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Mind the GAAP!

By | Finance, Markets

With the earnings season upon us we now go through the same dog and pony show. Companies report earnings, then the success of those earnings are based mainly on whether or not they beat consensus analyst’s estimates. Curiously enough, many often beat by one penny. What methods do they possibly use to beat by a penny per share? 

Prior to earnings, analysts tend to be busy estimating what earnings they think will be reported. Their estimates are based on guidance from the company itself, economic conditions and their own independent models and valuation techniques.

Companies prepare their accounting using generally accepted accounting principles, also referred to as GAAP. GAAP, are a set of rules that encompass the details, complexities, and legalities of business and corporate accounting. GAAP are controlled by the Financial Accounting Standards Board (FASB), a non-governmental entity. The FASB creates specific guidelines that company accountants should follow when compiling and reporting information for financial statements or auditing purposes. GAAP is not law, and there is nothing illegal about violations of its rules unless those violations happen to coincide with other laws. Today, all 50 state governments prepare their financial reports according to GAAP. While a little less than half of them officially require local governments to adhere to GAAP.

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However, more and more, companies are finding that by following a standardized set of GAAP rules, their earnings often come out less than attractive. So, over the years corporate accountants have become more and more creative through the use of “non-GAAP” methods to improve their bottom lines. 

A study published by Audit Analytics noted that 96 percent of S&P 500 companies used non-GAAP measures in earnings releases during the fourth quarter of 2016. In addition, a study published by FactSet indicated that for the first quarter of 2017, 63 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and that, on average, the difference between the GAAP and non-GAAP earnings per share was approximately 54 percent. The most common adjustments were found to be restructuring charges, acquisition-related items, stock compensation costs, and, to a lesser extent, debt costs and legal costs. 

As companies battle to present themselves as profitable, non-GAAP measures are becoming the norm as the disparity between GAAP and non-GAAP results grows larger and larger. So if you think you are going to get the true story from a company’s statements or earnings reports, think again. 

Off-balance sheet financing is another method of non-GAAP financial engineering. A business tries to keep certain assets and liabilities off its balance sheet in order to present to the investment community a cleaner balance sheet than would otherwise be the case. It does so by engaging in transactions that are designed to shift the legal ownership of certain transactions to other entities. The transactions are designed to sidestep the reporting requirements of the applicable accounting framework, such as GAAP or IFRS. So, therefore, considered non-GAAP.

Off-balance sheet financing played an important role in the Lehman Brothers bankruptcy. Through the use of off-balance sheet entity ‘Repo 105’, Lehman was able to move $50 billion of debt off of their balance sheet, making them appear more financially stable before the end of the quarter. Since it was classified as a repurchase agreement, it was ‘bought back’ after the reporting period. When the debt was originally moved off-balance sheet, the bank recorded the debt as a ‘sale’ and booked the $50 billion as revenue. This type of accounting manipulation contributed to the largest bankruptcy in U.S. history, wiping out the life savings of thousands of employees of the bank. 

Adjusted EBITDA is another non-GAAP financial measure that has gained a lot of popularity. Speaking on Jim Grant’s Current Yield Podcast, Adam Cohen, founder of Covenant Review, stated, “Some version of adjusted EBITDA is quite common, but we are seeing things turn into absolute fantasy land.” He took a recent example using the company WeWork, currently valued at roughly $47 Billion, with a stated annualized revenue of $2.5 billion. Cohen explained that the WeWork 2017 income statement started with a net loss of $933 Million. Once they got themselves to adjusted EBITDA, they reduced that to a loss of $193 Million, however since they wanted to sell a bond yield, this wasn’t good enough, so they invented something called “adjusted EBITDA before growth investments” but that still wasn’t good enough, so they invented a third version called “Community adjusted EBITDA,” which at what point they achieved a positive $233 Million community adjusted EBITDA. That is a $1.1 Billion swing from net loss to profit, which is more than the amount of revenues they booked that year. 

As an update to this example, the Financial Times just reported on March 26th, 2019, “WeWork bond prices slipped on Tuesday after the provider of shared office space said that its losses had more than doubled from a year earlier, as the company ploughed money into a breakneck expansion that has captivated the real estate industry.”

So, as a word of caution to those investing in the next potential Lehman, as all these fairy tale companies go public, and as the earnings season takes off,  “MIND THE GAAP.”

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The Great Gold Consolidation

By | Markets

It seems that the merger activity amongst gold miners is continuing. On Monday, January 14, 2019, gold miner Newmont Mining said that it would buy smaller rival Goldcorp in a deal valued at $10 billion. Newmont will offer 0.3280 of its share and $0.02 for each Goldcorp share. According to the company’s statement, the combined company’s reserves and resources will represent the largest in the gold sector and will be located in favourable mining jurisdictions in the Americas, Australia, and Ghana.

