March 2019 – Third Perspective Capital

Month: March 2019

U.K. Parliament Begins To Reveal Its Brexit Preferences

March 31, 2019
by admin

By Arnab Das, Global Market Strategist, EMEA, and Michael Siviter, Senior Fixed Income Portfolio Manager on Mar 28, 2019, in Market & Economic

In a series of March 27 votes, we saw more support for softer Brexit options – but no resolution yet.

The latest installment of the Brexit saga went into overtime again on the evening of March 27, as the House of Commons engaged in a first round of “indicative votes” on alternatives to UK Prime Minister Theresa May’s withdrawal deal. While the resolution remains uncertain, the contours of a way forward are finally starting to take shape based on voting preferences among the many alternatives put to an indicative vote.

We run through the key elements of the results; their probable implications for the shape of Brexit, the economy and the markets; and what to look out for next.

What happened in the House of Commons?

In Figure 1 below, we list the indicative votes on the eight motions considered in the House of Commons March 27. They are shown in order of their shortfall from a simple majority threshold as a direct way to assess both what form of Brexit Parliament would collectively like to see, and what might eventually be put to the European Union (EU) if there were to be a new negotiation.

The table includes key features of each of the motions, which are expected to see a next round of indicative votes on April 1, and perhaps even further rounds if a clear majority cannot be established. It is possible that unvoted alternatives or new ones may be tabled for debate and votes during the next or further rounds of indicative votes.

We scale the shortfall against two benchmarks: first, relative to a majority of the votes cast on March 27 (excluding abstentions and absentees); and second, relative to the 320 votes needed for simple majority of the Members of Parliament (MPs) in the Commons.1 We will bear these general thresholds in mind in case the government (or opposition) adopts a firmer hand in trying to “whip” party MPs in any specific direction in the future. It’s worth noting that the Cabinet was instructed to abstain, while other government ministers and Conservative backbenchers were given a free vote. We therefore interpret these results as reflecting current, unbiased parliamentary preferences.

We have also included the results of the two previous Meaningful Votes (MV1 and MV2) on May’s deal in March and January, which had a significantly greater distance to a majority compared to the parliamentary alternatives, because May’s deal may yet come back to life later this week.

Finally, we have imputed a qualitative “Softness Ranking” to all but one of the parliamentary motions: 1 represents the status quo – full membership of the EU Single Market and Customs Union, and 8 represents a no-deal, no-transition Brexit. In general, we believe that the softer the form of Brexit that eventually emerges, the stronger would be the fair value of sterling, the higher the level of Gilt yields, and the lower the equity risk premium on UK equities, especially domestic-facing firms.

Figure 1: The permanent Customs Union alternative came closest to a Parliamentary majority

Shortfall to Majority
Motion	Key Features	Ayes	Nays	Margin	Votes Cast	All Voting MPs	Brexit Softness Ranking
Customs Union only	UK-wide Customs Union/Exit Single Market	264	272	8	5	56	4
Confirmatory Referendum on any Withdrawal Agreement	A referendum not to re-run the remain vs. exit question, but on what form of Brexit to adopt	268	295	27	14	52	NA
Labour’s Alternative Plan	Customs Union/close alignment to Single Market	237	307	70	36	83	3
Common Market 2.0	EEA & EFTA Single Market, FTA & Customs Union	188	283	95	48	132	2
Revoke Article 50	Status quo ante	184	293	109	55	136	1
No Deal	Leave EU with no deal on April 12	160	400	240	121	160	8
Managed No Deal	Status quo pending FTA by Dec 2020	139	422	283	142	181	7
Single Market	Remain in the Single Market/Exit the Customs Union	65	377	312	157	255	5
Meaningful Vote 2 May’s deal, March	Single Market, Customs Union transition. N. Ireland backstop	242	391	149	75	78	6
Meaningful Vote 1 May’s deal, January	Single Market, Customs Union transition. N. Ireland backstop	202	432	230	116	118	6

Sources: Hansard, BBC, Bloomberg, Invesco. EEA = European Economic Area. EFTA = European Free Trade Area. FTA = Free Trade Agreement.

What did we learn from the votes?

This rendering of the voting preferences provides several useful pointers, in our view:

Although Parliament has not delivered a majority in favor of any alternative, it came quite close to a majority on various relatively soft forms of Brexit or a reconsideration of the issue:
- The permanent Customs Union alternative was only five votes away from a majority.
- A second referendum on any withdrawal agreement was short by only 14 votes.
- Labour’s alternative – a hybrid of full Customs Union membership with the Single Market (via alignment rather than membership) was short of a majority by 36 votes – a substantial but not overwhelming distance, especially compared to May’s deal or harder versions of Brexit.
That said, Parliament is very far from revoking Article 50. And it is quite far from the so-called Common Market 2.0 – Single Market plus Customs Union membership.
Parliament is very strongly opposed to a no-deal Brexit (defined as leaving the EU with no transition to trade in goods and services on World Trade Organization terms).
It is also strongly opposed to other forms of a relatively hard Brexit – such as a managed transition to a Free Trade Agreement

The main inferences we draw from these observations and our ranking are that:

It seems that Parliament would prefer to deliver some form of Brexit in deference to the original referendum result and is not inclined to rerun a similar “remain vs. exit” referendum, at least not yet.
The form of Brexit should entail Customs Union membership but an exit from the Single Market, cushioned by a transition. Thus, Parliament at present seems inclined to a softer version of Brexit, though not the softest forms that could be characterized as a Brexit in name only.
A second confirmatory referendum is in reach as a way of ratifying an actual decision. However, the complexities of formulating the referendum question and proceeding from a rejection of the proposed Withdrawal Agreement would be intensely problematic, just as with a new Brexit referendum. For example, would the alternative to the proposed Withdrawal Agreement be to remain, or to aim to respect the original referendum result – the latter could set the Brexit process back to square one.

Three further important political points stand out from the evening’s proceedings:

First: The earliest Brexit date has now definitively been delayed from March 29 to April 12, thanks to a strong majority vote of 441 to 105 in favor of aligning UK law with international law.

Second: May’s deal faces high hurdles, though the Prime Minister and some senior politicians remain committed to it. The House of Commons’ speaker promulgated a new procedural ruling that makes it more difficult for the government to hold a third meaningful vote on May’s deal without substantive changes to the Withdrawal Agreement package. In response, the government has announced plans to table only the Withdrawal Agreement – without the Political Declaration – for a vote. The speaker has accepted this change of tack as meeting his substantive change litmus test for allowing MV3. Indications from the EU are that the Withdrawal Agreement would suffice to get Brexit over the line. If passed, the Brexit date would shift to May 22 to allow time for the UK Parliament to pass the required legislation, by agreement between the government and the EU.

