Eyal Bar's Blog

A Changed Market

2011-03-02T21:15:00.003-05:00

In my last post I argued that it was a great time to short the market. My timing ended up being wrong. Stock prices have risen further, making them even more overvalued now (and therefore better to short). I'm not alone in having made this mistake. We have seen dozens of fund managers (publicly and privately) make the similar predictions in the past year and losing money. The worse aspect of this situation is that high-quality blue chips are not moving much while low-quality speculative growth stocks (such as the "cloud computing" sector, Netflix and Chipotle) are soaring and most overvalued. This looks a bit like the 1999 bubble, just not as extreme.

The market is also more difficult to decipher. Increasingly dominated by high-frequency trading, momentum chasers and Fed stimulus, the very nature of this market has changed. When one examines the market's internal structure, a disturbing but unsurprising conclusion emerges: big banks getting favors from government and the government itself are dominating. Many great fund managers have complained and elaborated on this point in recent months. We have seen various hedge funds and trading operations close their doors recently (big ones, small ones, profitable ones, money-losing ones) because they simply cannot figure out the market. Previously reliable patterns - both technical and fundamental - are breaking down.

This is very hard to take because Wall Street has historically rewarded the talented. Now it rewards the well-connected. In this annoying situation, the right thing to do is stand aside and let others do battle with each other. Taking myself as an example: I find myself unable to short stocks in any significant size - not because I doubt that they're ridiculously overvalued but because my previous methods for recognizing markets peaks have stopped working

But Hope Is Not Lost...

I am still optimistic. I believe that the patterns will return one day and that methods previously used by talented people will work, for two reasons: (1) I believe that real capitalism will eventually prevail, that the government will stop its policy of boosting stock prices and that big banks will lose their unfair advantage. (2) I believe that when the government bond bubble bursts, anything that depends on this bubble will collapse too, including the stock market. This means that I predict that interest rates will rise, we will enter a new recession and stocks & bonds will decline.

In summary, I am on the sidelines and watching developments in the U.S. treasury market. When the U.S. starts having trouble financing their deficit, it'll be time to short stocks.

A Historical Opportunity to Short

2010-11-02T16:12:00.004-04:00

Today is election day and tomorrow is QE2 day, an event which has been over-anticipated for the past two months, in what has been, until and including today, a very tough time for those shorting the market.

Since my last post a lot has taken place. A market scared of a double-dip recession quickly reversed into a market confident that there won't be a double-dip, and one that has traded based on this acronym that everyone has learned "QE2" (which stands for: round 2 of the quantitative easing policy).

A lot has been written about the U.S. stock market, its economy, and how they are broken. This post is intended to be a summary of everything I believe is happening and will happen:

State of the U.S. Economy and Markets

- After 24 straight weeks of retail investor withdrawals, clearly only institutions are participating in this rally.
- High Frequency Traders were responsible for the May 6th flash crash. Another flash crash will happen if regulators don't act vigorously enough.
- The Fed is boxed in, its policies are ever-more political. It is not politically independent as it was designed to be. Its purchase of MBS, its QE2 policy, and its asking banks for input on policy are the proof.
- QE2 is not going to meaningfully: lower rates, boost GDP, boost any component of GDP, boost anything that matter. Funds may be channeled into speculation, and more so abroad or into commodities, not in U.S. business.
- The economy is skirting on recession, though still growing a little bit. It may or may not double-dip, but it for sure will not sustainably grow much above 2% any time soon.
- Fiscal policy and anything else that Congress or the White House have tried doing is not meaningful and there is no political support for any major action.
- The only meaningful policy that will matter at this point is if the U.S. government stops supporting Fannie, Freddie and the big banks (Citigroup, Bank Of America, JPMorgan Chase, Wells Fargo) and figures out a long-term liquidation plan for their assets and their liabilities, along with FASB re-instituting mark-to-market methodology. This will hurt in the short run, and be beneficial in the long run.
- Home prices have now started a new downtrend and at some point the foreclosure/mortgage mess that is unfolding will only make it worse.
- Bonds are expensive, overvalued investments.
- Stocks are also overvalued, trading at a normalized P/E of 22, as high as it was in 1929, in 1987, and in 2008

What Will Happen

- Stocks will go down by 30-50% from current levels
- Bonds will go down (i.e. bond yields will rise)
- Employment and GDP growth will not improve
- The market will realize that the Fed cannot do anything about this situation, and therefore whatever is left of confidence that government can fix things will evaporate
- This new pessimism will lead the stocks markets and bond markets even lower. Precious metals will continue to outperform
- It will also lead to a questioning of U.S. sovereign credit, and maybe about the use of U.S. dollars as the reserve currency.
- At some point the Chinese construction bubble will implode, which will worsen the situation and lead to a decline in commodities prices
- At some point, stress in Europe will grow again and questions about whether the Euro can continue to exist will resurface.

I believe all of these will happen within the next two years, roughly in the order that I have written them.

It is possible that at some point, a lack of confidence in the USD and/or the Euro and/or the Yen will lead to a panic in currency markets and that people will chase commodities as a replacement. Under that scenario, commodities will not go down so much.

What Will Happen Real Soon

I believe that the U.S. stock market will crash by 10-30% within the next 4 months, at the most, and very possibly within this month. I highly recommend the work of John Hussman as a source of some of the reasoning behind this. These things are always hard to predict but I think it makes a lot of sense. And so now it's time to see if my predictions are right, and it all starts with political theater of the next 24 hours.

Radio Interview on the Global Economy

2010-08-16T16:01:00.003-04:00

On July 14th I gave the following 1-hour radio interview about the state of the global economy and how to balance one's portfolio from a macro perspective. The issues discussed include the whether or not the U.S. will go into a double dip, the housing market, Fed policy and the may 6th "Flash Crash". The interview was on Radio Shalom's Money and Business show hosted by Sam Ezerzer.

Enjoy!

Summer Thoughts After a Volatile Spring

2010-07-09T15:41:00.006-04:00

The markets have been through a lot since I posted my thoughts last July. After declining to 12-year lows amidst fears that the U.S. banking system would collapse, the government-engineered rebound (taking short-term interest rates below 0.25%, printing money to buy mortgage paper, allowing liberal accounting methods, creating incentives for people to buy houses and cars, large stimulus package) has surprised most observers.

Stocks rallied 80%, taking them almost to pre-Lehman levels. GDP grew 4%, the housing market rebounded slightly (and in some areas, significantly), corporate bonds traded back up and capital markets regained confidence. Many companies raised funds and reduced debt loads. Things improved overseas as well: China’s massive stimulus package led to a construction boom, which in turn drove up commodity prices; this led to sharp economic rebounds in Canada, Australia and Brazil. Europe also looked good...for a while...

But since the new year we’ve seen fissures in this recovery.

There are three important points to make here: (i) analysts with a notably precise forecasts agree that the rebound is mostly due to government interventions and that if those interventions were removed, it would send the economy back into recession (ii) The recovery's strength was still weak considering it followed such a deep recession. (iii) the big problem today is dropping confidence in government finances, which translates into political pressure to pass austerity measures.

The recent troubles began in Dubai and quickly spread to Greece, Spain, Portugal, and the rest of Europe. The ECB’s trillion-dollar response is not foolproof: Germans aren’t happy about it; the IMF commitments can be canceled for countries with rising debt costs; the plan is to take funds from Peter’s pocket and putting them into Paul’s; the market is relying on the ECB to keep buying Greek and Portuguese bonds and private investors are therefore more absent than ever. Furthermore, the ECB isn't perfectly sterilizing its bond purchases as it promised to. The banking system is also in trouble as European banks don’t trust each other and would rather borrow money directly from the ECB. Spain looks extremely vulnerable (houses there are still about 40% overvalued and ‘cajas’ are very poorly capitalized). Longer-term, the continent's debt problems can linger on. As observed in Ireland, austerity plans can backfire because sometimes they crush GDP to the point where the debt/GDP ratio ends up rising instead of falling.

Over the longer term, government bond markets are bound to get volatile in the U.K., Japan and the U.S. as well. This will be resolved with a combination of more spending cuts, tax hikes and inflation. In other words, all developed economies are going to have to accept little or no growth for the next 5-10 years and residents of these countries will have to get used to more difficulties.

Another variable to watch is the popping of the Chinese construction bubble, which I think will lead a dramatic decline in raw materials prices. Chinese exports will also slow down. Every country wants to export right now, therefore they must all share the burden of reduced consumption.

I’m still a long-term bull on commodities, precious metals and commodity-linked currencies like the AUD & CAD but in the short-medium term I am bearish on all of these, except perhaps precious metals. My favorite way to bet on China’s slowdown is shorting the Australian Dollar. The Chinese stock market has declined already but the AUD has not.

The U.S. stock market is also a great short as it is not pricing in these circumstances. As a matter of fact, up until recently, most on Wall Street predicted a V-shaped recovery. In addition to the jitters in Europe, over the past month data in the U.S. has pointed to a slowdown and maybe a double dip. The housing market as a standalone will go through a double-dip for sure. Even after the recent decline in stocks the S&P 500 remains approximately 20% overvalued based on historical standards. Therefore, although I’m not sure that stocks will revisit March 2009 lows or that the economy will reenter recession, I believe the April top is solid. I also think that Gold will outperform stocks over the next 5 years even if both go down. So overall I’d short stocks and commodities and go long gold until the point where stock valuations are more fair. Then there will be time to reenter commodity plays. That bottom is not necessarily close; I think a more volatile ride lies ahead...

Wall Street's Grip

2010-03-14T10:27:00.003-04:00

Yves Smith has an excellent post on the grip that Wall Street has on our society. The gist of it is that even the 'good' parts of Wall Street are not necessary for our society and shouldn't be making much money at all. I did not foresee Wall Street having so much political power that they'd still get their way after the downturn of 2007-2008. The discussion in the comments is just as interesting as the post. I recommend this article to anyone. This piece inspires me to contribute to change in America but how exactly to do it is the tricky part.

One year after Obama's election I fear greatly for America's future. The president came in with a massive amount of political capital and wasted it in two ways: compromises with bankers, and now, a health care bill. Instead he should have forced Wall Street down to the mat. He could have done it, especially with his sophisticated Internet-campaign apparatus. No one will convince me otherwise. Obama made a mistake and now power is in the hands of a congress which is funded by Wall Street and other "to big to push around" corporate interests such as big pharma, big oil and health "insurers".

The problem is not so bad though: America is in fact opposed to Wall Street in a big way, even if for the wrong reasons. This is discussed in Yves' post. But we need to take down this block of society using responsible intelligent leaders who will carry the masses with them while preventing those masses from being too violent. I think it's still doable.

Krispy Kreme Puts - again

2009-10-15T16:33:00.002-04:00

Guess what I shorted this morning?
KKD has recently shot up on strong volume for no apparent reason. Trading at 14x a stable EBITDA, it surely is overvalued. It may be that a sale of the company or other event is in the works, and people in the know have purchased the stock ahead of the crowd. Or, it could be just a head fake. I put a small sum into this trade so if they get bought out at $5 it's no biggie. Recently the company has closed some of its stores and expanded their commitment to the small-store concept. Still, EBITDA will not double magically.

This is my first post in 3 months and I haven't much else to say. On the right side of this blog is the Volcker article from 2005. I suggest reading it again four and half years later. I am impressed with its relevance.

What I'm Doing These Days

2009-07-22T00:56:00.007-04:00

I haven't posted anything in half a year. When I opened this blog I promised silence in case I've got nothing to say. Still, my portfolio and thoughts have evolved during the spring/summer. So here's a summary of what I've done, what I think, and what I plan for the future.

Recent Portfolio Activity

After shorting Citi and a few other stocks in February, I took it easy until I saw the potential for a rise in stocks. The combination of widespread panic and impending good news (PPIP, stress tests, mark-to-market changes) made me think a bottom is close, which I played by buying calls on OXM. The market turned a few days later. I also purchased some calls on banks which I thought would pass the stress tests and a variety of stocks. I made some profits but sold out almost all my earnings-valuation-based long positions by the end of May. So I've missed out on the rest of the rally but that's ok - chasing short-term performance is not my game.

What Now...

So now my portfolio consists mostly of a few special situations and small put option positions that expire in January (HE, COF, APOL, SPG and a few smaller ones). What do I see macro-wise? First of all, I'm refraining from low-PE stocks (or EV/EBITDA stocks) because I just don't believe we can tell the normalized earning power of most companies. The American economy seems to continue its slide toward a concentration of wealth in the hands of a few very large dominant players who, in turn, are increasingly connected to government and lobbyists. There isn't enough of a free market and America could fall behind if we continue of this path of government intervention and politically-motivated decisions. Furthermore, various other risks remain, most of which are connected with confidence in government.

Treasury Bonds and Interest Rates

So what's the deal with confidence in government? Personally, I have now become a gold bug. I believe that the entire world has embarked on a politically addictive adventure of printing money and that this must end in a crash of government bond markets, a rise in interest rates and inflation in commodity prices (especially Gold and Silver). Further, I believe there's a chance that central banking as we know it will end and that we'll see social unrest in some parts of the globe. The U.S. has a fiscal problem, Japan has a fiscal problem, Europe has a fiscal problem too. I understand the argument for deflation: banks hoarding money... cheap Chinese labour... a lost decade is what they call it. I don't buy that argument. When we talk about "banks" hoarding money, it's really depositors hoarding money. Depositors place their funds in the banks, who then proceed to hoard those funds. But if the economy stagnates for a very long time, eventually people will slowly withdraw their deposits in order to buy essentials such as food and energy. This would push up commodity prices. And no one else will replace these depositors because on a net basis the world economy is stagnating and as a global economy we will need to spend more than we produce. In other words, whether we have a recovery or not, I believe we're headed towards a day when people start to essentially trade away their cash for commodities. And just to point out something that isn't discussed elsewhere: China seems to be experiencing a reflation-bubble of the sort that the U.S. experienced in 2003-2007.

What's Next?

I will try to post to this blog, especially if I have a good idea about a specific stock. right now my best idea is for investors to take a significant portion of their cash and invest it either in investments connected with silver/gold or a diversified basket of resources-related investments. My predictions for the rest of 2009: an acceleration of pain in credit cards, in commercial real estate and in Eastern Europe. For 2010 I wouldn't be surprised to see a double-dip recession.

Bank Civil War Ahead?

2009-02-24T22:43:00.002-05:00

In my constant quest to make this blog relevant, I try to post about things that are not being directly discussed by other blogs, at least not in the same manner, and much of this amounts to reaching new conclusions based on facts that are not so new. So tonight I make a prediction regarding an issue that I've already heard about 3 times: I believe that a civil war is ahead in the banking industry: insolvent vs. solvent banks.

Just as the taxes we pay our government smoothes out society by unemployment, health and education benefits, the banking industry is regulated by the FDIC, which has a system of charging a 'tax' from all banks to fund the operation of the FDIC. More broadly, the FDIC along with the OTS, OCC and the Fed, regulate all banks to the same extent, even though banks differ in the extent to which they need to be regulated. That is to say, some bankers behave badly and were clearly underegulated while other bankers have been behaving conservativly and therefore have been arguably overregulated. Other industries work the same way.

While all this is reasonable in a society like ours, the TARP has magnified this situation to an extent that troubles me.

1) Consider the story that broke the news a few days ago about US Bancorp, a relatively conservative bank that counts Warren Buffett as a shareholder. Last week their CEO Richard Davis said that U.S. Bank was told, not asked, to participate in the TARP. Before last week this had mostly been a rumor but now one of the top 20 banks in the U.S. is confirming it as true. I quote from the article:

Davis said he would be “darned” if Minneapolis-based U.S. Bank would suffer collateral damage from the government’s “sloppy attempt at nationalizing the [banking] industry.”

And a second article about the matter:

"We were told not to talk about it," Davis said. Davis didn't detail those strings, but he said he and some peers intend to voice their opinions to Washington, D.C. soon. "Now they're punishing you for having the capital," he said, adding that he refuses to stand by and let his company become "collateral damage in an attempt to nationalize the banks.

2) Now consider a second case, widely reported today. Northern Trust is being trashed by the media for having taken TARP money and having a party at a golf retreat. Well guess what? Just like US Bank, they are one of the banks who were forced to take the TARP. Consider the following passage quoting a company spokesperson:

"Northern Trust did not seek the government's investment, but agreed to the government's goal of gaining the participation of all major banks in the United States," Holt said. [...]Northern Trust became the title sponsor for the event in 2007, about a year before it received federal funds as part of the bank investment program, Holt said. It has a five-year contract to sponsor the event.

Why is this troubling? Because the government is forcing solvent banks to take TARP money and then using that fact to dictate how much a party should cost and whether those banks are allowed to bring Earth Wind and Fire to sing at a golf weekend. This is the ugly type of nationalization.

I'm all for 'nationalizing' BAC and Citi, but don't nationalize USB, TCB and MTB. That is Chavez-like.

2008 In Review

2009-01-03T23:35:00.009-05:00

2008 will be remembered quite well by historians. It started with Kerviel and ended with Madoff. It started with Bear and ended with Citi. It started with oil rising nonstop, to $147, and ended with oil falling nonstop. The year threw houses and ANY mortgage-backed paper under the bus (including GSE paper) and then in September/October threw everything else under the bus. 2008 formalized many things that were so far said only by a minority: (1) that the world economy is leveraged (2) that Americans consume too much (3) that the American auto industry is almost worthless (4) that Peak Oil theories won't change the fact that inflation is ALWAYS followed by deflation (5) that using corn to make energy is stupid (6) that Wall Street became a casino uncontrollable by anyone (7) that government intervention is imperfect, to say the least (8) that this is the worse economic downturn since the Great Depression (9) that there won't be quick-fix bail-outs, not from the Fed, not from the treasury.

For next year, my best prediction is this rally continues, then gives up its gains (for most credit-spread products), at which point treasuries make their ultimate top.

Treasury Bubble?

2008-12-28T18:02:00.006-05:00

All asset bubbles have now deflated. Oil is below $40, the S&P hit the 700's (Dow hit the 7000's) and home prices continue to march downwards. The same thing is happening worldwide: worthless land in Eastern Europe; volatile currencies in America; layoffs in Asia. Toyota has its first operating loss since 1941. Many excellent bonds are yielding double-digits and stocks trade at fairer prices.

But right next to that carnage we find yet another potential bubble. This time the talk is about a treasury bubble. The arguments as to why it's a bubble are found all over the place and have been discussed for years. Massive deficits, used to fight the economic crisis, must eventually result in too much inflation. The timing for this inflation should logically be the bottoming of consumer confidence levels. The counter-argument says that we've just recently switched from inflation to deflation, we'll have this deflation for a long while and it will be so powerful that it'll overwhelm the arguably small deficits.

So which side is right?

I don't know about the readers, but personally I've seen enough bubbles to recognize the pattern of rising prices and arguments that rationalize the rise. The same pattern is here again - this is a bubble. While I do believe that we will see deflationary pressures for some time, treasuries are overpriced. Who wants to lend money to the U.S. government for 30 years at 2.6% ??? (especially when corporate bonds of some very solvent companies are yielding 8-15%?).

Article on How to Solve the Israeli-Arab Conflict

2008-11-27T17:24:00.003-05:00

Contrary to popular discourse, the Israeli-Arab conflict is NOT, by any measure, among the most important conflicts to solve. Far more people have died in the various African conflicts and perhaps Asian ones, as well as in car accidents. Nevertheless, I have always been interested in this topic since after all I am Israeli.

After two years of disinterest in the whole thing (because of my disenchantment with Israeli politics for various reasons that may be googled), today I found a wonderful article in a wonderful magazine, written by the former chief of staff of Israel's defense forces, Moshe Ya'alon, a man who is said to have political aspirations.

The article suggests a solution that is pragmatic, bottom-up, step-by-step, incentive-based, apolitical, not ideological at all, expectation-light, promise-light, yet filled with optimism. I have suggested such an approach for years and am happy to see it suggested by someone close to parliament - a parliament whose members have long been basing decisions on short-termism, conflicts of interest, pipe dreams, corruption, coalition-building, political considerations and aspirations for budget authority.

The approach suggested is simple: using common sense, capitalism and democracy to build things together with the residents of the West Bank and Gaza (but especially the West Bank) while at the same time decisively destroying anything that is harmful in the West Bank and Gaza (but especially Gaza). It'll take time, but it's the only way to do it.

Another thing I like about the article is that it summarizes the past 15 years REALLY REALLY well and as concisely as possible. Highly recommended.

A Beautiful Example for Wall Street

2008-11-26T14:19:00.003-05:00

The New York Times reports:

As a number of American banks resist calls to rein in executive pay, the unthinkable is happening — at least in Switzerland, where three former officials of UBS, the troubled Swiss financial giant, said on Tuesday that they would forgo more than $27 million in compensation.

“With the involvement of the Swiss government, I realized that decisive action was required on my part,” Mr. Ospel said in a statement. [emphasis mine]

...

Asked whether he thought executives at Wall Street firms might follow the example of their counterparts in Switzerland, Mr. Jenter was skeptical.
“I would not put my money on it — not that I have much left after what the market has been doing,” Mr. Jenter said. “But it certainly seems unlikely.”

For a long time I have thought that a perfect capitalist system is one where competition is free, charity is voluntary and the educational system puts a lot of effort into teaching people to do as much charity as they can and compete fairly but vigorously. Switzerland just took a step in that direction. Swiss teens are watching and will learn a lesson. North America is lagging. Good for the Swiss.

Citi bailout Awakens Cynicism

2008-11-24T20:02:00.004-05:00

Before I begin, Michael Lewis has written the best financial article I've read in a few months and probably one of the top five I've ever read.

On to today's subject: I have for years learned not to be cynical and thought myself to look at verifiable facts and reach conservative conclusions, if any at all. Over the past few months, many people with similar inclinations have drifted towards cynicism. While I've remained far behind, I feel much closer to their point of view after this weekend's bailout of Citigroup. Nothing justifies the lack of consequences for those at the top. It may be wise to bail out the company, but taxpayers need to recover as much funds as possible, get as high an interest rate as possible, as large an equity stake as possible and believe that their government is doing the most it can.

And when this doesn't happen? People start gettign cynical, thinking ahead and visualizing (perhaps accurately) a disturbing destiny. Personally, the structure of these bailouts lead me to ponder whether they are needed at all. Paulson and the Fed appear biased in favor of saving Wall Street. Today on a radio talk show, a guest pointed out that if Citigroup fails, it's not as if "a big volcano will erupt and cover us all with lava". I agree! America has had depressions before and bank failure chains as well. Guess what? It not only emerged from these calamities but emerged as the world's only true superpower. It's true that things are a bit different in 2008 and that this depression is more akin to Europe's depression in 1873, but the point still holds.

There is an argument out there that bail-outs will sink us into an ugly type of socialism, the kind that America has always criticized. While some people think we'll have a lost decade like Japan, a subset of these and others fear that this will cause massive U.S. Dollar inflation. Indeed, today U.S. government CDS widened to record spreads, clearly as reaction to Citi's bailout.

As this crisis continues, I continue to look for the next big bet, the next flagrant mispricing, and right now the leading candidate seems to be "short U.S. treasuries" - the last bubble that has not yet popped. Many prominent bears such as Peter Schiff and Yves Smith believe we're headed in that direction. Other bears such as Nouriel Roubini and Calculated Risk seem a bit more sanguine. I have yet to make up my mind but I'm getting cynical about inflation, cynical about politicians, cynical about their abilities to see ahead and cynical about how Americans can hurt their own country. I would not rule out the possibility of a nasty public war between CEOs, members of congress and/or other Americans. I continue to play around with GDX calls, as I have for the past year. Gold has held up better than other commodities and I increasingly believe in it as a very attractive storage of value.

Two words of optimism in all this: Obama, maybe.

Hedge Funds vs. Investment Banks

2008-10-21T00:31:00.004-04:00

In my late-2006 recommendation to short investment banks, I wrote about potential blame games between hedge funds and Wall Street banks. Today these banks are - by virtue of recent policy action - partially government controlled. And as per the Financial Times article below, there is a hidden potential for a real war between the government and hedge funds. It seems that government, or at least the Treasury Department under former GS CEO Hank Paulson, is very biased in favor of banks. It remains to be seen how the next admnistration will compare to Paulson, and how the congress will act. It is said that Chris Dodd and Barney Frank "get it" and will not group-punish hedge funds in stupid ways. I sure hope that's true.

