Follow the Money 7-15-24

Warren Buffet, perhaps the most successful long-term investor of the last hundred years, opined “When the tide goes out, you find out who is swimming naked.” Accordingly, we have just begun to observe the consequences of about twelve years of zero percent interest rates suppressed by worldwide monetary authorities, in turn causing many trillions of dollars of misallocated resources. While the politicians deal with the current election cycle, and the Federal Reserve suggests that the inflation dragon has been largely slayed, many distortions within the capital markets and asset valuations are yet to be addressed. Recall the failure of the Silicon Value Bank in early 2023, as the value of their fixed income portfolio plunged with the rise of interest rates, and depositor withdrawals drove insolvency. The Federal Reserve’s Bank Term Funding Program (March 2023) staved off a nationwide run on the banks by offering one-year loans to needy institutions, secured by the underwater securities, allowed to remain valued at par on bank balance sheets. This action, in essence, provided a federal guarantee on uninsured bank deposits. However, a Stanford University Graduate School of Business study observed that this Program “may have put a pause on the crisis and reduced the risk of acute deposit runs across the banking system. However, these polices do not address the fundamental insolvency risk, which…. could involve hundreds of banks and…. could involve a recapitalization of the US banking system.” Their study further indicated that “In aggregate, the market value of U.S. banking system assets became $2.2 trillion lower than suggested by their book value which is on the order of aggregate bank capital…if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment…. with potentially more than $250 billion of insured deposits at risk….” While no new government loans have supposedly been made since March 2024, interest rates remain high enough to sustain almost all the mark to market losses. Unfortunately, the politicians, bankers, and financial press have not updated the situation, so stay tuned.

A second indicative macro development is the limitation of redemptions in previously liquid private real estate funds, managed by “Best of Breed” operators, Blackstone, KKR and Starwood Capital. The lack of liquidity within the property portfolios of these managers, combined with surging redemption requests, have required Blackstone and KKR to start limiting redemptions to 2% of the funds’ assets per month, or 5% quarterly.  Starwood has announced they are reducing liquidity rights by more than 80%, limiting redemptions to 0.33% of its net assets a month, from the 2% it has allowed since the $10B funds’ inception in 2018. This is not an encouraging commentary on the state of the commercial real estate industry.

Shake Shack and Bloomin’ Brands are now demonstrating the variation within tangible consequences of the fiscal/monetary “Wild West” that prevailed from ’09 to ’22. Bloomin’ Brands, in May ’20 sold $230M of five-year zero interest rate convertible bonds, convertible 25% above the market, at $11.89 per share, and only about 7x EBITDA both pre-and-post Covid. In March ’21, Shake Shack sold $250M of seven-year zero interest rate convertible bonds, convertible, 40% above the market, at $170/share, and well over 100x Adjusted EBITDA in calendar ’21.  Because of the zero-interest rate environment, both transactions were essentially the sale of potential equity 5-7 years away. Because of the huge difference in valuation, however, BLMN has endured over 20% share dilution, which they have chosen to repurchase by incurring new debt. At the same time Shake Shack (with their stock still well below $170/share) will likely have benefited from the use of $250M of “free capital” for seven years, building stores, generating incremental cash flow sufficient to repay the $250M and benefit from $80-$100M of annual cash flow from the new stores.

Marketplace inefficiencies, stimulated in large part by the policies we have repeatedly described, sometimes create opportunities and Bloomin’ Brands’ (BLMN) may well be such a situation. The $230M they raised in ‘21 has been almost entirely converted to common stock, at a distress price to be sure. While the US restaurant industry is under pressure, it is doubtful that the BLMN fundamentals have deteriorated proportionate to the most recent decline (from $27-17). More likely it is related to the dilution from the bond offering described above, though those new shares have been re-purchased. Though there is $170M more debt in place than previously, material to some observers, it is not major in relation to the $2.5 billion Enterprise Value. Eyes wide open as to the risk of a potential “Value Trap”, BLMN is now changing hands at just above 4x trailing twelve month Adjusted EBITDA, with the possibility of a divestiture (their Brazilian stores) that could provide $500M of fresh liquidity. A strong activist (Starboard Value) is already “hooked”, fundamentals as reported by the Company less than two months ago, seem to be stable at the least. Further stock repurchase is authorized, and the balance sheet remains strong. Lastly, the 5.8% annual current dividend seems well covered. Overall, the potential reward seems to far outweigh the risk.