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June 2011
It's Dj V All Ovr AgaiHow to be ready when the cheap capitalenvironment ends
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Published by Corporate Finance Advisory
For questions or urther inormation,please contact:
Mac [email protected](212) 834-4330
Eva [email protected](212) 834-5110
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It's DJ Vu All oVEr AgAIn | 1
1. Dj vu
A modern-day Rip Van Winkle arising rom a ew years o slumber would hardly be ableto tell rom the current capital markets environment that the world just experienced a
historic nancial crisis. Crrt markt coditios ar, i may ways, rmiisct o
th big markt coditios o 2007. Volatility and cost o debt are low, highly-levered
buyout deals have returned and the credit market penalty or being more levered is once
again minuscule.1 At the same time, however, the atermath o the nancial crisis has let
consumers and governments weaker and on a slow path to recovery.
While we do not know i this disparity between corporations, consumers and governments
is a precursor to another asset bubble, or even another crisis, we recommend thatdecision-makers prepare or this possibility. By understanding the dierences between
2007 and spring 2011, and by taking advantage o todays relatively benign capital markets
conditions, rms can proactively manage these risks. Key executive takeaways are:
1) Todays capital markets are reminiscent o the spring 2007 capital markets
2) Corporate balance sheets are stronger than they were pre-crisis
3) The U.S. consumer and OECD governments have little monetary and political exibility
let to manage a new crisis
4) In light o the uncertain existing economic and political environment, the cost onancial insurance and liquidity seems low. This has implications or capital allocation,
M&A, nancing, risk management and shareholder distributions decisions
2. The 7/11 Quiz
To understand the similarities between the capital markets environments o spring 2007
and 2011, we suggest reviewing the 7/11 Quiz in Figure 1 below. The middle column high-
lights the state o some key nancial metrics at the peak o the crisis in early 2009. The rst
and third columns show metrics or the springs o 2007 and 2011, but we have mixed themup. Which os rprst 2007 ad 2011?
Fie 1
the 7/11 qiz
Capital markets have improved to the point where many indicators are indistinguishable rompre-crisis time
1 For historical cost o capital and volatility data, see appendix.
Source: Bloomberg, FactSetNote: Data is rom the average o month-end data in March, April and May 2007; January, February and March 2009;
and March, April and May 2011.1 J.P. Morgan High Yield 100 Index.
2007 2011? 2009 2007 2011?
VIX Volatility Index 14.0% 45.1% 16.0%
High-Yield Index1 6.8% 17.6% 7.4%
A to BBBspread 93 bps 226 bps 71 bps
T-1 to T-2 CP Spread 12 bps 130 bps 21 bps
LBO Leverage 68x 68x
Ination Rate 2.7% -0.1% 2.6%
Brazil CDS 72 bps 355 bps 107 bps
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2 | Cpae Fiace Adviy
Volatility14% i 2007 vs. 16% i 2011: The events o the past ew months in the Middle
East, Japan and Europe have once again highlighted how rapidly nancial markets can
move rom calm to ear or even panic. The VIX Volatility Index, a commonly-used metric
to measure equity market uncertainty, is the implied volatility o options on the S&P 500
Index. This index tends to jump when economic uncertainty roils equity investors. Despite
the tumultuous events we have experienced over the past ew months, the spring 2011 VIX
was still below the long-term historic averages and close to where it was in 2007.
Cost o high-yild dbt7.4% i 2007 vs. 6.8% i 2011: The low cost o high-yield debt
capital in the spring o 2011 has been one o the strongest indicators o how benign capital
markets have been. The cost o issuing high-yield debt this spring has not only been much
lower than the 17+% in early 2009, but it actually reached all-time historic lows.
Cost dirc btw strog ad wak ivstmt grad71 bps i 2007 vs. 93 bps i
2011: In tumultuous credit markets, investors tend to strongly dierentiate between strong
and weak credits. In a benign market environment, while borrowers with weaker credit
qualities still pay up relative to borrowers with stronger credits, the dierence in cost is less
pronounced. At 93 bps, the spread between BBB- and A rated borrowers is quite close to
where it was in the spring o 2007.
Cost dirc btw Tir 1 ad Tir 2 Commrcial Papr (CP) borrowrs12 bps i
2007 vs. 21 bps i 2011: At the peak o the crisis, investors shied away rom CP issued byborrowers that did not have the best credit (Tier 1). At that time, Tier 2 borrowers paid 130
bps more than Tier 1 borrowers. Today, Tier 2 borrowers pay about 21 bps more than Tier 1
borrowers, a level that is much closer to 2007 and historical norms.
