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from Breakingviews:

Graff Diamonds IPO gleams but doesn’t dazzle

By John Foley

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s hard to think of a company more plugged into the 0.1 percent than Graff Diamonds. The UK diamond merchant, which in 2011 sold rocks worth almost $100 million to a single customer, plans to list its shares in Hong Kong, in an offering that could raise $1 billion and value the whole at $4 billion. Strip out the hype over the ascent of the super-rich, and the valuation looks solid if not a steal.

The business model is pure plutocracy. Around half of Graff’s revenue in 2011 came from pieces worth more than $1 million. Whereas the likes of LVMH or Prada rely on expanding wealth, Graff can benefit simply from growing inequality. That helps explain its 25 percent revenue growth over the past three years.

Against that, investors have to weigh unusual risks. Sales could prove lumpy, since Graff gets around half of its revenue from just 20 customers. Billionaires, especially in Asia, can fall from grace alarmingly fast. There’s also the risk of false confidence. The super-rich are often touted as shock-proof spenders, but that was proven wrong in 2009, when Graff’s sales fell by 25 percent.

To see what Graff is worth, split it in two. First, there’s a super-high-end retailer. If Graff can expand last year’s $624 million of retail revenue by 15 percent, and sustain its current 20 percent margin, it could make $165 million in retail operating profit by 2013. Pop that conservatively on the 10 times multiple that LVMH commands and it’s worth $1.7 billion.

But Graff has another asset - its remarkable $880 million inventory of rocks, valued at cost, and mostly bought when prices were lower. Assume a market value twice as high, in line with the increase in high-grade diamond prices over the past five years, and these could be worth $2 billion. Combine the two parts, and $3-4 billion looks like a fair price.

from Breakingviews:

The pound’s climb may send the UK down

By Ian Campbell

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

British holiday-makers will welcome it. The pound is rising as the euro weakens. Sterling will rise further in the coming months if Greece exits the euro zone and exacerbates the single currency’s crisis. But the pound’s rise promises UK pain-and serious problems for policymakers.

The 4 percent rally against the euro so far this year isn’t dramatic enough to be called a problem or claimed as an excuse. The pound remains quite low. A euro now worth 80 pence is well down on its 97 pence peak but still up on the sub-70 pence that was the norm before 2008. But it won’t stay that way if the next phase of the European crisis is a euro exit - or two.

If Greece departs the zone, the resultant panic will be great. The pound would become still more of a safe haven. That 70 pence level for the euro, implying a pound appreciation of over 12 percent, could quickly be a reality. UK competitiveness in Europe would be harmed but the damage would go deeper than that.

An existential euro crisis would harm already weak European growth as investment plunges, consumers cower, banks struggle and financial markets tumble. All this euro-carnage would undoubtedly be felt across the Channel.

A half of UK exports go to the broader EU. The UK’s policymakers have been counting on rebalancing, with consumers overseas helping to pull a more competitive UK forward. Outside the EU that strategy is working. Export volumes to non-EU countries are up an annual 5.3 percent in the past three months - and by 21 percent since 2008. But in Europe a toll is already being taken by recession in weaker economies. Exports to EU countries in the three months to March are down by 3.3 percent in the past year and by 5.5 percent since 2008.

from Global Investing:

Three snapshots for Thursday

The Bundesbank is preparing to stomach higher German inflation than it likes, above the European Central Bank's target level, because of the euro zone crisis, a source at the central bank said on Thursday.

Although the Bundesbank still wants stable prices across the euro zone, its latest comments show the bank recognises that upward pressure on German wage costs and property prices suggest its inflation is likely to rise above the bloc's average.

As this chart shows, historically the Bundesbank was quick to react to any signs of inflation:

The Bank of England voted on Thursday not to give the struggling economy another injection of cash as concerns over stubbornly high inflation outweighed the risk of a prolonged recession.

The number of Americans submitting new applications for jobless benefits edged down last week, easing concerns the labor market was deteriorating after April's weak employment growth.

from Breakingviews:

State stranglehold on RBS now only slightly looser

By George Hay

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Royal Bank of Scotland is about to achieve a milestone. Chief Executive Stephen Hester’s five-year plan to remove the bank from intensive care by shrinking its balance sheet is entering its final phase. Better still, the UK group’s first quarter results held up despite it performing open-heart surgery on its battered investment banking arm. But while RBS is heading the right way, it remains in a state headlock.

All told, RBS made a 1.4 billion pound net loss in the first quarter. But this was largely due to a 2.5 billion pound accounting charge for narrowing spreads on its own debt. Elsewhere there were positives. Returns in RBS’s core bank - the bit left over after it sheds all its unwanted assets - now almost exceed its cost of equity, despite the drag of loss-making Ulster bank.

