Russian Business Forum

Last week, Irish Management Institute hosted another successful and very well attended Russian Business Forum. IBEC and Enterprise Ireland have promised to post all presentations on their sites, but here are the slides of my own presentation.

How big is our Capital Stimulus - NDP and Public Policy Waste

In the US, according to Bloomberg, $1.6 trillion has been erased from equities values since January 20, implying that approximately $800bn of this is attributable to "the market's reaction to the stimulus plan". Furthermore, since "a standard assumption is that the marginal propensity to consume out of wealth is 5 percent. That would mean $40 billion less in spending. Then there is the effect on investment of the drop in Tobin's q (the ratio of the market value of capital, reflected in stock prices, to the cost of capital goods). These effects kick in immediately, while much of the [Obama] stimulus will not kick in until next year. So is the multiplier for the stimulus positive or negative?"

A good question to ask in the context of Irish Government policies as well. So let us do the maths. Per Table below,
overall Irish Stock Exchange market capitalization (measured by ISEQ Overall Index Cap) lost €4.1bn since January 1, 2009 and €54.3bn since the arrival of this Government. Thus, losses in consumption out of wealth alone over the latter period can be estimated at more than €2.7bn. For Tobin-q induced losses, the figure is a whooping €39.7bn.

In my analysis of Anglo-Irish shares (here), I showed that the regulatory risk premium on the bank implied a 69% downward revision in the share price from fundamentals-determined values. Let us, for the sake of an argument, assume that a similar process of downgrades applies to the Irish market as a whole.

As picture below shows, current market differential between ISEQ and its US peers is in the region of -53% for ISEQ. This is the total risk premium differential on the Irish shares. Suppose that ca 40-50% of this is due to the Government policies in the markets and on economy. Recall that in the Anglo case it was 69%, while in Bloomberg estimate for the US - a country where the Government and Monetary Authorities were much quicker and proactive in policy formation and implementation than our 'Don't Panic' Brians&Mary. Thus, my 40-50% assumption is a conservative one.

What do we have?

Since June 1, 2008 – the time of the new Cabinet take over – a cumulative wealth-destruction effect of the deficient public policies (imputed on ISE losses alone) has contributed to the consumer demand contraction of roughly €1.1-1.4bn, plus a Tobin effect of €6.4-7.9bn. The grand total losses attributable to our Government's policies failures for June 2008-present comes to €7.5-9.3bn.

Now, recall that the Government has promised repeatedly that we are going to have a significant economic stimulus via an NDP-driven capital expenditure program which was aiming to provide €10.3bn in net capital expenditure (per January DofF estimates) in 2009. Together with 2008, total capital investment for 2008-2009 was to be €21.2bn, or roughly €15.8bn between June 1, 2008 and December 31, 2009.

Even assuming this figure holds through the mini-Blood-Letting-Budget of March 2009, Government's failure to present a strong policy front to the market has already cancelled out some 47-59% of the entire 'stimulus'... And we are only 2 months into 2009!

Irish Boardrooms in Denial

This is an unedited version of the article published in Business&Finance Magazine, February 26, 2009, pages 30-31

Almost a year ago, I warned in this column that Irish companies are going to face a tough recession, with rising bad debts, tighter payments collections and accelerating rate of insolvencies. A recession that is likely to last through 2009 and a good half of 2010. Figures for 2008 show us on track to fulfil these predictions with more than doubling of the number of corporate insolvencies in one year. By all possible indications, 2009 is going to be even tougher than the already abysmal 2008. And yet, when it comes to a realistic assessment of business conditions there is a strange sense of denial of reality taking hold in Irish boardrooms.

First consider recent evidence. Two weeks ago, CSO recorded the first drop in industrial output in Ireland since 1982. A combination of collapsed construction sector activity, decimated domestic consumer spending and ever-shrinking global demand, exacerbated by the overvalued Euro all have contributed to this trend. Even more significantly, these forces’ impact on Irish producers, exporters and service providers is getting stronger by the day.

