QE and inflation denial

What's Mr Bootle taking? As a leading proponent of Quantitative Easing and one of the world's inflation deniers, his piece in yesterday's Daily Telegraph came as a shock. It seems that he feels that there is a risk of inflation in 2011 after all!

Better late than never, this shift of stance, but I would suggest that we are already past the "minor uptick" he refers to; RPI has run at an annualised rate of 3.7% since January. I don't expect today's figure to halt this trend.

A key plank of Mr Bootle's argument for persistent deflation, is that of "spare capacity" in the economy. Unfortunately, there are few idle machines because in a service-based economy, there were few active machines prior to the downturn.

The argument thus hinges on labour availability. I would suggest that employers have little demand for workers at the minimum wage of #5.80/hour and the associated red-tape headaches of employment, equal opportunity and anti-discrimination etc. legislation - (it's a miracle that anyone is employed). In fact they would rather employ immigrant "gang" or other cheap manual labour to staff the leisure and food production sectors or outsource the job overseas, if it is an indirect service.

The same service industry skew means that sterling weakness does not boost exports to any great extent compared with past crises. It may serve to increase tourism levels in the UK, if the elevated oil price doesn't deter potential visitors, but for all the imported food, goods and energy, sterling's weakness is inflationary.

Back to the spare capacity argument, what about the supply of labour at #5.80/hour? It is perhaps not that great after all. Many of the unemployed would seem to be better off on benefits at a higher equivalent hourly rate. Furthermore, despite the internet, the plethora of databases and employment agencies, the ability to match buyers and sellers of labour has not noticeably improved. Systemic unemployment may well be higher than many think.

On the other side of the inflation equation, I haven't seen anything to threaten the pricing power of retailers, energy suppliers or tax gatherers.

QE at #200bn will be about 10% of money supply as measured by M4. Unfortunately, M4 still hasn't grown to reflect the QE already smouldering away. It has been totally useless because unlike national stimulus schemes that have targeted the borrower, such as in Singapore and Australia, throwing money at the banking system will never work if their potential customers remain too scared to borrow.

So more QE and more loose money until after the election next May. But what if inflation takes hold and the world tires of sterling before then, will we get a rise in interest rates to defend sterling? What about the capital loss on the government's holdings of debt which will be dramatic given the long duration of their holdings?

So will it be an IMF rescue or a surge in UK interest rates? Probably both.

UK Financial mis-selling at its worst

I am one of 20 or so people who made written representations to the FSA after the members of the Britannia Building Society had voted to approve the merger of the society with The Co-operative Bank Ltd.

Setting aside that the transaction is strategically wrong – why does the UK’s #2 building society by assets need help when it complies with the FSA’s capital requirements? – the transaction was mis-sold.

The bulk of documentation and all the publicity surrounding the “merger”, referred to a merger between the society and Co-operative Financial Services Ltd. This is incorrect and misleading. The CFS is the owner of the eponymous bank, but as anyone in business knows, a holding company is a separate legal entity from a subsidiary. The transaction was described as a merger with the holding company; the vote was for a merger with its subsidiary.

Merger implies that the parties merging are broadly equal and that shareholders in each party will end up with an ownership interest in the merged entity. This is not the case here as Britannia members will have no interest in the enlarged bank. Society members are being offered membership of the Co-op Group but this is the holding entity for CFS. Returns to society members will therefore be diversified and diluted not only by the Insurance business of CFS but also by the returns from Somerfield/Co-op supermarkets, housing development, undertakers and pharmacies, to name but a few.

The accounting for the transaction is a straightforward transfer of the net assets from the Society to the Co-op bank. At the end of December 2008, the net book value of the Society was GBP881 million – and this, in effect, is simply being given to the Co-op Bank’s shareholders. I am not expecting a windfall payment but for the Society’s board to imply that giving away the Society at a cost of over GBP200/member (assuming 4 million members) was the best deal they could get, is suspiciously mendacious.

Of course the representations to the FSA will be considered – but ignored. The documentation for the deal was passed to FSA for its prior approval. But just in case someone there has forgotten the definition of mis-selling, I attach the link to the FSA’s website.
http://www.fsa.gov.uk/Pages/Library/Communication/PR/2003/052.shtml

Should it still be signed off by the FSA, it will no doubt be discussed at a higher place. The Treasury Select Committee will bare its teeth and get to the bottom of the matter and then, led by its Chairman, John McFall MP, decide that apart from a couple of slapped wrists, it is all hunky-dory.