I'm not arguing that all hedge funds are innocent in this mess but if we had to label one party as having done the majority of "legal but evil financial deeds" since the beginning of modern capitalism, it is the Wall Street investment banks. Here's the article:

http://ftalphaville.ft.com/blog/2008/10/15/17076/in-defence-of-hedge-funds/

The Shorting Party is Over

2008-10-13T08:50:00.005-04:00

On Friday I cashed out of most of my put options and have no plans to return unless the market or certain stocks rebound very substantially. I believe the market is fairly valued if central banks do enough to prevent more disastrous events. Of course, markets tend to undershoot their value so I expect another leg down over the next year. It doesn't look like most people have capitulated and the crash is mainly from hedge fund liquidations. This is the first time in five years that I truly see bargain stocks and I've started to dip my toe into a few names. Interesting times...

Yes, Oil is a Bubble

2008-07-17T19:43:00.007-04:00

I was preparing to write about oil prices in the weeks to come but I should predict the crash before it happens, so this post is a summary of my thesis. In three days we've gone from an intra-day high of $147 down to below$130. Commodity markets, especially in times like these, are prone to persisting trends, sharper declines & advances and less/no bear market rallies or bull market corrections. And so, I decided to bet on declining oil prices by buying put options on the Canadian stock market, which is full of energy and metal companies. This is also a call on deflation in a way. In addition to that, yesterday afternoon, I sensed that oil is beginning its crash and backed up the truck on deep-in-the-money USO puts. This is essentially a huge bet that we've seen the peak, but not necessarily that prices will decline. In other words, it is a relatively safe bet.

I expect a decline to $60-90 by the end of 2008 but for all I know the price may surpass $200 or $300 in 5 years. This is not a call on long-term supply issues or a rebuttal of the peak-oil theory, it's a prediction that oil must crash hard in the short term, based on my expectation of the following: (i) since too many speculators have entered the market at once, not as many speculators will be able to pile on at the same rate and oil prices will have 'difficulty' rising (ii) China, India and other oil consuming emerging markets will see their economies sharply slowing down and/or will further cut the subsidies which create artificial demand (iii) short-term issues like Nigerian attacks and even Iran may go away and in any event should not have a large influence on prices when prices are already sky-high (iv) Wall Street analysts will no longer make predictions about $150, $170 and $200 oil. (v) the market will get bearish when it sees supply data of the type that came out yesterday (vi) when everyone realizes all of the above they will rush to the exits, contributing to the crash.

I'm predicating my USO bet on the assumption that trends in oil are severe. Therefore, if (and only if) oil rallies significantly, I intend to cover that position.

A bet on oil - speculation or not?

Valuing oil is difficult. We do know that at a certain price, people will cancel various projects (going on a road trip, commercial fishing expeditions...) but I don't know the exact value of a barrel of WTI Light Sweet Crude beyond common sense. One may therefore ask why many value investors are making a bearish bet in oil. Let me share my own thoughts in this subject, as this is a good time to discuss classical Graham principals. Not knowing everything about oil, I am being resourceful and seeking out research from those in the know. Of course, there are many smart people on both the bullish and bearish side so it's up to me to be the judge. Another Graham classic that I am applying is the lessons in the infamous Chapter 8 about the nature of markets, the force of the crowd and the magic of speculative bubbles. Without Graham's Chapter 8 I would never have made money off my housing & mortgage put options, and if this oil trade succeeds it will once again be thanks to Graham's (and Buffett's) teachings.

Fundamentals

Supply - I don't know what's really in the ground and I don't think people like us ever will. I did want to know at first but there is so much contradictory info and so much nonsense plus most of these oil fields are controlled by dictatorships. What this means is that MOST OF THE OIL MARKET IS LIKE ME. Most of the speculators, and anyone else who hasn't gone into these oil fields does not know. Therefore the oil futures market is prone to 'fantasizing' whatever supply numbers they want. Someone can yell "peak-oil, oil must go to $200!", and someone else can just as easily yell "environmental oil-burning disaster, oil must go to $20"! I assume peak oil is real, but that means nothing. The lack of fresh entitled land in coastal California was also real but that sure doesn't mean that California houses were fairly priced at their peak. Here's one interesting observation: GCC countries like Saudi Arabia and Qatar think oil's worth around $60. The Russian energy minister says $250... at least one is playing pure politics...

Demand - Demand in the developed world is going to be flat-to-down (something like 2% YoY in the U.S.) and demand in the emerging markets will decline due to the subsidy issue and the eventual tightening up of their economies that will surely come soon. As per my last post, deflation must follow inflation. Today we found out that China is growing a little slower than before. Still 10%, but the brakes are being applied. In terms of oil-derived products, clearly there is an environmental trend away from that. So where's this robust demand that everyone talked about?

Speculation in Oil - recently oil went up around 40-50% in both gold terms and euro terms, so USD inflation is not the only explanation of rising oil prices. I believe the ratio of gold/oil should maintain itself despite a secular multi-year trend of tightening supplies, so we know that supply&demand as well as speculation are pushing oil. Some people have asked how speculators can dictate prices to the spot market - nonsense. Speculators are creating demand, they want the right to buy oil at a certain price, the market will supply that to them, period. Speculators do not live on another planet, they live with us and they want our barrels.

Let me stop here. The above three paragraphs are tiny common-sense everyman-language summaries of what I've concluded from reading hundreds of pages of material. Tonight I have no time to expand but here are two recommended readings:

(1) All of Naked Capitalism's pieces labeled 'commodities'
Naked Capitalism discusses demand issues and trading issues. See his post linking to JD's comments and that linking to Hussman's letter (and the comments section of each post). In each case there is a good debate about the mechanics of futures markets. One of the main issues throughout this debate has been whether spot markets drive futures markets or vise-versa. I find much more logic in the vise-versa. Yves Smith, who operates the site, also wrote an excellent piece for Slate magazine, arguing that gouging how much oil is in the ground, what type it is, and how hard it is to get, is impossible.
(2) Masters testimony to Congress

It was incredible that many value investors didn't see housing/finance as being a dangerous bubble. It is even more incredible that some of the bears, who DID see those bubbles, are now themselves blind (in my view, at least) to the oil bubble. We shall see if I'm right.

I leave you with some fun quotes picked up along the way:

"In over 25 years in the financial markets, starting at the Chicago Board of Trade, I've heard a lot of talk about holding onto one asset class or another as a “long-term diversification,” and a lot of reasons why this factor or that has permanently changed the investment landscape (I have a Pets.com sock puppet in the office as a reminder of one of those times). Believe me – nothing shakes people out of their “long-term investments” faster than steeply declining prices. In commodity markets in particular, price trends feed on themselves in both directions, so we see pronounced cyclicality, and much more persistent trends – once set in motion – than we typically do in the equity and bond markets. It may be difficult to identify a peak in oil when it occurs, but most likely, the fallout from that peak will be spectacular".

- John Hussman

"The industrial-commodity complex is vulnerable because demand will slow down,''

- Marc Faber, formerly a commodity mega-bull

"Over the years we have asked over 2000 professionals for an exception to our claim that every asset class move of 2 sigmas away from trend had broken, and not one of the 2000 has ever offered an exception!"

- Jeremy Grantham, two years ago

Inflation vs. Deflation – Definitions

2008-07-14T01:10:00.004-04:00

Back in the days of the liquidity bubble, it was pretty clear to the bearish community that the final interesting macro debate would be about whether the impending credit crisis would end with inflation or deflation. Today the mainstream has embraced this debate and the right answer still isn’t obvious. It now also has a sister debate: “will oil prices go way up (like $200+) or back down (like $60-$90)”? It’s natural for these debates to be related because the inflation of oil prices leads directly to inflation of products/services that require oil – and those are quite numbered.

The inflation-deflation debate is ridden with definition problems. People are talking - and thinking – past each other because they don’t define words the same way, starting with the word “inflation”. Therefore, in today’s post I will define inflation and related phenomena as I see them, and apply those definitions to what we’re seeing in the world today.

Inflation (and deflation)

Inflation is an increase of the supply of money and/or credit. Deflation is a decrease. Inflation is currency-specific. For example, most of the inflation-deflation debates occurring in the US are about whether or not the U.S. dollar will experience inflation or deflation. Also, when we say “U.S. dollar” we must take into account not only the actual U.S. dollar but also any currencies that are pegged to it (e.g. 1 Saudi riyal = 0.266667 dollars, just as 1 U.S. cent = 0.01 U.S. dollars). China is pegged to a basket which is mostly USD so they must be taken into account in any analysis. For discussions on inflation in the U.S. dollar zone, I recommend Brad Sester’s blog.

Inflation “IN SOMETHING” (and deflation in something)

When we say that there is “inflation in the price of something”, it means that people took the extra money and credit that was created (the extra inflation) and directed it to that something, which caused prices to rise. For example, we have been witnessing inflation in the price of oil & food in 2008 but we have not seen wage inflation of equal magnitude. In the price of houses, we have actually seen deflation.

Sources and Drains of inflation

So inflation (or liquidity) does not seep into all things (or all “drains”) in proportional amounts. Why? Because various factors in our society “push” the extra inflation toward specific “drains”. For example: If certain federal government institutions encourage an incremental amount of credit to be created at the investment bank level, the investment bank will act as a source of liquidity to the market and will drain that liquidity to whomever "accepts it easily", for lack of a better term. In 2006, SIV creators accepted liquidity. In 2008 the concept of SIV is dead; investment banks don’t want to drain their liquidity into SIVs nor do they want to drain it into fly-by-night mortgage lenders. On the other hand, commodity hedge funds or conservatively underwritten corporate loans are still drains for investment bank liquidity. Another simple example: say a mortgage broker has the possibility of underwriting one New Century loan and chooses to use it himself to flip another house. This choice denies the liquidity to someone else. In other words, the extra money and credit that are created via inflation flow through various “agents” who, via their will and incentives, choose that inflation's next destination. Generally speaking, everyone today agrees that the US financial system, the housing/mortgage markets, the retail environment, and even CRE, are all experiencing deflation (i.e. these sectors are being denied inflation. Plus, as a consequence, they obviously are no longer sources of inflation for the next step (e.g. house prices are no longer a source of homeowner liquidity via HELOCs).

Hyperinflation

Usually hyperinflation is defined as persistently rising prices, mostly consumer prices and wages, sustained by a self-fulfilling prophesy of people buying goods frantically before the price goes even higher. But this is not a complete definition; it’s the 1970s definition. The real definition is more general and simple. Hyperinflation is synonymous with bubble, pure and simple. When people chase something out of fear that their price will only rise further, that must be a bubble. The 1970’s were marked by a bubble in consumer items and wages, the late 90’s gave us hyperinflation in dot-com stock prices and the early 2000’s gave us hyperinflation in home prices. It’s as simple as that.

Inflation is followed by Deflation

This is not really a definition; it's an idea. What they tought us about cycles of inflation and deflation in high school economics is precisely right and any fancy theories that “modify” this cycle theory are wrong. Inflation always tops out and is followed by deflation. Similarly, deflation must bottom out at some point. For example, Zimbabwe is in an apparent infinite hyperinflation, right? Wrong. One day their money will be worth less than the paper it’s printed on, which will lead to a wipe-out of their currency and a spectacular implosion. Many years later, they will hopefully start fresh with a new currency, or they will just remain in a barter system. What's for sure is that inflation is not infinite.

The adjective: “Inflationary” – separating planting & harvesting

This is the MOST important idea in this post. This idea is the reason I wrote the post in the first place. I’ve toyed with this for a long while but only recently gained firm belief in it, after reading a great presentation by Louis-Vincent Gave of GaveKal Research. People always throw around the words “this is inflationary” or “this is an inflationary environment”. What do they mean? Attempting to determine whether various events, actions, consequences and phenomena are “inflationary” is an ambiguous objective. Most observers and economists are confused about this. The effective way to analyze these events is separating them into “inflation seed planting” and “inflation harvesting”. Seeds are actions, decisions and policies that will lead to inflation in the future. Harvesting is the present result of past seed planting.

Example 1: The US government’s green light to expand the roles of Fannie and Freddie and the FHLBs in late-2007 and early-2008 were inflation seeds. We can also say this of China’s refusal to let its currency rise vs. the USD and its policies of keeping workers employed and subsiding fuel purchases.

Example 2: The popping of the mortgage finance bubble was a SEED for deflation in housing prices and this consequence has now been HARVESTED roughly half way. Now let’s assume theoretically that tomorrow morning Fannie and Freddie are allowed to make zero-down loans to anyone. A big debate will start all over again. Some will observe continued housing market weakness and yell “deflation” while others will observe the crazy new policy and yell “inflation”. The solution is simple: the housing market, net-net, will still be in an ongoing deflation mode, still HARVESTING the results of the bubble going bust. However, we can expect this deflation to be increasingly offset, as time progresses, by the results of this new policy, the new inflation SEED.

Stagflation

With all the above in mind, how should we characterize/explain “stagflation”? It’s very simple in my view: stagflation is an environment where there are the following three trends: (i) a harvesting of inflation, (ii) a hyperinflation “coming out of” certain segments of this harvested inflation and (iii) a background where seeds of deflation are being planted.

The third component needs to be expanded on: the longer the hyperinflation, the longer seeds of deflation will sit in the ground. In other words, we never know how long a bubble will last and the longer the bubble lasts, the worse will be the ramifications. This is the simple stuff that George Soros and Doug Noland talk about all the time. Just bubble theory. Let's think back to the late 1970’s: what Paul Volcker did was pop a bubble in wages and consumer prices. He popped a hyperinflation and the result was violent deflation. Why? Because the seeds of deflation were building up in the background. The bubble was just waiting to be pricked. Consumers were spending because they “had” to, not because they could afford to. So when he took away their wage spiral, there was a pretty nasty recession for everyone in the early 1980’s.

Today, many smart commentators say that we are experiencing stagflation. On the surface, the deflation crowd disagrees violently. But if they were to follow the above definitions, they would agree!! We are experiencing the buildup of future deflationary forces while currently witnessing inflating oil, food, and services prices. Maybe wages are not rising but that doesn’t change much, it just means that this “harvesting environment” is slightly less inflationary than that of the 1970’s (… probably…).

Back to oil prices…

So… if we want to know the right price for oil, we must analyze it as a drain of inflation, estimating how much liquidity will flow to that drain at various points in time. Most people agree that oil prices are rising for three reasons: (i) oil is priced in USD, which has declined in value vs. most items; (ii) there are secular trends of supply being more constrained and demand rising; (iii) there are speculative forces in the market. Of course, quantifying each of these three is the $64,000 question but that's not today's sunbject (by the way, there is possibly a fourth item: (iv) Iran war premium…but that’s really another issue).

So now let’s translate all this into seeding/harvesting terms: oil prices are inflating as we are witnessing the harvesting from 3 types of seeds that were planted over the past few years: (i) There has been USD inflation, which is itself a harvesting of various policies around the globe, (ii) demand in emerging economies is rising because those economies are inflating now, which itself is a harvesting of fruits that came from other seeds planted long ago (again, government policies) and (iii) Speculation in oil prices is the harvesting of the slowly snowballing commodity market interest by retail investors as well as high-net-worth investors and traders, which was created by Wall Street marketing departments. So that's how I'm approaching the question of whether oil is overvalued.

And now, back to economic cycles…

Finally, we return to high school economics class. My own answer to the inflation-deflation debate is that, generally speaking, the world and the USD zone particularly are HARVESTING inflation but planting the SEEDS of deflation. The gulf oil exporters will have to do something about their currencies soon. Dubai is already said to be on the precipice of a reversal (I can totally believe that… it seems to have typical boom-bust characteristics). And boom-bust means inflation-deflation, as they taught us in high school. The Chinese stock market foretells a slowdown there too; there is clear deflation in U.S. financials; India and Vietnam – you be the judge. Many parts of the world can no longer take current rates of inflation without significant new seeds of deflation (such as rate hikes and regulatory actions). The Fed can inflate as much as it wants but net-net they will not revive housing or the consumer any time soon. They will only revive oil prices which is undesirable. The biggest risk to this assessment of mine is inflating wage prices. I’m no expert there. And ultimately, no one actually knows how many 2008 dollars it will take to buy a 2058 dollar.

Oil Bubble?

2008-05-29T20:46:00.007-04:00

There seems to be growing speculative fervor in oil markets. This doesn't yet mean that oil is overvalued but it's a yellow flag. Over the past couple of weeks, the oil-bubble debate rose to new prominence as a string of info-packed articles were written by respected and prominent commentators. I am using these articles as starting points for what might turn into a comprehensive exploration - no pun intended - of this bubble debate. This effort seems large. After all, analyzing oil prices in U.S. dollars requires one to take into consideration U.S. monetary policy, and foreign monetary policy, in addition to supply & demand issues, the role of futures trading, the role of commodity index funds, hedge funds and much more.

I've always thought it clear that when excess liquidity is fed into an economically pessimistic market, people would and should get excited about only one thing: commodities. But what if the market were to somehow decide to go gaga over one specific commodity, namely: oil? What if everyone were running after oil just to hedge themselves against yet more increases, thus creating a self-fulfilling prophesy? That's called hyperinflation. Another word for hyperinflation: bubble. For a while it seemed we were faced not only with a potential oil bubble but also a general commodities bubble, but now, especially as the world gradually reconsiders corn-based ethanol, oil is continuing higher even as agricultural commodities retreat. Also, oil is continuing higher while Gold and other metals are not. That's quite interesting and increases the probability that inflation isn't the only cause of this froth.

Here are the articles that I am using as I begin this [probable] journey:
This WSJ blog from 2 days ago
James Hamilton's "oil bubble" post
All CR articles labeled "oil"

There is so much more, a lot of which is linked within these articles. This could be a bigger project than the housing market but if some of the most famous bears are starting to call it a bubble, it's worth it. I'll post more if/when I reach any milestones.

Seven Years Later...

2008-03-16T23:19:00.005-04:00

Spring 2001...

The equities bear market rages on... a friend and I are walking around downtown Montreal. "I tell people that banks can go bankrupt and they give me a blank stare," he says. "They think I'm young and crazy; they think the Great Depression won't happen again. Yet they can't say why they believe this. They just believe it blindly".

"You're right", I respond.

On Friday I bought some 22.5 Bear Stearns puts @ 3.50 (almost bought 'em on Thursday but hesitated). Earlier this evening the catalysts occurred. Jamie Dimon and the appropriate authorities have delivered what is my greatest investment ever: 500% profit in one trading day.

Is Lehman next? Will the extension of credit to primary dealers calm people down? One can only wonder... or ask reliable sources... I'm probably going to buy puts on one of the IBs but not Lehman. Here are some reasons why it shouldn't be Lehman.

MBIA's Strange Behavior

2008-03-07T08:55:00.003-05:00

It looks like March 2008 will be remembered as the time when banks pulled the plug on leveraged speculation. Management of Thornburg Mortgage would tell you that it is now in question whether ANY business model that uses repos or warehouse LOCs deserve to even exist. The big Wall Street banks don't want anyone too have liquidity & profits off of their backs and the Fed is supporting this desire. Crazy times.

But the March 2008 award for craziest development in financial markets has to go to MBIA, who this morning announced a downward repricing of stock grants. This is a practice which, the last time around (summer 2002) led to a massive crisis in CEO confidence. And earlier this week, MBIA CEO Jay Brown played the rating agencies like a mafia don and spelled Warren Buffett's name with one T at the end, in a sentence where he expresses respect for the Oracle of Omaha.

In the current sell-off round I am short staffing stocks. I have been expecting ugly employment numbers to "seal the recession deal". So far the public at large still doesn't see the recession that started in December (or January), but this morning's job numbers might help the cause.

Stock Markets Move

2008-01-24T09:20:00.000-05:00

January has arrived and the stock market recognized that we might be in for a recession. Yesterday, up until 2pm, may have been the craziest trading day in a decade. Various stocks moving sharply up or sharply down, with no clear market direction, can be guessed to be a consequence of distressed long-short equity hedge funds who are being forced to unwind trades by their lenders or by their clients.

Former Secretary of Labor Robert Reich expresses his views on the stimulus package on his latest blog post. Regarding the rate cuts: George Soros, Larry Summers and Stephen Roach have expressed their thoughts in Davos. Some links: Article #1 Article #2

I agree with all of these guys. Excerpts follow:

The politics here are more subtle because Bernanke and his Federal Reserve governors are supposed to be independent of politics. But as witnessed under the reign of previous chairman Alan "it's prudent to reduce the surplus with a tax cut" Greenspan, Fed chairs can have political agendas.

``It's hard to give central banks a very high grade over the last couple of years on recognition of bubbles and actions taken to address them in the policy or regulatory spheres,'' said former U.S. Treasury Secretary Lawrence Summers in a panel in Davos, Switzerland. Billionaire investor George Soros said central banks have ``lost control'' of financial markets.

``Central banks lost control of the situation when they allowed financial institutions to develop new financial instruments which they themselves didn't understand,'' said Soros.

Stephen Roach, a star economist from Morgan Stanley, accused the Fed of again caving in to Wall Street and market pressure with this week’s emergency US interest rate cut, and risking sowing the seeds of a future with the potential creation of a new financial bubble.

Oxford Industries (NYSE: OXM) - Simple Turnaround

2008-01-07T21:23:00.000-05:00

In the hunt for retail stocks that have been oversold amidst recent market volatility, we find Atlanta-based Oxford Industries (NYSE: OXM), a company that designs, produces, distributes and retails both branded and private label apparel. This past summer, Oxford had unusually poor performance in one of its divisions. The stock’s been halved and downgraded by two analysts. Management sees a turnaround but Wall Street hasn’t priced that in yet. Actually, Wall Street doesn’t seem to care that each division of the company is being repositioned/restructured very seriously. Management appears conservative in its prognostications, aggressive in its inventory management and they own lots of stock. Two weeks ago, the company entered into an accelerated stock buyback program for 14% of total market cap ($60mm). The shares trade approximately at 7.5x normalized EV/EBIT and at a post-buyback P/E of 9.5x

History & Management

Oxford has successfully created value via acquisitions & divestitures over the years. Hicks Lanier has been Chairman & CEO since 1981 and President since 1977. He owns 9% of the stock. The company now has 4 divisions. Two divisions are proprietary brands (acquired three and four years ago, respectively) that do both retail and wholesale. These divisions also license their brands for accessories, footwear, furniture, and other products. Then there are two legacy divisions that do more private label wholesale. Manufacturing is basically offshore and sales are mostly US + UK but global expansion is under way. Over the past few years, all four divisions have gone through restructurings. The following trends are nearing completion: shutting low-margin operations in the legacy divisions; switching from domestic manufacturing to outsourcing; shifting from prominent licensed trademarks to proprietary trademarks; moving higher up the value chain. In this post I'll review each division, project its operating earnings; and sum up these parts at the end.

Tommy Bahama

Tommy Bahama was purchased in 2003. It does both wholesale and retail and is now expanding online. There are 74 stores system-wide including 9 “compound stores” which are 10,000sq.ft store-restaurant combos. In calendar Q3, TB’s sales were soft in FL, CA, NV & AZ, which accounts for roughly 2/3 of the company’s retail sales. Also, some big customers have been taking delivery of product later than expected. The company responded by significantly reducing its inventory exposure; it views the quarter as an aberration and is seeing signs of a rebound.

Macro perspective: from a macro point of view they do not see, nor do they price in, a rebound. Still, they don’t except it to get much worse either. I think it’s safe to say that sales receipts in California + other data suggest that the 4 big housing bubble states are basically entering recession. If that recession doesn’t worsen, management is right on. However, if the situation turns in a “consumption depression”, the Tommy Bahama division will under-perform for longer.

On the conference call management said that the last week of September and first two weeks of October were looking good. An increase in gross margins is also helping to cushion macro blows. Last but not least, the company’s been working on brand awareness, organic growth & new store growth and will likely continue to capture market share. I think they can grow sales by 10% on a run-rate basis.

Valuation: past two fiscal years had operating margin of 17% and management indicated it should trend back up to that level. In FY2007 the retail/wholesale mix was 50/50. As retail takes over, the margins should surpass17%. Despite wholesale being reported as stabilized, I assume more wholesale declines – enough to offset all retail growth. So we keep the top line and the op. margins identical to FY07.

Estimated operating income: $82mm

Ben Sherman

Ben Sherman was acquired in 2004. Established in 1963 and based in London, this division designs and distributes branded sportswear and footwear and tailored clothing and accessories. Approximately 75% of top line is in the UK and Europe; 90% is wholesale. Over the past two years Oxford’s management repositioned Ben Sherman higher up by restricting distribution to upscale accounts and attaining higher price points. This turnaround is already proving itself but is ongoing. Customers have been buying slowly, but going forward into the spring there is visibility and results should show up in the numbers. As per the latest quarterly results and also common sense, this division has tremendous operating leverage and sensitivity to the top-line, so their April 10Q should be one of the catalysts to move the stock back up.

