IPO Market Sluggish In 2016

With less than two weeks left in the year, it appears that 2016 will be a slow year for IPOs. Only 105 companies went public in the U.S., raising $18.8 billion, while 2015 had 170 IPOs that raised about $30 billion. The amount raised in 2016 was the lowest dollar amount raised since 2003. One potential reason for the slow IPO market is that many privately held companies have reached lofty valuations, with a growing number of unicorns and decacorns. A recent report argues that many of these private companies have lofty valuations that are not supported by public markets. If this is the case, the only way for investors in these companies to cash out with an IPO is by venture capitalists taking a potential loss on the IPO or waiting until the public stock market feels the valuation is in line with the company value.

Share Repurchases Decline

Even though companies in the S&P 500 repurchased $115.6 billion in stock during the third quarter, this actually represented a decline of 28 percent from the third quarter of 2015 and was the smallest quarterly repurchase since the first quarter of 2013. Apple led the way, repurchasing $7.2 billion of its stock, while General Electric repurchased $4.3 billion of its stock. The top sector for buybacks was IT, with $27 billion in repurchases, while the financials sector spent $25 billion on buybacks.

Dollar Strengthens

With housing starts at a the highest point in nine years and the weekly jobless claims reaching a 43-year low, it appears that the U.S. economy is strengthening. As a result, it now appears likely that the Federal Reserve will increase interest rates in its December 13-14 meeting. This also lead to a stronger U.S. dollar as the dollar reached a 13 1/2 year high against a basket of six major currencies. The U.S. dollar reached its highest level against the euro in almost a year, and its highest level against the yen since early June.

Fewer Negative Bonds

As signs for a more expansionary U.S. monetary increase, the market value of negative yield bonds worldwide fell this week. Since June, the market value of negative yield bonds in the Bloomberg Global Aggregate Index has fallen 28 percent from the peak value of $12.2 trillion. An expansionary monetary policy will likely lead to higher interest rates and a steeper yield curve, at least in the short term. Japan is still the leader in negative yield debt, accounting for 58 percent of worldwide negative yielding debt.

Financial Distress Costs For Sears

For several years, the performance of Sears Holdings has been declining. Now, it appears that the company's suppliers feel that the company may be headed toward bankruptcy. JAKKS Pacific announced last month that it would stop shipping toys to Sears' Kmart stores, fearing Sears would file bankruptcy, making collection on the receivables problematic. Now it appears that other suppliers have reached the same conclusion as at least six suppliers have reduced shipments to Sears for the same reason, including at least one supplier who stopped shipping to Sears entirely. Chairman and CEO Eddie Lampert had extended credit to Sears three months ago to stop speculation by suppliers and some Sears suppliers have been paid in 30 days rather the typical 60 to 90 days. Given that Sears is headed into the Christmas season, the biggest sales season for retailers, problems with suppliers could signal a spiral into bankruptcy for the company.

Record Treasury Bill Sales

The U.S. Treasury Department sold a record $65 billion in one-month Treasury bills at an interest rate of .27 percent. Even with the record dollar sales, the bid-to-cover ratio, that is the ratio of bids to available bonds, was only 3.39, which is the lowest level since March.

Bond Call Provisions

A callable bond is typically only callable on the anniversary date of the bond or coupon date. However, this is not a requirement as the bond indenture is an individual contract specific to that particular bond issue. A common reason bonds are issued is to finance the acquisition of another company. These bonds are generally callable if the deal falls through and the call price is often set at 101 percent of par. Bondholders can be hurt by this fixed price call provision as bond prices can rise in the intervening period between bond issue and the deal being terminated. For example, when Sysco’s bid to buy US Foods  feel through last year, bondholders lost $309 million as the bonds were called at 101, well below current market price, which had reached as high as 113.3. Now, major bondholders are pushing to change the call value of bonds issued to fund acquisitions to a make-whole call premium, which commonly used for bonds issued for purposes other than acquisitions.

AT&T Buys Time Warner

AT&T announced that it had agreed to purchase Time Warner for about $85 billion. Under the terms of the deal, Time Warner shareholders will receive $107.50 per share, half in stock and half in cash. The share price represents about a 20 percent premium to Time Warner's closing price on Friday. Even though the terms of the deal have been announced, Time Warner shareholders and the Department of Justice still must approve the deal, and the chair of the Senate subcommittee on antitrust said the committee would examine the deal as well. Of course this is not the first time that Time Warner has been acquired: In 2000, AOL purchased Time Warner for $160 billion in one of the worst deals in history. In fact, the company had a $99 billion loss in 2003 and things went so bad, the merged company eventually changed its name back to Time Warner.

