Tag Archives: Morgan Stanley

A naughty or nice 2019?

They say if you keep making the same prediction, at some stage it will come true. Well, my 2018 post a year ago on the return of volatility eventually proved prescient (I made the same prediction for 2017!). Besides the equity markets (multiple posts with the latest one here), the non-company specific topics covered in this blog in 2018 ranged from the telecom sector (here), insurance (here, here, and here), climate change (here and here), to my own favourite posts on artificial intelligence (here, here and here).

The most popular post (by far thanks to a repost by InsuranceLinked)) this year was on the Lloyds’ of London market (here) and I again undertake to try to post more on insurance specific topics in 2019. My company specific posts in 2018 centered on CenturyLink (CTL), Apple (AAPL), PaddyPowerBetfair (PPB.L), and Nvidia (NVDA). Given that I am now on the side-lines on all these names, except CTL, until their operating results justify my estimate of fair value and the market direction is clearer, I hope to widen the range of firms I will post on in 2019, time permitting. Although this blog is primarily a means of trying to clarify my own thoughts on various topics by means of a public diary of sorts, it is gratifying to see that I got the highest number of views and visitors in 2018. I am most grateful to you, dear reader, for that.

In terms of predictions for the 2019 equity markets, the graph below shows the latest targets from market analysts. Given the volatility in Q4 2018, it is unsurprising that the range of estimates for 2019 is wider than previously. At the beginning of 2018, the consensus EPS estimate for the S&P500 was $146.00 with an average multiple just below 20. Current 2018 estimates of $157.00 resulted in a multiple of 16 for the year end S&P500 number. The drop from 20 to 16 illustrates the level of uncertainty in the current market

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For 2019, the consensus EPS estimate is (currently) $171.00 with an average 2019 year-end target of 2,900 implying a 17 multiple. Given that this EPS estimate of 9% growth includes sectors such as energy with an assumed healthy 10% EPS growth projection despite the oil price drop, it’s probable that this EPS estimate will come down during the upcoming earnings season as firms err on the conservative side for their 2019 projections.

The bears point to building pressures on top-line growth and on record profit margins. The golden boy of the moment, Michael Wilson of Morgan Stanley, calls the current 2019 EPS estimates “lofty”. The bulls point to the newly established (as of last Friday) Powell Put and the likely resolution of the US-China trade spat (because both sides need it). I am still dubious on a significant or timely relaxation of global quantitative tightening and don’t feel particularly inclined to bet money on the Orange One’s negotiating prowess with China. My guess is the Chinese will give enough for a fudge but not enough to satisfy Trump’s narcissistic need (and political need?) for a visible outright victory. The NAFTA negotiations and his stance on the Wall show outcomes bear little relation to the rhetoric of the man. These issues will be the story of 2019. Plus Brexit of course (or as I suspect the lack thereof).

Until we get further insight from the Q4 earnings calls, my current base assumption of 4% EPS growth to $164 with a multiple of 15 to 16 implies the S&P500 will be range bound around current levels of 2,400 – 2,600. Hopefully with less big moves up or down!

Historically, a non-recessionary bear market lasts on average 7 months according to Ed Clissold of Ned Davis Research (see their 2019 report here). According to Bank of America, since 1950 the S&P 500 has endured 11 retreats of 12% or more in prolonged bull markets with these corrections lasting 8 months on average. The exhibit below suggests that such corrections only take 5 months to recover peak to trough.

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To get a feel for the possible direction of the S&P500 over 2019, I looked at the historical path of the index over 300 trading days after a peak for 4 non-recessionary and 4 recessionary periods (remember recessions are usually declared after they have begun), as below.

Note: These graphs have been subsequently updated for the S&P500 close to the 18th January 2019. 

click to enlarges&p500 q42018 drop compared to 4 nonrecession drops in 1962 1987 1998 & 2015 updated


click to enlarges&p500 q42018 drop compared to 4 recession drops in 1957 1974 1990 & 2000 updated


I will leave it to you, dear reader, to decide which path represents the most likely one for 2019. It is interesting that the 1957 track most closely matches the moves to date  (Ed: as per the date of the post, obviously not after that date!) but history rarely exactly rhymes. I have no idea whether 2019 will be naughty or nice for equity investors. I can predict with 100% certainty that it will not be dull….

