Good Morning. In this month's newsletter, we discuss key economic updates, including the Bank of Canada's decision to maintain interest rates amidst high living costs, the Federal Reserve's likely steady rates despite rising inflation in the US, and challenges faced by Canada's declining GDP and consumer spending. Commodities like WTI Crude Oil and gold prices are highlighted, along with tech trends such as quantum computing, and renewable energy. Labor disputes in the North American automotive industry disrupt supply chains, and we touch on Leveraged Buyout (LBO) models. Lastly, the merger of Patterson-UTI Energy and Nextier Oilfield Solutions is explored. Keep reading for more information.
ECONOMIC UPDATE
INTEREST RATES
Where are interest rates going in the economy?
The Bank of Canada's (BoC) Governor, Tiff Macklem, announced the decision to keep interest rates constant for the time being, at a press conference last week. Macklem attributed this decision to the unwavering high costs of food and housing, as well as the current rebound in energy prices. Macklem reaffirmed Canadians by saying that although the downward progress of inflation rates from record highs of 8.1% to levels of 3.3 in July is a positive sign, the BoC's inflation objective remains at 2%. Furthermore, regarding the BoC’s upcoming meeting on October 25, Macklem said that while there are no intentions to hike interest rates over 5%, the BoC is ready to do so if need be.
The Federal Reserve is next meeting on September 20th to discuss policy, it is expected by most analysts that the Fed will keep interest rates constant between 5.25 to 5.5%. This comes despite a rise in the inflation from 0.6% in August to a level of 3.7% overall. Although this rise in inflation is worrying, it is tied to the increase in gas prices, which are sometimes overlooked while deciding whether to adjust interest rates.
The Fed has made it apparent that it will adopt a careful watch-and-see approach before raising rates once again, in order to prevent economic hardship on US citizens and businesses alike. With that being said, the Fed has not entirely ruled out the potential of further rate rises as they remain vigilant in their pursuit of their 2% inflation target. Therefore, although the Fed will likely hold rates steady at their September meeting they may consider raising rates at its meeting in November or in 2024 as long as inflation doesn't show further indications of falling.
What does this mean for the economy?
A number of economists have come to the conclusion that the long-anticipated recession has already begun as an indication of Canada's economic struggles in the face of rising interest rates. One of the biggest reasons to be concerned is the unemployment rate, which has dropped by 0.5% over the past three months and is the lowest it has been since 2008, discounting pandemic-related changes. Additionally, Canada's consumer spending trends are concerning because they have been declining since January and have dropped a startling 3% so far this year. Furthermore, as a result of these elements in conjunction with others, the GDP fell short of the government's 1.5% target over the previous quarter, declining by an annualized rate of 0.2%.
In the US, the economy has been resilient as consumer spending and the job market have both shown signs of strength throughout the rise of interest rates. According to Deloitte, a major proponent of this, is the widespread adoption of fixed-rate mortgages (FRMs) by both consumers and businesses, which make it so that each year the same interest is paid, and therefore those with FRMs don’t pay a higher dollar amount of interest while reaping the benefits of higher rates on investments.
Despite the Overall strength of the United States so far, certain troubles in the US economy are beginning to be brought to light as households are increasingly turning to debt as a means to fund their purchases; on the same note there is also an alarming upward trend in defaults for both mortgages and credit card payments. Additionally, in August, the labor market saw an 18-month high unemployment rate of 3.8%. Thus, showing signs that the economy, although once robust, may waiver in the coming months. With that being said the GDP still grew at an annualized rate of 2.1% last quarter, which is a sign that the Fed may need to raise rates further if they want to truly halt the US economy.
All in all, the general consensus among experts is that, even though a “soft landing” may be difficult to achieve, it is clear that central banks in North America are making significant efforts to lessen the financial burden on their citizens while also addressing their inflation targets.
COMMODITY PRICES
As of Sep 25th, 3:00 PM EST (https://www.cnn.com/business/markets/commodities/) :
COMMODITY NEWS
Commodity Prices Rise on China's Economic Resurgence
China’s economic rejuvenation has had a notable impact on the global commodity prices.
The economic resurgence’s lasting impact on the steel plate price remains uncertain due to the development of wind projects in the US.
