[Music]

Rama Variankaval

Hello everyone. My name is Rama Variankaval. I run the Corporate Finance practice at JP Morgan, along with our Center for Carbon Transition. And I'm pleased to have with me Evan Junek, my partner for almost 20 years in the Corporate Finance Advisory practice. Evan is a leader in our practice, spends his time on a day-to-day basis talking to CEOs and boards about a variety of corporate finance and structured finance topics. And the discussion we will have will hit on some of the most relevant topics he's been discussing with clients as we speak

Evan Junek

Thanks, Rama, it's great to be here. 20 years working together and this is our first podcast together. This year we just released our annual 10 Striking Facts For The New Year. And this is something we've released in the first week of January for more than 10 years now, and it's really designed as a curated set of materials for boards, CEOs, and senior management team members to understand the most relevant and compelling themes, not just of the last year, but to spark dialogue into the year ahead. Whether those be on strategic themes, capital structure, capital allocation, even more broadly on topics like stimulus and policy.

Rama Variankaval

Fantastic. So, let's dive into the 2023 edition of Striking Facts. So what would you say are the key thematic topics that you covered?

Evan Junek

I'd highlight four key themes that emerge from these 10 Striking Facts, perhaps even at a face value disparate facts. And I categorize those themes as stimulus, value, capital, and investment. We’ll  spend this time kind of ticking through those themes to dive a level deeper into how each of those ones is impacting decision making in the current environment. So let's jump right into the first one, stimulus. The striking fact here is we saw the most substantial calendar year hike of Fed fund rates in modern Fed history. 4.25%, a substantial increase of rates. But I think the real focus of the theme generally is that we have been in an era up until last year, more than a decade, where we've seen consistent low rate policy and a tremendous amount of QE, quantitative easing, pumped into the market to an extent where I think you could make a compelling argument that not only has the mechanics of the market changed, i.e. we've seen low rates, low borrowing costs, and we've seen behavior reflect that, but maybe even the psychology of investors has in some sense been effected. And we actually discussed this in a lot of detail, right around the COVID and pandemic era of early 2020, of this notion of the permanent QE mindset is what we called it.

Rama Variankaval

I remember, I remember that well.

Evan Junek

(laughs)

Rama Variankaval

It seems like we are well past that.

Evan Junek

Now we may be shifting into this paradigm where underpinning broad stimulus that's been in the market now for so long is going away. That's a big part of the uncertainty as we enter into 2023. People are obviously very focused on inflation and that's important, there's a tremendous amount of uncertainty there and how the Fed and central banks around the world react and what the ultimate consequences to capital markets and valuations ultimately are.

Rama Variankaval

And you point out in the Striking Facts that the current equity valuations do not seem fully reflective of the fact that the stimulus might be going away. The current equity valuations still seem pretty healthy compared to historical averages, so I guess the risk factor here is that valuations continue to face headwind if in fact this is the end of the permanent QE paradigm and in some ways it's a return to the, kind of the old normal. That a fair statement to make?

Evan Junek

Spot on. So I think that remains a risk that we are very focused on and I think it's a element of the underlying dialogue with our clients.

Rama Variankaval

Makes sense. So that was stimulus. What was your second big theme?

Evan Junek

The second theme we focused on is value. And maybe more specifically what's being valued most highly in the capital markets today. And there are a couple pieces of analysis we explored here. The first one is the value for scale in the market is well above historical norms, about three times the normal average. And we define this really as the valuation multiples between large cap companies and smaller cap companies. And there's a couple trends to unpack there. Part of that is the interest rate dynamic we just discussed but in particular is the inflationary dynamic, this notion of pricing power, of margins, and we also explore margins and see a very clear relationship between strong margins and size and the ability of larger firms to consistently access capital markets, right? Size and scale is highly correlated to credit ratings, stronger credit ratings in specifically investment grade rated firms have more consistent and regular access to the capital markets in a period of uncertainty like we've been living through in the last year

Rama Variankaval

So does that then imply that while overall equity valuations might well face pressure for all the reasons we discussed initially in your stimulus point, the differential or the premium that the large cap companies have or what mid cap or small cap is likely to persist?