Ben Sherman’s retail strategy is to open a small number of stores, in upscale locations - just enough to shape the brand (3 in US, 4 in UK, 6 outlets in UK, 7 licensed stores).

Internationally, Ben Sherman has a manager who just moved to Hong Kong to develop the Middle East and Asia. There are retail partners lined up in almost every country in Europe and in major Far East centers. The company expects a dramatic rollout of Ben Sherman stores over the next 2-3 years. My estimate assumes no such growth, sales at 160mm and operating margins consistent with the past two fiscal years.

Estimated operating income: = $160mm * 6% = $9.6mm

Lanier Clothes

Lanier Clothes designs and markets branded and private label men’s suits, sport coats, suit separates and dress slacks across a wide range of price points. They also make tailored clothing, namely through Arnold Brant which is an upscale tailored brand. The mix is nearly 50/50 between private label and branded products. Five customers represented approximately 70% of Lanier Clothes’ net sales in fiscal 2007: Macy’s, JC Penney, Sears, Men’s Warehouse and Nordstrom.

This division is not doing well. Demand for tailored clothing seems to be in a protracted downturn, particularly at chain stores and department stores. Operating income has been going down hard for a couple of years and the company is responding by increasingly curtailing production. They say this past year has been uncharacteristically terrible (and this is somewhat logical because one of the trouble-causing factors was the Macy’s-May merger) but still, they’re currently reviewing strategic options for that segment and I’ll value it at zero for the sake of simplicity.

Estimated operating income: $0

Oxford Apparel

Oxford Apparel is the second legacy division. In FY07, 63% of business was private label and the rest branded. The company has decided to aggressively cut underperforming lines of business which should take sales to 1/3 of what they used to be. They’ve cut out the first 1/3 (i.e. half of the work) and the other half should be done within a couple of quarters. Operating margins have already gone up from ~4% to 7% and eventually they should be left over with double digit margins. They also think the business can grow from that final basement-level. I assume they’re left over with 110mm in annualized revenues at 12% op. margin.

Estimated operating income: $110mm * 12% = $13.2mm

Sum-of-Parts Valuation

Assuming a corporate/unallocated SG&A of $20mm is used to generate the 4-segment total operating income of $105mm, we have $85mm of EBIT, putting EV/EBIT at around 7.5x. For the equity valuation we shall take into account the recently announced $60mm accelerated share buyback program, which OXM plans to finance with their barely used revolving credit facility. Assuming the entire buyback is consummated, I have interest expense at $25mm and 15.8mm shares left. The company has indicated taxes should come in at 34.5% and so the shares are trading at 9.5x my estimate of normalized EPS.

The company releases its quarterly report tomorrow afternoon. I expect continued weakness in the southwest yet continued progress of the turnaround.

Recessions & The Stock Market

2007-12-12T22:37:00.000-05:00

Well, well... how things evolve... look who's predicting better than 50/50 chance of recession: none other than Morgan Stanley! That's right, a mainstream investment bank! I've already predicted a recession on this blog and I believe MS's peers will follow suit now that Morgan's broken the ice for them.

The rule of thumb has always been that the stock market starts declining 6 months before a recession. Through the past 3 years I've generally held a hunch - not a view, just a hunch - that this time around, stocks will only decline AFTER the recession. We'll soon find out if this hunch is correct but the theory goes like this: P/E ratios are not that crazy; only the earnings are really crazy; since the market is priced on analyst estimates, market prices won't decline before companies spoonfeed lowered guidance into analyst models.

We know revised guidance is issued as companies' business is worsening, with a 1-2 month lag on average, perhaps. So roughly speaking, the equity markets should start declining 1-2 months after the beginning of serious recessionary consequences. We're starting to see nonfinancial companies issue profit warnings already. If this trend is serious, a sustained general bear market could begin in January... but I have no crystal ball.

What to Short

I've never been too fond of my fellow value investor Bill Nygren because of his adherence to the simplistic Fed model, as well as his steadfast belief in WAMU and H&R Block, but recently he made the following very-sensible comment to the WSJ:

"Retailers are one of the few sectors that appear to be pricing in the fear of a recession," says Bill Nygren, manager of the Oakmark Fund. As a result, he believes that the shares are more attractive than other stocks, including many in the materials and technology sectors, whose still-lofty prices reflect little risk that the economy will stop growing.

I agree. I'm short the Russell 2000 growth index. Not really shorting any financials and retailers anymore.

Krispy Kreme's Q3

2007-12-10T19:46:00.000-05:00

As I mentioned in the last KKD-related post, I'm still watching this one. First of all, the rally in the stock price is totally uncalled for. This isn't just a simple dead-cat-bounce. There's got to be some kind of trading program involved. Some will call it "manipulation" but I don't believe in conspiracies unless the evidence is there. Anyhow, if the price of KKD put options further drops, I might just buy them again!

So what can we say about Q3? Articles everywhere point out the "improvement" vs. last year (i.e. the EPS number is higher) but that was just due to various 1-time items! At its core, KKD's rolling EBITDA has once again dropped. It was worse than last year - and this, despite the substantial lessening of corporate overhead. The company-owned wholesale segment is weak: grocery stores are ordering less and C-stores are demanding consignment arrangements. We're still missing wholesale initiatives from Brewster and the retail segment is stagnant too; KKD has now admitted that hub & spoke is the way to go. Ya...we knew that long ago. They’re now converting some factories to satellites (i.e. machinery shut-down) as part of this "new" shift but this gimmick has been implemented by franchisees for 3 years. It's not a long-term plan - it's a temporary plan while waiting to sell the property. Effingham has not yet been sold and its assets were further written down - bad sign. The company made a third consecutive 5mm quarterly debt repayment to stay in compliance with covenants.

Now let's look at franchisee issues. KKSC is out of the business selling equipment to franchisees for profit. This is the first step in what I have always thought could be a return to a quasi-nonprofit status for this sorry company. Not only does KKD lack strategic initiative but they now lack the power to rip-off franchisees. How about franchisee balance sheets? Turns out KKD has no clue how much of KKSF's loans&leases they've been guaranteeing. They keep altering historical numbers dating back to 2006. I estimate they'll be on the hook for 5-15mm in the end. KKD also took full control of Priz, a 1-store JV whose debt it guaranteed. It's just 1 store but it's *yet another* example of a franchisee where KKD had to assume ownership of the full entreprise value (i.e. assume the debt+ take all the [worthless] equity. KKD also wrote off their stake in Kremeworks Canada.

In Japan things look ok but elsewhere in Asia KKD is sending in their own staff (i.e. those franchisees can’t be doing amazingly well). I think that future system size - as well as the stock price - depends on how well international growth goes and how the headlines look like. Post-liquidation KKD will be a true growth stock, and no one knows if the growth will fail or succeed. The ROIC from a specific type of satellite configuration – let alone a type of satellite store, is unknown. Maybe in year 1 it’s known but not in the long-run. You got Honeymooneffects + diet changes + competition + franchisor issues…there’s too much playroom.

Moody’s believes the company will violate covenants during 2008 if things continue in a straight line with no debt repayment. As always, from KKD’s point of view, this continues to be a race: their liquidation vs. franchisee liquidations. Sweet Traditions and KKSF now look awfully close to liquidating fully and I wouldn't be surprised if A-OK ended up with the same fate. But what I'm most curious about is the UK + Australia. If those two implode also, KKD's in a world of hurt. We shall see...

Hovnanian’s Challenge

2007-11-16T13:14:00.000-05:00

Just about a year ago I highlighted homebuilders’ ongoing troubles, contrasting the general bullishness which was led by Citigroup’s Stephen Kim and supported by various other commentators. Since then, builder stock prices are down substantially and CDS premiums in the sector have soared. Some of them are very close to following Levitt into bankruptcy (Tousa, WCI) while others are not far behind (Beazer, Standard Pacific). Today we examine a builder who, many would say, is right at the mid-point between survival and bankruptcy: Hovnanian (NYSE: HOV).

The large homebuilders’ business model has been one of holding land mainly as debt-financed inventory, build on it, flip it & generate a profit while servicing the debt. The HBs therefore cannot afford to let owned land sit until the market turns. They also control land via options but that’s not the focus of this write-up. Upon reflection, the land is an income-generating asset (i.e. its value is the DCF valuation of what can be done with it based on an IRR target or some other discount rate). In order to service their debt in this unexpected bear market the builders must - to an extent - either fire-sale the land to wealthy buyers or flip the lots to consumers via homebuilding. The success with which a builder can do this, as well as its specific capital structure, is what determines survival probability. The big HBs used to all be investment-grade but lately have been downgraded to junk, which changes the available financing options in case of problems.

Update on the U.S. Housing market

Today’s situation in the home market is much different than it was a year ago. Let’s divide home sellers into 3 categories. (i) homeowners (ii) bank REOs (iii) HBs. When a housing bear market starts, prices are sticky on the downside because there’s no desperation (very little REOs + existing homeowners suffer from various psychological biases causing refusal to lower prices). The HBs are the professionals. While they lower prices, they control the pace as long as they respect each other in the marketplace and trail existing homeowners. Plus, they can use incentives as a substitute for price cuts. We saw such a situation in most of 2006. Remember all the talk last year about how HBs are lowering their prices yet still profiting handsomely?

When the market gets worse than this, this situation evolves. The credit squeeze leads to foreclosures and takes away buyers’ capacity to borrow vs. their planned home purchase (especially if we’re coming off of a credit/mortgage bubble of historic proportions). Also, people are unable to move into new homes they want because the buyer for their old home can’t get financing. So volume dries up. In other words, a housing crash is not a price crash, it is a volume crash (i.e. housing bear markets are unefficient markets). But the volume crash turns into a price crash when banks come in with their REOs and compete hard vs. the HBs. Banks don’t play games because they hate owning homes. A recent study found 25% of Las Vegas' bank-foreclosed homes suffered intentional damage, including vandalism inside the house. When REOs and HBs compete, existing homeowners become the dear in the headlight and get left behind with their high asking prices. Eventually this shocks them into panic discounting.

Where are we now?

We are now at the point of a severe volume decline and a small (yet notable) price decline. September '07 new home sales were the lowest September since 1995. At the end of Q3, the Census Bureau reported the seasonally adjusted Months of Supply for new homes was 8.3 months. Adjusting for cancellations, the actual months of supply was 11 months. Sales at HBs currently are typically off 30-60% from last year with cancellation rates of 30-70%. Bear Stearns sees up to 40% of existing home sales from REOs by the end of ‘08, potentially pushing prices down by 15% - 20%. Over the next couple of months, REOs are already projected to take over 50% of the San Diego existing home market. Therefore, we are at the gate of panic discounting, especially in CA, FL, AZ, NV and perhaps NC. In California, existing home sales are typically off 20-50%. Price declines of 7-10% in each of 2008 & 2009 are being predicted by Goldman, MS and others. Indymac also published some pretty bleak 2008 numbers. Anyhow, it now appears that there will be a substantial price crash for a period of 12-24 months, followed by a slower paced protracted decline for a few more years. My bet is that 2008 will be the worse year for housing because I think the most shocking credit contraction action can’t occur over too long a time period, and that it is the main factor.

Our exercise is to consider how HOV fares in this environment. A significant portion of their business is in California, New Jersey, Texas, North Carolina, Virginia, Maryland, Florida and Arizona, so they are exposed to the trends in a big way.

Mortgage subsidiary

A few words about the mortgage sub. From the 2006 10-K: “9.5% of our home buyers paid in cash and 62.9% of our non-cash home buyers obtained mortgages from one of our mortgage banking subsidiaries”. And who buys these mortgages? From the latest conference call: “Chase, Citi and Countrywide. These three institutions collectively purchase 95% of the mortgages that we originated in the third quarter”. So we already see one risk: Citi and CFC both look like they have *some* probability of forfeiting this business, at least to an extent. We know there’s extra risk of this with HB homes due to potential building-quality issues. (By the way, this is not a focus in my write-up but various sources would testify that building quality has been shortchanged during the bubble). So we know liquidity is being hoarded in the banking sector and clearly HOV has had incentives to underwrite aggressively. Did it do so to a significant extent? We don’t know but we know what’s going on at BZH; we also know that PHM has a huge 92% capture rate and here’s an article excerpt regarding two other peers:

"We were told that our job was to control the customer," says a licensed real estate agent who worked 18 months for D.R. Horton's DHI Mortgage subsidiary in Nevada. Buyers who chose an outside lender would lose incentives (such as reductions in their closing and options costs) and would be required to increase their earnest money to $10,000, from $3,000 if they used DHI. The source-who was fired from DHI in May 2004 over what she claims was a dispute about splitting fees with her manager- adds that Horton tied a portion of its divisional managers' bonuses to DHI's capture rate. (Officials from D.R. Horton and DHI did not respond to calls from builder requesting comment.)

Another source, who worked 2 1/2 years as a manager for one of Lennar's UAMC offices in Nevada before she was laid off in October 2006, says the pressure to approve buyers for loans was "overwhelming." That pressure came directly from Lennar's divisional president, "who told us the relationship between the builder and the mortgage company was 'master and slave.'" When this source says she got tougher about qualifying buyers, Lennar removed several communities from her loan office's territory When asked why Lennar would sanction its mortgage subsidiary to approve loans for buyers it knew would not be able to pay them, this source replies, "Lennar wasn't thinking long term; it's a publicly traded company that's judged on how many homes it closes."

So basically, because the home seller in this case is a powerful homebuilder, there’s a chain of incentives potentially linking HB home sales to aggressive underwriting. And we know that warehouse lines of credit are still being pulled away until this day, so this isn’t over (HRB this week).

Also notable is that HOV still holds $163 million of mortgages held for sale despite declaring repeatedly that liquidity is the priority. So it’s fair to assume that the market for these loans is in trouble. Finally, I note that HOV still makes a few arguably risky loans, like stated income loans and 2nd homes with only 5% down. Not the end of the world but…

Management

A comment about management: during the conference call, Ara Hovnanian said the following regarding real estate downturns: “we have been through these before. It is not fun, but we know what we have to do and we're working hard to make that happen”. But earlier on he says “we did not see it coming”. Well… they didn’t see it. This is supported by their ramping up of land acquisitions late in the bubble, especially the Fort Myers, FL acquisition in 2005 which is discussed also in the call. (about 7% of their lots). Management’s casual attitude only increases the chance we’ll see more liquidations which benefit creditors at the expense of shareholders.

Land value

What ultimately matters for homebuilders is land value. As we said before, the value is measured by how much profit you can make off of it, which in turn depends on how bad your liquidity situation is. We will get to the liquidity soon. Here’s a passage from Big Builder Magazine:

For the quarter ending Aug. 31, Lennar wrote off deposits and pre-acquisition costs on 15,000 home sites it no longer plans to buy. That adds up to a total of 24,000 home sites the company has abandoned in the first nine months of this year.

"We look at costs to develop a parcel of land and actually develop home sites and include in that the cost of building a home, and you get to the point where the residual value of the land itself–even in well located areas–is close to zero," says Lennar CEO Stuart Miller.

"Lennar has mothballed some large projects because the effective result of selling currently implies the land has zero value," says Stephen East, an analyst with Pali Research. "It also provides the company some accounting breathing room. By mothballing the projects, LEN is able to avoid taking impairment charges on the land that would reduce the value effectively to zero."

Of course, HOV’s land isn’t necessarily worthless. HOV’s owned lots were about flat - around a 33000 average - over the past 2 years. There was no liquidation urgency until this summer. From the CEO: “We made significant investments in Florida in 2005, primarily in Fort Myers, and we are now paying a price for the poor timing”. Land has carrying costs, even before interest. Another problem with land is that neighboring parcels purchased by vultures put you at a huge cost disadvantage.

Builders value land at lower-cost-or-fair-value. Recently HOV had about 3.4B of straight-owned inventory vs. 1.2B in October 2003. We know that various sources and industry observers that back-of-envelope calculations point to prices as “fairly valued” sometime in 2003. Here’s a crude calculation: the Case-Shiller composite went up about 50% since October 2003 (i.e. needed to decline 33% in real terms). From various sources, it seems a good rule of thumb is that the amplitude of land price fluctuations is at least double that of home price fluctuations. So what’s going on in the land market? Some insight from Ara Hovnanian:

“On a brand new deal that hasn't been sold, land prices have not come down; they have come down but not nearly enough to make new acquisition sense. That's why you haven't seen much new activity in that regard. However, if there is a community that's under development and the properties already under option and it's proceeding but prices fall, in many cases the sellers are absolutely willing to discuss price and lower their price. Obviously we're only proceeding if they are willing to lower it sufficiently to get to a price that makes a reasonable return for us. It's getting more and more challenging without a doubt as the market deteriorates, but we're sticking to the discipline”.

This means land is likely to decline 50% from current levels, at least. If HOV was a pure land company it would eliminate HOV’s equity very soon but HOV is still successfully flipping land to consumers in the form of homes. Plus we haven’t even gotten to comparing entitled & unentitled land (HOV buys mostly entitled). By the way, HOV has not conducted a material amount of land sales.

Liquidity situation

Hovnanian claims that its liquidity situation is more than manageable (forecasts it will be cash flow positive in 2008) and this may be right but it wouldn’t imply anything regarding residual equity value.

This recent street.com article discusses the z-score of big HBs. As you can see, HOV’s score is pretty low. Those who have been following the sector will notice that there’s a reasonable correlation between the z-score, the stock prices, the news flow & the general situation of the builders in question. The main reason for HOV’s low score seems to be its elevated debt levels. Debt to total capitalization has been in the high 50’s for them which is among the highest in the peer group. Average is in the 40’s.

Would banks take big actions here? We know banks have been quiet until now but as soon as there will be a foreclosure on a big builder, other banks will notice and think twice about leniency. No one wants to be left holding the bag. This is similar to how foreclosures on wholesale lenders were first conducted only by Merrill Lynch, but later all banks did the same. Banks might also need to call in loans from speculators who bought/entitled land. The question is: what would banks actually do with the land? Plus, HOV is not violating covenants for now so it’s not the main focus.

HB Economics, Book Value and the “Deal of the Century”

Keeping in mind that building homes (and in many cases spec homes) is the best way to flip the land, let’s go through some quickie calculations of what HOV’s balance sheet is up against.

HOV’s average home price is around 350k. Developed lot cost is 25% of that. The cost to build a home on top of the lot and otherwise conduct operations is a little under 75%, leaving HOV with 1-2% margin. Note that prior to the tough times they had low-mid teen margins. They might eventually find a way to squeeze out a few hundred basis points but they aren’t promising anything (see the call’s slides for margin figures). The important thing is that HOV is obligated to pay its workers, its materials suppliers, etc’, so the cost of operations is fairly constant if you believe in an unrelenting bear market.

Therefore, as we enter these difficult times, if HOV discounts the price of the home and loses money on it, they’re essentially losing that money on the land and not the house. Since the land value is 25%, the land exposure is leveraged 4:1 vs. the ultimate home price! A 25% haircut to the home price wipes out their investment in the land.

HOV’s owned lot inventory is roughly 30,000. Recently HOV conducted a nationwide fire-sale of homes called “Deal of the Century”. The discount on these homes was typically 15-20% and they generated over 2,100 gross sales (1,700 contracts and more than 400 sales deposits). So the majority of these buyers didn’t even put a deposit yet! Cancellation rates lately have been 40% and contracts without deposits should have way higher cancellations - it’s got to be above 60%. In other words, despite all the rah-rah about this huge liquidation they’re promoting, we’re talking about closing only 1-3% of their lots.

Based on HOV’s owned land history and what we know about land markets, I’d ballpark their average land age at 3 years. So in theory let’s say all owned land was bought in fall 2004 and booked at cost. This land was selling for about 50% more than that at the top of the bubble and now prices are coming down.

Up until now, HOV's average home price has been 350k and the margins net of segment SG&A have come down to 1% despite the land being expensed at its 2004 prices. If it were to conduct a fire sale on its entire inventory at prices corresponding to what consumers can really afford (i.e. fair value of houses, i.e., a 25% discount of 90k) they would wipe out all land value.
But let’s be a bit more realistic and assume “deal of century” type figures. A 14% discount (roughly 50k) on the entire inventory of 30k is 1.5B of losses (or write-downs prior to transactions; however you wish to call it) leaving them with only 10% of their current book value. No one says this will happen. As a matter of fact, they’ve got a backlog for 6000 homes and in Fort Myers they’re doing block transactions. But the point is that there’s a good reason why HOV trades at 36% of book.

HOV will generate 25% cash-on-cash return (and, maybe 10-15% in a really bad case) in the HB business, but that represents losses on the land or break-even at best and the cash is used to service & repay debt. It isn’t accumulating into equity. In the meantime, any incremental discounts are hurting equity holders while pleasing creditors. Any panic on the part of the builders leads to this outcome as well. And by the way, back when the HBs were madly buying back stock using their free cash flow, they were basically returning capital to shareholders who agreed to be taken out, while giving exiting shareholders a bigger share of their illiquid book value (i.e. land minus liabilities). Although, there is definitely some earnings power there for the next boom, that is undeniable.

It will be interesting to see how much common shareholders will be left with vs. today’s market cap. My bet is “less”.

Separating from Krispy Kreme

2007-11-02T02:09:00.001-04:00

And just like that, with circumstances and market prices being what they are, I decided to sell my remaining stake in Krispy Kreme put options. Holding them with current parameters is unlikely to yield very attractive results given the risks and opportunity costs. Shorting the stock outright, though, should be easy and smart. All you do is sit and wait as franchisees close more stores and the company reports more horrible numbers. Why so easy? Give credit to the magician pictured on our left, Scott Livengood. Personally, I barely ever short outright - due to well known mathematical reasons - but I'll probably write and think about KKD.

Following and analyzing Krispy Kreme's problems for three years has brought tremendous future value for my career. The lessons learned about options trading are bringing unprecedented portfolio stability, substantial profits and the potential for more. The other benefit was building knowledge and wisdom: capital allocation, appreciation of unknown unknowns, corporate governance issues, relevance/irrelevance of small-fact analysis, NYSE and SEC regulation, franchise law, bankruptcy law, securities law...

Interestingly enough, last week, on the day I sold my last chunk of puts, it was announced that our central KKD store in Montreal is shutting down. And two months ago, I conveniently learned of the stock's crash at the onset of a day at the beach. It's almost as if this separation process was destined from the beginning to go smoothly. So despite the hardships of shorting this stock for three years and despite the psychologically painful downward pressure it had exerted on portfolios I manage, the whole thing ended with profits and satisfaction.

Thank You, Ambrose

2007-10-26T15:48:00.000-04:00

Ambrose Evans-Pritchard has just written a simple yet elegant sentence which I feel compelled to paste in my blog:
"If you are a bear, you must accept that you will always be wrong in polite society, and you will continue to be wrong all the way down to the bottom of recession".

More Macro-Economic Predictions

2007-10-21T14:51:00.000-04:00

As most readers already know or have discerned from this blog, I am a classic value investor (i.e. my investment methods and views generally stem from Warren Buffett, his partner Charlie Munger, his late mentor Ben Graham). During the liquidity bubble of 2003-2007, a lot of value investors, frustrated by the lack of bargains and low volatility, decided to spend time analyzing the reasons behind this lack (i.e. macro-economic analysis). It felt weird to do this because value investors have historically regarded macro research as a waste of time (and I do too, when it comes to stocks that are barely affected by the macro factors). Regardless, things eventually got to the point where I built myself a macroeconomic knowledge base and, much more importantly, defined my circle of competence. Over the past four months, substantial monetary gain has resulted.

In the past I've discussed my investments discretely; in this post I'd rather give a fuller flavor of how I think.

So I took most of my summer profits off the table during August (put options on BKUNA, BAC, GS, JPM and a few other stocks). A good portion was reinvested into other puts (Krispy Kreme, bankrate.com and a bit more) as well long stock positions. Most of the longs are trading at or below liquidation value. There’s also a litigation play, a management turnaround and Berkshire Hathaway. I hold more stocks now than at any time in the last three years and look forward to eventually allocating [almost] all my capital to long positions. In the meantime, though, I continue to be very confidently macro-bearish. Two weeks ago I began identifying a third set of shorting opportunities.

