of the company. I believe that this is sufficient incentive to ensure the creative team stays at DWA. The reason I belabor this point is because when we buy DWA stock, we are buying the creative team.

• Revenues – Revenues/ earnings for DWA are unstable because one cannot predict if the films produced are going to be hits or not. Also, revenues are highly dependent on the number of films DWA is able to produce in a year. They target 3 films per year. But in 2011, they were only able to produce 2 (Kungfu Panda 2 and Puss in Boots). Bear in mind that normally film studios produce 1 animated film every 18 to 36 months, so what DWA is pushing for is ambitious. The instability is offset by the fact that DWA is debt free.

• Distribution – DWA’s distribution agreement with Paramount comes up for renewal in 2012. I suspect that the reason DWA is trading at 52 week lows is due to the uncertainty surrounding the renewal of the agreement. Currently, DWA pays Paramount 8% of box office and home video revenues to distribute and market its films.

DWA has 3 options here – renew with Paramount, find an alternative studio to distribute the films (Universal, Lionsgate etc) or setup its own distribution. Renewal with Paramount is difficult because Paramount is likely to want more than 8% of revenues and DWA wants to pay less. DWA’s board has already said that renewing the theatrical and home-video distribution fee higher than 8% is out of the question. Furthermore, Paramount has announced that it is setting up its own animation division, which is targeted at making one $100m film per year. Paramount has now gone from distributor to competitor.

With regards to DWA setting up its own distribution network, that could be costly, as it only produces 2 to 3 films per year. Estimates on cost of distribution are around $235m per year if done independently.

Find an alternative distributor seems most likely. There are a few out there – the majors (Universal, Columbia), or a mini-major (Lionsgate). Distribution in the film business is a commodity. The true value is in the content. When DWA signed the contract with Paramount 7 years ago, DWA was an unknown with no track record of being able to deliver good animated films. Now DWA has a string of hits under its belt, there is no reason for it to pay more than the 8% of revenues that it currently pays. In fact, DWA should pay less if it negotiates with other distributors as it has a track record already.

For the TV distribution side, DWA recently signed a deal with Netflix. Revenues from this deal are unlikely to materialize until FY 13/14.

• Valuation – It is very difficult to figure out how much DWA’s intrinsic value is because the value lies in the creative team. Currently, DWA is trading at about 10x average past 6 years earnings (P/E), 2x sales with no debt. Disney bought Pixar at 40x P/E and 21x sales.

• Conclusion - Ordinarily, I would not recommend buying a company that is so difficult to value. But here are the facts, we have a company that is trading near its 52 week lows that has produced 2 hit films this year. Why should this be so? It doesn’t make any sense. Maybe it’s time to buy some DWA.

France Telecom Debt Alert

France Telecom Debt Alert

Just an update on France Telecom (FTE). I just read this article from Bloomberg on FTE's CDS spiking (date 25 Nov 2011). FTE's CDS apparently spiked to 182 basis points (bps), reflecting the market's fear of FTE's possibilty of default. The good news is that despite the spike FTE's CDS spread was still less than the French government's bond CDS, which hit an all time high of 249bps.

I just checked the CDS on FTE's 10 year bond today on Bloomberg. It's back down to 152bps.



However, when I compared the total CDS spread curve for FTE with 1 month back. Things aren't that great. The short end of the curve has hiked from 60+ bps to 80+bps. That translates into higher short term funding costs for FTE.



None of this is desperately dire for FTE but it does reflect the CDS market's concern about FTE's debt load. The good thing is that FTE only has 8.15% (Euro 2.7B) of its debt coming up for re-financing in 2012. So the increase in interest expense should be tolerable.

All in all, my opinion is that there is the CDS spike should not be cause for concern.




Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

France Telecom

France Telecom Inc (FTE)
16 Nov 2011

• The investment thesis is we buy France Telecom (FTE) for the dividend yield.

Company Overview
• Revenue Trends

Revenues - FTE’s revenue for first 9 months of 2011 was €33,848m, down 1.6% compared to comparable 2010 figures. EBITDA was €11,611m for the three quarters of 2011, down 5.4% from 2010.

