NOT AN ANALYST

For all the loyal readers out there, this is why it pays off reading this Blog. One of my earliest posts was about a value opportunity that was hiding behind a technicality on certain Citigroup non-cum equity preferred shares (CprP, CprM and CprI). Here is a link to my post in case you don’t remember:

http://www.notananalyst.com/2009/10/17/citigroup-preferred-shares/

Background In February 2009, Citigroup announced the suspension of dividends on certain non-cum equity preferred (CprP, CprM and CprI) as the securities were converted into equity in an effort to raise tangible common equity and capital requirements. In theory, preferred shares that don’t pay a dividend are worthless based on the Gordon Growth Model but those preferred continued to trade despite the suspension of the dividend due to a technicality. That’s when the value opportunity became evident.

Technicality As I described in my original post, holders of the non-cum equity preferred shares were required to vote on a series of amendments and the most important among them was the dividend blocker. That amendment was designed to eliminate the legal obligation of the issuer or Citigroup to pay dividends on the non-cum equity preferred even if some investors elected not to exchange their shares. However, the dividend blocker didn’t pass and Citigroup became legally obligated to pay a dividend on the outstanding non-cum equity preferred shares before it could pay a dividend on common shares. As a result, the equity preferreds that were trading ex-dividend continued to rise, on speculation of a possible dividend payment in the future.

IRR In my original post, I proposed a scenario in which Citigroup would defer the dividend for six quarters and resume it afterwards. Now, after only four quarters, Citigroup has announced the reinstatement of the non-cum equity preferred dividend. The trade idea yielded an IRR of about 49.5% for each security, significantly higher that the 20% IRR I expected.  Here is the press release:

NEW YORK – The Board of Directors of Citigroup (NYSE:C) today declared dividends on preferred stock as follows:

6.5% Non-Cumulative Convertible Preferred Stock, Series T, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full convertible preferred share, will be paid $.8125 for each receipt held.

8.125% Non-Cumulative Preferred Stock, Series AA, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.5078125 for each receipt held.

8.40% Fixed Rate / Floating Rate Non-Cumulative Preferred Stock, Series E, payable November 1, 2010, to holders of record on October 20, 2010. Holders of depositary receipts, each representing one-twenty-fifth of a full preferred share, will be paid $42.00 for each receipt held.

8.50% Non-Cumulative Preferred Stock, Series F, payable December 15, 2010, to holders of record on December 3, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.53125 for each receipt held.

On February 27, 2009, at the time of the announcement of its public and private exchange offers, Citi announced the suspension of dividends on its Preferred Stock. Pursuant to the exchange offers, Citi offered to exchange up to $14,923,650,000 of its outstanding publicly-held Preferred Securities for Common Stock at a price per share of $3.25; 98% of the Preferred Stock elected to participate in the exchange offers. Dividends declared today will be paid on the Series AA, T, E and F Preferred Stock that remains outstanding.

Common Dividend The dividend reinstatement on those outstanding non-cum equity preferred is a hint to investors. Citigroup should be in no rush to reinstate the dividend on the non-cum equity preferred unless the Company is getting ready to repay a common dividend.  In my opinion, Citigroup will announce the payment of a $0.05 quarterly common dividend in the 1Q of 2011. Stay tuned.

Morgan Stanly Research Here is a research paper from MS highlighting the firestorm of news related to the “ mortgage mess” that hit the market in the past few days. The issues include “robo-signing”, the right of MER to foreclose, the assignment of mortgages to securitization trusts, and putback risk. Although some of these issue such as putbacks represent a real threat to the banking industry, the media has somewhat overestimated the extent of some of these issues and the respective costs to the industry.

Putback losses MS estimates that putback losses to the entire banking industry can account to 105 billion on a base case scenario over the course of the next two to four years, while, in another research report, JPM speculates that losses could add up 55 billion in a base case scenario over the course of the next five years. As you can see, the putback risk is real but it’s certainly “manageable” for banks.