The Grain Oriented Electrical Steel (GOES) market boasts an increase of 24.73% month-over-month due to the boost of the Chinese economy.
High construction costs and interest rates boasts a major challenge in the long-term growth of the GOES market
Contrastingly the Renewables Monthly Metal Index dropped a significant 11.16% due to the drop of Cobalt prices in August.
Oil Price Fluctuating
The International Energy Agency predicts a significant shortfall of supply because of the loss of Organization of Petroleum Exporting Countries (OPEC) production starting in September
The resurgence of oil prices can be credited to the growing forecast of a tiger supply throughout the market
The Consumer Price Index (CPI) in August reported the largest month by month increase of the year due to the rising energy prices seen by a 10.6% increase of gasoline prices
This surge of oil prices has economists predicting higher gasoline prices contributing to inflation concerns.
INFLATION
Where is inflation now?
In July, there was a 3.3 percent y/y increase in the Consumer Price Index (CPI), which was higher than the 2.8 percent y/y increase observed in June. Gasoline prices rose by 0.9 percent m/m but were 12.9 percent lower compared to the previous year. Food prices increased both in stores (8.5 percent) and restaurants (6.1 percent). The Core CPI, which excludes food and energy, grew by 3.4 percent in July y/y, slightly lower than the 3.5 percent increase in June. This growth was primarily driven by higher prices in shelter and food subcategories. On a seasonally adjusted monthly basis, the CPI increased by 0.5 percent in July, compared to a 0.3 percent increase in June.
The average of the Bank of Canada's three core inflation measures decreased from 4.2 percent in June to 4.0 percent in July. Specifically, CPI-common decreased to 4.8 percent, CPI-median remained at 3.7 percent, and CPI-trim declined to 3.6 percent.
Key Insights:
In July, there was a notable increase in consumer price growth, with mortgage interest costs and rental prices rising significantly. Food prices also remained high.
Russia's withdrawal from an agreement allowing Ukraine to export grain safely is expected to impact global grain prices, which may affect Canada's CPI in the coming months.
Gasoline price growth leveled off on a y/y basis, and falling gasoline prices had previously contributed to easing inflation. However, they are now expected to add pressure to headline inflation.
What the Bank of Canada Has to Say
The bank did not declare victory over elevated price growth but instead projected that inflation would remain around 3 percent for the rest of 2023 and not reach its 2 percent target until 2025, at least 2 quarters later than previously expected.
Tiff Macklem, Bank of Canada Governor, spoke in Calgary in the beginning of this month, providing an update on Canada’s struggle with inflation and decision to modify monetary policy to help relieve inflationary pressures. (See video for clip of speech )
Summary:
Macklem states that the data since mid-July is providing clear evidence that higher interest rates are moderating spending, and rebalancing demand and supply in the economy.
Governing council decided to keep the policy rate at 5%, but may raise the policy rate further if inflationary pressure persists.
The biggest contribution to the slowing in inflation since the peak last year has been from energy, which accounts for ⅔’s of the slowdown.
Headlight inflation is expected to increase as global oil prices have risen again, pushing gasoline prices up as well.
Inflation has come down from 8% because supply chains have opened up, energy prices have come down, and big price increases from last year have dropped out of the data. Demand needs to continue to grow more slowly than supply in order for inflation to continue to decline. This will relieve price pressures, slow increases in labor costs and restore normal price setting behavior. Macklem says this is what will restore inflation back to the 2% target.
MARKET TREND
CANADIAN BILL C-18
History
In this digital, interconnected world, society is surrounded by a sea of media content readily available for consumption. Whether it be news articles, TV shows, radio channels, or Instagram Reels, there’s plenty of entertainment and information to keep us occupied. However, a new Canadian bill plans to alter the way this content is consumed and seems to be part of a growing movement to make multinational corporations respect and pay for access to local content.
Bill C-18 mandates that digital companies such as Google and Meta must pay to offer Canadian news on their products, by paying a small fee for each time a person accesses a story on one of their platforms.
The purpose of the bill is to provide an alternative source of revenue (estimated at around $329M annually) for Canadian news organizations, after the significant change in demand from newspaper and local ads to online advertisements on these platforms.
However, tech giants like Google and Meta view this bill as a tax on news links, which effectively charge them for providing significant web traffic to news outlets.
