Saturday, October 31, 2009

Again Random Thoughts, Again on Inflation, Paper Currencies and Other Topics

"Government is the only institution that can take a valuable commodity like paper, and make it worthless by applying ink."-- Google who said it.

If you are a newbie to the inflation discussion on this blog, please take time to read this, this and this. I have a PhD in Macroeconomics focusing on inflation from Garage Logic University, and, consequently, some of my ideas are not from the US mainstream books written by the macro-cabal. They come from reading real accounts and from bruised knuckles, not from lofty, enriching beret-tweed-pipe discussions in the faculty club.

Some of my examples present real dark case scenarios. Do not dismiss them as "this will never happen here." We've been very lucky in this country, and luck runs out eventually, especially if unappreciated, like the talent of a gifted basketball player who hangs out in the wrong crowd.

Black Swans do happen, and they are called Black Swans, not fluffy puppies, for a reason.

Inflation is asymmetric
This is an FYI point that I think I should clarify upfront. Most textbooks define inflation as the overall increase in price levels, including the price of labor. This is an overly simplistic view.
The prices do not go up in unison. Essentials go up drastically and first, and keep rising (water, food, energy, medicine, security items); non-essentials sometimes take years to catch up (salaries, many services). In E Europe it took years for salaries to catch up to the pre-hyperinflation real levels. Any credit-based products (think housing) will also lag in real terms because credit will disappear, and other "normal" drivers, such as incomes, employment, mobility and household formation stall. Try selling a house if the price is 200 American Eagles, the only accepted form of payment.

Inflation will not solve the entitlement crisis
The problem larger than the $12 trillion in debt is the $50-60 trillion in promises the government has handed out to the American people. Here and there you hear that inflation will help with the "national debt." However, the $60 trillion in Medicare, Medicaid and Social Security are present value amounts. They will not disappear unless there is entitlement reform (read, massive reductions). No elected politician will stand for it, and the majority of the electorate do not understand neither the cost nor the complexity of the problem, nor its implications. But, my point here as it relates to the rest of the article, is that inflation will not help with the unfunded promises.

Inflation in a service-based economy
The sad truth is that most services are non-essential. As essentials take up more and more of the consumer budget (in Weimar Germany, food went up for 30% to over 90% of the average family budget), many service businesses will collapse. As in, $0 in revenues. Think about it, when the choice is bread or a haircut. Or keep contributing to the $1 mm life policy when a gallon of gasoline is $2 mm? All 401(k)'s cashed out in a mad rush for food hoarding? What would be the demand for real estate appraisers then? Drycleaners? Florists? Car detailers? Professional baseball? Most retail? Hotels? Management consultants? Roofers?

Inflation is very hard to control
Inflation cannot be "controlled" once the genie is out of the bottle. It becomes as much of psychological phenomenon as it is a monetary phenomenon (as described in your favorite macro texts). What does it mean that inflation becomes psychological, and what are the implications?
Inflation becomes a front and center event. If it is on top of everyone's mind, then society as a whole will overreact to it, thus exacerbating the problem: pre-emptive price increases daily, workers demanding weekly raises, any money earned is spent right away (which really speeds up the velocity of money, making the problem deeper), and so on. The implications are that things that have historically worked to slow down inflation, such as raising interest rates, will not work as intended: businesses will still raise prices all the time anticipating inflation, no matter what the discredited (by now) government says. People will still be rushing to spend, keeping the velocity of money high. In short, the participants' actions to protect themselves individually will be hurting the collective outcomes. In addition, there will be supply-driven inflation, as inflation brings about business shutdowns, thus reducing capacity/supply of goods. Imagine the following headline: "Fed Raises Short-term Interest Rates to 400%; Bernanke Says Inflation Now Under Control" If we get to 400%, do you really think the Fed's decision will matter to anyone?
Only credible actions from credible people will solve the psychological problem, such as a new government instituting a credible currency board.

Inflation: dispelling the serious misconceptions about how it happens and how it affects people and businesses
Many people here in the US that actually have a clue about inflation think of it in textbook terms. In other words, both incomes and prices rising more or less at the same pace; no inflation if there is high unemployment and low capacity utilization; inflation helps companies as they can raise prices while debt service gets "easier", and so on. All in all, inflation is business as usual, may be with some more aggressive pricing action.

No, no, and no.

The above statements are true at when inflation is at low single digits. If unemployment is at 7%, inflation will be 2%, vs. 3% if u/e is 5.5%. Companies target price increases of 3-4% every year, and costs rise at about the same rate. So far, so good. This is roughly the US experience over the last 30 years.

What happens if inflation is higher?
High inflation leads to both high unemployment and low capacity utilization. How's that possible? Most businesses actually cannot pass on the cost increases simply because most businesses do not offer essential products or services. As a result, they simply shut down: you have both high unemployment and low capacity utilization. This also leads to product scarcity in many areas, further increasing prices.
Just think what would happen if diesel prices go up 3x tomorrow (not out of the normal for an essential good in a hyperinflationary environment). What would happen to UPS and FedEx? Will they be able to pass it on? No. They will shut down. What happens to shipping costs? They go up. What happens to unemployment? Up. Capacity utilization? Down.

What worries me even more is that the vast majority of US management teams are simply too young to have been in management in 1979-1980. They would have had to be born in 1940 at the latest, or they'd be 69 now. More than likely, these people are golfing somewhere in Florida.
US businesses are not run with an eye towards inflation: long term fixed price contracts, vendor credit, reliance on short-term and variable-rate borrowing, even mundane things, like gas station pumps having only single-digit per gallon prices, vending machines accepting only $1 bills, or average employee commuting distance becoming prohibitively expensive. Sure, they can adapt in the long run but only few will.

Inflation: how it happens even without "printing" and without changes in the wider money supply, and without changes in the velocity of money
Here is something I do not think you can read about anywhere else. First, inflation rates are personal as personal consumption patterns differ, housing choices differ (i.e. own outright vs. rent), etc. How is it possible that you can experience inflation even if you do not purchase products or services with rising prices?
Here in the US the last 40 years have been marked by increasing governmental involvement in healthcare and education. As a result, the healthcare and educational costs have risen far faster than the overall CPI. Even if you are not a user of either (unlikely) your personal inflation rate reflects it because there is no free lunch. The new money the government spends comes from taxes (sooner or later), and this means lower disposable income for you. All of a sudden, for a unit of your labor, you can buy less. De facto, your own personal inflation.

A similar mechanism works when there is a government decision to limit say, oil drilling. Prices go up across the board because of the higher oil costs. No change in money supply or anything, but what is in effect a tax, creates inflation as your money is now worth less.

Inflation: the signs you will see when it is already here
This section is for the benefit of my US/Canadian/Western European readers. People from Latin America, Africa and Eastern Europe will likely find nothing new in it.
- Inflation is headline news
- New dollar denominations: $500 bill, $1,000 bill, $5,000 bill, $10,000 bill
- Disappearance of coins (both because the prices now have zeros and the value of the metal)
- Lack of essential products: everything you take for granted now is gone
- Explosion of petty theft: gasoline siphoning, food, light bulbs from common living areas and offices, hospital thefts
- Disappearance of credit
- Currency controls: limits on foreign currency transactions, gold and silver ownership, limits on bank withdrawals, etc.
- Blame game: incessant attacks on a gray subset of the population called "speculators" and "hoarders". If you think the Exxon hearings in Congress two years ago were a farce, this will be much worse. Read up on Venezuela's confiscation of food producers. Think it can't happen here? Think again. "Chevron's new management committee compromised of ACORN activists will work to ensure fair distribution and prices for gasoline." Or "Kraft Foods pledges to produce 100 tons of cheese in 2015 in order to reduce prices." The theft, of course, has happened at the printing press.
- Social unrest: If you think that the LA Lakers championship celebratory events were riots, wait until the monthly food stamp benefit can't buy a loaf of bread
- Non-stop "initiatives" to control price increases at the federal, state and local levels: price and wage controls, rationing, new laws and regulations about "black markets", "hoarding" and "speculation"
- Breakdown in services such as hospitals, ambulances, public transport and police; even electrical and phone services become unreliable (imagine the local utility company with regulated rates not being able to cover half of their nat gas purchases at market)
- Rise in bartering
- Rise in reference rates for pricing (i.e. products priced in today's dollar equivalent of euros, gold or some other rate)
- Rise in foreign currency circulation
- Rise in local currency circulation (how does a Dixie Dollar sound?) and other methods of payment aimed at avoiding dealing in the depreciating currency
- Widespread disbelief in the "official" inflation rates and money supply stats (I strongly recommend that you start keeping track of several products that you purchase often now)
- Widespread drop in the standard of living (wages take forever to catch up)
- Change in societal values, usually for the worse (things like civility, respect, etc.)

Reading first-person accounts from Weimar, Argentina, Yugoslavia and Zimbabwe can give you a pretty good idea of how things change.

Deflation: is it all that bad?
Is deflation bad? Some say so, I disagree. Here is why.
Deflation, widely defined, is a lot more controllable than inflation. Deflation helps with "creative destruction": a business should be built and run in a way to survive the lean times (in other words, with less debt than what the bankers told you at the presentation.) Deflation is natural in many businesses as a part of the cycle (think iron ore pricing for example). Deflation is inherent in businesses such as computing power, and yet, you do not see Intel complaining that the price for a certain computing chip drops all the time. This deflation in computing costs has been a boon both for the players there as it has expanded demand for their products, and to society as a whole. Deflation in housing is great because the prices had gotten ahead of themselves. Deflation in the overall CPI is good because the US worker is squeezed by both global wage arbitrage and by the bubble policies of the government. Deflation in living costs can help soften the blow. There should be deflation in education and healthcare costs, if you ask me. Of course, it won't happen so long as the taxpayer is on the hook for the massive programs in both areas.

