#junkbonds

Harley’s horrible huffing contains plenty of puffing

HDQ1US

When companies won’t give guidance, we must find ways to see where we were relative to history to get a picture of the future. Harley-Davidson (HOG) makes a good case study. Coronavirus may be one factor but the company has already produced results that have undercut the worst levels experienced during the GFC. We have long criticised HOG for fuzzy maths under the disastrous leadership of the recently ousted CEO Matt Levatich.

While there are strictly no direct apples for apples comparisons on the timing of coronavirus and the GFC (the latter requiring no lockdown), we note the weakness in Q1 2020 unit sales in the chart above.

This is what the trend of Q2 looks like.

HDUSQ2

If we assumed a similar slowdown for April and May then theoretically the company would comfortably breach the Q2 2009 unit sales level of 58,179 which is only 18.6% below the Q2 2019 level. Q1 2020 global sales fell by 17.7%, even though the company made a very misleading statement which we’ll get to in a moment.

One thing that struck us was the steadily rising value of quarterly inventory as a percentage of quarterly non-finance revenues since Q1 2014. While the former value is a balance sheet item and the latter P&L, Q1 is generally a period where new models are rolled out ahead of the busiest Q2 & Q3 seasons to ensure the distribution network can move metal.

HDQ1Inv

Shipments reflect this. The inventory metric drops off into Q2 although exhibits a similar type of trend to Q1. Given Q2 2009 was the beginning of the tough times post-GFC, will we see the high watermark breached or will the slowdown in production offset it? How badly are revenues affected such even flat inventories lead to a deterioration of this measure?

In Q4 2019, inventories to motorcycle revenues surged to 69.1%.

We note that Q1 2020 shipments equated to an inventory of 12,534 units (+29.0%YoY).

HDq2Inv

Here is where it gets interesting. By HOG’s own admission in the quarterly investor presentation pack (p.7), it noted that Q1 2020 US retail sales were on target to be one of ‘the strongest quarters in the last 6 years through to mid-March‘, until COVID. 6 years ago US Q1 unit sales hit 35,730 units. US sales in Q1 2020 ended up at 23,732.

By deduction,

In Q1 2014, over 90 days HOG shifted on average 397 bikes per day. (35,730/90 = 397)

In Q1 2020, over the 74 days to mid-March, HOG was moving on average 321 bikes per day. (23,732/74 = 320.7027).

If we assumed that HOG was to hit that magic target over the 16 days stolen by COVID19, it would have had to punch out 750 bikes a day. (11,998/16 = 749.875).

We would love to see the order book for these magical beasts that were waiting for a home…it would seem the sales and marketing department cherry-picked one strong day and multiplied it over the quarter to create such a questionable statement.

Here is a chart of motorcycle related revenue for Q1 since 2008. No wonder the shares have underperformed since 2014, even with a small fortune squandered on share buybacks.

HSQ1rev

The Q2 revenue book doesn’t look too flash either if April is wiped out. At present 50% of dealers are shut since late March. Is the market prepared for a sub Q2 2009 print? The share price has rebounded strongly after the Q1 results even though there is no guidance to speak of.

HDq2Rev

But it gets worse. So poor has the Q3 season become for HOG that its unit sales have missed the Q3 2009 post-GFC low for seven out of the last 10 years. Are we to believe if the world is out of lockdown by Q3 that there will be a miraculous surge in new bike sales when unemployment is likely to remain at troubling levels potentially above that of GFC?

HDq3US

HOG is a great example of a divine franchise. It wasted far too much money on share buybacks (now suspended) and sits with a credit rating just two notches above junk.

The annualised Q1 2020 loss experience for the finance business sit at 10-year highs even before it has been thumped by the coming turndown. People buy HOGs as a hobby, not transport. A purely discretionary purchase. We imagine that restoring household balance sheets will take precedence to stumping up serious coin for a Harley cruiser.

Sadly Levatich and his 2027 vision have not been consigned to the dustbin of history which is the only logical filing cabinet for it. Completely unrealistic, devoid of reality and totally in denial of the shifting sands in the global motorbike market.

The new “Rewire Plan” (p.5) while sketchy on detail (as it would with an interim CEO) is a reheat of Levatich’s plan. Sad.

In our view, the entire motorcycle industry needs a strong HOG. New management is a good start but it won’t help if they intend to convince investors that they were on course to shoot Q1 to its best level in 6 years with questionable math. How quickly can inventory be pared? What models will revive its fortunes?

HOG needs to get in touch with its core customer base the way Willie Davidson did after the dark days of AMF ownership. It needs to build products which hark back to its former glory rather answer questions in segments that no one is asking it to fill.

