Monday 30 September 2013

Italian BTPs ... an economic reasoning to short

Monday 30th September 2013

I closed my Euro Bund short (Heresy to the Monetarist Taliban) a while back and will monitor it for a re-entry. This morning I’ve begun to short Italian BTPs, via the Long Term BTP Future (5 Dec 13) thru ETX. The weekend’s news flow, courtesy of the 'feckless and vain' (US officials assessment) Silvio Berlsuconi and his attempt to bring about a fresh election caught my eye and prompted some data digging. From my analysis below, I reckon that the Italian’s have been incredibly lucky to get their debt service cost back below 5%.
   
The debt-deficit arithmetic (DDA) doesn’t stack up. What DDA does is to quantify the ‘race’ between GDP and public debt, or more precisely, between the economy’s trend rate of growth and the rate at which public debt accumulates. If the real GDP growth rate exceeds the real interest rate, and the government achieves a surplus primary budget (i.e. takes in more revenue than expenditure ex-debt service costs), then the debt to GDP ratio shrinks. When the real interest rate exceeds the economy’s growth rate, the debt piles up, unless a primary budget surplus is enough to offset this.

This is evident in the charts below, which demonstrate how Italy got to its c. 120% public debt to GDP level. The International Monetary Fund (IMF) data highlight that Italy’s real GDP growth rate began to significantly decline from the 1980s, while its public debt to GDP ratio ballooned.

During the period 1950 to 1979, Italy averaged a primary annual budget surplus of 2.0% of GDP pa. This compared with 5.4% average real GDP growth pa and an average 0.9% real interest rate over the same period. However, during the period 1980 to 2011, the average primary budget surplus had fallen from 2.0% of GDP to just 0.6% pa, while average real GDP growth fell from 5.4% pa to 1.5% pa. Meanwhile the average real interest rate rose from 0.9% to 3.7%. It is little wonder that Italy’s public debt to GDP rose from 58% in 1979 to 120% in 2011 and is projected by the IMF to be as high as 131% in 2013-14.

Amongst other variables, Italy’s borrowing rate will respond to two key factors over the next five years; Italy’s GDP growth rate, and its primary budget balance. In terms of the growth rate, the problem is that the IMF forecasts Italian real GDP growth to average 1.1% pa during the next five years and inflation to average 1.4% during the same period.

Growth will likely remain anaemic because Italy is now so uncompetitive as compared to Germany, France and even Spain. Italy’s unit labour costs (ULC) are 26% higher than that of Germany’s, 18% higher than that of France, 17% higher than the UK, and 9% greater than Spain’s. Further, they are a whopping 43% higher than ULCs in the US. Unless Italy’s ULCs improve on a relative basis it would appear unlikely that Italy will achieve a significant pick-up in GDP growth. And as the country can no longer depreciate its currency, the only real way that ULCs can improve is either through productivity gains or lower wages. The former appears unlikely (or at least unlikely to prompt a relative improvement compared to other nations). The latter could lead to a nasty debt-deflation spiral whereby the public debt to GDP becomes even greater. It is unsurprising that the Italian Lira devalued by 600% from the seventies through to the mid nineties prior to Monetary Union. That lever is gone.
  
With the borrowing rate currently at c. 4.8%, real interest rates appear likely to average 3.4% or possibly higher; the latter of which I suspect will be the case. In this instance, Italy will need to achieve a primary budget surplus of 2.3% or greater pa over the next five years, in order for the stock of public debt to stand still. This appears a tall order when considering that Italy has only managed a budget surplus of 2.3% or more in 11 out of the last 70 years. Six of those years were during the all important fiscal rectitude period in the run-up to Euro entry. Further, during those 11 years, GDP growth averaged less than 1.3% pa, which would be about right in comparison to the IMF's projections.  

Now that Italian BTPs have fallen again through the 200d ma, I reckon they go lower to somewhere between €95-100. Which is why I’m building a short position.

