NOT AN ANALYST

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

Introduction The third quarter earnings season just kicked off few days ago and investors are looking for signs of an improving economy. Several companies are expected report good earnings but be aware that better then expected results doesn’t necessary mean good results. Here are some things to look for in the up comings earnings reports.

Guidance.It indicates the outlook for the future. If earnings figures are reported to be better then anticipated but the guidance is lowered, then you will see some heavy selling.

Good sales. Better then expected sales figures means that demand is stronger then originally thought. It’s probably going to be hard to see higher sales number versus a year ago so growing sales since Q1 is good news. Once it’s established that sales are increasing, look for drivers of sales growth.

For credit card companies and banks: revenue attributed to large reduction in doubtful accounts seems unjustified given this economic environment and it represents a warning sign for potential revenue overstatement.

For banks: Due to joint ventures, mergers and acquisitions, some financial companies may indicate higher asset values or one time gains in the income statement. Look for how much asset growth is attributable to goodwill and carefully monitor changes in reported goodwill. Absence of impairments in this tough economic environment or increase in goodwill is a sign of low quality earnings.

Retailers: large portion of revenue accounted to LIFO liquidation is not sustainable and should be removed. The company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. Once it runs out of cheap inventory, it will have to purchase new inventory at a much higher cost base.

Computer software companies: with providers of goods and services sometimes there is discretion on deciding when a service has been provided. Revenue attributable to large decreases in unearned revenue is another warning signs as the unearned revenue account could be built up during periods of strong growth (customers prepay for service) and tapped into when times are tough like now.

EPS. It’s not necessary a good indication of growth in this economic environment because better net income can be the result of heavy cost cutting or one time tax credits.

Conclusion. Earnings have a tendency to revert back to normal levels (mean reversion) and very low or very high earnings are not expected to continue in the future. This has an economic meaning as capital migrates to more profitable businesses, increasing competition and reducing returns. The net effect of these competitive forces is a return to “normal” earnings levels

Introduction Treasury auctions for long dated maturities have been closely watched by investors and market participants in recent months. The frequency of the auction for 30 Year Bond has been changed to monthly from quarterly and the size of each auction (for all maturities) have been significantly increased as an effort to increase liquidity.

Improving conditions in the equity markets and speculations about rising inflation in the near future, have risen concerned about the success of treasury auctions for long maturities like 30 Year Bond and 10 Year Note. However treasury buying has been very strong since the June auction, sending the 10 Year Note yield below 3.20% and 30 Year Bond yield below 4.00% on both 10/01 and 10/07 respectively, which are level not seen since the beginning of the year when the market was in worst conditions then now.

Bear Market A bear market for treasury bonds with maturities of 10 Years and higher can be on the way. The following are compelling reason for this thesis. Auction results are posted on table 1 at the bottom of the page or here

Recent Auctions The result of the last round of auctions was mixed. On 10/06 the 10 Year Note auction was very strong with a bid/cover ratio of 3.01 and high yield of 3.201 but the 30 Year Bond auction was weak for the first time in months with a bid/cover ratio of 2.37 and a high yield of 4.009%.

Trading Patter The week before the auction on September 28, equity market pulled back due to worst then expected manufacturing data and employment data, however treasury securities reaming unchanged, signaling a possible change of trend. Yields from 30 Year Bond closed on Friday October 02 at 4.011%, a small decline in yield from Monday’s close at 4.045%, the same situation happened for 10 Year Note where yields fluctuated from 3.302% on Monday to 3.221% on Friday

Geithner Factor Beginning in June, auctions experienced a sudden increase in demand from indirect bidders, giving the impression that foreign demand for domestic debt was stronger than ever. But in a little noticed switch on June 1, Geithner appears to have used some artifice in redefining ‘indirect’ buyers to include not only foreign entities but also domestic buyers who place orders to purchase Treasuries through a primary dealer. This “little change” of information reached bond desk just few weeks ago and now traders are speculating that foreign demand is not very strong after all and that yields could be too low at the moment to spur demand. If that’s the case, the fed will have no other option then raise rates.  

 Auction size Supply for recent actions reached levels. The auction size for 10 Year Note has been above 19B and above 11B for the 30 Year Bond since February 2009. The fed is probably going to reduce the auction size at the beginning of the 1^stQ 2010 which will cause a rise in yields, as the fear of inflation is rising and the foreign demand is now uncertain (see the Geithner Factor).

Conclusion Treasury yields are definitely on the rise with the 10 Year Note possibly reaching 4.00% and the 30 Year Bond reaching 5.00% in the 4^th Q of 2010.

10 Year Note Auction Results

30 Year Bond Auction Results

Table 1