Indian, its rival of 100 years ago is killing it with the FTR1200. Indian’s parent company, Polaris Industries, posted a small single-digit increase for motorcycles in Q1 2020. Enough excuses HOG. You are running out of time and your retained earnings are 1/5th what they were 5 years ago!

Why is the market giving it the benefit of the doubt when the worst is still ahead?

HOG

Harley needs a crisis manager. Will the incoming CEO possess those skills?

Who the hell is Leeroy Jenkins?

One of the more uniques ways of describing the behaviour of the US Fed. Zerohedge noted that the Fed has gone full Leeroy Jenkins. Who the hell is Leeroy Jenkins?

As you will see in the video clip, the team gamers are discussing a coordinated strategy to defeat the monsters waiting in the next stage of the game. Unfortunately one of the gamers, Leeroy Johnson takes matters into his own hands.

Since 2001, we have continuously said that easy credit would become so addictive. The resulting complacency would turn destructive.

We said that the then-Fed Chairman Alan Greenspan would go down as the most hated central banker in history. Despite being heckled, laughed at and mocked, we never waivered from the key tenet that his actions and those of the subsequent Fed chairs would ultimately end up in tears.

We should have had that cathartic moment to reset back in 2008/09 (and 2000 for that matter). Instead, we merely doubled down on the very same mistakes that got us into trouble in the first place.

If the Fed moves to support the junk bond market, undeserving companies run by irresponsible boards will be kept on life support instead of the free market being able to set clearing prices and potentially terminate them. Why not let market forces determine whether anything of value remains inside their entrails?

The Fed doesn’t have the power to buy equities yet but surely that is a coming attraction. We have seen how dismally it has worked in Japan.

The Head of Japan’s stock exchange admitted that  Japan’s central bank now owns around 60% of all Japanese Exchange Traded Funds (ETF) which is almost a quarter of the broader market. By stealth, the Bank of Japan has become a top 10 shareholder in almost 50% of listed stocks. In a sense, we have a trend which threatens to turn Japan’s largest businesses into quasi-state-owned enterprises (SoE) by the back door. At what point does it stop? When is enough?

We must accept a new reality where bankruptcy is openly accepted as a cure to weeding out excesses in the economy. Should there be demand, more efficient players can pick up the spoils.

We need this to make people realise that moral hazard isn’t going to be tolerated and personal responsibility is the order of the day. Anyone who is more than happy to have a winner-take-all mentality on the upside must be prepared to accept that the loser has to take all as well. Why should Main St bailout people who poorly assessed personal risk because our authorities provided a platform that encouraged the behaviour?

Let us not kid ourselves. There are no excuses in the game of greed. Lessons need to be taught to avoid such calamities in the future.

Sadly, our authorities will reject that advice and continue to fool around using the same reckless tools tried making us pay an ultimately higher price.

Buy Gold.

Boeing’s negative equity & prospect of zombie lending

We should have seen this earlier. One sign of trouble in industrial businesses can be seen through the lens of the cash conversion cycle (CCC). A CCC that is positive essentially means that payables are being executed way before receivables are being banked. Rising CCC is never a good thing. Amazon is at the other end of the spectrum with negative CCC which means they receive payment before delivery.

Note Boeing has seen its CCC blow out from around 124 days in Dec-2010 quarter to 344 days in Dec-2019. Effectively Boeing is sucking up a year of net receivables before collecting them. What escaped us is that the company is trading in negative equity at present and it will be a hard balancing act to let such CCC get much larger to a group that is so under the fiscal pump.

We recall the difficulties the supply chain had under the delayed 787 program in the early 2000s. Parts suppliers were bleeding because they’d invested and prepared for an expected ramp-up that ended up arriving 3.5yrs later than anticipated. All that high fixed capital formation and inventory that needed to be paid for by a client that couldn’t take delivery. Boeing tried to muddle through but was ultimately forced to rescue suppliers to keep them alive after some faced the brink. Boeing bought some suppliers in house.

One imagines the 737MAX delays will exacerbate the CCC again although Boeing contends it is in cash conservation mode. Coronavirus can only add to the misery of airlines reluctant to add to fleets where capacity is being slashed aggressively. Just look at the self-isolation bans being put in place in recent days. Who wants to holiday abroad if told they’ll spend two weeks in their hotel room feasting on room service? Airlines get the efficiency of new aircraft helping operating performance but at the same time running any planes at 20% capacity won’t help.

This is only going to get worse. For all of the pain of a much higher unit volume plane yet to be approved for flight, Boeing cash flows are being tortured. It is incredible that the shares had held on so well during the MAX crisis.

It is interesting to note that Boeing is trading in a state of negative equity. Liabilities are greater than assets. Where is the press on reporting this? It is hardly trivial for a business that hasn’t even faced the worst of its struggles.

