Saturday, February 27, 2010

Analyzing Non-Core Risks

This article was also a featured link on The Reformed Broker. 

My view on risks when analyzing a business is that there are two types of broad risks that investors take: core and non-core. "Core" risks are ones that are inherent to being in a business: input costs, competitive actions, regulations, pricing dynamics, lawsuits, even employee embezzlement, and so on. Then, in many businesses, there are "non-core" risks: these are risks that are above and beyond the regular business operations. The problems with non-core risks is that they are not always obvious and that they are harder to quantify, so it is difficult to know whether you, as the owner, get paid to bear them.

Let's look at some examples of non-core risks that an investor should be cognizant of.

Post-retirement liability risk

The two kinds I am looking at are pensions and healthcare. Like stock options, pension promises are a compensation expense that defers present cash payments for a future promise. The shortsightedness and the incentives of a number of management teams has been a factor in overpromising benefits to lower shorter-term cash costs. Many firms currently realize that taking on these kinds of liabilities is dangerous, and have discontinued their "defined benefit" plans. But the existing liabilities are on the books already, and the zero equity returns and extraordinarily low bond rates over the last 10 years have made meeting the target returns difficult.

-Pensions: The assets of the plan are well known, the liabilities are not. This is the essence of the "non core" risk: large cash outlays may be required in the future, lowering the equity value. Anyone with an iota of knowledge of pension accounting knows that it involves a number of actuarial assumptions including projected asset returns, projected worker tenure, worker compensation rates and worker lifespan. On top, these assumptions can be "massaged" by management for short-term gains.

- Post-retirement health benefits: some plans offer post-retirement health benefits. Normally these are unfunded: the costs are recorded as incurred without prior funding. Knowing what has been going on with health costs, would you buy a business that is paying for the healthcare of someone who finished working there 20 years ago? Ask Motors Liquidation Company, aka "Old GM." And I am not even discussing if employers should be involved in providing healthcare to being with.

Financing arm risk

There are financing businesses (banks, credit card companies, specialty finance co.'s) that are in the business of providing financing. And then there are goods- or service-producing businesses that end up providing financing to their customers. This is a non-core risk in my view. It is not a problem until it is, leading to unexpected losses. Some recent high-profile incidents are GMAC that got into a number of non-core areas, Harley-Davidson's financing arm, Target and J.W. Nordstrom with their own credit cards.
Think of it this way: providing both the product and the financing means you are "double-long" your customers. If you max out your Target card at the store, and then default on it, Target effectively "gave away the store". If you do not make the payments on your new Harley, and it gets repossessed, HD takes the hit both on the resale value and on the receivables. Further, as we saw during the credit crunch, trying to fund the in-house financing operations is impossible once the securitization markets freeze.

Hidden short-term funding risk

Again, one of those "not a problem until it is." Many businesses mix shorter and longer-term debt funding. Overreliance on short-term funding, with its constant roll-over can trip event the bluest of the blue chips. GE had problems with its commercial paper program, usually a low-cost, liquid form of financing even before Lehman (the largest CP player, I think) blew up. This risk can be mitigated if the company has access to ample revolving credit lines. It does involve reading the footnotes in the financial statements, of course.

"Cash-equivalent" risk

Another credit crunch issue, remember when the auction-rate securities markets froze completely? A number of completely unrelated businesses had parked cash there and had to reclassify those assets when they had no access to them. I am not aware of it being fatal for any particular business, but it is a good example of a hardly-disclosed non-core risk. You can be sure that Wall Street will come up with the next "better" product to push on their clients in the treasury departments, but we won't find out about it until it becomes a problem.

Unrelated equity investments risk

Surely there are legitimate, "core business" equity investments. These might include joint ventures with other industry players to develop a new product, or equity investments in foreign subsidiaries in partnership with a local entity, or equity ownership prior to a complete separation of a faster-growing business unit (i.e. McDonalds/Chipotle). But then, some companies, for historical or other reasons, have substantial chunks of completely unrelated businesses. Ralcorp, a mid-tier food company, is an example of such company: RAH has a sizable share in Vail Resorts, a resort operator. Deltic Timber has a golf course investment (seems legit, right?). Vector Group, a small cigarette maker, is also an owner of CBRE, a NY-area real estate brokerage. Medallion Financial, a specialty finance business that funds taxi "medallion" purchases in cities that have those, also has stakes in two SPACs (and BTW NYC yellow cab medallions cost 750k+ for a corporate, 500k+ for individual). One needs to think "do I get paid to bear all this additional, non-core risk here?" This risk also has potential upsides, if one can accurately identify a mispricing like we had with the Palm/3Com situation a while back.