Exporters under pressure
2008 slowdown in output was primarily due to traditional sectors of the economy – down 4.7% in y-o-y terms, with multinational companies expanding their production by an anaemic 1.7%. There is little hope that this latter trend will not continue through 2009 and into a good part of 2010. More ominously, December figures show broadly based collapse in industrial activity with output contracting by more than 10% m-o-m in both multinational sector and amongst domestic companies. 26 out of 29 broader industry categories recorded contractions in output. Figure below highlights this, while removing some of the seasonal volatility.
Source: CSO

This is broadly in line with international experience. Last week figures showed that in 2008 Europe posted its biggest trade deficit in 10 years – a whooping €32.1bn. This marked a deterioration in the trade balance to the tune of €48bn in y-o-y terms. According to the majority of the analysts, coming months will see severe recessionary pressures for eurozone exporters. Irish exports are particularly vulnerable, given the falling consumer demand and business investment activity in the US and UK, as well as in the emerging countries. Exports to the UK, the main destination for the region’s products, dropped 3 percent in the 11 months through November 2008. Exports to the US, the second-biggest buyer of euro area goods, fell 5 percent. In the case of Ireland, the two countries account for more than 36% of the goods exports flow by value and some 50% of all Irish trade is linked to either the Dollar or Pound Sterling.

The end result – our core industrial exports are facing a decline, as illustrated in the figure below, precisely at the time of already collapsed domestic consumption. Our services exports are also facing decline with financial services and tourism struggling to stay afloat, while broader business services exports are feeling the same pressures of currency overvaluation and high cost of credit as our goods trade.Source: CSO

The expectations are that the 2008 growth sectors – ICT and pharma – might be also hard hit by a slowdown in global demand this year. In particular, ICT is sensitive to households and business investment demand. Lack of new investment in plant and equipment, software and operating systems in the US and across Europe is taking its toll on the likes of Dell, Intel and smaller hardware and software suppliers. By all estimates, this sector is not going to see a significant recovery until the earliest second half of 2009. Dell alone accounts for some 6.5% of Irish exports.

At the same time, pharma sector is likely to face mounting cost pressures in the US, a significant decline in demand for higher-end drugs from the emerging economies, plus a stronger generics competition. A recent study by the International Pharmaceutical Policy Council has shown that traditional pharma and bio-pharma sectors are facing significant cuts in research spending and employment, with recession undercutting public and private spending on universities-affiliated research. In the mean time, last week, Israel-based Teva Pharmaceutical Industries Ltd., the world's largest maker of generic drugs, said it expects the deepening global recession to spur demand for generics – bad news for the likes of Big Pharma that dominate Ireland’s exports statistics. In other words, even the so-called ‘recession-proof’ pharma companies are starting to feel the heat.

Yet to face the music
Which brings us back to the corporate boardrooms perceptions of the near term future. Last week’s InterTradeIreland Quarterly Business Monitor sheds some light here.

A comprehensive survey of some 1,000 companies north and south of the border has revealed that businesses are more pragmatic in their assessment of the past than they are about the future. In other words, Irish companies are feeling the pain, but are potentially deluding themselves into believing that the first half of 2009 will turn out to be economically stronger than the consensus forecast predicts.

In terms of the current conditions, roughly four out of five businesses indicated that they have experienced an adverse impact on trading conditions in recent months. This is hardly surprising, given that the biggest problems reported by business leaders were impacting their core parameters: tighter cash flow (68%) and decline in demand (66%). Some 87% of businesses noted a fall-off in consumer spending. 61% of the Republic of Ireland businesses saw a fall in turnover as opposed to 44% in the North.

Nonetheless, when asked which policies the Government can undertake to help business,
• 27% cited the need for improving access to borrowing (most likely indicative of the severe pressures on debt-laden businesses to raise new credit and roll over maturing short-term debt),
• 9% called for reduced levels of VAT and 7% for reduced taxation,
• 7% named assistance for SMEs, and 6% identified financial assistance for distressed companies.
The low numbers supporting consumer confidence improving tax reductions measures suggests that majority of businesses are not perceiving the current downturn to be demand-driven. Instead, there seem to be a much stronger conviction that the recession is a function of the credit cycle. Yet, 61% of business in the South (as opposed to 44% of those in the North) reported declining turnover.

Do the companies underestimate the extent of the collapse in consumer confidence at home, demand for exports abroad and the extent of their exposure to debt markets? Judging by the main policy priorities listed above, the answer is yes. The same answer is supported by the fact that few companies so far have taken significant cost-cutting measures. Only 30% of the Republic of Ireland companies (19% in the North) have reduced their workforce to the end of 2008. This is reflective of the fact that just 18% of businesses expected the downturn to have a severe adverse impact on their business in the next 12 months. Majority (63%) still think that this recession will be a moderate and short-lasting one.

And this is despite the fact that forecasters virtually unanimously predict 2009 to be worse than 2008 when it comes to trading conditions. For example, McKinsey Global Economic Conditions Survey last month has shown that 71% of global businesses expected general conditions to worsen in Q1 2009.