Did I mention the Co-op Party? Society members after years of no political donations will now find that the new owners of their assets are funding the Labour party. The Co-op Party has 29 MPs who stand as Labour Co-op members.

Labour Co-op is abbreviated to Labour even on official documentation. How do I know? The published list of members of the Treasury Select Committee describes the following:- Rt Hon John McFall MP (Chairman), West Dunbartonshire, Labour.

Society members are being undertaken to the cleaners.

British Airways gliding to oblivion

I came away from yesterday's BA AGM feeling that this company is headed the way of the old US carriers. Its cost base is simply too high. It is the airline equivalent of GM; its pension liabilities (but a relatively modest healthcare liability) prevents it from competing effectively with its Asian counterparts or domestic greenfield operations. And this focus on the pension deficit and wage cost is almost to the exclusion of everything else, including ways that revenues might be increased.

BA provides nothing in the way of segmental financial information other than revenues by regional source. At least the monthly operating statistics split the world into four geographic area. No further disclosure is provided in case it is of potential help to competitors. So when asked at the AGM about the relative profitablility of its european and international operations, there was some obfuscation. There was no clear answer according to management, due to the high level of transfer traffic, up to 60%, filling the long-haul flights.

However, when the relative profitablility of Calcutta and Hyderabad services was discussed or the reasons for reducing flights to Poland, the Board claimed to have the numbers to know that they were doing the right thing.

If the transfer traffic muddies the revenue picture then BA's costs are equally shrouded in cloud as the variable element of total is relatively small compared with other airlines. Allocating fixed costs to particular routes or services becomes an art.

One shareholder suggested that BA should price closer to its marginal costs in order to fill its aircraft and at least get some contribution towards its massive fixed costs. Perhaps the problem here is that Ryanair and Easyjet are already pricing at these levels and making a profit. BA cannot compete with the low-cost carriers.

BA cannot sensibly compete with other premium operators. On page 21 of the latest annual report and accounts, there is a picture of an Airbus A380 in BA livery. The report notes that three airlines are operating this aircraft into Heathrow and that "the aircraft offers them the chance to enhance their products". But the picture is misleading; BA is not operating the A380. It is in fact delaying the entry into service by at least 5 months. When it eventually enters service in 2012, that will be a mere 4 years later than its key competitors on eastern long-haul routes.

So if the A380 is so good and BA wants to be a leader in premium traffic, why defer it? Why not instead sell some of the mothballed B747 and try and get some earlier slots on the A380 delivery schedule? It is a good passenger aircraft compared with the B747; in economy the seats are wider, legroom can be longer and cabin pressure higher (about 5,000ft equivalent vs 8,000ft). If the A380 is not as profitable as a B777-ER, for example, as may well be the case in the current market environment when bigger means harder to fill, then cancel the orders. If it is a viable proposition, buy it sooner rather than later. Even Singapore Airlines is now finding use for them on sub-four hour regional sectors in competition with LCCs.

In the current quest for revenue, as several shareholders pointed out, BA does a good job of scaring customers away. If it's not the unions threatening some action then it's Mr Walsh suggesting that the business might fail (make sure you buy tickets with credit cards if you have no trip insurance).

So what supports the great company. It doesn't believe in government subsidies but it is quite happy for other barriers to entry to persist such as landing rights or for others to build infrastructure on its behalf. BA are rightfully delighted with Heathrow Terminal 5 and the improvements in service levels are palpable according to their statisitcs. (I've not used T5. Since SQ introduced the A380 and coupled with a change in occupation, I've not flown with BA since 2006. Anyway pressure on T3 seems to have abated with the opening of T5). Furthermore, it is probably only BA that wants the third runway at Heathrow.

Nevertheless, BA's western long-haul business is also under the cosh. Following the end of the cosy foursome arrangement on the UK-US routes in March 2008, rival airlines are considering new point to point transatlantic routes or even new hub opportunities. Perhaps it is fortunate that the EU-US open skies agreement happened at a time of declining air traffic, making it more challenging for new players to start a new route, but it is once again forcing BA to look for a partner(s) such as American and Iberia.

As for the financials. For some reason shareholders were asked to approve special resolution 7, the allotment of new shares by placing or rights issue before special resolution 8 which created the headroom in authorised capital - cart before horse? Never mind, all resolutions were passed.