Just like we wrote two years ago about GE, Boeing went straight down the line of monster share buybacks. $43bn to be exact since 2013. Over half of the buyback has been conducted at share prices above the current level. The goodwill and intangibles on Boeing’s balance sheet total $11.398bn. Equity at minus $8.3bn. So negative $20bn.

bA

We did the following infographic some 3 years ago but the trend has deteriorated further. As we can see AAA-rated (top) stocks in the US have dwindled while BBB+ and below has surged. It is estimated that over 50% of US corporates have a rating below BBB. That is the result of artificially low-interest rates which have lured companies to borrow big and splurge on buybacks. Our biggest worry is if the market starts to reprice corporate debt accordingly, such as what happened to Ford when it was dropped to junk.

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So the question remains how does Boeing manage to get out of this pickle? Even if MAX gets certified, airline cash flow is being crippled. How big will discounts need to be in order for airlines to take on new planes? At the moment one imagines many airlines are deferring deliveries (787, 777 etc) until they get a clearer picture.

Boeing has delivered 30 aircraft in the first two months of 2020. At the same time last year, Boeing had delivered 95 planes. A lot of MAX impact but we imagine March will be even worse.

Airbus delivered 86 aircraft so far in 2020. At the same time last year, Airbus delivered 88 planes.

Think of the major gateway that is Hong Kong International Airport. It’s passenger flow for February 2020 – minus 68%! 6 months of this type of crippling volume would be catastrophic for airlines. 9-11 was a watershed moment for the aviation industry where the confidence to get back on a plane turned quickly after the terror attacks. Now we have a situation where passengers would be more than willing to fly again but governments simply aren’t letting them. The problem is whether they will be in the same financial position to fly if the virus isn’t contained rapidly

One sweet spot for Boeing is that it is a major defence contractor which means that government bailouts are a given. Sadly, shareholders shouldn’t think this current share price collapse has finished. Boeing feels a lot like mimicking GE when it sunk to $6 from over $30.

It is probably worth referencing AerCap Holdings which owns International Lease Finance Corporation (ILFC) one of the big two commercial aircraft leasing companies. Its share price has cratered from a high of $64.79 to $24.50. Moody’s affirmed the “Baa3” ILFC this month.


AerCap

The company has 3.1x leverage. $36bn of property (mostly planes) on its books. The shares are trading at 0.35x tangible book value presumably because the market is forecasting the value of the tin is going to fall through the floor if leased planes return from airlines that have been forced to cut costs or go bankrupt.

The only crux is the future appetite of investors to support AerCap in the debt markets. It has $17.5bn in unsecured notes and $9.8bn in secured debt with a further $2.3bn in subordinated, mostly via a 2079 maturity bond issue. The maturity profile is still comfortably beyond 2028. No problems just yet but times are only just starting to get challenging.

Of note, AerCap is paying $1.295bn in interest charges on $29.5bn of debt. Leasing rents from its airline customers total $4.281bn. It all comes down to the assumption that its multiple airline customers can keep honouring those payments or whether the leasing companies are forced to renegotiate their deals in order to keep the customer alive. The last thing a leasing company needs is a flood of aircraft to return because customers go belly up. Fingers crossed there is no zombie lending to avoid having to mark-to-market the value of the fleet (assets) which would flip the ratings and refinancing prospects considerably. The balance sheet would be slammed.

With so many financial excesses built into the global economy, a prolonged spell of coronavirus containment will come at the expense of a crippling economic armageddon which will undo so much of the disastrous can-kicking we’ve become accustomed to. You can’t quarantine the world for 6 months and expect a tiny ripple.

CLies IT

It is not the disease we need to worry about per se. It is government and central bank incompetence over the last 20 years which has created a situation where we are out of ammunition to rescue the situation because expediency is so much easier for voters – comforting lies are easier to take than inconvenient truths.

Be sure to reference our thoughts on

Aussie banks,

Aussie government debt,

central banks and the

pension crisis ahead.

Ford downgraded to junk

This week, Ford Motor Co’s credit rating was downgraded by Moody’s to junk. $84bn worth of debt now no longer investment grade. It will be the first of many Fortune 500s to fall foul to this reality. In 2008, there was around $800bn of BBB status credit. That number exceeds $3.186 trillion today.

CM has long argued that the credit cycle would be the undoing of the economy. For too long, corporates binged on easy money, caring little for credit ratings because the interest spreads between AAA and BBB were so negligible. The market ignored risk and companies went hell for leather issuing new debt to fu buybacks to artificially prop up weak earnings to give the illusion of growth.

Sadly this problem is likely to cause widespread sell offs by companies/investors which must stick to products (as woefully yielding as they may be) with an investment grade, exacerbating the problem of refinancing debt close to maturity. The thinking during easy credit times was simple – refinancing could be done with low interest rates because there was no alternative.