Governance risks

Governance risks are anything related to management actions (outside of running the business) that presents a potential harm to shareholders. There are a number of these, but I will look at two.

-Related party transaction risk: these are generally disclosed in the filings. But disclosure does not mean that the transaction is not harmful to the shareholders, even when it is "approved" by the boards. For example, if a company rents office or warehouse space from a senior manager somewhere in town XYZ, I have no idea if the price is fair. There have been some really egregious examples, including using a manager's wife's architectural firm for all new bank branches (Commerce Bancorp had paid $50 mm to the CEO's wife's firm; he was asked to leave by federal regulators, which also shows how useless the board really was).

-Retroactive option expense increases: this one hit me last year when the stock market tanked. All of a sudden, companies started re-pricing their employees' stock options at lower prices! The whole purpose of having stock options is that employees are incentivized to bring the share price up. When the market moved lower last winter through March, shareholders took losses all along. But some employees did not: they had their options repriced at the new, lower levels which defeats the purpose of having incentive compensation. This way the shareholders took a hit in the market, and are much more likely to get diluted down the road. I think the biggest offender there was Google. The "do no evil" folks over in Mountain View last March (note the timing) repriced over 6 million options from $500 strike down to $308. This is creating Silicon Valley millionaires not by sweat but by expropriation. So, the employees had no downside when the stock moved down, while the owners are hit twice, once with the stock loss and, second, with additional dilution.

The point of this missive is: as a shareholder (=business owner), you are likely to bear risks above and beyond the ones that come with the business. It is important to recognize that those come in a wide variety of flavors and it is often impossible to tell if one gets compensated adequately for them. With that, we are going to wrap it up for today.

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

Saturday, February 20, 2010

Analyzing Industry Pricing Dynamics

 This post was also featured on The Reformed Broker reading list.

One of the most important aspects in fundamental analysis for me is understanding the underlying industry dynamics. Questions one should be asking include where is the value captured in the chain, what really drives demand, what really drives the costs, and so on. One thing that is very helpful to know is industry pricing dynamics. Of course, there are many parts to this puzzle, but by and large, you want to invest in companies that have their finger on pricing (just think, with relatively inflexible demand, every $1 extra in pricing is an extra $1 in pre-tax profit: all the costs are already incurred).

One of the ways pricing "get done" is via signaling to the competition what the plans are. Since it is illegal to fix pricing, companies resort to specific language when they want to communicate what they would like to do. So let's look at some of the recent examples of such communication that I came across. I am not endorsing any of the companies discussed: they just serve as examples. (All transcripts are a courtesy of Seeking Alpha, I have truncated the questions and answers, the emphasis is mine.)

First up, Sara Lee (SLE). SLE produces a wide range of products, including Jimmy Dean sausages (listen to this customer call, hilarious), BallPark franks, Kiwi shoe polish, and, of course, the eponymous bakery items, both fresh and frozen. The fresh bread business in the US is dominated by a handful of companies: SLE, Interstate Bakeries, Flowers Foods (FLO) and Bimbo/George Weston. They make both branded and private label products and have extensive DSD (direct store delivery) systems. There has been some promotional activity in the space now that wheat costs have eased up.
Eric Katzman - Deutsche Bank Securities
On the bakery, I guess there’s been a lot of commentary as to like who shot first and I just wondered if do you think that you’re, like some people say that you’ve been the most promotional in the category. Some say that it was initially Interstate Hostess. You know Flower says that they’re kind of reacting to everybody. [etc]
Brenda C. Barnes probably will find most people are guilty... And to the extent that any of us drive the price to low, the retailer hurts, too. So I just expect there’ll be a little bit more rationality on everybody’s part.

