Thursday, March 29, 2007

Some Thoughts and Updates:

Hi readers, it has been awhile since my last post but I assure you I've been keeping busy. Here's what I've got.

I've been wrapping my mind more on different ways of looking at DFC. My newest perspective is to take the securitizations off the balance sheet to get a clear picture of what risk lies where.

At the end of 2006, DFC has:
489 million in assets + 45 million in Deferred Tax Asset
431 million in liabilities

Cashflow looks like:
-114 million in expenses
+147 million in net interest inflow
+33 million from non-interest inflow

There is 6160 mil in securitized loans with debt balance of 6017 mil off the balance sheet.

68 mil in equity +45 mil DTA+ 144 in overcollaterization.

In comparison, at 2005, there was 68 mil equity + 54 mil DTA + 50 mil overcollaterization.

This view is different because it ignores the provision for loan losses and other discounts which don't affect DFC's holding co. cash flow, but is expensed in the income statements. In reality, Delta Financial had 66 million in pre-tax cashflow come in for 2006. The deferred tax asset represents taxes they must pay upfront because the IRS does not recognize certain expenses, such as provisions for loan losses and gains on sale of older securitizations. I think it's better just to ignore this number as it will almost always exist (readers can correct me on this view if they disagree). What you clearly see though is two otherwise difficult to see facts.
1. Delta Financial generates a lot more cashflow than their financials show.
2. This cashflow is being used to fund further loan growth and ends up mostly in overcollaterization, which is equity that is at risk.

When analyzed in this perspective however, an investment in DFC at a market cap of 200 million seems a lot more compelling.

I guess it is standard industry practice to offer a 10% discount to listed prices for pulp. This negatively affects the assumptions made in our initial write-up. The overall effect drops my free cashflow estimate to 96 million. Still, with a market cap of under 500 million, SFK still makes for a very compelling investment. Just another one of the benefits of investing with a significant margin of safety.

Brick Income Fund (BRK)
I initiated a position in the Brick Income Fund. The Brick Group is a Canadian retailer of furniture, matresses, appliances, and electronics, and it has a market share of approximately 8.1%. The units have a distribution yield of 13.5% and the company arguably has a phenomenal Return on Investment of near 100%. With the ability to expand relatively cheaply and a growing franchise business, the company seems like a steal at these prices. Look for a further write-up shortly.

"Economist Thursdays"
Those devoted to reading the Economist know the new issue comes online on Thursdays (I've pinpointed it to 10:30 AM PST). Some notable quotes from this week's Finance and Business section:

"Loan securitisation disperses risk through the financial system and reduces the chances of a banking collapse. But it does have its downside, as has already been seen with American mortgages. In the old days, a bank was stuck with its loans and needed to worry about the long-term creditworthiness of the borrower. Nowadays, a bank will pocket an underwriting fee and get the loan off its books within weeks. In their eagerness to get deals done, argues Paul Watters of S&P, banks and investors do not differentiate sufficiently between good deals and bad."

"And remarkably, this lending free-for-all continues despite a sharp drop in credit ratings, says Martin Fridson, editor of the indispensable Distressed Debt Investor. No one seems bothered that 17% of senior, unsecured junk-bond issues are on the lowest possible rung, compared with 2% in 1990. "

I hope I can't get sued for that.

Friday, March 23, 2007

Fixing some reasoning behind DFC:

I was recently interested in finding out whether the overcollaterization provision made by Delta Financial would be a source of potential earnings boost for the company. Simply speaking, if Delta wanted to securitize 100 million in loans, they would only issue 97 million worth in asset-backed securities. The 3 million extra would serve as a cushion in order to add more security for the asset-backed securities and to obtain better credit ratings. So is there anything important here? My conclusion was yes, but for the wrong reason.

At December 31, 2006, the loan principal balance that is backing securitizations stood at 6.16 billion, while the debt balance was at 6.02 Billion. That's 140 million that is considered equity on Delta's balance sheet, but in fact is not free for them to use until these securitizations start to expire. So, my judgement that DFC had 100 million in "excess capital" is false. In reality, as these securitizations start to expire, this will increase the amount of freed and clear equity that DFC holds. But this is also important because now two things change:
1. I believe excess capital to be between 10-25 million, substantially lower than 100 million.
2. A doomsday scenario could wipe out practically all of the equity.