We would expect considerable opposition, though this change could improve the chances of May’s deal somewhat. The most controversial element – namely the Irish “Backstop” – is in the Withdrawal Agreement (a legally binding treaty) rather than the Political Declaration (a non-binding statement of intent about future UK-EU relations).1 The Conservatives’ junior coalition partner, the Democratic Unionist Party, indicated that it remains opposed to May’s deal. The hard Brexiters are likely to continue to oppose the deal because of the risk of remaining permanently in a Customs Union. And Labour, despite not having specific issues with the Withdrawal Agreement, has indicated that it opposes the Withdrawal Agreement without the Political Declaration as a “Blind Brexit,” presumably sensing another political opportunity to undermine the government.

Third: May has indicated she will step down as prime minister ahead of the next phase of the Brexit negotiations (assuming her deal passes). She did not set a date for her departure, but if her deal were to be passed this week and the Article 50 period extended until May 22, the formal Conservative leadership contest would be triggered very shortly after. May would remain as prime minister during the leadership contest. The precise timetable would be set by the Conservative Party.

Political possibilities: Brexit before the end of May?

We note that May’s conditional commitment to step down leaves open the possibility that she could yet cling to power if an alternative option is agreed upon between Parliament and the government.2

If May digs in her heels, she may complicate future negotiations with the EU as well as her authority to manage the UK government. Alternatively, if she refuses to accept any of the alternatives offered up by the indicative votes, other possibilities will come into market focus, including a leadership struggle within the Tory Party or Parliamentary motions of no-confidence in the government to secure an early election. What’s more, permanent Customs Union membership contradicts the Tory Party manifesto for the 2017 general election, which could present May with yet another difficult choice – break a campaign pledge and further exacerbate party divisions or risk an early election to resolve the issues. All this implies that the prime minister or the government could yet fall, in which scenario EU acquiescence would be required for an extension to accommodate a leadership struggle within the Conservative Party or a new election.

Such scenarios would extend uncertainty both about Brexit itself and about the general direction of UK policy, and would require a longer extension of the process to be agreed upon by the EU.3 The official EU position is that the UK must decide whether to participate in EU Parliament elections for which the deadline is April 12 – hence the new Brexit deadline. Brexiter politicians adamantly oppose participation given the result of the Referendum, but Remainers are more likely to participate, naturally. A workaround could be found based on precedents – some EU members temporarily seconded national MPs to the EU Parliament upon joining – but like everything else connected to Brexit, this requires elusive compromise.

However, if the May government and Parliament are able to agree on a way forward by April 12, we believe the EU would stand ready to offer a long enough extension to encompass a general election, a referendum or possibly even a renegotiation of the Brexit process – despite the doubts that some member states have raised with the EU, as indicated by European Council President Donald Tusk. While the EU and member states want to resolve the Brexit uncertainty as fast as possible, they would also want to avoid a no-deal Brexit. A no-deal scenario would undermine the EU economy overall, and would be expected to severely damage the economy of not just the UK but also Ireland and some the smaller member states with which the UK has close trading links. Such factors could affect the May EU Parliamentary elections, which are already expected to see a rise in the representation of anti-EU parties.

Economic and financial market implications

Stepping back, we believe that the general trend in the Brexit process is toward a softer rather than harder form of Brexit – though major uncertainties persist that are likely to continue to weigh on growth in the UK and eurozone.

First, Parliament’s indicative votes suggest a willingness to retain Customs Union membership to protect the UK’s privileged access to the large EU markets for merchandise trade (in which the UK shines only in a few high-end sectors but is otherwise lackluster and with manufacturing less than 10% of gross domestic product). However, Parliament seems less eager to hold on to the Single Market (useful for services trade, in which the UK excels, and with services at 80% of gross domestic product). Parliament may prefer staying in the Customs Union to Single Market membership, despite the greater economic costs, because it collectively interprets the referendum result as reflecting popular dissatisfaction with globalization including free movement of people within the EU, technological change and “financialization,” which are widely seen to have widened income and wealth inequality across the country, exacerbated by a perceived loss of legislative and judicial authority under the rules of the Single Market.

This interpretation implies that achieving political stability by addressing inequality is becoming more important than economic growth, efficiency and productivity growth per se, as well as the sheer scale of market access, in public policy choices. If so, the financial market implications would be a weaker fair value for sterling, lower Gilt yields and higher equity risk premia than prior to the referendum. More comfortingly, however, this interpretation also implies that the UK is not prepared to turn away from its largest trading partner, or run the risk of a plunge in economic activity in order to seek trade deals elsewhere – and reaffirms that the political shift can be accommodated via transition rather than a revolutionary economic shock.

Second, we caution that although the indicative votes have shed some light on Parliament’s preferences, there is still plenty of room for yet more disagreement, disappointment and delay – not least because the government has indicated that it will resist the will of Parliament, which could open the door to a new political process such as a referendum or election.

Such a reconsideration might yield quite a different approach to Brexit than May’s deal or could conceivably obviate Brexit, but the extended uncertainty would probably weigh further on business and household confidence, causing further delays in major investment and consumption decisions, weakening growth and keeping sterling volatile and weak. Gilt yields could remain low or fall even further, and via the additional drag on eurozone growth, could contribute to already rising concerns about falling global growth and inflation.

Wider ramifications: Brexit is not just a UK problem

We continue to believe that an amicable resolution to the Brexit quagmire would be a favorable political and economic signal not just for the UK or the EU, but for the global economy – and that a no-deal Brexit could have negative implications for other geo-economic and geopolitical tensions.

Within the UK, the rancor within the political system and popular polarization may be exacerbated by a no-deal scenario, a revocation of Article 50, a new election or referendum – at least until and unless there is a clear and unequivocal majority in favor of a specific form of Brexit or a choice to remain. All of the above would therefore very likely continue to drag on investment and household confidence.

For the EU, concerns about nationalism and populism continue to run high both within member state political systems as well as the EU political system – where anti-status quo parties could make a strong showing in this May’s European Parliamentary elections. If populist parties get their act together and actually make a sustained and strong effort to redirect the EU legislative process, they could have a meaningful impact on EU policy. Being able to re-engage with the UK as a continuing member, if at all possible, could be a good route – perhaps the best-case scenario – for political stabilization, renewed economic reform and stronger growth for the EU as a whole, in our view.

As a base case, managing Brexit amicably towards a softer outcome with a transition rather than a shock would send an encouraging signal – that reasonable governments, like reasonable people, may disagree about many issues, yet be able to resolve differences and engage constructively in other areas. Indeed, we are encouraged that this is the direction of travel in UK politics, even though the risks remain very high and the time frames too short to fully rule out a major shock.

