TheChek News Flow

Despite risk assets enjoying a few weeks in the sun our failsafe recession indicator has stopped flashing amber and turned to red. Newly released US whole economy profits data show a gut wrenching slump. Whole economy profits never normally fall this deeply without a recession unfolding. And with the US corporate sector up to its eyes in debt, the one asset class to be avoided – even more so than the ridiculously overvalued equity market - is US corporate debt. The economy will surely be swept away by a tidal wave of corporate default.

The temper tantrum risk assets threw at the start of the year was sufficient for the Fed to backpedal furiously on rate hikes. Like the Grand Old Duke of York, the Fed marched us up to the top of the hill and then down again - at the behest of the markets. And as more and more contorted excuses are wheeled out to justify its inaction we all surely know by now that the Fed’s articulated “data-dependent” rate hikes are primarily focused solely on the

level of the S&P, i.e., when it slumps they will quickly back off rate hikes and use any excuse necessary – including dismissing surging core CPI inflation. How sad that Central Bankpolicy should have come to this.

Emerging markets have recovered particularly well, with inflows surging last month to a 21-month high according to the Institute of International Finance (IIF). The esteemed folks at PIMCO are putting that down to the three Cs: China, Commodities and Central banks. Personally I think the first two Cs are very much driven by the last C, or indeed just the Fed. The IIF reports that inflows into EM rocketed in the two days after the Fed’s March meeting.

At the same time the US dollar slumped, hence relieving downward pressure on both commodities and the Chinese renminbi.

I suppose now the S&P has recovered we are about to go through another turn on the monetary/market merry-go-round. Ignore this noise. Recent whole economy profits data show that while the Fed plays its games, the economic cycle is withering and writhing from within. For historically, when whole economy profits fall this deeply, recession is virtually inevitable as business spending slumps. And if I had to pick one asset class to avoid it would be US corporate bonds, for which sky high default rates will shock investors.

SoftBank Is More Interested in Ending $240 Million Annual Fees to Yahoo Than in Buying It

Instead, those sources said, the company is more focused on what are described as increasingly tense discussions with Yahoo management in recent months over ending the annual payments that SoftBank makes to the Silicon Valley Internet giant. Those now total around $240 million and are related to fees for branding, technology and search.

As described in its regulatory filings, Yahoo said it “records revenue from Yahoo Japan based on a percentage of advertising revenue earned by Yahoo Japan.”

Half of that money is related to search — Yahoo Japan ended its search relationship with Yahoo many moons ago in the Carol Bartz era, moving to Google in a deal struck by former exec Nikesh Arora. He is now president and COO of SoftBank (and, fun fact, Arora also once worked with Yahoo CEO Marissa Mayer when she was at Google).

Since Yahoo Japan dumped Yahoo search, SoftBank has paid what amounts to an annual $120 million vig as recompense for getting out of that deal. Simply put, free money for nothing.

But that sweet arrangement is ending in 2017, which will mean a big hit to Yahoo’s results since the fees are pure profit.

That’s good for SoftBank, of course. But it also wants to end the second half of the annual payment for technology and branding that it must continue to pay to Yahoo for an unlimited time. According to sources close to the situation, SoftBank is arguing that Yahoo has not kept up its tech innovation for Japanese products as promised — which is sadly true — and that its branding has also become worth less (also, yep!).

“The deal was struck 20 years ago and things have changed,” said one source about the 1996 agreement. “Yahoo Japan gets hardly any benefit from the relationship anymore.”

It’s not clear if SoftBank can convince Yahoo to renegotiate the deal, said sources, but it has been applying pressure to do so. This is obviously not great timing for Yahoo, since it is already under massive financial duress.

And how! Earlier today, Re/code reported on Yahoo’s “book” that it has been sent to potential buyers that showed what everyone already knows: Its results get worse and worse, confirming already dire warnings that upcoming results will be simply awful.