Given that Brightwater’s pure Alpha fund has reportingly returned an impressive 14.6% for 2018 net of fees, I will leave the last word to Ray Dalio, who has featured regularly in this blog in 2018, as per his recent article (which I highly recommend):

Typically at this phase of the short-term debt cycle (which is where we are now), the prices of the hottest stocks and other equity-like assets that do well when growth is strong (e.g., private equity and real estate) decline and corporate credit spreads and credit risks start to rise. Typically, that happens in the areas that have had the biggest debt growth, especially if that happens in the largely unregulated shadow banking system (i.e., the non-bank lending system). In the last cycle, it was in the mortgage debt market. In this cycle, it has been in corporate and government debt markets.

When the cracks start to appear, both those problems that one can anticipate and those that one can’t start to appear, so it is especially important to identify them quickly and stay one step ahead of them.

So, it appears to me that we are in the late stages of both the short-term and long-term debt cycles. In other words, a) we are in the late-cycle phase of the short-term debt cycle when profit and earnings growth are still strong and the tightening of credit is causing asset prices to decline, and b) we are in the late-cycle phase of the long-term debt cycle when asset prices and economies are sensitive to tightenings and when central banks don’t have much power to ease credit.

A very happy and healthy 2019 to all.

Bye-bye buy the dip

As my previous post illustrated, I got caught up with the notion that the fall in the equity market of late was an opportunity to buy into some names in the expectation that we’d go higher into year end. It’s clear that the classic “buy the dip” strategy that has worked so well in recent years, well, doesn’t work anymore. The graph below, from a report by equity strategist Michael Wilson of Morgan Stanley, has been widely cited to illustrate the failure of the strategy in 2018.

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Wilson commented that “such market behaviour is rare and in the past has coincided with official bear markets (20 percent declines), recessions, or both.” There is much discussion amongst commentators about whether we are entering, or indeed have entered, a bear market. I like the simplicity of the argument by Peter Oppenheimer, another equity strategist this time at Goldman Sachs. Oppenheimer argues that a decline in corporate profits in 2019 implies a recession in the US and as a recession is unlikely in 2019, he expects corporate profits to continue to grow, albeit at a much-reduced pace.

As pointed out by Wilson, we will not know the answer about where corporate profits are going until firms report Q4 and guide for 2019. He did also say that equity analysts are always slow off the mark as they wait for firms to reluctantly report on bad news. The after the fact downgrades on NVDA are testament to that! With some commentators calling the bottom around 2,550 to 2,600 on the S&P500, it looks unlikely that there will be any major upside in the market until there is more clarity on Fed policy and the trade issues with China.

If the market moving up depends upon Fed Chairman Powell indicating a policy change to “one and wait” or for a breakthrough at the G20 on trade, then I think we’ll go down further or, at best, sideways. If there is some modest indicator that the pace of interest rate rises in 2019 will be data dependent from Powell and the G20 meeting results in a short-term cease-fire between the US and China, then markets could find a bottom and stabilize. Whatever about the likelihood of the Fed rescuing the market (unlikely in my opinion), I fear that any meaningful relaxation in US-China tensions is against the play-book of the Orange One in the White House. The rhetoric from side-kick Pence at the weekend with language indicating China was leading other Asian countries into debt bondage does not bode well for next week’s G20 summit.

On China, I really like Ray Dalio’s explanation of the fundamental difference between the Chinese and US system (here is just one example of his latest thoughts), being a top down versus a bottom up approach. As Dalio explained it, the Chinese place an importance on family and paternal direction as opposed to the US adoration of the individual above all else. Unfortunately, I doubt that the current US leadership has the intellect to nuance a workable resolution between these two philosophies.

Following on from the analysis in this post on peak quarterly earnings, the current market narrative is that the EPS estimates for 2019 and 2020 will come down over the coming months. Currently S&P is showing a 11% projected increase for 2019 operating EPS for the S&P500 (13% on a reported EPS basis). The current market jitters indicate the market view those figures as unrealistic. Oppenheimer indicated that Goldman Sachs is currently thinking about a 6% and a 4% growth in EPS for 2019 and 2020 respectively is more realistic. Wilson indicted Morgan Stanley are projecting EPS growth for 2019 in the low single digits.

