Tuesday, October 9, 2018

Brazil, the security vote

The results of the first round are in, and they represent a major rupture with the past.  While many commentators stressed that these reflected a rejection of traditional politicians tainted by corruption, I would suggest that, more importantly, these elections are a cry, or a scream, for security.

No doubt Brazilian voters sent many political tenors home, including Dilma Rousseff, a former president, Eduardo Suplicy, a co-founder of the PT; of nine returning candidates for the senate who had been under a cloud, only three were reelected.  Voters desire to clean up Congress triggered an historical turnover, with more than 47% new faces coming in.
 
The door was also shown to moderate presidential candidates who were not viewed as corrupt and who had fared well in prior national campaigns: Geraldo Alckmin, a former governor of Sao Paulo got 4.8% vs. in 41% in 2006; Marina Silva, a former minister, 1% vs.  19% in 2010.

Voters, who had remained undecided for the longest time in years (45% vs. 20% to 30% in the past), or perhaps had not disclosed their preferences, sent a clear message: we want big change, now, and we don’t think regular politicians are up to it. 

And the biggest change that Brazilians are clamoring for is security.  In a 10/2/18 Datafolha poll, 88% of respondents declared to feel unsafe; that is a staggering number and was their No.1 concern.  This time around, incoming military-related congressmen are double the number of those in the current assembly.  Bolsonaro is a former military himself and has made security the focus of his campaign.  Today, Jaques Wagner, a PT grandee, was reported[1] to have advised Haddad to do likewise ahead of the second round.

Military and ex-policemen and women are not elected to tackle public budgets.  They are elected to reestablish law and order.  Except for G. Alckmin, presidential candidates spent very little time presenting an economic program.  When Paulo Guedes, a free-market Chicago Boy[2] tried to present a possible future tax reform, he was promptly shut down by his boss, Bolsonaro. 

Economists will lament the lack of a serious discussion of the dire state of the Brazilian economy.  But in truth, there can be no sustained and vigorous economic development without, first, public security.

Which private business, small or otherwise, will invest large financial and human resources into projects that have a three to four year payback period if its owners, managers and staff feel under constant danger for themselves or their families, and occasionally think about emigrating in search of a better life?

In the 1980s and 1990s, Colombia lived through similarly difficult times.  People in the big cities and the countryside felt under constant threat from narco-guerillas, gangs and petty thieves.  In 2002, incoming President Alvaro Uribe initiated his key Policy for Democratic Security (PSD).  It was carried out within the framework of a functioning democracy, it succeeded and the economy soared.

I believe that both Bolsonaro and Haddad understand that this is their biggest challenge and what the people want.  They must also understand that the people will give either one a wide berth on other policy issues as long as security is returned.


[1]  In the Folha de Sao Paulo.
[2]  A 1979 PhD in economics from the University of Chicago.

Monday, October 1, 2018

Latest back of the envelop look at GE?


Yesterday evening, after having witnessed the GE stock price tank for a week, I decided to take another look at the company and try to come up with a rational “back-of-the-envelop” valuation.  My basic premises were that (1) the company had valuable businesses, (2) the world appetite for electric energy would keep growing, and (3) for the foreseeable future, renewables couldn’t displace fossil fuels, in particular natural gas.

My conclusion was that, under this set of assumptions, GE seemed undervalued by a wide margin.  The announcement today that a new CEO with successful experience at running an industrial conglomerate had been appointed only reinforced my views.

The valuation methodology was as follows:

·        Using market value for Baker Hughes  A GE Company since its stock is publicly traded,

·        Looking at competitors for the Aviation, Healthcare and Renewable Energy divisions,

·        Taking a mixed approach for the Power division,

·        Valuing GE Capital at zero.

Baker Hughes

I applied a modest 15% control premium since GE owns 61% of the company.  This yields a $26 billion value for GE’s stake.

Aviation

The comparable here was Safran, the French company which is also a 50/50 partner with GE in the commercial jet engine business.  The benchmark used was Enterprise Value (that is market capitalization + debts – cash) to Revenues.  For each division, I had to come up with an estimate of each division’s debt.  I am sure that my allocation of GE’s debts of $34 billion, ex-GE Capital, among each division was wrong, but overall, it probably doesn’t substantially change my conclusions.  Aviation was thus valued at $74 billion.

Healthcare

This was the most critical valuation, as it assumes that GE will successfully develop its imaging, life science and IT activities.  If it does and commands the same kind of valuation as companies such as Baxter International, Medtronic or Stryker, then I put its potential value at $82 billion.

Renewable Energy

Real difficulties start here as international competitors such as Vestas, Siemens Gamesa and Nordex carry widely different valuations.  In the end, I chose Siemens Gamasa as the more comparable given its size and low profitability.  This gave me a $4 billion valuation.

Power

The most difficult division to value given its gloomy medium-term prospects and the excessive price that GE paid for the power assets of Alstom.  Still, the assets of that division were listed at $71 billion.  Today GE announced that it was writing off $23 billion of goodwill, a good deal related to the Alstom acquisition.

Possible valuations using estimated book value, multiples of revenues and p/e multiples based on future estimated normalized profits range from $49 billion to as low as $8 billion.  In the end, I thought $15 billion was a reasonable number.

This sum of the parts exercise gets us to $201 billion, or $23/share.  Again, this is not a measure of GE’s performance today, or of its best long-term potential; it is a rough estimate that incorporates a moderate turnaround at Power and a market valuation for a stand-alone Healthcare.

Indeed, if I am correct, there may never be a spinoff of Healthcare; for that reason, and unless the new management can convince investors that they will be very successful at allocating capital and running a multifaceted company, the market may impose a conglomerate discount of 10% to 15% on GE.

I also didn’t make any adjustment for yet unfunded pension liabilities, but I didn’t take into account any cash holding either.  Could this and other as yet unidentified pitfalls subtract from our estimate?  Yes.  Would a $20 billion provision cover such “unknown”, I would think so.

In summary, GE’s reasonably optimistic medium-term valuation should range between $201 billion ($23/share) and [$201 bn - $20 bn]x85%, i.e. $153 billion ($17.6/share).  The current share price of $12 seems low to me.