PwC Capital Markets Flash

Volume 2, Issue 23: June 19, 2009

In this issue:

PwCCF Capital Markets Flash — June 19, 2009 (85 KB) Download the full PDF.

United we fall, divided we stand

Capital markets end the week largely flat compared to last week. While the "green shoots" vs "yellow weeds" debate still prevails, many suggest that increased M&A activity and equity/debt financings are proof that a "day of reckoning" scenario is far fetched.

This week, two major economic forums were held: A G8 Finance Ministers meeting and a historic first-ever BRIC (Brazil, Russia, India, China) leaders' summit. Results of these discussions suggest that, unlike the globally coordinated downturn, differing national interests may result in a less synchronized upturn, both between groups and between member nations.

	June 19, 2009	Crisis Extreme	Sept 1, 2008	Pre-Crisis Extreme1	Week-over-Week
CDN$ / US$	$0.881	$0.771	$0.936	$1.091
S&P 500	921	677	1,278	1,565
S&P / TSX	10,288	7,567	13,300	15,073
LIBOR2	0.611%	4.82%	2.81%	1.11%
TED Spread3	0.44%	4.64%	1.10%	0.14%
S&P / LSTA4	1,257	895	1,293	1,335
CBOE VIX5	28	81	21	10
Baltic Dry Index6	4,073	663	6,691	11,793
WTI Crude Oil7	$69.55	$33.87	$111.55	$146.85

Notable events this week

• The Obama administration announces a comprehensive overhaul of the financial system. Highlights of the proposed framework, which still needs to be passed into law, include:
  • Increased powers for the US Fed, namely a continued role in the oversight of large bank holding companies. The Fed will also directly supervise non-bank financial companies that reach a target size or complexity and will likely be the final decision maker for bank capital requirements.
  • Requirement for the originators, sponsors or brokers of securitized instruments to retain a financial interest in the performance of such instruments.
  • Formal regulation of the financial derivative market.
  • A new Consumer Financial Protection Agency tasked with eliminating predatory lending.
• In a race to relieve themselves from stringent government restrictions on lending and pay, 10 of the largest US banks repay more than $68 billion of taxpayer bailout funds.
• Gordon Nixon, CEO of The Royal Bank declares: "The financial crisis I think is over, if you define it as a crisis... We are now returning to a much more normal environment... The economy still has a ways to go... There are signs of improvement, but it's still a very difficult economic environment."
• According to Statistics Canada:
  • Wholesale sales in April fell 0.6% to $40.3 billion. Weak results in the building materials, machinery and electronic equipment sectors were the largest contributors to the decline. Wholesale inventories fell for a second straight month in April by 1.3% or $57.8 billion, representing the largest decrease since October 2003.
  • The annual inflation rate was 0.1% last month, down from the 0.4% annual increase in April. The forecast is not as soft as the deflation of (-0.2) % that economists had expected, and a contrast to the (-1.3) % posted in the US in May.
• Key US economic statistics surfacing this week include:
  • Housing starts increased 17.2% to a seasonally adjusted annual rate of 532,000, as ground-breaking for multi-family units surged 61.7% in May, after falling 49.4% in April.
  • Cost of living fell over the last 12 months by the most in six decades, easing inflation concerns. US CPI dropped 1.3% in the year ended May 2009, the most since 1950. Prices increased just 0.1% last month, less than anticipated, after no change in April.
  • The number of Americans collecting unemployment insurance plunged by 148,000 in the week to June 6, the most since November 2001, to 6.69 million. Initial claims rose by 3,000 to 608,000 in the week ended June 13, in line with forecasts.
• The Canadian government announces that its pulp and paper mills will receive up to $1 billion to convert to renewable energies and boost competitiveness, after a US subsidy controversially gave trade advantages to US mills. The funds are to be used over the next three years "to improve the energy efficiency of Canada's pulp and paper mills," including the installation of energy-efficient machinery, boilers or equipment to make ethanol from forestry by products.
• According to the Conference Board of Canada, Canada's auto parts makers will implement major structural changes in 2009, which include trimming the workforce by one-third as part of a 34% reduction in industry costs this year: "Conditions will be undeniably difficult in 2009, and many small and medium-sized firms could potentially go out of business," said Sabrina Browarski, economist. "The larger manufacturers, however, stand to increase their global market share when U.S. demand for automobiles starts to recover in 2010."
• Following the completion of a $200-million bond market issue, Connacher Oil and Gas announces a recommencement of the 10,000 barrel per day Algar in situ oilsands project.
• Two Japanese men are detained in Italy after attempting to move $134 billion of US bonds over the Swiss border. To put this into context, the men carrying these bonds would have represented the fourth largest US creditor. A US Treasury spokesperson claims that the bonds are "clearly fakes", although many conspiracy theorists beg to differ.
• Chrysler Group announces plans to resume production during the week of June 29th at its two Canadian and five North American assembly plants. The resumption in production comes after output was halted 40 days ago.
• The World Bank forecasts that China will grow by 7.2% in 2009, an upward revision of the 6.5% growth forecast in March. The bank also forecast that Chinese exports are likely to grow at a slower pace in the coming decade, creating a demand gap that will need to be filled domestically.
• The Paris Air Show, the commercial aerospace industry's most prestigious event, commenced this week with fewer orders than prior years, as expected. As of June 18th, total orders and commitments for planemakers amounted to $14.1 billion. Notable new orders were placed by: Qatar Airways (24 Airbus A320 jets), Air Nostrum (35 Bombardier CRJ-1000 jets) and a $1.5 billion Gulf Air order for Rolls Royce to supply and maintain engines for 20 Airbus A330 aircraft.
• Britain's Chamber of Commerce cuts its UK GDP estimate to -3.8% this year compared to an earlier estimate of -2.8%. 2010 is expected to return to low level growth of 0.6%. This compares with a 0.8% increase predicted in March.
• Britain's Office for National Statistics reports that retail sales unexpectedly dropped in May for the first time in three months. May sales declined 0.6% over April and 1.6% over May 2008. Consensus was for a month-over-month 0.3% increase for May 2009.
• FedEx's quarterly loss widens to $876 million, or $2.82 a share, in its fiscal fourth quarter ended May 31 from $241 million, or 78 cents a share, a year earlier. CEO Fred Smith expects the next two quarters will be "extremely difficult" as the recession and higher fuel prices bite into its bottom line. However, he also claims that "the worst of the recession is behind us" and expects to resume quarter growth by the end of the calendar year.