IK1 Comdty - Generic Italian Long Bond
Source: Bloomberg
Yield on Generic Italian Long Bond
Source: Bloomberg
Italian Gross Public Debt as a percentage of GDP, and IMF forecast 2012-18
Source: International Monetary Fund (IMF)
Italian Primary Budget Balance as a percentage of GDP
Source: International Monetary Fund (IMF)
Italian Real GDP Growth, and IMF forecast 2013-18
Source: International Monetary Fund (IMF)
Italian Inflation Rate, and IMF forecast 2013-18
Source: International Monetary Fund (IMF)
Italian Real GDP growth, Real Interest Rate,
and Government Primary Budget Balance, and IMF forecast 2013-18
Source: International Monetary Fund (IMF)
Italian Unit Labour Costs in manufacturing compared to other nations
Estimated cost to employers
Source: Bureau of Labour Statistics (BLS)
Italian Unit Labour Costs in manufacturing
competitiveness gap to other nations
Estimated cost to employers
Source: Bureau of Labour Statistics (BLS)
Historical cross rate of Italian Lira / Deutsche Mark
Source: Bloomberg
Disclaimer: The information, discussions or topics referred to on this blog should in no way be considered “advice” to buy or sell anything. The information which may be referred to is freely available in the public domain and where required the source of information is referenced to for verification. While every effort has been made to ensure the veracity of any information contained within this blog, the author accepts no responsibility for the accuracy of any information contained within this blog or for the sources of information which may be referred to. Readers are responsible for their own actions and interpretation of the information contained within this blog. 

Monday 23 September 2013

Avanti (AVN) ... bizarre reaction to further downgrades

Tuesday 24th September 2013

Avanti Communications reported its 2013 year end results on Tuesday 10th September. Bizarrely its share price has risen 49% on the back of this. If anything, I reckon the update and ensuing broker forecasts (see below) confirmed its weaker outlook.

Disappointingly, the company provided no update to its backlog, which was last reported on 10th July 2013 within its year end trading update. Two months prior, Avanti indicated the backlog stood at £290m. As at 30th June 2013, the group’s backlog over the next three years was reportedly:

FYE June 2014: £42m

FYE June 2015: £46m

FYE June 2016: £40m

This was re-iterated Tuesday 10th September, however, had the backlog been improved upon, then one would've thought the company pleased to update it. It didn't. I took that to imply that there’s been no further improvement during the two months since June.

The latest broker forecasts indicate further downgrades. I’d noticed the dramatic downgrades in November last (forecasts going wrong way) and the latest downgrades are just as severe. However, what is more concerning is the projected net debt profile and significant increase in forecast net debt for FY 2015.

In July 2012, Avanti’s broker confidently projected revenue of £56.5m to June 2013. This was downgraded by 39% in November 2012 to £34.5m. The final out-turn was 40% below November’s forecast and 64% lower than that in July 2012. 2015 revenue projections have also substantially fallen. Whereas £138.2m of revenue for 2015 was projected in July 2012, this was lowered by 20% to £110.5m in November 2012 and is now forecast to be 33% lower at £74.2m.

EBITDA projections have fared worse. In July 2012, £38.5m of EBITDA was expected for FY 2013. It came in at a negative £8.8m. For FY 2015, Avanti is now forecast to achieve £38.7m in EBITDA, which is 66% below July 2012’s projected £113.6m and 51% lower than November 2012’s predicted £79.4m.

What is most concerning is the evolution of the group’s net debt profile. Whereas in July 2012, Avanti expected to finish with net debt of £82.7m, this was raised to a forecast £140.9m in November 2012. The final result was £167.2m of net debt, or over twice that forecast a year prior. In July 2012, the group was forecast to be net cash positive by FY 2015, with net cash of £44.8m. July 2012’s projection is now thought to be off the mark by £209.3m. FY2015 net debt is forecast at a whopping £164.5m.