With contributions from Graham Hook, Head of UK Government Relations and Public Policy, Invesco

1. The core issue is that the Backstop represents an insurance policy to avoid the emergence of a hard border (such as customs checks) on the island of Ireland to safeguard the Belfast Treaty to which the UK, Ireland and the EU are signatories. The Backstop is consistent with one of May’s original “red lines” – that Brexit should not endanger the integrity of the UK, also crucial for the unionist Democratic Unionist Party on which May depends for a slim working majority in Parliament. However, the Backstop could continue to be unacceptable to the hard Brexiters because it could prevent the UK from striking its own free trade deals by keeping the UK within the Customs Union. Furthermore, remain-oriented MPs, soft Brexiters and Labour, which has been shifting its position towards continued participation in the Customs Union and Single Market, may well continue to vote against the Withdrawal Agreement. The party vote breakdown shows that the Conservatives mostly voted against softer forms of Brexit. In contrast, opposition parties, notably Labour, mostly voted for softer forms of Brexit.

2. On vote tallies, different counting thresholds would apply to different types of votes. The House of Commons has 650 MPs, but a simple majority for ordinary motions or legislation in a full House is 320 because only 639 MPs vote. (Seven MPs from the Sinn Fein party of Northern Ireland do not participate in Parliament, and the speaker and three deputy speakers do not vote.)

On toppling the prime minister from within the governing party; toppling the government by the Commons; or early elections:

May cannot be formally challenged for the leadership from within the Conservative Party for the balance of 2019 under Conservative Party rules, so she would have to agree to step down to make room for a leadership contest (or struggle). A palace coup could be organized by threatening a mass exodus of cabinet ministers, which would endanger governability and raise the chances of a motion for an early election or a new motion of no-confidence in the government. Tory Party power struggles are famously brutal.
A supermajority of two-thirds of all MPs is required to pass a motion directly calling for an early election. However, only a simple majority is required to pass a motion of no-confidence in the government, within 14 days of which a new government would have to be confirmed by Parliament or an early general election would be called. The simple majority threshold for no-confidence motions falls to 318 because four MPs serve as “tellers” to count the vote and do not themselves vote.

3. As for the politics of early elections: It has been observed that the opposition party seldom wins in a UK general election – rather it is the sitting government that has tended to lose. Accordingly, there could be widespread concern that the next government might be a Labour government under Jeremy Corbyn, and could be an old-style, hard left government rather than centrist, new Labour government – despite polls showing that the Conservatives lead. And, we would note that the surge in Labour membership and support was led by young voters, but many of these feel their pro-EU views have not been supported strongly enough by Labour’s leadership. The only high-conviction view is that the uncertainty challenge for UK financial assets and European economic performance might well be further elevated by election risk.

Important information

Blog header image: SHUBIN.INFO/shutterstock.com

In a “no-deal” Brexit, the UK would leave the EU with no formal agreement outlining the terms of their relationship.

The Irish Backstop provisions were designed to address Brexit-related concerns about the border between Northern Ireland (which is part of the UK) and the Republic of Ireland (which is part of the EU).

The opinions referenced above are those of the authors as of March 28, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

NOT FDIC INSURED

MAY LOSE VALUE

NO BANK GUARANTEE

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

UK Parliament begins to reveal its Brexit preferences by Invesco US

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Reuters

Pilots of India’s Jet Airways defer strike, seek salary…

March 31, 2019
by admin

FILE PHOTO: Workers cover the cockpit window of a Jet Airways aircraft parked at the Chhatrapati Shivaji Maharaj International Airport in Mumbai, India, March 26, 2019. REUTERS/Francis Mascarenhas/File Photo

NEW DELHI (Reuters) – The pilots’ union of India’s troubled Jet Airways said on Sunday it will give the carrier’s new management two weeks to clear unpaid salaries, deferring its plan to take strike action.

Jet has delayed payments to pilots, suppliers and lessors for months and defaulted on loans after racking up more than $1 billion in debt. The airline was bailed out on Monday by state-run banks, which have temporarily taken a majority stake in the company and given it a new loan of $218 million.

The National Aviators Guild, the union of Jet pilots, had planned to go on strike from April 1 because of non-payment of salaries. Jet on Saturday said it will pay December salaries to pilots and aircraft maintenance engineers but for now cannot pay more recent overdue wages.

The pilots’ union has decided to give Jet’s new interim management until April 14 to clear salary dues “in conjunction with interim funding”, and deferred the plans of a strike until then, the National Aviators Guild said in a statement to its members, which was seen by Reuters.

Once India’s leading full service carrier, Jet struggled to compete with low-cost carriers in recent years. In the past few weeks, its chairman stepped down from the airline’s board and lenders stepped in to rescue the airline from the brink of bankruptcy.

Reporting by Aditya Kalra; Editing by Susan Fenton

Our Standards:The Thomson Reuters Trust Principles.

Reuters

Daimler asks EU antitrust regulators to probe Nokia patents

March 30, 2019
by admin

BRUSSELS (Reuters) – German carmaker Daimler has complained to EU antitrust regulators about Nokia patents essential to car communications, a move underlining the tensions between tech companies and the car industry on the use of key technologies.

FILE PHOTO: The first fully electric Mercedes car EQC is seen at a presentation in Stockholm, Sweden September 4, 2018. REUTERS/Esha Vaish/File Photo

Tech companies and mobile telecoms providers are playing an increasingly important role in the auto industry, with their technologies used in navigation systems, vehicle-to-vehicle communication and self-driving cars.

Daimler confirmed that it had lodged a complaint with the European Commission against Nokia.

“We want clarification on how essential patents for telecommunications standards are to be licensed in the automotive industry,” the car maker said in a statement on Saturday. “Fair and non-discriminatory access to these standards for all users of the essential patents for telecommunications standards is a key prerequisite for the development of new products and services for connected driving.”

The European Commission confirmed receipt of Daimler’s complaint.

Nokia said Daimler was seeking to side-step taking out licenses.

“Though we offer a wide range of options for automakers, including through their tier 1 suppliers, Daimler has resisted taking a license to the Nokia inventions it is already using,” Nokia spokesman Mark Durrant said.

“Daimler’s allegations in its complaint to the EU are simply the latest in a long series of actions to avoid taking a license,” he said.

Nokia has a highly profitable patent business, a legacy of its history as the market-leading mobile phone maker.

Patent disputes between Apple, Samsung, Qualcomm and others have triggered mutual lawsuits worldwide in the last decade, with analysts saying the patent war could next move to the auto industry.

Reporting by Foo Yun Chee; Editing by Jan Harvey and Catherine Evans

Our Standards:The Thomson Reuters Trust Principles.