Conflict of interest The recent lawsuit filed by PIMPCO, the New York Fed and Blackrock against Bank of America  is embedded with HUGE conflicts of interest that deserve some attention. First, BlackRock is the largest holder of Bank of America shares, owning about 5.35% of the outstanding BAC shares, for a total value of $6.6 billion. Second, PIMCO has the most to lose if the MBS crisis escalates and if all the MBS are unwound as they hold large positions. Third, the FRBNY’s effort to force the buyback of several billion of mortgages runs against the Fed’s goal of strengthening the banking system and will certainly defeat the purpose of the Fed.  I will let you be the judge of this.

MS-Putbacks

Here you can find the Pershing Square Q1 and Q2 letter to investors. The Q3 letter highlights the possible consolidation of the retail book industry, which increases the probability that BGP is included in that potential merger activity. The Q1 letter, talks about the $20 bid from Simon Properties and why the GGP board wisely turned it down. Enjoy the reading.

Pershing-Q1-2010-Investor-Letter

Pershing-Square-Q2-10-Investor-Letter

It’s in the best interest of every investor to know the exact value of their investments. However, more often than not, business value cannot be precisely determined. Any attempt to precisely value an enterprise, will yield values that are precisely inaccurate because business value changes over time, fluctuating along numerous variables such as macroeconomic and microeconomic factors. This is the beauty of valuation. It’s more an art than a science. How can you precisely value a business that, unlike debt instruments, may not have a constant stream of cash flows? Thus, the value of a business is never a single number, but a range of values where the highest estimate is sometimes twice as much as the lowest one. For example, we all experienced the difficulties or impossibility to value an enterprise such as General Growth Properties. I remember that at the beginning of the bankruptcy process, valuation ranged from $5 per shares to more than $20. That’s where opportunities arise. If securities could be valued precisely, there would be few differences in opinion, market prices would fluctuate less frequently, and trading would diminish significantly, making our job useless. Discrepancies over the value of a business result from differences among the assumptions used, especially discount rates, projected cash flows, differences among the valuation methods used. I consider three different valuation methods that can be used to value en enterprise.

Absolute value

When futures cash flows are reasonably predictable and an appropriate discount rate can be chosen, the absolute value represents the most reliable source of information. However, cash flows are usually uncertain and the choice of the appropriate discount rate is usually an area of debate, hence we have to be careful when we use this valuation method. In the context of absolute valuation, cash flow, which comprises of dividends, free cash flow or residual income, is discounted at the required rate of return to find the PV of such cash flows.

Dividends

Generally, using dividends as cash flows is most suitable when the company is dividend paying, the board of directors has established a dividend policy that bears an understandable and consistent relationship with profitability and the investor takes a non-controlling ownership, because shareholders do not have control over the dividend policy.

Free cash flow

Valuation using free cash flow to the firm (FCFF) or to equity (FCFE) is most suitable when a company is dividend-paying but dividends significantly fall short or exceed FCFE, the company doesn’t pay dividends at all and the investor takes the ownership prospective. However, applying the free cash flow approach posts problems in some cases.  Some companies have intense capital demands and, as a result, have negative expected free cash flows far into the future. A profitable enterprise that is expanding may have a negative free cash flow indefinitely because of the level of capital expenditures. The present value of a series of negative cash flows is a negative number, therefore the use of a free cash flow model entails a long forecast horizon to capture the point at which expected free cash flow turns positive. The uncertainty associated with such forecasts may be considerable.

Residual value

Conceptually, residual income is the book value per share plus the present value of expected future earnings reduced by the equity charge.  Because the record of residual income can always be calculated, a residual income model can be used for both dividend-paying and non-dividend-paying companies, and for companies with negative expected free cash flow with reasonable forecast horizon. However, the application of the residual income model requires a detailed knowledge of accrual accounting. In some cases, the degree of distortion and the quality of accounting disclosure can be such that the application of the residual income model is error-prone.

