Wednesday, June 30, 2010

Tesla Motors: The Risky Fendi Bag of the Highways

 The article was also linked to by WSJ and Daily Finance Columnist James Altucher. The Kirk Report members-only section linked to it, too.

Tesla Motors (TSLA) IPO'ed today and rose 40%, underscoring investor enthusiasm for popular perceived "green" investments, underwriting ineptitude, or both. Congratulations to the lottery winners here, and best of luck because you will need it. Here is why:

(1) Tesla's product/s are/will be status symbols because they are transportation solutions that are inferior to existing, low-risk, well-known solutions. Here's my back-of-the-envelope calculation over an expected 200k mi life (and, no, if it does not work on the envelope, it won't work in Excel either). Tesla hopes that its "mass market" (20k units/year; 250-300 mile range) will sell for $50k. However, according to public information, the current battery pack needs to be replaced at 100k miles at a cost of $36k as it loses 30% of the range at 50k (and, presumably, 51% at 100k). Tesla reports subsidized (PG&E night charge) electricity cost of $0.01 per mile (per wikipedia). A 200k mile life of a Tesla would then cost $50k car + $36k battery pack + $2k power = $88k. A new VW Jetta Diesel is $23k, and gets 40 mpg. Over a 200k mi lifetime, that would be 5,000 gallons, at $3/gal, is $15k. So the Jetta cost would be $38k. Diesel would have to be $13/gal for the Tesla to break even. (As a side note, diesel at $13/gal would mean that a bunker with food and a shotgun would be the best use of money). I am making a number of simplifying assumptions here, including similar maintenance and insurance costs, and residual values. If I had to guess, Congress will make regular car owners subsidize the insurance of electrical car owners.

So the conclusion here is that because of its costs and limited range, the "mass market" Tesla will likely be a 2nd or a 3rd vehicle in for a well-to-do suburban household.

(2) The ecological benefit of electric cars is substantially overstated. First, most of the US electricity comes from fossil fuels (coal and natural gas), and, second, battery metals present problems both at the sourcing and at the recycling ends. So just relocating the tailpipe from the car to the power plant and the cyanide leaching ponds of the mines does not make electrical cars zero-emissions, despite them being advertised as such.

(3) The company has manufactured a little over 1,000 cars thus far, and the bodies are actually made by Lotus. This means that the production know-how is very low. On top Tesla plans to make the cars in a high-cost location (the old NUMMI plant in Fremont, CA). The location was unionized prior to the shutdown by Toyota and MTLQQ (aka "Old GM"). It is also highly visible politically, with Nancy Pelosi and Barbara Boxer hovering over the area. So you can imagine the pressure to have "good paying, union, green jobs"= tax payer and shareholder money spent for political favors. Also, Tesla does not even have the production machinery yet.

(4) Tesla is heavily subsidized by the taxpayer. The expected effective price of their "mass market" model is $50k after a $7.5k tax credit. Tesla also has a loan facility from the taxpayer via the Department of Energy. Just remember: good business ideas do not need subsidies. Apple's app store does not need them to thrive, nor do Biore strips, nor do tube socks, nor does the halal skewer vendor down at the corner.

(5) Tesla's CEO's personal financial problems are well-known. But here is what worries me: "We are a Silicon Valley company. Closer to an Apple or Google than to a GM or Ford in the way we operate the company"-- Mr. Musk said in a very recent public statement. I have some news for you. You are in the car business. This is a cyclical business that depends heavily on financing availability (for mass-market products). The scalability of your business is much lower. The likelihood that you will have to deal with a unionized, politically powerful, inflexible expensive workforce is high. 2 of the 3 US car companies are bankrupt, and the 3rd barely made it.

(6) Tesla is losing money hand-over-fist, but you probably knew that already. It will also have a period of no production as it gets ready for the "mass market" car.

(7) Last, but not least, Tesla means "adze" (a woodworking tool) in Serbian, Nikola Tesla's native language. Nice attempt to honor one of the most important inventors in history but it is also bringing a decidedly low-tech connotation to this aspirational company.

Wednesday, June 23, 2010

A Quick Look at Booz Allen Hamilton's S-1 Filing

 It was also featured on The Reformed Broker's Hot Links.