SeekingAlpha

Marathon Oil: Decent Margins, Attractive Price/Operating Cash Flow

March 29, 2019
by admin

Marathon Oil (MRO) has converted from an international E&P company to the U.S.-focused firm. Pondering the capex priorities and the future growth trajectory, MRO preferred to concentrate solely on assets with high cash margins and get rid of ones with burdensome opex. By now its portfolio is clearly U.S.-oriented; oil-producing assets in the Eagle Ford, Bakken, Northern Delaware Basin, and SCOOP/STACK in Oklahoma bring the bulk of revenue and cash flow. Portfolio structure was behind the 2018 revenue jump, a surge in cash flow, and the first full-year profit since 2015. In my view, in 2019 the company might have a relatively moderate upside if the tightening supply will support the WTI price. Considerable FCF as the firm’s virtue might support investor confidence. At the same time, I see no impetus for vertiginous growth, as analysts expect a slight decline in revenue in the current year accompanied by weaker profit.

Essential matters worth considering

In the 2013 Form 20-K, it was mentioned that Marathon Oil operated in Gabon, Angola, Ethiopia, Kenya, the Kurdistan region of Iraq, Libya, Norway, the U.K., Canada, Poland, and the U.S. You will not find the majority of these countries in the 2018 Form 10-K, as the company discontinued operations in practically all of the above-mentioned regions except the U.S. (mainly the Eagle Ford, Bakken, Northern Delaware, and Oklahoma) and Equatorial Guinea. Instead of pouring millions of dollars into the exploration and development abroad, Marathon decided to stay laser-focused on the most valuable assets in the U.S., generate cash surplus and reward shareholders; proceeds from divestments were used to fortify the balance sheet and return cash to shareowners. The firm has become risk-averse deciding to exit the regions with risky operations such as Libya and the Kurdistan region of Iraq. Marathon Oil Libya Limited was sold in Q1 FY18, while Marathon Oil KDV B.V. is classified as held for sale. Apart from that, in February 2019 it exited such a stable and predictable region as the North Sea, selling all the UK assets to RockRose Energy and leaving the 9th country in 5 years. The U.S. portfolio has also undertaken massive rebalancing, as MRO sold a few assets in Colorado, Wyoming, and the Gulf of Mexico. In 2018 after constant rebalancing MRO had 1,281 mmboe in total proved reserves (or 1,254 adjusted for TPR in the UK and Kurdistan) compared to 2,171 mmboe in 2013. It is pertinent to note that synthetic crude oil is no longer in the firm’s portfolio, as low-margin costly oil sands operations in Canada were ceased to lower opex. Ultimately, after proactive portfolio recalibrating, average production cost per unit went down from $14.47 in 2013 (see p. 21) to $8.68 in 2018 (see p. 10) boosting operating profitability and cash flow. TTM earnings of the company turned positive only in September 2018; before then since June 2015 it has been deeply in the red. In 2018, Marathon Oil had a spectacular revenue jump from $4.36 billion to $5.84 billion spurred by expensive WTI, combined with both robust cash flow generation and substantial accounting profit. For broader context, I should note that in FY13 the company had revenue of $11.38 billion.

Free cash flow

One facet of Marathon Oil I highly rate is its operating cash flow margin of 55%. Such peers as Hess (HES), Pioneer Natural Resources (PXD), Chesapeake Energy (CHK), and Noble Energy (NBL) have CF margin of only 31.5%, 23%, 19.8%, 23%, and 46.9% respectively. But the gist is that high capex directed primarily to assets located in the U.S. (300 wells in 2018 compared to 1 in Equatorial Guinea) consume ~85% of cash generated by operations. However, in 2018 the company had positive levered FCF of $481 million with FCF margin of 8.2%. It is also worth reminding that in 2013, when WTI price was more than favorable, Marathon had only $478 million left after financing PP&E and exploration. Here I should note that the company’s methodology of organic FCF calculation differs from the one I most often use. To calculate levered FCF, I take net CFFO and deduct additions to PP&E and other assets from the consolidated CFS. Contrarily, MRO deducts development expenditures, dividends, and a few other items. As a result, it reported organic FCF of $868 million. Here the firm’s preferable approach is explained in greater detail.

2019-2020 expectations

Marathon promised to increase 2019 total production by 10% and invest $2.6 billion in development and REx (resource play leasing & exploration). Most of capex is allocated to the Eagle Ford and Bakken. To consider what to expect from the top and bottom line performance of the company in 2019, I have taken a closer look at analysts’ consensus estimates. It appears that revenue is anticipated to equal ~$5.65 billion, while, importantly, OCF could decrease only 0.3%; consequently, the OCF margin will even go up. 2020 revenue is expected to equal $6.54 billion.

Data from Standard & Poor’s Capital IQ. Revenue is calculated as a sum of Revenues from contracts with customers and Net loss on commodity derivatives.

2019 consensus EPS equals $0.45.

Data from Standard & Poor’s Capital IQ

Most importantly, during the Q4 earnings call the CEO promised that Marathon would remain organic FCF-positive (after dividends) even with WTI of $45 per barrel. Besides, if WTI surpasses $50/bbl, MRO will generate $750 million in cumulative FCF in 2019-2020 and spectacular $2.2 billion in case oil benchmark will equal $60. At the moment rebounded West Texas Intermediate price is close to that level.

Valuation

I have selected a few U.S. E&P companies I consider as comparables to figure out if Marathon Oil is too expensive or too cheap among the peers. The comparable companies are:

Continental Resources (CLR),
Hess,
Concho Resources (CXO),
Pioneer Natural Resources,
Chesapeake Energy,
Noble Energy.

The picked firms have similar revenue, cash flow, nature of operations, capital spending, and regional mix of producing assets. In 2018 all selected companies had quite alike capex, while Noble Energy and Continental Resources had investment expenditures higher than the group median ($2.72 billion) by 7% and 20% respectively. It is worth noting that after protracted portfolio rebalancing business model of Marathon Oil is less similar to Hess and more akin to, for instance, Continental Resources because MRO curtailed practically all operations abroad.

Note: 1) Revenue of MRO was calculated as a sum of Revenues from contracts with customers and Net loss on commodity derivatives. Total revenue was $6.58 billion. 2) Green cells indicate the highest points in the dataset, red – the lowest.

The takeaways are as follows:

The main outcome is that Marathon Oil is the most attractive in the group regarding levered free cash flow. In fact, only MRO and CLR have excess cash after financing PP&E; the latter has higher FCF margin.
P/OCF ratio specifies MRO market capitalization of ~$14-15.5 billion by 2020 if the company generates OCF of $3.11 billion anticipated by analysts, and the ratio will increase slightly to 4.5-5x.
Pioneer Natural Resources is the most attractive regarding PEG; other firms have negative anticipated 2019 EPS growth.
At the moment debt and equity investors pay only $14.08 ($14.39 if not take into account reserves in the UK and Kurdistan) per every barrel of total proved reserves, while investors of Concho and Pioneer pay $21.99 and $23.77 respectively. However, Chesapeake and Noble are much cheaper with EV/TPR multiples of 9.8x and 9.33x.
P/E of MRO is slightly below the average of 13.28x.
In my opinion, the main culprit of CHK phenomenally low P/E of 3.7x is the company’s leverage and minuscule net worth ($467 million) compared to debt of $7.72 billion.
Ultimately, by now MRO is cheaper than the peers according to EV/EBITDA.