Relative value

A valuation method relies on price multiples that sophisticated and prudent investors have recently paid to purchase similar businesses. For example, multiplying a benchmark value of the price-to-earnings (P/E) by an estimate of a company’s EPS provides a quick estimate of the value of a company’s stock. The concept behind price multiples is that a stock’s price cannot be valued in isolation (absolute value). Rather, it needs to be evaluated in relation to what it buys in terms of earnings, net assets, or some other measure of value. The economic rationale behind the method of comparables is the “Law of one price”, which is the economic principle that two identical assets should sell at the same price. But what can constitute the benchmark? Generally, it’s the mean/median multiple of the company’s peer group within a certain industry, or the mean/median multiple of the company’s whole industry sector or the company’s own past multiples. However, this valuation method is not without shortcomings. The method of comparables argues that a firm with multiples below the benchmark is undervalued, and with multiples above the benchmark is overvalued. In this case, the fundamental of the stock have to be similar to the fundamental of the benchmark before we make any direct comparison and draw conclusions whether the stock is overvalued or undervalued. Let’s suppose that, after hours of research, you determine that the P/E of the stock you are trying to value is less than the benchmark. There are at least three possible explanations for this:

• The stock is undervalued
• The stock is properly valued, but it has a lower expected growth rate than the benchmark, which leads to a lower P/E
• The stock is properly valued, but it has a higher expected return (higher risk or required rate of return) than then benchmark, which leads to a lower P/E.

In order to conclude that the stock is truly undervalued, we have to make sure that the stock is comparable to the benchmark, it should have similar expected growth and similar risk/return.

Liquidation value

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment opportunity. The assets of a company are generally worth more as a part of a going concern than in liquidation, hence liquidation value is generally a worst-case scenario assessment. When no crisis is at hand, liquidation proceeds are maximized through an orderly winding up of a business. Cash is worth one hundred cents on the dollar. Investment securities are valued at market prices, less any transaction cost. Accounts receivable are appraised at close to their face amount. The value of inventories is not easily determined and it depends on whether or not the inventories consist of finished goods, work in progress, or raw materials, and whether or not there is the risk of technological obsolescence. The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flow and their next best use. Emulating Benjamin Graham, the approximation of the liquidation value of a company can be calculated as “net-net working capital”, which is net working capital minus all long term liabilities. As long as working capital is not overstated and operations are not rapidly consuming cash, if a company could liquidate its assets, extinguish all liabilities and still distribute proceeds in excess of the market price to investors, it represents an attractive opportunity.

Adjustment Error On the previous post, I introduced a capital structure trade on Town Sports International, recommending to sell short the equity and to buy the 11% Senior Note. However, it was brought to my attention by an alert follower that the adjustment for off-balance sheet liabilities was a little off. The correct adjustment for operating leases is to capitalize them, adding the PV of minimum lease payments to assets and liabilities and adding rent expense or calculating EBITDAR. For Town Sports Intl, the adjustment creates an EV/EBIDTAR multiple of 7.1 and EBITDAR/Interest Expense of 1.93, a slight improvement from my previous calculations but the fundamental idea remains intact. Now I want to take some time to go over few key aspects of investing: warning signs of earning s manipulation and balance sheet adjustments.  

Skeptical When you are valuing a company, as an investor, it is important to look at financial statements and management projections with skepticism. Sometimes management has an incentive to increase earnings or increase sales rather than maximize shareholders value. Sometimes financial statements need to be adjusted for valuation purposes, changing the picture of the overall company.

Manipulation When financial information is reported to capital markets, security prices move. This creates a clear incentive for management to report financial performance that meets or exceeds current expectations. The target that a Company is trying to achieve is a moving benchmark: the consensus sell –side analyst forecast. Investors need to be particularly skeptical about reporting earnings when: top management has a significant portion of vested options in the money, the company is trying to maintain a track record of successively meeting analyst forecasts and is looking to raise additional financing. The presence of these risk factors can provide an incentive to accelerate recognition of earnings or report aggressive earnings, which are transitory and non-persistent. A good example is Microstrategy. Between the end of 1999 and early 2000, the stock price of Microstrategy rose from $25 to above $300. But in March 2000, they announced a restatement of earnings because they accelerated the recognition of revenue by booking legitimate future sales orders in the current fiscal period. At a first glance, this doesn’t seem particularly egregious: after all, these would have been legitimate sales. But placed in the context of significant capital market pressures, where analysts and investors were looking for exponential sales growth to support very lofty stock prices, the front loading of revenues allowed Microstrategy to report very large revenue increases over the 1998-1999 period. When investors learned that this run up in sales was the result of front loading future sales, there was a quick correction in price. Did management knowingly accelerated earnings recognition? We will probably never know that but it’s beyond our point. A skeptical view on earnings report will help you identify potential manipulations.

