Good Morning. This newsletter covers the sharp decline in commodity prices, the impact of Tropical Storm Idalia on oil and gas production, rising Crude Oil prices, and BRICS' efforts to reduce reliance on the U.S. dollar. It also touches on the S&P 500's recent performance, speculations about the Federal Reserve's rate hike, and the influence of inflation data. The growth of resale markets due to inflation is highlighted, as well as Roark Capital's acquisition of Subway and the Medicare negotiations' impact on the pharmaceutical industry. Lastly, the newsletter includes insights into recruiting questions related to leveraged buyouts, accounting changes, and valuation methods. Keep reading for more information.
ECONOMIC UPDATE
COMMODITY NEWS
Commodity Prices Largest Decline Since the Pandemic
Commodity prices are expected to drop the most since the Covid-19 Pandemic. The anticipated 21% decline in 2023 compared to last year dampens the growth of developing countries whose economies are 65% dependent on soft commodity prices. This sharp drop of prices marks a growing concern for growing countries, but a counteractive relief for the 350 million people who suffer food insecurity. This commodity price drop creates a bubble of relief for the food crisis amid the second-highest price levels since 1975.
Tropical Storm Idalia
As the catastrophic Tropical Storm Idalia intensifies on route to the US Gulf, economists measure the implications on the oil and gas output. Expected to be upgraded to a hurricane classification, the extreme weather conditions will devastate the coastline of oil-rich regions in both Mexico and Florida. Economists are following the storm progression as the potential week-long shutdown of oil production looms on the prices of oil.
Brent and WTI Crude Oil Prices Increase
Closing the week at a price of $89.98 a barrel, Brent Crude Oil rose 1.61% as it reported a cease in continuous weeks of losses. While U.S. West Texas Intermediate Crude Oil rises 1.36% to $86.71.
Gold and Silver Prices
Analysts using the gold-silver ratio to determine the relationship of value between the two metals have determined the ratio has fallen below 80, suggesting silver will outperform gold amidst its continuous rise in 2023. The continued demand for silver production with respect to the development of solar panels, silver oxide, 5G technologies, and batteries is contributing to the increase in the value of silver.
COMMODITY PRICES
As of Sep 5th, 4:30 PM EST (https://www.cnn.com/business/markets/commodities/) :
GLOBAL-MACRO-UPDATE
History of BRICS:
BRICS, formed in 2006, is an acronym that represents a group of five major emerging economies: Brazil, Russia, India, China, and South Africa. The primary motivation behind the inception of BRICS was to provide a cooperative platform for dialogue on global issues. The member countries understand the need to collaborate in order to enhance their influence in global affairs and challenge the dominance of Western economies.
Interest rates and BRICS:
Given recent hikes in the US, the dollar - the world’s reserve currency - has significantly strengthened relative to other currencies as investors flocked toward the US given the attractive risk-adjusted returns
The strengthening of the dollar means that U.S. companies benefit from cheaper imports.
Foreign countries that rely on the US dollar are negatively impacted as they require more domestic currency to buy a dollar.
BRICS goal is to mitigate the dollar’s impact on alliance members’ economies by divesting from the reserve currency (de-dollarization) and using their domestic currencies to trade.
Chart: Strengthening of the dollar in the last 5 years.
What could this mean for the U.S. and Canada?:
Possibly nothing at the moment, the dollar hegemony is standing strong and is potentially unshakeable. But the BRICS momentum is growing stronger, threatening the world’s economic podium. According to a report by PwC, the BRICS economies are projected to represent 50% of the world’s GDP by 2050.
The US has been downgraded from AAA to AA+ by Fitch, citing fiscal deterioration and higher risks of default given the recent last-minute political debt ceiling negotiations.
BRICS countries, like China, are significant trading partners for Canada. Any shifts in the economies of BRICS nations such as changes in their trade policies, could impact Canada’s trade balance and economic growth.
Canada is also a major exporter of commodities such as oil, minerals, and agricultural products. BRICS countries are major consumers of these commodities, and thus any change in the consumption patterns of the alliance nations could have implications in terms of Canada’s bottom line.