Got that? Sara Lee's CEO is saying that pricing should be more rational (=higher) going forward. She also does not like that everyone jumped in and started competing on price. Will rational pricing happen? Something to keep an eye on as you're reaching for your turkey- provolone- chipotle mayo on whole wheat.

Next up, Spectrum Brands (old: SPC, new: SPEB). Spectrum is a Chapter 11 case that emerged last August but is still OTC. They had too much debt but now they think they've got it under control. SPEB makes a broad range of products within three general lines: batteries/personal care, pet supplies and home/garden products. Brands include Rayovac, Remington shaving, and Repel insect repellents. The battery business is a tough business: private label share is high, retailers left and right have been cutting the branded offerings, and, perhaps most importantly, consumers have been spending less on toys and, on top, have no idea if one brand is better than the other as battery lives are not easy to compare. The big branded players there, besides SPEB, are P&G (Duracell) and Energizer Holdings (ENR).
Karru Martinson - Deutsche Bank
And we've been hearing a lot from other consumer product companies about how there's increased trade spend, a very competitive environment. What are you guys running up against as you go to market?
Kent J. Hussey
Our business model has always been to win the consumer at the shelf...So we will take whatever steps are appropriate to maintain the value positioning of our products. That's most notable right now in the battery category...[answering another question]... Some of the step up in promotional activity that we're seeing right now in the marketplace will probably have a little bit of a dampening effect on the, call it the value growth in the category. But I personally think that's just a temporary phenomena, and as the overall economy begins to recover I think we'll go back to a more normal retail environment...[answering another question]...Of late we've seen competitors add two free batteries to their eight packs. Whether it's promotional or permanent I can't answer that. I think it's promotional. And one of our ways of competing is to typically give the consumer more batteries for the same price as a way of providing significant value. And so, during this particular cycle of promotional activity we'll increase the number of our batteries to main the value positioning, the value spread between us and the premium brands.

So what is happening here? This is signaling of a slightly different kind. One, Spectrum is saying that the ongoing trend of putting more batteries per pack is "promotional". This should be read as "we would like it to end some time", may be when the market stops shrinking. The second part, which we did not see with the SLE segment, is the threat that SPEB will continue to respond with lower prices if the competition continues to lower their prices (whether directly or by adding batteries to the packs). Some consumer products are priced based off the "premium" being a 100, and the value being somewhere lower, and this is the "spread" he refers to. For example, Tide detergent is the 100 in the category and, say, Cheer brand is an 86. I do not know what the battery indexing is.

On to the last signaling example, Sanderson Farms (SAFM). SAFM is a large chicken producers. Proteins in general are another tough business to be in. There are substantial swings in commodity input costs (i.e. corn) as well as in the output prices. In other words, these already low-margin businesses can have both the input and the output prices move against them at the same time. The results are not pretty. PPC (Pilgrim's Pride) just emerged from Chapter 11 last fall and serves as a direct proof of the dangerous mix low margins- commodity input/output volatility- leverage. Besides SAFM and PPC, the other big poultry player is Tyson (TSN).
Joe Sanderson
What those volumes are is a restoration of our normal slaughter schedule. Last year during January, February, March, April and part of May we had that cut back in place and we’re not going to do that this year. We’re going to be at our normal, a little bit less than normal at our Big Bird operations, but we are going to run at close to normal capacity. We feel like that with cutbacks that the industry has that we won’t be in as near the challenging environment that we were a year ago.
Christine McCracken – Cleveland Research
So you’re not expecting any improvement in demand, but you expect the competition to kind of stay rational?
Joe Sanderson
I do.

Again, let's read between the lines. If feed prices are high, operators sometimes produce too much, lowering output prices and shooting themselves in the foot. SAFM is not increasing production (trying to avoid the word "slaughter" here) and, more importantly, suggests that the competition does not do anything silly. Compare this to the battery business: there are no price wars or anything. Since the businesses are price-takers and cannot use other differentiators ("two gizzards for the price of one"?), SAFM is communicating regarding output quantities as a proxy for optimizing the industry-wide price/volume mix.

