A Second Look at Delta Financial

I mentioned in the last article that I needed to take a second look at Delta Financial. After all, 5.1% of their loans were 90 days or more past due, while the allowance for loan losses was only .88%. From previous research, I had learned that in Delta recieved at best 50% of the principal balance back on foreclosed loans, which makes the current provision for losses seem low. So, I took a look at the delinquency history to put the situation in perspective.

90+ day delinquencies, from 1994 to present.

2.1%, 1.44, .99, .96, 1.62, 1.55, 2.11, ?, ?, ?, .85, 2.65, 5.1
Note: The ?'s are for data that is unavailable.

30+ day delinquencies, from 1994 to present.

11.44, 10.5, 8.4, 7.4, 8.5, 9.6, 12.6, ?, ?, ?, ?, ?, 10.5

We are able to see two important facts. One, the 90+ days delinquency rate today is double anything that has been seen over the last 12 years. Second, the 30+ delinquency numbers are in line with historic standards. I don't know exactly what to make of these, but I do find the former very disturbing. This is one reason I've kept Delta at such a small position. (<4%)>

...

Edit: As I'm looking through this on 8/12/07, I realized that a paragraph i wrote after this is not here, probably due to some error on my part. The paragraph describes my decision to sell, which is subsequently confirmed in the next post on the same date updating Blog performance. Regardless, im disappointed this final decision to sell had not shown up on this post, but this has been why Delta Financial has not continued to be shown on my Current Holdings list for this time. I apologize for any misunderstanding.

A Comparison of Two Banks

I am going to show you some statistics for two different banks to demonstrate the importance of the criteria I have been talking about recently. The first is Wells Fargo, WFC. In a recent interview, Charlie Munger talked about "this company in an emerging market that was presented to Warren. His [Warren's] response was, 'I don't feel more comfortable buying that than I do of adding to Wells Fargo.' He was using that as his opportunity cost." What does Warren like so much about Wells Fargo?

WFC
89 billion checking deposits
134 billion cheap savings deposits (2.4%)
310 billion total deposits

20.7 billion non-interest expense
15.7 billion non-interest income
35 billion total revenue

1.12% nonaccrual loans (90+ days without payment) to total loans
1.24% allowance for loan losses

What makes Wells Fargo particularly phenomenal is that they earn so much of their revenue from non-interest income- mostly from asset management, credit cards, and insurance. These businesses have shown great growth and consistency. Meanwhile, the company still has a very solid deposit base, with 29% of deposits interest free and the rest very cheap. Finally, their asset quality is good and their allowance for loan losses is acceptable(not great).

The second company is Corus Bankshares, CORS. The numbers are much less exciting.

CORS
280 million checking deposits
8.3 billion high interest deposits (5.01%)

66 million non-interest expense
19 million non-interest income
760 million revenue

5.09% nonperforming loans to total loans
1.3% allowance for loan losses

Everything about Corus stands out as bad. They have a terrible deposit base with a very high cost. Non-interest income is an inconsequential part of total revenue. And their allowance for loan losses seems terribly weak.

There are a couple of important things to take from this demonstration. First is that Wells Fargo is much more than just a bank, and maybe conventional valuation will understate its many positive qualitative factors. Second, it appears Corus is in trouble. In a business where equity to assets is usually near 10%, any weakness in loan allowances can quickly wipe away equity, and at this point that scenario seems plausible. Finally, this exercise threw up a red flag for one of my own holdings, Delta Financial. Delta had 5.1% of their loans nonperforming last quarter, compared to an allowance of only .88%. Although most of these loans are securitized and have no recourse to Delta, the company can still be hit very hard by a large increase in defaults. Something to look into...

Analyzing Banks, Part II

The list of PICO holdings provided many examples of investments in banks. Through reverse-engineering, I was able to get a better understanding of their bank investing philosophy. In this article, we will focus on two PICO investments, Exchange bank of Santa Rosa (EXSR) and Farmers and Merchants Bank of Long Beach (FMBL). Between the two of them, we can see the important criteria in analyzing banks.

Deposit base
One of the first things that stands out in all of PICO's bank stocks is their high quality of deposits. EXSR has 400 million checking deposits out of its 1.38 billion total deposits. FMBL has 770 million checking out of 2 billion total deposits. Most banks can only dream of these deposit mixes. Checking deposits are non-interest bearing and less competitive- people have few reasons to switch checking accounts and it is usually not worth the hassle. Market share can be an important factor in attracting higher quality deposits; EXSR is currently number one in its county.

Asset Quality
EXSR earns 7.7% on its loans. Judging by non-performing loans, EXSR seems to have good asset quality. Non-performing loans over total loans were .29% last year. Going back to 2001(the earliest I can find), the figure was at .15%. This compares with their allowance for loan losses of 1.6%.

Expense Ratio
Companies that can keep their expenses low have an advantage in deposit competition. My measure of expense ratio is (non-interest expense - non-interest income) / net interest income. EXSR has a respectable 51%. FMBL has an exceptionally low 31.5%. I'm not positive this calculation is the best way to measure it, but the important thing to take away is that FMBL has been able to run its business much more efficiently than most banks today.