And the rights issue. The Board insisted that a rights issue was not planned and that a convertible bond was being considered instead with institutional investors. It seeks to maintain liquidity equivalent to 15% of revenues and it is already above this level. (1.38bn cash and equivalents at FYEMar09 vs revenue of GBP9.0bn.) However, the CB - diluting existing equity by no more than 7.5% if a shareholder meeting is to be avoided, would help to cover any further deterioration in operating conditions.

But 7.5% of the shares in issue is only 86.5million new shares. Based on a current share price of 128p, the conversion premium would need to be very large just to raise GBP200m. The issue of 9.75% convertible capital bonds (2005) in FY1990 raised GBP320m and represented a potential 18.3% of the then issued share capital. It looks like the proposed CB may need to be on a rights basis in order to raise a sensible amount of money at a sensible price.

But all is not well; we are still in a period of rising unemployment, rising oil prices and with BA's unions fighting to minimise job losses (3,700 further losses in the current FY). On top of that, there is the result of the triennial pension funds valuation after which the company's contribution level will be reassessed. The rating agencies are on top of the situation for once - both coming down a notch in the last few months to Ba1/BB. The company thinks the rating downgrades will have limited impact on its access to funds; it has committed facilities and adequate cash for 12 months of operations. However, the cost of hedging will now reflect a higher counterparty risk.

The company is in a stall but it is trying to regain control simply by pushing the cost stick forward. A stall can be recovered this way, but having a few revenue generating ideas to power the recovery might make the difference between meeting the ground hard and scraping the paint on the belly. Time to ring the broker and make sure that I'm not permitted to attend next year's AGM.

Avis Europe - try smarter not harder

Avis Europe - we try harder - but it's a dumb business model
I inherited a few shares in Avis some 8 years ago. Since then (FY 2000) Avis has managed to destroy value in spectacular fashion. Revenues have grown at 1.1% pa over this time, wage costs at 3.2% pa, staff numbers are now 2.3% higher and dividends declined prior to cessation in 2004. Debt continues to climb.
It's a relatively straightforward business which is why small, independent operators with a few cars and vans in their fleets can compete with the vast 100,000+ fleets of the big players - Avis, Hertz and Europcar.
In essence, Avis buys new cars and sells them a few months later at a loss. As all motorists know, you lose thousands of pounds the moment the car leaves the showroom, although one would expect Avis to get much larger discounts than most buyers, to mitigate the impact. In between it hires out the vehicles and seeks to make enough money to offset the asset depreciation, to cover the cost of finance and to cover staff and vehicle maintenance costs. It is the classic perishable goods business - so the ability to maximise revenue is crucial and yield management (charge out rates x utilisation) is key.
As part of its marketing, Avis has coat-tailed the major flag carrier airlines such as BA. Indeed almost one half of Avis’s business is derived from airports. However, the national, full-service airlines are being slowly massacred by the low-cost carriers, such as Ryanair and Easy Jet. Avis is unlikely to find a suitable way to work with these more aggressive airlines, so the slow death will continue.
Similarly its purchasing policy has been linked to the walking dead for much of this period. GM has now entered Chapter 11. Hopefully Avis is not too heavily exposed as a creditor of GM in terms of the residual value guarantees or vehicle buy-backs the manufacturer undertakes. Even if there is no monetary loss now, the depreciation costs on discontinued vehicles will need watching in the future.
Avis is broadly stuck with its 6 to 9 month holding period. Its customers want the new car smell, and beyond 9 months the pre-resale rectification work on the vehicles becomes more material in nature and cost. Furthermore, Avis may well need to pay extra mileage costs if the agreed limit with the manufacturer has been exceeded.
Meanwhile, our small operator with a dozen cars or so has flexibility on his car holding period and indeed on the marques he buys. If the local Nissan dealer has some sales targets to meet and wants to sell a few cars at a keen price, the independent operator can take quick advantage.
Similarly, in day to day operation, the small independent probably has a white board or production ticket arrangement to show him his vehicle status. Other than the accounts system and the website, there is no massive investment in IT.
In Avis’s annual report there are some data on market shares albeit untimely. In 2006, the share were Europcar group 23.7%, Avis 18.3% and Hertz 15.2%. In 2007, the figures were 25.6%, 17.7% and 15.3%, respectively. In the current year it claims to be maintaining market share. Let’s hope so.
So what works for Avis? The licensing income is small but growing. This are the fees paid by third party operators for using the Avis name and charged on top of any fees for using the Avis marketing system. Should the whole business go to an "asset-lite" brand management operation like a hotel? Do these licencees have the fire in the belly that the agent or corporate outlets perhaps lack?
Looking at the finances, the deterioration in the Parent Company P&L follows an impairment charge of GBP113m. This has reduced the P&L reserve to GBP11m as at FYE 2008 and we are almost headed for a re-run of mid-2005. In June 2005, a 4 for 7 rights issue at 35p raising GBP117m gross and a share premium release were needed to patch up the GBP335m deficit in the Parent P&L reserve following a GBP396m writedown in 2004 of Avis Parent’s investment in its subsidiaries.
The rights issue may not happen this time as the writedown is based on a discount factor applied to future cashflows. It’s great what you can do with discount factors to come up with the answer you want!
Debt-wise, there is nothing major to pay back until next year when the first USD48m tranche of US private placements fall due. The last four years have seen an increase in net debt from operating activities. In 2005, the reported EUR35m decrease in net debt was after tapping shareholders for EUR175m while in 2007, the sale of the Greek business released EUR196.7m, leading to an overall EUR27m improvement in net debt that year. Therefore, the only strategy for now is to reduce the fleet size in order to release cash, and to raise prices to maximise contribution.
Interestingly the covenants on the debt facilities are based on EBITDA interest cover and net debt to EBITDA. Given the high level of operating leases in the business and the scope for large variations in the level of profits on disposal of the vehicles, the ratios don’t seem to catch much at all. Some measure of fixed charge coverage to include the usual financial expenses plus the cash operating lease payments would seem more appropriate accompanied by some debt to total assets calculation.
What next? For the business, a healthy dose of inflation would help it reduce the nominal loss of value on its fleet transactions. As a shareholder, my hope is for the D’leteran group, the 60% shareholder, to put me out of my misery. Dealing charges would consume a large slug of my holding’s current value! It’s good to see Odey asset management taking an interest but with 3+% (as of March 2009) they cannot do much. Avis may be a global brand in some people’s eyes, but flipping a penny stock is probably the main route to a half-decent return for investors such as Odey.