Regarding dividends, MRO is in-line with three key peers, but still far from the dividend champions as (RDS.A, RDS.B) and ExxonMobil (XOM). Of course, it is not coincidental taking into account Capex/Revenue and Capex/OCF ratios of these upstream players.

Final thoughts

In sum, Marathon Oil’s virtues are low EV/EBITDA and positive FCF. Besides, its buyback program has ~$800 million left (see p.25), yet to be spent in 2019. At the moment analysts do not expect 2019 EPS to increase, while revenue could go up if another oil market meltdown will not strike suddenly. All in all, I suppose MRO has moderate upside potential closely correlated with WTI price movements. Apart from that, with $5.49 billion in total debt and EBITDA of $4.1 billion, the company has a decent total debt-to-EBITDA ratio of 1.34x, which indicates firmness of the financial position and low balance sheet risk. Marathon is obviously not immune to the headwinds of the commodities market and the WTI volatility. As the Financial Times told in the recent article on the oil market, hedge funds are bullish on the benchmark prices, while behemoths as Royal Dutch Shell and Glencore are moderately skeptical. So, adverse price swings could drag shares down.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Reuters

AstraZeneca pays up to $6.9 billion in Daiichi Sankyo…

March 29, 2019
by admin

(Reuters) – AstraZeneca Plc will pay up to $6.9 billion to work with Daiichi Sankyo Co Ltd on a hotly-tipped experimental treatment for breast cancer, in a direct challenge to the world’s biggest cancer drug maker Roche.

FILE PHOTO: A sign is seen at an AstraZeneca site in Macclesfield, central England May 19, 2014. REUTERS/Phil Noble/File Photo

The deal on the drug known as trastuzumab deruxtecan sent shares in Japan’s Daiichi soaring 16 percent, its daily limit, to a record high on Friday. Daiichi’s stock has climbed 45 percent this year on optimism about the treatment.

Britain’s AstraZeneca plans to use some of the proceeds of a $3.5 billion share issue to fund the deal. Its shares fell as much as 6 percent.

Under the deal, AstraZeneca will make an upfront payment of $1.35 billion to Daiichi. They will share development and commercialization costs for the drug worldwide, with Daiichi retaining exclusive rights in Japan.

Daiichi’s drug, also known as DS-8201, targets the HER2 protein, a major trigger of uncontrolled cell growth in about 20 percent of breast cancers, where Roche has been a pioneer with its aging $7 billion-a-year best-seller Herceptin.

DS-8201 is being tested in a patient group that would typically receive Roche’s Kadcyla or Perjeta, products which the Swiss drugmaker hopes will offset a sales decline in Herceptin after loss of patent protection.

AstraZeneca and its partner will also target patients with low levels of HER2, a much larger breast cancer subgroup with poor treatment options and the drug’s biggest market opportunity, as well as certain lung and gastric tumors.

“Over the last four years oncology has been focused on pipeline revitalization … We feel that we have re-emerged and now our sights shift toward true leadership in the oncology space,” said Dave Fredrickson, AstraZeneca’s head of oncology.

The deal is a big bet on Japanese research by AstraZeneca Chief Executive Pascal Soriot, who is seeking to replicate recent success in fast growing cancer drugs Tagrisso, Lynparza and Imfinzi.

Among the wide range DS-8201 patient trials underway, five are at a final stage where results may be used in requests for marketing approval.

“$1.35 billion upfront plus significant future milestones likely necessitates blockbuster peak sales to deliver a return,” said Jefferies analyst Peter Welford, using the industry term for drugs with more than $1 billion in annual sales.

Credit Suisse analysts said they saw an 80 percent chance of DS-8201 achieving that status.

“The upfront payment is particularly large. It’s a sign that AstraZeneca assumes the drug will become mainstream in the next generation,” said Takashi Akahane, a senior analyst at Tokai Tokyo Research Center.

The two drugmakers have a long-standing relationship which includes a 2015 agreement to jointly commercialize constipation drug Movantik in the United States.

DS-8201 is part of a drug class called antibody-drug conjugates (ADC), which link powerful cell toxins to antibodies that cling to cancer cells, sparing the healthy cells that are damaged during conventional chemotherapy treatments.

Roche’s Kadcyla, also an ADC, won U.S. Food and Drug Administration (FDA) approval in 2013.

Daiichi is expected to book sales for the drug in the United States, certain countries in Europe and some other markets where it has affiliates.

AstraZeneca is expected to book sales in all other markets worldwide, including China, Australia, Canada and Russia.

Daiichi has declared its long-term vision to focus on oncology, targeting 500 billion yen ($4.52 billion) in annual sales from the business in fiscal 2025, from 20 billion in 2017.

In a separate statement, Daiichi said its President and Chief Operating Officer, Sunao Manabe, would replace George Nakayama as CEO, effective June 17. It did not give a reason for the change.

Reporting by Ludwig Burger in Frankfurt, Sam Nussey and Takashi Umekawa in Tokyo; Additional reporting by Bhargav Acharya in Bengaluru; Editing by Muralikumar Anantharaman and Mark Potter

Our Standards:The Thomson Reuters Trust Principles.

SeekingAlpha

Should You Buy ‘High Growth’ Or ‘High Yield’ In…

March 28, 2019
by admin

Co-produced with Samuel Smith for High Yield Landlord

High-flying growth stocks have ruled the headlines in recent years during the current economic expansion. However, as economic expectations dim as we move further into 2019, should investors continue riding the growth train or is it time to dig into higher-yielding securities?

There are numerous arguments to be made in favor of either investment strategy, and to some degree it depends on the circumstances of the individual involved, but we believe strongly that over the long run, investing in higher-yielding, dividend-paying stocks is a superior strategy for retail investors, especially right now. Here are 7 reasons why:

(1) Dividends Outperform Historically

Perhaps the biggest argument in favor of dividend investing is that stocks that consistently pay out dividends have a history of outperforming. The S&P 500 Dividend Aristocrats, for instance, have far outpaced their broader index over the past decade.

(Source)

This outcome makes sense in theory, too. One study showed that between 1930 and 2015, dividends alone accounted for a whopping 43% of the S&P’s (SPY) total return. Therefore, if a stock doesn’t pay dividends, it requires it to grow a lot to make up the difference. While this is possible for spurts of time, during recessionary and low-growth periods it becomes exceptionally difficult. In fact, another study has shown that literally every quintile of dividend-paying stocks (sorted by yield) has outperformed non-dividend paying stocks since 1928. If you invested in all the dividend payers in the S&P 500 in January 1972, you would have achieved nearly three times the return you would have received by investing in the non-dividend payers of the S&P 500 over the same time frame.

