Month: August 2022

cheap money avalanche

But Rob Almeida, global investment strategist and portfolio manager at the $US581 billion ($818 billion) investment giant MFS, says it’s useful to think about how profit margins got to this point. The last two years, when an avalanche of global stimulus payments sparked the surge in demand that has delivered us this inflation spike is clearly part of the answer.

But Almeida argues this is really a story that’s been building for more than a decade, when central banks flooded the world with cheap money to try and spark an economic recovery in the wake of the GFC – and never really turned the taps off.

This capital wasn’t used to invest in productive capacity to drive organic revenue growth but instead used to fund fat capital returns (high dividends and share buybacks) and acquisitions to drive inorganic growth across most sectors.

“This explains why the 2010s produced outsized profits but saw a feeble economic expansion and a historic gap in wealth between the owners of capital and labour. The excess of this last business cycle was corporate leverage and profits.”

Pandemic stimulus did nothing to change this picture. Almeida says that “instead of investing in plant and equipment or research and development, the government issued previously unimaginable quantities of debt so that consumers could buy more goods than the economy could produce. The result? Inflation.”

Almeida’s point is simple: until these excesses are washed out of the system – until corporate profits have come down, until the retail investors who are yet to meaningfully sell stocks have done so – it’s hard to make the case that markets have bottomed and are headed. for a durable economic recovery.

Pressure on revenues to rise

There are signs in the ASX reporting season that some of the forces behind the strong profit growth of the past decade are starting to reverse.

Consider what Bahamian fund manager Mark Holowesko argues were four main drivers of historically high margins: low interest rates, low wage growth (partly through better efficiency, but also due to the utilization of cheaper offshore labour), lower capital intensity thanks to globalized supply chains. and lower tax rates, particularly in the US. The last few weeks have provided anecdotal evidence that these tailwinds are turning into headwinds.

Interest rates are clearly rising and while we’ve seen only muted increases in financing costs from the companies that have reported so far – average borrowing costs at property giant Mirvac, for example, rose from 3.4 per cent to 3.9 per cent a June 30 – 2023 is likely to see more pressure. There are also surprising implications of higher inflation and rates; Rio Tinto, for example, took an earnings hit of almost $US300 million because rising inflation and discount rates means it needs to put aside more to rehabilitate mine sites when they close.

Wage growth is clearly on the rise, perhaps most viscerally at QBE, which pushed through two wage increases in three months for its staff. Commonwealth Bank is yet to complete negotiations on its enterprise bargaining agreement, but it’s braced for a significant jump.

Supply chain pressures have been seen across the ASX in the first weeks of reporting season with retailer Baby Bunting, which reported on Friday providing a neat example; not only did it miss $3 million of sales because supplies of a top-selling pram have been restricted, but it lifted inventory by 20 per cent to mitigate further delays. The pressure on capital intensity is also highlighted by explosive giant Orica, which supersized a capital raising for an acquisition to give it more than $200 million of spare cash to manage supply chain issues.

Given the state of pandemic-ravaged government budgets, tax reductions are off the table. Indeed, booming coal miner Coronado Global Resources is already seeing royalties rise, but now faces a new royalty regime in Queensland. Given what we’ve seen in other parts of the world, tax hits on the energy sector would hardly come as a surprise.

How these trends are borne out across the rest of the ASX reporting season is yet to be seen. But as interest rates keep rising and economic growth slows (hopefully bringing down inflation with it) the pressure on corporate revenues is likely to increase. But their costs – interest payments, wages, inventory, taxes – are moving higher in what Almeida argues is a structural change; he’d add in the cost of ESG as another rising burden.

Which brings us back to our original question: can the market really be at the bottom if the reversion in global profits is only getting started?

It is possible, if valuations have come down far enough to account for the fall in profits, or if a soft landing means profits won’t fall as much as feared. After the rally we’ve seen since mid-June and the softer CPI print on Wednesday night, that’s clearly worth thinking about.

But Almeida has a nice analogy to explain where we might be in the cycle. Market rallies, he says, are like an event, sort of like a party that everyone wants to attend. But market bottoms are a process, more like a hangover, where the excesses of the night before are only fixed over time.

“Historically, markets have tended to bottom when investors give up, stop caring, vow never to invest again and no longer ask, ‘Is this the bottom?’” Almeida says. “I’ve lived through that twice and I don’t think we’re there yet. But when investors stop asking whether we are, we will be.”

Mr Di Sibio told the Financial Times last month that he did not “envision a lot of job cuts” if the firms were split.

EY’s consulting partners have also been separately told they might have their cash pay cut by up to 40 per cent as part of the cost reductions if they split off into a standalone company. This would be offset by the consulting partners receiving shares worth as much as seven to nine times their annual income, estimated to be worth as much as $US8 million.