The market's rebound over the last year+ has brought some "interesting" potential IPOs. Back in February, we had FriendFinder Networks, a company in default, trying to raise cash. These folks own a number of adult-themed social networking sites, including adultfriendfinder, which they claim was among the top traffic-ed sites worldwide. The market events in February shelved this masterpiece. Then in April, a small movie production company called The Film Department filed for an IPO. This company focuses on movie productions (as if the Hollywood Exchange was not enough to skim money off the naive), and outright warned that they face substantial liquidity constraints and that even with the IPO, they would still have to raise additional funds for each production. Also one of the underwriters was getting warrants for the deal: generally, not a good sign. So that IPO also got delayed as the market got rocky in May. One can even track how the offering price was dropped over the months through the S-1s.

On to a substantially better business that filed yesterday: Booz Allen Hamilton, a brand-name consulting company that derives 98% of its revenues from the taxpayers (the US government). The company is owned by Carlyle, a top PE shop, and has hired Credit Suisse (left underwriter) to do the deal. I browsed through their financials and I really do not see myself as an owner of this business. Here is why:

A feature of attractive businesses is earnings growth outpacing sales growth. This is called scale, and is an essential factor with any enterprise. Some kinds of growth are more capital-intensive (i.e. build more stores/get more inventory), some less so (app downloads). But the scale exists in both cases as the fixed costs are spread over more profit-generating units. Building additional stores does not mean hiring more accountants in corporate or upping the national advertising budget.

Since BAH was LBO'ed, I will look at EBIT margin instead of NI to eliminate the effect of the increased interest expense.
2007: Revs: $3,209,211 EBIT: $130,695 (Margin: 4.07%)
2008: Revs: $3,625,055 EBIT: $153,481 (Margin: 4.23%)
2009: Revs: $4,351,218 EBIT: $66,401 (skip, LBO year)
2010: Revs: $5,122,633 EBIT: $199,554 (Margin: 3.90%)

What is going on here? Revenues are up 60% and yet, the margins are going the other way. This is not desirable. Where is the money going? Here's a clue:
2007: Revs: $3,209,211 G&A: $421,921 (13.15% of revenues)
2008: Revs: $3,625,055 G&A: $474,188 (13.08% of revenues)
2009: Revs: $4,351,218 G&A: $723,827 (16.64% of revenues)
2010: Revs: $5,122,633 G&A: $811,944 (15.85% of revenues)

If the G&A in 2010 were at the 2007-2008 levels (13%), then EBIT would have been $146k higher, and the EBIT margin would have been 6.75%, or exactly in the way an owner would like to see it go.

On the positive side, comp expense seems to be coming down, with last year's being "only" 51% of revenues. This is not unusual for "professional" firms, such as investment banks (see JEF or GHL), but as the crisis showed, labor expenses tend to be fixed when things are going downhill and variable on the upside. There is no shareholder control over these which is something that even Buffett was unhappy about when he owned Salomon Brothers.

Then there is the whole "use of proceeds" aspect. A potential shareholder would like to see that he is funding future growth or paying down debt. At the other end of the spectrum would be a shareholder selling out directly. BAH is paying down debt, but how did this debt come about? There is the LBO debt, and then there is a subsequent recapitalization which resulted in the sponsor's receiving a special dividend last December (on top of receiving a special dividend last June). So, in effect, the IPO investors are funding the dividend that Carlyle pulled out. This clearly is not growth capital.

Finally, BAH's services are expensive. The company has 23,300 employees and generated over $5 bn in revenues from the US government. This means that the taxpayers are paying $220,000 per employee per year to Booz (all employees, not just front office). This is approaching investment bank levels but the money is coming from the pockets of the tax payers. With 98% of the revenues coming from the government, I would be worried that BAH's gold-plated services might be an easy target.

One has to keep in mind that there are two components to a purchase: price and value. If the price is low enough, then the purchase is de-risked and may present a good value. But somehow I doubt that the IPO will happen if the price is low enough for me to buy.