It’s time to aggressively buy puts again, not simply due to timing but also pricing (stock valuations and implied volatilities on the options). I’m bearish on a broad range of stocks. I shorted a financials index, a consumer index, a homebuilder and a few recession-sensitive stocks. In every case, valuation is of primary importance but catalysts drive the decision to transact. The right way to short is sticking to defined, limited bets: my bet is consumer recession in the U.S. and a continuing crisis in modern finance. I'm not yet betting on an emerging markets crash, a commodities crash or a dollar crash. These are issues which I view as more open to debate (said differently, outside of my circle of competence). And actually, I bought call options on certain commodity stocks as a hedge against monetary inflation (read: Fed rate cuts) hurting my bets. The market has already begun to go my way. Last week’s SIV fears sent the ABX indices plunging, junk debt down hard and CDS premiums up to August levels. Hopefully this will continue.

Here are the predictions I made in Mid-June after the Bear Stearns saga:

I predict a CDO market slowdown will lead to a couple of pending LBO deals breaking apart. I predict some people with minimal exposure to CDOs will sell them and force mark-to-market revisions for the major players. I predict funds of funds and other hedge fund clients will ask for redemptions, leading a few credit hedge funds to seize up. I predict margin calls and tightening by such hedge funds' creditors, with creditors taking over funds and/or liquidating their assets. I expect all this will negatively impact commercial and residential real estate, as well as corporate loans in the U.S. and western Europe. I also predict a few other broker-dealers going bankrupt. Less certain predictions: Yen and Swiss carry trades reverse; short squeeze in both of these currencies. Greater velocity of CDO downgrades.

Except for broker-dealers going bankrupt, every single prediction has come true. What I did not foresee is that they'll each happen within a mere four months. Stunning.

With the above discussion in mind, this is a logical time to once again put myself on the line and make new macro predictions. So here’s what I expect for 2008:

- A U.S. recession declared sometime during the year

- California and Florida housing markets nearly freeze up (sales volumes down 70-80% in many places). Following this shock, REO and homebuilder inventory gets fire-sold, dictating market prices to existing homeowners. Foreclosures and REOs continue to surge.

- An effective super-SIV will not come to fruition and in 6-12 months the issue will be forgotten and replaced by greater problems.

- The big investment banks' credibility in the marketplace will get so stretched that they'll relinquish any efforts to circumvent write-downs. Instead we’ll witness a transition to conservatism and honesty (i.e. mark-to-market adjustment galore). It’s important to remember that their CEOs aren’t the lame stock-option-obsessed types. They care about long-term reputation and long-term value creation.

- At least one big mortgage/credit insurer will fail (just for fun I’ll predict MBIA or Radian) and at least 3 big homebuilders will fail. I pick LEN, SPF, KBH, BZH but it’s a crap-shoot because homebuilder risk factors are manifold: leverage, geographical concentration, credit rating, accounting reliability, capital structure, quality of homes, manner of dealing with lawsuits and complaints, demographics served, management dedication, quantity of land on books and more.

- Many hedge funds will seize up (either collapse or prevent collapse by freezing redemptions). Many funds of funds will also collapse; de-leveraging across the board. The industry will earn a reputation for illiquidity, thus scaring away lots of pension funds. Ironically, fund managers who perform best will be scrutinized more than boring funds regarding liquidity issues, because consultants usually regard risk & reward as a couple. The consequence: unsexy hedge funds will become sexier than sexy hedge funds, thus rendering the entire industry boring and partially irrelevant. Still, I believe there’s room (and I hope regulators will leave room) for new hedge funds who want to open small-medium operations and make money for REALLY QUALIFIED investors without too much government scrutiny.

We'll see how my predictions fare this time… I doubt it’ll be a perfect score.

Krispy Kreme Finally Admits Failure, Stock Tanks

2007-09-14T03:22:00.000-04:00

The answer to my previous post's title is "Yes". Three years after Livengood was kicked out and Krispy Kreme's board took the direction of selfish needs vs. turnaround, the company has admitted that its factory store business is unviable and the stock is down over 50% during the last week. Referring indirectly to problems at ST, GCFF, A-OK and WD, they stated franchisees are in growing trouble. As speculated in my last post, they are selling Effingham, closing stores and liquidating debt. The market got the message and analysts downgraded the stock, which now sits just over $3. From this point forward, KKD will be valued with skepticism. For example, at 6x TTM EBITDA of $25mm minus $50mm of net debt, the valuation of the stock would trade at $100mm (about $1.50 per share).

But the value of the stock is much less than $100mm because sustainable EBITDA is in the $0-10mm range. We should note that when a stock drops below a $75mm market cap, it violates NYSE listing standards. So I forecast that over the next 12-24 months we'll see Krispy Kreme become a delisted penny-stock.

None of this means that 100 southeast stores will not still make a profit.
None of this means that international markets will not continue to expand.
None of this means that some franchisees won't survive or even take control.
None of this means that Krispy Kreme doughnuts aren't amazingly tasty.

What it means is that valuation is valuation is valuation. Stocks gravitate to their real valuation. After seven years of Brewster-Cooper-Livengood-BOD smoke-screens, gravity has worked for KKD.

Krispy Kreme Surrenders and Liquidates?

2007-08-24T22:02:00.000-04:00

Today’s news out of Winston-Salem might be the long-awaited surrender (I said *Might* hence the question mark). It seems KKD’s board of directors pulled the plug on an attempted turn-around of its company-owned store segment and/or a decided to pay down debt in serious doses. In a word: liquidation.

To perfectly understand KKD over the past three years has implied being an insider, which I am not. My thoughts as an involved outsider: take the words in today’s PR seriously and slowly. Brewster used the word Restructuring rather than the word Turnaround, which he has so far used extensively. His dichotomization of the US into southeast + non-southeast is even more telling. That should send the same shock waves Stephen Cooper sent in December 2005. There’s a difference though: this time it’s for real; this is an official KKD press release; Jervik - the retail guy - is out; the BOD has spoken and they chose to keep Brewster - the wholesale guy.

So what’s next? The press release already refers to layoffs at HQ. We'll probably see a Manufacturing & Distribution facility close. The 143,000 sq.ft. Winston-Salem facility could shut down with coffee roasting being outsourced and M&D consolidated at Effingham. Alternatively, they could close Effingham. This makes more sense given the new southeast focus, the ongoing franchisee liquidations and the extra value of Effingham to a buyer vs. to value to KKD. Many company-owned stores will be liquidated in my view - at least 20-30 over the next few months. Krispy Kreme will have to hand out discounts if it wants expedient liquidation. I wouldn’t be surprised to see a mass-transfer of retail property to Chick-Fil-A or a similar party. There are about 15 owned properties outside of the southeast and many more leases. All in, the proceeds should fall in the $30-60mm range. I previously estimated Effingham could fetch 21.5mm. Adding an estimated $15-20 of unencumbered cash, it looks like KKD could liquidate at least half of senior debt if they do this right. It's possible this whole process continues to happen at a snail’s pace (which in the long run is more damaging to going-concern value but better for liquidation value) but I still sense a meaningful change today. Krispy Kreme is now officially tied-up in continued shrinkage. Brewster's mediocre turn-around efforts have failed.

A Glance at Google

2007-07-16T22:25:00.000-04:00

It seems the world will forever debate the durability of Google’s competitive advantages. I recently had the chance to examine the company’s prospects and attempted a back-of-the-envelope valuation. This post is a condensed summary of the main factors affecting its future.

Management

As Yahoo’s 'Peanut Butter Manifesto' confirms, Google’s management of human resources is a strong advantage. The founders’ determination to stay involved full-time and enforce the “innovation from chaos” pet-project approach has resulted in significant out-performance. Even Bill Gates has admitted to underestimating Google. Nevertheless, allegations of self-righteousness and revelations of chaos’ side effects have somewhat tainted the company’s reputation. Notably, these risks were exposed following the termination of blogger Mark Jen. Finally, management’s capital deployment skills are relatively unknown, whether in terms of acquisitions, organic growth or return of equity capital.

User Applications

Google expands mainly by cross-marketing its web sites and software. For instance, software vendors distribute its search toolbar, which drives users into Google’s search site, where users are introduced to additional services (e.g. Google Maps, Google News, Blogger). The company conducts these activities in the scale that it does thanks to their server-farm network and its 500,000 PCs. The barrier to building such a network may only be cleared by a few large companies (e.g. IBM, Microsoft, Yahoo).

The software itself is another advantage: ‘Google’ has become a verb; YouTube and Blogger dominate their space and Gmail’s advanced features and spam filtering beat Hotmail and Yahoo Mail by any measure. By controlling prime internet real estate, the company has the potential to create new advertising markets and immediately dominate them. Such disruption has been met with inadequate reactions (e.g. Microsoft’s Project Underdog). Anecdotal evidence suggests that countless software ideas are regularly scrapped for fear that Google will copy them.

This edge, however, is weaker that the server clusters. There are virtually no switching costs for users. All that stands between competitors and Google is creativity and ambition. For example, Clusty’s categorized search results reduce the time to find a desired result from a linear scale to a logarithmic one. Google’s system may be too large to transition to such a model. The company also lags in some categories, notably online shopping and customer database formation. Dominating certain categories may require expensive buyouts, as illustrated by the $1.65B YouTube merger. Furthermore, gaining market share in intensive workstation-based applications such as word processing will depend on the trend toward server-centric computing.

Advertising

Google’s main source of revenue is AdWords, its auction-based advertising platform. Advertisers pay on a cost-per-click or cost-per-impression basis. Technology and HR constraints have made the ad network industry an oligopoly including Google, Yahoo Search Marketing, MSN AdCenter and to a lesser extent, Looksmart and Adbrite.

Each of these ad networks gets two forms of traffic: natural traffic (i.e. queries performed on their own domain) and third-party traffic (i.e. queries originating from portals, meta-search sites and domain name squatters). Natural traffic is inherently higher margin to the networks because the traffic acquisition cost (TAC) is negligible. Goggle’s leadership in consumer applications, gives it – by far – the highest volume of natural traffic. Yahoo And MSN have less and the rest have almost none. There are also second-order benefits to having high natural search volume. For example, users who perform natural searches tend to be savvier and more intent on buying. Ad clicks and ad impressions, therefore, are not commodities. The aggregate value of a click on google.com (i.e. to itself, its distribution partners and its advertisers) is higher than that of a comparable click on yahoo.com.

Advertising expenditures on the Internet are only 6% of the total. This compares to the approximate 25% of consumer media time that is spent online. With that in mind, a potential future integration of dMarc and YouTube could take AdWords to a whole new level. Blogs may also be tapped for their unprecedented degree of demographic segmentation and marketers are waiting impatiently for ad networks to address this increasingly important channel.

There are challenges as well. It isn’t clear that Google can continue to be everything to everybody. As advertising prices rise, those who are outbid for common one-word or two-word search strings explore other avenues. New entrants may appeal to them and create niches. Another trend to watch is whether the company will have to agree to more minimum revenue-share guarantees similar to last year’s guarantee deal with Fox Interactive Media.

Valuation

The crystal ball is murky on Google so let’s look at the best-case and worse-case valuations (within realistic boundaries). This unpredictability also calls for a relatively short break-out of pre-terminal-value cash flows. I used 4 years (2007-2010) with a terminal value of 20x EV/FCF.

I assumed the following:
- Top line growth rates for 2007-2010: worse case: 50%, 35%, 30%, 20%; best case: 50%, 50%, 50%, 50%. Growth rate of 10% thereafter.
- $11 Billion surplus cash & marketable securities: return to shareholders in year 0
- Discount rate: 10%. Effective tax rate: 30%.
- 310 million shares currently outstanding
- GAAP options compensation stripped out and share count increased by 12 million options exercisable at $200 per share

The following data is derived from the past 3 years:
- TAC as % revenue: worse case: 39%; best case: 31%. Other COGS: constant at 10%.
- R&D as % rev (ex-stock-based compensation): worse case: 8.9%; best case: 7.1%
- SG&A as % rev (ex-stock-based comp): worse case: 6.2%; best case: 4.3%
- Marketing as % rev (ex-stock-based comp): worse case: 7.8%; best case: 7.5%
- Cap-ex as % rev: worse case: 20%; best case: 10%
- # options granted annually: 1mm to 2mm. Strike price: $200 to $400
- Proceeds exercise of options: worse case: $300mm, best case: $500mm

Combing all worse-case variables cited above, we get a value of $132 per share.
Combing the best-case variables yields $588 per share. GOOG trades within that range and is likely not wildly overvalued. At this point, I would hold off buying the shares and sell half Had if I owned them.

Liquidity Bubble R.I.P. 2003 - 2007

2007-06-28T11:42:00.000-04:00

Over the past four years we’ve all been studying a new, unusual macroeconomic environment in real time. Tough always convinced that a massive bubble existed, it's been fascinating to learn about its exact nature. Hopefully, the friends and acquaintances who were lectured washed-down explanations learned valuable lessons about financial bubbles and the madness of the crowds. Not so in every case, though. Last night I learned that a 23 year-old family member (student) thinks she and her boyfriend should buy a $600,000 condo.

Soon, such irresponsibility will recede.

During the past three days it’s become clear that the Bear Stearns saga & Blackstone’s IPO will mark the top of “The Great American Debt Bubble”. Like 1989’s Burning Bed and 2000’s AOL-Time Warner merger, the history books will remember these events for having embodied the spirit of excess. The arrogance of an Internet start-up swallowing an established media giant is very well matched with that of an investment bank falling victim to its own deception, or an LBO shop ironically taking itself public.

Here are very fresh quotes by prominent people who have come out in public:

Eric Mindich, the chief executive of Eton Park Capital Management ... said the "day of reckoning" may be here, in reference to recent problems in the securitized debt markets. "There's dry timber out there," Mindich said at the Wall Street Journal Deals and Deal Makers Conference on Wednesday. "There are people's lives that are going to be changed by what happens."

“If every CDO [manager] was forced to mark to market their subprime holdings, it would be – well, I can’t think of a strong enough word to describe what it would be,” confesses a US policymaker.

The glut of credit in global financial markets, combined with excessive leverage, could all “end in tears” when a big transaction finally goes wrong, Stephen Green, chairman of HSBC, warned on Wednesday. In an interview with the Financial Times, Mr Green admitted that he was “worried by the degree of leverage in some big ticket transactions nowadays” and felt that “something is going to end in tears”.

Icahn, who is known for pressuring companies for strategic and management changes, said "I think it's peaked," referring to the private equity boom.

The credit rating companies ``were downgrading hundreds of these CDO structures in the last few weeks and that is an early indication of being fooled,'' Gross said in an interview today. ``We can see certain structures rated investment-grade losing much or most of their money over the next six or 12 months.''

Planned sales of collateralized debt obligations backed mainly by subprime mortgages are drying up and may shut down amid concerns about the integrity of the market following the near collapse of hedge funds run by Bear Stearns Cos., JPMorgan Chase & Co. said. The amount of U.S. high-grade, structured finance CDOs that are being offered to investors has plunged to $3 billion, from $20 billion a month ago."We expect events surrounding warehousing liquidations last week to further slow, if not halt entirely, the new issue market," JPMorgan analysts led by Chris Flanagan in New York said in the report.

The Bank for International Settlements, the world's most prestigious financial body, has warned that years of loose monetary policy has fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood. The BIS said China may have repeated the disastrous errors made by Japan in the 1980s when Tokyo let rip with excess liquidity."The Chinese economy seems to be demonstrating very similar, disquieting symptoms," it said, citing ballooning credit, an asset boom, and "massive investments" in heavy industry.

Why Are U.S. Stocks Trading at Seemingly Reasonable P/Es?

So in this final post on the liquidity bubble, I attempt to answer the difficult question of U.S. equity valuations. Many bulls argue that the S&P 500 is attractive at 16-18x earnings because it isn't at the nosebleed levels of other markets (Kuwait, China, Brazil, Poland, Greece, Israel, India, Venezuela… you name it). I begin by asking: are we sure that current earnings levels are sustainable? After all, is it really possible that worldwide arbitrageurs haven't yet noticed that the most liquid, reliable, admired market is so cheap? Bulls argue that everyone is needlessly bearish on the U.S. economy. Impossible: cap rates across the country are at 5%, 4%, even 3% and bond yields have been low thanks to minimal credit spreads tacked onto ~5% treasury yields. Economists and institutions are sanguine when surveyed. Aware that I sound like the proverbial economist spotting a $5 bill on the floor, I think there's a catch.

On April 9th I posted thoughts on credit’s role in propping up housing. Namely, the argument was that the housing market allows itself to be dominated by the mortgage market near peaks. Recently I’ve been going through a similar thought process regarding the stock market’s benign valuation. The market has had a nice run but earnings keep on climbing along, fixing P/Es in the 16-18x region.

My answer is simple: U.S. stocks have a special relationship with the debt bubble. Here’s what has taken place:

1) Over the past four years, aversion to stocks and ‘risky’ investments has created attraction to presumably safe fixed-income investments. Further, it has created an attraction to the presumably market-neutral hedge fund industry, much of which lives off various forms of fixed-income arbitrage and derivatives trading. Asset gathering is also key.

2) This attraction to fixed-income combined with abundant liquidity from various sovereign sources created a massive desperation for money to be deployed in fixed-income - even at ultra-low credit spreads. Adding these spreads to low interest rates (LIBOR, treasury or “carry-trade friendly” currencies) resulted in a cost of debt much cheaper than before. Therefore, American companies, either on their own volition or with the extra push of interested parties (investment banks, rating agencies, ‘activist’ hedge funds, private equity shops) replaced higher-cost equity capital with cheap debt capital. This came in various forms: debt-financed buybacks, LBOs, special dividends.

3) In most of these cases, the reduction in shares outstanding more than made up the extra financing costs. Is it also notable that since just the beginning of 2007, 30% of all U.S. leveraged loans were ‘repriced’ at lower rates, which is further accretive to per-share earnings. But these companies are not in paradise. If the cost of debt were to rise in the future, earnings would be negatively impacted.

4) U.S. corporate profit margins are at 8-9%: near all-time highs. The long-term average is about 5-6%. By returning to that range, earnings would be negatively impacted.

5) Approximately 30% of the S&P 500’s earnings come from the financial sector. In the 1990’s the 30% level was claimed by the tech sector and in the 1980’s it was oil. In both of these cases we had busts. As the liquidity bubble bursts, the financials will also bust and will cause the S&P 500’s earnings to be negatively impacted.

To summarize: American stocks are in fact as overvalued as many international markets. However, because *American* public companies have taken advantage of cheap debt more than others, and because *American* multi-billion dollar financial service companies are profiting off of this boom unlike other banks, and because *American* profit margins are higher than in other countries, it is *American* stocks, and not international stocks, which have successfully camouflaged overvaluation. I suspect *American* earnings will decline more substantially than those across the globe and for this reason, I expect an alignment with global P/Es and a bear market whose order of magnitude is the same – and not lower – as in other countries.

For reference purposes, here’s a review of my other posts regarding the bubble: I first wrote about the liquidity glut in my welcome post, focusing on junk bond spreads. Coincidentally, I felt an urge to highlight the growth in CDOs. I also discussed the lack of volatility and its correlation with the Yen. I finished 2006 with a post about homebuilders, a recommendation to short JPM, BAC and GS and a more detailed look at Goldman. These positions are finally starting to go our way. The year 2007 began with subprime breaking down. New Century is bankrupt, Fremont is in the process of reincarnation. What a disaster! And then, the “hard landing of 2007” hit us in the face: a Bear Stearns fund dependent on subprime CDOs, low volatility, stable housing market, cheap debt financing and investor confidence, suffered margin calls by a fellow investment bank. Talk about compounding risk factors!

Hopefully making money on short positions will be easier from this point forward.

Derivatives Pile-Up Closer Than Ever

2007-06-19T15:18:00.000-04:00

Warren Buffett’s derivatives warning is staring us right in the eye this morning. Bear Stearns - victim of its own greed - has stumbled. As I write this, lawyers, traders, bankers and accountants are considering a bail-out of the Bear Stearns High Grade Structured Credit Strategies Enhanced Leveraged Fund. Reliable sources predict that a failure would trigger a tsunami of market-to-market revisions (and credit rating downgrades) on various subprime ABS/CDO tranches. Margin calls would magnify this experience. Hedge funds would go bankrupt. Before delving into details, let’s review portions on Warren Buffett’s derivatives comments in his 2002 letter:

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market […] and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. […] I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both).

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

It’s worthwhile to convert this explication into “hedge fund language”. The words ‘company’ and ‘corporation’ in the paragraph above should be replaced by ‘fund. I think anybody that’s been watching the securitizations market (both for private mortgages and corporate debt) will agree that the moral hazards Buffett discussed are now omnipresent, mainly spread through the greed of credit rating agencies and investment banks. A recent Bloomberg article elaborates on the problem:

"As regulators, we just have to trust that rating agencies are going to monitor CDOs and find the subprime,'' says Kevin Fry, chairman of the Invested Asset Working Group of the U.S. National Association of Insurance Commissioners. "We can't get there. We don't have the resources to get our arms around it.''

Joseph Mason, a finance professor at Philadelphia's Drexel University and a former economist at the U.S. Treasury Department, says the ratings are undermined by the disclaimers. "I laugh about Moody's and S&P disclaimers,'' he says. "The ratings giveth and the disclaimer takes it away. Once you're through with the disclaimers, you're left with very little new information.''
"It's important to understand that unlike in the corporate bond market, in the securitization market, the rating agencies run the show,'' he says. "This is not a passive process of rating corporate debt. This is a financial engineering business.''

Credit raters consult with bankers in determining the makeup of a CDO, and banks make the final decisions, says Gloria Aviotti, Fitch's global head of structured finance.

Therefore, if a hedge fund’s creditors would decide to liquidate illiquid tranches of CDOs, substantial price declines will lead to mark-to-market revisions, and therefore more liquidation, at other funds. As explained in Roddy Boyd’s article today, Bear’s troubled fund could be the event-triggering fund. Merrill, as creditor, was ready to liquidate some seized assets yesterday. They’ve now given Blackstone a chance to orchestrate a happier ending:

The fund's creditors are listening to a proposal from fund management and Blackstone today designed to avoid the fund's collapse, presumably involving the combination of a cash infusion and a margin call moratorium.

Senior Wall Street bond executives familiar with the Bear fund's collapse are afraid that if it liquidates the balance of its holdings, "we are going to see billions of dollars worth of losses across hedge funds and dealers," according to one executive.

But the story’s background is more complex. The fund’s strategy consisted of going long various CDO tranches while shorting various ABX indices. Many other hedge funds had used the exact same strategy. Some of them were recently complaining about losses due to the ABX’s ‘failure’ to decline, alleging upward manipulation of the indices by someone who wrote billions in ABX insurance and wanted to prevent having to pay out losses on its bets. And who was the accused? One Bear Stearns!

In other words, the Bear hedge fund is potentially in trouble as result of greedy manipulative behavior at another Bear division! Having put both hands in the cookie jar at once, Bear has inflicted pain on itself.

Bear’s exposure to the subprime mess is more multifaceted: in addition to EMC and ECC related troubled, they’ve recently proposed an IPO of Everquest, which had shaky loans taken directly from the collapsing hedge fund. As of today, there seems to be some decent chance this IPO will fail, further exacerbating Bear’s exposure.

It looks like most of Wall Street wants to make an effort to prevent an across-the-board derivatives portfolio revaluation and a potential freeze-out in credit derivative markets. The proposed plan is for Bear itself to put up $1.5B and other banks to add more, and that effort may succeed. But what if more funds get in similar trouble? Will investment banks and powerful private funds diffuse every single time bomb that comes up?

I predict that even if the Bear fund is saved, authorities will try to engineer a controlled “soft-landing” of leveraged CDO positions and commensurate downgrades by rating agencies. In other words, disaster or not, the days of CDO glory are probably behind us. Warren Buffett’s prediction, which I have seen being dismissed countless times, is finally undismissible.

KKD’s First Quarter: Run-Rate EBITDA now $20 - $25 million

2007-06-06T00:46:00.000-04:00

This review of Krispy Kreme's Q1 of FY2008 is best read in conjunction with my previous writings on KKD, notably my review of Q4 FY2007, that of Q2+Q3 FY2007 and that of Q1 FY2007, which is the quarter ending April 2006.

Q1 was just as horrendous as Q4 from both the franchise and company-owned standpoints. KKD suffered permanent damage as assets were sold to satisfy $7mm of senior debt. This is no surprise, as EBITDA covenants would have otherwise been violated. Only a couple of months after the refinancing and the expansion rah-rah, KKD’s talking about re-franchising and shutting stores as a way to de-lever. They wrote off assets corresponding to some acquired AD franchisees and are getting ready to shut the corresponding stores (I’m guessing Montreal and North California, where the ratio of factory stores to population is above that of comparable markets). The company may also want to perform sale-leasebacks. Such actions put them on the slippery slope of replacing financial leverage with operating leverage. Since EBITDA in Q2 will likely be very ugly, more liquidation decisions are likely taking place already.