I looked to Avanti’s house broker’s latest research note to learn why the net debt level would remain so sticky over the next few years. The group is projected to spend £20.5m on capex and £2.1m on maintenance capex each year in 2014 and 2015. So a total capex related outflow of £45.2m during the next two years. This will be offset by a forecast £17.7m of operating cash flow in 2014 and a further £40.1m in 2015, or a cumulative £57.8m in operating cash over the next two years. Debt service payments are also projected to be at a cumulative £10.0m over 2014-15. Oddly, despite projecting £45.2m of capex related spend during 2014-15 and anticipating £62.4m in depreciation over the same period, Avanti’s house broker envisages its fixed assets on the balance sheet to increase by £100m from £424.8m in 2013 to £524.0m in 2015. These numbers appear difficult to square and if anyone has any suggestions as to how they can be reconciled I would be interested to hear.

With projected net debt remaining a burden, the group has indicated its ambition to seek access to further debt. Avanti declares:

“The Company continues to investigate some significant new business opportunities, and believes that the flexibility to grow offered by a bond financing structure might be more suited to its medium term needs.  Avanti has accordingly retained advisers to consider bond finance options, with a view to enabling it to respond quickly and positively to these opportunities as they arise.”

One interpretation may be, they need more cash and equity financing is not readily available. What is somewhat more apparent is that the company is still not yet capable of financing growth out of operational cash flows. It can barely service its current debt pile from its existing stock and flow of cash; well last year it couldn’t. It is forecast to be able to service debt out of operating cash in 2014 but unable to cover capex spend. Both net interest and capex are only covered by operating cash by 2015 and even then there is only £13.3m of headroom according to its house broker. In light of the poor forecasting record of Avanti’s broker I would be uncomfortable with that prediction.
     
Assuming that access to further debt financing is forthcoming, I would be interested to learn what the new creditors would have security over. It is the current debt providers, which have “a charge over the assets of the company”. Therefore it would appear that any further debt would be unsecured and therefore more costly. The group currently has an available drawdown of $328.2m with US Ex-Im bank and COFACE, at an interest rate of 5.5%. It is these lenders which have security over the assets of the company. Incidentally the company indicates that practically all of this available facility is now drawn down. With a reported £38.6m of cash on the balance sheet, a projected £28.3m of combined capex and debt service cost scheduled for 2014, the group is likely to be keen to get access to further funding sewn up soon.
   
Some investors may be encouraged that the directors have dipped into their pockets over the last few weeks to purchase Avanti stock. While this may appear promising, this is not unusual in promotions where the price has collapsed. I would also point out that Avanti’s CEO, Mr D Williams, was compensated by £749,693 in total remuneration during 2012, and most likely similar in 2013. Since the year end results, he has bought a further 10,000 shares at 180p, or £18,000 worth of stock. This appears a token purchase compared to the c. 858k shares that directors sold in 2010 at prices of 475p, 700p, and 735p/shr.

I reckon that the debt position is insurmountable for this satellite promotion; particularly as further debt appears imminent. Accordingly, I have increased my short position. 

And another thing ...
No mention of Filiago (still a space oddity). Whatever did become of that?

Avanti share price
Source: Bloomberg
Latest house broker revenue forecasts compared to those from July 2012 and November 2012
Source: Bloomberg
Latest house broker EBITDA forecasts compared to those from July 2012 and November 2012
Source: Bloomberg
Latest house broker net debt forecasts compared to those from July 2012 and November 2012
Source: Bloomberg
Historic progression of consensus revenue forecasts
Source: Bloomberg
Historic progression of consensus EBITDA forecasts
Source: Bloomberg
Historic progression of consensus net debt forecasts
Source: Bloomberg
Disclaimer: The information, discussions or topics referred to on this blog should in no way be considered “advice” to buy or sell anything. The information which may be referred to is freely available in the public domain and where required the source of information is referenced to for verification. While every effort has been made to ensure the veracity of any information contained within this blog, the author accepts no responsibility for the accuracy of any information contained within this blog or for the sources of information which may be referred to. Readers are responsible for their own actions and interpretation of the information contained within this blog.