Letter number 106 of September 2017
- QUESTIONS & COMMENTS
Blockchains are at times described as a revolution, capable of completely overturning the functioning of the financial industry as a whole, and at other times as a very elegant solution to a problem that still needs to be defined. So what’s going on here?
WHAT EXACTLY IS A BLOCKCHAIN?
On the list of TCP/IP (internet communications), SMTP (email), or FTP (file transfers) protocols, blockchains could become the method for transferring ownership over the internet.
Blockchains can in fact be compared to public accounting records that are time-stamped and immutable (in perpetual expansion with the addition of new information). These accounting records do, however, differ significantly from traditional systems: they are validated and updated without any central authority. Control and validation of the records is carried out via a distributed network of peer-to-peer computers, which provides them with unequalled resilience.
Today there are two main types of blockchain protocols:
- Public blockchains such as Bitcoin or Ethereum, open to all;
- Consortium blockchains, access to which is restricted to members.
Public blockchains promise full disintermediation, but consequently suffer from legal insecurity. Consortium blockchains, also referred to by the term DLT (Distributed Ledger Technology), could simplify the functioning of marketplaces and reduce transaction costs, in a clearer legal framework. However, the choice of the governance model for these blockchains remains a sensitive issue.
The main applications for blockchains that have been defined at this stage are:
- the transfer of value without duplication of ownership (currency, financial security, vote, etc.)
- proof of existence (notarised document, patents, copyright, etc.),
- coding of business rationales, using smart contracts, in order to automate processes.
BUT WHAT’S IT FOR?
Bitcoin, the first decentralised digital currency which made its appearance in 2009, introduced the blockchain concept. The major innovation of Bitcoin was that it made it possible to transfer digital ownership, without duplication of this ownership being possible. In this area, Bitcoin is and remains the first application of blockchains.
Financial institutions were among the first to take an interest in blockchains with the idea of rationalising their costs. They would be able to save over $100bn in structural costs according to certain top consulting firms.
The major applications of the blockchain protocol in this area today mainly involve market infrastructures and are carried by consortium blockchains. We’ve selected a few applications that we see as promising.
Recordkeeping for unlisted companies
If Bitcoin uses a blockchain register to transfer monetary value, a blockchain can also be used as a securities register. Because unlisted companies have reduced financial obligations, financial institutions have taken a close interest in the use of a blockchain for issuing their securities and recordkeeping.
Thanks to the reduction of transfer costs and the increased transparency, the aim is to make the financing of SMEs more fluid and to encourage the emergence of a more liquid secondary market.
Settlement-delivery of securities
The purchase and sale of shares on an organised market involve a large number of players (ordering bank, custodian, trader, market, clearing house, central depository). The existing system works efficiently but it does have certain limitations: operational risk linked to reconciliation by the various players of recordings in their own systems, settlement-delivery risk, or long and costly change system.
Blockchain technology could modify the processing of market transactions by enabling their end-to-end management, from the placing of the order to settlement-delivery, without breaking the chain. In fact, a blockchain can be imagined as a chain whose links resemble the ordering banks, brokers, market, custodians, central depositories, regulators, etc. The details of each transaction could be directly shared and confirmed by all of these players via a smart contract.
In January 2016, the biggest Australian stock exchange, the Australian Stock Exchange (ASX), announced that it was working with the start-up Digital Asset on replacing its clearing and settlement-delivery system CHESS by a private blockchain. ASX estimates that the cost savings generated would be between € 2.5 and 3.2bn for end users.
Interbank payments: towards a central bank crypto currency?
The Monetary Authority of Singapore (MAS) has just announced that it is working on a blockchain version of its local currency, the SGD. With the Urbin project, carried out with the banking consortium R3, the MAS issued a token that is fully covered by the real currency, which can be used for settling interbank payments in a very quick and transparent manner.
So, this could be the birth of the first cryptographic fiduciary currency which could expand the concrete possible usages of blockchains.