Notable M&A and financings this week

• Sun Life Financial agrees to buy the UK insurance business of Lincoln National for approximately $319 million cash. The transaction, which includes clients in life insurance, pensions and annuities, will double the number of Sun Life's UK policies to 1.1 million and will increase its UK assets to 10.6 billion pounds. The acquisition is consistent with the strategy announced last month by Sun Life CEO Donald Stewart to buy books and lines of businesses, rather than entire companies.
• Viterra purchases the assets of Associated Proteins for $64 million, subject to Competition Bureau approval. The acquisition will bolster Viterra's presence in food processing and will complement its position as Canada's leading canola exporter.
• Talisman Energy purchases British oil and gas explorer Rift Oil for $186.6 million. The acquisition will considerably strengthen Talisman's production capabilities in Southeast Asia.
• Integrated Device Technology purchases Tundra Semiconductor for $120.8 million after 99.86% of the investors voted in favor of the deal.
• Holcim, the Swiss cement maker, acquires rival Cemex for $1.81 billion. Cemex has recently been struggling to refinance $14.5 billion of debt that falls due by the end of 2011. The acquisition will substantially expand Holcim's Australian business.
• Koenigsegg Group, a niche sport car manufacturer, agrees to purchase Saab from GM. The deal includes an expected $600 million of financing from a European government agency, but further terms were not disclosed. Some analysts are skeptical on the outcome of this transaction, as economies of scale between Saab and Koenigsegg are questionable.
• Watson Pharmaceuticals agrees to purchase privately held Arrow Group for $1.75 billion. The deal provides Watson with a generic drugmaker with $647 million in revenues generated across 20 countries, including Canada, France and Britain.
• Bankrupt consumer products company Spectrum Brands reports it has received up to $242 million in exit financing from GE Capital. The new line of credit will replace the company's current $235 million DIP facility when it reorganizes and will be used for ongoing working capital needs. The financing is subject to approval by the bankruptcy court.
• TransCanada completes a common share equity offering for total gross proceeds of $1.6 billion. The net proceeds of the offering will be used to partially fund capital projects. TransCanada also announces that it has picked up the remaining 20% stake in Keystone Pipeline System that it did not already own for $550 million, plus debt assumption of $200 million.
• Banro, a gold exploration and development company, announces a common shares offering for gross proceeds of CAD$100 million, at a discount of roughly 12% to its closing price on the day of the announcement. The proceeds will be used for advancing its gold projects in the Democratic Republic of Congo and for working capital and general corporate purposes.
• Wind Telecomunicazioni, Italy's third-largest mobile-phone company, plans to sell as much as $3.8 billion of debt in Europe's biggest high-yield bond issue since October 2006. Wind is seeking the approval of existing bondholders to sell new dollar and euro debt and to use the proceeds to redeem so-called payment-in-kind loans. Wind also plans to pay a dividend of as much as 500 million Euros to refinance debt of Weather Investments, one of the holding companies that Egyptian financier Naguib Sawiris used to purchase the company. No indication of bond pricing has been provided as yet.
• Bally Total Fitness announces plans to emerge from Chapter 11. A group that includes JPMorgan Chase, Wells Fargo, CIT and Anchorage Crossover Credit has struck a deal that will help Bally reduce its debt by $660 million. The proposed balance sheet restructuring, still subject to court approval, calls for holders of secured debt under the prepetition term loan, which had provided financing up to $292 million, to receive 94% of the reorganized company's equity. Holders of Bally's general unsecured claims will receive 3% of the equity, with management retaining the balance.
• Private-equity firm Friedman Fleischer & Lowe announces it will acquire Church's Chicken from Arcapita Bank. Financing for the deal is being provided by a syndicate led by Bank of America, Golub Capital and Wells Fargo. Arcapita Bank has been looking for cash infusions since January, when its credit rating was cut to "junk" status by S&P.
• Teck Resources sells a 33% stake in a British Columbia hydro dam to BC Hydro for $825 million. CEO Don Lindsay commented: "This transaction with BC Hydro is the latest step in Teck's plan to significantly reduce our debt and position the company for long-term success." The gain from this sale, coupled with the proceeds from a high yield bond financing should allow Teck to retire a $5.8-billion bridge loan coming due in October.