Similar bills to C-18 have already been implemented in other countries around the world. Australia has its own version of the bill for local news. Meanwhile, the Canadian and Australian bills are being used as precedent, as countries like the US are considering enacting their own versions.
Given the increasing importance of a free, independent, and competent press, there is great potential for similar bills to be enacted internationally.
Implementation and Current Status
The bills are to come into effect by the end of the year; however, companies are already taking pre-emptive measures.
Meta has already blocked all news content in Canada as a protest against the measures. In response, Canadian organizations have retaliated by pulling funding and raising awareness. Several Canadian media organizations, political parties, and the government of Canada itself have stopped advertising on Meta platforms altogether.
Meanwhile, Google is attempting to negotiate with the government to find a potential compromise prior to blocking all news sources. This is a rather crucial negotiation; if Google decides to block all news sources, it would mean Canadians would not see news organizations like the CBC pop up as a search result entirely. Considering the potential significance of the impact, CTV news, CBC, and other media organizations are encouraging readers to use other sources of accessing their news, such as subscribing through email, bookmarking the page, or downloading their app.
These efforts seem to be successful, as 51% of Canadians are concerned about their ability to stay informed, and 70% of those consumers are planning to change how they access news to adapt to the Bill.
Implications
Assuming the law passes without a resolution for Facebook or Google, it’s possible that smaller Canadian content creators will find a much harder time monetizing their content ironically enough, since they won’t receive as much traction without the help of these platforms.
As well, while media giants like Bell and Rogers can survive the transition, an interesting unknown is the treatment of content from their sports subsidiaries of the Maple Leaf Sports and Entertainment, and the Blue Jays franchises.
Considering that these franchises receive hundreds of millions of dollars to be visible on the platforms, it’s unclear if they would also be pulled at the same time.
Furthermore, just the implications of this change could have a decent effect on the Canadian economy in general, since it impacts both media giants and local creators. Moreover, the difficulty of accessing Canadian news can impact the general awareness and knowledge of the Canadian consumer, which can have unprecedented political, social, and economic impacts.
INDUSTRY UPDATE
LABOR DISPUTES IN THE AUTOMOTIVE INDUSTRY
Introduction:
The automotive industry is in turmoil as labour disputes unfold on both sides of the U.S. / Canada border. With Ford workers on strike, represented by the United Auto Workers (UAW) in the United States, and a looming strike deadline for Canadian autoworkers, the sector faces unprecedented challenges. These developments have far-reaching consequences that extend beyond the immediate parties involved.
Why & What are the Implications?
The strike by Ford workers in the United States has sent shockwaves through the automotive industry. With production halted at several Ford plants, supply chains are disrupted, causing ripple effects for other automakers, including Stellantis, who relies on components from Ford. This disruption comes when the industry is already grappling with chip shortages and production delays due to the ongoing global supply chain challenges. The Ford-UAW strike exacerbates these issues, leading to potential delays in the delivery of vehicles and further impacting an industry already on edge.
Meanwhile, autoworkers are inching closer to their strike deadline in Canada. As negotiations with Unifor, the union representing Canadian autoworkers, continue, there is a growing sense of uncertainty.
A potential strike in Canada could disrupt production for several automakers operating within the country, further aggravating the industry's supply chain woes. The interconnectedness of the North American automotive market means that any disruptions in one region can have a cascading effect, affecting jobs, sales, and the economy on a larger scale.
The labour disputes within the North American automotive industry are sending ripples across the globe. With supply chains intricately interconnected, disruptions in one region have the potential to impact automakers, suppliers, and markets worldwide. International automakers, some of whom rely on components from the affected companies, are closely monitoring the situation, evaluating the potential risks to their production schedules, and considering contingency plans to mitigate supply chain disruptions.
Furthermore, financial markets are sensitive to developments in the automotive sector, with stock prices fluctuating in response to labor-related uncertainties. These events underscore the complex web of dependencies in the global automotive industry, emphasizing the need for resilience and adaptability in an environment where geopolitical tensions and labour disputes can have far-reaching consequences.