Lvrag lvl o LBOs6 to 8x i 2007 ad 2011: Another sign o the vibrancy o credit
markets is that private equity rms are, once again, able to consider nancing leveraged
buyouts with 6 to 8x leverage (i.e. leverage levels where the quantum o debt is 6 to 8
times EBITDA). Though leverage levels are similar to what they were in 2007, today's
transaction sizes are considerably smaller than the mega-deals that could successully be
executed prior to the nancial crisis.
Ifatio2.6% i 2007 vs. 2.7% i 2011: Averaging 2.7% over the last ew months, todays
ination rate is very similar to what it was prior to the crisis in the spring o 2007.
Brazil CDS lvls72 bps i 2007 vs. 107 bps i 2011: When markets are uncertain,
investors traditionally become more concerned about the incremental risk o investing in
emerging markets. For example, at the peak o the crisis, the Brazil CDS levels jumped to
over 350 bps. They have since dropped to about 107 bps, close to where they were in 2007
beore the crisis.
In summary, the capital markets environment this spring was in many ways indiscernible
rom beore the 20072009 crisis. A variety o technical and undamental actors are
driving this perormance: pension unds have broadly reallocated capital rom equities to
xed income, the low interest rate environment has driven demand or yield across asset
classes and ast-growing emerging economies have brought new capital into developed
economies rom both sovereign and individual investors. Despite the rothy capital markets,
the economic environment today remains drastically dierent rom beore the crisisa act
that senior decision-makers should consider when developing their nancial policies.
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It's DJ Vu All oVEr AgAIn | 3
3. It's Dierent Now
As we showed in Figure 1, many capital markets parameters are close to where they were inthe spring o 2007. In act, some parameters, such as the cost o corporate debt nancing,
are even lower than they were in the spring o 2007, a period renowned or its liquidity
glut. How dierent is the strength o the major economic actors in our economy, i.e. large
corporations, consumers and the government, today relative to 2007? More importantly,
how prepared are these groups to sustain another crisis?
Fie 2
lae m ppi he ecmy a he maj ac emai weak
Larg u.S. ad eropa Corporatios
With pressure on revenues, protability and credit markets, global recessions do nottypically improve a rm's nancial position. Ironically, however, as a result o the recent
crisis, large non-nance companies took signicant measures to strengthen their balance
sheets beyond historic norms. These measures included cutting costs, acquisitions and
shareholder distributions, while raising liquidity and extending maturities. This ocus on
ortress balance sheets has resulted in historic high on-balance-sheet cash levels and low
leverage, in particular or U.S. rms. What are the key takeaways o these strong corporate
balance sheets?
1) Should a double-dip recession emerge, large cap rms will, on average, be even better
prepared to weather the storm than they were prior to the recent crisis
2) Large rms will experience signicant pressure rom investors and activists to use their
balance sheet exibility to be more aggressive rom an acquisition, investment and
shareholder distribution perspective
3) With limited large nancing needs, credit investors will continue to crave opportunities
to nance the most creditworthy rms putting downward pressure on nancing costs
Source: J.P. Morgan
Cme
1) Wealth down 10%
2) High unemployment
3) Less condence
gveme
1) Ballooning debt
2) Decits meaningully higher
3) Ratings under pressure
lae Fim
1) More cash
2) Improved interest coverage
3) Extended maturities
Ecmic & capia
make evime
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Fie 3
lae u.s. cpaicah ich ad e h-em deb
U.S. corporate balance sheets are strong
Fie 4
lae Epea mcah ich ad e h-em deb
Equally strong European corporate balance sheets
Th Cosmr
The consumer is a main actor in any economic recovery. A strong and condent consumer
leads to stronger corporate and government sectors. According to some estimates, about
70% o the U.S. economy is consumer driven.2 Compared to corporations, however, the
recovery o the consumer has lagged and remains ragile.
1) Unemployment rates remain elevated and labor participation rates have dipped.This trend suggests that the headline unemployment rate signicantly understates
the true level o unemployment, as many people have simply stopped looking or
jobs and dropped out o the calculation
2) New lows in home price indices not only contribute to lower household net worth,
but also limit employee mobility because o the large percentage o underwater
mortgages. This, in turn, drives higher unemployment rates and also limits access
to personal credit and consumption
Fie 5
the u.s. Cmepe ha i 2007 ad i heai m he cii
Consumers still reeling rom the crisis due largely to weakness in the housing and labor markets
Source: Bloomberg; J.P. MorganNote: Figures calculated using 2007 FTSE 100 EURO constituents rolled orward based on aggregate data.