For the US, the reserve currency status allowed the country to run large deficits. A potential BRICS currency can reform the world’s currency reserve, impacting the U.S.’s capital market and its budget policies down to individual citizens. Given Canada’s dependency on the U.S.,
THE S&P500 STRIKES BACK
The S&P 500 soared to a 13-month high this Monday, closing at 4,338.93, a 0.93% increase. The Nasdaq and Dow Jones followed suit, posting significant gains. Investors seem optimistic that the Federal Reserve will forgo a rate hike in their upcoming policy meeting. A 72% likelihood of no hike is projected, as per CME Group's FedWatch tool.
Market Expectations on Federal Reserve Policy
Market sentiment suggests that the Federal Reserve may delay its 11th consecutive rate hike. Since initiating a policy-tightening cycle in March 2022, the Fed has raised rates ten times. However, investor confidence is growing that the streak might be broken, with a high probability of the central bank maintaining the current rates.
Upcoming Inflation Data and Future Rate Hikes
Economists predict that the upcoming consumer price index (CPI) will show a decrease in annual inflation rates, from 4.9% to 4%. This could further fuel the case against a rate hike. Despite this, Dylan Kremer, co-chief investment officer at Certuity, anticipates that more hikes could be in store, assigning it a 50/50 chance within this financial cycle. With recent rate hikes now proving useful in the latest CPI/inflation reports, it is probable that the Federal Reserve may also continue the hike streak.
What Lies Ahead
While the Fed may skip a rate hike this month, the focus will shift to its previously persistent commitment to controlling inflation. Market pundits forecast one final rate hike in July before the Federal Reserve adopts a more passive approach for the rest of the year.
MARKET TREND
CONSUMERS PROMISING RESALE MARKETS
Resale Markets
In the world of fashion, soaring inflation has led to a resurgence in the resale market. According to CBS News, the fashion resale market witnessed a remarkable 42% growth in the first quarter of 2023 compared to the same period in the previous year.
With prices of new clothing and accessories skyrocketing, consumers are turning to secondhand stores and online platforms to find affordable yet stylish alternatives. As of April 2023, the annual inflation rate for apparel in the United States stood at 8.2%, making the appeal of secondhand fashion even more compelling. This trend reflects the increasing recognition of pre-loved items as a cost-saving measure and a sustainable fashion choice.
The automotive industry is also experiencing the ripple effects of inflation on the resale market. Bloomberg reports that as new car prices continue to climb due to rising manufacturing costs, more consumers are opting for used vehicles.
As of April 2023, the cost of new cars had increased by 12.1% year-over-year, according to the U.S. Department of Labor. This shift is not only driven by financial considerations but also by the availability of well-maintained, pre-owned cars that offer good value for money. As a result, the resale market for automobiles is thriving, with robust demand and increased sales in the secondhand car sector.
The impact of inflation on the resale market extends beyond fashion and automobiles; it is equally evident in the realm of home equipment, including furniture and electronics. CNN's report from August 2022 highlighted that consumers are increasingly turning to platforms like OfferUp to buy and sell used home appliances and furnishings. Inflation-driven price hikes for new home items have prompted people to explore more economical alternatives. As of April 2023, the annual inflation rate for home furnishings and operations in the United States was 9.4%, as reported by the U.S. Bureau of Labor Statistics. This statistic underscores the growing importance of the resale market for home equipment as consumers seek both cost-effective solutions and environmentally sustainable choices.
Sustainability Gains Traction
The resurgence of resale markets amid soaring inflation underscores a significant shift in consumer preferences toward sustainability. As consumers grapple with the burden of rising costs, they are increasingly drawn to secondhand goods as a responsible alternative to purchasing new items.
This trend aligns with broader concerns about climate change and environmental sustainability. When consumers choose pre-owned items, they not only save money but also actively reduce their carbon footprint by decreasing the demand for newly manufactured goods.
Reflecting a growing awareness of the environmental impact of consumer choices, brands that prioritize sustainable practices and offer quality products with extended lifespans are gaining favour among consumers who value affordability and environmental responsibility.
Furthermore, within the resale market, the concept of a circular economy encourages the reuse and recycling of products, thus contributing to a more sustainable and eco-friendly future.