This is problematic for three reasons:

1) under the Obama era, much of the newly issued debt was short term meaning $8.4 trillion arrives for refinancing in the next 2.5 years, crowding out the corporate market.

2) more than 50% of US corporates are one notch above junk status. Refinancing will not be a simple affair.

3) more and more investment grade debt will be driven to zero or even negative yields as a result further exacerbating the problems for insurance companies and pension funds dealing with massive unfunded liabilities.

Last year, in relation to unfunded liabilities at US public pension funds, CM wrote,

California Public Employee Retirement System (CalPERS) lost around 2% of its funds in 2015/16. The fund assumed an aggressive 7.5% return. Dr. Joe Nation of Stanford Institute for Economic Policy Research thinks unfunded liabilities have surged to $150bn from $93bn in the last two years. He suggested the use of a more realistic 4% rate of return last year. At that rate, CalPERS had a market based unfunded liability of $412bn (or the equivalent of 2 years’ worth of California state revenue). At present Nation now thinks the number is just shy of $1 trillion using a 3.25% discount rate. He expects that the 2017 data for CalPERS will be out in a week or so which should give some interesting perspective as to how much deeper the pension hole is for Californian public servants.

N.B. California collects $232bn in state taxes annually in a $2.3 trillion economy (around the size of Italy).”

This is just California, which in the last 8 years has seen a 2.62-fold jump in the gap between liabilities and state total expenditures.

Unfunded liabilities per household. In California’s case, the 2017 figure is $122,121. In 2008 this figure was only $36,159. In 8 years the gap has ballooned 3.38x. Every single state in America with the exception of Arizona has seen a deterioration.

Switching to Illinois, we have a case study on what happens when pension funds go pear shaped.The Illinois Police Pension is rapidly approaching the point of being unable to service its pension members and a taxpayer bailout looks unlikely given the State of Illinois’ mulling bankruptcy.

Local Government Information Services (LGIS) writes, At the end of 2020, LGIS estimates that the Policemen’s Annuity and Benefit Fund of Chicago will have less than $150 million in assets to pay $928 million promised to 14,133 retirees the following yearFund assets will fall from $3.2 billion at the end of 2015 to $1.4 billion at the end of 2018, $751 million at the end of 2019, and $143 million at the end of 2020, according to LGIS…LGIS analyzed 12 years of the fund’s mandated financial filings with the Illinois Department of Insurance (DOI), which regulates public pension funds. It found that– without taxpayer subsidies and the ability to use active employee contributions to pay current retirees, a practice that is illegal in the private sector– the fund would have already run completely dry, in 2015…The Chicago police pension fund held $3.2 billion in assets in 2003. It shelled out $3.8 billion more in benefits to retired police officers than it generated in investment returns between 2003 and 2015…Over that span, the fund paid out $6.9 billion and earned $3.0 billion, paying an additional $134 million in fees to investment managers.”

Therefore Ford’s downgrade to junk will have the effect of repricing over a decade of misplaced central bank policy across all markets. The dominos are only beginning to fall. The market can absorb Ford’s downgrade but not if it has to deal with the panic of dozens like it.

CM has long been warning of GE. Despite being the world’s largest stock in 2000, it is 1/5 the size today, trades in negative equity, wasted $45bn on share buybacks in 2015/16 and were it be classified as junk would increase the pile of junk by 10% on its own. Broadcom and American Tower are other monsters ready to be hurled onto the ratings scrap heap.

Buy Gold. The US Fed will likely embark on QE. It requires an act of Congress to approve the purchase of equities but don’t be surprised if this becomes a reality when markets plunge.

This will be the reset of asset prices which has been long overdue thanks to almost two decades of manipulation by authorities. It has 1929 written all over it. Not 2008.

Plunging credit quality more troubling than market rout

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The Dow plunged 1175 points (-4.6%) overnight. 4.6% is a lot and yes 4-digit drops optically look worse but off the higher base we get higher (record) point drops. One thing to contemplate in a rising bond yield market is corporate credit quality. Since 2006 the average credit ratings for US corporates issued by the big agencies have seen the number of top rated (to the left) fall while those with deteriorating grades (to the right) soar. That’s right, the 4 categories before “junk” have risen sharply. After many years of virtually free money many corporations have let the waistline grow. When refinancing comes around just how will credit ratings influence the new spreads of corporates who’ve shifted to the right?

The IMF highlighted in 2017  that US companies have added $7.8t in debt & other liabilities since 2010. The ability to cover interest payments is now at the weakest level since 2008 crisis.

This despite near full employment, record level equity markets and every other word of encouragement from our politicians.

However if this is the state of the corporate sector at arguably the sweet spot of the economic cycle CM shudders to think the state of potential bankruptcies that will come when the cycle truly takes a turn for the worse. This is a very bad sign.

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