(2) Dividends Are Better Suited to a Low-Interest, Low-Growth Environment

High-yielding dividend paying stocks are also a good buy right now due to the fact that they do better than growth stocks in a low-interest, low-growth environment for the following reasons: (1) their valuations are usually quite low, meaning that they have less optimism priced in, and therefore, their prices have less distance to fall in the event of a deteriorating economic growth outlook; (2) their valuations are already attractive relative to growth stocks due to the recent fears of rapidly rising interest rates (which tend to hurt high-yielding real asset stocks that rely on significant leverage as opposed to capital-light, rapidly growing businesses); and (3) having a significant dividend underpinning a stock tends to give its price a firmer floor, since the intrinsic value of the share is more evident as a cash-flowing asset.

Since GDP growth is widely expected to slow beginning with this year and calls for a potential recession as soon as next year are beginning to resonate across the airwaves and internet, the Federal Reserve’s already dovish stance on interest rates will likely only get more dovish in the coming quarters. As a result, interest rates are likely to stay put (if not decline) for the foreseeable future. This should provide a tremendous tailwind to high-yield, high-leverage stocks which have already taken a beating due to interest rate concerns. Additionally, the slowing growth outlook will likely put a damper on the very optimistic valuations placed on high-growth stocks.

(3) Dividends Imply a Healthy, Shareholder-Friendly Business

Paying a sizable and consistent dividend is perhaps one of the greatest proofs that a business can give of the vitality of its operations and fundamental well-being. This is because paying out large sums of cash for a sustained period of time (especially if that number is growing) requires that the underlying operations are yielding considerable amounts of what is truly free cash flow. Many companies can (and do) massage and manipulate their financial statements to paint a pretty picture, claiming to generate a lot of earnings and even free cash flow, but shareholders never touch it. This is especially common with companies whose “adjusted” non-GAAP results differ widely from their GAAP numbers.

(Source)

However, if the shareholders are seeing these consistent results in the form of a dividend check, quarter after quarter, and ideally even growing year over year, they know for certain that this is truly surplus cash that is actually being generated by the business and is not needed to sustain its operations or competitive advantage. A sizable dividend payout also reveals that management is concerned about rewarding shareholders and treating them like true owners of the business who are entitled not only to the fruits of their profits, but also direct control over a sizable portion of them.

(4) Dividends Force Management to Behave

When a company pays out a large portion of earnings in dividends, it significantly reduces the amount of capital it has to reinvest in the business. As a result, two positive things happen: (1) management is forced to be very selective in its growth investments, thereby preventing it from venturing into areas outside of its area of competence or in costly (and often ill-fated) acquisitions, and instead requiring that it only invest in the most profitable ventures; (2) if management does want to invest in significant new projects and/or acquisitions, it must go to the markets (debt and/or equity) for additional funds and accept the price it offers them, thereby adding another layer of accountability for their actions and track record of capital allocation.

(5) Dividends Give Investors Flexibility

Dividend-paying stocks also give investors enhanced flexibility by creating a steady stream of income which can be redeployed into new investment opportunities as they come along. While it is always possible to sell shares to raise capital for reinvesting elsewhere, the advantage of dividend income as opposed to stock sales is that dividends are typically taxed at the long-term capital gains rate (or even have their taxes deferred as is the case with MLPs), whereas sales of stock held for less than one year will result in capital gains being taxed at the (higher) short-term capital gains rate.

(Source)

Furthermore, selling shares for a good price is subject to the whims of Mr. Market – which are often disconnected from the intrinsic value of the business behind the stock – whereas the dollar value of dividends is unaffected by Mr. Market’s current mood.

(6) Dividends Are Easier to Value

Because growth stocks typically have higher valuation multiples (due to their higher projected growth rates), they are inherently more difficult to properly value. This is because the rate of change in their earnings is often quite dramatic, and therefore, projecting an accurate growth rate even just 3-5 years in the future is often very difficult to do – especially for the average retail investor – given that such growth rates are often significantly impacted by macroeconomic forces and complex industry and/or technological forces.

Many dividend stocks, on the other hand, especially higher-yielding real asset businesses, have much simpler and more stable business models with slower and steadier growth rates that don’t generally change as dramatically with changing economic and industry trends. As a result, they are far easier to value and do not involve nearly as much margin of error. This helps to prevent many retail investors from getting caught up in hype and skyrocketing price action and overpaying for a stock only to see it crash down to earth again. Instead, dividend-focused investors simply focus on purchasing a stock for the passive income it will generate for them regardless of the short-term price action.

(7) Dividends Help You Sleep Well at Night

Finally, and perhaps most importantly, dividend-paying stocks can help investors sleep better at night. This is because the steady flow of dividends through all market cycles can help calm an investor’s mind even as his shares are tumbling in price. In fact, it can even help people see the silver lining in a market downturn by giving them the opportunity to reduce their cost bases with the dividend payments they are receiving.

(Source)

Additionally, as already mentioned, the lower valuation multiples and more stable, cash-flowing business models involved with higher-yield dividend stocks also lead to less disastrous price drops and enable an investor to trust that his business will make it through a downturn safely.

Investor Takeaway

Given these factors in favor of yield-focused investing, how should investors go about building their portfolios?

One easy option is to simply invest in a broader high-yield index fund such as the Vanguard Real Estate ETF (VNQ), the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), or even a preferred stock index ETF such as the iShares International Preferred Stock ETF (IPFF). However, this means buying every REIT in the index regardless of its current price, quality, prospects, or management.

While “know-nothing investors” (to borrow a term from Charlie Munger) may find this broad diversification useful, we believe (as does Munger) that using an intelligent analysis of the qualitative and quantitative aspects of each REIT in order to pick and choose the most opportunistic investments will provide the best total returns over the long term.

A great example of just that is EPR Properties (EPR), one of our “top holdings” that has very significantly outperformed passive indexes while paying higher dividends.

This is what we aim to do at “High Yield Landlord” by specializing in REIT investing. Our objective is to maximize performance by following an active approach to REIT investing with a special focus on value and high yielding opportunities. So far, the results are paying off and we are outperforming the market by a large margin while enjoying an ~8% average dividend yield.

We are the #1 Ranked Real Estate service for a reason. Take action now and join us before we hike our membership rate! We have a few Discounted Spots left!

Disclosure: I am/we are long EPR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Reuters

EU court clears German green charge exemption to industry

March 28, 2019
by admin

The towers of the European Court of Justice are seen in Luxembourg, January 26, 2017. Picture taken January 26, 2017. REUTERS/Francois Lenoir

BRUSSELS (Reuters) – Germany acted legally when it exempted heavy industry from a green energy surcharge in 2012, the European Union’s top court said on Thursday, overturning a decision by the EU antitrust regulator and annulling EU orders to recover the aid.

