Buckle up – the wheels have come off
The Saturday print edition headline went something like “Fed intervenes: Too little, Too late” in reference to this past week’s multi-billion capital injection by the U.S. Federal Reserve Bank.
I agree with The Globe & Mail’s sentiment vs. the normal situation where they agree with us (see various posts including ““It’s all about ‘alchemy’“, July 20-07, “News flash!: Dead Tree Media unearths connection between subprime and corporate debt”, June 27-07, “Is imitation truly flattering?” June 16-07, “Henry Kravis might be wrong“, June 6-07, “Kravis, the Globe and us”, June 2-07).
The Fed should have known back in July (see post “‘Panic’ sets in to the debt markets”, July 29-07) that banks on this side of the pond had decided to cease buying anything but overnight paper from European banks, if that. A dramatic change from their traditional relationship. So, if our banking system had pulled the plug on credit for Europe, you’d assume that the Europeans had done the same to North American institutions.
I used the word “panic” last month as that was exactly what I was told was the mood around the banks’ trading and funding desks. Why didn’t the Bank of Canada get the same feedback? The Globe Saturday editorial reports on the “panic” here. CNBC finally found an economist using the “panic” word here.
Bringing liquidity two weeks late might not be a timely Fed move, and frankly seems more in reponse to the reactions in the stock market than the credit market. But it did calm things on Friday.
Which brings us to Home Depot (HD:NYSE). Home Depot is unwittingly at the centre of this entire debacle, and it can’t come as a surprise that the sale of its supply business to private equity concerns is on the rocks, or certainly subject to a price reneg.
The economic growth of the past few years has largely been driven by the consumer. But it hasn’t been wage increases that have driven the run, as inflation has been running in the 2-3% range for the entire decade.
House prices have been the key driver to the increased sense of wealth folks have felt. Whether it be the U.S. “working poor” buying a first home with a subprime mortgage or the middle class doing renovations with a home owners’ line of credit (a home equity line in the U.S.). For several years, billions of dollars of mortgages have been issued against appraisals reflecting an increase in home values. They come under many names, such as equity re-fis or cash out refinancings.
In the third quarter of 2005, for example, Freddie Mac in the U.S.A. reported that 44% of new mortgage applicants were of the equity re-fi type. US$60.4 billion that quarter, about steady with US$60.7 billion during the prior quarter.
Where did that money go? Renovations, furniture, landscaping, HDTV televisions, the usual places. The trickle down effect was flawless and effective. The renovators raised prices and brought new Ford F-150 and F-350 trucks, ensuring it would remain the best selling truck during the period even as the price of a U.S. gallon of gas rose from $1.00 to $2.75. The materials for these new homes and restorations came from chains such as Home Depot, driving that stock price from $21 at the beginning of 2003 to $39 at the end of 2006.
Louis Vuitton raised the price of a basic handbag from $285 in 2002 to more than a $1000 today. Brioni suits went from $2100 to $4000 without a hint of a consumer riot. Hotel chains were easily able to charge $100 more for the same room nary a year later; didn’t even upgrade the comforter. Airlines raised a business class ticket from North America to London, U.K. from $2400 to more than $4800. An economy flight between Toronto and New York went from sub $700 to more than a grand.
Restaurants changed their pricing policy on wines from the traditional 100% markup to 150% or 200% in many cases; even if it was too early to drink a 2002 Pomerol. Firms such as Restoration Hardware suddenly grew by leaps and bounds, unable to build a supply chain fast enough to meet the inventory needs of their popular stores.
With interest rates down to 30 year lows, companies were able to grow profits, despite the challenges they might be having with their own increasing input costs.
Which brings us full circle to Home Depot. In response to falling operating margins (Q1 fell to 8.5% from 10.65% for 2007) and weaker sales, the decision was taken to take advantage of the “Golden Era of Private Equity” (see post “KKR Founder Henry Kravis on PE climate“, May 29-07) and sell their supply business to a consortium of buyout shops. The use of proceeds? Buy back shares that were waning as a result of the drop in new home construction and renovation activity due to falling home prices and increased interest rates. Makes sense if you believe this industry swoon is a very temporary thing.
Which it may well be. As large as equity out re-fi figures are (US$200 billion for 2005) they are still a small percentage of U.S. GDP (US$13.2 trillion in 2006). In theory, removing those dollars from the retail chain won’t change the 2008 U.S. economic growth forecast more than a few basis points.
But as we’ve seen over the past few weeks, in the wake of the Dow Jones hitting 14,000 for the first time, a reduction in confidence among global lenders has an immediate effect on the capital markets. Doing away with the “cov-lite” deals is one positive outcome, but it’s still a bit embarrasing that huge Wall Street banks needed an excuse like this to tell their favoutire P.E. clients that they were returning to more traditional credit disciplines. The lemming effect goes both ways.
The next move may well be reductions in economic growth forecasts for 2008; what else can an economist do, other than holler for a rate cut as Cramer and Kudlow are wont to do? As recently as July 26th, the International Monetary Fund had U.S. growth increasing to 2.8%, up from 2.0% in 2007 (which is a far cry from 2006’s 3.3%). The IMF forecast was updated barely two weeks ago, but things are changing rapidly.
For the rest of us, all we can do is wait this out on an individual basis. What else can you do?
Professionally, we are very much in business with five signed term sheets on the go. Each time we look at a new story we ask ourselves what would a recession do to the financials of a prospective client, haircutting EBITDA forecasts by 25, 50 or 100% as a downside case? Naturally, the profile of the end customer base and the sector they operate in are crucial determinants. Right now, we’d probably prefer exposure to the domestic mining industry than a North American autopart maker. And tech is always a fav.
Overall, our wicket is still open, despite the growing global credit crunch.
But buying the Home Depot supply chain business against this backdrop? More than 70 bankrupt subprime borrowers and a doubling of the U.S. mortgage default rate across the board. On the bright side, many of the home builder stocks, such as MDC and NVR, are actually up on a 12 month basis. It’s a marquee name, this is true. But if there are dramaticaly fewer new mortgages and equity re-fi’s, who is going to drive the revenue?
Ignoring panic is tricky business.