Chart below shows that Irish business leaders pessimism about the future has increased only marginally between the end of 2007 and the end of last year, despite the rapid deterioration in Irish economic conditions.

Potential Impact of Economic Downturn, 12 months forward
Source: InterTradeIreland, 2009

Optimism amongst businesses, although having abated in 2008, remains relatively high. Only 39% of all Irish businesses anticipate a decrease in turnover in Q1 2009 as opposed to 52% of global businesses in McKinsey survey. Similarly, for profitability – only 35% of Irish businesses expect a decline in profitability in Q1 2009, against 67% for the global sample.

Thus, only 14% of businesses across the island (18% in the Republic of Ireland) expected more layoffs and redundancies in Q1 2009. This is well below 29% of the global sample firms that were planning layoffs for this quarter.

In short, consistent with the findings on employment, turnover and profitability, the Intertrade Ireland results suggest that Irish businesses, both sides of the border, expect a mild recession to last no longer than 6-8 months. At the same time, global business leaders expect “a battered but resilient economy …[that] implies a recession of 18 months or so”, much in tune with the forecasts by the EU, IMF and the OECD. One side of the sea is clearly foolin itself here…

Box-out: IFSC Liabilities

A research note from the Davy Stockbrokers last week attempted to clarify the issue of the banking sector liabilities in Ireland. According to the Bank for International Settlements data, in Q3 2008 banking liabilities of the Irish-owned banks totaled €575bn, or 309% of GDP – the third-highest in the euro area. The Irish government has guaranteed €440bn (or 237% of GDP) of this. At the same time, the liabilities of all financial institutions resident in Ireland were €1,424bn, or 839% of GDP. But €849bn of that “…is not in any way a liability of the Irish government,” says the Davy note.

Well, sort of. €849bn might not be a liability under the Government guarantee scheme (although it remains to be seen how the foreign banks deposits and loans by and to Irish residents will be treated in the case of default) but from the economy’s point of view – some share of the €849bn debt represents a potential risk exposure for the state.

Here is how. Recall the good old days when our country leaders trotted the globe telling everyone that IFSC is a flagship of our knowledge-based modern economy? How come we now conveniently shrug off any liability inherent in having IFSC on our soil? IFSC is an asset to Ireland: a major contributor to the exchequer, a large employer of Irish workers and a significant purchaser of associated business services, including the services of the stockbrokers.

Now, imagine if excess debt exposure of IFSC-based companies was to drive them out of business. Where would that leave the State, not to mention the economy? A rough guess – ca €700mln in Exchequer revenue, plus the returns from employment of ca 20,000 people, plus commercial rents returns and VAT returns due to business activity. The total state take from the IFSC can easily exceed €1.5bn. If the risk of losing this dough is not a liability for the Irish state, what is?

Davy is correct in the strict sense of listing the actual figures. However, ignoring the IFSC-held liabilities creates an illusion that somehow Ireland Inc is independent of what is happening in the Docklands and beyond. It is not. Just as in good times we reaped the benefits of the IFSc, we must, at the time of challenges acknowledge its liabilities as being at least in part our own.

Buffet's Lesson from Ireland

Buffett Can't Find Green in Ireland, says Barron's (here)

"IT'S RARE FOR WARREN BUFFETT to suffer a near-total loss on an investment, but he did so with the purchase of shares of two Irish banks last year.

As he admitted in his annual shareholder letter, Buffett, the CEO of Berkshire Hathaway, invested $244 million in shares of two unnamed Irish banks. "At year-end, we wrote these holdings down to market: $27 million, for an 89% loss. Since then the stocks have declined even further. The tennis crowd would call my mistakes "unforced errors."

What were those two Irish bank stocks? We suspect that one of them is Allied Irish Banks (AIB), whose U.S.-listed shares are down to just $1 from a high of $45 last April...

What might have attracted Buffett to Allied Irish? Assuming he bought the stock, we suspect that he was motivated by the same reasoning that attracted Michael Price, a former mutual-fund star who runs MFP Investments.

At the Ira Sohn investment conference last May, Price recommended Allied Irish Banks, then trading around $41. Price said the stock looked cheap because it held a valuable stake in Buffalo-based M&T Bank (MTB). Excluding the M&T stake and another investment, Allied Irish was trading for just five times annual profits, Price asserted.

