TheChek News Flow

Asian equity markets opened higher as North Korea’s Founder’s day passes without another missile launch. The PBOC set the yuan reference rate at 6.4997, the 11th consecutive stronger setting and the longest streak since 2005. The PBOC also again skipped open market operations (OMO) for the 3rd consecutive session and drained a net CNY40B. Offshore yuan 1-day interbank rate rose 78bp to 2.29433%. Over the weekend China August CPI and PPI came in hotter than expected rising 1.8% on the year and PPI 6.3%, Shanghai Composite remained one of the more modest movers in the day.

Nikkei +1.34% Hang Seng +0.99% CSI +0.04% Shanghai +0.23% Shenzen +0.52%

Eur$ 1.2012 CNH 6.5270 CNY 6.5127 JPY 108.40 GBP 1.3175 CHF 0.9499 RUB 57.2910 WTI$ 47.88 +0.84%

S&P +0.48% EuroStoxx +0.69% FTSE +0.35% Dax +0.75% SMI +0.23%

* Simcorp Raised to Buy at Goldman, PT DKK450

Dow -0.68% S&P -0.41% Nasdaq -1.07% Russell -0.42% Mexico -1.95% Brazil +3.17% (+4.95% in $) Nikkei -2.12% (+0.07% in $) Hang Seng -1.02% CSI -0.12% (+0,87% in$) Shanghai -0.06% Shenzen +1% EuroStoxx +0.11% (+1,60% in $) FTSE -0.82% (+1.04% in $) CAC -0,19% Dax +1.33% Ibex -1.90% MIB -0.37% SMI -0.33%

Macro :

- Ministers to Propose New EU Tax Push on U.S. Tech Cos.: FT

- Oliver Wyman: MiFID II to Cut Research/Execution Spend by ~$1.5b

Keep an eye on :

- ABN NA : ABN Amro Investor Parvus Sells Its Stake in Bank: Telegraaf

- AIR FP : Boeing Is Said to Get SES 03B Constellation Order: Tribune

- AZN LN : AstraZeneca’s Imfinzi, Tagrisso Succeed in Lung Cancer Trials

- BNP FP : BNP Hires Paul Frankfurt for European Blocks Business

- BP/ LN : BP Said Near to Starting Search for Chairman Successor: S. Times

- CRG IM : Banca Carige Seeks to Return to Profit in 2018: Sole

- EVK GY : Evonik Plans Cost Cuts, Bolder Acquisitions Program: Rheinische

- FCA IM : FCA Seen Considering Magneti Marelli Sale or Spin-Off: Corriere

- GLEN LN : Glencore and Qatar Investment Authority to sell 14.16% stake in Rosneft to CEFC

- MC FP : LVMH’s Zenith CEO Expects Single-Digit 2017 Growth: NZZamS

- NESN VX : Nestle Said to Be Looking at Merck KGaA Units: Reuters

- UG FP : PSA to File Legal Complaint After Le Monde Diesel-Probe Report

- SBRY LN : Sainsbury Chairman Tyler Is Said Likely to Leave Next Year: Sky

- SCR FP : Scor Sees Minimal Co. Loss From Irma Damage to French Caribbean

- LOCAL FP : SoLocal Group CFO Virginie Cayatte to Step Down by Year End

- SREN VX : Natural Disasters Not Major Issue for Swiss Re, SamW Reports

- UN01 GY : Uniper Sees Potential Asset Purchases, CFO Delbrueck Tells FAZ

- FR FP : Valeo Workforce May Grow to 130,000 in 5 Years, CEO Tells JDD

Bills are rising to fund massive shareholder payouts

How hard can it be to be the chief executive of a privatised British water company? Your customers are determined by geography, your prices set by a regulator and designed to offer ample scope to fund both capital expenditure and to pay returns to your investors. Pretty much all you have to do is to make sure your sewage plants work and to keep the public waterways clear of human waste.