The latest merger falls on the heels of last year’s mega merger between Barrick Gold and Randgold Resources. Trading in the shares of the new company started at the opening of business on the New York and Toronto Stock Exchanges January 2. The new company is still known as Barrick but its trading symbol on the NYSE has been changed to GOLD, the ticker formerly held by Randgold on NASDAQ. On the TSX, the ticker remains ABX.

The merger created a gold company which now owns five of the industry’s Top 10 Tier One gold assets1 (Cortez and Goldstrike in Nevada, USA (100%); Kibali in DRC (45%); Loulo-Gounkoto in Mali (80%); and Pueblo Viejo in Dominican Republic (60%), and two with the potential to become Tier One gold assets (Goldrush/Fourmile (100%) and Turquoise Ridge (75%), both in the USA). 

Overshadowed by the Barrick merger was the acquisition of Beadell Resources and its Tusan Gold mine in Brazil by Great Panther Silver. In a telephone interview with Kitco News, Jim Bannantine, president and CEO of Great Panther Silver (NYSE: GPL, TSX: GPR), said that he thinks investors are only seeing the start to more mergers within the mining space as companies are beginning to take advantage of low valuations in the marketplace.

According to a new report by Fitch Solutions, Gold miners are expected to remain committed to cutting costs and capping expenditures in 2019. Gold prices are predicted to average $1,300/oz and it is believed that most major miners’ cash costs of production should remain comfortably below $900/tonne. The largest firms are expected to remain committed to spending cuts in order to reduce debt loads, and continue to follow a strategy of improving both operational and cost performance. Fitch also stated that, “Capital expenditure estimates for 2019 indicate that although gold companies may have turned a financial corner in 2016, spending will not return to the heights of the past decade. As such, priority will be given to reinvestment in brownfield assets rather than the development of greenfield projects.”

Following the Barrick – Randgold merger (completed in January 2019), and now the Newmont – Goldcorp merger, we should expect more M&A activity to filter through the industry in addition to and increase in joint ventures as a strategy to reduce risk, especially in unstable countries. An example of notable joint venture activity in 2018 include Gold Fields & Asanko Gold’s 50/50 deal in the Nkran and Esaase gold deposits in Ghana and Indiana Resources and Cradle Arc’s 65/35 deal in the Kossanto West Gold project in Western Mali.

Not surprisingly, as an added measure to further reduce risk in these volatile areas, miners are expected to invest in blockchain technology. According to Fitch, such a system would allow them to effectively track the sourcing of minerals across the supply chain in order ensure they abide by ethical and sustainability standards.

Gold prices have been consolidating since the previous move up in 2016. If the price of gold moves up above the resistance level of $1,400 it could help propel the miners who have gained the greatest operating efficiencies. 

Previous to today’s takeover of Goldcorp by Newmont, articles of the past few years were focused on who Goldcorp would takeover, disregarding Goldcorp as the target. So now in light of that, the question is, “Who is the next prime takeover target?” The top 10 in the industry according to current market capitalisation levels are now Barrick Gold, Newmont Mining, Franco-Nevada, Agnico Eagle, Kirkland Lake, Royal Gold, AngloGold Ashanti, Kinross Gold, Goldfields and B2Gold. Will we see consolidation amongst the 10 largest as we have just witnessed or are the juniors ripe to be taken over? Either way, the current consolidation activity should create some strong valuation plays for the future should the price of gold finally make its move upward. 

Kirkland Gold has broken away from the pack.
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A Day of Carnage in the Trading Rooms

By | Economics, Markets

Thirty-one years ago, on Oct. 19,1987, the Dow Jones Industrial Average plunged 22.6%, its largest one-day percentage-point drop ever.

You may have noticed that the financial media has started to highlight the point drops as opposed to the percentages. To say the Dow lost 500 points makes better news than saying it lost 2%. In percentage terms though this years recent plunges pale in comparison to what “could” happen as we have seen in history.

Here are five of the worst stock market crashes in U.S. history, based on daily percentage losses (source: ajc.com):

Oct. 19, 1987

Percentage change: -22.61 percent

About: Known as “Black Monday,” this devastating crash began in Hong Kong, spread to Europe and then hit the U.S. hard.

Oct. 28, 1929

Percentage change: -12.82 percent

About the crash: The Wall Street Crash of 1929, also known as the Great Crash or the Stock Market Crash of 1929 started on Oct. 24 and signaled the beginning of the 12-year Great Depression. Black Monday, the fourth and worst day of the crash, saw a drop of 12.82 percent.

Dec. 18, 1899

Percentage change: -11.99 percent

About the crash: During the Panic of 1896, the U.S. experienced an acute economic depression caused by a drop in silver reserves and deflation.

Oct. 29, 1929

Percentage change: -11.73

About the crash:  Black Tuesday was the fifth day of the the Wall Street Crash of 1929, also known as the Great Crash or the Stock Market Crash of 1929 that started on Oct. 24 and signaled the beginning of the 12-year Great Depression.