CEO Pay Ratio

The ratio of CEO pay to that of other workers has been a hot button topic and reports often peg the ratio at 300:1 or higher. A controversial part of the Dodd-Frank Act requires companies to begin reporting the CEO pay relative to the median compensation at that company. In a new survey of 117 companies, the majority of the companies reported a ratio less than 200:1. Surprisingly, the financial services sector, which has drawn considerable scrutiny for CEO pay, has a lower CEO pay ratio, in part because the wages in that industry are relatively high. Industries that have high CEO pay ratios tend to have mare part-time and less-skilled employees.

Ethics In Finance

You may have noticed that there is not a lot of discussion of ethics in your textbook. A major reason is that from a financial view, if the market or society values ethical behavior, unethical behavior by a company will hurt its market value, thus defeating the goal of maximizing shareholder value. Consider the case of Wells Fargo, which is under fire for fraudulently creating up to 2 million deposit and credit card accounts. In addition to the fines paid by the company, last week, California announced that it was barring state transactions with Wells Fargo, including underwriting state bond issues. Today, Chicago announced that it was divesting $25 million that it has invested with Wells Fargo and next week Illinois plans to announce its plans to suspend Wells Fargo from the state investment network. So, while Wells Fargo may have temporarily increased value by fraudulent actions, these actions will now negatively affect shareholder value.  

Ticked Off

If you look at stock prices, you will see bid and ask prices that may only be different by a penny. What you may not realize is that this has only occurred since 2001. Prior to that, stock prices were quoted in eighths or sixteenths, so a price quote of 40 1/8 meant $40.125. Part of the reason for the change was that the bid-ask spread was the dealer profit, which also meant that investors were paying this difference. However, it has been argued that small cap stocks were hurt by decimalization because market makers have less incentive to trade less liquid small cap stocks and this has also lead to less research on small companies. Today, a pilot program was begun in which 10 small company stocks began trading on 5 cent tick sizes, meaning the smallest change in the stock price for these stocks is now a nickel. About 1,200 stocks will eventually be included in the test program, with three different groups with different trading rules. The goal of the study is to determine if increasing the tick size can lead to increased liquidity in small cap stocks.

Monster Write-off

Usually with a new project, a company will wait until after the project has begun to determine if the project will be successful or not. With the Paramount pictures movie Monster Trucks, the company decided that it had it had a monster flop on its hands. The movie, which has been in development since 2013, reportedly cost $125 million. Even though the movie won't be released until January 2017, Paramount announced that it would write off $115 million related to the movie. Write-offs due to poor box office receipts usually occur after a movie is released, but the move is not unprecedented. For example, in January 2015, DreamWorks wrote off $155 million due to unreleased films, which is the option to abandon. Whether Monster Trucks is ultimately released will help determine if the remaining development costs are written off.

Microsoft Pays Shareholders

Microsoft announced that it was raising its dividend by 8 percent and would buy back an additional $40 billion in shares after the company concludes its current $7.1 billion buyback, which is left from the company's previous $40 billion buyback. The buyback amounts to about 9 percent of outstanding shares, although because of the company's ESOP, the number of outstanding shares will be reduced by less than that amount. The dividend increase means that Microsoft is allocating nearly $1 billion more toward dividends this year than last. Total dividends paid by Microsoft this year should top $12 billion.

Corporate Overseas Cash Grows

The cash held by foreign subsidiaries of U.S. companies has reached a record $2.5 trillion. Microsoft and GE both hold more than $100 billion overseas, while Apple and Pfizer have $91.5 billion and about $80 billion, respectively. Overseas cash now tops cash held domestically, which reached $1.94 trillion. Of course, much of the reason for the foreign cash holdings is the U.S tax system, which taxes repatriated earnings at 35 percent, the highest corporate tax rate in the world. Although various tax breaks on the repatriation of cash have been floated, naysayers argue that the last repatriation tax break in 2004 resulted in little investment. Rather, repatriated cash was used for dividends and stock buybacks. We should point out that a repatriation tax break would actually be a boon to the IRS. Consider, if the repatriation tax rate were lowered to 15 percent, companies would only get $.85 for every dollar repatriated. Assuming a 35 percent personal tax rate, investor would only receive about $.55 in dividends after tax per dollar repatriated, an effective tax rate of about 45 percent.