It's always important to note when you are wrong. The margin of safety has largely been taken away. Now, my thesis involves simply owning the highest quality company with high insider ownership in an industry in danger. The price is very cheap at 7 times earnings. And over the past few months, hundreds of billions of underwriting capacity has come off the market, leaving the potential for Delta to become choosier and perhaps more profitable. But most this capacity coming off wrote mostly very poor loans, which Delta has chosen to avoid.

Normally, I start a position small and build it up as I get a better understanding of the company. Delta currently consists of 3% of my portfolio. At this point, I would choose to not add to my position due to a lack of a definitive margin of safety.

Subprime Implode-o-meter

Tuesday, March 20, 2007

Chou Fund 2006 Annual Report:

Francis Chou is an exceptional value investor and I highly recommend everyone reads his annual report below. I would particularly emphasize the following excerpt:

"General comments on the market
We continue to have problems finding compelling bargains in the marketplace. Not only are
the P/E ratios and price-to-book values still high, and dividend yields low, relative to historic valuations, the number of companies that are underpriced is at an all time low. We would
caution all investors that their chances of a large permanent loss of capital are high if they
invest in today’s market leaders at current prices."

He goes on to list several examples of risk being forgotten in today's investment pricing.

Chou Funds 2006 AR

Monday, March 19, 2007

SFK 4Q Results:

-Ebitda of 14.4 million for 4Q
- Acquisitions contributed an adjusted 4.2million EBITDA for 2 months of operations
- $684US realized prices for Q4, compared to $668 US in Q3. Average List price was $770US
- Cost per tonne decreased in 4Q due to lower fiber costs and delivery costs
-2.1 million in one time charges included in the quarter due to acquisition.
- Sales mix is 81% NA, 19% Europe, compared to 72%, 28%, respectively.

-Expect 15 million in capital expenditure for 07.
- 10 million allocated to upgrade at NBSK mill which should boost production by 5%

- .8777 Exchange Rate for 4Q, currently standing at .8495
- Prices have subsequently increased to $790US and a further $20 increase has been announced by many industry players for April.
- SFK implemented price increases for both pulp types at beginning of the year.
- Management feels RBK is mistakenly tied to Hardwood pulp prices, they believe it will develop into its own market index eventually because it has "up to 30% higher value softwood fibre and increasing demand from customers for more post consumer recycled content." Management hopes to capitalize on this by owning two of the very few RBK mills in the world. (45% of NA market share)

Overall, the results were mostly as expected. I am dissapointed that the realized prices are taking so long to match with list prices, but management has said they are basically working on it. Also, the decrease in costs is a great sign that we may see the discrepency in fiber costs between Western and Eastern Canada continue to fall. Management was positive about the future for the company. They continue to own one of the lowest operating cost NBSK pulp mills in the world, and they were able to purchase the RBK mills with a clear vision of its future potential for only 5x EBITDA.

Friday, March 16, 2007

Some More Info on Subprime:

Below are two links providing more information for those trying to better understand the subprime problem.

Challenging and Emerging Risks in the Home Mortgage Business

Comments of the Center for Responsible Lending

One can't underestimate the effects this could have. If many of these subprime loans prove unsustainable without the hope of refinancing, this could increase defaults, which could decrease home prices, which could spread the default risk up the credit quality ladder. Meanwhile, mortgage insurers will be affected, along with banks, which pretty much spreads out to everywhere. Consumer demand, which has been so reliant on asset monetization, can drop. That branches out to affect the whole economy. I wonder if Japan 1990 started this way... If anyone knows of a good book describing the run-up and consequences of the Japanese depression, please do share.

Comments on SFK Earnings tomorrow after I listen to the Conference Call.

Saturday, March 10, 2007

Some Recent Portfolio Earning's Reports:

Several portfolio companies have reported earnings in the past week. Below are some notes taken for each. I'm still waiting for SFK's earnings release.

Fairfax Financial (Current Price: $200.04)
Market Cap: 3.55 Billion

-Book value is up to 2.7 Billion, or $150.16 per share.
-2.6% benefit of float
-Runoff seems to be very well contained and costs should be down next year due to office closures.
-ICICI Lombard (equity accounted) is the largest private insurer in India with a 12.5% market share, and grew premiums over 80% this year to $700 million
-Expecting a soft market ahead for insurance, Fairfax's goal is to write costless float.
-8.1% return on portfolio for 2006, long term average of 9.3%. This is amazing and what makes Fairfax stand out from its competitors.
-continued to be hedged for 1 in 50 year market meltdown with S&P puts and CDS.
-Subsequent to year end, Hub Group was bought out for consolidated pre-tax gains of 220 million, and the CDS portfolio has regained much lost ground after the recent market scare. Note that the CDS portfolio is against several US mortgage companies, which is where we are seeing a lot of devastation. It is also mark-to-marketed each quarter, affecting Fairfax's income statement.