Online Marketplaces Flourish
The thriving online resale platforms have played a pivotal role in the expansion of resale markets. The convenience and accessibility of these platforms have made it easier than ever for consumers to buy and sell pre-owned items with just a few clicks.
This shift towards online marketplaces has significantly broadened the reach of resale markets, allowing buyers and sellers to connect from different geographic locations, increasing the variety of available items, and fostering a vibrant online community.
The growth of these online platforms has led to increased competition and innovation within the resale market space as well. As consumers grow more accustomed to the convenience of online shopping, these platforms are evolving to offer a seamless user experience, including secure payment systems, detailed product listings, and user reviews.
Moreover, the integration of artificial intelligence and data analytics is enhancing the efficiency of online resale by matching buyers with their desired items more accurately. This digital transformation in resale is also prompting traditional brick-and-mortar retailers to adapt by incorporating resale sections in their stores or partnering with online platforms, as they recognize the potential and growing appeal of the online resale market. Ultimately, the continued expansion of online resale is expected to shape the future of retail by blurring the lines between new and secondhand goods, redefining consumer shopping habits, and driving further innovations in the retail industry.
The current trend of increasing inflation has reshaped consumer behaviour across multiple markets. In the face of rising prices for new goods, consumers are seeking cost-effective and sustainable options in the resale market. Whether it's fashion, automobiles, or home equipment, secondhand shopping has become a compelling choice for individuals looking to make the most of their budgets while contributing to a more environmentally conscious society.
The interplay between inflation and resale markets reflects not only changing consumer behavior but also broader economic, environmental, and societal shifts. This trend is reshaping how people view consumption, value, and sustainability in an ever-evolving market landscape.
MERGERS & ACQUISITIONS
RORARK CAPITAL PLACED ORDER IN SANDWICH BUSINESS
On August 24th, Roark Capital, a PE firm, announced that they’ve reached an agreement to acquire Subway, in a deal worth up to $9.55B.
Transaction Details
Roark and Subway agreed to an “Earn-out agreement,” where Subway must hit certain targets in its financial performance to earn the entire $9.55 billion. Without hitting these targets, the deal is worth $8.95 billion.
The financial details of the transaction, such as the amount of debt/cash used to fund the deal, are still unknown as the acquisition has only been recently announced (August 24th, 2023)
The deal must still pass antitrust regulators prior to being finalized, however, it’s likely to be approved given the fragmented market.
Roark has up to 12 months to close the deal before paying a break-up fee equivalent to 4% of the deal’s value.
Accretion / Dilution is irrelevant, as the PE fund is likely to sell the firm at some point rather than keep it in its operating portfolio indefinitely. Therefore, only IRR and MoM metrics are relevant.
Strategic Rationale
Roark Capital is a PE fund specializing in value-add services for franchise-based business models in consumer and business service industries.
Subway makes for a complimentary add-on to Roark’s portfolio of leading food businesses such as Arby’s, Baskin-Robbins, and Hardees.
Following Subway’s recent strategy overhaul, with significant changes in its menu and expansion efforts, Roark is likely to provide counsel, leveraging their extensive experience in the industry by expanding their other portfolio companies.
Thoughts
Global sales for Subway peaked at $18 billion in 2012, which has turned heads in terms of the validity of the acquisition by Roark.
Roark Capital is looking to revitalize the Subway brand by focusing on refining the branding strategy, reducing the number of restaurants, and focusing on increasing the revenue per outlet.
Subway currently has 41,600 stores worldwide, after hitting a peak of 44,702 stores in 2016. With an average Subway store earning $500K as compared to competitor locations earning $1M per store, Roark may capitalize on the oversaturation and cut on store locations to boost profit margins.
Alternatively, there’s a chance Roark may focus on the opposite. The firm has a history of focusing on franchise royalties to boost revenue (such as with current holding PetValu), and, therefore, may prioritize menu innovations and international expansion to boost profits.
Franchise owners may feel significant pressures amid the new acquisition, which is pushing the possible closure of outlets across the world.
They have also tried to diversify their menu by adding in breakfast options; however, this venture posed mediocre at best. Once again, this acquisition poses oversaturation mitigation for underperforming business ventures within the chain.