Notable restructurings and insolvencies this week

• Eddie Bauer files for bankruptcy in Canada and the US, citing a crushing debt load and prolonged recession. However, the company purports that the move is temporary, saying it will be business as usual as it completes a quick sale. New York PE firm CCMP Capital Advisors has offered to pay $202 million (from its own assets under management rather than via leverage) for most of Eddie Bauer's assets, including those in Canada. Market watchers point out that the potential deal symbolizes "the new world of private equity" where pure equity investments are replacing traditional leveraged buyouts.
• Building Materials Holdings files for Chapter 11 as part of a prepackaged restructuring plan. The proposed plan of reorganization will see the company's existing secured lenders participate in a debt-to-equity swap and interests in $135 million newly issued long-term notes. Building Materials has received commitments for $80 million in DIP financing from Wells Fargo and certain of its other existing lenders.
• Extended Stay Hotels files for Chapter 11 protection due to a crushingly high debt load and declining revenues. Extended Stay began negotiations in December with lenders to restructure $3.3 billion in mezzanine debt. However, discussions failed earlier this month when two junior debt holders filed a lawsuit to block the possible foreclosure of the chain after Wachovia, lender and servicer of the mezzanine and first mortgage debt, claimed a $3.5 million payment default. The Lightstone Group, a US based private equity firm, bought the chain from The Blackstone Group at 92.5% leverage two years ago for $8 billion.
• A bankruptcy court judge approves the sale of the Tropicana Casino and Resort on Friday to a group of creditors led by Carl Icahn at a valuation of $200 million. When the casino-hotel first went on the market in 2008, it was expected to fetch about $1 billion. The 80% discount is due to the fact that the winning investors were able to use their position as holders of a $1.4-billion mortgage on the Tropicana to craft a competitive offer. They agreed to act as a "stalking horse," laying down a bid to exchange $200 million of their debt for the casino. The bankruptcy court auction set the floor for other bids, but none were received. To beat this bid, another party would have had to offer more than $200 million in cash or securities. The Judge defended the valuation by arguing: "Value these days is difficult to assess... There is basically no other option available at this point."
• Allarco Entertainment, parent company of Canadian pay-TV movie network Super Channel, has filed for bankruptcy protection. "We want to make it clear to our customer base that Super Channel is not bankrupt or in receivership," said Super Channel president Malcolm Knox, in a statement issued to affected programme suppliers. "Operations continue without interruption." In its filing, the company listed assets of $68 million and liabilities of $139 million.
• Canadian specialty paper company Fraser Papers files for bankruptcy protection in an Ontario court and will seek protection under Chapter 15 of the US Bankruptcy Code. Fraser cited continued operating losses, lower selling prices for pulp and lumber, impending debt repayments and significant pension funding obligations as the key reasons for its actions. CIT Business Credit Canada has agreed to continue to revolve the existing working capital facility and Brookfield Asset Management has agreed to provide DIP financing. The company said together these facilities will provide up to $20 million to fund operations during the process, which is hoped will result in a stronger, more viable paper business.