Conclusion:
The labour disputes on both sides of the border underscore the challenges faced by the global automotive industry. As automakers struggle with supply chain disruptions, labour disputes, and the transition to electric vehicles, these recent developments serve as a stark reminder of the sector's vulnerability. The outcomes of these strikes and negotiations will not only impact the livelihoods of thousands of workers but also shape the future of an industry in flux, where resilience and adaptability have never been more crucial.
All eyes remain on the bargaining tables in the United States and Canada as stakeholders hope for resolutions that can stabilize an industry amid profound transformation.
MERGER AND ACQUISITION
PATTERSON AND NEXTIER'S ALL STOCK MERGER
Who Bought Who
On September 1st, 2023, Patterson-UTI Energy (NASDAQ: PTEN) and Nextier Oilfield Solutions (NYSE: NEX) completed a merger of equals in an all-stock deal. The joint company will have an enterprise value of around $5.4 billion and will trade under Patterson-UTI.
NexTier Company Overview
Nextier is a leading provider of integrated completions that employs sustainable practices within the oilfield service industry. They operate within Hydraulic Fracturing, Cementing, Pumpdown, Wireline Operations, Natural Gas Fueling, and Oilfield Logistics.
Patterson-UTI Company Overview
Patterson-UTI is an American oilfield services provider headquartered in Houston, Texas. They specialize in offering pressure-pumping, contract drilling, directional drilling services to major oil and natural gas companies. Patterson-UTI operates primarily in the US.
Oilfield Service industry in the U.S.
Oil & Gas Field Services is a 94.2bn$ industry in the US.
Industry revenue will decline by 2.9% in 2023 and at an annualized 0.4% over the next five years.
Sector’s revenue in the U.S. (in mm):
Given that the industry is commodity-dependent, oil and other hydrocarbon commodities drive the sector’s revenue.
Significant threats include renewable energy and low-cost alternatives (nuclear / low-cost hydrocarbon aside from oil)
Technological advancements increase barriers of entry and competition, an example would be the amount of operational rig within the US (from 2000 to 800 in 15 years)
Innovation is important within the sector, in 2012, rigs became much more cost-efficient through hydraulic legs that allow them to “walk” for a short distance.
Strategic Rationale
The merger will create a powerhouse contract drilling (Patterson-UTI) and well completions (Nextier) company that will attract a diverse range of customers due to its ability to service the full well life cycle. Together, Patterson-UTI and Nextier can enrich their service offerings and increase market share.
The newly formed company will have 3.3 million hydraulic fracturing horsepower (pressure power to create fractures in rocks that contain oil or gas), 172 super-spec drilling rigs (high tech, faster drills), and around 70% of engine fleets with dual fuel capability (can operate using a mix of two fuels). This makes it the largest pressure pumper in North America in terms of capacity, surpassing Halliburton (NYSE: HAL).
Andy Hendricks, CEO of Patterson-UTI states that as a merged company, Patterson-UTI and Nextier “will have a significantly expanded comprehensive portfolio of oilfield services offerings across the most active producing basins in the United States, along with operations in Latin America”
Combining balance sheets also signals strong revenue and cash generation with more free cash flow to invest in technology, innovation, and deliver strong returns back to shareholders.
Transaction Details:
Patterson-UTI Energy (EV/EBITDA: 3.65x) has agreed to merge with Nextier Oilfield Solutions (EV/EBITDA: 2.84x) in an all-stock deal valued at $5.4 billion.
After the deal closes, expected in the fourth quarter of 2023, Patterson-UTI shareholders will own about 55% and NexTier shareholders will own the rest of the combined company.
NexTier shareholders will receive 0.752 shares of Patterson-UTI common stock for each share of NexTier common stock they own. Patterson-UTI shares rose about 12%, while NexTier was up 6%. It is important to note that the merged company will retain the name Patterson-UTI Energy, Inc., continue trading under the ticker symbol PTEN
The transaction is expected be accretive to both earnings per share and free cash flow through 2024. The Company expects to realize annual cost savings and operational synergies of approximately $200 million within 18 months following the merger closing. Forward NEX EBITDA is estimated at $900mm while the PTEN estimate is about $1bn.
Thoughts:
This deal showcases the current trend in which mergers and consolidation may be due to the declining profits of the industry as oil and fossil fuels prices decline while other alternatives grow in popularity.
