KeyStone’s Stock Talk Show, Episode 212.
Great to be back with you this week. We have a busy show this week with. I will kick the show off with a look at consumer spending in the US, how it affects the general economy and what some of the bellwether consumer stocks which report this week are telling us about spending habits looking to the next quarter. In our YSOT segment Aaron answers a viewer question on Zoom Video Communications, Inc. (ZM:NASDAQ) the pandemic darling which offers a unified communications platform, reported earnings last week that appeared to disappoint once again, but did mention an investment in AI – Aaron let’s you know if it is an opportunity on the drop. Brennan answers a viewer question on Converge Technology Solutions (CTS: TSX-V), a software-enabled IT & Cloud Solutions value-added reseller which we have reviewed and warned against on the show in the past – yet keep receiving questions on. Brennan let’s you know his thoughts after the recent price drop. Is it finally an opportunity as most Canadian brokerages seem to think or a stock to continue to avoid. And last, but not least, Brett reviews the topic du jour – the US debt ceiling – which is once again being debated in the US Congress as part of Biden’s 2024 budget. He will let you know what is going on and if it will affect the markets!
Where is the US Consumer Today?
What Is Consumer Spending?
Consumer spending is the total money spent on final goods and services by individuals and households for personal use and enjoyment in an economy.
Why is Consumer Spending Important?
Because it directly affects a country’s GDP.
In fact, this is a 10-year chart on US Personal Consumption Expenditures as a percentage of GDP or Gross Domestic Product which is market value of all the final goods and services produced and sold in a specific time period by a country – as we can see here in this chart in the reference to the US – Consumer Spending is currently 68.41% of total GDP – about the average of the last 10-years and at that percentage, it is very significant to the economy as a whole.
Serves as an economic indicator.
The consumption of final goods is the ultimate motivation for and the result of economic activity. This is because companies produce all the goods that individuals consume. It also shows the overall consumer confidence in an economy. Consumer confidence measures how optimistic customers are regarding their financial situation and that of the economy. This means that high consumer confidence can lead to a higher level of spending.
Consumer Spending as an Investment Indicator
Real GDP which is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year, often is considered a key economic indicator to watch.
If consumers spend less, they provide fewer revenues for a given business or within a given industry, companies must adjust by reducing costs, wages, or innovating and introducing newer and better products and services. Companies that do this most effectively earn higher profits and, if publicly traded, tend to experience better stock market performance. For the company’s that do not or cannot, the opposite is also true.
We can also look at Bellwether companies for indication of where the economy is at present and where it may be headed. A couple report this week – BJ’s Wholesale and Coscto – the first is by far the smaller of the two has already reported, Costco will Thursday afternoon and we will look at the numbers and management comments next week.
BJ’s Wholesale Club Holdings Inc. (BJ:NYSE)
Costco Wholesale Corporation (COST:NASDAQ)
BJ’s Wholesale Club Holdings Inc. (BJ:NYSE)
BJ’s Wholesale (BJ) reported first quarter results Tuesday morning that were a bit shy of expectations, with earnings matching estimates while comparable-store sales were shy of estimates.
Comparable-store sales rose 5.7% in the first quarter, missing expectations for an increase of 5.9%, according to estimates from S&P Capital IQ. Earnings per share of $0.85 matched expectations, while revenue of $4.72 billion was below forecasts for $4.8 billion.
But commentary from BJ’s leadership offered something bigger picture for investors trying to make sense of the consumer in the US economy right now.
Management continued to suggest consumers growing more cautious while the primary factor driving that caution — inflation — continues to moderate.
During prepared remarks on the company’s earnings call, CFO Laura Felice said the company is dealing with an “increasingly discerning consumer environment.”
The CEO, Bob Eddy, referenced the theme of “trading down” which dominated big box earnings last week. “Everybody wants to save money. Everybody feels like it’s a bumpy economy out there.”
“As we sit here today, we see a consumer that is continuing to visit and spend in our stores. On the margin, while they are spending more with us, they are also being more choosy with their dollars and allocating those dollars in favor of necessities.”