But the best bit of news is that RBS will soon have paid off all 75 billion pounds in emergency long-term liquidity it borrowed from the UK government in 2008. That’s mostly due to its progress cutting a 258 billion pound heap of non-core assets to its current 83 billion pounds, which in turn has allowed the bank’s short-term funding to shrink from almost 300 billion pounds in 2008 to 80 billion pounds.

Yet RBS still faces a triple state grip. First is the government’s asset insurance backstop, which helps boost RBS’s core Tier 1 capital ratio by about 0.8 percentage points. Second is a rule imposed as a result of the 2008 bailout that obliges the bank to hand the UK 1.8 billion pounds if it ever restarts dividend payments. Finally, the government still owns 82 percent of RBS’s equity.

Unpicking these locks won’t be easy. Private investors who might be interested in the shares will want a dividend, which means convincing the government and European Commission to waive or water down the dividend blocker. Even then, with RBS’s core Tier 1 ratio at around 9 percent without state insurance and on a Basel III basis, the UK regulator may still prevent the bank from paying dividends, or force it to keep holding billions of pounds of expensive contingent capital. Escape from the government’s grasp still looks years off.

from Breakingviews:

Mervyn King’s mini mea culpa is missed opportunity

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

“Don’t blame me, blame the banks.” That, in a nutshell, is Mervyn King’s assessment of Britain’s most severe recession for seventy years. The Bank of England governor admitted in his radio lecture to not shouting loudly enough about financial risks. Yet his retrospective largely ignored the many criticisms of central bank policy, after as well as before the crisis. That’s a missed opportunity.

Anyone who tuned in expecting new insights about the financial crisis will have been disappointed. King offered a conventional - and partial - explanation of what went wrong: banks became risky, interconnected and too big to fail. When the financial system wobbled, taxpayers and central banks were able to avert a total collapse, but not a severe recession. Even King’s mea culpa came with an excuse: because the central bank was stripped of responsibility for regulating banks in 1997, it could not intervene directly.

King’s praise of pre-crisis monetary policy was especially baffling. The governor insisted that the central bank had got it about right, because there was “a bust without a boom”. That totally ignores the giant debt-fuelled property bubble that helped bring about Britain’s subsequent economic woes. And if the Bank of England was broadly correct before, why has it set up a Financial Policy Committee, chaired by the governor, which is seeking far-reaching powers to prevent future bubbles?

King may have felt that a radio broadcast, the first such peacetime address since 1939, was not the best forum in which to explore such contradictions. Besides, Federal Reserve Chairman Ben Bernanke and former European Central Bank President Jean-Claude Trichet have hardly been more apologetic. And lack of contrition has so far proved a successful strategy. The Bank of England has emerged from the crisis more powerful than ever, while the Financial Services Authority, which has completed several painful self-examinations, has been dismembered.

Such stubbornness may yet backfire. The Bank of England is under intense pressure for its expanded responsibilities to be combined with greater transparency and accountability. King’s self-congratulatory revisionism will only embolden his growing band of critics. The governor’s successor, who is due to take over in July 2013, may face greater restraints.

from Breakingviews:

Lloyds investors’ long wait may soon be over

By George Hay

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Lloyds Banking Group’s battered investors may be nearing redemption. Before the financial crisis, the UK’s biggest mortgage lender was the epitome of a stolid, dividend-paying stock. Since 2008, when it agreed to rescue HBOS and wound up 40 percent state-owned, its shareholders have not received a single payout. But an end to the drought is in sight.

It may not look that way right now: the bank’s first quarter contained some unpleasant surprises. The gargantuan 3.2 billion pound provision Lloyds set aside last year to cover mis-selling of payment protection insurance policies had to be topped up with another 375 million pounds. And its attempt to offload 632 branches by 2014, as demanded by the European Commission, is foundering amid doubts that the erstwhile frontrunner, the Co-operative Group, will last the pace.

But the first quarter also marked a return to form for Antonio Horta-Osorio, the chief executive who took time off last November suffering from exhaustion. Horta-Osorio took advantage of the market rebound to speed up disposals of nasty non-core bits of the balance sheet. The bank now thinks it will hit its non-core shrinkage target a year early. Deposits, which were six percent higher at the end of March than a year earlier, now almost cover the assets in Lloyds’s core bank. Besides, the lender has already secured all the wholesale funding it needs for 2012.

