Monday, April 30, 2007

Negative Amortization for UberNerds:

Here is a great article on Calculated Risk explaining how exactly negative amortization loans work. Beware- this reading is not for the faint of heart.

Friday, April 27, 2007

Some Updates:

Delta Financial
The company released their 2006 Shareholder letter, which can be downloaded at the link below. It is a great read for anyone trying to understand more about in the subprime industry.

2006 Shareholder Letter

The company reported first quarter earnings today. Net income was $.21 per share, and Book value increased to $7.54. Legal fees began to decrease, but the expense ratio is still abnormally high at 42%, compared to their historic average of 27%. They also repurchased 75,000 shares of their 500,000 share buyback within the first 24 days of its announcement. With the share price currently at $6.50, this seems like an excellent use of capital.

Jeremy Grantham released his 1st Quarter 2007 Shareholder Letter, which discusses his thoughts about "the first truly global bubble."

"The amount borrowers owe on their home-equity lines of credit has slipped in the past six months, to $561 billion at the end of March, the first such decline since 1999, according to new data from Equifax Inc. and Moody's Inc. Although that decline was partly offset by a pickup in fixed-rate home-equity loans, total home-equity borrowing rose just 9% in the 12 months through March, well below the 21% average annual growth rate of the past five years."(my emphasis added)

"This month is terrible," Ford chief sales analyst George Pipas said in an interview. "We are not even close to where we expected to be in April." Pipas said industry volume appeared to be down 10 percent to date before seasonal adjustment,…

Tuesday, April 17, 2007

The Brick Dhando:

As the title suggests, I just finished reading Mohnish Pabrai's new book, The Dhando Investor. Mr. Pabrai is an exceptional investor and his book focuses on the concept of Dhando- minimizing risk and maximizing return. As Pabrai likes to explain it, "Heads, I win. Tails, I don't lose much." Overall, the concept provides another useful way of approaching investing, especially for investment such as Harvest Natural Resources (HNR) which faces two distinct possible outcomes. Outcome 1, the political risk in Venezuela that Harvest faces is very real and they end up losing control of their oil assets, leaving them with just the net cash on their balance sheet. Or there is outcome 2, where Harvest gets to keep the terms that the Venezuelian government has recently proposed and they can continue on their business, resulting in a very profitable investment. I haven't done the analysis myself, but it must be highly favorable if Pabrai is willing to make it one of his largest positions.

But the Brick Group seems to also be utilizing this Dhando concept, too. The Brick is a large Canadian retailer of furniture, mattresses, electronics, and appliances, controlling 8.1% of these markets. What is interesting is the economics behind the business. Brick's strategy is to have a large centralized distribution center and then roll out numerous stores in each market. This concept works out very well because most of the goods they sell require delivery. So once a distribution center is up, each new store requires less inventory and less space for warehousing. The result is that each new store can be started up for about $750,000 in capital will average revenues of 5 million. "Heads, you win, tails, you dont lose much!" And, their overall results display this. The Brick is not exceptional at retailing, but it has a very profitable warranty and credit business that goes along with it, giving them an overall return of investment nearing 100% (25% for just the retailing side)

What becomes real interesting is when you look at this entire sector. Brick has many publicly traded competitors to compare to.

Note: I assume 10 million of cash on the balance sheet as needed for operations, and ROI refers to EBITDA/Invested Capital. (so, it is pre-tax)

420 million revenue
27 million ebitda
??? invested capital

1.33 billion revenue
69 million ebitda
ROI -100%++

505 market cap +57 million net debt = 562 EV

211 inventory to 800 cogs
approx 25,000 sq ft / store
$320 sales / sq foot

Tax Free for next 4 years
Higher ROI than peers due to Credit business

Leon’s Furniture
289 million revenue
37 million ebitda
79 million invested capital
47% ROI

591 million revenue
94 million EBITDA
177 million invested capital
53% ROI

1076 market cap -110 net cash = 966 EV
10.3 x EV/EBITDA

75 inventory to 341 cogs
89,000 sq feet per store
$188/ sq foot

Disadvantages: No central distribution, resulting in larger stores that require warehousing.
Advantage: Owns it's property, resulting in savings on lease costs.

BMTC Group
423 million revenue
22 million ebitda
74 million Invested Capital
30% ROI

835 million revenue
70 million ebitda
114 million invested capital
61% ROI

700 market cap - 109 net cash = 591 EV

82 inventory to ??? cogs
47,000 sq feet per store
$629 sales / sq foot

Advantages: Centralized Distribution, Owns its property.

Overall, BMTC seems to be the best run business, while Leon's is arguably the worst. What is really amazing, however, is the phenomenal returns all of these competitors are making. Why have all of these companies been able to able to earn such great returns for so long? Has Capitalism been caught falling asleep? (no pun intended) Here, even I am unsure. An arguably important aspect is regional market share. From Sleep Country Income Fund:

Regional market share is particularly critical to operating successfully in the mattress retailing industry in
Canada. The retail mattress industry is characterized by the existence of substantial regional fixed costs (advertising, management and distribution), that are independent of the number of stores in a particular region. Sleep Country believes its strategy of becoming a regional market leader with multiple stores brings regional fixed costs to an effective level on a per-store basis, which allows the Company to invest in creating competitive advantages.

When you compare locations, BMTC is the most concentrated, dominating the Quebec market and having the best per-store economics. Leon's has the worst economics, and Brick is in between. So perhaps, regional dominance is a very important factor.

Do you, the readers, see any other competitive advantages that allow these companies to make such great returns? If so, please leave a comment sharing your thoughts. Brick Group is pretty cheap regardless. But a strong moat could add more safety and make it a phenomenal investment.

Disclosure: I own a small position in The Brick Income Fund.

Wednesday, April 04, 2007

The Financial Instability Hypothesis:

This is straight from the horse's mouth. The following is an excerpt from Hyman Minsky's Financial Instability Hypothesis published May 1992.

"The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated. In contrast to the orthodox Quantity Theory of money, the financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers (using the term generically for all intermediaries in finance), whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market. This innovative characteristic of banking and finance invalidates the
fundamental presupposition of the orthodox Quantity Theory of money to the effect that there is an unchanging "money" item whose velocity of circulation is sufficiently close to being constant: hence, changes in this money's supply have a linear proportional relation to a well defined price level. Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified.

Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on "income account" on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to "roll over" their liabilities: (e.g. issue new debt to meet commitments on maturing debt). Governments with floating debts, corporations with floating issues of commercial paper, and banks are typically hedge units.

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts. It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values."

Sunday, April 01, 2007

Ponzi Nation:

Here is a great article about Hyman Minsky and his view of economics. His thoughts mirror exactly how I feel, although I have never heard of him before. I think the article clearly describes just how dangerous things are today. I look forward to trying to find out more about him.