Let’s compare the results to tidbits from my past posts (which are in italics):

For Q1, the segment's adjusted EBITDA pre-overhead was 7mm

That was the company-owned segment for Q1 of last year. The figure was followed by 2.7mm in Q2, 5.9mm in Q3, 3mm in Q4 and 3.3mm for the just-ended Q1. The deterioration since Q4 is corroborated by qualitative evidence and one may assume this year’s Q2 and Q3 will deliver more of the same. Assuming an EBITDA of 3mm below last year’s levels in these quarters, the segment is on track to do zero in Q2 and 3mm in Q3. Assuming things stabilize where they are, that would imply a run-rate EBITDA of 9mm. Deducting 25k cap-ex per door, we’re left with 6.5mm in segment FCF.

My best guess: margins will stay in the [-2%,+2%] range (i.e. less than 6mm annualized).

This guess was in reference to the company-owned store margins, but with D&A instead of cap-ex. To compare apples-for-apples, we deduct 14-16mm depreciation from the 9mm above number, which gives us NEGATIVE 5-7mm. This is at the most bearish end of my prediction.

By the way, the 0.1% same-store sales figure doesn’t mean much. Franchisees are a more reliable indicator of SSS progress because they’re actually focused on profitability and they’re doing -2.4%. Besides, the inflation rate has been much higher than 0.1%.

The KKM&D segment (now renamed to KK Supply Chain) is also getting weaker. From an average of 9mm in the first 3 quarters, its EBITDA declined to 6mm, due mainly to lower margins.

This was a review of FY2007 figures. In Q1, KKSC did 7mm and that includes over 1mm worth of one-time international equipment sales. Therefore, it appears 6mm will be the quarterly run-rate.

EBITDA Estimate

To estimate run-rate EBITDA for the entire company we can use a method similar to that from last quarter. I will take Q4 + Q1 and multiply by 2. As discussed above, Q1 is much more representative of the new reality than Q3 was. Note that - once again – some conservatism is implied because Q2 is weaker than the other three quarters. I’m doubling anyway. Also, I assigned a 3mm loss to the company segment instead of the 5-7mm loss calculated above. This is because I’m predicting store closures will yield a benefit. Also, I've reduced my SG&A estimate to 32mm because the company has shown it can force this number down.

+Company owned stores: -3mm
+Franchise: 2*6.5mm=13mm
+KKM&D: 2*12mm = 24mm
-SG&A : 2*16mm=32mm
+D&A: 2*10mm=20mm
= 22mm

Therefore, I am once again down-shifting my run-rate EBITDA estimate: from the 25-30mm range to the 20-25mm range. This means that despite the recent stock price declines, EV/EBITDA is still in the 25-30x range.

Franchisee Health

The company finally acknowledges what many observers, including this blogger, have claimed for ages: that there are more franchisees at risk of liquidating. During the quarter, three of the biggest franchisees had symptoms of difficulty: Sweet Traditions abruptly closed 3 stores and its CEO resigned; Westward Dough got behind on several municipal tax payments; KKSF continued its liquidation of stores yet its KKD-guaranteed debt is still outstanding.

Who was the $1.5mm write-off for?

KKD wrote off $1.5mm of receivables from a nonaffiliated franchisee. This franchisee is clearly nearing insolvency. Who was it? Let’s Assume that this amount was owed for 6 months worth of receivables, that KKD gets 8% of top-line sales and that AD factory stores do $2mm annually per door. The number of stores this franchisee possesses equals 1.5mm*2*(100/8)*(1/2mm) = 18.75

One may play around with the months-late number (i.e. replace the 2 with a 1.5, a 3 or a 4) but the number of stores can’t be too far from 20; let’s say 15-25. Who has 15-25 stores? Sweet Traditions and Westward Dough. I postulate that one of these is in big trouble and my educated guess is WD. This blog has discussed franchisees sufficiently and I refer you to my summary post.

Panic in Winston-Salem

I believe Q2 will continue to be the history-making quarter that it is proving to be. The resignation of the CFO, the GC and some BOD members might be followed by the end of the SEC/DOJ investigations and/or more resignations. There are other catalysts: analysts have reduced their estimates and will continue to downgrade if stores are shut and EBITDA weighs on. Jim Cramer has sworn off the stock and declared KKD’s attempt to restructure outside of chapter 11 a failure. Dunkin Donuts is planning an IPO and this may provide another easy comp and a reasonable pair-trade opportunity.

At 8-10x run-rate EBITDA, the company’s EV would be 200mm. Deducting 100mm in debt gets us to a bit over $1 per share. However, continued sale/re-franchising of negative-contributing stores will help pay down debt and support EBITDA, though this is outweighed by continued franchisee liquidations. But in any event, even if there were no debt and the stock trades at 200mm worth of market cap, that would be under $3. This is where we’re going.

KKD is clearly panicking about franchisee closures and their owned-store underperformance. Both problems have coincided in timing. It’s a perfect storm in Winston-Salem, NC. Watch the weather channel for Hurricanes.

KKD’s Q4 & FY2007: Run-Rate EBITDA now $25 - $30 million

2007-04-19T15:47:00.000-04:00

Krispy Kreme’s fourth quarter turned out much worse than my ballpark estimate three months ago. Rather than being similar to Q3, it was as bad as Q2, which is their seasonally weakest. Full year EBITDA was approximately 22mm. Normalizing for one-time KZC expenses of 14mm, it was 36mm. I’ve updated my run-rate EBITDA projection to $25-30mm, putting EV at 25-30x. I continue to predict that EBITDA will slide further, based on future closures of franchisee factory stores and a reduction in royalty and supply margins.

The company-owned store segment actually had negative EBITDA in Q4, totaling only 2mm for the year, compared to my already lowered projection of 6-7mm. My best guess: margins will stay in the [-2%,+2%] range (i.e. less than 6mm annualized).

The KKM&D segment (now renamed to KK Supply Chain) is also getting weaker. From an average of 9mm in the first 3 quarters, its EBITDA declined to 6mm, due mainly to lower margins.

Given the steady deterioration, I calculate the $25-30mm run-rate EBITDA based on Q3+Q4 multiplied by two. This is conservative because it doesn’t account for the weak Q2:

+Company owned stores: 2*(700k)=1.4mm
+Franchise: 2*8mm=16mm
+KKM&D: 2*15mm = 30mm
-SG&A : 2*20mm=40mm
+D&A: 20mm
= 27.4mm

Franchise System Health

All JV franchisees did worse than last year. All had revenue declines of 10-20% and greater net losses, as well as declines in shareholders’ equity. Specifically, despite growing from 20 to 25 shops, Mexico started losing money as revenues declined by approximately 15%. KKSF’s equity plunged from negative 1.5mm to negative 5mm. They’ve recently closed another two stores and have agreed to try to cancel KKD’s 10mm guarantee. This entity is a good candidate for a KKD takeover but also for survival as a much smaller independent entity. Their Western NY segment is all but liquidated. The South Florida segment should see more closures over the next few months. Along with A-OK & KK-TX, as well as Priz, KKSF’s receivables are still considered uncollectible. Kremeworks’ only Vancouver, BC store had a negative 20% net margin. In summary most “doughnut theatre” stores in the KKD system have been unprofitable and uneconomic.

The non-JV franchisees are largely doing just as bad, with an exceptionally small number being FCF positive. Total franchise top-line sales were down 10% year-over-year.

Certain large shareholders and franchisees are advocating – and impatiently waiting for – the reversal of two Livengood-era “rip-offs”:

(i) They’d like to see AD ‘franchisees’ pay the same wholesale royalties as ‘associate’ franchisees (1% + 1% brand fund contribution, as opposed to 4.5% + 1% brand fund). The discrimination needs to end. I estimate this change would hit EBITDA by 3mm annualized.

(ii) They’d like to see the complex, opaque, for-profit SCAP program eliminated. For those who don’t know, SCAP stands for Supply Chain Alliance Program. This program is implemented via KK Supply Chain (formerly KKM&D) and constitutes of a mechanism by which KKD forces its franchisees to buy ‘proprietary’ supplies from it at mark-ups averaging 40%, in violation of the originally-deemed honest & true intention to charge only a 3% mark-up. There, I estimate an 11-18mm hit to EBITDA.

Together, both changes would shave off 14-21mm, taking EBITDA to 4-16mm and making it impossible for the company to cover current interest expense. Therefore, whoever implements such changes would have to drastically reduce debt. How: liquidating company-owned factory stores which don’t earn their cost of capital; performing sale-leasebacks for those that do; re-franchising anything they can; use some of the cash on hand; shut down and sell Effingham and maybe more.

Shrink-to-grow, as Wall Street analysts call it. This blogger agrees. But what are your numbers? Quantify ‘shrink’. If a dozen factory stores in all of SoCal is potentially problematic, how can we sustain 15 such stores in Chicago, 8 in South Florida or 10 in Austin & San Antonio? If we have zero in each of Phoenix, Philly and Houston, and one in each of NYC and Toronto, why do we need 3 in Montreal? A still unveiled/nonexistent satellite model is needed. The current model is worthless.

Housing Markets, Mortgage Markets

2007-04-09T14:33:00.000-04:00

In the course of a discussion yesterday, I reached an elegant summary of the ongoing housing boom/bust: when mortgage credit gets extremely loose, the housing market approximates the mortgage market. At or near that point, historical analysis using past housing markets loses value and the investor is better served by comparisons to past mortgage markets, or even debt markets of other kinds.

This idea makes room for all bullish and bearish arguments that have been thrown around in housing-market debates. It also makes room for all phenomena surrounding the market: financial, emotional, psychological, political or social.

Let’s highlight some of these phenomena:

- When a person can get a stated income 100 LTV loan or an 80/20 (especially with silent seconds) and that loan can be sold off into a careless secondary market, what we essentially have is a difficult-to-predict borrower bidding up a property for which some third party is willing to pay anything.

- Building on top of that: we know prices are often set on the margins, especially when markets near extremes. Our theoretical 100 LTV borrowers will very bid for the properties with fervor and their activity will set the prices.

- To mesure the strength of that trend, we recall all of the factors which sustained the boom: the desire to “keep up with the Joneses”; the perception of residential property as a safe and attractive storage of value regardless of price; the various broker / agent / appraiser / loan officer / lender frauds; Wall Street’s temptation to put together securitizations and sell ABS easily and efficiently while shaving off basis points on title searches, servicing quality and other important components; the psychological, operational and financial ease with which one would extract home equity and spend it; the generation of housing-boom-dependant jobs which create the illusion (to an extent, of course) of healthy economic growth; the desire to promote homeownership among various government branches, organizations and political figures, which is even easier to do when all of the other factors are there to help (i.e. our national satisfaction from home appreciation reduces our scrutiny of pro-homeownership policies)… the list goes on and on. Financial bubbles are made of the confluences of such effects, the compounding of consequences and the consequences’ consequences.

- Upon searching the above list for the one ingredient which had the power to make or break the boom, it’s obviously the availability of credit to the extent that it has been. On this subject I shall not expand because numerous sources have done so already.

The point is: now that the secondary market has put back marginal loans and rejected marginal borrowers, it has nudged the sensitive market in the opposite direction. We’re seeing a confluence of factors compounding in the opposite direction: uncovering of fraud; presidential candidates indicting mortgage market participants; regulatory agencies asserting themselves; reduced availability of various loan types; reduced desire to buy homes or borrow against one’s home; layoffs in housing-related industries, and so on.

Clearly this isn’t limited to – nor even related to – the subprime mortgage market. It is across the board and exacerbated by the ongoing discovery that unverified income/assets was a much bigger risk than estimated by the market. Last week’s profit warnings from MTB and AHM are likely to be echoed by their peers. This includes BKUNA, DSL, FED, NDE, WM, CFC and others. Inventories continue to surge and mortgage credit is tightening.

This turn of events is unmistakably similar to past mortgage/debt markets (e.g.: telecom debt, junk bonds, Japan) and dissimilar to past housing markets. At this point in the cycle we’re still too close to the peek for any classic housing market variables (demographics, immigration, land entitlements, taxation, insurance, inflation etc’) to have a meaningful impact on direction.

As we continue to go down, we’ll eventually approach a point of equilibrium where the housing market will again be decoupled from the mortgage market. When we get there, the above “classical variables”, often pointed to by housing bulls, will regain their relevance.

Precursor Earthquakes

2007-03-02T18:52:00.000-05:00

5:35 pm New Century Fincl: NYSE Also Probing Securities Transactions Dow Jones
5:34 pm New Century Fincl Says Acctg Errors Also Probed By US Atty Dow Jones
5:33 pm New Century Fincl: Probe Involves Trading In Co's Securities Dow Jones
5:32 pm New Century Fincl Says Cooperating US Atty Criminal Probe Dow Jones
5:25 pm Fremont Genl: Order To Prohibit Unsatisfactory Practices Dow Jones
5:24 pm Fremont Genl: Expects To Agree To Formal Order With FDIC Dow Jones
5:22 pm Fremont Genl Says In Talks To Sell Subprime Lending Business Dow Jones
5:20 pm Fremont Genl Delays 10K Dow Jones

Approximately three hours ago, Fremont announced that it has been essentially kicked out of the subprime business by the feds; the stock is down 20% in after-hours trading. Interested readers are urged to go through the late filing notice - literally an indictment of the subprime business. A bombshell like this gives pause even to the most bearish of investors. Here's the language on the PR:

Fremont Investment & Loan ("FIL"), today announced that it intends to exit its sub-prime residential real estate lending operations.
. . .
These moves are consistent with regulatory guidelines issued today, and were prompted by the Company's receipt on February 27, 2007 of a Proposed Cease and Desist Order (the "Proposed Order") from the Federal Deposit Insurance Corporation ("FDIC").
. . .
'Our valued deposit customers should be reassured by both our strong capital level and the fact that deposits at FIL of up to $100,000 are insured by the FDIC.'

Reassured by the capital level AND the FDIC insurance? If I had deposits at Fremont, I'd pull out right away. The very thought of deposit insurance invokes panic in most of us.

There was also news out of New Century. It is down 25% after-hours after announcing that they might not get lender waivers for newly violated covenants.

In the event the Company is unable to obtain satisfactory amendments to and/or waivers of the covenants in its financing arrangements from a sufficient number of its lenders, or obtain alternative funding sources, KPMG has informed the Audit Committee that its report on the Company’s financial statements will include an explanatory paragraph indicating that substantial doubt exists as to the Company’s ability to continue as a going concern.

I might as well take this opportunity to comment on Tuesday's mini-crash (large-cap indices down 3.5%) which, according to conventional wisdom, was due to an 8.8% decline in Chinese stocks plus a Greenspan comment. The VIX's 60% surge was too breathtaking for me to believe these were the real causes. We note the Yen's significant appreciation all through this week. When supporting leveraged positions in overvalued assets, a Yen carry trade unwind is a self-feeding cycle.

Liquidation of assets --->
Yen debt pay-down --->
Yen appreciation--->
Yen carry trades less attractive --->
Downward pressure on markets --->
Liquidation of assets . . .

The events of February 2007, in my view, are precursor earthquakes to "the big one". People who, like me, have made bearish bets on banks exposed to risky mortgages, will admittedly joy at such prospects. This is compounded by our expectation that safe, juicy bargains will appear when the smoke clears. The 3-year drought is finally ending.

But our joy has limits. Health, family, friendship, emotional satisfaction and existential geopolitical issues take precedence over money.

According to babynames.com, Fremont is a male name which means - simple enough - freedom mountain. To me, this brings up the image of America as the shining city on a hill. Over the past six years, Fremont was arguably the shining leader among fellow imprudent California lenders. Those California lenders, in turn, were leaders among imprudent American lenders. They did it 'better' than anyone.

Nevertheless, long after Fremont's meltdown, California and America will rise again. We have an amazing legal system, well-regulated markets, lethal doses of entrepreneurship, relatively healthy absorption of immigrants and politicians who eventually fix problems for us. I'm proud to identify myself with America, despite being Canadian. Tonight, therefore, I cross my fingers and pray that whatever financial unwinding occurs over the next few months won't be too chaotic. May all readers live though this period with health, happiness and a sustained hope for a better future.

Welcome to the 'hard landing' of 2007.

Please fasten your seat belts.

“Shock, Shock” in Subprime Land

2007-02-18T14:23:00.000-05:00

In the comments to my “Welcome” post, puttemout suggested that mortgage paper would tip the liquidity bubble's scale and I pointed out increasing caution in the industry. While asset markets have not yet caught a cold, subprime is sneezing louder and louder.

What began as the shutdowns of Sebring, Ownit and MLN – as result of mounting EPDs - has now expanded into substantial secondary market turn-off, with at least 23 wholesalers closing shop as and ABX indices plunging. The “big one”, of course, was February 8th, when New Century disclosed a projected 20% decline in volume & their need to restate financials and HSBC disclosed an extra $2 Billion in losses, adding to a heap of $10 Billion.

Rather than repeat everything that’s been said and heard, I’ll discuss a few interesting factoids:

- Although most lenders, led by Fremont, will be eliminating second mortgages (the 20% piggyback loan in 80/20 arrangements) they’re still accepting 100% 1st lien mortgages for the borrowers in question. To be sure, this policy is official and applications will be scrutinized much closer. As an example, LEND pointed out in their conference call that managers will be more involved in origination. Elsewhere, we’re seeing requests for more complete appraisals, pictures, and similar items not seen in years. The key question is how will 100% subprime deals be structured. Potential answers: mortgage insurers covering the extra 20%; other forms of credit enhancement; unenhanced 100% financing thrown inside mortgage pools with healthier paper. The first option is not very plausible as MIs don’t look like they’re up to such risk-taking (though there’s a price for everything). Overall, I think there will be a marked reduction in 100% deals over the next six months.

- NINA vs. SISA – here’s an interesting anecdote. Someone I know spoke with a senior executive at a mortgage insurer and was told NINA loans (no income no assets) performed better than SISA (stated income stated assets) even though NINAs are almost always priced higher. Why? The illusion that some info is always better than no info. It turns out, apparently, that SISA borrowers are much more unreliable than NINA borrowers. Makes sense in hindsight, especially during a bubble.

- Also from the LEND cc: the subprime market is still way oversaturated and more players will get hurt. Other sources report that prime volume is picking up the slack from subprime, as a way to leverage fixed costs.

- A few appraisers and brokers whose business declined as result of their refusal to participate in fraud (especially widespread in Florida and California) have now put together fraud databases and gotten fellow disgruntled professionals to report to them. The most well-known is Pamela Crowley, who quit her appraisal business to fight fraud full time. These people are in contact with the FBI, the rating agencies, lenders, the HUD and other participants. This is serious and is accelerating the downward pressure.

“The” Question: Spillover Effects

Everyone wants to know if the broader market will catch the proverbial cold.. First of all, within the mortgage market, the consensus is that damage will be limited to subprime. Morgan Stanley’s Richard Brener said: “These developments seem to confirm that the subprime meltdown is showing all the classic symptoms of an idiosyncratic bust with few implications for the overall supply of credit”. And Ben Bernanke weighed in: “the exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably.”

Nonesense. Some people are still amazingly blind to the sheer lack of substance behind the booms in the bubble's epicenters: CA, FL, NV, AZ, VA. There must be large problems lurking in the ALT-A space. Rapidly increasing volumes in documentation-less loans cannot end well. The complexity is increased by the recently morphed definition of ALT-A: marginal lenders have been putting together loans for applicants with 620 FICO’s without docs and calling them ALT-A. What is ALT-A? What is ALT-B?

On top of that, we have negative/no amortization loans (mainly I/Os and Option ARMs) which were issued to prime borrowers. A significant contraction of credit has not yet occurred for these exotic loans and the media seems to have forgotten the segment altogether, instead covering the subprime market almost obsessively.

As to the greater macro picture, liquidity is still abundant. The Japanese Yen sunk following last month’s controversial central bank decision and the US stock market is stable. Outside of subprime stocks (which have absolutely cratered) there hasn’t been much movement. This applies even to California-based purveyors of prime exotic loans such as BKUNA, FED and DSL.

My view is that the housing bubble has only begun to pop. In the words of Warren Buffett, the hangover is usually proportional to the binge. Steadily increasing REOs, foreclosures, layoffs, insurance premiums and taxes, in my view, will throw the average consumer back into saving (and mortgage amortization) mode. The economic slowdown is not over yet.

KKD’s Annual Meeting + Franchisee Assessment

2007-02-02T20:52:00.000-05:00

I will comment a bit on Krispy Kreme's annual meeting and then review the health of large franchisees one by one.

It was pleasing to hear that Krispy Kreme plans to hold quarterly calls and force management to expose itself to performance-based compensation. The BOD & management have understood that interacting with the investment community is best for a company whose marketable securities are being traded daily. It was also pleasing to hear Mr. Brewster state that the company plans to follow Special Committee recommendations. This wasn’t clear up until today. I look forward to seeing the company exercising balanced disclosure of good news and bad.

Nevertheless, much work remains business-wise. Instead of elaborating on all turnaround activities, let’s summarize: the focus on the Hot Original Glazed doughnuts, the various plans exemplified by, and relating to, the Valentine’s Day offering and the pushing of Krispy Kreme Coffee as a respectable choice, are all examples of solutions tried by previous management teams. Working on the top-line or cutting costs within the current model can only do so much. In the meeting, the company made it clear that a new business model is not something which exists.

More complex, bold, necessary initiatives have so far been all bark and no bite. They include long-shelf-life product, non-trans-fat product, better use of day-parts, partnerships, a revamping of the wholesale cost-structure and satellite stores.

Franchisees

The most striking aspect of the meeting, in my view, was lack of focus on franchisees. Brewster said that the company intends to boost AD performance using, among other methods, a monthly conference call and a franchisee coaching team. Somewhere in the mix it was lost upon KKD that many of the ADs' numbers look better than its own and that most ADs are led by people with years of experience in the restaurant and real estate business, as compared to 10 months experience for Mr. Brewster and low-level management experience for Mr. Jervik. Not that there’s anything wrong with that, but CEOs and BODs need to realize that certain tasks require delegation - before it’s too late.

Having said the above, I believe the main avenue for keeping ADs alive is to provide them with a new business model, lower royalty rates (perhaps, at Associate-like levels), to review KKM&D and reach appropriate conclusions. Pre-overhead, 75% of KKD’s EBITDA comes from franchisees. Post-overhead it's nearly everything. If the above is not implemented, franchisee health will continue to deteriorate and KKD itself will suffer.

Recently, a couple of observers have suggested that remaining ADs are healthy. Today, a Tampa-area store closed. This follows the Missoula closing earlier this week and Rion’s restructuring a couple of weeks ago. With that in mind, let’s scrutinize that observation by rounding up a list of large franchisees and examining their health/history/status.

Franchisee-based profit consists of mark-ups on supplies & doughnut mix under the Supply Chain Alliance Program (SCAP), plus royalty payments. Associates, the old franchisees which have existed for decades, typically pay 4% royalty on retail and 1% on wholesale. Area Developers (ADs), the newer, bigger franchisee entities, typically pay 5.5% on either retail or wholesale, despite having no advantage. On top of that, Associates mostly own their real estate outright. Let us tabulate extinct and existing franchisees:

Extinct

KremeKo
Lone Star Doughnuts
Rigel
New England Dough
Glazed Investments
KKNY
Freedom Rings
1/2 of Golden Gate Doughnuts
2/3 of Great Circle Family Foods
2/3 of Gulf Florida Doughnuts (this is not an AD but it is large)

Existing

Westward Dough (L&L, KK Wyotana + former GI stores)
Rion
KK Australia
KKUK
A-OK + KK-TX
Amazing Glazed + Amazing Hot Glazers
KKSF + Dynamic Doughnuts
Priz
Glazing Saddles
Kremeworks
Sweet Traditions
1/3 of Great Circle Family Foods
Mexico, Korea
Tokyo, Indonesia Philippines, Honk Kong & Macau, Middle East

Extinct ADs come from various parts of the country; they have are various demographics, geographies and market competitors. Still, they are had similar margins, sales trends, costs, etc’. Let us summarize their stories:

KremeKo: The story of KremeKo, the Canadian franchisee, is very public. Ernst and Young’s database of court documents, the Fisher lawsuit and Judy Richardson’s article in BC Business provide all the details. This operation was scaled back from 18 units at minus 10% net margins to 6 units breaking even. These stores exited their honeymoon periods only months ago. There is only one KKD left in Toronto – Canada’s biggest city – but hundreds of Tim Horton’s stores.