For those just tuning in, it’s the same drill under Mayer as with all the other fire drill of CEOs who have run Yahoo over the last decade: Declining revenues; declining earnings; declining product innovation; declining declines.

In other words, if Yahoo was a ski resort at Lake Tahoe, all that downhill would make it a vacation hit!

But it is not, the now the lucrative Asian assets cannot mask the truth of the situation to investors. While Yahoo’s shares in those two entities make up all of its value — $30 billion for China’s Alibaba Group and over $8 billion for Yahoo Japan — what’s more problematic is that the gravy train of fat fees from Asia is pretty much over.

In fact, while not addressing Yahoo Japan, the slides reminded possible buyers that $200 million of payments that Yahoo has dubbed TIPLA from Alibaba went poof in 2015 after its IPO and they are not coming back.

Now, SoftBank is looking to be completely free of those payments too. And while some speculate that it could also be a buyer of all of Yahoo — thus, getting rid of the fees, taking back its shares and acquiring a nice shot of traffic and content for its Sprint unit — another source notes that the complexity and difficulty of fixing Yahoo’s weak core might be too much.

“This is a bankers’ fantasy more than anything,” said one person.

SoftBank declined comment to me on banking dreaming or anything else above and Yahoo has not commented to me since 2012.

The market has weathered one of the most volatile first quarters in recent years. Since February lows recession fears appear to have faded, with the US market rallying 13% since then, the forward equity multiple re-rating back to its 2015 highs of ~17.5x, and the VIX back below 14. We think this recovery has been largely driven by fundamentally insensitive strategies and broad based short covering. Our highfrequency Utilization Ratio for stocks and ETFs has almost fully normalized to pre sell-off levels, implying little room left for further short covering. Positioning wise,

trend-following strategies (CTAs) have covered most of their shorts and are currently close to being neutral equities. Risk parity portfolios and macro funds are long equities with their exposure approaching levels seen late last year. Long/short equity strategies exposures remain above average levels, and if anything have started to come off their

mid March highs. With most of the technical factors having already run their course and with equity valuation at elevated levels, we believe a re-acceleration in earnings growth and weaker USD are needed to warrant a more constructive view on US equities.

The fundamental backdrop remains challenged. S&P500 earnings growth has contracted for the last two quarters and is expected to decline further in 1Q16 (-9.6%) and 2Q16 (-4.7%) of this year, making this a stretch of four consecutive contracting quarters. While most of this contraction has been centered in oil sensitive industries,

the weakness appears to be broadening. For the first time in this cycle, S&P500 ex-Energy earnings growth is expected to turn negative (1Q16 -4.6%, 2Q16 -0.8%). There is a plausible case that lower commodity prices may be masking fundamental weakness in low-oil beneficiaries, like parts of consumer discretionary, staples, industrials. Based on credit card data for ~57 million users, JPM Chase Institute estimates that ~80% of oil savings has already been consumed. Our economists share a similar opinion. Savings rate has remained unchanged at ~4.6% since the start of the oil decline, suggesting the oil windfall has been spent. Additional measures, such as record miles driven, above trend demand for light trucks/SUVs, suggest low oil windfall is getting put to use. With the oil bonanza largely getting consumed, it may be wishful thinking to expect a sudden lift in EPS growth from higher consumer spending.

This leaves the USD as, perhaps, the most important and plausible factor in determining the fate of the current profit cycle (see report). Further weakening in the USD could help profits re-accelerate from the current slump. However, this could come with some friction as it will likely result in higher inflation and longer-term bond yields that could start to pressure the equity multiple. We estimate that for every 2% move in USD (trade-weighted), S&P500 earnings growth moves inversely by ~1%. With USD largely a function of oil and most importantly FED policy, a more dovish

rate path should help alleviate earnings pressure and prolong the life of this cycle, while a more hawkish path will likely bring us closer to the inevitable end. The above line of reasoning implies an unfavorable risk-reward for US equities from current levels, with 5% upside potential compared to 10% downside risk.