With that, we are wrapping it up for the day. This sort of pricing analysis is obviously not applicable to every industry. Points to remember: coordinated higher pricing = good, price wars = bad, and listen to what management says about pricing. Are they cutting prices, and why? Do they worship "share" disregarding profitability? Or do they say "we did pricing actions across the board earlier this year, most of it stuck, and we'll continue to be rational in today's tough environment"?

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

Saturday, February 13, 2010

Should We Get the Taxpayer Out of the Real Estate Business?

This post was also featured on The Reformed Broker. The TRB now has a weekly stocktwits TV show.

The taxpayer is more deeply involved in the real estate business than most people realize. I think it is time we pull the plug on the on-going blatant give-aways that go from our tax money to various constituents in the real estate business. So let's look at some of the known and lesser-known ways the real estate complex has been leeching for years. You can answer for yourself whether this is fair or not.

Multiple instances of preferential taxation
(1) At the corporate level, REITs are "special" in the eye of the taxman. REITs, unlike other perfectly good businesses, do not pay corporate-level income taxes so long as the income is derived from real estate operations and mostly paid out in dividends. Additionally, a substantial percentage of these dividends might not taxed at all as they are considered "return of capital." Just like this, the tax code has created a chosen sector, while "regular" companies pay income taxes and their owners pay taxes again on the dividends. (please no comments about BDCs, LPs, "c"'s, etc.: I am talking about regular mainstream businesses)

(2) RE developers also get local tax breaks for new construction in certain areas. Is this fair to the businesses providing jobs constantly in the area that do not get any breaks? I do not think so.

(3) There are breaks at the personal level as well. The big one is the mortgage interest deduction. Of course, you are fooling yourself if you think you are getting deal. If I were the seller and you were the buyer, and we both thought that a market price of X made sense, we'd transact at X. However, if I know that because of the tax break, you can actually afford X+20, guess the new market price? It is X+20. I will keep the surplus to myself while you think you're getting a deal on your taxes. For tax breaks to really work, they have to be private. Otherwise, in a large marketplace, the price will migrate up to where the sellers (the real estate industry) will capture the entire surplus.

(4) Another personal tax break are the very generous exemptions from what are in essence capital gains taxes. No other assets are exempt: short-term stock wins are even taxed at the high personal income tax rates. In other words, the tax payer encourages investment in largely non-productive assets with high carrying costs, while discouraging potentially appreciating, income-producing investments, such as stocks. Think about whether this makes sense.

(5) A loosely similar situation exists with 1031 exchanges of properties. In short, they allow sale and purchase of separate properties without taxes on any appreciation if the transactions happen within a certain time frame. Again, do you get a tax break if you sell a stock and buy a new one? No. The taxpayer is supporting a certain asset class over another for no good reason, in my view.

In addition to the taxation situations listed above (I am sure there are more but I am neither a tax nor a RE guy), the taxpayer is deeply involved in the real estate financing business whether the taxpayers want it or not. Let's look at some of the ways. Just remember that secured real estate lending is a mainstay of banking so banks have a vested interest in having collateral that receives preferential treatment.

(1) The taxpayer is the ultimate backstop for the FDIC. The FDIC insures deposits even in the most questionable banks. This (a) removes a source of discipline for the bankers and (b) perpetuates the lowest-cost funding for these questionable operators. Now, what do these questionable operators do? Well, they go out and lend to.... the real estate industry! If you look at most of the bank blow-ups since the "crisis" started, you will notice that they have been giving far too many mortgages and C&D loans to buccaneers who rolled the dice with little equity, or to johnny-come-lately's who knew little about the business.

(2) The taxpayer is on the hook for unlimited support for the "mortgage giants" FNM, FRE (+ the FHA). Remember that the news was released on the day before Christmas in the afternoon because the Nation's #1 TurboTax User (TM) was hoping that people would not notice? Anyway, what has been happening with these folks? For many years, under the guise of "making homes affordable", they have been interfering with the mortgage market and transferring value from the taxpayers to the real estate industry, in addition to being beacons of political cronyism. Now that the chickens have come home to roost, who gets stuck with the losses? You guessed it, the taxpayer.

