Together with Reorg |
|
Welcome back! Recently, I've been stewing a bit on going deeper in my investment analysis process. So much of the materials provided to investment professionals are surface level in nature and require much more in depth thinking. Over the next few months, I'm going to write a bit about some of the "second-level" considerations you need to consider when making an investment decision. For today, here's some of the thinking I contemplate when evaluating how catalysts or trends cause a bond to trade higher (or lower), or can provide a homerun direct lending underwrite (or a total wash). |
|
A message from Reorg: Access European Direct Lender Rankings |
|
Reorg, the premier global provider of credit data, analytics, and intelligence, recently released its latest edition the European Direct Lender Rankings. These league tables analyze and compare direct lender activity across deal count, sector, sub-region, debt size and more. |
To access the full report, including over 20 unique sets of rankings, on our website, follow this link |
|
|
A lot of markets based investing and more thematic based 4-5 year direct lending transactions are based on being to successfully identify 1) catalysts that change the story and 2) understanding and quantifying trends that will take place in the future (both good and bad trends). How much weight you put in the catalysts is dependent on the execution of the management team and financial sponsors. You'll need to have some goalposts you need to hold them by…because it can be a tale of two cities. You can have stories where you're getting quarterly updates on how their progress is going, with hard data on the costs associated with the project and KPIs regarding how far along they are. They're either on track or they're not, and the financial returns are either flowing into cash flow, or they're not. Secondly, a company can give you all of these same datapoints and KPIs and post an incredibly unimpressive result. This is an example of poor execution and poor capital allocation. In a world where capital is scarce, and where capital structure profiles can get dicey in a moment, trusting management teams and sponsors to make the right capital allocation decision is pivotal. I often think the companies that are unable to make the pivot or execute are generally companies dealing with such enormous pressure that no matter what they do it won't make too much of a difference. The phrase for that is called "moving chairs on the Titanic". Doing and caring about little, meaningless things that don't matter when the ship is sinking…. |
|
In terms of understanding trends…it's all about understanding where the puck is going... |
|
Here's some quick frameworks to think about: |
1) Is this bump in revenue a short term trend? Post-covid was the best example of seeing short-term trends fall apart. This was a great example of seeing temporary trends instead of fundamental shifts. Parsing together how many years of demand were pulled forward is a fun, but "knife falling" exercise. |
2) Capex is coming down (is that good or bad?). Some companies need to increase growth capex in order to remain competitive. Businesses with high capital intensity but highly competitive dynamics are not good businesses. It would be much more appealing to see a surge in capital intensity if you knew coming out of the spend that the company would be coming out the other side as a monopoly or duopoly. Even an oligopoly may not be enough to justify the spend. |
3) Interest rates are coming down (floating rate structure). As interest rates have risen, companies with a high floating rate structure that don't have material interest rate hedges have been worse off. But of course, on the way down this might be a great catalyst for these companies. I've tried to be thoughtful personally about which PA equities would be big beneficiaries of rates coming down. This basket could see a meaningful bump in earnings and FCF if financing costs go down. However, rates seem a little stickier now than people thought a month ago. |
4) Cost savings/initiatives can be great when assessing a bloated organization, or an organization that needs to be simplified. This is a core part of a lot of private equity LBOs or mergers. In order for the math to work and for the free cash flow spigot to turn on, there has to be some sort of operating leverage. While some corporations are understaffed and cut to the bone, there's plenty of organizations that are very bloated and are full of people "having meetings about meetings" and a bunch of middle management non-revenue producers. There's certainly real potential to rightsize if the latter is the case. |
5) New verticals are an important part of the value creation thesis. It's just a question on when it ramps up, the margin profile, contract length, stickiness, how easy it is to upsell/cross-sell to clients etc. |
6) The decline in revenue and earnings are stabilizing, or improving faster than people expected: Numbers being "less bad" than people expect can actually be a big catalyst. While it's important not to "catch a falling knife" there's a point where demand trends may normalize or revenue may find a floor. When I think about some of the cuspyier high yield names with public equities, sell-side research will typically overestimate numbers as the business (and stock) is in a free-fall, but then once the business finally finds a floor, the street may be caught offside because generally there was probably a "short squeeze" that occurred in conjunction with the stabilization of the business. |
7) Demand was elevated due to ____: Some temporary spike or surge can drive a one-time or short lived event that sends results higher, but recognizing what's sustainable vs. what's a blip or fad is how you keep your head. |
8) Revenue is declining and management doesn't have a clue. This happens – sometimes you may have more of a clue than management. Yes, I truly mean this. There's plenty of instances where the market or existing investors have realized management has been caught offsides (maybe they're pricing a product too high, spending too much money while cash is projected to shrink a year from now, focusing on something stupid instead of paying down debt, etc.) If you tell a company "hey your leverage is too high" and they say "nu-uh" your argument might actually end up getting vindicated if management keeps fumbling around. Obviously though as a lending or equity partner, you want the companies you give money to to succeed, but sometimes you need to accept they may not be listening to you and use that as an opportunity to take action. |
9) There's a new product in the market and innovation: Unfortunately, when you're a middle-market sized company there's a lot larger, highly scaled companies that can launch something with incredible scale, ease, and at a lower price point than what you're offering. If you're in some space that involves digital innovation, then you are subject to upstarts that can try to take share from you. This brings me to my next point. |