With a dovish FED and weakening USD, we continue to favor Value stocks and US Multinationals (negatively correlated to USD, positively correlated to commodities/yields) over Momentum stocks within US, and see better risk-reward

abroad, namely in emerging markets.

Debt-plagued Valeant Pharmaceuticals International Inc. has a number of options it can take to improve its balance sheet, but a sale of Bausch and Lomb or Xifaxan apparently aren’t among them. Nor is an outright sale of the company, according to CIBC World Markets analyst Prakash Gowd.

That’s because of Valeant’s high debt load, various investigations it is faced with, and other issues overshadowing the company.

“Strategic buyers who see value in Valeant’s assets would rather pick and choose than take on the task of integrating Valeant and absorbing its debt load,” Gowd told clients.

In a take-out scenario, based on Valeant’s 2016 EBITDA guidance of US$5 billion, he thinks shareholders would only receive between US$5 and US$19 per share.

While the analyst does think Valeant needs to consider the sale of specific products and businesses, he noted that selling the Bausch and Lomb eye care business (bought for US$8.7 billion in 2013) would only have a minimal positive impact on its solvency ratio.

The same goes for irritable-bowel disease treatment Xifaxan (Valeant’s top-selling product) as Gowd thinks the lost earnings and cash flows do not justify the opportunity to pay down debt.

“Given Valeant’s distressed situation, we believe that these assets would not garner attractive multiples,” the analyst told clients, adding that they may fetch a multiple of only about 6x EBITDA, or US$3 billion in the case of Xifaxan.

The company’s Neurology and Other business line, which includes products such as Wellbutrin XL, is also “not a great option since the resulting cash is less, and the de-leveraging opportunity even less impactful,” he said. “Furthermore, we think that this division has less potential for growth than either Bausch and Lomb or Xifaxan, even in the hands of a strategic acquirer.”

Instead, Gowd believes the most likely scenario would see Valeant sell its underperforming assets.

Under Valeant’s credit agreement, it is only permitted to sell four per cent of its total assets in any calendar year.

Assuming that US$1.9 billion of assets can be sold this fiscal year, the analyst estimates the company’s leverage ratio can be cut by approximately 6.5%, and its interest coverage can be boosted by 7.5%.

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* Five factors plus desire to pre-empt may catalyse cross-border

* Most (though not all) obvious transactions do not look imminent

* In the meantime, both eventual targets & acquirers can prosper

We have long argued a wave of consolidation would take place in Europe, starting with in-country mergers then gradually escalating to cross-border deals. As recent events in France have shown, in-country deals are fraught with difficulty, but there is at least broad agreement among operators and investors that they have merit. The same

cannot be said for cross-border transactions, which are regarded suspiciously. We try to maintain an open mind (albeit one that is necessarily a little sceptical). Nonetheless, we can identify several factors that might drive the industry towards a phase of pan- European consolidation: 

(1) While most telecoms scale effects operate at the local, regional or national levels, this is not always the case – such as with some payTV content. 

(2) There are levers that European regulators may wish to pull in order to encourage the emergence of a more pan-European industry, with the approach to spectrum licencing providing one obvious (if controversial) example. 

(3) There is in theory also the potential to modify the approach taken in merger control to facilitate transactions with a cross-border dimension (though we must quickly add that this currently looks, in practice, unlikely). 

(4) Technological developments, such as all-IP platforms, may enhance cross-border scale effects by comparison with what has been possible historically. 

(5) Low interest rates. Individually these drivers may not be seen as compelling (hence our view that the phase transition towards cross-border M&A will likely take time), but bear in mind also that a desire to pre-empt rivals’ conjectured moves may be as likely as anything else to catalyse the process.

FT - United Utilities gained 2.5 per cent to 929.5p on the highest daily volume since December. Dealers retreaded persistent speculation that it might be a target for infrastructure funds.