This could be a shareholder-focused perspective to drive inorganic growth, garner market-share, and spread costs / increase margins by decreasing impact of fixed costs and trying to create synergies to counter the decrease in industry revenue.
Due to extenuating evidence the deal is in fact not an add value, but rather a representation of the declining popularity of hydrocarbon-based industries such as oilfield services.
An example of balance-sheet driven M&A would be General Electric spinning off its position in Baker Hughes to reduce its corporate debt., triggering a $7.4 bn loss for GE.
FINANCE CONCEPT OF THE MONTH
LBO MODELS
A leveraged buyout (LBO) is a transactional acquisition of another company using borrowed funds (debt) – usually in the form of bonds or loans – to meet the acquisition costs. An LBO primarily uses a ratio of 90% debt to 10% equity, which means a higher debt/equity ratio. As a result of the elevated debt/equity ratio, the bonds issued in the buyout are usually not investment grade, but rather bonds with a higher risk attached. The higher risk comes from the increased possibility of the company defaulting on its interest payments.
An LBO works by leveraging a candidate's assets, which are used as collateral by acquiring the company. It promotes the entire idea of an LBO, which allows firms to make sizeable acquisitions while minimizing risk (leveraging the target companies' assets against themselves).
There are three primary reasons for LBOs:
1. To take a public company private.
2. To spin off a part of an existing business to sell it.
3. To transfer private property.
Private equity firms generally target mature companies in thriving and established industries. Prospective LBO candidates often have strong operating cash flows, designated product lines, robust management teams, and feasible exit strategies.
There are various exit strategies an equity firm may choose from, including the outright sale of the company to a strategic buyer or financial sponsor, an IPO, or recapitalization.
1. A strategic buyer is a buyer who is looking for opportunities for horizontal or vertical expansion to invoke synergies that will improve their firm's operations. They want to identify companies with product/service lines that can smoothly integrate into their existing operations. In contrast, a financial buyer is an entity looking to invest in a company and realize it for exponential returns. Typical financial sponsors include PE firms that use leverage (such as an LBO) to capitalize on substantial returns.
2. An initial public offering (IPO) is the process of offering shares of a private company to the public through a new, first-time stock issuance. It allows a company to raise equity capital from public investors. A company may issue an IPO to help fund company expansion, invest in R&D, and pay off debt, among other financial activities that require large sums of cash.
3. Recapitalization includes restructuring a company's debt and equity ratio to stabilize its capital structure. It usually involves the exchange of one form of financing for another. It includes removing preferred shares (equity) and replacing them with bonds (debt) or vice versa. Essentially, decreasing debt lessens a company's leverage, causing its EPS to diminish. However, it allows the company to lower risk through less debt obligations and enables them to return more profit and cash to shareholders (dividends).
There are three primary drivers of LBOs. These drivers are significant as they help to create positive returns through the buyout of a target company. The three primary drivers include:
1. Deleveraging. It happens when a company attempts to decrease its total financial leverage, most likely by lowering debt and obligations on the balance sheet. As debt diminishes, equity rises, increasing the profits the acquirer makes.
2. Operational improvement. It includes organic growth, cost-cutting, and realization of synergies from existing acquisitions. Realizing synergies will help to cut costs as they merge assets and business lines of a company to create a more efficient work cycle, increasing overall revenues and profits. Organic growth refers to R&D, improved marketing tactics, and pricing structure, among other things.
3. Multiple expansion. The expansion of market valuation multiples (EV/EBITDA, EV/Revenue, etc.,) will help to increase the value of an investment in an LBO. Essentially, the idea is to buy low and sell high, which creates value for the financial sponsor. However, it is worth noting that multiple expansion is market-driven and should not be solely relied on to make worthwhile investments.
Overall, LBOs are an adequate way for companies to acquire other companies without pumping out large sums of cash. They can cultivate companies by taking on a more substantial amount of debt through bonds or loans and leverage the target companies' assets against them to minimize the purchasing firms' risk.
Additional Information - M&A Model vs LBO Model
M&A models are used to evaluate the purchase of a target company, which is usually a strategic buyer. In contrast, LBO models are used to assess the investment of a target company, which is most likely a financial buyer.
