PM Bolt-On: Non Farm Payrolls & Weaklings - Freeport & Valeant wth some hindsight on IMIC (International Mining & Infrastructure Corporation)

Good Afternoon,

The UK wasn’t the only place with fireworks this with week. What with the Non-Farm Payrolls (NFP 271,000) increasing the probability of a rate rise – now the odds are looking at 85/15 in favour.

The NFP fanfare has forced investors to consider the risks of heavily leveraged companies and those made vulnerable by the liquidity contraction across emerging markets and/or commodities space.

In the longer-term there may be some reward by investing in restructuring plays like Freeport-McMoRan, but not for the faint hearted. The recovery in leveraged companies isn’t clear cut either, so expect some reality/stresses in the short-term.

Commodities producers reacted this week (selling) –

1. China’s focus on innovation and a limited response to an infrastructure stimulus. (Hopes of higher PE - long the SHCOMP on hopes and/or China 300 only on momentum).
2. Standard Chartered’s (STAN) prudence sticking the knife into the commodity sector and a realisation of avoiding a light in a tunnel or two (Qingdao). We hope for STAN’s sake it’s not a train coming towards them - Currently no reason to hold the stock.
3. Fears being realised of a credit bubble/liquidity contracting in emerging markets.
4. German Manufacturing Data (negative for copper) – answers on a post card.

& Friday’s…

5.  Boom busting NFP figure that was a wildcard and above expectations.  

Companies will need to bolster their balances sheets if they operate in a deflationary market, especially those with significant debt and limited operational free cash flow. Remind you of anyone? Not just Anglo, but the market will now belatedly start focusing on rightful candidates. We had the analogy in the morning call that “certain traders are like a bunch of hyenas!!” As if!

The open secret of “debt to revenue service costs” is finally acknowledged as a risk. Not that the writing hasn’t been on the wall for some time. Admittedly, It’s difficult to find a reason to hold US equities with the dollar strengthening. Those goliaths are going to take a haircut to earnings.

With fears of larger scale corporate default and financial bubbles, the market is now factoring in restructurings whether it be fundraising, equity issues, convertible notes or debt for equity a k a dilution for the weak.

Shareholders should be prudent to the possibilities of losing control via the back door or worse, there being limited equity left for shareholders. Freeport-McMoRan (FCX) are not immune to these woes either, but with Icahn on board at least there’s some form of hope signal for the shareholders.

Valeant - without repeating the woes of Valeant (VRX) verbatim (See Citron Research) – it is the pharmaceutical equivalent of VW as it has so many unquantifiable liabilities. With three + warnings out now, it’s likely a case of the die-hards hugging the stock. "Value seekers" will no doubt be sifting the wreckage and be tempted to trade. 

From a psychological model, with such a nuclear fallout and one suspects more to come, is there any reason to hold Valeant? What is the value? What are the risks? With the market perversely needing to be told of the value or limit the slow motion car wreck, what is the likely outcome? With such a wide range of variables, what pricing methodology does one use for Valeant? The price range here up until Thursday was $56-$103 and now, we suspect there’s more potential liabilities, so have narrowed this to $38-$44 a share.

The damage within the pharmacy/dispensary industry cannot be ignored. Pharmacists may now follow the cost conscious route across all prescriptions, not just related to Valeant medications.

In coming to a price, we’ve considered Valeant’s responses and what we assume Pershing Square may be ignoring. Of course Pershing may be selling/have sold, but in the absence of a notification, we’ll assume they’re holding.

For consideration:

1.       Was Philidor using pharmacy codes for pharmacies it had not (yet) acquired e.g. R&O?  

a.     Did they have permission to use them?

b.   What are the implications for Valeant if they are considered to a shadow director/owner of Philidor? Do the rights that Valeant acquired in Philidor mean they have also liabilities?

2.      Its been suggested that dermatology products sold through Philidor were of average profitability -  if we assume that at least some revenues comprised of generics costing $5 or less, but when combined by Valeant and branded it enabled a charge of $400 plus++. If this is correct, then it becomes very difficult to buy into the average profitability claims suggested as the ‘worst case downside.’