At the end, I'd like to present you with a paper currency story, that of the not-so-mighty Bulgarian lev (pl. leva).
The story starts in 1944. Bulgaria started WWII on the side of Germany but switched over to USSR once the Germans left, and the Russians showed up on the border in 1944. Fortunately, save for some Allied bombing, there were no battles on its territory, unlike most places in Europe. The USSR installed its own muppet government, and the said government went on to execute, chase into exile or put in forced labor camps most of its political opponents, including most of the "bourgeois." Post-war inflation picked up (see Hungary), in part because there was no one to produce any goods after the factory and land confiscations (see Chrysler LLC). By 1952 inflation forced a replacement of the "old lev" with new ones at 100-to-1 (these numbers are a proxy for the actual inflation) but prices were changed at 25-to-1 (the government can do whatever it wants to prices in a planned economy). In other words, the purchasing power of the lev went down about 400 times in the post-war period.

Think of it this way, if in 1944 you had 100 leva that could buy you 100 boxes of nails at 1 lev each. By 1952, those nails were worth 100 devalued "old" leva each, and 4 leva each in "new" post-reform leva. Those 100 leva you had in 1944? They could then buy you 1/4 of a box of nails post reform (you had 1 "new" lev but nails were at 4 leva each.)

But wait, there's more. Scratching zeros does not work that well. Continued inflation forced a 10-to-1 conversion ten years later in 1962. Again, this is a proxy for the devaluation that happened. Those 1944 100 leva you had turned to 1 lev in 1952 are now 0.1 "new new" leva. The box of nails at 4 leva in 1952, probably went up to 40 in 1962, back to 4 after the 10-to-1 exchange. Your 1944 100 leva that could buy you 100 boxes of nails can now buy you 1/40th of a box.

But wait, there's even more! Several years of price stability followed largely due to below-market oil from the Soviet union. However, inflation accelerated again in the late 1980's leading to a currency board, pegging the lev to the Deutsche Mark, and a subsequent exchange into the "new new new" leva at 1,000-to-1. Again, using the exchange ratio as a proxy, those 1944 100 leva could buy you a 1/40,000th of a box of nails, when they could have bought you 100 boxes of the same product in 1944.

How does your purchasing power go from 100 boxes to 0.000025 of a box? The same way you go from 1 box to 0.00000025 of a box. Inflation.

Of course, the example is highly theoretical, as the old paper money itself is no longer a legal tender after each exchange, and the money exchanges are a proxy for the actual inflation rates. They could be over or under those but not by much.

Wikipedia has a nice list of examples of what inflation does to paper money. For example, 1x 1992 Argentina peso is 100,000,000,000 (100 billion) pre-1983 pesos.
Greece, the 1953 1x drachma was 50,000,000,000,000 (50 trillion) pre-1944 drachmas.

Of course, the winner and the runner-up are Hungary (1946) and Zimbabwe (to Jan 2009).

My ($0.02) advice is: do not take inflation lightly. Do not think it cannot happen here. Do not think that it can be "controlled" once the ball really starts rolling. "You can't predict but you can prepare."

Update 1 11/2/2009:
Mish, one of the top econ/business bloggers, has a good post on deflation. I strongly recommend clicking through on the links to read up on the deflation argument. He makes the best argument for deflation that I have seen. There is one to be made, and some would argue we are in a real deflation (if Case-Shiller is subbed for owner-equivalent rent in the official CPI). There is a particularly interesting link about debt deflation: no doubt we have seen some, but I think the paper overall is too academic (1), and (2) does not look at all mechanisms through which we can have inflation spiraling out of control: currency shocks leading to supply problems, new legislation that will undoubtedly raise both taxes and prices (health care and cap and trade are the two big ones): remember your own "personal" rate of inflation goes up if you can buy less with your labor as I described above.

Wednesday, October 21, 2009

Ackman on Corrections Corporation of America (CXW)

Bill Ackman fired up CXW yesterday at the Value Investing Congress, presenting it as a long idea. Of course, it is not an "idea" per se, he's already long big time and owns nearly 10% of the company. I like reading Ackman's materials: I have been a fan of his product ever since I read his old 2002 Gotham Partners 66-page white paper on the bond insurers. Over the last two-three years, I have seen several other pieces from his fund: Wendy's, Fannie and Freddie, Target, Wachovia, General Growth, updates on the bond insurers.

More recently, I saw his Realty Income (NYSE: O) presentation. He is short, and I agree with his thesis: low quality tenants in lower tier properties should be over the current 7-7.5 cap. He has a few other auxiliary arguments regarding disclosure, management incentives and how O is marketed to the unsuspecting and naive. You can see it here.

Of course, Pershing would get hurt if cap rates are up across the board: they have a large position in the bankrupt mall owner General Growth Properties (GGWPQ), and he argues that GGP's cap rates should be about as low as they get. I had GGP puts last fall largely based on Reggie Middleton's research. I almost wonder if O is a hedge on the highly appreciated GGP position: shorting the lower quality operator, long the higher-presumably- quality company.

There is a substantial real estate component in many of Pershing's activist investments. They play book is generally the same: separation of real estate from op co, and then, if applicable, transforming op co to a full franchiser to the extent possible. The argument goes that the split would help with raise the overall value through both asset transparency and self-selecting investor constituents. The first case with this was McDonald's back in 2004, if I remember correctly. The most famous case was the recent proxy fight with Target. The idea was to separate and spin-off Target's real estate into a separate entity, and have the stores there on a long-term contract. Presumably, this would be a very high quality REIT that would achieve a superior valuation, while old TGT would be a pure-play opco. He was also (rightfully) critical of TGT's holding credit card risk instead of moving to a private-label credit card provider.

So, on to CXW. The Investment Linebacker, one of the better blogs I follow on Reader, has notes on the argument for CXW.

Again, it is viewed as a real estate-type play. Ackman likens it to a healthcare REIT (think long-term care), which is about as close of a comp as one can get.

I am swiping most of the TILB notes from yesterday:
Rehashing the same ole private prison thesis: Only 7.8% of nationwide inmates are housed in private facilities. CCA does it cheaper, and "better". In 2007, private prisons took ~50% of incremental industry "growth". (Trend is sloping up and to the right). Currently industry (public + private) is operating at 94% occupancy. Doesn't see that declining as states can't afford to build new, current are overcrowded, and nationwide # of prisoners trends up and to the right Catalysts: 1) Recession is good for prison operators • More Crimes • States/Munis constrained to build new facilities 2) Operating Leverage from incremental prisoners is very high 3) Stock Buyback Bought 8% of stock back in Feb / March (at $10.61, now trading at $24.50). After-tax ROIC are 20-30% (low/high case). # of beds has increased from 46k to 61k in last 3 yrs, should be very accretive as occupancy on new beds increases. 5% of equity held by the Board. VALUATION 13x FCF, 12.2% Cap Rate (above where he thinks Realty Income will trade - Bill thinks its a good pair trade - see prior TILB post on Ackman's O short here) Key Qualitative Investment Factors: CRE Business, Govt is sole tenant, Triple-Net Lease (sorta), LT Secular Growth, Low Maintenance Capex (~2%), High ROIC, Local Monopoly/Nationwide Oligopoly Best comp is a Healthcare REITs (trade at 7% cap rate) From 1997 to 1999 operated as a REIT. Had to give up REIT status as a result of a large acquisition at the time. But at least it created a lot of NOLs. Company makes much higher margins on owning & operating than just management contracts. Recently expanded # of beds in owned facilities. Increasing margins. 25-33% of contracts roll each year, so decent predictability [TILB note: also allows for replacing in an inflationary environment]. All in all very simple. Clearly a lot of regulatory risk, but Bill thinks its mitigated by supply / demand dynamics in incarceration industry. Pershing owns 9.5% of company. "

I agree with his thesis overall. Before you rush to buy CXW, there are a few things to consider.
(1) Ackman bought at $10, the stock is now at $25+. Your "margin of safety" just went poof.
(2) The prison population has been growing but there is a limit to this: the US already has the highest incarceration rate in the world.
(3) The reason for it is the enforcement of drug offenses, and the federal government just made its first step loosening the enforcement of those.
(4) Another reason for the high population is the popularity of the so-called 3-strikes laws which have led to some absurd sentences, and are now being looked at more critically.
(5) More crimes does not mean more prisoners: he is assuming that enforcement will stay the same. It will not: state and local budgets are suffering big time, and this sometimes means less policemen on the street, and same number of detectives working on a lot more cases.
(6) The "government" as a sole tenant: this is a double-edged sword. If more states start issuing IOU's or reviewing state contracts for "savings," having this one tenant might not be such a great deal. On the flip side, it might help with privatization.

The image above is from CXW's site. I love it how companies put all those happy families and puppies on their sites, but not CXW.

Update 1 10/23/2009: The Investment Linebacker has posted the full CXW presentation here. Essentially, as described with some more relevant detail, i.e. capex lower than depreciation due to the nature of the construction, benefits of own vs. manage, incarceration trends, and others.

Update 2 10/25/2008: So here's something about the pushback against the mandatory sentences from the NYT: "Last Wednesday, changes to New York's notorious Rockefeller drug laws went into effect, allowing judges to shorten the prison terms of some nonviolent offenders. This measure will further reduce New York's prison population, which has already declined, in the past 10 years, from about 71,600 in 1999 to about 59,300 today. (The state's crime rate also dropped substantially during that time.) Nevertheless, mainly because of opposition from the correction officers' union and politicians from the upstate areas where most of our correctional facilities are, the state has been slow to close prisons. It was not until earlier this year that policymakers in Albany, confronted with fiscal crisis, mustered the will to shut three prison camps and seven prison annexes--a total of about 2,250 prison beds--in a move that is expected to save $52 million over the next two years. ... The prison system still has more than 5,000 empty beds in 69 prisons. What's more, there are other ways to lower the prison population. For starters, state lawmakers could repeal the Rockefeller mandatory sentencing provisions that remain on the books. ... In addition, the state could reduce the number of people--last year, more than 9,000--who are returned to prison for technical parole violations like missing a meeting with an officer or breaking curfew. ... Also, more prisoners with good institutional records could be given parole. ... After New York passed the Rockefeller drug laws in 1973, a mandatory sentencing movement swept the country, raising the nationwide prison population to nearly 2.4 million, from 300,000"

So be careful with the slides that Ackman has about the rising tide. There might not be one. This then makes it much harder for someone like CXW to swim against it: everyone's a champ with the wind in his sails. Again, remember that if you buy now, you do not have Ackman's margin of safety. He's already up 150% and might well be a seller, at least partially.