Thursday, June 3, 2010

Long Book Review: Confidence Game (the "Ackman/MBIA book")

 Update (July 5th, 2010): I strongly recommend reading John Hempton/Bronte Capital's review of the bond insurers (it is not exactly a book review but Mr. Hempton provides an incredible personal perspective on several of the underlying themes in the book). 

In short, I recommend to anyone with an interest in finance to read Christine S. Richards’s Confidence Game, probably better known as “the Ackman/MBIA book.”

Since I enjoyed Mr. Einhorn’s book on his short position in Allied Capital (“Fooling Some of the People All of the Time”), I think that that drawing some comparisons is appropriate as it would help me flesh out the intrinsic worth of the new book. I have not read “The Big Short” and “The Greatest Trade” yet, so no parallels there. Also, the latter two are not about specific companies that turned on their critics, unlike MBIA and Allied. Please do read Dasan’s book review that was posted here a short while ago.

To better understand the significance of both Mr. Ackman’s and Mr. Einhorn’s roles in the crisis, one needs to understand the role that iconoclasts play in society. The term “iconoclast” derives from the old Greek/Byzantine movement against the use of icons in church services. They questioned the use of artificial, human-created objects of worship much like Moses many years earlier had objected to the Golden Calf as a man-made idol, an action that, at its time, was, well, iconoclastic. Later in history, other men would risk their lives to challenge the man-made status quo, men like Galileo and Copernicus. In other words, the iconoclasts, the people who challenged authority, with the appropriate intellectual backing, did more to advance the world than did millions of compliant, complacent men. Much along the same lines, this book is a story about having the intellectual wherewithal to question an edifice raised by man, the triple-A credit rating, AND to take the iconoclastic position financially AND to have the courage to see it through. Mr. Einhorn, for those who have not read his book, took on the privileged status of Allied Capital as a BDC, which, much like a top credit rating, enabled its holder to do things that would not be done if there were sufficient market discipline. Mr. Einhorn was also probably the loudest voice regarding Lehman Brothers’ troubles, and was viciously attacked by the Repo 105 crowd that in a normal country would be digging ditches in orange jumpsuits for life.

In addition to appreciating the important societal role of iconoclasts, I also had the benefit of having read Mr. Ackman’s original white paper on MBIA, along with having followed all of his public presentations on investment ideas, such as GGP, TGT, CXW, O, KFT, and FNM. These materials, along with a basic understanding of the principles of general finance, financial reporting, credit ratings, municipal bonds, structured finance and insurance operations, will make the book much more enjoyable.
On to the book itself. It starts out in 2002, when Mr. Ackman, then a manager at Gotham, established a very inexpensive position in MBIA CDS. MBIA had enjoyed a cozy position for many years, using its own triple-A rating to guarantee municipal obligations against default, for a certain fee. There were three problems with this. First and foremost was the dependence on MBIA’s own triple-A credit rating. Its single largest producing asset was not under its control. Second, the ratings agencies admittedly used a two-tiered bond rating system, which was much harsher on municipalities (from a default standpoint), meaning that the agencies were costing taxpayers billions of dollars in either extra interest because of the lower rating or in fees to MBIA/cronies. The third problem with MBIA was that it had practically no insurance reserves because it operated recklessly on the assumption that even if a municipal issuer were to get in trouble, they would get bailed out one way or another by the state as a “moral obligation.” When that was not likely, MBIA would muscle the states into shifting funds all over the place to cover the shortfalls so that MBIA would not have to incur losses. In other words, if the game were not rigged, there would be no underlying need for municipal bond insurance.

Since the muni business is so sweet (even Buffett got into it when the established players got in trouble), this attracts competition. Eventually, MBIA decided that they are smart enough to do insurance on other products, namely structured finance. This is where Mr. Ackman’s 2002 white paper comes in, well before subprime became word dujour. The white paper itself is not a Cassandra-style vision of the financial system or of the credit bubble, but rather a very interesting and thorough analysis specifically focusing on MBIA’s risk exposure, and its inconsistency with the company’s triple-A rating.