A currency never leaves its monetary zone of origin: any transfer of money has a counterpart on the books of the issuing central bank in the form of a transfer between two commercial banks. Accordingly, to access the world markets, each bank has to create commercial relationship with a network of correspondents, known as correspondent banking. The result is that international transfers are slow, not always reliable and expensive.
The blockchain network Ripple, which today groups together 75 banks, intends to transform the transfer of funds as radically as email transformed communication, through a real-time international payment infrastructure, in which Ripple plays the role of pivotal currency, connected to banks and to market makers, which should result in transparency, trust, speed and lower costs.
The ongoing rationalisation of processes linked to international trade is being hampered by major constraints, mainly relating to the use of paper documents in the logistics chains. Around half-a-dozen players are involved in the purchase or sale of an asset (the buyer, the buyer’s bank, the loader, the maritime transport company, the seller, the seller’s bank, etc.). Many documents are still created manually and entered in different systems, which often results in errors and fraud.
To rectify these problems, Natixis, Trafigura, and IBM have been working on a blockchain solution applicable to trade in crude oil in the USA. By including the buyer, the seller and their respective banks on a single distributed register, all of the parties can simultaneously view and share the data relative to the status of the transaction (from confirmation and validation of the new transaction, through inspection of the cargo to final delivery, then cancellation of the related letter of credit). This solution makes it possible to reduce the duration of the cash cycle and the transaction management costs and provides greater transparency over transactions reducing the de facto risk of fraud.
Furthermore, on the side of public blockchains, we are witnessing an unprecedented wave of technological innovation, driven by a new means of financing: ICOs (Initial Coin Offerings) or Token Sales. Operating on the basis of the same principle as an IPO, an ICO is a fundraising using tokens. The token has a dual function: it is used to finance the project and is the endogenous engine of the application.
For example, the blockchain Ethereum financed its development through an ICO which involved the issue of Ether, tokens which are used as fuel run the IT programmes hosted on the blockchain. We’ve recently seen a lot of ICOs, some of which are a bit crazy but others which are interesting: Sia is a decentralised cloud solution, BAT is a project of the Mozilla founder based on a dedicated internet browser which completely overhauls the on-line advertising paradigm, the Bancor project is the brainchild of one of the architects of the euro, etc.
SO, WHAT'S NEXT ?
This list of applications in the financial field, which is just a small sample, shows the disruptive potential of blockchains. However, there are still many challenges that are yet to be met.
Although solutions will be found for the technical challenges, what the industry needs is a clear regulatory framework. In this regard, it is interesting to note that French lawmakers are playing a pioneering role in this area. Regulators are also following these developments with interest, because a blockchain architecture will provide them with a comprehensive and transparent vision of the markets. Their support will be crucial for experimenting with the industrialisation of competitive solutions.
So, are blockchains a revolution of a passing fad? It’s too soon to provide a definite answer, but the market does tend to overestimate the consequences of technological breakthroughs in the short term, and to underestimate their impact over the medium term.
The BELEM team though is convinced that the blockchain protocol blockchain will completely overhaul the world of finance, and that the first commercially viable solutions will emerge within the next two to three years, in the after-market area. We also believe that the transformation of the financial industry by blockchain will result from a combination of consortium blockchains, shared among players within a single sector, and public blockchains, which will provide an unequalled level of security and resilience.
BELEM enables financial institutions to leverage blockchain technology thanks to a vertical offer of services: training, ideation, prototypes, and industrialisation. Our added value lies in the complementarity of our team in finance & technology.
For more about BELEM: www.belem.io
Published by the Financial Times, this chart illustrates:
1/ The overall reduction in the activity of European banks, some of which (Commerzbank, RBS, Unicredit) no longer have any strong activities outside the country where they were born; but also the growth in disposals of doubtful loans (Italy, Spain, Portugal, etc.) which alleviate balance sheets and the rise in disintermediation with companies increasingly getting financed on the bond market (from 15 % in 2009 to 22 % in 2016 according to the ECB).