Monday, October 19, 2009

More On The Ratings Agencies

There are a couple of things this weekend that dovetail nicely my post from some time ago regarding Moody's fine handiwork. The major point there was that I tracked the public equity performance of Moody's March 10th "Bottom Rung" list, and if you had followed their advice and shorted the equities listed, you would have been better off sniffing asbestos dust out of a plastic bag, financially speaking. Not unlike buying newly-issued triple-A rated tranches insured by triple-A rated bond insurers circa 2006.

So, the things that caught my eye this weekend:

(1) Calculated Risk has a thing from McClatchy about how Moody's- at one time considered #1- "sold" ratings. I personally think they are getting off too easy: where are the indictments for negligence, misrepresentation, breach of duty and the like?? Mind you, the reason for Buffet's (now declining) investment in MCO was its officially bestowed moat: it was an oligopolist in the "nationally recognized statistical ratings organization" racket that zombified pension managers' brains so they swallowed hook, line and sinker anything "rated above...".

(2) The second, and far more interesting piece is from something written exactly 6 years before the now-infamous "Bottom Rung" list by Mr. Howard Marks. In one of his "memos"- dated March 11th, 2003, on page 5, he discusses his love (really) for the ratings agencies. I am quoting somewhat liberally but one should really spend some time reading his stuff.

"I confess: I love the rating agencies! Oaktree would be lost without them. My whole career and many of Oaktree’s activities are based on opportunities created by credit ratings...What are inefficient markets? They’re markets where mistakes are made...My favorite example: literally for decades, Moody’s has defined B-rated bonds by saying they “generally lack characteristics of the desirable investment.” How can they say that based on the risk alone, without any reference to price or promised return? Once they imply “there’s no price at which this bond could be a good buy,” people will shun it, making it cheap. That can create an opportunity for a bargain hunter...And the ratings agencies are wrong a lot. Not in every case, but at the margin where it counts. The agencies are convinced they do a good job because the bonds they rate low default more often than the bonds they rate high. But the majority of speculative grade bonds never default, and every once in a while an investment grade bond does. Both of these phenomena have significant financial consequences..."

Supremely clairvoyant. And while Mr. Marks has been picking up profitably the B- and C-rated and D-rated pieces, guess which hedge fund manager launched himself into the stratosphere by going mirror-image and shorting the A-rated pieces?


Friday, October 16, 2009

Smart Balance, Inc. (Nasdaq: SMBL): A Saturated Valuation

I do not know Mr. Kabourek over at The Crusty Credit Analyst but what we have in common is that we both like boring stocks. He offers good, no-nonsense analysis of individual stocks: nothing about unit growth in China, market shares in India, FDA approvals, Stage 2 trials, and the like events that spell l-i-f-t-o-f-f for a stock.

He recently wrote a positive piece about SMBL (basically, good business, buy and hold) and I do not disagree with the argument as presented: chances are SMBL will continue to grow fast and will get acquired by someone for a nice multiple (i.e. up to high teens, IMO) because of that growth. However, to me, personally, SMBL appears fully valued.

Let's talk about the business itself first.

Everyone has seen their products in the supermarket. About 75% of the sales, for now, are in the spread category, where they compete with the likes of Unilever's I Can't Believe It's Not Butter. The other 25% are in various adjacent categories, such as oils and peanut butter, with more to come. Management has a good vision for where to go next: they are already testing extensively milk and sour cream, and have a few other closely related spaces in mind.

There is one important point about the main spread product, in my view: it is one of the very few substitutes with a patent-protected, legitimate benefit claim. While most patents in the food space are not essential in my view, SMBL's claim should make a difference: they do offer a unique product, and the people in their target market are likely to read/be more educated about the benefits of healthier eating, and how SMBL might fit there. The same can be said about the milk they offer: it is enhanced, again with patent protection.

Another unique thing about SMBL is that it is a true "virtual" company. They do not manufacture, distribute or broker the product: production is done via two contractors, and Acosta does the brokerage. They do not own the patents to their products either: the spreads are licensed from Brandeis and the milk is licensed from a smaller company. SMBL pays a commission based on product volume. This model has some obvious advantages: focus on its "core" competencies, superior scalability, easier to manage and others.

SMBL also has management with substantive executive experience at a number of food majors, and one can tell by both looking at the growth projections and the how they plan to get there. In addition, their marketing has been top-notch, an excellent combination of store facings, information and brand-building.

So these factors (quality management, virtual company, patents and growth) have turned SMBL into a true "story" stock, but unlike the "story" stocks we see IPOed today, SMBL is cash-flow positive.

Now on to the valuation part with some history.

SMBL burst on stage in 2007 when a SPAC (just like with APP) called Boulder Specialty Brands acquired GFA, which was the original Smart Balance. The acquisition introduced several tricky points in the valuation: first, the company took on substantial indebtedness to complete the acquisition. Then there were also the warrants, preferred stock, performance shares, founders' warrants, etc. that made the capital structure a bit more difficult to analyze. The dust has settled now, after conversions and private placements, and SMBL has only one class of stock outstanding, 1 mil founders' warrants (counted in the diluted count) and stock option awards. On the debt side, they have about $65 mm in two term loans.

SMBL has been growing phenomenally well for a company that operates mostly in the dull margarine space. Of course, you will never see the word "margarine" on their site. The company recently turned even earnings-positive, and it has been cash-flow positive for a while now: last 4 Qs and 6 of 9 Qs as a public co. have had positive CFO. Management has a long term goal of reaching $1 bn in sales (vs. $243 mm LTM), and expects to hit $500 mm in 2012. This implies growth rates of about 20-25% topline.

As revenues are increasing, we are seeing two positive tail winds. One, the company is lapping now serious commodity inflation, which should be good for the margins, and, two, there is the scale effect, which, again, should be good for the margins. We are already seeing that: looking at LTM EBIT and EBITDA vs. LTM a year ago, both metrics have reversed from negative to positive, and a part of that are lower SG&A costs. SMBL should also continue to benefit from the eat-at-home trend due to, you guessed it, "the economy."

I project for NTM and NTM a year from now 25% and 20% topline growth, and EBITDA margin improvement to 7.5% and 8% (lower-end for packaged food). LTM margin was 6.4%, and LTM year-ago was (2.0%). This works out to an estimated $26 mm in 2010 EBITDA. I apply a pretty wide range of multiples, from 10x to 15x, and get an implied discount from current of 10% to 45%. In other words, at the current $5.83 price, SMBL appears to be fairly valued.

A discussion of the proper value of the company would be remiss if we do not look at the outstanding options. The stock has been in a range of $6 to $8 this past year, and I think the number of options outstanding has something to do with it.

See, good management does not come free. SMBL's management is particularly dear: SMBL has to pay near par to the big guys, and if cash is tight, this means options. Lots of options. If you add in the SPAC "hertiage" to the mix, you get the picture.

Since companies are required now to expense options, we have good data on how much those cost based on the standard formula they use to calculate the value of the grants. For the LTM, the company has recorded $15.7 mm in options costs vs. EBITDA of $15 mm. This is substantial, to say the least. In aggregate, there are 12.2 mm options issued and outstanding (on 62.8 mm diluted shares, by diluted they mean that 1 mm warrants are counted; the regular options are not in the money for the most part). The weighted-average exercise price on those 12.2 mm is $9.43. For the current year, the shareholders voted an increase in the options available under the equity comp program, and this year, chances are that the exercise price will be lower. In other words, a move up in the stock price means potentially substantial dilution for the existing shareholders as the options move into the money. This might be keeping lid on the price, at least for now.

There are many positive sides to substantial management ownership: they have the same incentives as the other shareholders. Also, in SMBL's case, the management options vest immediately in a change-of-control situation. This clearly indicates that when someone knocks on the door with the checkbook, management will be dealing and will act in the best interest of themselves, which is aligned with that of the wider shareholder body.

To summarize, SMBL appears to be fairly valued at this point by my quick calculations here.

UPDATE: APRIL 2010 Dear readers, I keep getting hits from searches with search terms such as SMBL valuation, SMBL stock, and so on. Please note that the information presented was current at the time the article was published. There have been several interesting developments with the company since then which might be materially altering the potential value of the stock (i.e. the Best Life line and the national rollout of the milk). Please conduct your own research based on the updated information. While SMBL appeared overvalued to me at the time, the stock has run-up nicely since then along with the rest of the market, indicating that I was probably wrong.  

Monday, October 12, 2009

American Apparel Inc. (Amex: APP): The Unsinkable

APP wins "The Unsinkable Stock" prize of the month.

I wrote about the trendy apparel maker and retailer back in June, when in turned out that a substantial part of their employees were illegal aliens. But it was difficult to ascertain the actual proportion it represented as the company's disclosures are a bit inconsistent.