From that point, all the way until MBIA’s collapse in 2008, Mr. Ackman and his team would uncover more and more problems with the company, while Mr. Ackman takes on the role of being the lone voice warning about the danger to anyone and everyone that would listen. Quoting Natalie Merchant, “a wild-eyed misfit prophet,” Mr. Ackman’s unstoppable zeal is described in full detail, including calls, letters and meetings with then-NY AG Mr. Spitzer, insurance commissioner Mr. Dinallo, the SEC, a number of analysts following the stock, the CEOs and chief credit officers of the ratings agencies, the board of directors of Moody’s, later on, the Warburg Pincus and Citigroup “rescue” financing teams, the auditors, and so on. Clearly Mr. Ackman had no shortage of courage, persistence and resourcefulness to bring the world to his viewpoint.

What makes this persistence even more admirable is that Mr. Ackman defacto took on “The Establishment” even as his original fund, Gotham, was falling apart because of an unrelated court decision on portfolio entities’ merger. It must not have been easy, particularly in the somewhat small and insular world of Wall Street. The bond insurers have been great fee generators to Wall Street, both via their own financing needs as well as their role in making sure that the municipal and structured finance machines keep churning. Obviously, the banks’ self-interest was not aligned with Mr. Ackman’s regardless of who was “right.” Additionally, companies and their management teams do not like having their stock shorted: it seems that many managers take this as a personal affront, and are classless enough to show it like MBIA’s CEO who demonstratively refused to shake hands with Mr. Ackman after threatening his career. MBIA goes on the offensive in many ways, some are direct, some are alleged, like having NYAG Spitzer (at the peak of his power) and the SEC investigate Mr. Ackman, or having undue influence on the court case regarding an unrelated Gotham investment. While it does not seem like MBIA went to the lengths that Allied Capital admittedly did (phone record theft, having his wife fired), MBIA and its management did engage in a number of unsightly and completely inappropriate tactics in their attack on Mr. Ackman.

Again, remember that this is a book about iconoclasm. Being a dissident in the financial world is not easy, because it is costly, the timing is very difficult, and simply, it is much harder to win against a large, entrenched member of the system. But, just like Goliath was taken down through leverage, so was MBIA taken down through its inadequate capital reserving, aggressive underwriting and greedy, myopic management. More contemporaneously, be alert when someone from the “establishment” blames market participants or critics for unfavorable development in the market, be it MBIA, Lehman Brothers or Greece. Ask yourself, why aren’t these “evil speculators” or “wolf packs” or “sharks” attacking the creditworthiness of Norway, Nestle or Exxon?

Unlike Mr. Einhorn’s book, which is written (predominantly, I assume) by the fund manager himself, the Ackman book is written by a journalist. While obviously edited/redacted by Mr. Ackman, the book is sorely lacking the true insight of what went on in the manager’s mind as well as the intricacies of the actual security analysis that went on inside the fund. Mr. Einhorn’s provides much of that, including the careful research of specific (fraudulent) properties backing the BDC financing, such as shrimp boats in Louisiana or gas stations in Detroit (yes, Allied, with its privileged tax status and SBA relationships, did lend against such “gems.”) The author here does describe only one specific situation uncovered by the fund, a hospital bankruptcy, along with several cases of municipal finance or collateral abuse that were investigated by herself in her own role as an MBIA reporter. While the journalistic gumshoe work is interesting, I found the lack of insight in the workings of Mr. Ackman’s funds’ approach to analysis quite disappointing.

Additionally, while very-well footnoted, the book is written with the grandeur vision of a classic novel, and, as a result, it does not have a single graph of MBIA’s stock price or its CDS! Not even as an appendix. I can probably blame the number-phobic liberal arts establishment for that, but I do hope that the soft cover would include at least a two y-axis time graph that plots the stock price and the CDS over the six or so years, along with notations of the major events in the book. That should not be that hard to do.

Finally, one should also remember Howard Marks’s maxim that being early is often indistinguishable from being wrong. Mr. Ackman’s vision of reality did lose money for the original investors in Gotham Credit, as they had a negative carry position in the MBIA CDS. People who stood by did eventually make a lot. So, much like the Dutch buying Manhattan for $600, timing is (nearly) everything, and Mr. Ackman’s campaign was, in my opinion, his way to accelerate the perceptions of the market participants towards his view, which, with the benefit of 20/20 hindsight, was absolutely correct.