Yet even this bare minimum seems to have eluded Martin Baggs, the former boss of Thames Water. He, you might recall, was the man at the corporate stopcock when the utility’s malfunctioning plants spilled so much excrement into the Thames that locals in the Berkshire town of Little Marlow took to referring to the scum-covered surface as “crappucino”. The company was this year fined a record £20m for venting 4.2bn litres of raw sewage into the rivers Thames and Thame between 2012 and 2013.

Not that this escapade unduly crimped Mr Baggs’ career prospects. Despite evidence of negligence in its operations that later led a judge to brand the company’s actions “borderline deliberate”, he not only prospered after its disclosure, but received a rise of 60 per cent in 2015, taking his pay to a princely £2m. He stood down last year, showered with encomiums for his “huge contribution”.

To be fair to Mr Baggs, he is not alone. The boring job of plumbing seems almost an afterthought in determining the rewards of water supremos. Not only is pay uniformly high: Steve Mogford, chief executive of United Utilities, collected £2.8m last year, for instance. But if things go wrong, well, why should a bit of sewage stop those cheques rolling? In 2016, Yorkshire Water was fined £1.7m for polluting a lake near Wakefield and a section of the River Ouse. But that didn’t prevent it handing its boss Richard Flint £1.2m.

So what primarily drives the financial incentives offered by these businesses, if not customer service or the wider public interest? The answer is finance.

There was a reminder of this last week when it emerged that Thames Water (or rather its customers) had obligingly paid off £2bn of the £2.8bn of debt that the Australian investment bank Macquarie took on when it acquired the company in 2006, despite conditions set by the regulator that the utility’s finances would be ringfenced from the acquirer. The financing cost of this corporate transaction — from which water users derived no conceivable benefit — was simply lobbed on to their bills.

Other companies are similarly accommodating when it comes to prioritising shareholder interests. With the removal of all but three utilities from the stock market, these are now mainly international private equity firms and infrastructure funds operating through complex offshore, tax resistant structures. Over the past decade, the nine main English water companies have made £18.8bn of post-tax profits in aggregate, according to a study by Greenwich University. Of this, £18.1bn has been paid out as dividends. Consequently, almost all capital expenditure has been financed by adding to the companies’ debt piles. Collectively these now stand at a towering £42bn.

In the long run, this approach is clearly unsustainable. But Ofwat, the regulator, permits it because it takes no interest in the companies’ capital structures as long as they retain investment grade ratings. No utility, needless to say, has ever lost its licence for this reason, and the regulator has a (somewhat circular) duty to take the ability to raise finance into account when setting prices.

The result has been very juicy for private equity investors. Macquarie, for instance, received returns of between 15.9 per cent and 19 per cent during the 11 years it controlled Thames Water, according to Martin Blaiklock, an infrastructure consultant. According to him, that is twice what an investor might expect from a private utility.

But it is harder to see what is in it for the customers, who have to pay the mounting debt interest. Their bills are, in effect, rising to fund the massive shareholder payouts.

The utilities insist they are putting in investment. But it all adds up to some very costly infrastructure. Those annual interest bills might be £500m lower if the companies were still in state ownership, according to the Greenwich researchers. Customers also would not have to finance the £1.8bn in dividends. Bundle it all together and that could knock £100 off a £400 annual water bill.

The regulator needs to look again at the generosity of its regime, and its cock-eyed governance. As things stand, water privatisation looks little more than an organised rip-off. Quite why this natural monopoly should not operate through not-for-profit, public interest companies is ever less clear.

Buffett’s index investment bet is so far ahead that Seides concedes the match, although it doesn’t officially end until Dec. 31.

That means Seides’ $1 million hedge fund investments have only earned $220,000 in the same period that Buffett’s low-fee investment gained $854,000.

“For all intents and purposes, the game is over. I lost,” Seides wrote. The $1 million will go to a Buffett charity, Girls Inc. of Omaha.

A sports gaming firm says it makes sense for Seides to pay up now. “Our oddsmakers believe there is a 96.8 percent chance that Buffett will win.