I did not write about their walking-liability CEO but the Daily Mail steps up to the plate today and minces no words: "The Sleazy Sexual Predator Behind...American Apparel"
"Former sales manager Mary Nelson spoke of a 'reign of sexual terror' and claimed she once attended a meeting where Charney wore nothing but a sock to maintain his modesty - something Charney tried to justify by claiming he was modelling a 'potential product'. "
"According to legal papers filed at Los Angeles Superior Court: ' American Apparel employs many women who have had sex with Mr Charney. These women are commonly referred to as "Dov's girls", "lovers of Dov" or "FOD" (meaning "friends of Dov"). Dov's girls received bonuses from American Apparel, even when their performance created monetary losses.'"
"According to another complainant, Roberto Hernandez, who used to work in IT at American Apparel, Charney conducted meetings in the nude, held business meetings at his LA mansion surrounded by pornographic videos and stored pornographic images on his computer."

There is a lot more in the article.

But that is not why I call them "unsinkable." Last week, their second lien lender, Lion Capital, agreed to a temporary covenant waiver regarding APP's leverage ratios. Normally, this would have been considered bad news, considering that Lion can accelerate the repayment in the event of a default. But APP was down 5%ish on the day, and has drifted and stabilized at 10%ish off.

One would have thought that, with an aggregate view of the companies troubles, it would now be trading at some low option value but Mr. Market thinks otherwise, at least for now.

I would be very curious to see how things play out in mid-November when the waiver expires. Lion's loan terms are sharking at its best: $80 mm at 15%, with $5 mm upfront fee. Lion also got $2 strike warrants for 16 mm shares, or about 18% of the company if converted, and board representation.

Of course, they were not afraid to invest in early March and got their pound of flesh. Audaces fortuna juvat.

More Random Thoughts

These pieces could have really been three separate posts but I chose to have one bigger, disconnected, less-readable chunk: looking at informational asymmetries (again), taxation and financial news/analysis sourcing via blogs.

Informational Asymmetries

These are almost omnipresent in any transaction: stock sales, used cars, dating, you name it. I wrote about them a couple of times earlier this year, one, looking at GE's attempt to unload a portion of their CRE portfolio by targeting 1031 money, and, second, looking at insider sales to insider buys as early as May of this year (the ratio sells/buys is still very unfavorable for stock buyers, if viewed as an indicator). My view is that you should be paranoid about them: like the old saying that if you've played on the poker table for a while, and you still can't figure out who is the tuna...

So, on to today's news from PE-land: Blackstone (NYSE: BX) is up a cool 7.50% today as Schwartzman announced that the company is in the process of selling 5 holdings and IPOing another 8. "Trader Mark" has a nice summary of the news from the FT and the WSJ.

What does this imply for Schwartzman's/BX's views on where the markets are headed? While PE shops are natural sellers because they have to return the money to the LPs eventually, this also makes them expert sellers.

Kenny Rogers sings "if you're gonna play the game, boy, you gotta learn to play it right. You gotta know when to hold 'em, know when to fold 'em, know then to walk away, know when to run."

Swartzman clearly knows how to "play it right." BX itself was IPOed at the top of the market in '07, and went on to tank 90% within 1.5 years or so. We're not talking canned tuna here, we're talking tuna tartare.

So, without knowing what the companies in question are, I would be careful. Buying an asset after the locusts have had their way with it may mean very, very slim pickings. Or, as Dasan says, "I'd stick with quality."

Update 1 10/14/2009: PE HUB has a good overview of recent PE IPO exits, titled "RailAmerica Crashes on First Day of Trading." In part, "A number of private-equity backed IPOs this year have raised less money than expected and fallen in their debuts in what could be a warning for big-name IPOs waiting on deck not to overprice their deals even as they seek to take advantage of the market rally to unload portfolio companies." AlphaNinja has a good analysis on why RA was not hot: "Because you can't even BACK INTO numbers that justify the share price. This company looks like they could earn 16million, or 39cents per share, if they were lucky. How about we pretend we're in fantasyland and DOUBLE that earnings number, getting to 77cents. A PE of 15 on that fantasyland number gets to 11.50 per share, or 16% below where the stock closed. And remember that's in fantasyland. Last time they did 80cents a share in earnings, interest expense was $20million versus the current $70million, and they had a GAIN from taxes. Over $700million in debt, versus the current stock market value of $590million. Their interest coverage ratio is at about 1.8. And keep in mind that Fortress wouldn't be peddling this IPO without pulling every last cent they can out of the company's cost structure -->> meaning operational improvements aren't going to materialize. All they can hope for is carloads returning to higher levels, but even then I can't back into this stock price." Just like I wrote above, "buying an asset after the locusts..."

Update 2 10/15/2009: Now the FT is reporting that Permira has promised to "return a wall of cash" to their shareholders. Are they thinking of a cash wall Weimar-style? Otherwise, guess where that cash would be coming from... And pay no attention to the 140 P/E behind the curtain.


There has been some noise about the introduction of a VAT tax in the US. I would be all for it, if it replaces income and payroll taxes. Unfortunately, it will not, it will be just another tax on top of all other taxes that we have. So that got me thinking about the number of "instances" of taxation in the modern world. The list is by no means exclusive, of course:

Direct/visible instances:
(1) Income taxes: federal, state, local
(2) Other payroll: FICA, Medicare
(3) Sales tax
(4) Real estate taxes (direct or via renting)
(5) Taxes collected via utilities (electrical, phone, cell phone, water, etc.)
(6) Taxation on investment activities: capital gains, dividends, interest income

(1) Corporate income (federal, state, local) built into any purchased product or service, at every step of the way, "from farm to store"
(2) Excise taxes (federal, state, local) for certain products (gasoline, diesel, alcohol, cigarettes)
(3) Transportation-related: (this is in addition to state taxes, somehow they need more money): tolls, registration, insurance surcharges for the state on top of the premium, driver's license fees, higher parking sales tax, street parking permits
(4) Recreation-related: additional fees and sales tax on car rentals, hotels, airplane travel, state parks, "facility fees" even for public arenas, and the like
(5) Permits and licensing: anything from burn permits to "cosmetologist" licenses
(6) Import duties
(7) More subtle compliance taxation: lawn mowing, building height restrictions and other similar regulations
(8) Educational taxation: tuition (outpacing inflation) charged by tax-exempt institutions operating on public property, receiving huge support from the federal and state governments

And, yet, somehow nearly all states are out of money, and the federal government is likely to hit a 40% deficit this year.

"You cannot legislate the poor into prosperity by legislating the wealthy out of prosperity . . . . What one person receives without working for, another person must work for without receiving . .. . . The government cannot give to anybody anything that the government does not first take from somebody else . . . .. When half of the people get the idea that they do not have to work because the other half is going to take care of them, and when the other half gets the idea that it does no good to work because somebody else is going to get what they work for, that my dear friend, is the beginning of the end of any nation . . . .You cannot multiply wealth by dividing it." * Adrian Rogers, 1931*

Blogs/Newsfeeds Thoughts

One of the nicest web 2.0 advancements for me has been newsfeeds and blogfeeds: I subscribe to a good number of them via Google Reader: the aggregation in one place makes it very easy to keep up with numerous sources without having to go out and visit those individually (unless their newsfeed is not "full-article", one of the annoying approaches to get traffic. Just put ads in your feeds as well, people.

Here are my top business reads, ranked by Reader by # of read articles. I am skipping over the news feeds (like Reuters, CNBC, Y! Finance, PE Hub, Robert Amsterdam and others):

(1) Clusterstock: this is Henry Blodget's production. Yes, that Henry Blodget. They are a news-focused site, with little to no analytical content. Every once in a while there is something more thought-provoking or "breaking news."
(2) Seeking Alpha: an aggregator site with low-to-no quality control. A number of contributors regurgitate news/basic analysis. Per Reader, I have read only 10% of the articles there. In fact, it is less because SA does not have a full article feed, which, as I mentioned above, is rather annoying. On occasion, SA does have great things and I have found and subscribed to a good number of authors via SA.
(3) Zero Hedge: ZH has a large number of quality contributors and is rather well plugged-in. Whether or not every bombastic conspiracy theory presented there resonates with you, it is well-worth the reads.
(4) The Pragmatic Capitalist: quality insights
(5) Dealbreaker: the Wall Street gossip site; they are often the first ones to break substantial news
(6) Market ticker/Denninger: great analysis, often
(7) Slope of Hope/Knight: technical analysis/patterns focused; he seems to have a great following.
(8) The Big Picture/Ritholz: some hits, some misses there
(9) AlphaNinja: good fundamental analysis
(10) Fund My Mutual Fund: investing is pure technicals but he also has some pretty insightful fundamental analyses there
(11) Calculated Risk: this is a well-known, heavy-weight RE blog
(12) Davian Letter/Dasan: I read mostly the Dasan daily blog, which focuses on tech and gaming. Rare find to see an independent thinking, experienced buy-side guy sharing his thoughts, no-holds-barred. There is a more in-depth newsletter which, unfortunately, is bundled with the other paid subscriptions they've got, and is not available as a stand-alone.
(13) Felix Salmon: a financial journalist/blogger. He has some fairly unique themes, like the business of arts, third-world sovereign debt defaults and others.
(14) Credit Writedowns/Harrison: great both for analysis and good international links collections via
(15) The Reformed Broker: again good analysis
(16) The Daily Reckoning: independent views on the markets
(17) Trader Feed: probably the best site on trading psychology; a real treasure-trove
(18) Mish: excellent analysis, not afraid of throwing punches around; probably the best-supported deflationary viewpoint
(19) Simolean Sense: he finds great information around the web, not only on finance; if you view yourself as a polymath even to a small extent, he's for you
(20) Naked Capitalism: has been a bit irregular recently with the author working on her book (is everyone writing a book nowadays?); otherwise thoughtful analysis; her excellent pensions contributor moved over to ZH
(21) Coyote Blog: great writings on various topics from a former Princeton/HBS/McKinsey guy, now a business owner
(22) Skeptical CPA: digs around for good quotes with some commentary; not PC at all
(23) Across the Curve: frequent updates from a "true" fixed income guy
(24) The ETF Corner: technical analysis of ETFs; have not followed him long enough to have an opinion
(25) Rolfe Winkler: seems less insightful than before, now that he's with Reuters

Reader ranks them based on number read so there are a quite a few quality blogs that post less often so the brute read article count is substantially lower, even though the % read is much higher than some of these.

