Mind the Gap
Brexit vote manana. Yellen returns to Capitol Hill. Home sales up. The rent is too high. Puerto Rico sued before pending default. Tesla buys SolarCity. Innovation versus buybacks.
Financial Review by Sinclair Noe for 06-22-2016
DOW – 48 = 17,780
SPX – 3 = 2085
NAS – 10 = 4833
10 Y – .01 = 1.69%
OIL – .82 = 49.03
GOLD – 1.70 = 1267.00
Tomorrow, UK citizens will vote on whether or not they want the UK to remain a part of the European Union. This is the referendum, also known as the “Brexit” vote. While opinion polls suggested the vote was too close to call, betting parlors in the UK put the odds of a vote to remain in the EU at 76 percent. Nevertheless, the whole process has been a source of great uncertainty. The euro currency hit its lowest level vs. the dollar in 12 years. Politicians on both sides of the debate will be making their last arguments today ahead of polling stations opening tomorrow at 7:00 AM London time. We probably won’t know the final vote count until Friday morning, although there might be a decision based on exit polls and early voting trends.
The major issues for Britons who want to leave: sovereignty, regulation, and migration. The major issues for Britons who want to remain in the EU: free trade, investment, unity, and peace. And while the greatest impact will be felt in the UK and the Euro Union, the vote will impact the US as well. The UK is a major trading partner with the US, our seventh largest trading partner last year.
Beyond economic ties, the US government is most concerned about the political instability a Brexit could portend for Europe on the whole. There has been tremendous speculation about how the vote will affect financial markets; everything from a complete crash, to a minor blip, to a big rally. The truth is we don’t know. No states have ever left the EU before, so this is uncharted territory.
Fed chair Janet Yellen was back on Capitol Hill this morning. Yesterday, Yellen delivered her semi-annual Humphrey-Hawkins testimony before the Senate Banking Committee; today she testified before the House Financial Services Committee and she repeated her dovish outlook for the economy. Yellen cited “considerable uncertainty” about the economic outlook, and the potential for a Brexit vote to shake up the markets, she said the employment picture should improve, but she basically took a July rate hike off the table. Yellen once again stressed the word “patience.” The Q&A session following the prepared remarks revealed a few interesting points: Yellen opposes legislation that would force the Fed to reveal the design of its stress tests, she does not think Fed regulations pose much a headwind for business, the Fed plans a conference on student debt, and she said it is not the Fed’s job to boost the stock market. Yellen did ask Congress for help to boost productivity but she wasn’t very forceful; as if she knew there was no chance of Congress doing anything worthwhile.
Sales of previously owned homes increased in May to the highest level in nearly a decade. The National Association of Realtors said existing-home sales rose 1.8% to a seasonally adjusted annual rate of 5.53 million, the fastest pace since February 2007. Constrained inventory continues to dog the market, pushing prices higher. The median price in May was $239,700, 4.7% higher than a year ago.
In a separate report, the Federal Housing Finance Agency said home prices rose 0.2 percent on a seasonally adjusted basis from March, and 5.9 percent in April from a year earlier. Prices rose from a year earlier in all regions, led by the Pacific — including California, Washington and Oregon — with an 8.6 percent gain. The FHFA says the national median price of an existing single-family home was $233,700 in April.
The rent is too high. A new report from Zillow shows that rents across the U.S. are increasing, and not just in the expected regions of New York City, San Francisco and Boston. Overall, rents increased 3.3% year-over-year as of January. In Phoenix, rents are up 5.3% year-over-year.
Puerto Rico is being sued in New York by a group of hedge funds claiming it’s illegally using an emergency fiscal-crisis law to dodge payments that are supposed to be guaranteed by the island’s constitution. While Governor Alejandro Garcia Padilla has not yet implemented a temporary debt moratorium, many speculate he will soon because the territory is expected to default on a payment of nearly $2 billion on July 1.
Elon Musk’s Tesla is buying Solar City from…, Elon Musk. Tesla Motors, made an offer to buy his solar installation firm SolarCity in a stock deal worth as much as $2.8 billion. Tesla shares plunged more than 13 percent in extended trading – amounting to a loss in value of about $4.3 billion, or more than the value of the offer for the other company. Shares of SolarCity rose about 18 percent. After the volatility caused by the news settles down, we’ll be able to see how investors really feel about it. But the move is classic Musk; the chairman of SolarCity, CEO of Tesla and the largest shareholder of both companies, described the deal as a “no brainer”; the company could sell customers an electric car, a home battery and a solar system all at once.