Lloyds Banking Group - share offer: what to do as unconsolidated shareholders lose out again

Shareholders of both Lloyds and HBOS who have not consolidated their shareholdings of Lloyds shares post-takeover will lose out again.
You would have thought that the company, and Equiniti (the registrar), would want to minimise the cost of administering its large shareholder register. Apparently not; instead of searching out duplicate names and payment details on the register it is happy to let shareholders run two separate accounts. The reason is obvious - Equiniti presumably gets paid according to the number of names on the register and Lloyds gets the benefit of all the rounding down of entitlement calculations.
Shareholders in such a situation may have already lost a free share from the recent capitalisation issue of 1 new share for every 40 held. For example if you held 500 original Lloyds shares and then received 310 share in Lloyds in exchange for your HBOS shares you had 810 Lloyds shares in total. After the recent capitalisation issue you now have 512 + 317= 829 shares instead of 830 had your holdings been merged.
The current offer of 1 new share @38.43p based on 0.6213 shares for each existing share means you lose out again.
Our hypothetical 829 shares give us the chance to acquire 515 shares. However, split shareholders are offered fewer. Our 512 shares entitle us to buy 318 new shares and the remaining 317 shares means we can apply for 196 new shares. Net result - we can only get 514 new shares.
The application does give the shareholder the mechanism to combine and consolidate accounts for future issues but in this instance the total that can be applied for is the sum of the individual entitlement totals on each form.
Can anything be done?
I intend in my consolidation covering letter to apply for my extra share that I would have been entitled to had the consolidation of holdings occurred earlier.
I shall therefore send in a cheque for the amount on the forms plus an extra 38p for this lost share. I will also add a further 101p to this cheque to ensure that I get a refund of the overpayment - amounts for less than 100p are being retained for the benefit of the company.
Whether or not I get the share that is rightly mine is only part of the grievance. If it causes more stress and cost for Lloyds Bank then it will be a reminder for them that the acquisition of HBOS was the most obvious "no deal" of the bank's 300 year existence. This deal has caused stress for all its small shareholders who were incapable of outvoting the large investment fund managers. The latter are so closely associated to the investment banking salary gravy train that they struggle to think for themselves.
As for Equiniti, there will be even more rumblings of dissatisfaction among shareholders required to use this company's service once this administrative overload hits them.