Thursday, October 8, 2009

Why Dollar Down, S&P Up Makes Little Sense

One of the more interesting correlations we have seen in the markets over the last few months, is the dollar down, markets up relationship.

The theory seems to go that there is asset reflation across all asset classes, so stocks, an asset class, should go up as they represent "real" businesses so these "real" businesses are now worth more nominally.

Let's analyze this a little bit.

Stock ownership represents a claim on future earnings. If those earnings look better now than they did some time ago, then the stock should be up, ceteris paribus.

But are those earnings going to be better, if the dollar weakens more?

The short answer, in many cases, is NO.

There are very, very few non-commodity US businesses that are truly global. The commodity businesses are largely global because both the markets and many of the operations translate directly across geographies: an oil rig looks the same in Mexico as it does in Equatorial Guinea, and mine in South Africa looks a lot like a mine in Australia. So, for example, miner A mines copper in Chile and sells it in China. The real price has not changed but the dollar is now down 50%. Miner A is traded on the NYSE, reports in dollars, so its EPS in dollars goes up and its share price in dollars goes up. These are the exceptional cases.

On the other hand, most S&P 500 companies are still largely US centric. There is a reason for this: for many, many years the US market and the US economy have been the largest in the world, so businesses have not had to expand internationally to grow. The market is large enough to provide excellent scale. Compare this to a business that originates in a small country: it has no choice but to be international from a very early stage. Look at IKEA or Nestle or Nokia or, dare I say it, the Icelandic banks: all major international players not by choice but by necessity.

A second reason is that, culturally, "average" Americans are rarely exposed to foreign customs, and often find cultural adaptation difficult. The US even has a commercial law banning US companies from giving bribes, even in locations where this is considered just a cost of doing business. This puts US companies at a great competitive disadvantage internationally, as, guess what, bribes are required at most places. I am not judging it as right or wrong: I am simply making an observation.
Finally, most Americans do not study any foreign languages which makes conducting international business even more difficult- lacking both the awareness for the cultural subtleties and the language skills is not a recipe for success.

So, in the end, we have a lot of US businesses claiming that they are "international" when only 10-20% of the revenues come from abroad, and most of it is from Canada and the UK.

In addition, there are plenty of service businesses that are very US-specific and as a result, do not scale easily internationally: tax prep services, for-profit schools, payroll processing services, car insurance, some medical services, student loans, you name it: all structurally US-only or near US-only.

So, to recap, for a number of reasons, most US-based companies are not what I call "truly international."

So what does this mean in relation to the reverse relationship dollar/market?

Let's look at an example to better illustrate the point.

Apparel retailer A operates 1,000 apparel stores across the nation, and imports 98% of its products from Asia. The goods get shipped to Long Beach, CA, and then trucked to the three distribution centers that the company has in California, Texas and Pennsylvania for distribution to the 1,000 stores via common carriers.

The company pays for its products in dollars based on a certain exchange rate band, and then pays for shipping three times over thousands of miles for the products to reach the end consumer. What would happen if we have currency devaluation and the dollar drops 50%? Now both the imported garments and the distribution costs are much, much higher because the garments are priced in the foreign currency in effect, while oil is global commodity. The company has a choice: either raise prices drastically to reflect the new realities (and take a hit on volume) or not raise prices, and take a huge hit on margins.

In effect, the company will be playing Russian roulette with a fully loaded gun: it would get hit either way. Does it make sense for most of the non-food retail stocks to go up when the dollar drops? No, in my view.

Similar picture with food retail and restaurants. Their main inputs are agricultural commodities. Agricultural commodities are traded globally, and, in addition to factors like crop yields, a part of their cost is fertilizers and oil, again traded globally. Since those costs will inevitably go up because of the weaker dollar, this means that all agricultural commodities will be going up as well, with some variance based on how good the harvest was. Then, on top, you've got distribution and packaging costs, again commodity based. So the end businesses again have a bad choice to make, raise prices or take a hit on the margins. Why their stocks would be higher because of a weaker dollar is beyond me.

Refineries: same thing. They sell their products in dollars on the local market, but if their costs are determined globally (which they are), what is going to happen to their margins? We found out when gasoline hit over $4 at retail: demand was more flexible than previously assumed. What would happen if oil is at $300, and gasoline has to be at $10/gal for the refiners to break even? I would not want to hold refiners' shares at that time, I can tell you right now.

Distributors: same thing. A smaller food distributor, Nash Finch, had NI of $36mm on $4.7 bn in revenues. This is under 1% NI margin. How much do diesel costs have to go up to push them under 0%? UNFI is under 2% margin, and the single largest distributor, SYY, is under 3%. UPS is, what, 5%?

Since a highly devalued currency would not be popular, of course, the government will have to step in and support it. One of the ways is to increase interest rates. But regular banks have been enjoying some pretty fat interest rate margins recently as they have been able to borrow at practically 0%, and lend at whatever they can charge. A cheaper dollar may well lead to the curve flattening, which will crush banking margins, thus banking earnings. Should bank shares go up when the dollar goes down? Probably not.

Finally, and more broadly, since most "necessities" are globally priced (food, energy), if the average consumer budget has to dedicate more money to those, this allocation will come out of somewhere: entertainment, clothing, or other discretionary. So the money will be going to the global commodity producers (at the end) and not to most others. So why should the S&P be up again? Higher energy/commodity costs act as a tax on everything else.

Dollar down/shares up should hold true only for those businesses who bring in substantial earnings from abroad. Even if the earnings are flat in real terms, they will grow in dollar terms post repatriation, making the equity more attractive in dollar terms. But why have we been observing this relationship across the board for any equity? Beats me.

Update 1 10/08/2009: One, go read this article. Probably the article of the day: weak dollar is not a good thing overall. US GDP per capita in euros is down 25% since 2000. And other fun facts.
I also got some nice feedback from a friend. He makes the a number of valid points, which I think illustrate that investing (especially trying to guess the effects of macro factors) is rarely a black-and-white game. He brings up a few points that I had not considered and are valid as considerations for a dollar vs. S&P scenario.
(1) Competitive devaluations: no one will let the dollar drop too much relative to their own currencies
(2) Tech and natty res (natural exporters) are a substantial chunk of the S&P, and they are first in line to benefit from a cheaper dollar
(3) A cheaper dollar will turn many other companies into exporters, thus increasing their real business
(4) Nominal incomes will be adjusting- possible with lower unemployment, imo- and this will continue to help low-end products and operators
(5) Very interesting distinction: how quickly a currency devaluation happens will affect a lot of outcomes. A gradual sinking will be substantially less stressful than an abrupt one. I agree but I think the latter might be more likely

Update 2 10/21/2009: Here is something good via Einhorn/Winkler/Clusterstock: P/E ratios get crushed during inflation. So, sure, you're getting 25% EPS growth but no one is paying a high multiple for it.

Monday, October 5, 2009

Views on Jobs, and Why "They Ain't Coming Back"

New Jersey's own Bruce Springsteen recorded a hit single in 1985 called "My Hometown." There is a somber verse in it: "Foreman says these jobs are going boys and they ain't coming back to your hometown."

"Jobs" has become a key issue over the last 12 months as it is becoming clearer that they really are not coming back: I think that there simply aren't any new ones, and there won't be for a while.

Most of the discussions have been limited to "wow, look at the numbers" and "look at the graph." I intend to take a deeper, more fundamental look.

Let's discuss some basics before we look at "jobs":

Risking to parrot some macro textbook, in my view, there are three kinds of unemployment. One is frictional: people between jobs, may be moving on to something better, may be relocating, who knows. Happens all the time, especially when the economy is healthy.

The second is cyclical. Cyclical industries create cyclical jobs: a worker can be doing tons of overtime shifts one year, and be laid off for months the next year. Historically, we have had the safety net to tide people over when something like this happens. I see it as an exaggerated case of seasonal unemployment: people are generally aware of it, and plan accordingly. There are no Mister Softee trucks in the wintertime, and yet, every summer, the same guy has his spot near the park. Obviously, he has found a way to cope.

Third, and the scariest kind, we have is structural unemployment: this is when there is a severe mismatch between the opportunities available and the skills of the labor force. Industries come and go: the specialized skills from one are not necessarily transferable to a new one. Sometimes, there even isn't a new one: look at the declines in shoes and textiles for example, or farmers as a % of the labor force over 100 years.

The biggest employment problem in the US, in my view, is structural unemployment, and I will get to weave it in in the broader discussion.

Since we are looking at "jobs," I divide them into two basic categories: private and public sector. A private sector job, in my view, is a better job as it would not likely exist if the employee was not offering a positive ROIC. In other words, businesses would not hire anyone, unless they think they can make more than it costs them to hire that person. Simple logic. Thus, that hired person creates value both for himself (paycheck) and for the employer (profit), and both get taxed. The profit motive (often demonized by the commies as "greed") makes sure that the resources are allocated properly.

The government "jobs" on the other hand, are largely driven by bureaucratic growth and internal department empire-building. The vast majority of these jobs are a net drain to society and to the taxpayers because for the most part they cost more than they bring in income taxes. That is not to say that we do not need policemen or teachers: but by and large, the growth of government employment should be viewed as a net negative. In addition, because of union involvement and other factors, governments at all levels do not manage performance at all, resulting in bloated, inefficient operations. Look at NYC park personnel (why do they move slower than molasses?), look at the DMV, look at state troopers pushing to have a state trooper with the lights in a cruiser at every highway construction site, the prison guard union demanding "tough" sentencing guidelines, and so on. Government employment is supported by the taxation of private employment, and growing government employment means more taxation for the positive ROIC activity that is private employment. As simple as that. And remember that since these groups provide an identifiable voting block, no politician (the people who later vote on local, state and federal budgets) in his right mind is going to say "I think policemen make too much" or "public sector benefits are completely out of line."