In turn, they are giving Protégé Partners about a 3 percent chance to win at this point,” according to Jacob Crossman, a spokesman for Diamond Sportsbook International, which has tracked the bet.

In conceding defeat, Seides said the high investor fees charged by hedge funds was a critical factor.

Hedge funds tend to be a good deal for the people who run the funds, who pass on big bills to the investors.

“Is running a hedge fund profitable? Yes. Hedge fund managers typically demand management fees of 2 percent of assets under management,” according to Capital Management Services Group (CMSG), which tracks the hedge fund industry. “Performance fees for managers can be 20 percent to 50 percent of trading profits,” CMSG adds.

By contrast, the costs of an average index fund are minimal. A fund that tracks the S&P 500 fund might have an expense ratio of as little as 0.02 percent.

Indeed, Seides, in a sentiment that sounds as though he is now using the Buffett playbook, wrote that “the higher the price an investor pays for an asset, the less he should expect to earn.”

Altaba’s Endgame Could Reward Investors Nicely

The former Yahoo! trades at a 30% discount to the value of its assets, including a 15% stake in Alibaba. Management is aiming to close the gap.

Alibaba Group Holding is having a stellar year. Shares of the Chinese e-commerce leader have risen 95% in 2017 to a recent $170, giving the company a market value of $437 billion. The stock added to its gains after management, headed by CEO Jack Ma, announced better-than-expected results in mid-August for the June quarter, including a 56% increase in revenue and a 65% jump in adjusted earnings per share.

A cheap way to play Alibaba (ticker: BABA) is through Altaba (AABA), the former Yahoo!, whose 15% stake in Alibaba is valued at $65 billion. That’s more than Altaba’s entire market value of $57 billion.

Altaba shares are up 65% this year, to about $64, on Alibaba’s big gains, but trade at a 30% discount to the value of the company’s assets (see table). These include the Alibaba stake; a 36% interest in Yahoo Japan, worth around $9 billion; net cash of $8 billion; and a patent portfolio worth about $700 million. There are some potential liabilities stemming from data breaches at Yahoo! a few years ago, but they aren’t expected to be significant. Barron’s has written positively about Altaba this year, including in a Follow-Up on July 1, when the shares traded around $54.

After Yahoo! sold its core business in June to Verizon Communications (VZ) for $4.5 billion, the company morphed into a New York–based investment concern and changed its name to Altaba. Its goal probably is to wind down its assets and realize as much value as possible for shareholders. The challenge is doing so in a way that preserves most of the value for holders.

The current discount to net asset value reflects several issues, chiefly investor concerns about potential taxes imposed and concessions that could be required in order to unwind the equity interests, mainly in Alibaba, which accounts for more than 75% of Altaba’s asset value. It is uncertain how long the process will take; many investors in Yahoo!/Altaba want to see the situation resolved by the end of 2018.

Altaba will probably not realize its full net asset value due to the cost of unwinding the equity stakes. But, bulls argue, the discount is too steep.

“Management at Altaba is singularly focused on creating shareholder value,” says Jeff Lignelli, a portfolio manager at Incline Global Management, a New York investment firm that holds Altaba shares. “We expect a large share buyback to help close the discount, and a tax-efficient sale of the Yahoo Japan stake, followed by the ultimate transaction: a share swap with Alibaba.”

He values Altaba at about $77, assuming a 20% discount on the Alibaba stake and a 10% discount on Yahoo Japan. Lignelli is bullish on Alibaba, calling it one of the fastest-growing megacap companies in the world. He thinks Alibaba shares could top $200.

Robert Willens, a New York tax expert, also thinks the discount to net asset value is too wide. “I’m convinced that Altaba will be able to dispose of or monetize its holdings on a tax-efficient basis,” he says. “The market is seriously undervaluing Altaba’s stock.”