2/ A US banking world where accounting standards allow for offsetting of assets and liabilities, particularly for derivatives, that are not permitted under IFRS; and where the cantonment of the activities of commercial banks to one state for a long time has prompted groups, since much earlier than in Europe, to seek in the financial markets financings that their too small commercial banks could not grant them. Not to mention the securitization of loans developed a long time ago which is both the best tool (the diversification of portfolios) as well as the worst (the subprime contamination).
3/ An impressive growth in the size of the balance sheets of Chinese banks, impressive but worrying because it is far larger (almost 17% per year since 2009) to that of the economy, which is half less. Hence the well-known fears of overinvestments and therefore of outstanding loans with a high risk of delinquency explaining the P/E ratios of the major Chinese banks (around 5-6), half of that of European banks. By valuing Chinese banks with a 5-6 P/E ratio, investors do not believe that their current profits will be maintained in the future.
With Simon Gueguen, Lecturer at the University of Cergy-Pontoise
The downgrading of the credit rating for sovereign debt is one of the consequences of the 2008 financial crisis. In particular, for the first time in their history, the USA (in 2011) and France (in 2012) lost their AAA rating attributed by Standard & Poor’s. This month we look at an article that studies the consequences of these downgradings for companies. Almeida et al use a particularity of the rating system used by agencies, which ensures that the debt rating for firms remains (except in exceptional circumstances) below that of sovereign debts of the countries in which they operate. The sovereign rating acts as a ceiling on the corporate rating.
The consequence of this particularity is that, all other things being equal, a downgrading of sovereign debt has a greater impact on firms with higher ratings (those that are subject to the ceiling) than those that are not as highly rated. This makes it possible, by using a precise empirical methodology, to measure the economic effects of a downgrading of the credit rating, by distinguishing them from the effects linked to the company’s fundamentals. The general principle involves measuring the change in investment and financial data of companies that are subject to the ceiling, and comparing them with the change in the same data for comparable companies (size, country, valuation rations, investment level, financial leverage, size of government stakes, etc.). The first are referred to as “treated companies” and the second as “control companies”.
The most significant effect measured concerns the level of investment. This falls from 26.6% to 17.7% for the treated companies, i.e. a drop of 8.9 points; for the control companies, this drop is only 2.6 points. With regard to financing, the amount of net debt issues falls from 7.5% to 2.4% for the treated companies, i.e. a drop of 5.1 points. For the control companies, this drop is only 2.3 points. At the same time, the treated companies issue more equity capital, and see the cost of their debt increase.
It should be noted that Almeida et al factor in the links between the company and the government in their analysis (both from the point of view of company ownership and the dependence of their results on government orders). Without the inclusion of element, it would be possible to explain the results by the fact that the companies with the highest ratings (subject to the ceiling) are more linked to the government and so more impacted by the downgrading of public accounts and the sovereign rating.
You should not consider the effects of the ceiling linked to the rating system as the main takeaway from this article. In fact, the sample used by Almeida et al concerns the period from 1990 to 2013 (over 80 countries). However, in 2013, a change in the Standard & Poor’s rating system made it easier to obtain a corporate rating that is higher than the sovereign rating, and reduced the ceiling effect. The main contribution comes from the use of this effect to distinguish between the economic consequences of a downgrading of the rating from those of a downgrading of the fundamentals (while the two are generally linked).
There are several reasons that explain these real effects of credit ratings. Firstly, ratings have consequences for investors. A downgrading could lead to an increase in cost in equity of holding shares for banks and insurance companies; in some cases, institutional investors could even not be authorised to acquire these securities (or be forced to sell them). Next, the downgrading could trigger (depending on the clauses of debt contracts) obligations to repay or increases in coupons. So, the article provides empirical support for the existence of economic effects of credit ratings.
What is the impact of a capital increase on the enterprise value of a firm?