(3) The taxpayer is also paying for VA program mortgages. Since we have a 100% volunteer army, why is the taxpayer subsidizing the career choices of other people by giving them money to give to the real estate complex?

(4) Let's not forget the current programs such as the housing purchase tax credit (another blatant giveaway to the industry), the various financing facilities from the Fed (only $1 tril in support of MBS), etc. Much is written on those (and not enough on the basics, so I am focusing on the often-overlooked latter).

So, the taxpayer is subsidizing both the industry via various tax breaks and its financing structure. Nice job if you can get it. But there are some other ways in which the taxpayer gets hit.

(1) Public housing and housing vouchers. The taxpayer, in addition to providing for his/her own shelter, is also providing for the shelter of many other people. Setting aside the discussion whether housing is a "right", lets look at some of the effects. (a) Voucher programs, such as Section 8, cover the difference between "market" rent and income, so the rent levels are artificially propped up. Also, there is a direct benefit to working as little as possible as any increase in income would go for rent. Not bad of a deal. (b) Public housing. "Projects" are now being widely demolished as a failed experiment. Is someone going to reimburse the taxpayer for the construction and demolition costs, along with the maintenance, policing, etc. costs that were associated with the projects? I doubt it. In places like Manhattan, vast swaths of the island are occupied by public housing thereby reducing supply and driving the market price up for the "regular" taxpayers (there are other factors in that price, of course, such as rent controls, being on an island, etc.). So the taxpayer has paid for the construction, maintenance, current housing AND has to pay higher rent because of the restricted supply. Makes no sense. Who benefits, besides the direct beneficiaries? The holders of the remaining housing stock, who can now sell high-priced condos and/or charge the highest rents in the country.

(2) Eminent domain abuse. Some cases in recent memory: the Kelo case up in New London, where a developer forced people out of their homes for a private project. Second, the Atlantic Yards project in Brooklyn (involving the participation of a Russian nouveau riche oligarch and Acorn- to hand out the "affordable units" allocation), the developer there is trying to squeeze some holdouts again for a private development (condos, office, retail and a new center for the New Jersey Nets). Also, Columbia University, a private entity, trying to expand its campus by steamrolling over the local property owners through incessant court battles, as well as through letting its own buildings in the area rot in order to create an appearance of "blight" and anoint itself as the savior. In all three cases, the developers are getting tax breaks to violate eminent domain principles. Big Pharma cannot confiscate your organs to do experiments, Big Oil cannot drill in your back yard, the local transit authority cannot confiscate your van to add to their fleet, and yet Big RE can defacto take your property against your will (the whole "has to pay a market price" argument is weak, there is no market price if the other side simply does not want to sell).

To summarize, the taxpayer has been too involved in subsidizing the operations and financing of the RE industry. This has lead to untold amounts of malinvestment and to widespread personal financial ruin for underwater home "owners." The taxpayer involvement should stop. Will it happen? Realistically, I doubt it: hoping it would happen is about as futile as trying to convince yourself that all children are above average. But, like Dexter's blog on suspicious trading, I am doing the SWPL thing here: "raising awareness."

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

Thursday, February 11, 2010

Is Whitney Tilson Running an Alpha-clone Fund?

This post was subsequently featured on World Beta/Mebane Faber  and MarketFolly. It was also linked to by WSJ columnist James Altucher on his dailyfinance blogwatch.

Let me preface this by saying that I like Mr. Tilson's work. He has done a lot in the worlds of  value investing and value investing education. Further, he has been very forthcoming with a number of high quality materials on the housing crisis. I also follow all of his slides from events like the Value Investing Congress, as well as situation-specific presentations, like the General Growth dispute with Hovde. In addition, I doubt I will ever reach his level of prominence or AUM, or write a book, or have 5-star mutual funds like his.
Mr. Tilson is also one of the better thinkers on school reform (bet you did not know that). I have been blogging for over a year now, and Mr. Tilson is on my original "People Smarter Than Me" list on the blogspot site. I have no axe to grind.

So, back to the topic, is Mr. Tilson running a "clone" portfolio? I think the answer is yes.