Rating agencies - Reform can wait - we're busy right now

One of the main beneficiaries of governments' push for kamikaze interest rates and more credit in order to add to the mountain of toxic debt already built, are the rating agencies.
Far from being bypassed in the current new debt issuance bonanza, the rating agencies, who manufactured the structured finance ratings that propelled the credit crisis, are mainstream in the ratings of the various government-backed issues of new bank debt.
Instead of punishing the rating agencies for their past greed-induced blindness and insisting on fundamental changes to their business models, the desperation to create more money has led to the political expediency of doing nothing to change the agencies' flawed methods, for fear of delaying the issuance of the supposedly much-needed debt.
As for quantitative easing, will governments be buying unrated debt or will they too be demanding the illusory comfort of a rating agency prognostication?
Warren Buffet's fund which continues to hold over 20% of Moody's (MCO) seems to have correctly backed the embedded rating agencies over the interest-ridden, prevaricating politicians in the various public spectacles and recriminatory showdowns.
However, all it needs is for the SEC which, through its own laziness, started the process of hard-wiring the rating agencies into bondmarket regulation in 1975, to cut some of the wires. One example that springs to mind is that bonds issued by banks which carry full-faith government guarantees could be automatically designated by the SEC as risk-free and therefore not requiring of a rating. OK, so the rating agencies would then potentially seek to invoice the US government more for its sovereign rating but normally the agencies only charge against the traded liability - not against the contingent liability.
But this is not going to happen.
Rating agencies will not have to change; regulators cannot think of an alternative and who knows, the next quantitative black box models might get it right, so why bother looking for an alternative.
Meanwhile, investment managers are either mandated to follow ratings or potentiallly expose themself to legal challenge from their investors if they lose money on unrated transacations - how can that Catch 22 change?
So it's business as usual for the agencies with the added bonus of Basel 2 work to support their revenues and cement their position in the regulatory framework.

Quantitative easing - no -sell CDS

One thing governments are bad at is intervention in markets. The only success I can think of is the time when the HKMA bought a slug of Hang Seng index shares during the Asian crisis to put an end to the interest rate - property stocks shenanigans that were going on. What's more, after the crisis, the acquired shares were sold at a profit.

At the moment in the UK we have too much credit and not enough lending. At the same time interest rates have been cut and money market meddling undertaken in order to restart the lending process. The interest rate changes have had little impact - pushing on a string - as some commentators say. The reason for this failure of policy is that, thanks to the CDS market, the price of credit and the overall cost of borrowing have become detached.
So Mervyn King should step in and sell credit protection (CDS) in all the UK financial names.

This has many benefits and few drawbacks.
a) Selling reduces the price and so the cost of credit as measured by the CDS spread would decline. The lower CDS value would lower the cost of cash borrowings for these institutions.

b) It is so cheap - in fact selling means that HMG receives regular premiums from the buyer of the CDS protection. These are only a small percentage of the underlying notional debt but could be used to buy back cash debt in the underlying institutions or to buy their shares or for the money to be applied to whatever financial support measure the government has in mind. This would help close the gap between the cash and credit markets.

c) Unlike quantitative easing a) the impact of the CDS sales activities can be readily seen from market prices and adjusted more rapidly than interventions in the money market and b) there is no long-term such as hyper-inflation; once the CDS term is reached, the liability expires and the notional credit disappears.

d) By upsetting the players in the CDS market, the government might be able to bring to an end the derivatives monster. This is where all the credit is lurking and hence we have the paradox of seemingly too much credit in the system but not enough in the real world. Initially, the CDS sales are creating more credit but once the market has decided that it can't win against a sovereign that is backing the underlying credit, the CDS market would shrink. At this stage, the regulators can then step in to control banks' further exposures to derivatives by, for example, changes to the capital adequacy ratings for such instruments.

e) As CDS market players have found, you get a lot off bang for your buck. So don't waste money in cash bondmarkets, invest in derivatives where you can have some impact.

f) As CDS is essentially a form of insurance, HMG could reassess the level of guarantees it has set for the UK bank indebtedness. Maintaining a blend of CDS and guarantees would help bring equilibrium between the cost of credit, the credit risk of banks and the credit risk of the sovereign.

While the government has many consultants, I note that Mr Brown's key adviser is probably Baroness Vadera. Methinks her knowledge of day to day trading in CDS and cash bondmarkets might be limited, given that she left Warburg's in April 1999 - when CDS was the plural of compact disc and the Euro was only 3 months old!

But there again, is Dr Bernanke up to date? How much notional credit was wafting round the credit default swap markets in the 1930's? Is his study of the Great Depression that relevant or do we need the blend of barrow boys and quant jocks that got us into the mess to tap away on their laptops (another consumer staple of the 1930s) and find a way out?