Roark also owns Jimmy John’s, a direct competitor to Subway. Therefore can exploit cost synergies within their portfolio to fully extract value from purchasing economies of scale.
Further, there is the possibility to generate leaner operations by being acquired under Inspire Brands, which is the current Holding Company of Jimmy John’s.
The PE fund also has a history of holding onto investments. For instance, the firm still owns a stake in Carvel, their first investment back in 2001. With multiple opportunities for margin and profit expansion, it’s possible the firm may own Subway for an equivalent period of time.
Roark Capital Background
Roark Capital holds approximately $37 billion in AUM with an extensive food portfolio, including Arby’s, Auntie Anne’s, Buffalo Wild Wings, Carvel, Sonic, and various others.
Roark Capital focuses on franchise and franchise-like businesses in various industries, including food and restaurants, health and wellness, education, consumer products, and more.
They participate in several transaction types, including family-owned business transfers, management/corporate buyouts, recapitalizations, going-private transactions, corporate divestitures, and acquisition/growth capital.
Roark Capital utilizes a five-pronged approach for selecting suitable investments, which includes finding an experienced management team, ensuring the investment boasts a predictable cash flow (stable and growing EBITDA), has identifiable growth metrics (established in a growing market with organic growth opportunities), has a sustainable competitive position (strong market position and meaningful barriers to entry), and suitable investment size (revenue: $20 million - $5 billion, EBITDA: $10 million - $500 million, and equity investment: $50 million to $1 billion).
INDUSTRY UPDATE
What The Release of The 10 Drugs Subject To Medicare Negotiations Means For The Pharmaceutical Industry and US Economy
On August 29th, the Biden administration finally circulated the list of the ten drugs that will be subject to Medicare price negotiations, which will occur over the next two years and be fully implemented in 2026.
The aim of these price negotiations is
to help lower the financial burden on elder consumers and American taxpayers, while also ensuring that the medical needs of all Americans are met. Thus, it comes as no shock that the chosen drugs are both common needs and some of Medicare's largest expenses, with prime examples being Xarelto and Eliquis (blood thinners), along with Jardiance (a medication for diabetes).
While many consumers are happy with the idea of lower prices, pharmaceutical companies are discontent with the idea of either engaging in negotiations or paying a tax to maintain their Medicare eligibility, as they perceive it as an attempt from the government to take products without providing adequate compensation.
Therefore, as a result, well-known pharmaceutical companies like Johnson & Johnson, Merck, and Bristol-Myers Squibb have filed lawsuits in an effort to avoid negotiations saying that it infringes upon their rights to fair compensation. Furthermore, these companies argue that they need to remain consistent in their pricing in order to fulfill R&D needs, which leads to medical innovations that continue to support American citizens through a variety of conditions.
Industry and Economic Effects:
In regards to immediate effects, despite their vocal dissatifaction, major pharmaceutical firms such as Pfizer have said these negotiations are negligible for the company’s health as a whole.
However, given that the United States leads the world in per capita drug consumption, and the ten medications selected generated $50.5 billion in revenue during the 2022 fiscal year (from June 1, 2022, to May 31, 2023), there's a feeling from some industry experts that Big Pharma companies maintaining a facade to keep shareholders at ease.
Since pharmaceutical companies have substantial R&D requirements, their constrained profit margins might limit their ability to allocate cash toward R&D projects. As a result, this could cause a shift in their focus, transitioning from innovation hubs to becoming product providers, which would hinder their financial growth.
Addtionally, these negotiations will have a significant impact on the US economy as a whoke. Since the pharmaceutical industry is the third-largest sector in the US, the byproduct will be felt across various segments of the economy. With reduced taxes, Americans will have more disposable income, which will positively affect other sectors. Additionally, for many senior citizens, one of their demographics largest expenses will see a significant decrease in costs.
All in all, it is a little bit early to say what all the implications will be, but it will, without a doubt, be negative, making this a very interesting industry to follow for the foreseeable future.
RECRUITING QUESTION
LBO
What makes an ideal candidate for an LBO?
Note: Leveraged Buyouts occur when a private equity firm acquires a company through a mix of debt and equity, operates it for several years, and then sells the company after a certain period to gain a return on their investment. During the ownership period a private equity firm will typically use the acquired company’s cash flows to pay for the interest expense and principal on the debt borrowed to finance the acquisition.