One reason we think that Buffett bought Allied Irish Banks is that Berkshire is the second-largest holder of M&T Bank at 6.7 million shares, behind Allied Irish Banks at 26.7 million shares. Buffett may have known about the Allied Irish holding in M&T, a bank that Buffett has praised in the past..."

Buffett's losses were small for Berkshire, but they are material for Ireland Inc.

Berkshire's mistake in buying into AIB had nothing to do with M&T share, which fell by only a third, as opposed to a 90%+ loss on AIB and BofI ("The other Irish bank whose shares were purchased by Berkshire could have been Bank of Ireland" says Barron's).

The real mistake was to buy into the banks run by the likes of Eugene Sheehy - a man who just last summer had a nerve to raise AIB's dividend in a clear case of mad macho bravado. And of course, his mistake was to buy into Ireland Inc regulatory circus - ran by a gang of financially inept political appointees of a regime that itself had one economic policy for all problems: throw more money at its cronies.

Now that Mr Buffett has learned his lesson, he will share it with the rest of the investment world. Who would bother putting any institutional money into this economy ever again? And who would bother buying Irish Government bonds backed by a claim on economy that is built on AIB-BofI-Anglo-IL&P-Nationwide & Co sand and issues bonds to keep this sand from liquefying under our feet?

A sight of carnage: GE

GE - that Titan of global economy - is under a threat of becoming the next AIG.Although the company is forecasting USD18bn in profits this year (on the back of its industrial arm), GE shares have now dipped below USD6.50, their lowest level since 1991. All due to the GE Capital exposure in the risky commercial and residential lending.

Since October, GE sold USD15bn in new shares and USD31bn in new bonds, cut down its loan book and reduced its reliance on short-term debt funding. GE has cut its dividend by 68% to generate additional USD4.4bn.

Sounds good? Not really. GE has set aside roughly USD10 billion in provisions for losses on its USD380 billion in receivables at the finance unit. The company loans total USD680bn against equity cushion of USD34bn in cash and USD36bn in assets. The latter is taking a hit in the current markets, implying today's equity cushion of only ca USD63bn and falling.

It would take a USD9bn hit to earnings and equity for GE were to write down its real-estate portfolio by 25%, according to UBS analysts. GE has transferred some of its real-estate holdings, into real-estate lending. As a result, its total real-estate assets increased USD6 billion, or 8%, last year.

But let us get back to the USD10bn provision. Here is my view on the share price going forward:

Assume they set aside cash (otherwise this set-aside is itself open to downward revaluations over time). This implies expected impairment provision is 2.63% of receivables. Globally, AAA rated CDOs carry the recovery rate of only 32% on face value, while for mezzanine vehicles the recovery rate is only 5%.

So, suppose GE gets a 25% boost on that via higher debt seniority and tighter loans management, etc. Assume the recovery rate of 40% on higher quality junk (hqj) and 8% on lower stuff. Take a blend on the book at 90% hqj, 10% 'stuff', this gives us an average - across-the-book - expected recovery rate of 37%. Suppose 12% of loans are under threat (rather generous in this commercial and residential real estate markets), allowing for some earlier writedowns that already took place. You have a required impairment provision of 12%*(1-0.37)=7.56% or almost 3 times more than the USD10bn they provided for.

This level of provisioning - if set in cash - will take us into a set-aside of an additional USD18.7bn on top of USD10bn set aside today, bringing equity down to USD17.3bn cash and USD34bn in assets or total equity of USD44.3bn - some 30% haircut. Assume deterioration in the assets part of equity pool at 1/4 of the rate of deterioration in broader assets, i.e. 3%pa, you have additional shave-off of 2% on equity, implying equity cushion fall will depress the overall share price by at
least 30% from today's level.

Now, I suspect that when they quote USD34bn cash equity today, they actually include the USD10bn provision into that as well. If so, the total haircut should be based on USD34.3 equity, implying a cut of 45.6% (provisions) + 2.5% (asset deterioration on equity side) = 48% on
today's share price.

So you have USD3.5USD as the equity-underpinned price target. And that is where the stock heading next, in my humble opinion...

Another Day of Carnage

Just pictures...
And this is the day of rates cuts: ECB down 50bps (should have been down 75-100bps, but hey, when was the last time Germans had any guts for serious actions?) and BofE down to 0.5%... If anyone needed a proof that the markets are not treating Irish banks shares as a part of the broader world, preferring instead to price them as sick puppies, here it is:
So is the next stop for this train of sorrow 'Nationalization II: Bank of Ireland'?