Lone Star Doughnuts: 8 Houston stores reduced to 0. Lone Star chose to leave the KKD system and tried operating under the Jumbles brand without the 5.5% royalty and excessive supply costs yet were still unprofitable. Even with an expanded food offering, the real estate proved too expensive. KKD has been far behind the likes of Shipley’s.

Rigel: Instead of suing, Rigel chose a break on royalties. Yet it still went bankrupt. 10 stores downsized to 0. No more Krispy Kremes in Arizona or New Mexico.

New England Dough: 8 stores in the entire region reduced to 4.

Glazed Investments: 20 stores reduced to 12 and sold to Westward Dough. Out of the 12, 1 has been shut down and the others might as well. More on WD later.

KKNY: 8 stores reduced to 2. This area included all of NYC; long island too.

2/3 of Great Circle Family Foods: We shall not expand here on this franchisee, for its story is well known

Golden Gate Doughnuts: this one was repurchased by KKD a few years back in what became a messy legal situation. With two round of closures in each of 2005 and 2006, this market now has less than half of its original 17 stores left over. Of course, the Dough-Re-Mi and other acquisitions have brought equally unprofitable stores to KKD's balance sheet.

Freedom Rings: The Philadelphia franchisee’s bankruptcy filings (case #05-14268) show why this operation went from 6 stores to 0 – Dunkin Donuts trounced it. The hidden story, however, is the mistreatment of Fiorentino and his crew.

Gulf Florida Doughnuts: today’s closure leaves only 2 out of 6 Tampa area stores. Yet we also know that this franchisee pulled out of many wholesale routes. That means Tampa is all but caput (a southeastern Associate franchisee, with low royalties).

Remaining franchisees – we are told - are healthy despite the 10-K show that all JVs except Mexico have a negative net income. And there's much more evidence than that. Let's review it:

Westward Dough (L&L, KK Wyotana + former GI stores): Lincoln Spoor executed an LBO of 12 GI stores as mentioned above. Since then, he’s closed 1 and 5 have been up for sale. Furthermore, he closed a Utah store a few weeks ago and the Missoula store this week (the same Missoula store that opened only one year ago). Given the population & density thereof in Montana, Idaho, Utah, Colorado, Minnesota and Wisconsin, and the fact that the $10mm LBO debt is not backed by any owned land whatsoever, this entity looks like it is in turmoil.

[ anyone interested in Krispy Kreme should carefully read the above Missoulian article and think about all that it implies, including the fundraising cards flip-flop, demographics and real estate ]

Rion LLC: this is Rigel’s sister-entity. It recently announced a restructuring, shutting two stores. Rion operates in Iowa, Nebraska, North Dakota and South Dakota, in which the population numbers are just as big a headwind as they are for Westward Dough.

KKUK: In the UK we notice three trends: lack of profitability; deep, pervasive and repeated desire by its partners to sell their stake, and the opening of small outlets. The third one looks good on the surface but the second one explains it, and the first confirms that explanation. Here’s a chronology:
- April 2006: rumors KKUK has hired Ford Campbell to find a buyer. Concurrently, KKD discloses it is exploring the sale of its stake. Third-party sources claim that Dick Clarke, Ed Fishman and Haven Burke want out.
- Summer 2006: KKD finally succeeds in selling its equity stake back to the entity, settling its receivables and disconnecting.
- A few weeks ago: KKUK announces its intention to be sold, and follows up by disclosing that a certain entity has begun doing due diligence on it and confirming that the trio named above wants out.

KK Australia: The Australia situation is very similar to the UK. KKD sold its stake and settled guarantees & other matters. Food and Beverage, the company, then attempted to go public. Trounced by an editorial for valuation reasons, the IPO was cancelled. The entity still has private equity support from SOE. So what now? Here’s what SOE writes in their recent annual report: “In view of the decision not to proceed with the IPO of Food andBeverage Company, Spel (SOE) and Hunter Bay, over recent months, have been in discussions to rearrange Spel's interest in the company and the investee companies”. In other words, just like in the UK, the partners buying out KKD’s stake was due, at least in some part, by a subsequent opportunity to flip.

*** Magic number: $4,676,000 ***

Let us now refer to a few franchisees at once as we discuss a very important number on page 16 of the Q3 report. Under “Receivables from Equity Method Franchisees” we have $4.676 million in allowance for doubtful accounts. Scrolling down to the October 29th table on page 26, we can sum up 1,539 + 161 + 1,832 + 1,144. What do we get? The very same $4.676 million. In other words, KKD considers that receivables from KKSF, A-OK, KK-TX and Priz are uncollectible, implying those entities are unhealthy.

KKSF + Dynamic Doughnuts are sister entities which control Miami, West Palm Beach, Buffalo and Rochester. They have closed a few stores so far and are in restructuring mode. KKD guarantees $10mm of their debt. A-OK + KK-TX, also sister entities, are a source of $4mm in guarantees and they’ve had a recent closure as well. KKD has assumed control of Priz but it is, of course, quite unprofitable.

Amazing Glazed + Amazing Hot Glazers: the Pittsburgh area franchisee is down from 8 stores to 4. It might as well have been classified in the dead franchisee list, but it has not been taken over by KKD. They have steadily closed stores over the past year.

Glazing Saddles: This entity has also closed a store very recently. Why would anyone conclude that it is healthy?

1/3 of Great Circle Family Foods: Great Circle has eloquently expressed its views and its need for franchisor support as a pre-requisite for survival. They have suffered a great deal, as have all of the other ADs. It is unclear to me why this is not a pre-requisite for other ADs as well. And support is not a "franchisee coaching team" - it's the approval of indispensable reforms.

Here are the franchisees with less signs of financial distress:

Kremeworks: The northwestern franchisee hasn't shut down any stores yet and its capital structure seems to have received extra support. Of course, the store performance is not any better than elsewhere. They are still unprofitable.

Sweet Traditions: With support from Allied Capital, this franchisee also has a chance to do something. However - again - its operational results can be extrapolated from numbers disclosed in their lawsuit (case # 05-CV-511-DRH on PACER)

Mexico & Korea: these two was mildly profitable as of the last 10-K and unlike the UK & Australia, there have not been signs of partners

Tokyo, Philippines, Indonesia, Honk Kong & Macau, Middle East: The health of phase 2 franchisees is unknown but will be determined eventually. Reports from all these regions have varied, between long lines and cameras, to free doughnuts, dismissal of high prices, and copycat products. Most of these entities’ partners are similar to Compass, the KKNY partner (i.e.: easy come, easy go). By the way, all of these countries are ones where UFOC-type documentation is not required. There's a reason for everything.

So overall, Krispy Kreme’s large franchisees are not healthy; not by a long shot. And the recently disclosed company-owned store numbers are just as bad.

KKD’s Q2 & Q3 Filings: Run-Rate EBITDA now $30 - $35 million

2007-01-24T13:59:00.000-05:00

Krispy Kreme has now filed Q2 & Q3 results and will be current on financials in time for the new fiscal year and next week’s annual meeting. The disclosure within these filings is a welcome change since most observers will now clearly see the terrible economics of this business.

SG&A is running at surprisingly high levels and the Q2 loss in the company-owned segment was equally striking. In my last update, I suggested the segment’s annual profits should be 6-12mm. It’s now obvious that it will come in at the low end of that range (6-7mm) for the past year and possibly under 6mm in the coming year. This corresponds to a 3-4% PRE-OVERHEAD EBITDA return on "real estate capital", as per prior calculations. I am breaking out the segments as the company does (i.e. allocating inter-company profits to the KKM&D segment).

Franchisees run their stores better than KKD because they’ve got more incentive and experience, meaning that they too must be earning these types of returns. Indeed, this is precisely what franchisees have confirmed through private conversations and public disclosures. The only arena where KKD makes an acceptable margin is in KKM&D sales to struggling franchisees. In the Q3 filing the company was kind enough to confirm my past suspicions about “price increases”: KKD did not pass through commodity costs at retail. Rather, it increased prices of KKM&D supplies on franchisees while decreasing the wholesale prices of doughnuts in some places. It is not around consumers that KKD has successfully steered; it is around franchisees. But this rip-off relationship is temporary. Local newspaper articles continue to suggest troubles at Rion LLC, Glazing Saddles, KKUK, Westward Dough, A-OK, etc’.

To estimate EBITDA for the past year we take the 5.2mm operating loss figure (page 24 of the Q3 report) and add back the 16.1mm in depreciation & 6.5mm in impairment charges. It is also fair to add back KZC’s nonrecurring Q1 & Q2 costs which were about 14mm in total. That gives us 31.4mm for the first nine months. For Q4, we can ballpark 1mm in D&A, 3.5mm for the sum of the franchise + KKM&D segments and 2.5mm for company-owned stores. The grand total is 38mm.

But run-rate EBITDA is less than that because franchisees keep pulling away and SG&A has grown. In fact, as per the company’s disclosure, KZC fees are close to 3mm annualized at this point and that cost is staying as long as Brewster is CEO. Annualizing Q3 gives about 34mm in run-rate EBITDA. This calculation disregards the company-segment loss that KKD will surely experience in the next Q2. Therefore, run-rate EBITDA is more likely to be 30mm.

The covenant ratios (page 18 of the Q3 filing) fit right in with the aforementioned EBITDA numbers. To perform this calculation, one may refer to the definitions from the 2nd lien debt agreement.

Despite all that, Prudential Securities pegs EBITDA at an insane $69mm for the coming year - about double the real numbers. Though the company-owned segment performed about half as well as Prudential expected, they raised their target from $15 to $17, sparking a powerful rally in the shares. This values the company at 30x EV/EBITDA and at $17 we’d be talking 40x. A more normal valuation of 6-10X EBITDA would send these shares to $2-4.

As I plan to summarize in my next post, franchisees are continuing to struggle and KKD’s EBITDA will continue to decline, the equity's real value is surely below $1.

Good for the company that it sold some assets - only that as after being on the market for a year. The dilemma of fire-sales vs. interest expense reductions is therefore still in play. The $4.6 million impairment of long-lived assets (due to the North California closures) is notable as well. Many of KKD’s owned buildings on leased land face a similar “reality shock”. One wonders how the collateral would be appraised in the future. KKD may have a decent chance of covering that collateral but it needs to liquidate land sooner if it wants to optimize the situation. Keeping 108 factory stores open can’t be the right thing to do.

Even if the company refinances at LIBOR+200, the EV/EBITDA ratio still stands and the company will be more vulnerable to future credit market spread shocks. Furthermore, even if they pay off their 80mm in current net debt with hard asset sales, we'll still have a stock trading over 25x EV/EBITDA. Neither KKD stores nor franchisee stores earn a bottom-line profit. The system is rotten almost to the core.

KKD's Q1 – Below Expectations & Below Cost of Capital

2006-12-26T20:21:00.000-05:00

Krispy Kreme has filed its 10-Q for Q1 of FY2007 (year ending Jan. 28, 2007). Since Q1 is post-CJV-bankruptcies and post-special-charges, we get an unprecedented view of KKD's finances. Everything can be figured out by adjusting for one-time KZC costs and adjusting D&A, cap-ex and R&D (and of course, by keeping in mind that half of franchisees have liquidated and the other half is hanging in the balance, waiting for Winston-Salem to make logical decisions). As always, we cross our fingers for franchisees and their employees - it's not clear that Winston-Salem speaks the language of cooperation.

Today we strip out the numbers for KKD's company-owned store segment.

We know KKD hasn't brought changes to its 4000sq.ft. stores (no new coffee program, no ice cream, no square-foot-sharing, not even a CEO with retail background). Until this week unallocated G&A was too messy to provide any bottom-line visibility but now this has changed.

For Q1, the segment's adjusted EBITDA pre-overhead was 7mm. There are various ways in which we can distribute the unallocated overhead. To be conservative, let's assume even distribution. I see a total of 10mm in adjusted overhead for the quarter (taking unallocated G&A of 17mm minus the one-time KZC fees which I estimate @ 7mm, as per the KZC-related disclosure). So dollar-for-dollar, the segment's post-overhead EBITDA was around 4.5mm. But the segment also enjoys a good dose of cap-ex, closing costs and a share of R&D. All together, I'd ballpark these at 1.5mm - 3mm per quarter. In other words, pre-tax run-rate annualized unlevered pro-forma FCF for the segment was 6-12mm in Q1. It may have declined since then but we let's assume the same range.

My previously estimated value of the 51 stores on owned land was 57.2mm. If these stores were all large, new and doing an average amount of wholesale, they'd generate about half of the 6-12mm (i.e. 3-6mm). But they don’t match that description so a more accurate range is 2-4mm, which corresponds to 3.5% - 7% of real estate value PRE-TAX. Should KKD's creditors not liquidate these and buy treasury bonds instead? And what about KKD? They're leveraging those properties @ 12% interest. Does KKD really think they can clear 12% pre-tax with no turn-around plan, no retail CEO, an inexperienced retail assistant who's been living in Hawaii, and a dream-case scenario of a capital-requiring satellite business? Those who read all unofficial Krispy Kreme news and who listen to what the parties involved have to say should be able to figure out the answer.

Under ideal conditions, the real estate would kick out the tenant unless a new business model emerges. Turning around implies much more than a still unproven satellite prototype. It's about issues like efficient distribution, national accounts, coffee partnerships and franchisor leadership. On all these counts, Brewster and the BOD have decided that all is well.

The only part of KKD's business which is earning more than its cost of capital is franchise and KKM&D but these segments have proven to be temporary vis-à-vis half of the franchisees. If KKD doesn't give up some very significant margin, they will prove temporary with respect to the other half as well. More on franchisee health next time.

In my view, the company should bite the way it barks and outsource decision-making and capital deployment to franchisees – including franchisor-level decisions. Though getting rid of real estate may cause incremental loss of scale or brand damage, I still think KKD should just let go, de-lever, and reincarnate as a patient, diligent, equity-financed start-up with a new business model: manufacturing branded high-class wholesale long-shelf-life product in the US. The doughnut theatres: leave one per metro area as a tourist attraction and use it for brand enhancement. They will need remodeling, of course. And then, KKD will be able to also take its time to build a carefully-considered satellite model. I know that many franchisees/shareholders feel that building a satellite system now is the best course - and indeed that may be ideal - but for that plan to succeed, "corporate governance events" must take place.

Q1 numbers vs. Prudential's Expectations

Prudential's pro-forma G&A (i.e. net of KZC and other 1-time expenses) for FY2007 is $33mm. My reading of the 10-Q suggests that number should be closer to $40mm (annualizing the above calculated 10mm). Prudential's pro-forma EBITDA is 49mm. That was also off the mark, in my view. I've got a 37-43mm estimate, calculated by taking a 50mm Q1 number and adjusting downward for recent franchisee bankruptcies/liquidations, and ongoing franchisee abandonment of wholesale accounts. Most importantly, Prudential's assumption of debt repayment and low interest expense is not panning out as they initially thought.

Additional notes: over the past few months, KKD's outsourced PR representative told me three times that the company has no borrowing availability under its 1st lien facility as of April 30th, but the filing says there actually was 40mm available - so much for Brewster's desire to be accurate! The rep also wrongly stated that the April cash level would not be altered. It was altered.

Goldman Sachs - Short Thesis

2006-12-18T13:44:00.000-05:00

Goldman Sachs is an immensely profitable, high quality investment bank with an irreplaceable culture. They hire talented, disciplined, hard-working employees who are dedicated to making more profit than competitors, monitoring risks as best as possible and doing what’s right for the firm without turf wars.

Nevertheless, much of GS is a discount-deserving cyclical trading business near a cycle peak. However, GS is priced at 10x colossal peak earnings. Since July, the stock has zoomed from $150 to $200 based, apparently, on the perception that current capital market frothiness is somewhat sustainable. I believe earnings will begin to compress sometime soon, with a ceiling valuation of $150 (and possibly much lower, depending on the circumstances). This write-up will not be a comprehensive review of GS. Rather, the aim is to find the current profit-growth driver and expose the cyclicality and operating leverage.

This particular recommendation is more catalyst-dependant than my other investments. The reason is that GS will continue to pile up profits, buy back its shares and thus, build a little bit more shareholder value while we wait for the catalysts. The good news: if this happens, the stock will likely rise and therefore remain overvalued. This means that one can time the short (or purchase of puts) to suit one's prediction of when the turn in the credit cycle.

Why GS and not other Investment Banks?

- Low risk of being acquired (unique culture + many potential future CEOs lined up)
- Pure play on turn in the credit cycle. 80% of profits are in trading, as opposed to more diversified peers.
- High-risk high-reward. GS’s trading profit is pumped because they’re very aggressive on the way up. They will earn as much as possible while the going is good but current earnings cannot be used as a normalized mid-cycle number.
- Sticky compensation expense on the downside. GS stands on solid ground; they're diligent, focused on long-term success and have no need to please Wall Street. As in past cycle downturns, they will likely retain staff much more than others, which will further compress earnings.
- For similar reasons and also because GS has remained profitable in past cycles turns, this shorting opportunity has no risk of management lying and pumping up the share price.

Looking at GS’s statements is like reading the market’s history. Earnings have suffered in past liquidity crunches: down 81% in 1994 vs. 1993 and down 35% in 2002 vs. 2000. These losses were driven mainly by (i) a decline in the volume of trading or M&A activity (ii) losses in proprietary trading, long-term investments and other collateral damage. In the post-2003 credit roar, investment banks have seen booming profits in anything fixed-income related (froth in bank loans, derivatives, housing and hedge funds). While there’s nothing wrong with these, the trading profits and volumes of trading/hedging/selling/securitization are unsustainable. Many unsound mortgages, corporate loans and other investments have been assumed; there is also a surplus of hedge funds and other investors engaging not only in hedging but also naked positions. When the excitement surrounding unsound assets, unsound trades and unsound market participants disappears, the go-go trading, inventory creation and prop desk profits will decline. Some trades will even take a beating or two. In sum, Wall Street is a sales organization that operates in cycles and this time is no different.

GS breaks out its reporting into the following 3 segments, the second of which we shall later split into 2 sub-segments.
(i) investment banking
(ii) trading and principal investments
(iii) asset management and securities services

Latest 10-Q, nine months ended Aug:	2006	2005
Investment banking net revenues	4,285	2,723
Trading & principal investments net revenues	18,565	12,258
Asset management & securities net revenues	5,045	3,515
Total Net Revenues	27,895	18,496
Total operating expense	18,320	12,702
Pre-tax earnings (millions)	$ 9,575	$ 5,794

Observations: (i) earnings growth benefited from operating leverage (ii) the rise in net revenues was due mainly to trading & investments, which we examine next:

Trading & investments - nine months ended Aug:	2006	2005
FICC (Fixed Income Commodities & Currencies)	10,795	6,634
Equities trading	3,730	2,073
Equities commissions	2,622	2,175
Other	1,418	1,376
Total net revenues	18,565	12,258
Operating expenses	11,900	8,025
Pre-tax earnings (millions)	$ 6,665	$ 4,233

So growth in trading mostly comes from FICC. To explore further, we examine data on GS’s potential loss from exposure to its off-balance sheet VIEs (entities that are formed to issue ABS and CDO paper). This gives us an overall view of risks associated with holding residuals in securitizations as well as market making & guaranteeing of pieces thereof. Highlights from page 24 in the 10-Q:

	Aug 06	Nov 05
($ amounts in billions)
Interests in CDOs	2.1	0.8
Derivatives off of CDOs	9.4	5.3
Derivatives – asset repackagings & credit-linked notes	3.2	1.5
Other	4.1	2.4
Total	18.8	10.0

So the huge increase in 2006 was mostly linked to the CDO boom. According to JP Morgan’s survey, CDO issuance is now running at about 80% YoY.

Goldman offers a list of direct holdings which are more difficult to fund on a secured basis during times of market stress. We examine this list to further narrow things down:

	Aug 06	Nov 05	Nov 04
Mortgage whole loans & CDOs	36,507	31,459	18,346
Bank loans (funded commitments & inventory)	27,254	13,843	8,900
High-yield securities	8,318	8,822	6,057
Emerging market debt securities	2,285	1,789	1,653
SMFG convertible preferred stock	4,938	4,058	2,556
Other corporate principal investments	3,207	1,723	1,278
Real estate principal investments	621	745	820

Two important observations:
(i) GS was mass-producing mortgage CDOs until 11:59PM of the housing bubble, which indicates a culture of attempting maximum profit from all booms (with noteworthy risk controls, no doubt). This culture assures growing profits throughout the boom, a certain amount of pain when the cycle turns and more importantly, a massive slowdown thereafter.
(ii) GS’s current profits in CDOs & derivatives is largely attributable to bank loans as opposed to anything connected with real estate. We note that the volume in M&A, debt-financed dividends and buybacks & rescue loans is currently at unsustainable levels. To assess future earnings, we therefore ask what lies ahead for the bank loan market. Here are some opinions, the first from Goldman itself.

GS’s Chief Underwriting Officer for Europe and Asia, Eugene Leouzon: “The markets are really, really red hot […] The things we are seeing being done, both on the investment grade side and the non-investment grade side, are I would say borderline stupid.”

Warren Hellman speech: “Hellman said his firm recently passed on a deal that had bankers offering to lend at nine times cash flow”

Michael Peterson, editor of Creditflux: "Just about every man and his dog is trying to do a CLO at the moment"

Louise Purtle, senior analyst at CreditSights: "Times are good, default rates are low, and you're probably seeing loans that in a few years will seem far too generous"

Mark L. Gold, HillMark Capital (CLO manager): "If you look at the record issuance [of loans] that's been done, clearly you're setting the stage for record problems."

Simon A. Mikhailovich, Eidesis Capital: “Fundamental credit analysis of borrowers' ability to repay loans is being shortchanged”

To guess how GS will be impacted by the turn in the credit cycle, we point out that earnings declined sharply in 1994 and 2001-2002 not only due to losses and dropping volume, but also because compensation was sticky:

	2005	2004	2003	2002	2001	2000
Net Revenues	24,782	20,550	16,012	13,986	15,811	16,590
Compensation	11,688	9,652	7,515	6,744	7,700	7,773
Other expense	4,821	4,222	4,052	3,696	3,951	3,079
Pre-tax earnings	8,273	6,676	4,445	3,253	3,696	5,020

	1999	1998	1997	1996	1995	1994	1993
Net Revenues	13,345*	8,520	7,447	6,129	4,483	3,537	5,764
Compensation	6,459*	3,838	3,097	2,421	2,005	1,789	2,126
Other expense	4,894*	1,761	1,336	1,102	1,110	1,240	980
Pre-tax earnings	1,992*	2,921	3,014	2,606	1,368	508	2,658

* Irregular jump from 1998 to 1999 reflect GS’s conversion to corporate form

Next, we compare the Underwriting and M&A booms of 2000 and 2006 using the Investment Banking segment:

	2006	2005	2004	2003	2002	2001	2000
Net revenues	5,629	3,671	3,374	2,711	2,830	3,836	5,371
Op. expenses	4,300 (E)	3,258	2,973	2,504	2,454	3,117	3,645
Pre-tax profit	1,329 (E)	413	401	207	376	719	1,726

Two observations: (i) operating expenses for the segment have been much sticker than revenues (ii) pre-tax earnings could very easily return to sub-500mm levels if/when the market returns to normal

Next we look at revenue for the three big areas in Trading & Principal Investments: FICC, Equity Trading (ET) and equities commissions (EC). Later, we shall brake off EC profits into its own segment because it's more stable and deserves a higher multiple. (GS used to report EC as part of its asset management and securities segment. After switching to the fee-based business model it moved it into trading).

	2006 (E)	2005	2004	2003	2002	2001	2000
FICC revenue	14,262	8,484	7,322	5,596	4,680	4,272	3,004
ET revenue	4,965	2,675	1,969	1,738	1,008	2,923	3,489
EC revenue	3,518	2,975	2,704	2,543	2,994	2,603	2,053(E)
Net revenues	25,562	16,362	13,327	10,443	8,647	9,570	8,680(E)
Op. expenses	16,000	10,144	8,287	6,938	6,505	7,310	N/A
Pre-tax earn.	9,562	6,218	5,040	3,505	2,142	2,260	N/A
In the rows below, given historical commissions margins (pre and post conversion) we estimate pre-tax income for EC and subtract to find the non-EC pre-tax income. For 2000, 2001, 2002, we can use the actual numbers from the 2002 10-K to cross-check our assumptions.
EC (E)	1,266	1,071	973	915	1,077	937	739
Non-EC (E)	7,296	5,147	4,067	2,590	1,065	1,323	N/A
Actual Non-EC	N/A	N/A	N/A	N/A	976	1,215	2,428

Observations: (i) in equity trading, profits got smashed 71% from 2000 to 2002. 2005 didn't surpass 2001 and only in 2006 did they finally blow through previous results. (ii) the new froth culprit, FICC, was growing nicely up until this year and is now going berserk.