Answer:
Price is the most significant factor … a good price means the company is relatively undervalued compared to similar companies. If price makes sense for the deal, then an ideal LBO candidate should also:
Have stable and predictable cash flows to service debt (most important after price)
Be a leader in a fragmented industry (many companies competing with no monopoly) where it is easier to make add-on acquisitions
Have a strong and competent management team
Have minimal CapEx and working capital or have significant fixed assets to use for debt collateral
Have a feasible path to exit where returns are driven by EBITDA growth and debt paydown rather than multiple expansion since multiple expansion is speculative and unpredictable
ACCOUNTING
A company sells some of its PP&E for $120. On the Balance Sheet, the PP&E is worth $100. Walk me through how the 3 statements change.
Answer:
When going through accounting questions, always go in the order of Income Statement, Cash Flow Statement, and Balance Sheet and always assume a tax rate of 40% or some other round number that will simplify calculations (another option is to ask the interviewer what tax rate to assume).
Note: PP&E - Plant Property and Equipment are a company’s long-term, tangible assets such as trucks, land, and factories.
First step is to recognize that there is a $20 gain on the PP&E sale.
Income statement: Record a gain of $20 since the equipment was sold for $120 even though it has a book value of $100. This gain increases pre-tax income by $20. Assuming a 40% tax rate, net income increases by $12 since $20 * 60% = $12.
Cash Flow Statement: Since net income from the income statement flows into the top line of the cash flow statement, net income is up $12. However, you also need to subtract $20 from net income here since a gain increases net income but is a non-cash event. Therefore, cash flow from operations is down by $8 since $20 - $12 = $8.
You also have to subtract the total amount received from the sale under cash flow from investing so cash flow from investing is down by $120. Therefore, net cash flow is up by $112 since $120 - $8 = $112.
Balance Sheet: Net change in cash from the cash flow statement links into the cash line of the balance sheet, so cash is up by $112. However, PP&E is down by $100 since we sold $100 worth of long-term, tangible assets. This means total assets are up by $12.
On the other side, Shareholder’s equity is up by $12 since net income is up by $12 as seen on the income statement. Net income flows into retained earnings under shareholders equity.
Remember that ASSETS MUST ALWAYS EQUAL LIABILITIES + SHAREHOLDER’S EQUITY.
Since assets are up by $12 and shareholder’s equity is up by $12, the equation balances.
DCF
What happens when depreciation increases by $20 on the DCF?
Note: A Discounted Cash Flow values a company based on the present value of its cash flows and the present value of its terminal value.
Answer:
EBIT falls by $20, EBIT then gets multiplied by 1-Tax Rate so Net Operating Profit After Taxes decreases by $12, then you add back depreciation so Unlevered FCF increases by $8.
What is beta?
Answer:
A measure of volatility compared to the general market.
How does tax affect a DCF?
Answer:
Tax affects a DCF in three spots, The first instance is when Calculating FCF, the second and third occur when calculating WACC (one in cost of debt and one in cost of equity in beta).
VALUATION
How many valuation methods do you know/can you list? What is the difference between intrinsic and relative valuation?
Answer:
The three ways to value a company are:
Discounted Cash Flow Statement (intrinsic): estimating the present value of a company using its expected future cash flows.
Comparable Companies (relative): comparing a company to other similar companies.
Precedent Transactions (relative): Use price paid to acquire similar companies in the past as an indicator of value.
Intrinsic valuation focuses on estimating the net present value of future cash flows and relative valuation focuses on comparing a company to other similar companies.
How would you value an apple tree?
Answer:
If doing intrinsic valuation, first multiply the annual yield of apples by the market price to find revenue. From there subtract costs or CapEx to find the annual free cash flow from the tree.
Next, project the expected future cash flows and find the tree’s discount rate. The discount rate could be based on the tree’s opportunity cost - what you could earn each year investing in another apple tree.
Then, discount the future free cash flows and terminal value back to the present value to find the tree’s implied value.
Alternatively, you could do relative valuation and compare the tree with the price of other similar trees.
SECOND YEAR RECRUITING TIMELINES