In the short term none, as the proceeds of the capital increase are in cash and do not affect the entreprise value which is the sum of the value of the fixed assets and the working capital.
When the funds raised are invested in the operating assets, this will depend on investors' perception of the future return of these investments relative to the cost of capital of such investments. If they believe that return will be higher than the cost of capital, the entreprise value will increase more than the amount of the capital increase. And vice versa. This is the anticipation mechanism.
In the long term, it will no longer be the expectations of investors that will be significant, but the ROCE actually generated compared to the cost of capital of the projects thus financed.
How do you calculate the entreprise value of a company with a negative working capital (software publisher in this case)?
The fact that the working capital is negative or not does not change the case. You calculate the entreprise value in the same way by discounting free cash flows or by using a multiple of
peer companies, thus also with a negative working capital.
If this negative working capital is recurring, its counterpart will most often be lower operating margins to take into account the fact that the company benefits from a cash advantage because of its negative working capital which generates financial income.
In the case of a business valuation using the DCF method, with several negative free cash flow (FCF), followed by positive FCF, do I need to discount negative FCF in exactly the same way as positive FCF?
The negativity of FCF is not in itself a reason for taking a different discount rate from that for positive FCF.
What can justify different rates is whether the risk of the economic asset or the investment changes over time (think for example of the digging of the Channel tunnel, then of its operation). In this case, it may be justified to put an additional premium for the first years. But understand us, this premium is not justified by the positivity or negativity of the FTD, but by a different market risk over time that justifies a different discount rate
Can we say that if ROCE is higher than WACC, then the return on equity is higher than the cost of equity?
Yes, there is no doubt about that and it can be seen in the following way:
If the ROCE is higher than the WACC, then the enterprise value is higher than the carrying amount of the operating assets.
Since the value of the net debt has no reason to be greater than its carrying amount simply because the ROCE is higher than the WACC (since the debt does not participate in the creation of value beyond the interest rate paid), and since the value of equity is equal to the enterprise value less the value of the net debt, the surplus between the enterprise value and the carrying amount of operating assets, benefits only to shareholders and not to debt holders.
Therefore, the value of equity is greater than the book value of equity as it is equal to the book value + this surplus.
And if the value of equity is greater than its book value, it is that the return on equity is higher than the cost of equity.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.
WPP, the biggest fall of the London Stock Exchange since 1998
Following the announcement of its quarterly sales, its share price has dropped by 11.2%, a sad record since 1998 for a member of the FT100 index. In fact, what is at work in the advertising agency sector, which, thanks to the 6 surviving global players, has become a small world, is the convergence of ROCEs towards the cost of capital, a relentless economic phenomenon.
WPP's 2016 ROCE was 10.5%, about 2.5% higher than its cost of capital. The surplus is not huge, but when major advertisers are under pressure to improve their results (Nestlé, Unilever, P & G, SABMiller) with advertising spending cuts in the pipeline; and when Google and Facebook absorb an increasing share of advertising revenue by disintermediating advertising agencies, the scissors effect is clear.
"There are no impregnable fortresses, there are only badly besieged fortresses" to quote Maurice Levy, the former leader of Publicis.
When is the turn of Facebook and Google?
Dilution of breakpoint following an acquisition
Total has announced the acquisition of Maersk Oil, paid in Total shares, and its president said "Their break-even point is $ 30 a barrel after investment. We are at an average of $ 40 worldwide, so the transaction is accretive to shareholders."
This is the first time we have seen the concept of accretion applied to breakpoint. Usually, it is used in relation to earnings per share (EPS), or shareholders' equity per share, or even return on equity. This seems to be a good idea, especially in a cyclical industry like oil, where the management of break-even is not a theoretical subject.
That said, the reader of the Vernimmen knows that accretion is not automatically synonymous with value creation, including in terms of break-even. Nor dilution is tantamount of destruction of value. And if he or she had forgotten, chapter 27 is there to remind him or her of it.