FtsE 100 Euro (ex. Fiacia) 2007 2011
Debt/EBITDA 1.8x 2.1x
Coverage Ratio 11.0x 10.4x
Cash/Total Assets 7.1% 8.2%
Short-term Debt/Total Debt 30.6% 25.0%
2 Based on the Bureau o Economic Analysis estimate o U.S. personal consumption expenditures.
Source: FactSet; Bloomberg; J.P. Morgan
Note: Figures calculated using 2007 S&P 500 constituents rolled orward based on aggregate data.
s&P 500 (ex. Fiacia) 2007 2011
Debt/EBITDA 2.1x 2.1x
Interest Coverage Ratio 9.5x 10.5x
Cash/Total Assets 8.2% 10.8%
Short-term Debt/Total Debt 22.9% 16.8%
Source: FactSet; Bloomberg; CoreLogic; Federal Reserve; J.P. Morgan
Includes prime and subprime mortgages, securitized and non-securitized loans, xed and adjustable loans
and agency and non-agency debt.
Conerence Board Consumer Condence Index.
Cme Baace shee 2007 2011
Unemployment 4.5% 9.1%
Mortgages Underwater1 6.9% 22.7%
Consumer Condence Index2 108.5 60.8
Household Net Worth $64.2 trn $58.1 trn
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It's DJ Vu All oVEr AgAIn | 5
OeCD Govrmts
The nancial position o sovereign entities has deteriorated signicantly since the crisis
began in 2007. For example, the U.S. debt to GDP ratio has exploded rom 62% to 100%.
Furthermore, with a current decit to GDP o 10.8% in the U.S., the debt to GDP ratio
is projected to continue to balloon. This trend is equally evident in several large EU
economies, all o which are currently experiencing signicantly higher debt loads and more
signicant budget decits than in 2007.
1) Should another crisis occur in the near term, sovereign entities in OECD countries have
limited capacity or desire to be as proactive as they were during the recent crisis
2) Sovereign entities will continue to be pressured to reduce their involvement in the
economy with a potential "near-term" negative impact on economic growth,specically or industries that depend on government spending
3) Sovereign entities will continue to seek sources to increase tax revenue which could
be ocused on industries that have outperormed
4) Because some o the sovereigns, especially the U.S., are very short-term nanced,
rising rates would lead to a signicant increase in nancing costs
5) While the U.S. government has oversized debt obligations, its cost o debt (i.e. Treasury
yields) is signicantly lower than in 2007
Fie 6
oECD gvemeie fexibiiy e
...sparking debate over credit worthiness
Source: International Monetary Fund; J.P. MorganNote: 2011 gures represent IMF projections as o April 2011.
u.s. Baace shee 2007 2011
Debt/GDP 62.2% 99.5%
Decit/GDP 2.7% 10.8%
S&P Credit Rating AAA/Stable AAA/Neg
Federal Employees/Total 19.9% 21.9%
Deb/gDP Deci/gDP
Eu Baace shee 2007 2011 2007 2011
United Kingdom 43.9% 83.0% 2.7% 8.6%
France 63.8% 87.6% 2.7% 6.0%
Germany 64.9% 80.1% (0.3%) 2.3%
Spain 36.1% 63.9% (1.9%) 6.2%
Source: FactSet; Bloomberg; International Monetary Fund; Bureau o Labor Statistics; J.P. Morgan
Note: 2011 debt/GDP and decit/GDP gures represent IMF projections as o April 2011.
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4. Lessons or when the music stops
With consumers and governments likely to remain weakened by the crisis or years tocome, how should senior decision-makers consider todays very benign capital markets?
The range o orecasts, as well as the last ve-year experience or the 10-year Treasury,
the USD/EUR exchange rate, oil prices and the S&P 500 level, are summarized in Figure 7.