3.   It’s been inferred that Philidor filled/dispensed prescriptions even when they were not required / requested. If Valeant’s revenues were reliant on the revenues of 3 units when only one was needed - what are the real implications on Philidor closing/departing company? Repeat prescription business will in essence be torched?  

4.       There’s been vague disclosures as to what other 'specialty pharmacy' networks Valeant has. Will this have further implications?

In making a few assumptions from the above, it’s easy to come to conclusion that the impact on Valeant profits is likely to be double digit. As a reminder, Valeant in October 2015 disclosed they had $1,420M cash and debt of $30,883.3M. What will earnings be and the outlook? If one conducted a simple calculation, deducting net debt from the market capitalisation, what equity would left for shareholders?

In the small caps it would appear there's a sense of déjà vu. Those that remember the views expressed here EMC: International Mining & Infrastructure Corporation (IMIC). To quote yours truly:

International Mining & Infrastructure Corporation plc (IMIC) loan conversion shows the faith in the company, a mere 30% discount to the SP. One hopes you've sense my irony with the mere...the 1 year chart must surely look like the cellar steps! Next stop 10 pence? 

It would be wise to think how the terms are fair and reasonable as Strand Hanson Limited, the Company's Nominated Adviser (NOMAD), consider that the terms of this transaction are fair and reasonable insofar as the shareholders of IMIC are concerned. Its not something I shall be complaining about having rated this as a sell since they acquired Afferro Mining Inc.

IMIC was suspended after the resignation of their NOMAD Strand Hanson in October.  As a positive those holding the Afferro Mining Inc. bonds of yesteryear get a few more shares (whether they’re tradable is another issue), with the conversion notice yesterday.  Is IMIC now extinct? Or can they pull off the unthinkable in the current mining space? Perhaps even find a NOMAD?

So whether it’s goodbye or see you in another form? Who knows…It’s wise to keep an eye on the assets of the micro craps, perhaps not the companies that trade them left and right, but follow the assets.

In other news, the South African and Australian “anti-EMC fan club appears to have gone silent!” Surely it’s not the Zumba Iron Ore share price? Atlas or perhaps Slater & Gordon?

The final thoughts go to Anglo American (AAL) having a rights issue?? The odds are getting higher! BHP Billiton (BLT) tailings damn could be a significant liability...what are the implications and costs? We have varying ranges and estimates as high as $2B excluding losts dividends and as low as $450M, 

Atb Fraser

Evening Bolt on: International Mining & Infrastructure Corporation plc (AIM: IMIC) & Tesco (the final update) a double dose of!

International Mining & Infrastructure Corporation plc (IMIC) loan conversion shows the faith in the company, a mere 30% discount to the SP. One hopes you've sense my irony with the mere...the 1 year chart must surely look like the cellar steps! Next stop 10 pence? 

It would be wise to think how the terms are fair and reasonable as Strand Hanson Limited, the Company's Nominated Adviser (NOMAD), consider that the terms of this transaction are fair and reasonable insofar as the shareholders of IMIC are concerned. Its not something I shall be complaining about having rated this as a sell since they acquired Afferro Mining Inc.

Tesco: Buy

One thing that Dave Lewis has just been talking about is the category reset. Basically done one category so far (other than Christmas), which is Home Care. Sounds like they have reduced SKU's by 31% and seen better volumes and lower prices. He then gave the example of toilet paper, where the SKU's were down 44%, but pricing to consumers were down 11%, so volumes well up. Now the manufacturers will have made far more money out of that (or the big players that won) as they have got rid of hi/low pricing, high/low stock levels and so production can be smooth, consistent and ultimately profitable. This will happen in more categories, so big brands should win. Sensible way to go forward, especially when you have c.29% of the market (they have the scale to deliver it).

Shares have had a good run due to no rights issue, many investors were hoping to get some cheap shares on a rights. We certainly can't rule out a rights at some time, but we suspect Tesco will do it from a position of strength, when they have sorted a good chunk of the balance sheet issues out (maybe this time next year). We expect the shares to follow through a little more in the short term, but we must remember that we haven't seen much regarding the profits yet. At some point in February the Group will need to lay out their profits forecasts, all we know is that they will be no more than £1.4bn, we don't know how much less of this number it will be. Write-offs will come through, but underlying profits will need to show the level of investment that Tesco has done to achieve the improving sales performance, we would expect the new Tesco management to throw in as much costs as possible in these historic numbers. Consequently we could see the shares see a small sell-off over the next few days, but fundamentally we still like the medium term story here. Getting the performance back to what it should be will give huge upside in the shares over the next 18 months. We remain a buyer.