Brett Harriss, an analyst at Gabelli, values Altaba at about $76, assuming a full tax bite on the sale of the Yahoo Japan interest and a 15% discount on Alibaba. He says SoftBank Group [9984.Japan] is a potential buyer of Altaba. Both SoftBank and Altaba own stakes in Yahoo Japan and Alibaba.

After the Verizon sale closed, Marissa Mayer departed as Yahoo’s chief executive officer. Altaba’s small executive team now is headed by CEO Thomas McInerney, a former chief financial officer at Barry Diller’s IAC/InteractiveCorp (IAC). There are just 15 employees.

In a June 19 letter to shareholders, McInerney pledged to reduce the discount to net asset value, which has remained around 30% since then. Management compensation is based in part on reducing that discount. The company maintains a live NAV calculation on its website. Last week, it was nearly 31%.

IN ITS FIRST ACT as an investment company, Altaba bought back $3.4 billion of stock at about $53 a share. It has since authorized a new, $5 billion share buyback. But it probably needs the cooperation of Alibaba to unload its 15% stake in the Chinese company, equal to nearly 384 million shares, without incurring a huge tax bill.

The scenario favored by investors, as outlined by Lignelli, would involve a return of Altaba’s current cash to holders via buybacks, followed by a tax-efficient sale of the Yahoo Japan stake to Yahoo Japan, possibly through a technique called a dividend strip, involving the payment by Yahoo Japan of cash and equity warrants. Willens favors this approach. If it happens, Altaba would be left with one dominant asset: its Alibaba shares.

It could sell its Alibaba stake in the open market, but unloading such an enormous block of stock could depress the price and generate a huge tax bill, because Yahoo! originally paid little for the shares more than 10 years ago. “We would be highly unlikely to ever sell Alibaba shares at a 36.5% combined federal and state tax rate because there’d be no incentive to do that,” McInerney said at an Oppenheimer investor conference last month.

The preferred scenario would involve Alibaba buying Altaba for stock in a tax-free exchange, essentially swapping its shares for the Alibaba stake held by Altaba. Since Alibaba is the only company that can make this happen, it has leverage. Alibaba might demand a concession as an incentive for the swap, such as getting a 15% or 20% discount on the shares. That means it could offer, say, to issue 310 million shares to Altaba holders in order buy Altaba and its 384 Alibaba million shares, effectively netting $12.5 billion (74 million shares times the recent Alibaba price of $170).

This financial incentive and the desire to keep Altaba’s large block in friendly hands might motivate Alibaba to act, although it probably couldn’t retire the stock without incurring a tax penalty. Willens says this issue is overblown and could be “just a negotiating ploy” by Alibaba to get a better price. However, it is unclear whether Alibaba wants to do a deal and whether it might seek a steeper discount, to accommodate Altaba. Alibaba declined to comment.

ALTABA’S MCINERNEY has said the company is watching to see if the tax-reform push in Washington will lower taxes. A cut to a 20% or 25% corporate rate from the current 35% would help reduce Altaba’s potential tax bite on an open-market sale of Alibaba stock.

A big risk with Altaba is a drop in Alibaba shares. To hedge the risk, some investors have sold Alibaba shares short to create a cheap “stub” of the remainder of Altaba. If the discount narrows, Altaba investors could score, even if Alibaba shares decline.

Another risk is that Alibaba won’t execute a transaction with Altaba. If that happens, Altaba’s options may be limited, possibly leading to a sale of the Alibaba stake in the open market—and a tax hit. In 2015, Yahoo! sought to spin off the Alibaba stake tax-free, but dropped the idea when it couldn’t get a blessing from the Internal Revenue Service.

Willens notes that Altaba could convert to a regulated investment company and pay out the Alibaba stock to shareholders in a tax-friendly way through a technique called distributions in redemption. But that approach is complicated and could face challenges from the Treasury or IRS.

It is tough to handicap the Altaba situation, given the uncertainty about Alibaba’s intentions. But the Chinese e-commerce company just might want to negotiate a share swap that benefits itself and Altaba, finally concluding the Yahoo!/Altaba saga.