Nov. 6, 1929

Percentage change: -9.92

About the crash: Just a week after the height of the 1929 Stock Market Crash, investors saw another dip.

As many often refer to these numbers when speaking about this event the real point of interest should be in what they were saying back then, which not many financial media tend to refer to. Ironically they were saying many of the things they say today.

We looked back at a Nightly News Broadcast of that time in order to gain a better understanding of the mindset of the time. You would be advised to watch the broadcast because in the words of Philosopher George Santayana, “Those who cannot remember the past are condemned to repeat it.” (See The Nightly News Broadcast October 19, 1987 at the bottom of the post)

The 1987 crash lost much more than the crash of 1929, and although (as they said at the time), “Conditions today are much better than they were then,” “today’s precipitate decline struck fear in hearts and pocket books of even Wall Street veterans.”

All the same actors showed up as they do today with the same speech tracks. New York Stock Exchange Chairman at the time, John Phalen, tried to be reassuring. “We are extremely fortunate today that the country is in a very strong position.”

The word of the Economists was that they were worried that the market plunge at the time could impact the psychology of even those that didn’t own stocks. They worried the consumer would stop borrowing and spending which could grind the economy to a halt. Compare those worries of the time to today. They are the same. The big difference is that today consumers are already heavily indebted. They are carrying mortgage debts, auto loan debts, student loan debts and credit card debts that are far higher than they were in 1987.

The broadcast pointed out that, “A week ago most economists were saying that the stock market decline was merely a correction.” This is also familiar territory. Of course it is always a correction until it isn’t, however making that judgement before the fact is just a guess. On October 19, 1987, that guess turned out to be very wrong. They went on to say that, “Today’s plunge was so huge, so shocking, that no economist, no Wall Street analyst was willing to predict where it would end.” Irony so thick you could cut it with a knife.

By the end of the day, everyone was looking to Washington for some action that may help stop the carnage. At the time President Ronald Reagan ignored the plunge and continued to “brag” about the Reagan recovery. This doesn’t sound to different to anything we would expect today. Although we can probably assume that no matter what kind of serious drop that the stock market may go through in the future, Trump will be quick to blame the Federal Reserve (however that will not stop him from taking credit it for it if it keeps moving up).

All in all, it is a fascinating 9 minutes to watch. We shouldn’t expect to hear anything different today than we did 31 years ago and that means we should have a pretty good idea of what to expect in the future.

The FED – Are We Being FED Bullshit?

By | Finance, Markets

Did the market reaction after last week’s 25bps rate hike announced by Janet Yellen and the FOMC (Federal Open Market Committee) leave you scratching your head? The dollar went down, Wall Street rallied with the S&P spiking near all-time highs, commodities including gold rallied … was this what you were expecting? Well, if not and if you are scratching your head, be comforted that you are not alone. Many others are also scratching their heads, from amateur investors to seasoned industry veterans.

As typical with post game couch side review, explanations are being created to match with what happened. One of the explanations that is being repeated is that this was a dovish event on the part of the Fed. A bit surprising because in the recent past, this would most likely have been considered a hawkish move from the Fed, as with most rate hikes, along with the maintained position on a forecast of three hikes this year. Apparently for this latest FOMC meeting to have been considered hawkish the Fed would have had to announce an increase in the anticipated number of rate hikes and there would have had to have been a change to the notorious dot plot of Fed member positions.

If you do not buy the explanation that the announcement was dovish, another plausible explanation is that this is the kind of behavior just driven by ongoing euphoria of the late stage bull market. Jan Hatzius, chief economist of Goldman is quoted as saying that this market reaction does not really make sense and was more akin to what you would expect if it was a 25bps move in the other direction – in other words how the market would have reacted if the Fed had announced a rate cut.

Another dynamic at play here is the bullish rhetoric of Trump, decreasing corporate taxes and regulation, infrastructure spending, US dollar repatriation which would lead to a stronger dollar but also more difficulty for the US economy versus the Fed who want to be sure they have enough powder to keep inflation in check. Another elephant in the room is all of the outstanding US debt which would become impossible to service if rates get too high.

Nothing is ever in isolation and another event with a side-effect impact to the dollar was that the Dutch elections were on the same day as the Fed announcement and there was a boost to the Euro exchange rate due to the non-populist outcome of the Dutch elections. Next month will see additional events outside the US that will have side effects towards the US dollar. Sentiment towards the Euro will surely be impacted as the French elections start heading towards a climax over the next two months as well as the UK’s self-imposed deadlines for Brexit talks next week. In addition, both the ECB and BOJ will be convening towards the end of April and these sessions will surely add to the exciting things to watch out for next month. The next FOMC session is not scheduled until June 13-14 and that session will also be associated with a Summary of Economic Projections and a press conference by the Chair.