Given that estimates usually increase over time in the good years and decease in the bad years, I am going to assume a 3% and 1% increase in operating EPS for 2019 and 2020 respectively in this no recession but slowing growth scenario. Given that forward multiples would also decline in such a slowing environment (I have assumed to a modest 14), I estimate year-end targets for the S&P500 for 2019 and 2020 of 2,500 and 2,300 respectively, a decline of 6% and 13% respectively over the S&P500 today! The graph below shows the scenario as described.

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Economies generally don’t have slow gentle soft landings, it’s nearly always turbulent. Just look at the chart above to see how improbable the gentle scenario is compared to history. We need a major boast, such as a comprehensive resolution of the US-China trade issue, to maintain the bull market. Otherwise, I suspect the great EPS growth party is over.

Interestingly, Morgan Stanley also highlighted the headwind of quantitative tightening, as per the graph below, on the current market fall. I last discussed this issue in this post in January.

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No more buy the dip for a while yet I fear…….


Hi there LIBOR

According to this article in the FT by Bhanu Baweja of UBS, the rise in the spread between the dollar 3-month LIBOR, now over 2.25% compared to 1.7% at the start of the year, and the overnight indexed swap (OIS) rate, as per the graph below, is a “red herring” and that “supply is at play here, not rising credit risk”. This view reflects the current market consensus, up until recently at least.

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Baweja argues that the spread widening is due to the increased T-bill-OIS spread because of increased yields due to widening fiscal deficits in the US and to the increased commercial paper (CP) to T-bill spread due to US company repatriations as a result of the Trump tax cuts. Although Baweja lists off the current bull arguments to be cheerful, he does acknowledge that an increasing LIBOR will impact US floating borrowers of $2.2 trillion of debt, half of whom are BB- and below, particularly if 3-month US LIBOR breaks past 3%. Baweja points to rises in term premiums as the real red flags to be looking out for.

Analysts such as Matt Smith of Citi and Jonathan Garner of Morgan Stanley are not as nonchalant as the market consensus as articulated by Baweja. The potential for unintended consequences and/or imbalances in this tightening phase, out of the greatest monetary experiment every undertaken, is on many people’s minds, including mine. I cannot but help think of a pressure cooker with every US rate rise ratcheting the heat higher.

Citi worry that LIBOR may be a 3-month leading indicator for dollar strengthening which may send shock-waves across global risk markets, particularly if FX movements are disorderly. Garner believes that “we’re already looking at a significant tightening of monetary policy in the US and in addition China is tightening monetary policy at the same time and this joint tightening is a key reason why we are so cautious on markets”. Given Chairman Powell’s debut yesterday and the more hawkish tone in relation to 2019 and 2020 tightening, I’ll leave this subject on that note.

The intricacies of credit market movements are not my area of expertise, so I’ll take council on this topic from people who know better.

Eh, help Eddie….what do you think?

CenturyLink levelled

It’s been over 6 months since I last posted on the upcoming merger of Level 3 (LVLT) and Centurylink (CTL). Since then, LVLT’s CEO Jeff Storey has been named COO of the combined entity and CEO from January 2019, after a gentle push from activist investor Keith Meister of Corvex Management (here is an article on their latest position), effectively meaning the merger is an operational LVLT takeover of CTL. In June, CTL also got hit by a lawsuit from an ex-employer alleging a high-pressure sales culture which ripped customers off (an avalanche of class action suits followed). And, potentially more damaging, the recent results of CTL continue to point to deteriorating trends in the legacy part of their business and lackluster growth on the strategic part of the business. CTL missed their quarterly estimates again in the most recent quarter, the third miss in a row.

Picking up on my recent telecom industry post, the sector will struggle in the short term to find top line growth before the full impact of new “digital lifestyle” opportunities emerge. The figures below for enterprise, including public sector, and wholesale revenues for some of the biggest US players (which have been adjusted judgmentally for items such as the impact of the XO acquisition on Verizon’s revenues and the ever-changing classifications and reclassifications that telecom’s love) illustrate the current struggle in getting newer IP enabled services to fully compensate for declining legacy revenues.