The European Commission, which is responsible for competition policy, had ordered Germany in 2014 to recoup some of the multi-billion euro reductions on the green surcharge it granted in 2013 and 2014 to some 2,000 heavy energy users.

They include chemical giant BASF and steelmaker ThyssenKrupp.

The Commission’s decision was backed by the EU general court in a ruling in 2016. But the European Court of Justice on Thursday overturned that verdict, saying Brussels had not proved the exemptions offered were illegal state aid.

Reacting to the ruling, a Commission spokesman said the EU executive would assess the judgment and that the recovery orders for the discounts granted had “lost their legal basis”.

He also said the judgment did not necessarily imply Germany’s current charge exemptions, introduced after the 2012 provisions expired, were compliant with EU state aid rules.

Seven years ago, Germany imposed levies on power bills to subsidize the development of renewable sources such as wind turbines and solar panels, but exempted from the surcharge firms that were heavy users of energy, such as aluminum or copper, to avoid affecting their competitiveness.

The EU Commission said this was illegal state aid and ordered a partial recovery of the discount granted to those firms, which in total was estimated at about 5 billion euros ($5.6 billion).

But the EU top court said the commission failed to establish that the advantages provided by the 2012 German law were illegal state aid. It also said the EU court of first instance “was wrong” when in 2016 it stated that those subsidies were illegal.

Reporting by Francesco Guarascio; Editing by Philip Blenkinsop and Edmund Blair

Our Standards:The Thomson Reuters Trust Principles.

SeekingAlpha

Noble’s Nefarious Contractual Nuances

March 27, 2019
by admin

Even with predictions for significantly higher day rates for floating drill ships (floaters), it may be too early for new investors to begin investing in Noble Corp. plc. (NE). Recently Diamond Offshore (DO) CEO, Marc Edwards, predicted that in 2020 contract rates for deep water drilling ships were about to increase maybe double. Since in our view Noble Drilling is slightly cash flow negative with existing contract rates, we wanted to explore how Noble’s cash flow might change during the next few years. Obviously, we are assuming that rates increase as predicted. Noble has been particularly protective of its cash uses delaying until roughly 2024 major debt repayment. This action puzzles us. A slide from the company’s most recent presentation illustrates how dedicated Noble management has been toward delaying its debt repayment, owing only approximately $300 million of its $4 billion in debt through the next five years.

A Look at Past Contract Durations

Noble, in the past, has provided slides showing contractual end dates. The first slide included below is from the company’s 1st quarter 2018 report. Four of the drill ships are contractually tied up until at the earliest, mid-2021. The next slide is the latest fleet update.

The Floating Ship Market Place

Figuring cash flow begins with average rates. Vladimir Zernov wrote in a recent article referring to floaters, “This improvement led to a modest increase in dayrates, which are now $175,000, according to Bassoe estimates.”

Our assumptions are hypothetical and simple. Contracts beginning in 2019 will be at the current rate of $175,000/day until into 2020. Thereafter, the rates double to $350,000/day. The margin for the first $175,000 is 50%, the balance is operating profit. Future on-stream time is assumed at 80%. Floaters already under contract will remain at the current rate. The table below consists of the floaters for which contracts expire before 2022.

Floaters	Contract End Date	Operating Profit 2019 (Millions)	Operating Profit 2020 (Millions)	Operating Profit 2021 (Millions)	Total (Millions)
Tom Madden	March 2020	0	$75	$75	$150
Sam Croft	Mid 2019	$12.5	$75	$75	$160
Don Taylor	May 2019	$17.5	$75	$75	$180
Total		$30	$220	$220	$480

We understand that contract upgrades won’t magically occur for all assets on January 1. A hypothetical simple average ramp adds some level of accuracy. When adding revenue in yearly order and prospective, 2019 may add $30 million, 2020, $100 million and 2021, $200 million. In our article, Noble Corp.’s Precarious Position, we calculated for Noble to continue bleeding cash at $100 million or more with revenues of approximately $1.05 billion under its current cost structure. The company’s need for spending a $100 million more in capital than normal, further exaggerates 2019 cash flows.

The following table projects a hypothetical cash flow through 2021.

Cash Flow Balance by Year (Millions)*	2019	2020	2021
Beginning Cash	$400	$230	$230
Net Operational Cash Flow	($100)	($100)	($100)
Extra Capital Expenses	($100)	$0	$0
Cash From Floater Contractual Increase	$30	$100	$200
Cash Balance	$230	$230	$430

*Excludes bond repayments.

Under this hypothetical, Noble recaptures its cash in 2021, but doesn’t make extra debt payments. In our view, debt reduction to $3 billion from $4 is absolutely the single most important goal Noble needs to achieve. After 2021, should increases in contract continue to materialize, Noble could begin paying down significantly its debt. That doesn’t begin for three years.

We admit that these numbers are best guesses based on the information we have, nothing more. But, the results tell an important story, how important and difficult increases in contractual rates might be to level this ship. We suspect that management really understands the nuances of its contractual structure. This contractual structure seems to also come with a nefarious affect, which could hamper Noble’s near-term financial health and investor faith. We also fully understand that our best knowledge, especially regarding the truth about Noble’s cash flow circumstances, may be in error. A simple change of being a $100 million too low, matters.

What Might This Mean?

Noble might continue its outward appearance of being susceptible to bankruptcy for some years. If so, it will or could trade with significant price penalties longer than others. Unless we see significant cash flow improvement, we plan to continue selling covered calls. New investors may want to wait until a truer understanding of cash flows is known.

Disclosure: I am/we are long NE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are selling covered calls on large portions of our holdings.

Reuters

Southwest trims first quarter outlook after 737 Max groundings

March 27, 2019
by admin

A number of grounded Southwest Airlines Boeing 737 MAX 8 aircraft are shown parked at Victorville Airport in Victorville, California, U.S., March 26, 2019. REUTERS/Mike Blake

(Reuters) – Southwest Airlines Co on Wednesday was the first major airline to formally cut its financial outlook in the wake of the recent groundings of Boeing 737 MAX planes.

Shares of Southwest, the largest operator of Boeing’s 737 MAX 8 with 34 jets, were down as much as 2.5 percent at $48.8 in premarket trading after it said its operating revenue per available seat mile (RASM) would rise by a full percentage point less than previously forecast.

The revenue indicator is a closely followed measure of airline performance and had been forecast to grow by 3 percent to 4 percent before the crash of an Ethiopian Airlines jet on March 10 caused the grounding of 737 MAX planes globally.

The fourth leading U.S. airline, which has been battling flight cancellations on the back of bad weather, maintenance disruptions as well as the MAX 8 groundings, also cut its capacity forecast for the first quarter.