I recommend that everyone reads their shareholder letter to get a clearer understanding of the company and to understand the rationale for their market hedge.
Prem Watsa 2007 Shareholder Letter

Bancinsurance (Current Price: $6.05)
Market cap: 30 million

-Shareholder's equity up to $36.4 million, or $7.30 per share
-Net income of $5.5 million ($1.08/share) for 2006, affected by:
1. 1.8 million loss in discontinued bond program
2. 2.5 million realized gain on sale of publishing subsidiary
-Only the highland arbitration remains, and:
During the third quarter of 2006, the Company received information indicating that Highlands and the U.S. Department of Homeland Security (“DHS”) reached a global settlement concerning Highlands’ immigration bond obligations, which settlement is subject to the approval of the court in which the receivership is pending. Based on this information, the Company recorded reserve redundancies of approximately $0.1 million during 2006.
-So, I expect to see little to no more losses from the bond program.
-15.5 million in debt
-91 million investment portfolio
-Loss ratio of 53%, Expense ratio of 45%, premiums of 50 million.
-For 2007, company has already been informed of 4 million in premiums that has been moved or transferred.
- For 2007, the company expects a significant reduction in arbitration legal costs.

I believe legal costs have been costing the company about 4 million/year, so look for huge improvements in the combined ratio and earnings now that the legal disputes have been largely resolved.

Delta Financial (Current Price: 9.72)
Market Cap: $227 million

-Shareholder's equity of $150 million, or $6.23 per share.
-Net income for 2006 of 29 million, or $1.28 per share.
-92% Fixed Rate Origination, 8% ARM
-52% Retail , 48% Wholesale
-Cost to Originate down to 1.6% for 4Q, expect about 1.8% for 1Q due to seasonality. Still, very great progress on the expense side.

With all the bad press surrounding the subprime industry, many of you are probably wondering why DFC is any difference. Well, besides their disciplined underwriting and focus on fixed rate loans, DFC also uses very conservative accounting, that chooses to realize residual interests as they occur rather than try to estimate the gain and record it on the sale. Also, DFC has a much safer balance sheet than its competitors.

Loans held by co: 340 million
Loans securitized: 6 billion
equity: 150 million

Loans held by co: 9 Billion
Loans securitized: 13.8 Billion
equity: 2 Billion
Residual Certificates: 223 million

Loans/Securities held by co: 2.35 Billion
Loans securitized: 2.05 Billion
equity: 500 million

As you can see, Delta holds a far lower proportion of loans in their own name, lowering their own risk. That said, the 90+ day delinquency for the quarter was about 5% for DFC. Going back to '94 for the company, this percentage has always been closer to the 1-2% range. The sudden rise does bring some cause for concern, and this is why Delta still remains a small percentage of our portfolio. But, i still believe Delta will survive any disaster and will become a bigger player in the future of the industry as more competitors go under.

Sunday, March 04, 2007

What's going on?:

The markets have been pretty jittery of late, losing about 5% over the last week. What should we as investors make of this? Well for one, not much has changed. The markets still at 20 times earnings and 3.6 times book value, implying that companies have been generating great returns on equity. Unsustainable returns, in fact. Throughout history, the magic number for corporate returns on equity has been 12%. Throughout every period, regardless of even inflation, 12% has been the average and the range has been fairly narrow. (see article) We are now at over 20% due to several factors. One has been lower labor costs due to globalization, which has fattened profit margins. The other has been cheaper and more leverage. None of these lead to sustainable higher returns on equity however. A majority of the SnP 500 companies are still commodity companies with little real moats, and as yields continue to get lower everywhere else, they will eventually flood directly to capital investments. People forget that things do get worse, that market cycles are inevitable, and they push stock prices to unjustifiably high levels. So dont expect me to be jumping in to buy anytime soon even with my huge cash position. Things can get a lot worse.

" Q: What do you see as the biggest threat to economic recovery in the

John Templeton: We don't need an economic recovery because we're already operating
at a very high level. The greatest threat to maintaining this level of
economic activity is debt. There's never been a time when people
worldwide, and especially in America, had such a high proportion of
debt. I think 20 percent of people who have mortgages on their homes
are likely to lose them in foreclosures. When a home goes into
bankruptcy, it's sold at auction. That pushes the price down and
affects the prices of other homes."