In his 2009 annual letter, Mr. Tilson comments on a number of topics, but what got me thinking is the list of his top 12 positions. It seemed to me, after a cursory look, that most of his top positions are in equities that are in one way or another pre-approved or "blessed" by prominent value or activist investors (or both- i.e. Ackman).

(1) GGP Brand-name investor: Ackman
GGP/GGWPQ is one of the most fascinating stories of the crisis (yes, geeky). Mr. Ackman hit it out of the ballpark by realizing that (1) the assets are of superb quality, (2) the problem was a roll-over rather than a solvency issue, and (3) the structure of the liabilities was favorable. He coined what I am sure will be a classic: "good liabilities are an asset." GGP has returned multiples for his fund. More recently, Pershing and T2 have been involved in a public discussion vs. Hovde regarding GGP: if you like reading arguments about the proper ways to calculate NOI (even arguments about cash!), this series of presentations are for you.
(2) BRK Brand-name investor: Buffett
No further comments are necessary. Let The Oracle do your thinking for you.
(3) IRDM
This is a formerly bankrupt satellite phone service provider. T2 has some great slides on the whole idea, a nice "deep value" situation.
(4) MSFT
No comments here, either, though one has to wonder how much alpha generation is possible with everybody's favorite monopolist.
(5) AXP Brand-name investor: Buffett
In addition to being a long time  BRK holding, AXP has been attracting attention of other value investors, such as Katsenelson. No longer in the deep value category.
(6) HUN Brand-name investor: Black/Apollo
This one is a bit of a stretch (both the idea and calling Black a "brand-name" investor). Huntsman will be a case study in corporate finance. Apollo and its banks were penalized for trying to walk away from a buyout/merger deal with Hexion, a portfolio company.
(7) PFE Brand-name investor: Berkowitz
Pharma is also attracting a lot of value investors, now that valuations have been depressed for numerous reasons. Berkowitz is a value investing celebrity, and his Fairholme Fund was the largest single fund holder in PFE the last time I checked. I do wonder what PFE's holiday gift baskets contain.
(8) DLIA
This is a unique T2 situation. Delia's is an online clothing retailer for girls. Market cap is ~50 mm. Tilson has quite a bit on it in both the '08 and '09 letters.
(9) Sears Canada Brand-name investors: Lampert, Ackman
Lampert, if you remember, had a huge hit with the Kmart bankruptcy and subsequent acquisition of Sears (US). It seems that he was the first fund manager in the recent past to both recognize and monetize the value of the underlying RE in a retail context. Both Lampert and Ackman own Sears Canada shares. There was some noise last year about Lampert trying to acquire the whole company after his failed attempt in 2006.
(10) YHOO Brand-name investor: Icahn
Yahoo, as probably everyone knows, was targeted by one of the old school raiders, Icahn, around its potential sale to MSFT. Icahn is still a holder.
(11) FFH Brand-name investor: Watsa
Watsa is often compared to Buffett; FFH is the insurance company he runs. Large holdings in KFT, WFC, just like The Oracle.
(12) WEN Brand-name investors: Ackman, Peltz
This is another two-fer. Ackman was an activist there a while back with his usual approach (also seen with MCD and TGT). WEN was then acquired by Arby's, which is a holding of Nelson Peltz. For the uninitiated, Peltz is a well-known activist in the consumer space, he has been involved at one time or another with Snapple, Arby's, Kraft and Heinz (probably the most public battle).

The more substantive question is, does "cloning" matter?

Probably not, but at 2 and 20 (presumably) one would expect more of the IRDMs and DLIAs and less of MSFTs or BRKs or AXPs. It is not unusual for big-time investors and their teams to reach the same conclusions about certain companies, especially ones of larger capitalization. This is particularly true when these investors adhere to a well-defined style, such as "value" which describes most of the names above. Further, PMs obviously share and discuss ideas, and selling your ideas to other investors then becomes a bit of a self-fulfilling prophecy as demand for the stock picks up.

But if you want a true "alpha clone" portfolio, there is a service for that (ain't America great?). It is run by Mr. Mebane Faber. (I have not used it/not affiliated with it/do not know Mr Faber. I just read his blog regularly.)

Do you know of other "alpha clones"? Or, even, "alpha clowns"? Let us know in the comments.

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