Ethics And Legislation

Unfortunately, most legislation is the result if unethical behavior. As part of the Sarbanes-Oxley Act, the SEC passed Rule 13a-14 that said CEOs and CFOs are required to sign and attest that the financial statements filed with the SEC do not include material misstatements or omissions. In 2013, a judge found that the CEO and CFO of Basin Water were not liable for sham transactions since they were not directly involved in the transactions. The 9th U.S. Circuit Court of Appeals recently overturned this decision and stated that "a mere signature is not enough for compliance" and is allowing the SEC to sue for disgorgement of gains. The recent ruling makes it even more important for CEOs and CFOs to run ethical companies.

Accounting Cash Flow Makeover

The Accounting Statement of Cash Flows received a makeover as FASB updated the treatment of eight different cash flows. As you will read, whether the updates provide any meaningful change is not clear, as two Accounting professors interviewed have differing opinions on the update. Unfortunately, FASB did not address what we feel is a glaring weakness in that interest expense is still considered an operating cash flow, rather than being included correctly in the financing cash flow section.

Currency Trading Shrinks...Maybe

So how much currency do you think is traded daily? According to a recent report published by the Bank for International Settlements (BIS), average daily trading in April 2016 was about $5.1 trillion! This was down from $5.4 trillion per day in April 2013. However, if the dollar had not appreciated over the period, average daily volume would have risen about 4 percent. Spot currency trades were about $1.7 trillion per day, swaps accounted for about $2.4 trillion per day, and the rest of the trading was for other over-the-counter foreign currency derivatives. The U.S. dollar was on one side of 88 percent of trades, while the euro was on 31 percent of trades.

Negative Yield Triangular Arbitrage

A question we often get is if the material we discuss is actually relevant to the real world. However, we can see the application of triangular arbitrage with the seemingly strange desire of investors to purchase the $9 trillion in below zero interest sovereign debt. A Japanese 3-month government bill is currently returning about negative .24 percent. The buyer can borrow at the yen 3-month LIBOR, which is about negative .02 percent and receive the dollar LIBOR at .82 percent. The buyer then executes a yen-dollar swap, which results in a dollar-hedged yield on the trade of 1.24 percent. With the 3-month U.S. Treasury yield about .25 percent, and increase in annualized return of about one percent is a huge increase for portfolio managers.

High Yield Bond Defaults Expected To Rise

Standard & Poor's Ratings Services expects default rates on high yield bonds to increase to 5.6 percent over the next 12 months, which implies that 99 issuers will default. The increase is due in large part to the decline in oil prices, although a delay in an interest rate increase by the Federal Reserve could offset the increase risk. However, in large part due to the low and negative interest rate environment, investors are pouring money into high yield investments resulting in a decline in the yield spread of high yield bonds dropping from 815 basis points in February to 560 basis points in July.

Indexes Win Again

One method that has been used to examine if the stock market is semistrong form efficient is the performance of actively managed mutual funds. A recent study by S&P indicates that most actively managed mutual funds still lag the appropriate market index. From 2011 to 2015, over 88 percent of mutual funds failed to beat the S&P Composite 1500. And 84 percent of large cap funds failed to outperform the S&P 500. In fact, over the past five years, the fund category with the best performance for retail investors relative to its index was the mid-cap value category, with only about 30 percent of mutual funds in that category outperforming the S&P Midcap Value 400. Small cap growth funds were the worst, with only about 8 percent of funds beating the S&P SmallCap 600 Growth index. So, even if you don't believe the stock market is efficient, as this shows, it is very difficult to outperform the stock market.

2016 Working Capital Survey

CFO just published the 2016 working capital survey by REL Consulting. The 1,000 large U.S. companies included in the survey had about $1 trillion in excess working capital based on companies in the survey matching the top quartile performers. Overall, the cash conversion cycle increased by 2.5 days, although much of this was driven by the oil & gas sector. If this sector was excluded, the cash conversion cycle actually fell by .1 day.

The best performer in the cash conversion cycle was Murphy Oil a negative 463 days due to a payables period of 600 days! Some of the other top performers in the cash conversion cycle were Noble Energy (negative 295 days), ITC (negative 282 days), Anadarko Petroleum (negative 245 days), and Apple (negative 66 days). On the other end of the performance scale, some of the longest cash conversion cycles were at United Therapeutics (794 days), Zoetis (344 days),  Eli Lilly (277 days), and KLA-Tencor (246 days).