The Dallas, Texas-based airline estimates about 9,400 flights to be canceled through March 31, and said it now expects capacity growth to be about 1 percent, compared with its previous growth forecast of 3.5 percent to 4 percent.

Southwest expects costs to shoot up due to a substantial growth in flight cancellations and the airline now estimates first-quarter unit costs to increase about 10 percent, compared with its previous forecast of about 6 percent. This excludes fuel cost and profit-sharing expense.

Air Canada and United Airlines had earlier warned of negative impacts on business due to the groundings, with the Canadian carrier suspending its 2019 financial forecasts.

Several airlines are also reconsidering Boeing orders.

American Airlines Group Inc, the largest U.S. carrier, said earlier this week it was cancelling about 90 flights per day. American is the second-largest U.S. operator of the MAX with 24 jets, behind Southwest Airlines, while United has 14 737 MAX jets in its fleet.

Reporting by Rachit Vats and Sanjana Shivdas in Bengaluru; Editing by Patrick Graham and James Emmanuel

Our Standards:The Thomson Reuters Trust Principles.

SeekingAlpha

Netgear: Challenging Times Ahead

March 26, 2019
by admin

Shares of Netgear (NTGR) have remained distressed for the better part of the past year now; the stock is down 30% from the highs it created in last year’s July. The company is lacking in short-term growth catalysts and I believe its shares will remain under pressure and can head lower from the current levels over the next two quarters at the very least. Let’s take a closer look.

(Source: Bigstockphoto, Image license purchased by author)

Growth Catalysts

Let me start by saying that Netgear does indeed have a few growth catalysts lined up ahead that have the potential to materially bolster its sales over 2020 and maybe even beyond. The only problem here is that we realistically don’t know how big or small these opportunities are going to be, and when they’ll start to account for a meaningful portion of Netgear’s overall revenue.

For instance, there’s a new buzzword in the networking domain of late: Wi-Fi 6. This next-generation standard of wireless networking, also known as 802.11ax, is better than the currently leading 802.11ac tech on several fronts – throughput, bandwidth and power efficiency amongst other facts. The slide by Intel (NASDAQ:INTC), attached below, highlights the applications and benefits of Wi-Fi 6.

(Source: Intel)

Now, Netgear is into the business of manufacturing and selling routers, so naturally, the industry’s shift from 802.11ac to 802.11ax would trigger an upgrade spree amongst retail and enterprise customers. This may result in higher shipments for Netgear. Besides, the new tech would naturally be sold at a premium compared to the dated 802.11ac-based products, which is dated and has more or less become mainstream by now, so the upgrade spree stands to also boost Netgear’s ARPUs in 2020-21.

(Source: BusinessQuant.com)

The industry’s transition to Wi-Fi 6 is expected to happen quite quickly, at least on fancy marketing slides and ambitious excel sheets. ABI Research forecasts that WiFi-6 routers would reach 1 billion shipments by 2022, within merely three years of its first commercial rollout. I’ll let readers decide whether this is a realistic forecast or whether it sounds too good to be true.

Besides, the transition from 4G to 5G wireless services over the coming quarters stands to enable a myriad range of IoT applications. This is another area where Netgear stands to benefit. The company recently announced the rollout of world’s first millimeter wave 5G mobile device and their management noted during their Q4 earnings call that they would be coming out with more 5G devices over the course of 2019.

During the fourth quarter we also announced the release of the world’s first millimeter wave 5G mobile, the Nighthawk 5G Mobile Hotspot with AT&T. It’s the first standard-based mobile 5G network device in the world and is available on AT&T’s mobile, 5G plus network for early adopters…You can expect more 5G related products from us in 2019.

But with that said, let’s also look at some of the challenges faced by Netgear.

Challenges

For starters, the problem with Netgear’s 5G and Wi-Fi 6 prospects is that these two potential catalysts won’t start accounting for a material portion of Netgear’s revenue over the coming quarters. For starters, Netgear is still in the process of developing and rolling out Wi-Fi 6 routers. The commercial rollout of these products may begin in 2019 but we can’t expect it to go mainstream this year itself. I’m of the opinion that the mass adoption of Wi-Fi 6 routers will begin in 2020, once the new tech has made its way into consumer devices (phones, tablets, IoT devices), meaning we still have to wait for a few more quarters before the Wi-Fi 6 upgrade spree starts to bolster Netgear’s sales.

Not to mention, Netgear’s 5G business isn’t exactly expected to ramp exponentially right away either. When asked about the size of this business vertical during their Q4 earnings call, Netgear’s management noted:

…we expect that business, on average, to be at $35 million range. I think as it relates to 5G, I think, that’s tail end of 2019 phenomenon as the network gets fully rolled out as newer devices come out. But at this point, we believe it’s on average $35 million a quarter.

To put things in perspective, Netgear registered $288.9 million in Q4 revenue. This means that its $35 million worth of 5G business represents just about 12% of its overall revenue. Sure, the segment may turn out to be a huge revenue driver for the company over the coming years but we aren’t there yet. Also, as the management stated, its 5G-related revenues won’t be sizable during 2019 at least, so investors shouldn’t go overboard with expectations.

The challenge for Netgear and its shareholders would be that there aren’t any short-term growth triggers that can meaningfully drive the company’s growth over the next three quarters, or at least until its 5G and Wi-Fi 6 products start to become mainstream market products and subsequently revenue drivers for the company. I suspect the next few quarters would be dull for the company and its shares would languish along the way unless the networking giant comes up with a new roadmap that materially changes this sales outlook.

(Source: BusinessQuant.com)

The chart attached above would highlight that Netgear’s revenue has been more or less range-bound if not stagnating across both its operating segments. One factor that can particularly weigh on its revenue trends over the coming couple of quarters is Amazon’s (NASDAQ:AMZN) acquisition of a mesh router company called Eero which is a direct competitor for Netgear. This development has twofold repercussions:

Amazon should ideally put its financial and operational might behind growing this business which could weigh down on Netgear, and/or;
we can expect Eero products to be featured more often on Amazon’s web front as the parent company would want to grow its subsidiary, and/or;
Netgear’s revenues could shrink as it already generates a sizable portion of its revenue from Best Buy (NYSE:BBY) and Amazon as evident in the chart below.

(Source: BusinessQuant.com)

Takeaway

Granted that Netgear is a prominent name in the networking space but it’s currently faced with a few challenges for the time being at least. Only time will tell how big of an impact the Eero acquisition would have on its business, and when exactly its 5G and 802.11ax products would start to become a material growth driver for the overall company. As a result of this dynamic, I expect its shares to stay distressed over the next couple of months and forecast a rebound only beyond H2 CY19 if all goes as per management’s plan.

Author’s Note: I’ll be writing another report on Netgear this week, you can click the “Follow” button at the top of this page to stay updated. Thanks!