Sure, we can reduce unemployment by creating a brand new federal department of paperclip counting, and dispatch a million workers to count and recount the paperclips in every federal building. Boom. Done. We have "created" jobs and "reduced" unemployment. This is what some of our elected reps and unelected experts seem to think. It is obviously absurd, let alone that since the budget has a 40% hole in it, those same elected reps should be looking at how to cut federal employment. Those are pretty expensive jobs to create, while helping private sector employment is actually beneficial.

So back to the more recent news.

The employment situation in the US is bad. Really, really bad. Everywhere one looks, the statistics are frightening. The mass firings have subsided a bit, but there is no hiring (more on that in a second). All UE measurements are through the roof (or through the floor for some). See the slides.

This, in and of itself, is not that scary: yes, there are challenges and it is hard on people BUT the bigger problem is, what is the government doing to address the problem. I wish I could say "nothing." No. It is worse.

My opinion: we have one of the most anti-job creation governments one can think of.

I will list the ways, but at first, I have to walk you through a simple decision model in private hiring. Unlike most talking heads, in another life I have personally hired and managed more people than I can remember so I think I have a better view than "the people who only sign checks on the back," like "The Governator" used to say when he was trying to show off his "real" business experience.

Hiring people is in essence a difficult break-even analysis. One has to make more than the cost in order to "create" a job. More, precisely, the business has to expect that they will make more than the cost of hiring/employing. I can tell you that hiring is both a risky and a costly enterprise, and is done with great trepidation. You have search costs, interviewing, hiring, training, then ongoing salaries and benefits, sick days, personal days, holidays and so on. On top, you have all sorts of risks, underperformance, carelessness/safety, embezzlement/theft, client alienation, sabotage and others. You also run risks from lawsuits for anything from harassment, to discrimination to worker's comp to alleged underpayments to unlawful firing. You get the picture: even in the best of times, hiring is a risky business and is approached with caution. This is particularly true for small businesses-- remember, they are the big job growth drivers-- because a single employee can do a lot more damage than an employee in a 50,000-person organization.

Most financial opinion "drivers" do not realize this because in their world, hiring is relatively safe: they only deal with pedigreed professional people. Let me break the news to you: this is a very, very small sliver of the labor market. You can see that just people with a four-year degree or more account for less than 25% of the adult population (and this includes the many people who have the sheepskin without having attained any substantial educational benefits). Most higher-level finance professionals are either top MBAs and/or top JDs and/or CFAs, which really raises the level. The average GMAT score for a top MBA program is around the 95th percentile: these people are, roughly, in the top 5% of the top 25% of the population that has the undergrad degrees. Similar with the LSATs. I personally do not overweight test scores in vacuum but I think they are indicative. Anyway, back to the "real" job market.

So, how is our government anti-job?

(1) Federal minimum wage: while most "experts" and politicians like jetting around the coastal cities where no one makes under the minimum wage, there are large parts of the country, with lower cost of living and lower average incomes, where a federally mandated minimum wage completely prices out many entry-level candidates. The min. wage is sold as something that "protects" the little people. It does not. It harms them. Need proof? Look at the teenage unemployment rate: record high of 25.6%. Black teenagers, 50%. Again, remember that hiring is a break-even exercise: if the value of what these teenagers provide is less than the min. wage, there is absolutely no way they will be hired.

What most people do not realize is that the minimum wage affects all other employees at the nearby levels: if a business has two employees, unskilled at the old $5.15 min. wage, and one skilled at $7.50 (a 45% premium, to do the math for you), if the unskilled is now artificially mandated to be at $7.50, what would the skilled do? Walk or demand a raise. The skilled should now be at $10.88 if the same skill differential holds. What if the output of the two employees is valued at less than their combined $18.38 hourly rate? One or both are fired, or the business is gone all together. Alternatively, the business can try to hike up prices, which in this economy would be suicidal in many cases.

Has the government done away with the minimum wage? No. They actually increased it on July 24, 2009. How is this affecting jobs? Well...

(2) Health care "reform" and "cap-and-trade"
Without discussing the specifics of either proposal (I might in separate posts), anyone operating a business has realized by now that these are both stealth tax increases, HC particularly a tax on employment. The HC reform will likely make providing coverage mandatory while it will likely do nothing at controlling costs (including limiting malpractice awards or reducing demand by people who get HC absolutely for free). "CaT" will transfer money from businesses and average citizens to financial institutions and incumbent polluters. The bite of these taxes is not known, and, more importantly, will be known only in retrospect.

Again, remember hiring is a break-even analysis. If a business does not know the cost part of the break-even analysis, how can it do it? It can't.

So businesses are not hiring, and will not be hiring until there is some clarity on the impact of these stealth taxation proposals. The costs will be known only after the initiatives are enacted, which means years.

(3) Underfunded promises and budget deficits
Most people, in my view, do not fully realize the actual monetary cost of employment. Employers do not pay just the agreed-upon rate. Employers also pay "payroll taxes" just like the employee, and pay a lot in benefits (from vacation accruals to health insurance premiums).
Due to our governments' profligate promises and spending over the years, the government is now not only broke, but cannot even find enough people to loan it money, so Zimbabwe Ben is printing the cash to cover the current spending costs. Anyone smart enough to run a business employing people knows that there will be higher taxation in the future, including a very likely hike in "payroll taxes" for both the current spending and the promises that will be coming due because of the population aging. But when and by how much? Who knows. What does this mean?

Very simply, again, no hiring because an employer has no clear view of the longer term employment costs.

(4) Labor unions
Labor unions are bad for new job creation and provide no real job protection. This is a two-pronged statement, so let's look at the second part first. There are no successful unionized industries in the US: autos, steel, airlines, you name it. Why? A union generally is of no help when the business fundamentals of a certain industry deteriorate so much that one or more players in the industry have to liquidate, or go through a substantial restructuring. UAW's membership in the 1970's topped 1.9 mm workers, while now it is under 500k. This is a 75% loss for the mathematically challenged. Of course, non-union auto employment in the South has grown.

Now on to the more important point: labor unions are bad for new job creation. Remember that people are greedy under any circumstances. Labor unions act as a fixed cost during tough times because contracts limit layoffs, and act as a variable cost during good times because they often strike and demand higher wages at the top of the cycle. In other words, they want only upside with no downside.

So if I were making a decision to deploy capital somewhere (for the finance types, this means actually building a factory or a distribution center or other real "things"), I would definitely take a hard look at the dangers of being unionized in the future. This means, in part, looking at local and federal laws, as well as the administration stance.

Does Obama have the big unions on his speed-dial? Yes. Is the "card-check" legislation likely to pass? Probably. What does it mean for job creation? Bad news, again, folks.

(5) Government-created structural unemployment
This works on several levels.
On the macro level, by blowing and trying to reinflate various bubbles, the government (I am including the so-called "independent" Fed) is sending the very wrong signals to the labor force. Recently we observed the expansion and the collapse of the so-called FIRE economy (Finance, Insurance, Real Estate). The bubble had been sending the wrong signals about the employment opportunities in these areas, so we had a lot of people going into the FIRE, thinking it is for real: builders/trades, agents, mortgage brokers, assessors, and so on. The bubble popped, and what do we have?
Huge malinvestment in housing, and a huge malinvestment in human capital.
This means that the bubble created structural unemployment as the skills required for the bubble are no longer, and will not be, in demand. The adjustment process is pretty painful.

On another level, I think we have the next subset of structural unemployment already baked in. Every communication coming out of the brilliant, well-fed statisticians at the BLS is encouraging people (and educational institutions) to get care. How come? Well, I am not sure how the BLS projections work, but it seems to me that they are using some straight-line extrapolations based on the demographic changes, so they are projecting huge future demand for the likes of home healthcare aides, nursing assistants, medical assistants and the like semi-skilled medical occupations.

The only problem with it? There is no one to pay for it. The baby boomers have not saved enough to afford it on their own, and the government won't be able to afford it either very soon. As it is, health care is a way bigger part of the economy vs. other OECD countries, and I think the days are coming (call it 5-10 years) when instead of starving real estate agents and mortgage brokers, you will have unemployed nurses and the like. I think Jim Chanos has publicly come out with a similar thesis regarding health care stocks, so to me, its extension into health care employment is only logical. We might be witnessing the next malinvestment in human capital.

The third way the government creates structural unemployment is via its involvement in higher education.
I think it should be obvious to anyone that the rising cost of higher ed is directly linked to increases in grants and loans via the federal government. But there is another problem: by providing funding on an equal basis to anyone, regardless of both intended majors and personal intellectual potential. This makes it easier for students, especially first-generation, lower-potential students to major in non-challenging majors, making them absolutely unprepared for a normal, productive college-level entry job. The same can be said about loan availability for almost any of the non-top-14 law schools, where people end up in some basement as J.D. doc reviewers.

So we have a government creating, aiding and abetting structural unemployment, even with the best intentions like "educating people" and "supporting the economy."

(6) Restrictions on high-end immigration
Most OECD countries, including our Northern neighbor, have "brain drain" programs in place that aim to attract high potential, educated professionals in their workforces. Most work under some sort of a point system: I am fairly familiar with the Canadian, Australian and UK systems. They basically ensure permanent residence, including the ability to switch employers any time, to high potential educated immigrants.

Here not only we do not have that, we have H-1B, which has absolutely random quota limits set by our bright congressional leaders, and also, restrict labor mobility severely for the employee. In addition, once the two three-year terms are through, the employee has to leave. In other words, the six years count for nothing, they do not lead to permanent residence.