Adjustments I will now introduce a brief discussion on two balance sheet issues, off-balance sheet debt and goodwill. Off-balance sheet debt includes items not reported in the body of the balance sheet but that might be associated with an obligation for future payments. The classic example is leases. US GAAP recognizes two types of leases (operating and capital) and provides different accounting rules for each. The treatment of operating leases relative to capital leases is dramatically different. An operating lease treats the cash outflow associated with the lease as a rental expense, which will be recorded on the income statement. With a capital lease, the PV of minimum lease payments is recognized on both assets and liabilities at the inception of the lease, and amortized over the life of the lease. Companies have a strong preference for operating leases, as this keeps the lease obligation off the balance sheet. The use of operating leases is pervasive in the retail sector with companies such as Walgreen, Wal-Mart, CVS and others having very large off-balance sheet operating leases obligations. The consequence of bringing these leases onto the balance sheet will be to increase leverage ratios; and depending on how these companies amortize the value of their assets, there could also be significant impact on reported earnings.

When a company acquires another company and records part of the acquisition price as goodwill, the goodwill is capitalized as an asset and no periodic amortization charges are taken against it. Instead, companies evaluate goodwill and other acquired intangible assets for impairment annually or whenever circumstances indicate that the value of such an asset is impaired. Disclosures for goodwill can be found in the supplemental information to the financial statements. Investors should look carefully at changes (or the absence of an impairment given overall economic conditions) in reported goodwill. Companies that continue to report goodwill on their balance sheet, but they have a market capitalization less than book value of equity, are certainly worth an examination to understand why an impairment charge was not taken.

Last week, legendary value investing fund manager Seth Klarman made some rare public comments at the CFA Institute in Boston. Here are some notes from the conference, reported originally on Distressed Debt Investing.  

Seth Klarman Discussion with Jason Zweig of The Wall St. Journal

Additional-Seth-Klarman-Notes

New “TARP Tax” on Banks The Administration has proposed a “Financial Responsibility Fee” that would be levied on banks and other financial institutions with assets exceeding 50 billion. The goal would be to recover the losses and costs associated with the TARP program.

Fee to be based on liabilities The fee would be 15 bps based on the “covered liabilities”, which are assets minus Tier 1 capital, FDIC-insured deposits and insurance liabilities covered by state regulated funds. The logic is that Tier 2 and Tier 3 liabilities serve as a proxy for risk trading activity and that firms engaged in such activities should bear additional costs.

Support The proposal will strike a positive tone from a populist perspective and be politically popular. The Democratic leadership in the House has indicated support for the proposal and it’s too early to speculate where the Senate might stand.

In details The fee would go into effect on June 30 2010 and would last for 10 years. The fee collected would contribute to the overall reduction of the budget deficit. I believe that is the bottom line, the Administration will need to decrease the horrifying budget deficit by increasing taxes to someone, and financial institutions look like the perfect candidate.

Flaws and uncertainties About 50 institutions could be subject to the new tax, including US subsidiaries of foreign firms. The Administration has not yet decided if off-balance sheet liabilities would be eligible to be taxed. So here is what needs to be clarified: If the tax is on only domestic liabilities, then a financial institution could avoid the tax by allocating the liabilities to its foreign subsidiaries or to a foreign SPV (Special Purpose Vehicle).  An SPV is an off-balance-sheet liability that is usually created by the parent company for the purpose of selling asset backed securities and securitization purposes. If the tax is on consolidated liabilities, then the Administration has no authority to tax the consolidated liabilities of foreign institutions operating within the US, which means that foreign institutions can avoid the tax while their US competitors cannot. 