10) The world is shifting digital: This is undeniable. There are things we do online or on a computer that are never reversing. The amount of content we consume digitally instead of on the radio or via a cable cord isn't going to decrease. The amount of things we're going to be able to do on our iPhone is only going to increase. Do not bet against this. If your business is subject to this, then it's all about managing the decline and trying to find new ways to get in front of your users and provide value. Companies with cloud computing, AI, e-commerce, software, and digital service offerings are big beneficiaries. Technological disruption is eroding several legacy businesses such as Retail and Media. |
11) Geopolitical volatility or concentration on one specific supply chain: Sometimes companies say "Ya so if tariffs go through we'll just pass along the price to the consumer" – I view this as an inadequate answer unless you're highly scaled operator. As we've seen the past year or so in a lot of names, there's a point where you can't just push price aggressively year after year. Not everything is a 1 =1 effect. There's definitely some level of margin degradation that would take place if tariffs rise. For example, there's several examples of retailers or consumer goods companies who were very poorly equipped for a rise in tariffs and who arguably haven't done enough to mitigate a potential round 2 of tariffs. Having a poorly diversified and heavily concentrated supply chain can be a massive negative catalyst. Think about this as we near a potential change in President. |
12) Regulatory changes: There are several industries that are regularly exposed to potential changes in rulings and regulations. Having a head on a swivel is important, because management might not include this in prepared remarks. It will be up to some analyst to ask about this on calls sometimes. Healthcare is one particular industry that is highly dependent on changing regulations. Given how expensive it is for the consumer (and government), and given that the stakes are enormous, they're always under a heavy microscope. |
Absolute dominance by a competitor may make efforts to compete futile: |
The best example I can think of is Netflix. By brute force, by being the first mover, by loading up on an endless amount of content (even if content quality suffered), and by initially convincing competitors to give all their content to them, Netflix was able to begin their building blocks masterplan of being the new cable. Anyone who has the "know where the puck is going mentality" could see that eventually Netflix was going to get into entertainment such as reality TV and NFL games. This year really showcased that and we're only going to see this intensify over time. In 2010, we'd turn on our TV and see a bunch of channels and content distributed by network brands. Now what if just one Company has ALL of that content? That's Netflix's dream and they're set to capture (IMO) everything that some streamers won't license out (like Star Wars will probably stay on Disney Plus). The 2020/2021 push for every platform to have its own streaming platform was a big L for the subscale guys….you saw this play out where everyone LOVED The Office in the late 2010s from streaming it on Netflix. While people cried about The Office leaving Netflix initially…eventually, The Office faded from people's memories and big fans didn't need to sub to Peacock just to start their 3rd rewatch of the show. That was an example of a company that failed to recognize their efforts were too little too late. I don't see how Peacock will ever even come close to Netflix. That ship has sailed – so this sums up how if you have absolute brute force dominance from a scaled competitor – your efforts may be for naught. |
How to spot improving or declining trends: |
1) Look at comps and see what they're saying. Even if you're looking at a private market deal, there has to be some sort of comparable within the public markets. Go see their revenue trends last quarter and what they're saying in earnings transcripts & quarterly materials about the operating environment and next quarter! |
2) Industry research: Go look at some specific trends and indicators – housing is the easiest one. There's so much data out there from a macro standpoint, from a forward and backward looking standpoint, with sentiment, and with very precise regional data. But there's even more specific data you can source, especially with companies tied to retail traffic and spend, or consumer habits. Expert network calls are certainly very helpful. Plus Industry rags can provide a lot of color from people who actually know the industry very well (I generally think public credit guys typically don't understand industry dynamics as well as they think they do). |
Understanding catalysts and trends is massive – like Wayne Gretzky said – you need to figure out where the puck is going, not where it's been. What looks like an okay story at underwriting can turn very dicey 2 years later. Being able to assess who can execute and who can't is pivotal and a lot of it comes down to whether industry pressures or absolute dominance by a competitor creates a scenario where a company won't be able to escape a negative outcome. Alternatively, people (and the bond/loan market) are often too hard on companies that have some hair on them…if you can find a catalyst or reason to get excited (whether it's over the short term or long term) you can execute a nice trade or investment. |
Until next time guys. |
In Other News: |
Want more Finance Newsletter Content from High Yield Harry? Subscribe to our twice a week 5-minute finance newsletter The Wall Street Rollup here. We just added our earnings blotter, which includes all the updates you need this earnings season! Join 35,000+ other subscribers |
HYH Premium: Want full access to HYH Premium? HYH Premium is my Library of Credit Career Resources and City Guides; including the materials I've used to land high-paying jobs in Private Credit and Public Credit. The latest city guide was on Atlanta! If you're planning to recruit for a new job in the Spring then now is the time to sign up! |
Upgrade Below For $105/Year and Lock In That Price On A Go Forward Basis Before Pricing Increases in January 2025 👇️ |
|
Credit Jobs: We don't have any Credit Jobs for this week, but I want to highlight that if you're trying to hire young finance professionals at a cost that is significantly less than what recruiters cost please reply to this email. We're excitingly in the early innings of launching our Credit Recruiting arm. |
Reorg's Latest Report: Click here to access Reorg's European Direct Lender Rankings. |
Finance Merch: With 4Q and the holiday season kicking off, we've revamped our Finance Meme Merch Store! We've got you covered - check out our current suite of must have mugs 👀 |
|
Disclaimer: Obviously none of what is included in this newsletter constitutes financial or investment advice. |
Tidak ada komentar:
Posting Komentar