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These figures imply average quarterly declines since 2014 of -0.3% and -1.2% for enterprise and wholesale business respectively. However, the trend has been getting worse. The average quarterly change was 0.2% and -1.1% for enterprise and wholesale business respectively from 2014 to 2015. Since 2016, the average quarterly change is -0.9% and -1.3% for enterprise and wholesale respectively. Not exactly a cheery trend when contemplating the prospects of a merged CTL/LVLT!

As can be seen below, the share price of LVLT and deal implied price have converged, particularly as CTL’s dividends get paid, albeit with a sharply downward bias in recent weeks over worries about dividend sustainability, valuation, sector trends, lawsuits and uncertainty over the closing date of the merger (a delay by California, the last State approval needed, may mean the end of September deadline is missed).

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My estimates for a standalone LVLT compared to analyst figures and those presented by LVLT management in the S4 (figures presented for merger negotiations are generally on the optimistic side) are below. Even factoring in higher interest rates (about 40% of LVLT’s debt is floating) over the coming years, I am comfortable with a standalone share price around the current mid-50’s, in the unlikely event the merger falls apart.

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To recap on my confidence in the ability of LVLT’s current management team to deliver, the results of the last merger between LVLT and TWTC show that management delivered a 40% uplift in the amount of free cashflow (e.g. EBITDA less capex) on flat revenues from 2014 to 2017 (e.g. combined FCF of both entities in the year prior to the merger to actual H1 results and my estimates for H2 2017). Some of my many previous posts on LVLT are here, here and here. Such a repeat in FCF in the CLT/LVLT merger is not a realistic expectation given the larger scale and different business mix, as the analysis below illustrates. Of course, the flat revenues over the past 3 years is a key concern (but worthy of praise given the industry trends highlighted above) and one of the catalysts for the CLT deal. Also, the health of designate CEO Jeff Storey may also be a factor over the next few years given his heart issues a few year ago.

My knowledge of CTL’s business is not as deep as that of LVLT’s and my confidence in their prospects on a standalone basis is nowhere near as lofty. My projections, split over a conservative base scenario and a more conservative low business scenario, can be seen below. My projections are primarily based upon the more recent trends in their business lines across their legacy and strategic enterprise and consumer businesses. The vast variance in my estimates, based upon recent trends, and those presented by management in the S4 (again, acknowledging that these are generally optimistic) illustrates why the market has lost such confidence in the outgoing management team at CTL, in my opinion.

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In terms of trying to model the merged CTL/LVLT, I have assumed the deal closes by the end of 2017 with 2018 being the first year of the merged entity. I have made a number of judgmental adjustments in my model, including assuming some loss of revenue due to the merger and cost reductions above published target synergies (e.g. $1 billion of operating synergies by end 2020 and $150 million of capex synergies by end 2019, higher than the announced target savings of $850 million and $125 million for opex and capex respectively). I have taken analyst estimates as an optimistic case (in CTL’s case I have taken their EBITDA estimates but still can’t get anywhere near their revenue figures) and called it the high scenario. My two projections above are used for the base and low scenarios. The resulting operating metrics for each scenario is shown below.

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The high scenario shows revenues flat-lining slightly above $24 billion for 2018 and 2019 with top-line growth returning in 2020 (YoY above 2.5%). EBITDA margins hit 40% by 2019 and remain stable around 40% thereafter. Capex is assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 30% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The base scenario shows revenues flat-lining around $23.5 billion for 2018 through 2020 with top-line growth returning in 2021 (YoY just below 2%). EBITDA margins hit 40% by 2019 and slowly trend down toward 39% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 22% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The low scenario shows revenues around $23.5 billion for 2018 and drifting down to $23 billion before slowly hitting $23.5 billion again by 2022. Thereafter revenue growth builds slowly from 1.5% to 2.5% by 2027. EBITDA margins hit 39.5% by 2019 and slowly trend down toward 38.5% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 18% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