The reality While the behavior of many major financial institutions or their leaders was unjustifiable, the proposed tax is both designed incorrectly, irrelevant and it makes little economic sense.  Moreover, the spin that the tax is intended to recoup the losses banks caused to the TARP is misleading, because the primary sources of those losses to date have been Freddie and Fannie and the automobile companies that are exempted from the tax. There is no justification from the taxpayers’ perspective of excluding them from responsibilities for losses, as well. I guess it would make little sense for the Administration to tax itself. Finally, it should be noted that government support to financial institutions extends far beyond just the TARP. Subsidies have come in the form of access to low-cost funds, through borrowing at subsidized rates utilizing Federal Reserve special programs, from merger assistance, from FDIC deposit and debt guarantees, and from the implicit subsidy inherent in too-big-to fail.

Introduction A leveraged ETF is designed to replicate X times the daily investment return of an index or asset class before fees and expenses. A swap based leveraged ETF is a leveraged ETF that utilizes swaps transactions to reproduce the desired leveraged return. Due to the basic nature of these funds, increasing fees and risks, swap based leveraged ETFs are going to experience a significantly fall in value. Let’s take a closer look.

How it works In a leveraged ETF swap transaction, the fund enters in an agreement with a counterparty where the latter delivers the performance of the index to the fund and the fund delivers the performance of a basket of securities it holds which can be completely unrelated to the index it’s tracking. Prospectuses from Proshares and Direxion indicate the use of swaps to replicate the desired return and alert investors about several risks (counterparty, credit) involved but there are other factors to consider.

Counterparties The names and credit rating of the counterparties it’s not disclosed. If a counterparty defaults on the swap, the fund NAV will be significantly reduced regardless of the performance of the index.

Collateral The liquidity and quality of the collateral or the basket of securities used to back the ETF in the swap transaction have to be considered. Direxion and Proshares disclose the holding of each ETF daily but it is unknown which securities are used as collateral.

Fund Manager The name of the fund manager for ProShare Funds (Proshare Advisor) and for Direxion Funds (Rafferty Asset Management LLC) is disclosed but the fund manager track record, its ability to monitor counterparty exposure and performing fiduciary duties are unknown.

Fees Transaction fees are a fixed cost. The desired leveraged return is replicated before fees and expenses, therefore higher fees will significantly impact performance. Counterparties will start charging higher fees to enter in a swap transaction with ETF issuers due to increasing credit risk. In June, FINRA issued a regulatory notice alerting brokerage firms that suitability and sales material have to be updated for investors looking to buy a leveraged ETF.

Leveraged ETF Trading Pattern Holding a leveraged fund for more then a day can cause unintended consequences. Some factors become evident after analyzing returns for a period that is longer than one day. We look at returns of FAZ and FAS that follow an asset class, the Russell 1000 Financial Services Index.

Tracking Error The actual performance of a leveraged ETF significantly deviates from the predicted performance when we look at a time frame longer that one day, especially for volatile funds that track an asset class (FAS and FAZ) rather than a large cap index. This demonstrates that a buy and hold strategy can result in a significant reduction of value over time as the funds tend to largely under perform the predicted performance.

Confidence Interval of Errors It indicates what the upper and lower levels are for the tracking error of monthly returns with a 95% confidence. For example, looking at the data below, we observe that there is a 95% possibility to have a tracking error between -1.66% and -15.40% from its mean for FAS and between -5.01% and -38.69% from its mean for FAZ. The upper and lower limits are significantly wide, especially for FAZ, indicating a high deviation of  the tracking error when we look at monthly returns.

 Mean= Average of the tracking errors

SEE (Standard Error of Estimate) =Standard deviation of the tracking errors

Confidence Interval= Mean+/-1.96*(SEE/square root of Mean)

Tracking error= ETF Return – Leverage Factor*(Index Return)

Prices for FAS and FAZ  are adjusted for a reverse stock split

Rebalancing Most funds rebalance their holdings at 15:00 EST or right before the close in order to maintain their target debt/equity. The rebalancing effect is magnified by the presence of a trend and volatility of returns. The highest returns are obtained in trend markets with low volatility. The lowest returns are in volatile and non trending markets.

