“Se vogliamo che tutto rimanga com’e, bisogna che tutto cambi”

It must be a terrible thing for a business to face “reopening headwinds”. This is how a Wall Street analyst characterizes the disappointing quarter and outlook presented by Zoom Video Communications’ management on Tuesday’s earnings call. While the Pandemic may have accelerated the rate of digital adoption, it is no less true that a large customer base coupled with other incumbency advantages in combination with deep pockets remains a great advantage when new markets open up. Microsoft Teams is not free, but it is included in the office license, and is also conveniently displayed on the Outlook task bar. We wish Zoom enthusiasts all the best in their David against Goliath struggle. In any case, should history repeat itself; this still fast growing company will receive a tempting offer to merge with a bigger company soon. In this kind of effervescent environment, smart people are actively on the outlook to acquire assets, revenues or customers and place them under their gargantuan market capitalizations. Just as the fourth wave takes off in Europe, WFH (work from home) stocks are finishing a round of earnings that suggests that sometimes, the classics are more informative about the future than youthful enthusiasm for shiny new things.

Yet, just as soon as market participants started writing off WFH as a thing of the past, we went to bed on Thanksgiving day with the news that a new mutation of the virus had been identified in Southern Africa. The WHO quickly moved to classify the newly named Omicron variant as a variant of concern just as it did previously with the Alpha, Beta, Gamma, and Delta variants. Journalists did not miss another chance to stoke mass hysteria by pointing out the obvious as they did at the time of the appearance of all the other variants of concern. Fear took over greed in financial markets in yesterday’s abridged session. For those unfamiliar with Black Friday sessions, we will just point out that this is the date that a famed top-tier Wall Street investment bank chose to mark its fiscal year-end for decades. Rumour had it that their traders took advantage of the illiquidity on Black Fridays of yonder to mark down some positions to build up some P&L reserves for the following year. Thus, markets on Monday may be a different story. In any case, we may not know for 100 days or so whether the available vaccines are effective against the Omicron variant. Perhaps this second wonderful market year may not have a stellar finish after all. (By the way, does anybody know the reason for the 11-letter jump from Delta to Omicron?)

WFH stocks are not the only theme buffeted in recent weeks amidst the whims of nervous investors; Covid beneficiaries have also suffered, as well as SPACS, reopening plays, payment companies and other recent Go Go stocks, not to speak of Chinese tech stocks, which are the current whipping boy on Wall Street. It is fitting that in the middle of this stealth carnage, as the FAAMGs continue their upward march propelling all the indices to new all-time highs, for KKR to announce an unsolicited tender offer for Telecom Italia. To remark that this headline triggered a long spell of nostalgia would be an understatement. The headline was a digital madeleine that brought back memories of a much simpler proto-Internet time full of unmet promise and unwarranted optimism. The Italian government has made it clear that it has three priorities in analysing a potential offer for TI. These are protecting employment, protecting technology and protecting the network. Little has changed in nearly a quarter of a century since Telecom Italia was allegedly quietly approached by Deutsche Telecom. The Italian Government still has veto powers and shareholders’ rights are of no concern in the discussions that will take place over the next few days.

Interestingly, Dr Mario Draghi, the current Italian Prime Minister, already played a relevant role in the partial takeover choreographed in the late 1990s to keep Telecom Italia under Italian control. We met Dr Draghi in April 1999 at a conference near Como where he was the dinner guest speaker. Back then, Dr Draghi was the Director General of the Italian Treasury. His address, versed on a new Law, popularly known as the Draghi Law, which he claimed would forever improve and modernize Italy’s infamous corporate governance. Many people believed that the Draghi Law would take care of minority shareholder rights in a way that would prevent a repetition of the recent partial takeover of Telecom Italia by a cascade of levered Chinese boxes on top of which sat Tecnost-Olivetti as a controlling shareholder (through Bell an aptly named SPV). The head of Tecnost-Olivetti, Roberto Colaninno had already tried to swindle Telecom Italia shareholders by offering an exchange of telecom Italia Mobile shares for Tecnost shares. Colaninno was a very shady character acting as a front man for Carlo de Benedetti after the latter’s fall from grace. The plan was for Carlo’s son Marco to run an asset stripping exercise of one largest companies in Europe with €9billion in annual cash flow and just €9 billion in debt. Colannino was in essence a strawman; nevertheless, he received widespread support for his eventually successful blocking manoeuvre that thwarted an unannounced Deutsche Telekom takeover attempt on Telecom Italia. The subsequent history of Telecom Italia is a case study on how to defile shareholders’ rights while destroying value.