Chinese listed companies controlled by the state: we cannot say that we had not been warned!
For the last few months, most of them have included in their articles of association a clause replacing the State by the Chinese Communist Party as the inspirator for the directions to be taken. As an example, the China Railways group mentioned to its shareholders "when the board of directors decide matters of importance, it will first listen to the views of the party committee of the group." The justification given to this change was "to integrate the strengthening of the leadership of the party to the improvement of the governance of the company".
But rest assured, these provisions were approved, as it should, by a two-thirds majority. The Chinese state was able to vote with its shares without being deprived of its voting rights, as these amendments were of no financial consequence (a necessary condition in Hong Kong for the beneficiary not to vote). For those who would have forgotten that China is a dictatorship.
There are so many other companies in the world where to invest.
Citigroup: to have its cake and to eat it. Really?
The US banking group, which share price is currently less than 10% of its 2007 level, reports annualized return on equity in the first half 2017 of 6.8%, which is far from the cost of its equity and the performance of its competitors (approximately 10%). In order to make up for it, it also shows a return on equity of 9.3%, after deducting its deferred tax assets (which represent future tax savings due to its past losses). For details see Chapter 7 of Vernimmen.
But we cannot have your cake and eat it. During the years of deficits, Citigroup reduced its losses by recognizing future tax credits in the income statement, and communicated of course on these reduced losses. Now it is intellectually dishonest to present investors with a return on equity that does not take into account deferred tax assets, which are only the counterpart of these reduced losses. In addition, they are not deducted for the calculation of shareholders' equity per share in order to suggest an undervaluation of the share. In short, we cannot deduce them when it suits, and not deduce them when it suits.
Investors are not the idiots of the village and are not fooled. They continue to underate Citigroup shares compared to its competitors and its share is priced at a discount to book equity. Dura lex sed lex.
A small exchange risk for a small gain of interest?
Bonduelle refinanced its US acquisition (Ready Pac Food, paid $409m) by a USPP comprising two tranches: one of €150m and the other of $50m; and a $200m bank loan. The cost of debt remains unchanged at around 3%, probably at the price of a foreign exchange risk of €150m since Ready Pac Food is only active in the USA, unless it has set up a currency hedge on which Bonduelle did not communicate.
Improve financial communication on acquisitions
A group announced a few days ago an acquisition, probably of small size (the amount has not been disclosed), which makes sense (built-up in a sector ripe for consolidation) and "which impact will be accretive on the return on equity (ROE) and earnings per share (EPS)."
This statement is surely true, but is it relevant to judge the financial interest of the operation? We do not think so.
Indeed, it is not to set the bar high enough to request an accretion in ROE and in EPS when the acquisition is in all likelihood funded by available cash which, at best, yields nowadays around 0%. Provided the acquired company is not at loss, the ROE and EPS will automatically increased in the current monetary context, whatever may be the price paid. There will be an increase in net income (due to the net income of the target being included in the net income of the group), an accounting cost of zero and no increase in equity nor in the number of shares.
As an illustration, let's take a fictitious company with a cost of equity of 8%, with a 3% ROE that would make an acquisition with a 6% ROE. It would claim that such an acquisition would undoubtedly improve its return on equity. However, this acquisition would be value destructive because the profitability of this investment (6%) would be less than its cost of equity (8%). The increase in ROE is therefore not synonymous with value creation, nor is the dilution of the ROE tantamount to destruction of value.
An acquisition that would, for example, yields 1%, would also be EPS accretive if it were financed by available cash yielding 0%, but it would be destructive of value, since the cost of equity is 8% in our example, much bigger than the profitability of the acquisition (1%).
It would be more relevant to communicate, if this was true, a ROE greater than the cost of equity than to talk about ROE or EPS.
For more details on how to avoid being manipulated by financial criteria put forward by deal makers, see Chapter 27 of the Vernimmen which is devoted to measuring value creation.