Anecdotally, I was in Costco this weekend and saw the price of chicken breasts at $50 a for a pack of organic vs. $30 dollars for the non-organic and found myself thinking…do I really love my family that much and what the hell is organic chicken anyways…is anyone even checking what this birds are really eating….$20 makes a difference and the thought of trading down entered my head.
Consumers pending is a huge part of the economy and if the consumer pulls back, there will be repercussion for economic growth. We keep hearing of a recession, but we are still waiting for it, but there are more signs of a slowdown.
Your Stock Our Take
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Slide 1
Converge Technology Solutions (CTS: TSX-V)
Current Price: $3.44
Market Cap: $716 Million
Dividend Yield: 1.2% (forward)
Description:
Converge Technology Solutions Corp. is a software-enabled IT & Cloud Solutions value-added reseller (VAR) focused on delivering industry-leading solutions and services. Converge’s global solution approach delivers advanced analytics, application modernization, cloud, cybersecurity, digital infrastructure, and digital workplace offerings to clients across various industries. The company supports these solutions with advisory, implementation, and managed services expertise across all major IT vendors in the marketplace.
We have covered Converge Technology Solutions a few times on the podcast.
- The first time was in October 2020:
- EV/EBITDA: 3x
- Adj. EBITDA Margin: 5%
- Net Debt: $207M
- Net Debt to EBITDA: 5x
- Shares: 122M
- The second time was in March 2022:
- EV/EBITDA: 22x
- Adj. EBITDA Margin: 7%
- Net Cash: $229M
- Shares: 215M
And both times, my conclusion was that it had great growth driven by acquisitions which was funded by both debt and equity dilution… but the stock had very thin margins.
And I noted that several of Converge’s executives were originally from the publicly traded company, Pivot Technology Solutions (PTG:TSX), which was in the similar IT solutions industry as Converge. But in the case of Pivot, we saw management rapidly grow the top line of the business through acquisitions with the use of financial leverage, however the company was unable to establish accretive acquisitions and generate per share cash flow for shareholders over time which led to a dismal share price.
Slide 2
Slide 3
Company Updates:
In late 2022, the Board of Directors announced a strategic Review process to evaluate a full range of strategic alternatives, including a sale, merger, divestiture, recapitalization, other strategic transaction, or continuing to operate as a public company. However, on May 9th the company concluded the process and indicated that it will continue as a public company and execute on its business plan.
Recently the BOD authorized the initiation of a quarterly dividend of $0.01 per share.
The company also intends to resume purchases under the NCIB that commenced last summer.
In the company’s Q1 Conference call, management indicated that after acquiring approximately $1.2 billion of gross sales through 10 acquisitions last year, they are pausing to focus on integration, cross-selling and cash generation. Therefore, the company has decided to prioritize organic growth over acquisitions in the short-term and to continue to gain efficiencies through integration.
Slide 4
Recent Financial Results: (Q1, 2023)
- Net Revenues were up 37% to $678.2 million, compared to the same period last year.
- Dollar terms organic growth was 6.8% year-over-year.
- Adjusted EBITDA increased 39% to $41.2 million, (Adjusted EBITDA margin 6%).
- Adjusted EPS was up 20% to $0.12 per share, compared to the same period last year.
- The company now has net debt of $321 million and a trailing net debt to EBITDA multiple of 2.1x
- Variable interest rate as at March 31, 2023, was 5.1%
- And trades with a trailing EV/EBITDA multiple of 6.7x
Slide 5
Now lets just quickly look at how the company is adjusting its “Net Income”
You can see that every quarter the company is adding back significant “Special Charges”…. And if we look to see what those special charges consist of, the company provides a definition of:
“Special charges consist primarily of restructuring related expenses for employee terminations,
lease terminations, and restructuring of acquired companies, as well as certain legal fees or provisions related to acquired companies.”
Now personally, I think adding back these “special charges” may be a little suspect, as the company is consistently making acquisition, and incurring these costs….
Slide 6
- Revenue growth has been tremendous – driven by an aggressive cadence of acquisitions but in the near-term management plans to slow down on acquisitions and focus on integration.
- Essentially, we have seen the company go from significant net debt, to then issuing shares to improve the balance sheet and get back into a net cash position, but now the company is back into a significant net debt position again, now with debt of $460M and a net debt-to-EBITDA multiple of 2.1x. And again it pays interest at a variable rate on this debt.