Tesco: Buy

We were impressed with the presentation that Tesco has just delivered, not least because it shows a complete change in the culture of how the management are looking at the business. Moving the Head Offices away from their traditional home also signals that the new management team want to be involved far more in the underlying business than they have in the past few years. Here are some of the positives and negatives that we believe came through.

Positives:

One thing that Dave Lewis has just been talking about is the category reset. Basically done one category so far (other than Christmas), which is Home Care. Sounds like they have reduced SKU’s by 31% and seen better volumes and lower prices. He then gave the example of toilet paper, where the SKU’s were down 44%, but pricing to consumers were down 11%, so volumes well up. Now the manufacturers will have made far more money out of that (or the big players that won) as they have got rid of hi/low pricing, high/low stock levels and so production can be smooth, consistent and ultimately profitable. This will happen in more categories, so big brands should win. Sensible way to go forward, especially when you have c.29% of the market and the scale to deliver the potential positives that should come through.

The management has finally realised that you need to get sales growth to deliver shareholder benefits. We were encouraged by how Dave Lewis continually stressed how if they realise internal funds from either cost savings or better execution on the sales line then this would be invested back into price to grow the sales line. Margins therefore will be subdued for the next few years, but if you start gaining significant market share as you use your already strong position to get great prices on brands and own-label, then as time moves on the competition will struggle to invest to keep up. Ultimately this was a simple expression of offering the consumer what they want when they want it, this could make life much tougher for Discounters as they do offer value, but the range is very limited and so maybe they don’t offer consumers always what they want.

The most important comment that was made by Dave Lewis was when explaining the £1.4bn forecast which was put into the market on Dec 9^th. Here he made it clear that this would be the number when you take into account what had been expensed by that date. It was clear that they have therefore funded some Christmas and New Year investments via internally generated funds. The Company wants this to become the key driver in the business, if it does then they will be gaining share and hurting the competition, then many of the other worries regarding cash flow and debt will dissipate pretty quickly.

Finally, regarding debt and the worries over this issue for Tesco, they reminded analysts that they had issued £5bn of debt just after the new CFO arrived in October, so there is no immediate pressure on the balance sheet. We suspect this is why the shares have risen so much on today’s news, but we are still encouraged by all of the other fundamental changes that the  new team has started to make.

Negatives:

Debt is still high, though there is no immediate issue to repay this debt the short term cash outflow (c.£2.3bn) doesn’t make good reading. With lease commitments high, a Pension deficit and underlying debt, they do need to make sure that the underlying business is being run properly so that they can fund the business from that cash flow. Asset sales though can now be done at a time when it suits Tesco rather than the markets.

No final dividend isn’t great either. Here the comments seem to suggest that they will think about paying a dividend once they have the right investment grade, so that doesn’t look great for the short to medium term as it will clearly take time to repair the balance sheet.

We guess there will be some questions as to whether seeing no margin growth and just focussing on what is good for consumers is good for shareholders. Undoubtedly yes. If consumers start to come back to Tesco then cash flow should turn positive quickly, this will allow Tesco to sell assets at better levels, and maybe even have a rights issue on their terms rather than just having one as a necessity to reduce debt. Getting back into this virtuous circle is what investors want and should allow the shares to recover. Tesco has started turning this tanker round. We remain a buyer.

With limited time to highlight items above, thanks to Duncan for some more in depth thoughts.Even

Rare earths and China’s self-correcting folly might be a tad premature with export restriction in the form of permitting rather than quotas I hope to return to this REM, REE and Rare Earths item. 

Tomorrow due to meetings and a few items outstanding it'll be touch and go but it would be rude not to consider the pricing out to 2016 giving an idea what the market thinks for 62% FE. 

Atb Fraser