Stocks fell yesterday after President Trump said he would respond to any more North Korean Threats with “fire and fury”. While the North Koreans responded overnight threatening Guam as a military option, for now the political world will have to sift through the statements from both sides and decide what, if anything, has changed. Judging by the reaction in the markets overnight, it would seem that the noise levels have risen, but the underlying facts haven’t changed all that much.
While it might seem that Mr. Trump’s “fire and fury” statement was off the cuff, he had some prepared notes in front of him. One, therefore, has to speculate which audience he was speaking to. Of course he was talking to North Korea, but he was also talking to China, Russia, South Korea and Japan. If there has been any change recently in hard news, it may be the emerging conclusion that North Korea is close to developing a miniaturized nuclear warhead that could be placed on a missile. However, North Korea still appears to lack the capability to launch an intercontinental missile and safely move it through atmospheric reentry to hit a defined target. Thus, most of the U.S. may still be off limits for now. That is hard solace, however, as millions of people, including Americans in Guam and Hawaii, are at threat. Thus Mr. Trump’s real message may have been directed to China that it is imperative that it must take a more proactive role to rein in Mr. Kim. Anything more I could add politically would be beyond my pay grade.
As for the investment implications, they are extremely hard to define. Any serious military action would likely be devastating on all sides. Don’t ask me to define devastating; we can all define that for ourselves. Clearly, markets would react sharply and negatively to any military action. But as World War I and II and even 9/11 show, war isn’t what causes enduring market moves. Markets react to economic change. The reality here is that the odds of a North Korean event, while very stark and very real, are still small. Investors can’t factor in what they don’t know and don’t want to contemplate. So far, the only economic impact is the likelihood that increases in certain forms of defense spending are increasingly probable. That has already been reflected in stock prices.
Now let’s move away from what we don’t know to what we do know. In the late 1980s, Michael Milken led a boom in leveraged buyouts. The theory was simple: growth could be accelerated through the prudent use of leverage. As the 1980s wore on, the definition of the word, prudent, got stretched. When United Airlines, a capital intensive and highly cyclical company, decided to go that route, the bubble burst. Dozens of imprudently created LBOs subsequently failed. For a year or so, the stock market stopped dead in its tracks.
Yesterday, we read that Tesla is going to the debt markets to raise $1.5 billion. The rating agencies gave the offering a B- rating, several steps below investment grade. Duh! Tesla already has over $7 billion in long term debt and almost $13 billion in long term liabilities against equity of about $6.5 billion. It doesn’t make money and burns cash in bundles. It will burn through almost $1 billion this year. I am not trying to trash Tesla. It may become the largest and most successful car company in the world someday. Obviously, anyone who buys their bonds believes in Tesla’s success. Eight years from now the only way the bond buyers are going to be repaid is if Tesla becomes a hugely successful company.
That’s all well and good. But let me ask a question. Isn’t what Tesla is trying to do very similar to United Airlines’ attempted LBO? Tesla may be too small to be cyclical today, but it is a car company and it will be cyclical. It is extremely capital intensive. If we have another stiff recession, you have to be kidding yourself if you think Tesla is going to escape unharmed. This company is going to have to service almost $10 billion in debt, and one shouldn’t think that this week’s bond offering will be its last.
Which brings me to my real point. In the latter stages of a bull market, greed starts to show its face. Snap was a hyped initial public offering (IPO) that was vastly overvalued. It now sells well below its IPO price. Blue Apron was an IPO that never should have happened in the first place. If Tesla wanted to raise $1.5 billion, the safer way would have been to sell equity. Given its very high stock price, the dilution would have been 3% or less. As my father said to me, it’s hard to go broke if you don’t owe anyone any money. Tesla should be selling stock, not bonds. In 2000 leading web hosting companies sold large amounts of debt to support expensive data centers. Demand subsequently fell short, and virtually all of them went broke. Google Exodus Communications to learn more.
Thus, the bad news is that greed is appearing. The good news is that it is still pretty isolated. Blue Apron’s stock stayed above its IPO price for less than a day. There isn’t a surge of dumb IPOs yet thanks to healthy investor skepticism. Thus, the warning flags are out, and we have to be watchful. But no red flags yet.
Let me switch topics again and talk a bit about Disney#. Last night’s earnings were a bit disappointing, and the stock will be down some this morning. But that wasn’t the big news. The big news is Disney’s announced entry into online over-the-top delivery of content. In 2018, it will add a subscription service to its ESPN website that will provide thousands of hours of live sports viewing not seen on cable. This could be anything from Major League Baseball to bike races to lacrosse games. Clearly this will appeal to a real niche audience of sports junkies. Don’t think of it as anything more than a beginning. So far, Disney is not taking ESPN content away from traditional channels to be shown exclusively over the Internet, but you can see that coming.
Maybe the more important announcement is that in 2019 it will no longer provide new and original Disney and Pixar branded content to Netflix. Instead it will show that content through its own dedicated Internet subscription channel. 2019 is a good year to start. Its current agreement with Netflix ends next year. In 2019, Disney and Pixar will release Frozen 2, Toy Story 4 and a life action version of The Lion King among other movies. Perhaps more importantly, Disney’s announcement sends a message to every other content company that it must consider over-the-top options. Some companies without enough content to replicate what Disney is doing will have to partner. We saw the Scripps/Discovery merger this week. CBS has already moved over the air and owns Showtime.
The real unanswered question is where does this all lead. People will want to customize what they see and how they see it. Mobility is part of every solution. But I doubt the answer to reducing your cable bill is to pay one fee to Netflix, another to Disney, another for local programming, another for sports, and so on. If you remember back a generation, buying a car meant pouring through a list of hundreds of choices and customizing your choice. Neither buyers or manufacturers found this satisfactory, and today the most wanted features are built in. Options are far fewer.
My guess is that in the future, the cable companies and others that deliver bundled services will offer maybe three basic options, one with bare essentials (essentially what you can grab over the airways with an antenna), one that adds the most desired channels, and one that carries what you get today. They will offer a sports bundle, a movie bundle, and will integrate paid services like Netflix or Hulu as some already do today. Some disciplined buyers will save money and only buy what they deem absolutely necessary. Others will probably spend as much tomorrow as they do today. A few will buy everything that comes down the pike and spend more. It will probably take a decade to sort out. The world doesn’t need Netflix and Disney and Amazon and Hulu and whatever follows next. They are redundant. Ultimately, users will choose which survives. It is also likely that we will see big megamergers in the entertainment space. Netflix plans to spend billions on original content, but it will never gather a majority of eyeballs at any one time if there are dozens of competing entities. The market will simply be too fragmented for that to happen. When the dust finally settles not all that many years from now, there will be probably a handful of media conglomerates that control the majority of content and perhaps the ability to deliver that content to you anywhere. Thus, not only are the content companies in the mix, so are the phone companies, the cable companies and even the video game companies. Paying to watch others play video games is fast becoming a major new entertainment opportunity.
Forecasting how it all ends is akin to forecasting next year’s weather. There are simply too many moving parts. Even the government will play a role. Are you ready to watch the Super Bowl on Pay-per-View? What Disney did last night was simply another step down the path towards tomorrow’s delivery of entertainment. When Steve Jobs introduced iTunes, would you have guessed what the music industry would look like today? Disruption brings change, some predictable, some not. It will be very interesting to watch. My best guess is that over the next two years we will see some real big merger announcements that will continue to reset the bar.
Today Anna Kendrick is 32. Michael Kors is 58. Melanie Griffith is 60. One of the best voices in Hollywood, Sam Elliot is 73. The Dude imbibes.
James M. Meyer, CFA 610-260-2220
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