Evan Junek

I think that's a reasonable expectation. And I think the way that translates into the dialogue with clients is in the M and A dialogue. The value for scale is so substantial today that the combination of potentially attractive valuations from an acquirer standpoint, certainly relative to the last 24 to 36 months, coupled with this notion of the value for scale and implicitly sort of the synergies one can extract from acquisitive growth, maybe top of mind as we think about the strategic dynamics into 2023.

Rama Variankaval

Interesting. One topic that you do explore in the Striking Facts is the strength of the US dollar. What is, in your mind, the implication of the strong dollar in all of these themes? Does this make cross-border M&A more attractive going forward? Is that one way for US companies, for example, to buy scale?

Evan Junek

So it's a great question. One of the things we highlight is the relative multiple of US versus non-US companies, particularly European companies and that premium, just on a relative trading basis is frankly extraordinary. So on the order of 40 to 70% today to the US side. And that relative premium being driven in part by the currency dynamics you referenced certainly warrants attention from firms who are assessing their growth opportunities. Now, those growth opportunities do need to be carefully assessed. Because ultimately in many cases there's no free lunch. If you're buying a bunch of operating assets in Europe that are generating cash flows in euros, it very well may be that those assets are appropriately valued at the relative multiple in which they trade. We see there being an interesting opportunity particularly for firms who are in more asset light businesses or are looking to buy capabilities.

Rama Variankaval

That's great, Evan, thanks. The related point you make on value is around corporate clarity? At first glance it might seem that scale and corporate clarity are actually contradictory, but you have these interesting pieces about how they are actually quite related. Would you mind elaborating on that?

Evan Junek

The analysis that we've performed, and frankly have been tracking for many years now, is an attempt to approximate the value of more pure play companies. We've actually looked at the number of reporting segments that a firm has and used that as a proxy for the level of the sort of pure play profile of the company. How do you reconcile this notion of scale versus the notion of pure play versus diversification? Our view is that what the market is seeking today is focused scale. And that ultimately the ability to drive higher margins, have pricing power, have the benefits of synergistic operations through a focused and concentrated business model are what the market is currently rewarding most.

Rama Variankaval

And is that a phenomena you see across most sectors? Or is there a sector bias to that statement as well?

Evan Junek

There's certainly a little bit of a sector bias to that statement. There are also certainly notable exceptions to that rule. I think you can look at some of the large cap tech names today, you could make a pretty compelling argument that those are, in many ways, technology conglomerates. And I think there is a reasonable view that those are models that are being valued highly in the market today. But we also see examples of firms taking steps to move towards that pure play model. The J&J transaction that was announced recently is one example of that, where you have obviously one of the largest companies in the world pursuing a separation that is creating two more pure play but highly scaled businesses in the market.

Rama Variankaval

So I want to ask you a question on a comment you made about large companies and the cost of capital benefit they have. So talk a bit more about where you see costs of capital going for companies generally, and implications for overall capital search or decision making.

Evan Junek

That's a great segue into the next theme, which is capital. And I think there's two dimensions to the capital topic. There's cost and there's quantum. And to your question around cost, I think it's safe to say that most if not all firms have incurred higher levels of cost with respect to their capital base than they've seen historically, a simple reflection of where interest rates have gone over the last 12 months. The other interesting dynamic of the cost component, though, is not just the absolute cost but the relative cost. And one of the things we explored in striking facts is the relative cost between debt and equity. It's the same thing we were actually exploring five or six years ago when we identified the notion that debt was historically cheap relative to equity. And ultimately the consequence of that is that many firms went out and raised a lot of debt on an incremental basis either to fund projects or, in the extreme sense, to buy back equity, right? You think issue cheap debt, buy back relatively more expensive equity. Today we see the opposite taking effect. We actually see the highest ratio of cost of debt to equity that we've seen since the financial crisis. People will be equitizing their balance sheets, and it's not surprising, especially when you start to look at the balance sheets of a typical large cap company. S&P 500 firms still have about one turn of additional leverage on their balance sheets relative to that financial crisis, or pre-financial crisis time period.

Rama Variankaval

Got it. Makes sense. On to fourth theme, and one that I actually found the most compelling of all, not that the others are not. But your chart on the value of investing and the ability to provide return for the investments, I thought was a very fascinating one. Why don't you talk about that for a minute?