M&A models focus on accretion (increase) and dilution (decrease) analysis, which is an analysis tool used to evaluate whether the earnings-per-share (EPS) of the acquirer will increase or decrease.
To better understand the drivers of accretion and dilution, there are three primary financing methods used in M&A deals:
1. Cash on the acquirer’s balance sheet. This method has the lowest burden on the company since cash does not incur expenses. However, by using cash, a company forgoes the interest income that would be had they not used cash. Since the interest income is low (due to cash being invested in safe securities), M&A deals financed with cash have a better chance of being accretive.
2. Debt the acquirer raises from the capital markets. This method lowers the acquirer’s earnings as they must pay interest on the debt they took on. Since debt is an expense on a company’s balance sheet, it becomes an inherent risk to the company if it cannot make the subsequent interest payments.
3. Deals financed through equity the acquirer issues (shares it sells to the public or issues to the target company). Although there is no financial cost to issuing shares (other than underwriting fees), stock issuances increase the total share count. In turn, this affects the EPS since EPS is calculated by taking the net income, subtracting the preferred dividends, and dividing that by the share count (in simplistic terms), which decreases the EPS.
RECRUITING QUESTION
Q: How do you determine the valuation of a company in an M&A deal?
A: Valuing a company in an M&A deal can be complex. It is important to analyze and consider which method is best for calculating the company’s value.
Common valuation methods include a discounted cash flow (DCF) analysis, publicly traded comparable analysis (most common), and comparable precedent transaction analysis.
These methods involve forecasting future cash flows, comparing the target to similar companies, and analyzing historical deals in the industry. It's essential to use a combination of these approaches to arrive at a fair and justifiable valuation of the company.
Q: Walk me through a basic merger model
A: Step 1: Assumptions about the Acquisition
In the first step of a merger model, analysts make key assumptions about the acquisition. These assumptions include:
Purchase Price: Determine how much one company is paying to acquire the other. This can be in the form of cash, stock, debt, or a combination of these.
Method of Payment: Specify whether the acquisition is being financed using cash, stock, debt, or a mix of these methods.
Step 2: Valuations and Shares Outstanding
Next, you need to calculate the valuations and shares outstanding for both the buyer and the seller:
Buyer's Valuation: Calculate the total value of the buyer's equity and any outstanding debt or other liabilities.
Seller's Valuation: Determine the total value of the seller's equity, including any debt and liabilities.
Shares Outstanding: Find the number of shares of both companies' common stock that are outstanding.
Step 3: Projecting Income Statements
In this step, you project the income statements for both the buyer and the seller. These projections typically cover several years into the future and involve estimating key financial line items, including:
Revenue: Project the future revenue for each company based on factors like historical growth rates and market trends.
Operating Expenses: Estimate expenses such as cost of goods sold (COGS), operating expenses, and taxes.
Interest Expense: If the acquisition is financed with debt, include the interest expense associated with the debt.
Step 4: Combining Income Statements
Combine the projected income statements of the buyer and seller. This involves adding up corresponding line items from both companies' income statements. However, some adjustments are necessary:
Foregone Interest on Cash: If the buyer used cash for the acquisition, account for the interest income that would have been earned on that cash.
Interest Paid on Debt: Include the interest expense on the debt used to finance the acquisition.
Step 5: Applying Tax Rate
Calculate the Combined Pre-Tax Income by subtracting the interest expenses and adjusting for the effects of cash. Then, apply the buyer's tax rate to determine the Combined Net Income.
Step 6: Determining Combined EPS
To calculate the Combined Earnings Per Share (EPS), divide the Combined Net Income by the new share count, which is the sum of the buyer's and seller's shares outstanding after the merger.
Step 7: Consideration of Goodwill and Balance Sheets
In more advanced merger models, you would also consider factors like Goodwill, which arises when the purchase price exceeds the fair value of the seller's assets and liabilities. Additionally, you would combine the balance sheets of both companies to assess the impact on assets, liabilities, and equity.
A basic merger model helps financial analysts assess the financial implications of an acquisition on the buyer's earnings per share (EPS) by making assumptions about the acquisition, projecting income statements, and combining financial statements. More advanced models would involve additional complexities, including the treatment of Goodwill and the combination of balance sheets.
SECOND YEAR RECRUITING TIMELINES