I also assume the merged entity will carry $38 billion of debt from the offset (resulting from merger expenses, the cash payout to LVLT shareholders, and existing debts from both firms, after factoring any proceeds from recent CTL divestitures). I estimate that only 30% of this debt load is subject to a floating rate. In all scenarios, I assume the LIBOR rate linked to the floating rate increases incrementally by 275 basis points over the next 3 years (the current 12 month US rate is about 175 basis points). With a net debt to EBITDA ratio of approximately 3.8 at the end of 2018 across all scenarios, I believe that getting that ratio below 3 within 4 years by 2021, at the latest, will be a primary objective of the new management team. That would only be prudent in my view given the likely tightening monetary environment over the next few years which will punish valuations of corporates with high debt levels. Also, management will want to remain flexible if higher capex is needed to compete in new technologies for the IoT and digital lifestyle era (see recent sector post). I haven’t factored in an upside from LVLT’s CFO Sunit Patel proven ability to actively manage debt rates and maturities (his ability is highlighted by the fact that LVLT’s fixed debt costs 5.5% compared to CTL’s admittingly much larger fixed debt costing 6.8%)

That leads to the thorny question of the sustainability of the annual dividend of $2.16 per share (particularly given that share count will double, amounting to $2.3 billion per year). Under the high scenario, maintaining the current dividend and getting the net debt multiple below 3 by 2021 is doable if a little tight (primarily due to the cashflow benefits of LVLT’s NOLs). For both of the base and low scenarios maintaining the current dividend level is not realistic in my view, with a cut in the dividend to $1.30 and $1.00 needed in each scenario respectively (a 40% and a 55% cut). The current dividend yield on CTL is over 10%. Each of the cuts above would reduce that yield to approximately 6% and 5% for the base and low scenarios respectively based upon the current share price. Addressing the uncertainty over the dividend should be one of the priorities of the new management (and may even result in Jeff Storey’s move to the CEO position ahead of the planned January 2019 date).

Finally, before I reveal my per share valuations, I haven’t given any consideration to the financial impact of the current legal cases on alleged aggressive sales tactics as the level of current detail makes any such estimate impossible. Some of the class action cases claim anything from $600 million to $12 billion but these claims are always bloated and the eventual settlement figure, if there even is one, are often for a lot less than that claimed. Nor have I considered the potential impact of a spin-off of the consumer business (that’s for another time!).

So, based upon the analysis outlined in this post and using a discount rate of 8.5%, my valuation estimates for each of the three scenarios are below.

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The market’s current valuation of CTL around $20 indicates scenario 3 as the current expectation. This emphasizes the need to address the uncertainty over future dividend levels and the validity of the legal cases. Uncertainty over the closing date of the deal is overblown, in my view, and a few months of delay will not prove material. I do think the current valuation is harsh, given the potential upsides from the deal and longer-term industry trends. Interestingly, my base scenario valuation of £31 is not too far off the value of $34.75 by BofA Merrill Lynch and Morgan Stanley in the S4 (see this post on the S4). The base scenario is the one I would have the most confidence in, based upon my current knowledge, rather than the high scenario of $43 which does look too optimistic to me given current market trends.

I was never going to reinvest the cash component of the deal for LVLT shareholders given my current reservations about market valuations and move to cash across my portfolio. The analysis presented in this post indicates to me that the CTL shares due from the deal for LVLT shareholders are worth holding from a valuation perspective. For now.

For new investors, I’d wait to see how some of the uncertainties play out, particularly the dividend issue.

A gaggle of bankers

How many investment bankers does it take to change a lightbulb? Well there are numerous jokes on that. Here’s one: two – one to take out the bulb and drop it and another one to sell it before it crashes!

In the case of the Level 3 (LVLT) and Centurylink (CTL) proposed merger (see previous post), it took no less than five investment banking firms according to the recent S4 filing to get a deal agreed. Centurylink had Bank of America Merrill Lynch and Morgan Stanley as its main advisors with Evercore added for another fairness opinion. Level 3 had Citi as its main advisor with Lazard for another fairness opinion.