- The company trades with an EV/EBITDA multiple of under 7x. But Adj. EBITDA margins and net profit margins continue to be very thin and as I indicated the adjustments that the company is making to get to its “Adj. Profitability” are a little suspect.. at least in my opinion.
- Now Converge continues to be a company which we monitor, but not a name we would recommend to our clients.
US DEBT CEILING
The US debt ceiling is once again being debated in the US Congress as part of Biden’s 2024 budget. This is a uniquely American issue as it is the only country other than Denmark which has a nominal debt limit, and the Danes raise it well in advance of any chance of hitting the limit. The debt ceiling has been raised over 90 times historically, but since the great financial crisis, it has been more contentious amongst policymakers.
The debt ceiling is simply how much debt the US treasury can have outstanding.
If the debt ceiling is breached the US treasury is unable to issue more debt and is unable to pay the government’s bills for medical care, and social security as well as unable to roll its existing debt amongst other things. Which in turn would freeze or at least hinder many government operations.
The debt ceiling for the US is a nominal amount currently at roughly $31.4 trillion, for size comparison the US GDP is expected to be approximately $23.6 trillion for 2023.
Equity markets although have been reacting to the shifts in news and opinions of policymakers, it has not seen a significant lasting shift one way or the other over the past month as these debates go on.
However, the fixed-income market has seen a significant shift, in other words, the market as a whole is recognizing the potential risk of a default on Debt.
[Graph 1]
We can look at this shift between April 14th and May 2nd, the period in which the debt ceiling discussions became heated. We see a clear shift in t-bills maturing in early to mid-June, the expected time period in which the ceiling would be breached. The yield for t-bills expiring during mid-June rose from roughly 4.50 to 4.75% to about 5.5% depending on the exact maturity. The yields have stayed elevated since with other money market instruments, that is treasuries with under 1 year to maturity have risen since but to a lesser degree.
[Graph 2]
Another way we can look at how the fixed income market is pricing these events are through credit default swaps or CDS which are effectively insurance for a bond or T-bill if it defaults.
In the following graph of CDS premiums, you can see a massive spike to 160 to 180 basis points up from 20 to 40bps prior to the debt ceiling being put on center stage. For our listeners, the graph is effectively a vertical line.
[Graph 3 & 4]
We can also use the premium to derive the market’s implied probability of default as a percent. Which shows roughly 3.5% to 4% implied default chance for 1-year treasury bills.
Compared to previous debt ceiling debates in 2011 and 2013. 2011 peaked around a 6% probability of default, for context the 2011 ceiling was raised 2 days before the expected x-date, the date when the treasury can no longer issue debt. And in 2013 the government passed the continuing appropriations Act to extend the timeline before default and effectively ended the crisis as they were able to eventually reach a deal.
If you’re wondering why the default chance is notably lower than in 2011 yet the premiums are higher it is because yields are currently higher as a result of higher interest rates which in turn increases the CDS premiums as the securities trade at greater discounts increasing the value at risk for treasury holders.
So really what does this mean for investors, right now if you are investing in US treasuries you are receiving a premium due to a higher chance of default. If the debt ceiling is raised before default yields will drop as the risk of default is lower.However, if a deal is unable to be reached and the US defaults on its obligations and payments in the real world we would see significant and far-reaching effects.
According to the CEA, the council who advises the president.
Immediately following a default day-to-day operations would shut down, the US credit rating would fall into restricted default or RD for Fitch ratings with the individual treasuries that do default go into D rating. In the real economy, a real decline of GDP would occur, and according to Moody’s an expected 2 million jobs would be lost. As well it would likely lead to borrowing rates increasing long term for the US government further increasing interest rates, and even potentially weaken the dollar’s hegemony worldwide.
[Graph 5]
If we saw an extended default the stock market fall by 45% in the first quarter of default, and 8 million jobs would be lost. You would see any credit, loans, and mortgage interest rates skyrocket to unprecedented levels. The US would fall into a deep recession. As the real economy of the US would be severely weaked, and credit markets would be devastated the effects would ripple throughout the global economy as well.
Not exactly a positive note to end on but I’ll open it up to you guys.