But talk about synergies is just short-term. In the long-term, Musk is trying to build a fully vertically integrated energy company, from energy installation to storage to application. It would be a company that generates power from the sun, stores energy in batteries, and uses those batteries to power cars and buildings. On a conference call this morning, Musk said that the cost of sales for SolarCity and Tesla could drop by potentially half, or perhaps by 30% to 40%. On the solar and battery installation set up side, there would be one crew instead of two to three visits. For ongoing maintenance, there would be one point of contact instead of two to three. The cost of hardware would also be lower.
The plan is not without risk. SolarCity is building a massive solar panel factory in upstate New York; this at a time when energy prices have dropped substantially. Tesla has brought many of its development needs in house, moving away from suppliers as much as possible. With the Gigafactory, its massive battery factory under construction outside of Reno, Nev., Tesla will soon be making its own batteries, too, by bringing that core technology in house. Tesla has taken reservations and deposits for nearly 400,000 Model 3 electric vehicles and now they need to figure out how to manufacture all those cars. And in his spare time, Musk launches rockets into space and plans a mission to Mars. Musk said the deal doesn’t really add debt because SolarCity should be cash flow positive before the end of the year. Still, SolarCity comes with massive debt burdens, and Tesla itself is not cash flow positive.
The SolarCity deal, and for that matter everything about Elon Musk, is risky. Many Wall Street veterans and hedge fund activists seem to hate Musk. At the same time, many Wall Street veterans think the best way for companies to create shareholder value is to scrap spending on research and development and innovation, borrow money on the cheap and buyback their own shares; an obsession with delivering short-term returns to shareholders while ignoring the future of the business.
From 2009 to the end of 2013, corporate investments rose by $400 billion. But those investments were dwarfed by shareholder payouts, which increased by $740 billion. During that same period, companies borrowed $900 billion. The financial system is no longer an instrument for getting money into productive businesses and then increasing profits through growth, but has instead become an instrument for getting money out of them. Consider the differences between two well-known companies, Apple and Amazon. Apple’s stock has lost about a quarter of its value over the last year, despite a bunch of stock buybacks at the urging of former shareholder and billionaire investor Carl Icahn. Apple needs another billion-dollar product, and no one sees one coming down the pipeline. Apple spends 3.5% of its revenue on R&D; Google spends 15% of revenue on R&D; Facebook spends 21% on R&D; Amazon consistently denied shareholder profits in order to reinvest in the business. Now, through that constant reinvestment, Amazon has found itself on the cutting edge of not just e-commerce, but also the cloud computing it developed.
Consider Michael Pearson, the former CEO of Valeant Pharmaceuticals; he cut R&D to single digits. He once said that the unfortunate thing about curing cancer was that there was no money in it. And his philosophy on drug pricing was to charge as much as the market could bear. As a result, he drove the price of two lifesaving heart medications up hundreds of percentage points. In 2014 Pearson said, “there’s only one metric that really counts, and it’s total return to shareholders.” Valeant shares lost 90% of their value. Pearson was fired.
Now consider Elon Musk; he dreams big, he makes the most innovative cars we have seen since the Model T, his products are environmentally friendly, and massive disruptors across several industry sectors (auto, energy, space); and now he faces one of his biggest challenges. Institutional investors own more than 63% of Tesla shares. Tesla is not following standard procedures on this deal. Musk owns 21% of Tesla and 22% of SolarCity; his cousin, Lyndon Rive, is a founder and the CEO of SolarCity. There are already charges of a potential conflict of interests. It does not appear that Tesla or SolarCity truly formed an independent committee or hired independent counsel. It is a good bet that shareholder lawsuits will be forthcoming. Whether the deal falls apart or not, you should appreciate that we are watching one of the most compelling characters and one of the most remarkable business stories. Musk, Tesla, SolarCity, and the deal could be the next great thing, or it could all come crashing down harder than a SpaceX Falcon rocket, but it is hard to take your eyes off whatever unfolds.