Margins – FTE’s EBITDA margins were 34.3%, down 1.4 points from previous year.

Cashflows - FTE confirms their full year guidance. They expect their operating cash flow to be slightly above €9b for 2011.
• France Telecom’s Operating Segments
France


France is FTE’s largest operating region by revenue. FTE took new steps in offers segmentation implemented in France driving successful momentum share of broadband net adds. That is the reason naked ADSL customers increased 31.2%. Revenue fell 3.1%. ARPU for Personal Communication Services (Mobile Phones) fell 2.6%.


Market share for Orange is stabilizing.



Excluding regulation, ARPU grew 1.6%. With regulatory restrictions, ARPU fell 2.4%.



Churn rates have been brought down and stabilized at 14% to 15%. Strong net contract adds of 229,000 new subscribers.
Overall, the picture looks bleak. But the good thing is the metrics (Market share, churn, ARPU) have stabilized.
The remaining segments are small compared to France. The various key metrics are in the following tables:














Note that Everything Everywhere is FTE’s Joint Venture with Deutsche Telecom in the UK. FTE merged Orange UK with Deutsche’s T-Mobile. FTE owns 50% of the resulting JV.
• Capital Expenditure
CAPEX was equal to 11.0% of revenues, representing 3.731 billion euros of investment in the first nine months of 2011, a 7.5% increase on a comparable basis on the previous year. FTE confirms their guidance that CapEx will reach 13% of revenue for the full year. I estimate that to be 5,868m for the full year.

• France Telecom Debt Profile


The above table is accurate as of 30 June 2011. No table was given in 3Q 11. FTE’s debt maturity profile is quite benign for 2012, given that only 2.7b in debt is coming due. That is only 8.15% of total debt on 30 Jun 2011. Even if the new debt is refinanced at a much higher rate, the overall average interest expense will not increase significantly because the amount of debt to be refinanced is not a large part of the total.

FTE’s total debt as of 30 Jun 2011 is €33,137m and €660m in financial lease liabilities. Bonds and perpetual bonds (TDIRA) make up €29,830m of the debt. Total Gross financial liabilities is €36,902m. The difference is made up of commitments to purchase shares, derivatives and other financial liabilities.

At an average interest rate of 5.5%, FTE will have a 10% head room to meet dividend payments. At 6.6%, FTE will just be able to cover all dividend payments.

Company Positives
• Dividend yield is 11.25% at a €12.445 share price.

• Business is stabilizing – ARPU, market share and churn - are all stabilizing.

• Debt maturity profile over 2012 is benign.

• Cash flow coverage of the dividend is adequate. There is approximately 10% headroom in terms of dividend cover.

Company Negatives/Risks

• If the European Sovereign crisis were to spread to France, and FTE is not able to re-finance or has to re-finance at punitive rates, then the company will miss its dividend payout.

• FTE cuts their div. While this is unlikely in 2011, given the fluidity of the situation in Europe, this remains a possibility.
• Key drivers of a div cut is a fall in revenue, increase in operating costs or a sudden increase in capex.
• Of the 3, I believe that a fall in revenue is the most probable threat because of the bad economic situation in France. It is hard to model how bad this could get. The reason is a lot of this is driven by the macro-economic situation. So if we buy this stock, a critical signal for us to sell would be consecutive quarters of revenue/ ARPU drops.
- Consequences of a div cut would be a drastic drop in price. Again here, it depends on how bad the div cut is. If they do cut, I suspect that it will be to make the div yield fall to ~5% - 6% or Eur 0.70 (div now is Eur 1.40). The reason is the US telcos are yielding around ~5%. I'd be ok with a 5% div yield, esp if we buy the US ADR. They are unlikely to cut to 0 because the French gov is a large shareholder of the company (~25%) and the French gov needs all the cash they can get their hands on.

Conclusion & Recommendation

• I would buy the stock at ~€12.00 or alternatively buy the US ADR at around ~$16.00. There’s no need to chase the stock.