Evan Junek

One of the bits of feedback that I've received from clients, particularly working with clients in the industrial space or the energy space, is this notion that they are frustrated by the perception that they are asset intensive, capital intensive businesses that may, in fact, not have the commensurate return profiles of a software company or a high-gross tech company. And the bit of analysis we did is to illustrate this notion of tech being capital light or ultimately less intensive from a capital perspective is, frankly, false. And if you go back to 2012 and you look at the S&P 500 and add up all the dollars spent in terms of capex and R&D, just to draw the comparison, energy was basically a quarter of total dollars of capex and R&D and tech was about a quarter as well. So between those two sectors was about 50% of total capex and R&D spent. Today energy is 6% and tech is 50%. So one of every two dollars spent in capex and R&D across the entire market is in tech and tech-enabled companies. That in and of itself was certainly striking. But if you take that a level deeper and say, "How are these firms generating returns on all this asset intensive investment, capital intensive investment?" What we found is that the returns have actually been somewhat lackluster. And when I say returns I don't mean share price returns, I mean asset level, cash-on-cash returns on the dollars that they're putting to work through capex and R&D. And we see sectors like energy that has been subject to an incredible amount of investor pressure to become more focused on returns, much more disciplined in terms of capital deployment, generating spectacular returns over the last few years as a result of not just the discipline but also, of course, the tailwinds from commodity prices compared to those tech firms I mentioned who have effectively generated 0% returns over the last few years.

Rama Variankaval

Do you see this as a point in time phenomena, this notion that the returns when you measure today on the investments that the tech enabled firms have done don't look great? Do you think that's simply a reflection of just today's market condition but the reality is over time those investments that they have made in the past will, in fact, be [inaudible 00:21:42]?

Evan Junek

I certainly think if you were to ask the tech firms themselves how they think about these investments, they would argue that the long term return propositions of these investments are spectacular, right? That ultimately they're investing for the future. And I think in some sense that's a very reasonable answer from companies who have been the most effective at delivering new technology solutions for the world. So it's pretty hard to bet against some of the best companies in the world when it comes to technological development. The combination of price returns and total shareholder returns in the market that have been, frankly, lackluster over the last 12 to 18 months, coupled with poor economic returns under measurements like ROIC, are likely to ramp up the pressure on these tech companies to more clearly justify their investment trends and objectives.

Rama Variankaval

Makes sense. And in the very last striking fact is the Inflation Reduction Act. We started this conversation talking about the broad based stimulus, actually receding, from the economy, but what we are seeing, in fact, is the more surgical application of stimulus in certain cases. Whether it's a CHIPS Act or the IRA. Clearly we think the IRA is a really a once in a lifetime type event and is going to mobilize a tremendous amount of capital, right? The Inflation Reduction Act itself is scored at about a 400 billion dollar price tag over a 10-year period, but the way we see it, it's likely to mobilize a couple hundred billion dollars of capital every year across multiple industrial sectors. It's not just about energy, it's industrials, it's a whole lot of the economic activities that are going to benefit from this capital flow. So is that a theme in your mind moving away from a broad based stimulus regime to a bit more surgical specific targeted stimulus regime?

Evan Junek

I think you could argue that's almost the most important theme. This notion of broad based to more focused stimulus as a potential tailwind to future investment and profitability is, I think, something that our clients need to better understand. It's something that we as advisors are going to have to challenge ourselves to better understand, and that at the end of the day we all need to step back and recognize the fact that whether we're talking about pursuing investment, pursuing a transaction, pursuing a capital raise, we're gonna have to be comfortable dealing with the complexity of new structures, new dynamics in terms of the interplay between policy and business and a willingness to get creative to get stuff done. Because if there's anything that we've learned here it's that life isn't gonna be quite as easy as it's been for the last 10 years when money was, in essence, free. And to be competitive, to maintain an effective and low cost of capital, you're gonna need to be willing to roll up your sleeves and dig into issues like this.

Rama Variankaval

Fantastic. I think that's a great place to wrap this up. Thank you, Evan. And for anyone who wants to learn more about this particular piece of work or want to discuss any of these topics we covered today in detail, please reach out to your J.P. Morgan contact or to Evan or myself directly. Thank you.

Evan Junek

Thanks for the time, Rama.

[End Of Podcast]