In short, the split would financially benefit older partners the most, while middle-ranking and junior partners, especially those heading to a newly independent consulting outfit, would face the most risk.

Another detail not mentioned during the briefing is Mr Di Sibio also told the UK paper that the rate of partnership promotions might be reduced to every two years instead of the current annual process. That’s a potential change that would concern any staff member with aspirations of becoming a partner.

However, a spokeswoman for EY said the opposite would be the case, with two independent firms actually looking to “accelerate partnership promotions, possibly promoting more often”.

“We will want to maintain a partnership culture in a corporate model. To unlock growth we will look to accelerate partnership promotions, possibly promoting more often,” she told The Australian Financial Review.

The following slides, which have not been previously detailed publicly, were shown during Mr Di Sibio’s global broadcast, and were part of a wider overview of what was happening at the firm presented to staff late last month.

Seven forces ‘shaping’ the profession

One slide outlined the seven forces the firm says are “shaping” the professional services market for EY and its big four rivals, Deloitte, KPMG and PwC.

These include the “regulatory environment”, the “capital requirements” of the firm, the competitive landscape and market conditions.

A note on the slide answering the question of why split stated: “The transformative forces reshaping professional services are evolving at unprecedented speed and scale – there is an imperative to consider strategic options now.”

Not mentioned is that Deloitte, KPMG and PwC have now all publicly ruled out splitting. The senior leaders at Deloitte, who is understood to review potentially splitting on a monthly basis, think that the advantages of having a combined operation outweigh the risks of splitting into two smaller firms.

Another slide said if there was a split, the auditing arm, AssureCo, would have estimated revenue of $US18 billion and be 100 per cent owned by partners staying in that business, while the consulting arm, NewCo, would have estimated revenue of $US24 billion and be a new corporate entity majority owned by EY partners moving to the new standalone advisory business.

Not mentioned: how the firm’s existing legal woes would be dealt with. EY’s overseas operations have been at the center of a string of high-profile audit failures.

EY was the auditor of Wirecard, a German payment processor that filed for insolvency in 2020 after admitting that €1.9 billion of cash on its books probably never existed. EY also audited Luckin Coffee, a Chinese coffee chain that filed for bankruptcy filings amid its executives inflated income, costs and expenses.

The firm also audited British hospital group NMC Health, which collapsed amid a suspected multibillion-dollar fraud. The administrators of NMC Health filed a $US2.5 billion lawsuit against EY, alleging negligence in its work on the accounts.

A third slide outlined the “benefits and long-term value” of creating a NewCo, boasting the newly independent consulting firm would be “unique in the market” with a “radically different approach that connects design and deliver at every step across advise, transform and operate”.

NewCo would also be able to “expand alliances and strategy partnerships” and raise external capital to invest in “technology, solutions and people” and acquire other firms.

A fourth slide reinforced that “any decision must lead to a sum greater than its parts”.

A fifth “summary” slide noted that the firm’s leaders would pursue the split if they “believe [it would] unlock greater long-term value for all our stakeholders by becoming two purpose-led, standalone businesses”.

A sixth slide outlined what was in a split for employees. This claimed the firm would be “boldly leading professional services” by splitting with the new firms to gain “access to new clients”. It also promises faster growth with more and faster promotions and the ability for staff to “share in the rewards”.

A seventh slide outlined potential next steps for the split. This indicated that even if the 15 country managing partners agree to go ahead with the split, the entire exercise would not be completed until the end of next year.

Mr Sibio has ruled out a trade sale of the firm’s advisory business during the presentation, in part to preserve the culture of consulting division.

This will avoid a repeat of the problems that emerged when EY sold its consulting business to French IT services company Capgemini in 2000. Former leaders at EY and Capgemini have said the sale was a “value destroying” move, with culture shock and an unexpected economic downturn leading to mass job cuts less than two years after the deal.

EY consulting partners should keep in mind the consulting firm BearingPoint. In 2001, KPMG floated its US consulting business as BearingPoint, while the firm’s UK and Dutch consulting businesses were sold to French IT services company Atos for €657 million. By 2009, BearingPoint had filed for Chapter 11 bankruptcy protection.

Mr Di Sibio has cited a range of reasons for pursuing a split of the firm, ranging from increasing regulatory scrutiny of its auditing work, restrictions around the firm winning consulting work from its audit clients and the desire to enter into managed service partnerships with the Silicon Valley companies it audits such as Amazon, Google, Oracle, Salesforce and Workday.

EY’s inability to do partnerships with five of the most important technology companies because it is their auditor is unique to the firm. No other big four audits as many critical technology companies, raising the question of why EY doesn’t stop auditing some of these firms instead of splitting into two.