True, Lloyds is still hugely geared to the UK economy, which shrank in the first quarter. But the bank only expects the UK economy to stay flat for 2012, while provisions for bad loans and its net interest margin are both better than expected. If Lloyds can hold the line, it could have 1.8 billion pounds in net profit for the year, according to Thomson Reuters consensus estimates.

Whether Horta-Osorio is able to distribute some of this to shareholders depends how much capital UK banks need to satisfy the European implementation of global Basel III rules, and the size of any add-on deemed necessary by UK regulators. But provided June disclosure on both goes his way, Horta-Osorio could be sorely tempted to at least announce a roadmap to restoring the dividend. For long-suffering investors, that would be the first step to getting rid of its government stake.

from MacroScope:

UK recession in charts

Britain's economy slid into its second recession since the financial crisis after official data unexpectedly showed a fall in output in the first three months of 2012:

Starting real GDP at 100 in 2003 for the UK, U.S. and euro zone shows UK GDP flat since mid-2010 and well below the 2007 peak.

Survey data had been suggesting a stronger GDP number and perhaps points to upwards revisions to come.

As this chart shows past revisions have been substantial.

from Breakingviews:

UK gas bounty will be tricky to exploit

By Kevin Allison

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The British government may have warmed to fracking. But while shale-gas extraction has put America on the road to energy self-sufficiency, it may be premature to bank on a similar boom in the UK. The country’s shale formations could be enough to meet decades of demand if bullish interpretations of geological data are right. But economics may keep much of the shale bounty under ground.

Tapping onshore shale fields might seem straightforward. Today’s import prices mean UK drillers would only have to be about half as efficient as their U.S. counterparts for onshore shale to be competitive with liquefied natural gas from abroad. But UK shale exploration is still embryonic. Britain’s small land area and dense population could complicate matters. Lancashire, where UK driller Cuadrilla says it has found about 200 trillion cubic feet of gas, counts more than 1,220 people per square mile, compared with less than 10 per square mile in shale-rich North Dakota.

Offshore reserves are likely to be five times whatever lies onshore, according to the British Geological Survey. That’s prompted talk of the UK sitting on 1,000 trillion cubic feet of gas. But offshore fracking has yet to be pioneered. The UK industry’s vast experience in the North Sea might help in developing the technique. Still, experts say it could take gas prices of up to $200 per barrel of oil equivalent to make it commercially viable. Today’s UK liquid natural gas imports go for $50/boe. And global LNG prices look set to fall as the United State begins large-scale exports from 2015.

U.S. drillers have made huge strides in efficiency, with some producers drilling wells twice as fast as they were just two years ago, according to energy consultants Navigant. Costs won’t fall forever. Some combination of tighter environmental controls, equipment shortages and rising labour costs is bound to bite eventually - just as it has in conventional petroleum production.

Given these pressures, it’s not immediately clear how UK shale could compete with LNG imports over anything but the very long term. It looks more like an insurance policy against a dystopian future of $200 oil.

from Breakingviews:

The Bank of England needs a home-grown governor

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Must the governor of the Bank of England be English? That’s the intriguing question raised by a report that Mark Carney, the governor of the Bank of Canada, has been sounded out as a possible replacement for Mervyn King, who is due to retire next year.

In most other developed countries, the question would not even arise. It’s inconceivable that, say, an American could be head of the European Central Bank, or that the Federal Reserve would choose a German or Chinese chairman.

The UK is different. It has long shown an admirable willingness to install foreigners into senior positions. Almost half the chief executives of the constituents of the FTSE 100 index aren’t British. Quintessentially English sporting events like Wimbledon and the Oxford-Cambridge boat race are dominated by foreign contestants. Even England’s national football team was, until recently, managed by an Italian.

But such internationalism has its limits. The governor of the Bank of England is no faceless technocrat; he is the most powerful non-elected official in the country. The job has become more powerful, and more political, since the financial crisis. The central bank has embarked on a controversial bond-buying spree and is set to receive sweeping new powers for regulating banks and pricking future financial bubbles.

The governor will be at the very heart of economic and social policy. King has been rightly criticised for the Bank of England’s lack of transparency and accountability. The last thing his successor will need is a row over nationality.

from Global Investing:

Three snapshots for Wednesday

Spanish house prices fell 7.2 percent in the first quarter from a year earlier while Spanish banks' bad loans rose to their highest level since October 1994 (see chart).

The Bank of England is poised to turn off its money-printing press next month. Minutes of the Bank's April meeting, combined with a stark warning on inflation from deputy governor Paul Tucker on the same day, signalled a sharp change in tone that could bring forward expectations for interest rate rises.

Does the E in PE need a reality check too?