(No Amazon commissions here, I purchased my own full-priced copy, I earn no compensation for writing this and I am not affiliated with the author, publisher or any of the characters in the book, save for the first Pershing analyst on MBIA, Mr. J. Bernstein, whom I knew only socially from a b-school committee we sat on; I was left with highly positive impressions of him.)

Shorting Treasurys In Anticipation of Inflation: Harder Than It Seems

One of the “slam dunk” trades for the inflationist camp has been to short treasury bonds, especially the long ones. On the surface, it makes perfect sense: a fixed income instrument should decline in value when rates rise. Notwithstanding the recent gains in T-prices, along with the commensurate pain for the shorts, this trade is much less of a slam dunk than it appears. Here are my views on why it will be a while before the short LT treasurys trade works the way it is supposed to.

First, interest rates in general. A bond short can be based on two views. One is credit quality, the other one is a view on rates. Credit quality (i.e. getting paid back as contracted) would be a problem for the US if we were not borrowing in a currency we do not control. For now, we can get away with both taking the loans out and keeping the printing press, and this privilege has been recklessly abused. In other words, the US government will almost certainly take the easy road of printing rather than the harder road of actually paying down the debt. So if there are no nominal credit problems, this leaves rates. Normally, the central bank/s raise rates when inflation picks up in order to cool off demand/growth, generally believed to be the driving factors behind inflation (a misguided, incomplete view, but this is another topic). When rates rise, bond prices fall. Longer duration bonds drop more for the same increase in rates. But my problem with this is that the interest rates are one of the most managed (manipulated, if you prefer the conspiracy lingo) aspects of the economy. There are very strong incentives besides steroid-based economic growth for low rates, namely the cost of government borrowing and bank profitability. The Fed is not really independent, and Zimbabwe Ben has this moniker for a reason, so you can be almost sure that headline rates will be managed to stay low by all means necessary.

Second, in-built structural demand and potential new (!) demand. Do not forget that there is substantial built-in demand for treasurys from a number of market participants. Since bonds mature, there is a ready roll-over market. If bond fund flows increase (which could be just a function of increased retirement savings contributions in target-date plans), this creates additional demand. Pension plans, endowments and so on have pre-set government bond allocations, and the simple act of portfolio rebalancing can increase the demand for treasurys. Then you have insurance companies that are subject to rigid portfolio holding regulations, as well as to liability matching (which is done via longer-term treasurys). I am sure that there are more examples. Finally, you have “your” politicians “working” hard to “protect” your retirement savings from the evils of the stock market, so do not be surprised if there is an Argentinean-style theft of the 401k/IRA balances to be put in treasurys (or removal of their tax status, unless they invest in Ts). This can be in addition to new, mandatory employer retirement contributions to all employees (de facto, an employment tax) that automatically goes into Ts unless otherwise specified by the employee.

Third, a possible slow-down in new supply. Despite Washington’s best attempts to saddle the economy with a whole new round of structural problems (healthcare “reform”, “climate” bill, financial “reform”, idiotic stimuli programs, etc.), the economy and the tax base may begin creeping back up, surprising everyone. Some of it might be natural, some of it might be due to some productivity breakthroughs, some might be due to baby boomers working much longer than anticipated, or withdrawals from the cesspools that Bush got us in and so on. This will reduce the supply of new paper (the rollover requirements will stay, have no illusions, the national debt cannot be paid off, let alone the unfunded liabilities). But shorter term, lower funding requirements for admitted tax cheat Turbo Tim might end up putting a lid on the yields.

Finally, the coupon. Don’t forget that the bond is a contractually yielding instrument. So in effect, you are already swimming against the tide to begin with, hoping that the rates move down enough to beat the coupon pass-on, and then cover the opportunity cost of the position.

Frankly, I am as bearish as anyone, may be even more, regarding long-term government finances/demographics/entitlements/etc. I am just afraid that there are too many tricks in the bag left to keep the government borrowing costs low. A few weeks ago I closed out of TBT (2x inverse LT Ts) at a small profit, and I do not foresee re-entering the trade any time soon (and if I do, it would not be with TBT for sure)..