The S4 also reveals that there was no auction process. Although both sides have no doubt talked to many potential partners about deals (both telecom firms have extensive M&A experience) in the recent past, this merger proposal really got started after discussions with the CEOs in May, initially about a LVLT purchase of CTL’s business segment and a tracking stock on the consumer business. The tracking stock idea quickly got dumped with the cash and share purchase of LVLT by CTL discussed in principle in September with the details agreed in October. Given the breakup fee is only around $2 a share for any alternative bidder, LVLT decided it was best to nail down the deal with CenturyLink rather than look for other deals. The S4 stated the following:

In light of the premium being proposed by CenturyLink, Level 3 management’s view of the relatively low likelihood of any potential alternate bidder being willing to make a superior proposal within a short time frame and the risk of potential leaks raised by pursuing such a pre-signing market check, coupled with the ability of any potential interested bidder to submit a competing offer following the signing of a definitive agreement with CenturyLink and the ability of Level 3 to terminate any definitive agreement with CenturyLink post-signing to accept a superior proposal from another bidder, the Level 3 Board determined at that time to continue pursuing the transaction proposed by CenturyLink without approaching other parties.

Relying on investment bankers to give fairness opinions could be viewed with scepticism by anybody with a memory and a sense of humour. However, in this case, I believe that the strategy is a sensible one for shareholders. The business segment of CTL and LVLT clearly makes sense as a match up with the possibility of significant synergies (more I think than has been assumed). The consumer side of the merged entity can always be offloaded at an opportune time in the future. Also, any other potential bidders of LVLT, such as Comcast or a technology firm like Goggle or Microsoft, will be forced now to act if they want the unique assets of the firm. My sense is that the possibility of another bidder emerging over the coming months remains low.

The financial projections, shown below, from management of each firm on a standalone basis are presented in the S4 and make for interesting reading.

click to enlargecenturylink-level3-projections

The projections for LVLT show higher capex figures for 2016 and 2017 than analyst estimates. From 2017 onwards, LVLT’s estimates of revenue are higher than analyst estimates whilst the resulting EBITDA is lower. This suggests a slower progression in EBITDA margins than analysts’ expectations with a figure closer to 35% and stable over the medium term. For CTL, the longer term revenue growth figures from the firm are more aggressive than analysts with EBITDA margins drifting down to the 35% level and below over the medium term.

It is unclear how many adjustments have been made by advisors to the figures provided by management of both firms. I am not that familiar with CTL’s figures but the LVLT figures look reasonable enough. The fairness opinions generally state that they reviewed the figures provided and the assumptions behind them without actually coming up with their own figures. The valuations of a standalone LVLT in an M&A context, and the assumptions behind the methods used, outlined in the S4 are shown below.

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The valuations are generally consistent around a $60 per share level, varying from $50 to $70. Most include the value of the NOLs with Citi estimating their value separately at approximately $7 per share. A number of the bankers also valued the targeted synergies of the deal assuming 100% of these were assigned to LVLT shareholders. These estimates and the valuations of a standalone CTL are shown below.

click to enlargelvlt-and-ctl-valuations-from-s4-december-2016

Comparing the average LVLT standalone valuations and those including the synergies shows a value of $25 per share (i.e. $84-$59), assuming shareholders get 100% of the synergies. That assumption is clearly unrealistic. If 50% of the synergies were assigned to LVLT shareholders (who will get 49% of the combined entity), than a reasonable expectation in the longer run would be a value equivalent to $72 per share. As can be seen below, this is equivalent to a share price of $32 per share for CTL under the merger terms. BofA Merrill Lynch and Morgan Stanley in the S4 calculated a proforma value of CTL after the merger (with the synergies realised) of $34.75 which would put the value of the deal to LVLT shareholders around $76 per share, as below.

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With CTL’s stock still trading just over $24, there is obviously a lot that can happen before this proposed merger closes. And even more time before the deal synergies are realised. One thing is for sure through, the investment bankers are making out well as the exhibit on their fees below shows. $25 million alone for a few week’s work to provide the fairness opinions is outrageous.

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The amount of such fees investment bankers get away with charging always boggles the mind and shows what a closed shop the business still is. Whatever happens to LVLT and CTL shareholders, these masters of the universe always make out like bandits.