Olivetti’s financial targets were not achieved in spite of some sales of assets and layer upon layer of debt. By 2003, the banks in the syndicate were getting impatient with their exposure to telecoms and possibly suggested the merger of Olivetti and Telecom Italia. The merger terms were a terrible deal for Telecom Italia minority shareholders as they were asked to buy Olivetti’s Telecom Italia stake at a premium to market prices. The terms were in fact so prejudicial to Telecom Italia shareholders, in spite of the Draghi Law, that one of the investment banks that provided a fairness opinion changed its policy for accepting such engagements as its Prime Brokerage department was put in the penalty box by many of its large customers because of this fiasco. In 2005, Telecom Italia merged, also in beneficial terms for Tecnost-Olivetti, with its mobile subsidiary Telecom Italia Mobile in order to eliminate the “leakage” of minority interest and gain access to 100% of the group operating cash flow. In spite of all these transaction, the deterioration of the business and the huge debt pile amassed to persevere on a self-defeating dividend policy have yielded a total shareholder return of -79% (including dividends) for the period going from that patriotic intervention of the spring of 1999 to the Friday before the KKR announcement. So much for benefits of the Draghi Law.

For the lucky few who bought Telecom Italia shares recently, this bid is a dream come true. If they were to study carefully the history of the governance of this company, they would be well advised to take some profits just in case politicians once again scuttle a beneficial deal because of national security concerns. For others, this is further proof that the long-suffering telecom industry is due for a revival. In any case, this offer has already triggered a knee jerk reaction from the Spanish Government to extend a legally dubious blanket protection on Telefonica from an unsolicited bid. It would be preferable if Telefonica shareholders tried to protect themselves from their current board of directors and management. More specifically from two large shareholders with board representation which persist on demanding an unaffordable dividend policy that a dutiful and pliant management funds with dilutive asset disposals when piling on more debt was no longer an option. Thus Telefonica’s total return since April 1999 is -6.5%. While this may seem to be a marvellous outcome when compared to France Telecom (-55%), Telecom Italia (-79%), or Portugal Telecom (-100%), it is less compelling when one observes that Deutsche Telecom returned 9.6% or Hellenic Telecom returned 38% for that same period These are the long term returns for some of Europe’s largest companies in revenues and total assets. Banks, another large European industry, has probably fared worse. This is as well the Europe claims to be a world leader in adherence to ESG principles. “Se vogliamo che tutto rimanga com’e, bisogna che tutto cambi.” remains as true today as ever before. Caveat emptor.

Posted in Reports from the Field | Leave a comment

Modern Financial Theory: Size Matters, so do Taxes and Liquidity

This past week, Elon Musk conducted a poll on Twitter on whether he should sell 10% of his Tesla stake to raise cash to pay for taxes on vested options grants. Survey said “yes”. Mr Musk exercised just over 2 million options on Monday and may exercises more than 20 million more options before August 2022. The gains on the exercise of options is taxable income in the US. Somewhat unusually, Tesla’s stock sold-off. Mr Musk owns 16.9% of Tesla’s shares outstanding. The announcement of the sale of a 1.69% stake resulted in a drop in the market value of the company of 15.44% for the week. On a fully diluted basis, this loss of value is 12 times as large as the amount of taxes the Federal Government will collect. Some will ask why would a large insider flag a large sale of stock when this is not required. Certainly, Jeff Bezos’s sale of 2 million Amazon shares earlier this year for $6.6 billion was far less publicised.

One possible explanation is that flagging the sale to the legion punters that follow his every Tweet, when they are not too busy buying short dated call options on Tesla, is necessary to retain his demi-God status. Another plausible explanation is that, with this apparently silly banter, Elon Musk has shown millions of Americans, and not just his day trading fan base of “Popular Capitalists”, what is likely to happen to their stocks portfolios if Congress retakes the billionaire’s tax issue after the mid-term election. The cost basis for the founders of the largest US public corporations is essentially zero. It is going to be very interesting to see how this new tax works out. Forbes magazine estimated the cost of this tax for just the 20 wealthiest US residents at $345 billion had it been implemented in 2020. The market impact might have been quite something to judge from what we have seen with Tesla’s price action. For now, democrats have backed off on this billionaire tax proposed by Senator Ron Wyden; instead, Congress passed a surcharge on those with adjusted gross incomes above $10 million per year.

