|Summary: Gold, Apple and BHP are a warning that that there is pain in the derivatives market. The mass unwinding of derivative positions in all three is one of the forces affecting those global stocks and commodities in general.|
|Key take-out: As in gold and Apple, the complex derivatives plays behind the BHP stock drives it down further as traders are forced to liquidate what are leveraged positions.|
|Key beneficiaries: General investors. Category: Portfolio management.|
I experienced three cold shivers this week – first when I saw the university funding cuts, and second the big fall in gold and the below $US400 dip in Apple stock. Then came the third, BHP. As I will explain, gold, Apple and BHP are a warning that that there is pain in the derivatives market. And that is one of the forces affecting those global stocks and commodities that have become big derivative plays. And then, finally, I have an exciting “start-up” story (with obvious risk) that the market does not believe.
First the university cuts. I am not going to go into the debate between spending money at universities and state primary and secondary schools, but there is no doubt that before the Cabinet in that fateful meeting several weeks ago was the choice between the university cuts and much higher superannuation taxes.
As you would have read last Friday (How we dodged a super bullet) I believe the superannuation industry has dodged a dangerous bullet and the debates in Cabinet must have been fierce, with the possibility of an odd resignation being threatened. What I didn’t appreciate was the superannuation/university choice, which must have added enormous intensity to that debate. Given the animosity deep inside treasury towards superannuation, I hope the current set of changes go through because I think there is a real chance that will give us stability.
Derivatives danger zones
Why do I link gold and Apple, plus BHP? For some time we have marvelled at the enormous QE3-generated capital power behind the sharemarket, but that capital power is not behind the commodity markets. And we saw with gold that the web of derivative products that were surrounding that particular metal just simply fell over when major selling was triggered. I believe the gold selling was triggered by the Cyprus sale threat, but it could also have been the Federal Reserve minutes. It doesn’t matter. It is the web of gold derivatives that makes the market so dangerous. And we saw how that danger materialised in a major fall when triggered by selling pressure. One of the most derivative-ridden global industrial stocks is Apple. It has fallen 44% since September last year, closing last night clearly below $US400 at $US392, compared to its peak of over $US700. That’s a big fall in around seven months, and although more gradual than gold it will also be putting great pressure on the leveraged derivatives markets.
The fall in gold will put pressure on all commodity markets, and we are vulnerable because too many of our miners are now high-cost producers. And, as you know, I’m fearful of the outlook, particularly in energy.
The BHP fall from its peak has been 22% – half that of Apple. But just as Apple is struggling on the sales front to justify high prices, the same thing is happening to the Big Australian, BHP, in minerals. Moreover BHP, like most miners, has been looking to maximise profits in the boom, and it will need a period of much greater investment to lower its costs to compete in the new environment. The realisation that that was behind the management changes helped send the company’s shares down. But, as in gold and Apple, the complex derivatives plays behind the BHP stock drives it down further as traders are forced to liquidate what are leveraged positions. When derivatives are a key force in a stock, it accentuates both the highs and the lows. We saw this today with BHP, which rebounded in trade on the stock exchange. The flow-on effects of derivatives can spread, and so the Apple fall is also now having a similar effect on the US industrial market as gold is to the broader minerals sector.
NewSat counts down to blast-off
But today I want to do something different and talk about a high-risk stock that the market does not believe. And that stock is NewSat. And the first question you ask is, “have you put your speculative money where your mouth is?” The great difficulty I have is that if I buy stock in NewSat I will correctly be accused of plugging my own stock.
NewSat has the most incredible vision to be a major satellite player in the world. I remember when Adrian Ballintine, the CEO, first told me about this vision, I really found it hard to believe. Here was a company at the time with a capitalisation under $100 million and we were talking about a $600 million to $700 million venture. I didn’t show him the door but rather set a number of targets . When he performed those tasks, I set him some more, and in the end he now actually has all the funding in place.
NewSat, which developed its reputation in the industry as a satellite manager, has contracted to launch a telecommunications satellite in 2015. The export-import banks in the US and France are funding that satellite to the order of about $400 million in non-recourse loans. It is true that the satellite launch venture creates a lot of employment both in France and the US, but the two banks have been through the NewSat sums with a fine toothcomb. And they know the satellite business. So it is one thing for a CEO to say he can do various things, but it is quite another for experts in the satellite industry to endorse those claims and put $400 million on the line. Then he has raised another $108 million in equity, and guess who was a major subscriber (with around 5%) – the world’s largest investor Capital Group. Capital is also a shareholder in BHP. So this is no ordinary situation.
To get this backing, NewSat had to sell more than $618 million worth of telecommunications contracts to use the proposed satellite and to provide the cash flow. The US military is one of the main customers. That cash flow will provide the costs of the launch and repay the debt. Any further cash flow is basically cash profit, but subject to depreciation etc . Once again, Ballintine tells me that NewSat will have no difficulty securing the additional telecommunications contracts. Ballintine says the planned satellite, at “70% utilisation is expected to generate in excess of $3 billion of revenue over its 15-year life at 85% EBITDA margins.”
NewSat Key Statistics
Return on Equity
Earnings Per Share
Once again, it seems too good to be true, but I now don’t discount the predictions. I have embeded a video interview above, which I did with Adrian Ballintine just a week ago. Like any speculative stock, there are at least two things that can go wrong. The first is that the satellite may fail, but the insurance policies that back the bank loans are extensive. The banks would not commit that sort of money without proper insurance. And the business of launching satellites is now much lower risk than it was a decade ago.
The second thing that can go wrong is that the extra satellite space is not sold, or something goes wrong with the whole revenue model. Of course, that could happen but the stock is trading at just under 40 cents, which is the price Capital paid. It’s worth a punt. Australia needs good news smaller company stories, companies that can take clear risks to break international frontiers and do things differently, providing excitement to the stockmarket. In other words, we need more NewSats but it’s tough going, particularly when the leader’s market is down from the peaks.