How is this affecting the labor market?
One, they make the high-potential, high-earning people avoid the US because they do not have legal status clarity via the most common work visa program.
Second, and more important, the high potential people cannot start their own businesses (and sponsor themselves for permanent residency), which means that there is a lot of lost potential simply due to stupid immigration policies.

What does this mean, in laymen terms?

The next Google and Microsoft will NOT be located in America, which means that the next generation of high-quality employment opportunities will NOT be here.

On the flip side, we have had a practically open-door policy for low-end immigration. While many of those workers are enterprising, and open their own businesses, the next Google and the next Microsoft will not come from a corner bodega, a landscaping business or a drywall crew. In addition, the flood of illegals hurts the employment of the lower-skill native citizens. On top, the social cost of this kind of immigration is immense (schooling, health care, incarceration).

I, personally, have nothing against illegals: at one time, years ago, I ended up working on an industrial construction site with a mix of Mexican crews and locals. The locals could not bear the hard work, and dropped out within a week, while the Mexicans kept chugging along in the unforgiving heat day after day. So I have personally witnessed the truthfulness of "jobs Americans don't want." It also seems to me that any major city would shut down without its recent arrival population: how we ended up there is OUR problem, not their problem.

What is the conclusion? We are chasing away the high-end human capital, and we are inviting the low-end human capital.

The immigration policies of the US have hurt, are hurting and will continue to hurt employment levels in the US by chasing away high-potential migrants and by inviting low-skilled labor.

(7) Inflation or deflation?

If there is high inflation (which will be first displayed in high commodity costs- might already be happening), then hiring will be muted because of the cost uncertainty. Inflation is very destructive to businesses as costs and customers behave unpredictably, and common forms of financing disappear. Inflation hurts hiring.

Deflation can mean declining sales, while many costs (i.e. interest) remain fixed. This crushes margins, and forces employers to reduce variable costs as much as possible. This means layoffs, not hiring.

So to summarize (1) through (7), THE JOBS AIN'T COMING BACK.

The only thing that can help us is some productivity advancement, like the internet or mobile communications. What could it be? I do not know: decentralized power generation, new models of personal transportation, nanotechnology, genetically-driven medical care, etc. Instead, what "jobs" is the government "protecting": the bubble-era jobs and the dinosaurs.

As an addendum, here are a few relevant slides as to "how bad it really is" and how the mass media - guv PR complex (the "professionals") treat the populace like mushrooms (that is, kept in the dark and fed manure).

Note the following: the stimulus is a fail, hours worked (=output) is tanking, unemployment duration is stretching, ratio seekers to jobs is extraordinarily high, etc., etc., etc.) Look at each one carefully, because they will give you a fuller picture of what is happening. Because if you have to create a web site called "" means you have a big, big problem.

Update 1 10/07/2009: The NYT has a good write-up of an idea that has sprung up recently: payroll tax cuts for businesses that are hiring. All of the counter-arguments are valid. A tax cut will not help hiring much because hiring is a break-even analysis. The cut would be temporary. Funny how the UE rate has the White House talking about tax cuts of all things.
Having a payroll tax cut is like using bandaids to cure cancer. The government needs to address the fundamental problems that I list above in order to reduce the long-term economic/business uncertainties.
I have some other thoughts on a possible tax-cut for hiring companies:
(1) Larger employers are better equipped to capitalize on every freebie that comes down from the taxpayer. Since they have the big payroll processing systems in place, they will be able to capture most of the cut.
(2) Employers with high employee turnover will likely benefit more as they hire anyway. Think McDonalds or Walmart: even now, I am sure they hire quite often as the nature of their workforce can be transitory.
(3) The tax cut is quite blindly targeted at "jobs." This inherently favors low-skill, labor-intensive operations (retail, restaurants) and disfavors highly automated or sophisticated scalable businesses, as they can grow without adding labor.

Update 2 10/9/09: The Peridot Capitalist agrees with the idea that tax breaks for hiring won't really work. He says that a break won't make an employer hire unless the "real" need to hire is there.

Update 3 10/18/2009: Now "Obama is looking at all options for creating jobs..." Of course, see the graph on top: the stimulus failed, so they want to do another one. It is very clear to me that "job creation" is beyond the comprehension of Obama and his economic team. Jobs are a derivative of a healthy economy. The economy is a self-correcting organism that needs good conditions to grow: stability/predictability, rule of law, access to capital, property rights, low taxes, low regulations and so on. One of its outputs is jobs. The Obama team is doing everything possible, unknowingly- I hope-, to destroy the conditions that help the economy grow! And then they wonder why there are no jobs. You can't have sustainable job growth by shooting the moribund corpse with ever-larger amphetamine doses!

Update 4 10/23/2009: Here is a good interview with Steve Wynn in part about jobs. Unlike most CEOs who are completely PC (if you're not PC in most of the corporate world, you get kicked out pretty quick), Wynn recently said he feels better about doing business in China. This is a very important statement. Now in this interview, he discusses jobs: "The growing deficit and broken tax policies are killing job creation and causing long term damage to the middle class of the US, Steve Wynn, chairman and CEO of Wynn Resorts, told CNBC Friday.

“If we continue to allow the economy of America to suffer from deficits, then every single working person in America will be damaged,” said Wynn.

Current government policies do not focus on job creation and only increase the national debt, sending a message to the American public that the future is bleak, said Wynn.

Update 5 11/13/2009: Here are a couple of great pieces. One, Emerson Electric CEO: "Washington Is Destroying US Manufacturing", a sad, but good read. The second is from Peter Schiff: he echoes a lot of what I said, with good additions that I wish I had come up with.

Special thanks to The Pragmatic Capitalist, Ritholtz, Clusterstock, Seekingalpha, Market ticker, and American Thinker for the graphs.

Friday, October 2, 2009

Green Mountain Coffee Roasters (Nasdaq: GMCR): A Dangerous Short

<<<< Spiderwebs without and with caffeine, from Wikipedia. GMCR continues to be one of the most shorted stocks in the market but I think it is a dangerous game to play. I have never worked in the coffee business but I have a thesis. I can't say "go long"- at least not right now- but I think there are some dangers to shorting them. Here's why: At first, let's discuss why GMCR is so heavily shorted (something like 32% of the float as of 9/10!). One, according to some views, it is overpricing the future earnings growth of the company. Second, the stock has returned 165% for the last 52 weeks, and 1,310% for the last five years which is nothing short of phenomenal for a "consumer staple" stock. And, yet, it keeps going up, aided by short squeezes here and there. Third, there are the more qualitative views on competitive entries from allegedly better competitors (Kraft, Sara Lee). I am sure there are more reasons (i.e. algorithmic trading shorting runner-ups and the like) but I am a complete dilettante in those areas. Now, let's take a look at the coffee business overall. (1) Caffeine is an addictive substance. It is often mixed with sugar, high fructose corn syrup and various flavors to induce additional intake by the consumers. The FDA just banned flavored/"sweetened" cigarettes (but menthol is somehow ok, NAACP, where is the outrage?) but, fortunately for the caffeine purveyors, caffeine is still widely available in a wide range of flavors from energy drinks, colas, teas to coffee. There are certain benefits to dealing in addictive substances, as Altria (NYSE: MO), Philip Morris International (NYSE: PM), Reynolds American (NYSE: RAI), Lorillard (NYSE: LO) and others can tell you. The three big ones are (1) repeat business, (2) relatively inelastic demand and (3) juicy margins. As a matter of fact, the CPG company with the highest margins until recently was UST (US Tobacco), makers of various brands of moist snuff (aka dip), such as Copenhagen. They were at something like 70% gross and 50% EBITDA! Compare these margins to, say, Microsoft's, a near monopolist. And UST, unlike MSFT, was all about one thing: returning cash to shareholders via dividends and buybacks. I just wish MSFT would stop throwing good money after bad with their failures, and separate the Windows and MS Office business in a nice, slow-growth, stale toll-collecting company that pays big dividends and does not waste money on bricks like Zune or antiperspirants for Steve Ballmer. But I digress. Unfortunately, for us, the cold-blooded profiteers, UST was swallowed up by Altria as a part of their "total tobacco" platform.

While caffeine is not as addictive as nicotine, there are similarities, especially when mixed with sugar and established in a ritual ("having my morning coffee", anyone?) just like smokers are looking forward to taking a "smoke break" as a part of their ingrained daily behaviors. There are similar mechanisms of addiction related to food but this is a whole different topic: it is not only the biological/neuro-chemical response is my point.

(2) So let's expand on the "juicy margins" point from above.

Coffee is a commodity. It costs about $1.30 per pound these days. "Better varieties", whatever that is, cost a bit more.

Roasted coffee, Green Mountain brand, was $6.50 for 12 oz in the local supermarket yesterday. This is $8.67 per pound (vs. $1.30ish for the green commodity)

GMCR are the main maker of the Keurig single-cup "k-cups" but I was not able to find online the weight of the portion packs used in the machine. Why do you think they hide it? I called customer service to find out the product weight, and they quoted me a weight in grams (8.5-9.5 grams for most varieties). Call it 9 grams, which is ~.32 oz. A k-cup retails for about 50 cents a piece. There are about 50 9-gram k-cups per pound, or in other words, a pound of coffee is now selling at $25 per pound. Yes, there is more packaging and all that but still.

So let's review the numbers: $1.30/lbs commodity to $8.67/lbs roasted on the shelf to $25/lbs in the form of a k-cup. This is called "value added." Putting more colloquially, someone is getting really fat here, and it sure isn't the farmers and it sure isn't the coffee drinkers, either. No wonder when you order online, you never see the net weight, just cup count per box!

(3) Let's also expand on the "repeat business" and "inelastic demand" from above.