------------ Valuation ------------

In putting it all together we have 4 segments. My valuation only assumes that the market's behavior returns to normal; no blowup is assumed whatsoever. Since we don't know when exactly the cycle will turn, my numbers are not necessarily a prediction for the next 4 Q's. I assume an overall tax rate of 31%

1) Investment banking: assuming return to 2005, adding 25% global growth, I estimate 500mm in pre-tax earnings. 14 P/E * 69% * 500mm = 4.8B

2a) Non-EC portion of Trading and Principal Investments: A lot can be said about this segment. For any type of market-making or structured products, this is driven by volume. For prop trading, it's about what GS can do. No one knows if they'll get whacked a lot, a bit, or not at all, but 2006 profit levels are just not realistic. Assuming a simple return to 2005 numbers, 5B pre-tax, 10 P/E * 69% * 5B = 34.5B

2b) The EC portion of Trading and Principal Investments: assuming 1.2B pre-tax: 14 P/E * 69% * 1.2B = 11.6B

3) Asset management and securities: though this segment includes hedge funds, I'm still going to give them credit for stability, growth and success. 2.2B pre tax: 14 P/E * 69% * 2.2B = 21.2B

Total Valuation: 72B
Diluted shares 480mm
Per share value, assuming negligible preferred dividend: $150

Risks:
- “Go-go” trading volume stays high, i.e. bets in various derivatives continue at the current pace, hedge fund growth does not reverse by any significant amount and markets forever remain more short-term oriented and data-dependant than they used to be. Historically short-termism has gotten whacked but we never know. The “this time is different” argument is difficult to refute 100%.
- GS buys assets on the cheap or otherwise profits from increased volatility. I only list this as a risk because GS is known to be ahead of the pack. The fact of the matter is that even for GS, there are limits to what can be done - they're not a Berkshire Hathaway sitting on cash and ready to pounce. Their capital is mostly tied up with a strategy of riding the wave; the stock is likely to follow that ride and their destiny will eventually be correlated with that of Wall Street as a whole, even if above-average
- The liquidity cycle does not end in a bang. Personally I believe soft landings are more catch-phrase than reality but this risk may be offset by doing a pair trade - I would recommend Barclays as a hedge
- International growth. The decline in earnings may be partially cushioned if international business doesn't slow down.
- Acquisition risk: quite unlikely because Goldman is Goldman, plus it’s a quite large, but today anything is possible

Catalysts:

My personal guess is that the peak in the credit cycle is Q4 2006 but we can easily have a blow-off period for another 3 - 12 months. I’d be surprised if financial markets were to remain calm for all of 2007 but one never knows. Here are the catalysts:

- Unexpected tightening by Japanese or Swiss central banks, unexpected action by the Fed.
- Accelerating losses in mortgages, MBS other ABS, escalation of buyback demands, tectonic plates further shifting in housing
- Economy unexpectedly slows down, deceleration of consumer spending
- Bank loan boom fizzles out for whatever reason
- The market for credit protection chooses to simply reverse its momentum
- Less likely: Exogenous event, hedge fund blow up, derivatives cascade, credit insurer (or CDS writer) gets into trouble, etc’

Long Puts on GS, JPM and BAC

2006-11-21T02:57:00.000-05:00

Earlier this year I established small put option positions on each of Goldman Sachs (GS), JP Morgan Chase (JPM) and Bank of America (BAC). The small size is explained by the uncertainty of when the current boom will end. I feel we’re close, though.

A Word about Put Options

My opportunity-scanning style is to look at asset classes that the market dismisses as unattractive. In today’s environment of low volatility, low risk premiums and credit-dependent GDP growth, the primary areas of undervaluation are put options and credit default swaps (solid large caps and cash deserve a mention as well). CDS come with financial and legal counterparty risks and perhaps even technical risks (shortage of underlying bonds), as seen in the case of Dana. Who’s writing your CDS? Banks? Hedge funds? Who regulates these entities? How do their books look like and how will they look like if everyone runs for the exits at once? With equity put options such risks are unlikely to arise because the Options Clearing Corporation (OCC) guarantees obligations.

Investment Banking and Wall Street Cycles

My thesis for GS and the investment banking arms of JPM and BAC is “large company with earnings compression”. This certainly isn’t a “bad business model” thesis. Based on the current growth in hedge funds, derivatives and short-term trading and credit, these companies’ profits and stock prices have recently zoomed. I judge this boom to be unsustainable and unhealthy. History shows that Wall Street banks experience earnings cyclicality surrounding such unhealthy booms: profits soar every time the banks find new products to peddle and decline when the mania surrounding those products subsides. I believe we’re near the apex of yet another cycle and that IB earnings will compress during 2007 and 2008. As ‘gravy’ on top of my thesis, a potential so-called exogenous event may cause sharp declines in IB shares, just like in September 1998.

Consumer Banking: Credit Cards, Mortgages and more

I’ll discuss the exposure of JPM and BAC to the consumer sector in one paragraph. The global credit boom doesn’t just ‘affect’ consumers; consumers and their homes are ground zero. As consumption declines, so does the output of goods and services. It appears that a consumer lending slowdown is slowly taking hold. Pressure on the consumer is based on the negative savings rate, a housing hard landing, record non-discretionary spending, tightening of lending standards, increasing pass-though of Chinese inflation, outsourcing, eventually rising risk premiums in the secondary market, higher taxes of certain kinds, continued elevated gas prices (relative to wages) and more. In my view, the case against the American consumer is well established and eventually most will need to lower their standard of living. But before that happens, the financial markets will take the first hit, as they always do.

Management at JPM and BAC

I’ll also briefly discuss management and provide links to related material. During 2003 it became apparent to me that JPM’s derivatives book was growing like weed and it was becoming the market’s junk yard. This Risk magazine article provides interesting testimonies from their very, very satisfied clientele. Though Jamie Dimon has offset this and other concerns by somewhat cleaning house since then, I still view JPM as a short. Their own book is massive, plus they operate the second biggest hedge fund business. They did not (and, one presumes, cannot) isolate themselves from the today’s capital-market binge and the inevitable hangover.

In contrast to Jamie Dimon’s team, BAC’s management, led by Ken Lewis, works in favor of the short thesis. I refer the reader to Tom Brown’s excellent work exposing (i) BAC’s “grow at any price” strategy, (ii) the underperforming volume-focused credit card business, (iii) the unimpressive Fleet acquisition, (iv) the likely expensive MBNA acquisition, (v) the hours-old U.S. Trust acquisition and (vi) BAC’s low-quality earnings. It is worrying that a management team like that is responsible for one of the world’s mega-banks. How safe is their proprietary trading? Do they know how to manage their MBS exposure? How conservative is their accounting? In my view, BAC is an earnings compression story even without the investment banking risks.

Overview of Current Market Backdrop

Let us now consider what investment banks are doing these days. A good starting point is this Business Week Article:

At least one big investor isn't taking many chances on banks. Anton V. Schutz, who manages the $131 million Burnham Financial Services Fund, held almost every investment bank stock last year. Now he holds only Morgan Stanley. Why? "Investment banks are trading like there's no risk in the world," he says.

The article elaborates:

Consider what happened at Morgan Stanley. Its stock price trailed many of its rivals for four years in large part because the bank wouldn't take on more risk. As it remained cautious, the gap between its bond, currency, and commodities trading revenues and those of Goldman ballooned to $1.7 billion in 2005, up from less than $500 million in 2001. Some say that's one reason why former CEO Philip J. Purcell lost his job.

John Mack is now back, taking MS into the world of risk, seeking to compete with his peer group. This is precisely the danger. All these investment banks and their employees cannot resist the temptation of winning business and being “the best”. I will explore each line of business, using GS for most examples. Readers will notice that the rise of GS’s profits and stock price was accompanied by commensurate growth in risky lines of business. As returns decline and competition increases, they’re ramping up volume and taking more risk, while prudent people are getting further away.

Private Equity

Investment banks finance/fund LBOs, which gives them interest income, advisory fees, syndication and underwriting fees, potential equity stakes, potential profits on hedging related to the purchase, and a new relationship. The risks: credit risk of loan amounts which haven’t yet been resold to others or of residuals. If the credit markets were to turn and reject bank loans, IBs would have to keep sizeable amounts of the former. For the nine months ending August 2006, total bank debt on GS’s books rose from $13B to $27B.

And what’s the private equity market looking like? Warren Hellman recently sounded a bell:

Hellman said his firm recently passed on a deal that had bankers offering to lend at nine times cash flow
Elsewhere, here’s Eugene Leouzon, GS’s Chief Underwriting Officer for Europe and Asia:

“The markets are really, really red hot...[…]… The things we are seeing being done, both on the investment grade side and the non-investment grade side, are I would say borderline stupid.”

Coincidentally, Blackstone announced its purchase of Sam Zell's Equity Office Properties this morning, in what is now the biggest private-equity deal in history. Eventually, the credit cycle will turn and the market will get uneasy about IPOs flipped by private equity firms, which will clog the system with ‘inventory’.

Warehouse Financing

Investment banks fund the warehousing CDOs, mortgages, MBS and other ABS or other debt instruments. GS’s maximum loss exposure to its off-balance sheet entities jumped from $10B in November 2005 to $19B in August 2006, driven mainly by growth in CDOs, credit-linked assets and repackaged assets. Most of that exposure is through credit derivatives (total return swaps and written put options). ABS issuance is currently slowing and the market may yet turn ugly. As for CDOs, they’re fine when the waters are calm but on average, their managers are not conservative enough and the appetite for them could quickly dissipate. Year-to-date U.S. CDO issuance is $298B, 80% more than last year. This growth rate is quite unsustainable, as discussed in a prior post.

Trading

GS’s profit nearly doubled from 2003 to 2005 and most of the growth was in trading. Investment banks trade around the retained portions of the deals they arrange, and then they also trade just about everything else: equity, debt, currencies, commodities, plain derivatives, exotic derivatives, whole companies, power, ABS, mortgages, futures & options. For the nine months ended August 2006, over half of earnings growth and 70% of revenue growth came from trading. Goldman certainly isn’t shy about its position:

“ We believe our willingness and ability to take risk to facilitate client transactions distinguishes us from many of our competitors and substantially enhances our client relationships.”
This growth is based on Wall Street’s extreme short-term trading orientation, which has taken hold alongside the hedge fund boom. Since 2003, trading of all kind has exploded. Even penny-stock trading is up 640% from three years ago. Constrained by volatility ceilings, year-end performance fees and computerized models, most hedge funds care about showing results soon, not in the long term. Only a minority of fund managers think about their investors’ long-term well-being before all else. This is further exacerbated by an alarming decline of what James Grant dubs “looking people in the eye”. Hedge funds manage a lot of capital for investment banks, funds of funds, pension funds and other institutions. They increasingly don’t know whose money they’re managing and, by extension, do not care as much. In addition, traders working for banks or hedge funds care mostly about their year-end bonus.

From the Business Week article:

The appetite for proprietary traders is growing "exponentially," says Richard Stein of executive recruiting firm Korn Ferry International. Banks are paying up, offering some traders $10 million to $20 million a year, he says.

Risk management tools and maximum-loss assessments (whether in the form of VAR or better methods) are likely being relied upon too much:

"Right now everything on my screen is flashing red," said Michael Alix,
chief risk officer at Bear, Stearns & Co. But "that doesn't make me nervous.
[...] The machine works."

Relationships between Investment Banks and Hedge Funds

My last area of focus is what brings everything together: prime brokerage. The problems in this segment go way beyond increased competition. In the trading segment, the only thing which distinguishes investment banks from hedge funds is power - mostly in the form of influence and access to information in the markets. And such information is often obtained from trusting prime brokerage clients.

There are raising suspicions of banks trading on advance knowledge. Front-running is nothing new to Wall Street but today there are four central ingredients which are unprecedented: (i) the temptation to break laws is driven by desperate “reaching for yield”, which is more powerful than the classic binge-type greed seen in past bubbles, (ii) massive volume in new, lightly regulated financial products such as credit derivatives, (iii) front running of hedge funds as opposed to individual investors and (iv) helping some clients front-run other clients. Even the New York Stock Exchange is investigating a major investment bank to see if it's giving a hedge fund it runs preferential treatment - this isn’t limited to SEC investigations.

In the “not illegal” department, there are of course many financial mistakes being committed, including favors being done to please hedge fund clients. From Business Week:

More surprising, banks are also regularly agreeing to buy huge blocks of stock from trading clients even when they know they will likely lose money on the trade.

In the bond markets, money managers ring up traders routinely and ask them to bid on messy multibillion-dollar portfolios of bonds and other financial products with expiration dates ranging from 2 to 10 years. "You have a trader committing in one or two minutes to a trade that could lose or make tens of millions of dollars," says Thomas G. Maheras, head of capital markets at Citigroup.
As a prime broker, a bank has a multifaceted relationship with its hedge fund clientele. Other than broker and trade clearer, the bank is potentially a:

- Partner (through equity stake in the fund management companies)
- Investor (through stakes in the funds themselves)
- Creditor (both through leverage and securities lending)
- Counterparty (buying out positions, providing hedging)
- Investment supplier (classical sell-side role)
- Provider of advice or research
- Competitor: GS & JPM are now the two biggest hedge fund firms. Other banks have been seeding, or buying out hedge funds in whole or in part. This raises potential insider trading type issues, such as the connections between LBOs and CDS trading.
- Potential savior in case of liquidity crisis
- Potential vulture in case of liquidity crisis

All of these factors allow investment banks to profit from their knowledge of hedge funds’ position in the market. The problem is that these profits are not sustainable.
I note that hedge funds generally have a lot of cash at their disposal and to the extent that they spot bad behavior, things could get ugly. When individuals were being ripped off, investment banks were only getting slapped on the wrist. The current boom, however, will be followed by lawsuits going into discovery and sizeable private settlements. The politics are over; hedge funds care about money, not politics.

I am also hopeful that government will respond in an effective non-political way. Since the voters won’t be direct victims of potential violations, there’s a decent chance that securities regulation will be amended following intelligent high-level discussions/debates with knowledgeable fund mangers.

Catalysts for IB earnings and share prices to decline: declining GDP, other disappointing economic data, significant bounce in CDS premiums, tightening of central bank liquidity (Japan in particular), housing hard landing, problems with MBS and mortgage CDOs, rising volatility, high-profile bankruptcy, possible dollar sell-off, volatile commodity markets, possible exogenous event.

Risks to thesis: central banks maintain enough liquidity to sustain the current boom, that liquidity goes where they want it to go, when they want it to go there, the eventual day of reckoning is delayed. In this case I propose a pair trade with Barclays, which is less exposed at trading at a lower multiple.

KKD's Class-Action Settlement

2006-11-14T22:05:00.000-05:00

As response to a question from spout, here's a summary of the settlement's terms:

- Plaintiffs waive rights to pursue with respect to events which have occurred but haven't been discovered by the date of the settlement. PWC and KKD released from future claims

- Insurers to deliver $34,967,000

- PWC to pay $4mm

- Former CFOs Tate and Castevens to pay $100,000 each

- KKD to issue a fixed number of shares to plaintiffs, based on the average stock price between Oct 24 and Nov 6. By my calculation it's about 1.86mm shares.

- KKD to also issue warrants worth $17,916,500 based on the average price between Oct 24 and Nov 6. The other variables are: 5-year expiry, current risk-free rate, volatilities of KKD and peer group stocks, exercise price approximately $11.58 (calculated as 125% of the average stock price between Oct 24 and Nov 6). Unless we see another rally in this stock, these warrants will be worthless. I get a value range of about $6.50 - 9.00 per warrant (assuming a beta range of 1.0 - 3.0). That corresponds to 2-3 million warrants or about $23-$34 million into KKD's coffers upon full exercise.

- So the shares and warrants should result in 4-5mm new shares issued in total, or about 6-8% of shares outstanding. But if the potential $23-34mm in proceeds comes in, KKD would get much more than they are giving and essentially ripping off the plaintiffs for a 2nd time. The equity is worth a fraction of $11.58.

- When KKD announced the settlement on Oct. 31 they estimated an issuance of 1,875,000 shares and 4,400,000 warrants. I may be mistaken; perhaps their assumed beta is much lower than 1.0 but I will not get into these details as they are immaterial.

- "Krispy Kreme will authorize and/or prosecute the pending Derivative Action against Livengood, including any claims Krispy Kreme has against Livengood"

- "Krispy Kreme has agreed to hold the Excess Insurers harmless with respect to any claims for coverage that Livengood may assert"

- "The Krispy Kreme Settlement Warrants shall be exempt from the registration requirements of the Securities Act of 1933 under §3(a)(10) of the Securities Act of 1933. Within ten (10) business days of delivery to Class Lead Counsel, Krispy Kreme will cause the Krispy Kreme Settlement Warrants to be listed upon the New York Stock Exchange"

- KKD will use its best efforts to cause shelf registration of common stock to be issued upon exercise of warrants

- The shares from the stock portion of the award do not necessarily have to be registered.

Housing and Homebuilders in Late 2006

2006-11-10T17:34:00.000-05:00

It's too bad I didn't have this blog in fall 2005, when I was collecting anecdotal evidence or 'ingredients' for a hard landing in housing. Today I have nothing intelligent to add because the media has now exposed the truth. Now it's more interesting to focus on the mortgage market's instruments and participants: MBS, CDOs, GSEs, banks, sub-prime lenders, mortgage REITs, mortgage insurers, hedge funds, pension funds, and more. Determining who's "holding the bag" is not simple.

Today, though, I want to revisit homebuilders one last time before 2006 ends.

There has been some talk lately about the housing market bottoming and maybe rebounding, mainly as result of a rise in mortgage applications and eventually normalizing levels of construction. Also, speculation about interest rate cuts has fueled hope for another refinancing boom. To start off, the cutting of short-term interest rates does not imply a commensurate decline in [potentially much] longer-term rates on home-based loans. Secondly, even if long rates were to decline, ARMs will not be written/taken so willingly and lax lending standards will not return. The boom in I/O loans and Option ARMs is gradually receding, as are fake appraisals, flippers, strong GDP, willing financial markets, and all kinds of other activities which fueled the 2000-2005 housing bubble.

At a UBS conference this week, CEOs of the large publicly-traded builders all said they don't see a bottom in 2007. I will paste some recent CEO quotes and we end with an entertaining CNBC video from the conference.

Here's what KBH CEO Bruce Karatz said last week:

"I don’t think the macro statistics reflect accurately what’s going on in many local markets," says Bruce Karatz, CEO of national home-builder KB Home. "In many once-hot regions, order cancellation rates are running above 40 percent, new-home sales volume has dropped 50 percent, and new-home prices are down 10 percent to 25 percent". Karatz says the current downturn is worse than any he has seen - even the early 1990s market that left so many big builders reeling.

But here’s what he said in March:

"I don’t see a fundamental slowdown other than in the hottest markets. Things don’t continue through the roof forever. This is a breather in prices, and that takes some steam out of the market. In some markets, 10% to 15% of buyers were speculators. You take them out, and the market drops 10% to 15%, and it takes three to four months for whatever overhang there was to be sold, and then the market stabilizes. That’s where I think we will be three to four months from now".

Obviously there's been a change. On to Pulte Homes:

Richard Dugas, chief executive of home builder Pulte Homes Inc., during the company's quarterly earnings call Thursday said although some evidence points to flattening inventory and stabilization in some regions, management will wait for the trends to continue and to broaden before concluding the housing market has hit bottom. "Given our expectations that market conditions will remain challenges for the foreseeable future, we continue to throttle back, consistent with operating a slow demand environment," the CEO said. During the call, Pulte management said it cut just under 800 employees in the third quarter, and about 1,400 positions during the first nine months of 2006

Toll Brothers:

"As long as the market is concerned with not how much can I make on this investment, but how much can I lose on this investment, as long as they're looking at the cup half empty, I think the current market will continue," he said. "Nobody wants to buy something that they think will cost less two weeks or two months later."

Centex:

Centex Chief Executive Tim Eller speaking at a UBS-sponsored investor conference Wednesday said judging by previous housing downturns, it normally takes about two and a half years from the peak to the trough. "So we still have further to go" since most experts place the top of the housing boom in July 2005, the CEO said.

Standard Pacific:

"Our financial operating results and new home order levels for the third quarter reflect the further weakening of demand for new homes in many of our markets," said Stephen J. Scarborough, chairman and CEO. "Accordingly, we have adjusted our business plan for 2006 to reflect lower absorption rates and gross margins."

Hovnanian:

"As we begin fiscal 2007, we are optimistic that some of our more challenging markets will begin to experience decreasing cancellations and an improved sales pace. However, we have not seen signs of such improvement to date, despite reasonably healthy levels of buyer traffic at many of our communities," President and CEO Ara Hovnanian said in a statement.

Beazer:

CEO Ian McCarthy: "Most markets throughout the country continue to experience higher levels of resale home inventories, lower levels of demand for new homes, significant increases in cancellation rates, and considerably higher discounting…We're not telling you today that there's any improvement in our business."

Now here's a good website to track sales and median prices for major U.S. metro areas: www.housingtracker.net. Notably absent from that site is Virgina, where the median price is now down 9% YoY.

As promised, check out this video from the UBS conference, where Ara Hovnanian gets a little politically incorrect and accuses fellow builders of building specs to move land.

[Pictured Above: Lincoln, CA - The Estates at Lincoln Crossing. These houses have been completed in March 2006. No one lives any any of the houses shown. 138 homes in the subdivision. The approximate data is: 3 owner-occupied, 5 rented out, 80 sold to Flippers, and 50 still owned by builder. The builder is cutting prices $200,000 (from $750,000) to dump them, without much success. The picture comes to us from the Ben Jones Housing Blog]

Liquidity Bubble Update

2006-11-07T13:26:00.000-05:00

During October, the world's financial markets decided to use easy credit and go crazy again, gobbling up risk stronger than they ever have. In the meantime, the U.S. economy continues to slow, puzzling an increasing number of people in both the private and public sectors. Reuters reports:

Investors ploughed money into European company bonds and credit default swaps in the last month, reversing months of caution and taking their holdings to a two-year high, a JP Morgan survey showed on Monday.

The survey follows a month-long advance in European credit and chimes with a Citigroup poll last week, which found respondents holding their longest positions since early 2005 -- before General Motors Corp's fall to "junk" sparked turmoil in debt markets.

JP Morgan's survey, mainly of traditional institutional investors, found 47 percent of respondents were "slightly long" or "very long" credit compared with the indexes they are benchmarked against, up from 26 percent in late September.

The survey also showed investors warming to triple-B rated corporate bonds -- in the lowest investment-grade category -- with 58 percent now long lower-rated credit.

This activity logically brought with it a decline in CDS premiums. The premium for a five-year contract on the iTraxx Europe (index of investment grade CDS) has collapsed in the past month from 30bps to 22bps. The Financial Times reports:

Investment banks and hedge funds are being forced to rapidly adjust their trading strategies amid a wave of reported “panic selling” in the US and European credit derivatives market last week.

This heavy selling has driven the cost of insuring debt against default in the market for credit default swaps to record low levels – signalling either that investors are extraordinarily optimistic about the outlook for corporate debt, or that prices are so distorted that they are no longer being paid for the risks they are taking on.

The VIX (a.k.a. fear index) is back near record lows. In order to see the movements more precisely, let's see the YTD view of the VIX. We're under 11 as I write this, compared to 24 at the height of June's volatility.

Why is this happening? The Yen carry trade has been put back on in a big way. Plotting the VIX vs. the Yen's inverse reveals a remarkable correlation. The question is whether the BOJ, like any other bank, is happy about its money being borrowed for speculation - the answer should be obvious. Such concern led the BOJ to drain their reserves in the first half of the year and this caused financial market volatility. The interest rate, however, was kept low and speculators have put on a carry trade again. Well, this morning we have some news:

At the same time, the yen received a boost after Toshihiko Fukui, governor of the Bank of Japan, said that the central bank should not take a long time to adjust interest rates and that Japan's core consumer price inflation was likely to rise.

"The comments were interpreted to mean the Bank of Japan could lift rates as early as this year, reversing a rising consensus that no further rate hikes were to take place until next year," said CMC's Laidi.

Note that the rate hike goes against consensus. We all know what happens when 'everybody' crowds into the same trade and is proven wrong. The current popular trade is borrowing Yen, selling it for dollars and purchasing dollar-denominated bonds.

While many speculators will be "shocked, shocked," that the BOJ is defending its currency, this was predictable, as it follows public statements of concern from top world central bank officials (I have pasted a compilation of such quotes below, for the readers' reference).