Global economies in focus — Will the real Masters of the Universe please stand up?

Two notable global economic events took place this week. The first was a meeting of G7 Finance Ministers (or G8 including Russia) and, the second was a historic first summit between BRIC countries, (Brazil, Russia, India and China).

A brief look at trade and investment data from these two cohorts reveals startling contrasts. BRIC nations eclipse the G7 in both population size and US dollar investment holdings. Based on the most recent comparable public data, they also boast an average debt-to-GDP ratio that is less than half of the G7 average and have a collective net trade surplus triple the size of the G7 deficit. Among the BRIC are the world's two offshore manufacturing and service powerhouses — China and India — and two key resource providers — Brazil and Russia.

Despite this pivotal role on the world stage, BRIC nations control less than 10% of IMF votes and, to date, have had little say in global policy directives, where the needs of the G7 rule. It would seem logical, at this juncture, to consider new policy directives, perhaps some that are more accommodative to BRIC interests. Do this week's meetings bare this out?

BRIC summit — Just another BRIC in the wall

The BRIC Summit in Siberia, early this week, was hailed as the first step in an inevitable "changing of the world economic power guard." Many expected that the BRIC nations would take a hard line and jointly call for a swift shift away from US dollar assets and perhaps encourage the adoption of a supranational reserve currency. What was officially recommended, however, revealed that the BRIC policy agenda is largely uncoordinated. Soft ambiguous language dominated recommendations, of which key highlights are:

• A call for emerging economies to have a "greater voice and representation in international financial institutions."
• A recommendation for the international community to keep multilateral trade stable and curb trade protectionism.
• A vague directive to embrace a "more diversified" currency system, without any direct mention of the US dollar or new reserve currency.

After headline grabbing rhetoric from individual BRIC nations in recent months, why did the joint BRIC communiqué not take a tougher stance on G7 nations? The reason lies in the sharp differences that still prevail between BRIC nations, namely:

• China's massive holdings of US treasuries far outstrip holdings of other BRIC counterparts, making it the "odd man out." Overall, the Chinese remain nervous about further collapses in the US dollar. While Russian president Medvedev came to the meetings demanding a new global reserve currency, Chinese President Hu was a moderating counterforce, recommending that any change to the monetary system maintain the stability of the existing reserve currency.
• Differences between Russia and China were also visible in policy recommendations for Central Asia, a key source of energy and materials, with China committing $10 billion of loans to the region. According to Russian strategist Chris Weafer, "That raises the stakes for Russia... while both China and Russia are keen to keep the US and Europe out of the region, Moscow is none too keen to be displaced as the political power in the region by its eastern neighbour."
• Domestic BRIC economies are exceptionally dissimilar. India and China are net commodity importers, favouring low commodity prices, with China exporting manufactured goods and India basing its growth on domestic demand and services. Conversely, Russia and Brazil depend on commodity exports and favour high commodity prices.
• Despite their similarities, the four countries do not have sufficient intra-trade relations to support a trade alliance and, as a group, still remain reliant on the Western trade partners.
• Professor Daniel Drezner astutely highlighted that the BRIC coalition: "...is at an early stage of its evolution... They are a heterogeneous lot, consisting of energy exporters and importers, democracies and autocracies, aspiring hegemons and demographic disasters. This is not an easy group to keep together..."

G8 Meeting — Is eight enough?

The lead-up to the meeting of G7 Finance Ministers (G8 including Russia) over this past weekend, optimistically entitled "Strategies for Emerging from the Crisis" was less theatrical. The market only expected some clarity on stimulus exit strategies and a response to US dollar criticisms. The developed nations, however, did not clearly address either of these issues and proved to be as divisive as their emerging market counterparts. Key highlights of the meeting included:

• The Ministers agreed that the worst of the recession has passed. However, all participating country representatives also opined that there is a clear and present danger of further economic uncertainty without continued meaningful and coordinated regulatory reform.
• G8 leaders directed the IMF to begin the necessary analytical work to help governments prepare exit strategies to unwind huge stimulus packages, without any specific practical guidance or recommendations. There was an implicit split between countries over the pace of unwinding:
  • Germany pressed for clarity around short- and medium-term exit strategies and indicated that it has already assigned a considerable number of resources to preparing its domestic exit strategies (largely to avoid a resurgence of domestic inflation).
  • French Minister Christine Lagarde insisted that crisis management should be the key priority for G8 governments and was adamant that countries should be careful not to lay out exit strategies too soon. The US echoed this sentiment, with Treasury Secretary Geithner purporting that G8 members need to stay the course on economic and monetary stimulus spending.
• Despite the plethora of BRIC rhetoric on exchange rates and trade imbalances, G8 Ministers remained silent on both matters during the weekend discussions, even the outspoken Russian Minister Alexei Kudrin. Some discussion centered on welcoming a more flexible Chinese exchange rate specifically in Lorenzo Bini Smaghi's opening remarks: "China must equip itself with its own monetary policy and must allow the exchange rate of its currency to fluctuate on the basis of relative competitiveness, avoiding the systematic accumulation of international reserves." However, there was no mention of a flexible Yuan in the official G8 communiqué.
• Most all of the Finance Ministers were divided on whether Europe should conduct US-style "stress tests" on its financial system. Although Britain has conducted tests, they were considered to be less onerous and transparent than their US counterparts. While the US is pressing for increased European "stress tests", Germany and the UK argued that public disclosure of test results could undermine any economic confidence, with France's Lagarde insisting: "Each one of us is following its own schedule. We're not looking at the example of this or that country."
• A further request that the IMF boost lending resources, echoing the earlier recommendation by the G-20 to increase the IMF war chest to $750 billion.

The sudden shift in G8 policy discussion away from crisis planning to exit planning is primarily due to fears that the recent sell off in long-term US government bonds will result in a flood of cash that will fuel inflation, high interest rates and increased borrowing costs for debt-laden consumers and governments.

With only an ambiguous outcome from this meeting, most expect that the dilemma of "when" and "how" to exit will be the near-term challenge for most developing nation governments and will also form the centerpiece of discussions at the next G8 meeting in L'Aquila in July. Mohammed El-Erian, Chief Executive of PIMCO, firmly stated "What the market wants to know is how the exit from stimulus will look when the time comes... It's not looking for an exit now, but wants a credible plan."

Concluding Remarks — Gridlock

Both these events concluded without a clear forceful statement of unanimous intent to act together. Although the G8 appeared to conclude with a call for action, in the context of an unprecedented global economic crisis, the policy response can hardly be described as forceful.

The immediate capital markets implications of the meetings are therefore surprisingly few. Without a clear consensus for action, the status quo is likely to be maintained. Going forward it appears that collective, coordinated action by the G8 or the BRIC countries may no longer be the driving force behind capital markets behaviors.

Suggested action of the week — He who has the gold may not make all the rules

It is not clear what nations, or group of nations, will emerge strongest from this downturn. Expect less global coordination as a "new world order" is, or, more surprisingly, is not established.

Stay tuned next week for a "season finale" before the Capital Markets Flash team breaks for the summer.

_Notes:

1. _{Over five-year period.}
2. _{BBA US LIBOR, three month.}
3. _{Difference between rates on interbank loans and three month US Treasuries. Indicator of perceived credit risk.}
4. _{Mirrors market weighted performance of leveraged loans. Tracks returns in leveraged loan market.}
5. _{An expectation of the market's 30-day volatility, measured by tracking the money calls on companies in the S&P 500. Historically, VIX values greater than 30 are associated with high volatility and values below 20 are associated with low volatility.}
6. _{An indicator that predicts future economic activity by measuring global shipping supply and demand for commodities, such as building materials and coal.}
7. _{West Texas Intermediate (WTI), also known as Texas Light Sweet, is a type of crude oil used as a benchmark in oil pricing and the underlying commodity of New York Mercantile Exchange's oil futures contracts.}

_{All dollar amounts are expressed in US dollars, unless otherwise indicated.}

_{Sources: Bloomberg, Reuters, Capital IQ, Dealogic, Random Lengths, US Census Bureau, Statistics Canada, company websites and press releases, National Post, The Globe & Mail, The Associated Press, RBC Capital Markets, CIBC World Markets, Scotia Capital, Bank of Canada, FT Alphaville, TD Securities, S&P Case Shiller, Nouriel Roubini, RGM Monitor, Forbes, Sprott Asset Management, Barton Biggs (Newsweek), Statistics Canada, Bank of Canada, OECD, WorldFactbook, G8 — The Lecce Framework, Wall Street Journal, RGE Monitor, International Monetary Fund, World Bank, Reuters, The National Interest, Guardian UK, The Economic Times, New York Times, Xinhuanet.com, The Economist}