Negative Bias There is a natural negative bias embedded in leveraged ETFs. We can calculate the return needed to bring the value of an asset to par as R=1/ (1-R)-1 which means that if the asset declines 10%, we would need a return of 11.1% to bring the value back to one. Given Ru=2[(1+Rd)/1]-1 the predicted return on a index and Rd= [(1/1+Rd)-1] the return on the leveraged ETF based on that index, the first equation will always be larger than the second one when the return is negative and will always be larger when the return is positive. The equation will hold for short term trades and in absence of a trend. An investor who wants to capitalize on the fall of a particular index is better off shorting the long bull leveraged fund rather then go long the bear leveraged fund for that same index.

Conclusion   Swap based leveraged ETF like FAS, FAZ, DIG and DUG that track a certain asset class (financials, oil and gas) rather then a large/small cap index, are the most likely to fall first because of higher volatitlity of returns and the nature of the funds.

Bank of America

 JP Morgan

 Provision for Credit Losses

Note: values are in millions of dollars.

Looking at 3Q 2009 earnings releases from JPM and BAC, it’s  noticeable that despite improving economic condition, credit costs remain high and continue to negatively affect earnings. Profits from trading, investment banking and brokerage fees are offset by losses related to deteriorating credit quality. Provisions for credit losses remain elevated compared to 3Q 2008 levels as the consumer continue to remain under stress, but the rate of increase is diminishing. Part of the credit losses are attributable to growth in loans (in 3Q 09, BAC extended 183.7 B in credit) and part to weak economic conditions in US and around the globe. Non-Performing Loans, or loans that are at least 60 days past due, and Allowance for Loan Losses, or an estimate of uncollectible loans, continue to climb as a percentage of total loans  (table above).

The business segments that are negatively impacting banks the most are:

Card services Delinquencies and losses related to credit card loan portfolio continue to climb as the consumer spend less on average and unemployment remain high.

Commercial and residential lending High unemployment rates and home prices declines continue to drive higher estimated losses related to the consumer and commercial lending.

Take a look at the article below, it’s pretty good. I want to share it with everyone and discuss, but I am not going to talk about the good or bad of GS. Maybe you can.

From Economist.com “Heads I win, tails you lose”

“Much of the outrage over bonuses is unjustified. People who create wealth are entitled to be rewarded for their efforts”.

I agree but the statement is too general. First of all, how do you measure wealth creation? Is it calculated with higher revenue or with creation of good for the overall benefit? Also is it the company’s wealth or the shareholders? My take is that bonus payouts should be approved by shareholders through proxy voting and bond covenants should define acceptable ranges for packages. After all, the capital received from the issuance of a bond is used for operating and investing activities.

“The best solution would have been for the Government to have taken an equity or equity-related stake in every financial firm it helped when it bailed out the system last year”

I don’t disagree with the statement but it’s too easy to say now what could or would have been a better course of action a year ago. A decision needed to be taken promptly and the shape of the crisis was something that was never seen before. Of course now, few months after a huge bank rally, “the government missed out on much of the profit it could have made from a stake in the better firms that were saved”. It was almost impossible to distinguish a “good” bank from a “bad” bank a year ago.

 “This doesn’t look like a good outcome for Citi’s part-owner, the taxpayer” Commenting on the forced sale of Phibro.

I cannot agree more. The US Government does own more than 30% of Citigroup, which makes it an influential party, but it shouldn’t get involved with buying or selling of assets. But this is not all, the Government’s involvement can make things worse for Citigroup as it may force to sell Mexico’s Banamex Bank, a key element of the Company’s retail business, which contributed with $900M in profits for 2008. There is a law in Mexico that prohibits a foreign Government to own more than 10% of any bank that operates inside of Mexico. This would be a big loss for Citigroup as these bank deposits represent cheap funding, making them one of the least toxic assets. This can be good material for the next post.

Full and fair disclosure

Do you have any beneficial interest in the security or product reported. NO

Do you have any compensation agreement with a third party regarding the performance of the security or product reported. NO 

Do you have any outside relationships that might give the appearance of a conflict (e.g. board memberships, trustee positions) with the company reported. NO