Together, these ranges suggest that we should continue to consider a wide array o
possible economic and capital markets outcomes when making nancial decisions. Our
recommendations are:
Capital allocatio
Takeadvantageofcurrentcapitalmarketsopportunitiestolockinalowcostofcapitalor major projects
Considertoday'slowcostofcapitalwhenallocatingcapital,buttakeintoaccountthe
likelihood that long-term cost o capital is likely to be higher than todays, particularly
i unding needs are ongoing
Evaluatenewprojectsinthecontextofmorepronouncedcyclicalityandnew
emerging risks
Mrgrs ad acqisitios
Takeadvantageofcurrentcapitalmarketsconditionstobuildaplatformthatwillallow
or strong returns through cycles
Withstrongerbalancesheets,rmsmaybemoreproactivefromanM&Aperspective
than they were beore the crisis. Prepare a deense strategy that will allow or
unexpected overtures rom acquirers and activist shareholders alike
M&Atransactionshavealongleadtime.DevelopanM&Astrategyearly,includingthe
preservation o nancial exibility, to make sure opportunities can be seized on short
notice during the next major downturn
Fiacig
Donotpostponemajornancingneedsforprojects,M&Aorshareholderdistributions
Continuetoconsidertheentirenancingtoolbox,includingdebt,convertibles,hybrids,
equity and the bank market, when making nancing decisions
Donotaddleveragejustbecausedebtischeap;opportunisticallytakeadvantageof
todays conditions to extend maturities and achieve the optimal leverage levels
Sharholdr distribtios
Adoptdividendpoliciesthataresustainablethroughcyclesandassessliquiditybased
on realistic downside scenarios while returning excess capital to shareholders
Atransparentcapitalreturnpolicymayattractanothersetofinvestorsandachievea
better valuation (particularly in a down cycle)
Continuetoprioritizestrategicopportunitiesoverdistributions
Risk maagmt
Planforthefuture,takingintoaccountawidevarietyofoutcomes
Inthecontextoftheperceivedeconomicandpoliticaluncertainty,buyinginsurance
either through options or by raising liquidity seems inexpensive
Takeintoaccounttheinteractionofriskmanagementwithcapitalallocation,leverageand liquidity decisions
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Fie 7
Aay expecai ae vaied ve he ex yea
Source: Bloomberg; gures as o 5/31/11. Estimates all as o Q2 20121 Figures implied by one standard deviation moves o the S&P 500 based on current option-implied volatility o 15%.
7%
6%
5%
4%
3%
2%
1%
0%
2012Current
5.5%
(+80%)
5.3%
3.2%
(+5%)
2.1%3.0%
$2.00
$1.75
$1.50
$1.25
$1.002012Current
$1.19$1.18(-18%)
$1.52(+6%)
$1.44
$1.60
$150
$125
$100
$75
$50
$25
$02012Current
$117(+14%)
$90(-12%)
$146
$31
$103
1,600
1,400
1,200
1,000
800
600
4002012Current
Max analyst estimate Min analyst estimate 5-yr historic range
1,5481
(+15%)
1,1421
(-15%)
1,565
677
1,345
Long-term rates (10-yr U.S. Treasury yield)
Oil prices ($ per bbl)
Equity prices (S&P 500)
Exchange rates ($USD/EUR)
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5. Appendix
Fie 8
C deb ea hiic w ad c capia cve eay a fa a i 2007
Historically low Treasury yield driving low cost o debt
Fie 9
Vaiiy ha eed pe-cii eve depie ece epiica mi
VIX Index
Source: Bloomberg based on weekly observations as o 5/31/11
Sep. 08: Lehman Brothersbankruptcy
Historical average: 20.2
80
70
60
50
40
30
20
10
0
1990 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
VIX volatility index
1-yr rolling average
Source: J.P. Morgan, Bloomberg
Note: Calculations perormed using average 10-yr U.S. Treasury rates, cost o debt and market risk premiums (basedon J.P. Morgan estimates) or BBB and BB industrial rms. Assumed current BBB beta o 1.0 and relevered beta o 1.5
or BB WACC. Implied debt/cap ratios or BBB and BB ratings based on rating agency guidance. Marginal tax rate o 35%
adjusted or Moodys deault rates. 2011 gures reect year-to-date averages as o 5/31/11.
17%
15%
12%
10%
7%
5%
2%
Yield
10-yr U.S. TreasuryBBB industrial indexBB industrial index
1992 1994 1996 1998 1999 2001 2003 2005 2007 2009 2011
Diference in BBB vs. BB WACC over time
11%
10%
9%
8%
7%
6%
BBB WACCBB WACC
2001 2003 2004 2006 2007 2008 2010 2011
Source: Bloomberg. Data through May 2011
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This material is not a product o the Research Departments
o J.P. Morgan Securities Inc. ("JPMSI") and is not a research
report. Unless otherwise specically stated, any views or
opinions expressed herein are solely those o the authors
listed, and may dier rom the views and opinions expressed
by JPMSI's Research Departments or other departments or
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Copyright 2011 JPMorgan Chase & Co. All rights reserved.
We would like to thank Akhil Bansal, Tomer
Berkovitz, Stephen Berenson, Ben Berinstein,
Phil Bleser, Mark De Rocco, Veronique Ferguson,
Adetola Lawal, James Luo, Santiago Roel Santos,
James Rothschild and Anca Tohaneanu or their
invaluable comments and suggestions. We would
like to thank Jessica Vega, Anthony Balbona,
Jennier Chan and the IB Marketing Group or
their help with the editorial process. In particular
we are very grateul to David Laword or his tire-
less contributions to the analytics in this report
as well as or his invaluable insights.
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