One of the simplest business models out there to ensure repeat purchases is the so-called "installed base" model. The most famous historical case is Gillette: the story is, if I remember correctly, that he gave away the safety razor but he sold the replacement disposable (!) blades. The model still works well for them, 100 years later. You can see the "installed base" concept everywhere: printers/ink cartridges, iPods/iTunes, soap/cleaning dispensers ("free" from the likes of 3M and EcoLab), custom toilet paper and napkin dispensers ("free" from Kimberly Clark), fast food ketchup pumps (fitting only the Heinz bag, of course), Coke/Pepsi dispensers, free, that hook up only to Coke/Pepsi concentrates, satellite dishes that work only with one network, hardware that works only with an ongoing software "subscription", and so on, and so on. I remember even Reebok tried selling shoes with inflatable insoles, with CO2 cartridges sold by...Reebok, of course.

Great business models but not so great models from a user perspective, as it makes it very easy to raise pricing due to the high switching costs created by these modern-day Trojan horses. It is one of the main reasons I am the last person without an iPod (or any other similar device): I view them as the leaches and the ticks in the world of personal finance.
Some, like the whole Apple suite, can even be upgraded to herpes, gifts that really keep on giving, especially to the world's most important liver transplant recipient. But I digress again.

What does it have to do with coffee?

A lot, in my view. Today's GMCR is pretty different from the GMCR of 3-4 years ago. GMCR has become a qualitatively different company: they have largely moved from the $8.67/lb coffee business to the $25/lb coffee business. This fact, of course, has not gone unnoticed by Mr. Market, as you can see by the returns I point out above.

They have had an ongoing relationship with Keurig, a marketer of the Keurig single-serve coffee makers and the k-cups for those, for several years, culminating the outright purchase of Keurig in 2006. Keurig is a major player in the single-serve coffee machines, along with Kraft (Tassimo) and Sara Lee (Senseo). I should also include Mars (Flavia): makers of the most hated coffee in offices nationwide.

They all work on the same principles: marketed as better-tasting "gourmet" coffee with little wait (under 1 min), they all use their own disposable cups or pods, and they are marketed as better value than Starbucks. Somehow, they are able to make consumers spend money on buying a machine that virtually locks them in with a provider. That much for rationality.
Then you have the cup cost of about $0.50 each. On top, this one cup makes 8 oz of coffee. For better or worse, who drinks 8 oz of coffee? Realistically, a 16-oz cup is now closer to $1 in cost.

So, GMCR has been working very diligently at expanding the built-in base of proprietary coffee makers thus ensuring a good stream of near-automatic, not-too-price-sensitive reorders from its caffeine-addicted customers. They have also worked hard at expanding the heavy-usage office machine business, as well as the hotel/hospitality business. While most other businesses are reporting declining sales, GMCR machine sales are actually accelerating! So are their coffee sales! See the spreadsheet. I should also note that GMCR tries to cover its cost on the machines, and is not making money on them.

GMCR now owns the whole chain from the roasting and the machines, to the cup shipments. GMCR does not make all k-cup brands that are available. About 40% of the volume comes from k-cup licensees. The notorious, gravity defying widow-maker Diedrich Coffee (Nasdaq: DDRX) is a major k-cup licensee. The profitability of the k-cup business has not been missed by Mr. Market, of course, and DDRX has been topping the charts this year as the top gainer. I used the adjectives to describe the stock and its effect on the shorts, not the company itself. I have no impressions of them either way.

So GMCR has a nice revenue stream from the licensees, who pay Big Brother by the k-cup. I dug around to find out how much they charge (DDRX actually filed the licensing agreement with the SEC) but all the numbers were blacked out. GMCR mentions somewhere in one of the K's that they raised the fee by $0.01 per cup, so I estimate it at $0.02-$0.04, or 5-10% of the retail price. Don't ask me why, just a gut feel of what a "typical" franchise fee would be as a % of topline sales: there is a fine balance between confiscation and yet, making sure the franchisees have something to eat. Ask McDonald's. This estimated fee per cup will come in handy soon.

Then GMCR has the "legacy" GMCR business, the food service and retail coffee. I remember them from 10 years ago when they were taking over numerous gas station coffee businesses around New England and getting increased shelf-space vs. the mass-market coffees in supermarkets in the region. Obviously, this business is not as profitable as the k-cup business, and it accounts for about 30% of the sales of the company.

So, to summarize for my ADD readers, GMCR sells an addictive substance at jacked-up prices (20x the wholesale) to addicts who also give them money to have the proprietary IV drip on their kitchen countertops. In addition, GMCR collects protection money from the little people that make 40% of the k-cup volume in the form of license fees.

Now on to the fun part.

GMCR publishes both machines shipped and k-cup volume by quarter, which is very helpful.
I went back to 2006, and compiled the data, along with growth rates.

A very, very relevant statistic for me here is the average annual k-cup usage per machine.

Since 2006, GMCR has shipped 3.3 million machines and systemwide 3.3 billion k-cups (landfills be damned!). I am ignoring the pre-2006 machines as those numbers are likely very small in comparison to the recent volume (i.e. Q1 '06: 71k machines, Q1 '09: 711k machines). To estimate the usage, we need a relevant metric. This metric is what I would call "machine-quarters", a measure of how many quarters has each machine been in use. It is very similar to the standard unit of labor, man-hours. So, those Q1 '06 machines have been in service roughly 15 quarters, while the 711k machines have been in service for 3 quarters. I say "roughly" because one should really use the midpoint, but whatever.

So, GMCR's machines have clocked in a grand total of 16,739k machine-quarters.

System-wide k-cup shipments for the same period have come in at 3.3 billion units, so, doing some simple arithmetic, we get that the actual k-cup usage per machine-quarter is 196 cups. Makes sense, using my Garage Logic University skills: a quarter has 90 days x 2 cups per day is 180 cup usage. Sounds like a regular home coffee drinker to me (this is their biggest market; institutional is smaller). No red flags here.

Q4 (Q/E 9/30/09) is not out yet, so I am ballparking some of the figures. In Q4 last year, they sold 315k machines, and YoY growth in the three quarters since then has been 120-190%. This means that in Q4 it would be reasonable to expect about 700k in machines shipped. This would put the total installed base at over 4,000,000 machines as of end of Q4.

GMCR has sold nearly 2 million machines LTM, with growth rates each quarter b/n 76% and 190%, with growth rates accelerating YoY. So, for next FY, I think 3 million new machines would be a conservative estimate (deceleration to about 50% from LTM of 100%+). Since those are sold throughout the year, from a usage perspective we have a net add of 1.5 mm machines for the year, if we take the midpoint.

So, for FY2010, the year that just started, I estimate that GMCR will start with an installed base of 4 mm units, growing to 5,500,000 million mid-year and to 7 million by year-end. Again, this builds in a fairly substantial growth slow-down in units.

So now we have to look at the spreadsheet.

GMCR has 4 streams of income: GMCR produced and marketed cups, licensing fees from the licensees, machine sales and GMCR "legacy" business.

The easiest is the machine business: they say they cover costs, or NI from there is $0.

The next easiest is the legacy business. I estimate $250 mm in sales for next year for that line, with a 4% net income margin. GMCR has ~7-8% NI combined margin on the cups, the licensing and the legacy, so legacy should be lower than the combined.

Third is the licensing business. Since it is shrouded in secrecy, I estimate that they charge $0.03 per cup sold, with the licensees being responsible for 40% of the volume for the year. I estimate the margin on the licensing business to be 95%, not dissimilar to IP holder businesses. This simplifies it a bit, as there are taxes involved (i.e. 35%ish) but they also have some related R&D credits, if I remember correctly.

Fourth, and trickiest, is the main NI source, the GMCR owned cup business. I estimate, based on historicals, that GMCR will have 60% of the volume, and the system-wide volume will be based on 5.5 million installed machines, with 160 cups/machine/quarter. I lowered it vs. the historical calculation of 196 because even 160 cups/quarter implies a 100%+ growth rates of the cups business, which is a bit higher than historical norm. It seems that there is a bit of a lag b/n machine sales growth and cup sales growth, so with the machines really taking off LTM, cup revenues should not be far behind, and should move towards 100% from the 60%+ rates. Very similar to the move from 40% to the 60% that has happened since '07. I also estimate the NI margin of the GMCR own cup business to be 10%, again based on the aggregate margin of 7-8%.

So, in all, my back of the (FedEx) envelope calculation implies that GMCR can hit $120mm in NI for 2010, making them valued at 20-22x. Not something I would call "overvalued".

As a caveat, their interest rate expense will be changing because of the Tully's acquisition this last summer, there might be some sloppy merger-related charges, coffee prices at wholesale and packaging can go out of whack, the divergence b/n the units shipped and cup growth rates might mean more than meets the eye, my work is not warranted, etc., etc. caveats. Too many to list. You should do your own analysis: there must be a reason why they are so shorted.

But in aggregate, I think that shorting GMCR going into Q4 results (announcement date is Nov. 11, 2009) has the potential of burning your fingers, especially if we get a massive squeeze like we did a few months ago.

Here's a one-pager in Scribd, select view full-screen, and then zoom.

UPDATE MARCH 29, 2010:   I feel I should do a quick update here as I still get a lot of hits from people searching for information on GMCR (often "GMCR short" and similar). The article above was current as of late October last year. Several material changes have happened since then that you should be aware of. One, GMCR has reported two more quarters of results, and the shares have advanced accordingly, currently trading at around $95 vs. $65 when this article was written. A second material event is the pending acquisition of Diedrich Coffee (DDRX) which, when combined with the smaller acquisitions over the last two years or so, brings the k-cup production back in house. As the company moves from collecting licensing fees to own production, the economics change as, in my view, GMCR will be growing both sales and profits at a quicker pace than before. You can do your pro-forma on the DDRX acquisition: my estimate is that GMCR probably has another 20-25% upside from here, provided that it keeps the high forward P/E multiple. Entry now at $95 does not offer a compelling risk/reward in my view, and, hence, I have no position.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)