Mr Musk’s not so subtle message may ignite the legion of aggrieved parties to let their congressional representatives have a piece of their minds. Very few people understand the psychology of the American public as well as Mr Musk does. Americans love a success story, especially if such susses is the work of a maverick outsider. Mr Musk is that in spades and follows on a proud tradition started by Thomas Alba Edison, the founder of General Electric, which many decades later became the most valuable company in the world during the late 1990s. Yet uncharacteristically, by selling today 10% of his fully vested stake in the company, he is not only sending a message to Washington, he is also sending the message, that this is a very good time to sell.

Mr Musk’s options grant has an exercise price of $70.01 per share (the cent is clearly quite important for shareholder value creation!). The intrinsic value of this option grant as of Friday’s close is $97,450 million, the Federal income tax payable on this income might be as much $43,852 million, so we can expect a lot more tesla stock selling from now until April 15, 2023 and beyond. This should not be very reassuring for investors. Mr Musk is not the sole recipient of large stock awards. Gone are the days of the frugal founders who took no compensation such as Mark Zuckerberg or Jeff Bezos, today’s entrepreneurs are more often than not receiving massive stock options grants in the form of giant special stock awards. Welcome to the ESG era.

There are numerous examples. The Wall Street Journal reported on October 16 how Alex Carp, CEO of Palantir Technologies, received a package valued at $1,100 million, three times as large as Tim Cook’s over at Apple. He is not alone, “seven of the 10 most valuable compensation packages for U.S. public companies in 2020 were to CEOs of start-ups that listed publicly that year, according to public-company data-and-analysis firm MyLogIQ LLC. Five of those start-ups paid their CEOs more than any company in the S&P 500, an index that includes the largest corporations in the country”. What is going on here?

Apparently, these companies’ financial backers offer these incentives gladly to motivate executives to sustain rapid growth. It would appear that currently the balance of power between venture capital investors and founders is favouring entrepreneurs. This may be a reflection of ample liquidity chasing these investments. Alternatively, in a world worried about slowing growth and rising inflation the value of innovation may have gone up significantly because it is the asset class that offers the best risk reward. In any case, while markets generally discount quite efficiently all publicly available information and therefore you would expect stock prices to reflect these technical matters, our experience suggests that true market liquidity is the risk factor most investors underestimate more consistently.

While equity market value matters to the success of a company today because it may be the source of cheap funding and makes it easier to recruit talent, the appetite investors may have for large insider selling programs may not be as large as you might expect. Ever growing secondary placements competing with the primary offerings of new IPOs is not a good development. The volume of Global IPOs rose 87% in number and 99% in proceeds for the first 9 months of 2021 setting a record of $321 billion. The combination of record high issuance and growing insiders’ selling with tapering may have a sobering effect on many people’s expectations of what is a reasonable valuation sooner than most of us would like it.

P.S. What is going on in Madrid? Our sources tell us that every other weekend the central part of town, when not the whole city is cordoned-off for a footrace or any number of popular and populist events as interesting as thousands of people in purple T-shirts walking their dogs on the main thoroughfares as these are closed to traffic. To add insult to injury, the police officers, who should be happy with all the extra-time, are not very helpful. They either have no information on the times of the closures or alternative routes or else they are unwilling to share such information. These events may be very popular, although you would be hard pressed to tell from the diminutive number of spectators. They certainly are an unwanted inconvenience for those who live or visit the city centre and for surface public and private transportation users. These events remind us of Taki Theodoracopulos’s vivid description of the National Puerto Rican Day Parade on Fifth Avenue, which is sadly likely to be too offensive to modern sensibilities to reproduce here. Somebody please tell the Mayor to look for new venues, bring the Circus closer to where the vast majority of the people live. Please stop imposing your populist agenda on the retail and restaurant owners who pay premium rents and whose businesses you have been trying to ruin so effectively since the outset of the Pandemic. Is this show of indifference for the business community of City he governs somehow a result of the pitched battle with the pro-business regional government President? Whatever the reason for this might be, he should take his fight elsewhere.

Posted in Reports from the Field | Leave a comment