There are other sources of liquidity, including Switzerland, the U.S., and China's reserve accumulations. Japan, however is likely the key ingredient. I predict some financial market jitters within the next six months. How significant they will be is speculation but the unfounded optimism witnessed in October does not appear to be sustainable.

---- For Reference ----

Reported by Bloomberg:

Available money is encouraging "barely profitable and highly risky'' investments, French Finance Minister Thierry Breton said last month.

"Interest rates in the main economies have still not been raised enough,'' says Tim Congdon, visiting fellow at the London School of Economics and one of the "wise men'' who advised the U.K. Treasury in the 1990s. "There is a buoyancy in asset prices one gets with high-risk monetary growth.''

While the ECB will probably leave rates unchanged when its governing council meets Nov. 2, President Jean-Claude Trichet said earlier this month that "liquidity in the euro area is ample by all plausible measures'' and recommended "enhanced monitoring'' of money-supply growth.

Former central bankers are even more honest:

"Central banks are now realizing they must take global levels of liquidity seriously", the ECB’s former chief economist, Otmar Issing, said Friday.

"I am concerned about excessive liquidity in the world." This concern is shared by the current members of the ECB’s Governing Council, who have taken the lead in alerting other central banks to the risks at hand, "There is now increasing support of the view that excessive liquidity world-wide is fueling asset prices and is something which has to be taken seriously by central banks…This is a real concern."

Blooper in Japan, three weeks ago:

Business daily Nihon Keizai said the BOJ was concerned about the trend in which investors borrow yen cheaply -- taking advantage of Japan's ultra low interest rates of just 0.25 percent -- to invest in higher-yielding assets overseas.

Playing down the newspaper report, a BOJ spokesman told Reuters that the central bank was not specifically beefing up its monitoring of such carry trades.

The carry trade report followed news on Monday that Russia's central bank was increasing the yen share of its foreign exchange reserves, highlighting the risk that speculators could rush to cover a massive build-up of short-yen positions.

Rebuttal to Prudential's KKD Report

2006-11-02T16:39:00.000-05:00

Today we estimate pro-forma free cash flow for FY2007 and compare it with Prudential's $30mm figure.

But first, let's consider their company-store predictons:

KKD has 108 corporate stores now. Assuming the current run rate AUV is $54,000 per week, that's $303 million annualized.

In FY2003, company stores had revenues of $320 million and operating income of $32 million, as KKD grew from 75 to 99 company stores (an average of 87 store-years during that year). So, each store-year averaged about $367,000 in income. Company stores had AUVs of $76,000 per week.

In FY2005, company stores operating profit had dropped to $10 million or about $70,000 per store. Company stores had AUVs of $60,000 per week.

Mr. Penney assumes operating income of $43 million for the company stores in FY2007. How could he expect each store to make $398,000? He sees more per-store profit in FY2007 than in FY2003 despite the fact that AUVs have fallen by nearly 30% per week since then.

Now let's consider what Prudential's Mr. Penney said today:

"It is our belief that these numbers are archaic and have little to do with the company's future," said Prudential Equity Group analyst Howard W. Penney in a research note issued Wednesday. "Importantly in our view, fiscal 2006 represents a year in which the company was not focused on improving operational efficiencies, but rather correcting the errors of the past."

Really? Let's start with the PR from August 10, 2005:

On January 18, 2005, the Company retained Kroll Zolfo Cooper LLC ("KZC") to provide management services to the Company. Since such date, under KZC's leadership, the Company has:

* obtained a new $225 million secured credit facility
* closed certain unprofitable factory stores and is working to fix company store operations through the implementation of production efficiency and margin improvement programs
* restructured and is continuing to restructure complex franchisee relationships and obligations
* hired a new Chief Accounting Officer and is working to assess and develop improvements to internal financial controls
* reduced the number of employees in its corporate, mix plant, equipment manufacturing and distribution facilities by approximately 25%

In addition, KZC is working with the Company on assessing and developing:

* new product offerings for both retail and wholesale channels
* traffic building marketing and promotion programs
* wholesale volume and margin improvement programs and conducting testing and route profitability analyses
* ongoing cost reduction initiatives
* new store concepts and formats

We also know, from the "Protectors" blog, that Mr. Jervik, the man who is supposedly responsible for KKD's retail, still lives in Hawaii 1 year after being hired, and commutes back and forth to Winston-Salem. We also know that in the class-action settlement, directors' insurers had to pay up on behalf of the insured. My very vague understanding of the insurance industry is that insurance companies do not payout losses if they do not see that the claim is valid.

Prediction: within the next 6 months, BOD members resign. The board is what's archaic, not the FY2006 numbers. If I go into a KKD store now, the business that this store is doing and the numbers that they are seeing inside the store, and the profit on those numbers are similar, and likely worse, than FY2006.

Let's make some conservative cash flow estimates and compare them to Prudential's:

For FY2006 the company generated 1mm in operating cash flow and disclosed about 32mm in one-time professional & legal fees net of insurance recoveries, so pro-forma operating cash flow was around 33mm.

Now, since then, certain big events have impacted the company's cash flow. Let's look at them and their impact to KKD's operating profits:

Wholesale exits (As estimated/disclosed by various franchisees, 50mm worth from GCFF, Gulf Florida Doughnuts and Westward Dough, @ 6% royalty (4.5% to KKD royalty after all op. costs) + 3% Mix&Supply op. profits)

TOTAL ANUALLIZED EBITDA LOSS: (3.7)

GCFF 15 retail closures (15mm worth since associated wholesale no longer existed, 4.5% royalty + 3% M&S, always assuming retail/wholesale have a 50/50 split dollar-wise and 1/3 - 2/3 split doughnut-wise)

TOTAL ANUALLIZED EBITDA LOSS: (1.2)

Rigel 10 closures (20mm worth, 4.5% royalty + 3% M&S op. profits)

TOTAL ANUALLIZED EBITDA LOSS: (1.5)

Other: $500 Decline in AUVs at each company factory store, on the retail side + losses from reverse-operating-leverage effect due all the above items

TOTAL ANUALLIZED EBITDA LOSS: (3)

FY2007 PRO FORMA EBITDA based on current run-rate =
33 – 3.7 – 1.2 – 1.5 – 3 = 24 million

ESTIMATES FY2007 INTEREST: 17 million

(the new rate is LIBOR+725, assume KKD pays LIBOR = 4.75% (taking into account their hedge on 75mm notional amount), assuming Tranche A LOC has 25mm outstanding + Tranche B facility has $115mm outstanding)

FY2007 FREE CASH FLOW (net of interest) = 24 – 17 = 7 million

Not only is the $7 million pro-forma (no professional expenses) but I am excluding a very real cap-ex which I estimate at $3 million minimum and a very real R&D for the new prototype. This compares to Mr. Penney's $30 million FCF number.

Let's continue:

Today, there is a franchisee-originated push for prototyping a new business model, not for implementing a new business model: only PROTOTYPING one. Prudential is therefore telling investors to take a venture-capital type of risk on a stock trading at 35-45X EBITDA, on an EBITDA which is declining, with a loan whose CEBITDA covenants were once again breached this week, and needed to be amended on Tuesday night.

And more on the 10-K supposedly "archaic" content:

This week's 10-K shows how much the sales and profits of franchisees, like Kremeworks for example, declined during FY2006. Is Mr. Penney arguing that franchisee numbers, too, were archaic? Is he arguing that franchisees, too, were distracted by investigations during FY2006? Is he suggesting that they did not focus on operations during FY2006? Is he arguing that company stores somehow did not suffer the same honeymoon-sales-drop-off declines suffered by franchisees?

Ridiculous. Anybody who read even 1/4 of the Protector blog knows that Mr. Reinis, Mr. McGuigan, Mr. Centioli, Mr. Spoor, Mr. Morrissey, Mr. Sigurdson , Mr. Gordon, Mr. Metz, … and the rest, they all struggled, day and night, night and day, week after week, month after month. Many franchisees either went bankrupt, suffered partial liquidation, or experienced negative net margins of 10-20%, as disclosed in the 10-K and on the PACER filings.

Ripping off franchisees is high-ROIC but unsustainable. On the other hand, letting them guide the company is sustainable but very low-ROIC. One of these two difficult paths will eventually be taken. We just don't know which one.

CLOs, CDOs, Synthetic CDOs, CDOs of CDOs...

2006-10-17T17:37:00.000-04:00

Businessweek pre-publishes some of their articles on the Internet one week before the paper version. This article in next week's edition includes notable passages:

Wall Street is pushing CLOs with full force. Year to date, CLO managers have gathered in $90 billion, double last year's pile at this point, which was double the year before that. "Just about every man and his dog is trying to do a CLO at the moment," says Michael Peterson, editor of Creditflux, an industry news service.

Things have gone so well, says one investment banker, that now smaller foreign commercial banks, notorious trend followers, are aggressively buying loans.

"Times are good, default rates are low, and you're probably seeing loans that in a few years will seem far too generous," says Louise Purtle, senior analyst at CreditSights Inc., a research service for institutional investors. "You've got classic cyclical behavior happening right now." Mark L. Gold, co-founder of HillMark Capital, a CLO manager, says: "If you look at the record issuance [of loans] that's been done, clearly you're setting the stage for record problems."

Worrisome signs are mounting. The amount of leverage used in deals right now is greater than the previous record set in 1997, according to Standard & Poor's LCD

The worse mix suggests that in a recession on the order of the one in 1991, default rates would soar more than four percentage points beyond the record 12.8% set that year, says Martin Fridson of FridsonVision, a research service.

"Second liens could be the potential Achilles' heel of the current credit cycle," says Gold, the CLO manager at HillMark.

Fundamental credit analysis of borrowers' ability to repay loans is being shortchanged, says Simon A. Mikhailovich, managing director of Eidesis Capital, a hedge fund group specializing in structured credit. In other words, investor diligence has been less than due: A pool of 85 diverse loans may look good by the rating agencies' statistical and historical models but still hold bombs. "More and more, there is an actuarial approach to credit analysis rather than the old-fashioned practice of looking each borrower in the eye," says Grant.

And for those still new to these derivative structures, here's some more:
http://www.tavakolistructuredfinance.com/Risk3.html

Janet Tavakoli – a former head of financial engineering at Westdeutsche Landesbank in London – advises prospective CDO squared investors to be wary: “If you think you will be able to analyse each underlying CDO, then look at the overall structure and get a clean answer about risk, you are mistaken. It’s way too complex,” she says. Tavakoli now runs a consultancy – Tavakoli Structured Finance – in Chicago.

Inexperienced CDO investors sometimes heavily rely on rating agencies’ assessments when forming opinions about the attractiveness of potential CDO squared deals – something Tavakoli says can be dangerous.

While the approaches of the major rating agencies to CDO squared share many common features, there is a fundamental difference: correlation assumptions. “Opinions [between rating agencies] diverge significantly when it comes to correlation,” says Matthias Neugebauer, an analyst at Fitch Ratings in London who helped develop the rating agency’s approach to CDO square analysis. “Different correlation assumptions can produce very different answers,” he adds. Caveat emptor.

And some research from Lehman Brothers
http://www.mathematik.uni-ulm.de/finmath/ss_05/fe/CDOsquare.pdf

I haven't seen these symbols since college. James Grant is right to be concerned that "more and more, there is an actuarial approach to credit analysis rather than the old-fashioned practice of looking each borrower in the eye". It is better to be approximately right than precisely wrong. If margins of safety were built into credit analysis, there would be less of a need to rely on complex equations and minutia. And so, the fact that derivatives are untested in downturns, combined with the very existence of these mathematical deliberations, is in itself a sign that our credit markets stand on a pin head.

Krispy Kreme's Real Estate

2006-10-10T01:21:00.000-04:00

Once upon a time, in a land far, far away there was a concept known as “margin of safety”.

Two strategies are implied in a secured loan: tangible liquidation value (downside protection) and going concern upside. To estimate the former, a lender would (i) conservatively calculate liquidation value and (ii) lend even less than that - perhaps 65-75% - to ensure safety. Another important concept: liquidation value means: “the value of these assets if we actually liquidate them”. It doesn’t mean book value, nor ‘appraised’ value, nor market value, or replacement value.

It appears, however, that KKD’s secured creditors did not employ these time-tested principles when structuring their April 2005 loan.

For reasons which are off-subject, the business has disappointed in the intervening 18 months. The lenders are now careful, as evidenced by, among other things: the ceiling on further borrowing; the new definition of Net Liquidity; the interest hike to LIBOR+725 and the stunning decision to let Rigel slip into chapter 7 liquidation rather than provide it a DIP loan. Franchisee conflicts and restructurings have taken their toll and EBITDA is probably around 25-30% of what it was 18 months ago.

This post will focus on the main source of tangible value: real estate.

The April 2005 loan package came in 3 parts:
$75mm 1st lien credit line
$120mm 2nd lien term loan (fully withdrawn at closing)
$30mm 2nd lien credit line with letter of credit (mostly being used)

The 1st lien portion, arranged by Wells Fargo Foothill, was capped at $75mm. Since it's a 1st lien, they likely didn’t see liquidation value much above $75mm. It is well known that Wells Fargo uses the conservative methods of the pre-2003 era: any junk loans are based strictly on tangible assets. The 2nd lien lender group is led by CSFB and Silver Point Capital.

According to the deal, KKD withdraws the $120mm up front and uses it mostly to repay old debt. The balance is added to the small cash stash. The $30mm facility would mostly be outstanding, used by letters of credit. The 75mm 1st lien credit line sits idle, waiting for future usage. By April 2006, the 2nd lien group was concerned enough to restrict any potential 1st lien borrowing, saving the collateral for themselves. Therefore, KKD never touched the 1st lien and today has about $120mm outstanding on its term loan.

The 2nd lien lenders recognize their mistake and are now looking at this the conservative WFF way: asset value. But notice the subtle difference: if they were as conservative as WFF to begin with, they too would have capped their exposure at about $75mm. Their former belief in the upside going-concern value leaves them with an exposure far larger.

Let us look at their liquidation value downside.

As of January 29th KKD operated 113 factory stores. They owned the land and building for 51 stores, owned the building and leased the land for 52 stores, and leased both the land and building for 10 stores. Of the 15 factory stores operated by consolidated franchisees, they leased both the land and building for seven stores and leased the land and owned the building for eight stores.

Of the 51 stores owned outright, 32 existed in 1999. Since these are old, small and southeastern, we value the land under them at $500K on average and another $100K for the structure. The other 19 are newer 4000 sq.ft. “Doughnut Theatre” stores. Looking at the costs of land/construction of “theatres”, data available through their bankruptcy filings as well as other sources, and taking into consideration the substantial renovations required of a new tenant, their average value is $2mm at most.

The 60 owned buildings on leased land are not worth much, again, because of KKD’s highly customized interior design. The 4 Freedom Rings leases which were transferred suggest the company would fetch about $200-300K for leases of the big stores, unless the location is outstanding. Let’s assume outstanding and awful locations cancel each other out and value all 60 at $300K a piece. It should be mentioned that KKD has abandoned quite a few such locations in the chapter 11 filings of the three ‘subsidiaries’ (Glazed Investments, Freedom Rings and KremeKo). In one case, they’ve even abandoned the building with equipment inside it.

KKD also has about 10 empty leased stores which were not operating as of January 29th. At 300K per store we can add another $3mm. Actually, it's about time we stopped calling them stores. Even KKD calls them "factory stores" because 2/3rds of doughnuts are shipped out at wholesale prices.

There are also industrial facilities:

The 190,000 sq.ft. plant in Effingham, Illinois is right by the rails. This plant is 2/3 warehouse and 1/3 processing. The warehouse portion is worth around $40-50 per sq.ft., while the processing portion has a lot of useful equipment for any company in grain processing or similar activities. This equipment can fetch anywhere between 0-100 cents on the dollar, depending on the item. I assume they can fetch 6.5mm for the warehouse and 15mm for the upstairs portion including all equipment.

Then there’s a 143,000 sq.ft. mix manufacturing plant in Winston-Salem. Assuming characteristics similar to Effingham (generous) it’s worth $15mm.

Finally, there’s a 100,000 sq.ft. equipment manufacturing and training facility in Winston-Salem. If the plant is needed there’s no liquidation and no value. If it isn’t, there’s a lot of worthless equipment there. At $60 per sq.ft. we add another $6mm.

So we’ve got a total of about $121mm. Now we need to assume the “actual liquidation” scenario, so we'll discount that down to $90-100mm.

There are other assets and liabilities:

- KKD's inventories, tax assets and equipment are not worth much in liquidation
- Accounts and notes receivable, guarantees, lawsuit settlements: given that most troubled Area Developers have either gone bankrupt or were otherwise restructured, almost all of these assets and liabilities are gone. The positive and negative effects have accrued on the cash balance.
- Proceeds from exercise of the KZC warrant: in my estimation KKD received these proceeds and this too has accrued on its cash balance.
- Extra cash: KKD last reported having $28mm of cash. Taking into account the 9.3mm of inflow from warrant exercise and $3.8mm from Australia, it appears the company broke even in Q1 & Q2. A certain amount of cash is needed as a cushion in a liquidation scenario because of the substantially fixed cost structure, the fixed interest expense, and the continued franchisee closures. Assuming they dip into $1-2mm in cash burn per month, I don’t see how more than $10mm cash can truly be considered “free”.

Adding the extra $10mm to our $90-100mm estimate gives us a best case of $110mm.

Wells Fargo was willing to lend $75mm - that’s around 2/3 of $110mm, matching classic definitions of "margin of safety". The 2nd lien group, however, does not enjoy such a margin. Instead of looking “under the hood of franchisees” when they made the loan, these boys just ate up the biased view of KKD’s BOD and put together yet another credit facility, which then undergoes the customary slicing and dicing. In addition to the $120mm, they don’t know what will ultimately happen to the 30mm LOC facility. How anyone can make a loan to a franchisor without carefully scrutinizing its franchisees is beyond me.

Back to the future

So what's the actual state of affairs today? The interested reader is urged to google brokers whose job it is to get rid of Krispy Kreme stores. Hilco’s database appears to have the largest number but there are others. Some listings have come and gone but this doesn’t mean they’ve been disposed of. Nearly all for-sale company-operated stores are from last year’s October-December mass-closure campaign. They're sitting for a year with no takers, diluting each other’s value with every passing moment. There may be hidden cases of future mass-closures. Here's one case: the Fortress Investment Group, which still owns 5 Midwest KKD stores purchased at about 2.8mm each, is trying to get out. On top of all that, a consumer-led slowdown is likely on the horizon. Retail employment numbers have already weakened and a rise in “restaurant for sale or sublease” signs is almost certain.

The store pictured above was operating on a busy Charlottesville road near the University of Virginia. Though its population of 40,745 (SMSA 185,041) is 100 miles away from either Washington, DC or Richmond, Charlottesville was the #1 place to live in the United States according to Frommer’s Cities Ranked & Rated (2004).

KKD acquired that store from a franchisee in 2003, shut it down in 2004 and has been looking to sell out ever since. They're not about to get a boost from this #1 city's economy: median home prices at Q1 2006 were $277,000, up from $177,000 in 2004. As a result, 40% of the population is spending over 35% of income on their house.

How much is this property worth? To whom?

Welcome

2006-10-05T14:22:00.000-04:00

Going public is inherently tricky because, as attorneys like to say, "Anything you do will be Exhibit A in a lawsuit against you". An extension of this fact, perhaps, is that blogging teaches authors to feel accountable for their public behavior - a free lesson on public life. One never knows how far their public life will mushroom. Earlier this week a friend asked how I'd feel if I had microphones shoved in my face. I honestly don't know. The variety of reactions to Paparazzi in Hollywood offers interesting food for thought. Some stars, like Paris Hilton, play the cameras brilliantly. Others, like the late Marlon Brando, sadly enter the quicksand of frustration and helplessness. To be sure, 99% of bloggers including myself are very far from celebrity. But I do reflect on this issue.

Another interesting aspect of blogging is the "me" factor. Revealing one's feelings to the world is liberating yet selfish. The readers want value, usually in the form of education or entertainment. In some cases though, the blogger's feelings and personality are tools for effective dissemination (just as when politicians state a policy conceived by unknown intellectuals).

This blog will not be artificially bound. Having said that, the main course will be business & finance, with a serving of psychology on the side.

My decision to start writing was based, first and foremost, on my gradual realization that it would be beneficial at this stage of my career/life. The second reason is less significant yet relevant to the timing: I'm currently party to a certain situation where months-long private efforts might reach a dead end. If this were to happen, going public would become a legitimate option and the blog would be a useful tool. The 'comments' section is a great way to get feedback, something I've always enjoyed.

It'll be interesting to see where this blog goes and who its audience becomes - these things tend to take on a life of their own. I will post whenever I've got something interesting to add. A French maxim says it best: "la parole est d'argent, le silence est d'or".

Given that the audience of this first post includes many friends and acquaintances, the language and content will be lighter than in future writing. The next few topics will (tentatively) be: relationships between investment banks and hedge funds; corporate governance standards; company-specific issues.

Often when I meet new people, they ask: "So… what should I invest in now? What's hot?". Fellow money managers know exactly what I'm talking about. Depending on the mood, the reaction is either (i) a patient explanation of why 'hot' is to be avoided or (ii) a "token answer", likely a recommendation of something conservative that can be safely held for a long time.

But none of these options are great. I leave the conversation hoping I've reduced the probability of them making a mistake, but hope springs eternal. So today I'm going to give a fill-in-the-blank investment recommendation assuming current market conditions. This recommendation will not be valid in 10 years, and perhaps not even in 10 months.

First, we need to know what not to invest in.

Today's financial markets are indisputably more liquid than they have been historically. Those who, like me, believe that this phenomenon is temporary, call it a "liquidity bubble". In a sentence, that means financial institutions feel increasingly encouraged to lend funds too easily and/or too cheaply. Borrowed funds are used to invest (e.g., alternative energy research) or produce exportable items (e.g., Disney movies). But some of these funds are also used to speculate (e.g., Nigerian bonds, natural gas futures), consume (e.g., renovations, private health care, "pimping up" one's automobile), or re-lend to others. In an out-of-control bubble there's usually an excess of consumption and speculation.

One consequence of over-speculation is a increase in risk/reward ratios (i.e.: people are not being compensated enough for risks they take).

For example, S&P tracks the spread between currently available rates on U.S. government bonds and investment-grade corporate bonds. They also track the spread to non-investment grade bonds (a.k.a. junk bonds). Here's the data:

	Investment Grade	Junk
October 2006	1.36%	3.70%
January 2003	2.11%	7.77%

So today, for lending money to the average healthy company for an average duration, you're making 1.36% more than you do lending to the government. This compares to a 2.11% spread in January 2003. For junk bonds we're talking about 3.70% vs. 7.77%, even more significant a difference.

In other words, you're assuming the same risk as you were in 2003 (risk of insufficient cash flow) but you're not being compensated as well as you were back then. The average junk spread since 1986 has been around 5.5% but in the recession of the early 90's and that of 2001-2002, it spiked above 10% within months. At these points of economic pessimism, a diversified portfolio of junk bonds was a very attractive investment because you were being handsomely rewarded for your bravery.

The same idea has manifested itself in other ways over the past couple of years. Small spreads between prices of houses and condos render condos unattractive. Similar P/E ratios on stocks of dissimilar qualities render low-quality stocks unattractive. The's also been a reduction in reward from lesser-known forms of investment like catastrophe bonds, credit default protection, private equity, second-lien notes, CDOs and even art. Therefore, generally speaking, there's little reason today to invest in anything but safe high-quality assets.

So what's safe? In our simplified discussion it's assets with little or no credit risk:

Stocks of well-capitalized companies who carry little debt and possess a sustainable competitive advantage vs. their competitors. Procter & Gamble and Wal-Mart are good examples.
Real estate with a predictable and sufficient stream of future free cash flow
Bonds (especially short-term) issued by politically and economically stable countries.
Commodities, provided that one understands the supply-demand picture (I personally don't know much about any commodity).
Cash

Alan Greenspan referred to the liquidity bubble last year, saying the following:

The growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk.

The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power.

To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

In plain english, he's saying that if the liquidity bubble goes away, history will not deal kindly with the prices of houses, stocks and other investments. In May and June, as a consequence of the Bank of Japan's liquidity tightening campaign, his prediction partially came true - investments linked to commodities and emerging markets plunged.

Junk bonds have suffered a bit already but will likely suffer much more, along with stocks of marginal companies, condos in San Diego & Florida and many other assets. When and how much? Impossible to know for sure.

In the meantime, my hot tip is: "settle for safety; avoid junk".