Capitalization
Generally. a well-capitalized bank has a ratio of equity to assets of 1:10. A lower ratio means undercapitalization, and a higher ratio means the company has excess capital. EXSR has 128 million in equity for 1.5 billion in assets- it is slightly undercapitalized. FMBL, on the other hand, has 650 million in equity for 3 billion in assets. This is highly overcapitalized, and makes the company's return on equity look weak. (This is why when screening for banks, you should focus on Return on Assets, with greater than 1.3% generally being a very well-run bank) The company can dividend out 350 million and still easily be considered well-capitalized.

Valuation
PICO must have been foaming at the mouth when they bought FMBL shares at a market cap of 550 million. The company could dividend out 350 million and leave a security with an adjusted 17.5% yield on a best-of-breed bank. Trading at over 1 billion today, the valuation for FMBL is much less compelling.

EXSR does not have excess equity it could dividend out, but the company does currently trade at only 10x earnings. This is cheap for a high quality bank, especially when compared to the valuations of other banks. But is it cheap on an absolute basis?


Additional Write-Up on 8/9/07

A List of Research Ideas from PICO:

A list of holdings from a successful "deep Ben Graham" investor is always a good place to look for research ideas. Through some maneuvering, I was able to get the list of holdings for the insurance subsidiary of PICO Holdings, a value-focused public company (Thanks to the Cheap Stocks blog for the idea). I filtered through the holdings and made a list below of all the ideas that were trading near the purchase price at 12/31/06. These are all small companies. Finding shares in many of these companies is very difficult, and information is even more illusive. The ideas in bold are transparent and relatively liquid.

JG Boswell Company
Cloverleaf Kennel Club 'A'
Extra Space Storage
Hanover Foods Corporation
Laaco Ltd
Merchanges National Properties
Mortgage Oil Corporation
Sadlier (William H)
Stonecutter Mills Corp Class B
Western Areas Ltd.
Bank of Utica
Beverly Hills Bancorp
Exchange Bank of Santa Rosa
First of Long Island Corp
Mechanics Bank of Richmond

A Checklist for Investing in Banks:

Albert Einstein said to "make everything as simple as possible, but not simpler." When it comes to analyzing banks, simple as possible is definetely not easy. By all means, banking is a marginal business, but finding out replacement value is tricky. Relying on traditional metrics such as Price to Book and Price to Earnings can get you in a lot of trouble, as I found out the hard way early in my investing career. Using just these ratios would be oversimplifying.

All banks are not equal. There are many ways a bank can add value that are not readily identifiable on a balance sheet.

Source of Funds: Analyzing the source of funds for a bank is probably one of the most important things that you must do. There are a few things you should be looking for. The most important is the cost of funds- the lower, the better. But do not look just at the cost, but the source behind it as well. For example, in 2001, banks could borrow all they wanted at 1% from the Federal Reserve, but flash forward to today and that borrowing would now cost 5.5%. This just shows how some funding sources are more susceptible to interest rate changes. Money market accounts are also very competitive, and savings are usually as well. The golden egg of sources are checking accounts, because they cost no interest and will probably stay that way long into the future. You also want to look at deposit growth. Over a long period of time, has this company been able to grow its "good" deposits(checking, low savings, etc.)?

Assets and Quality: Analyzing assets is a mess. Some companies choose to only invest in government and state municipality bonds, which are essentially risk free but have a low interest rate. Most banks though originate their own loans in order to earn a higher interest. You must not be fooled into complacency however. Some banks may seem like they are squeezing out excess interest returns, but it is only after it is too late that you realize these loans might also be riskier (Think what might happen to most banks' incomes if house prices were to fall 10%). Analyzing non-performing loans and charge-offs over a long period of time is a good way to figure out whether a bank is actually adding value on the origination side of the business.

Non-Interest Income: Finally, there is non-interest income- the more of it, the better. It is usually less dependent on interest rates and the economy, and therefore adds stability to the business. Wells Fargo's non-interest income almost equals its non-interest expenses. But a majority of banks would be lucky to have even 10% of non-interest income to expense. Also, some of this business might have superior growth prospects or other competitive advantages that should be looked into. Read the VIC on Meta Financial for an example.

I am definetely no expert on analyzing banking institutions. But if I was considering investing in one, these checks would be the least I would do.

FPA Capital Understands:

The title says it all. FPA Capital's 2006 annual report highlights many of the points this blog has been making for some time. The market is underpricing the risks of credit contraction and it's fallout on the economy and market valuations. As a result Mr. Rodriguez has 39% of his fund's assets sitting in cash. In addition, Rodriguez mentions one new investment holding in Atwood Oceanics (ATW). The thesis, which he spells out in the report, focuses on the fact that Atwood is trading at 70% of replacement value and 11 times earnings, making it a great example of true marginal company investing. I plan on analyzing more on FPA Capital and its holdings.

The Marginal Investing Framework Self-Test:

I wanted to do a quick overview to show how my portfolio holds up to my marginal company framework.

Fairfax Financial (FFH)
The Industry: Insurance. Barriers to Entry: Capital.
The Price: when I purchased Fairfax, the company was trading at approximately 70% of book value.
Qualitative Aspects: Fairfax has one of the most astute value investing teams around, with an amazing track record to match. In an industry where most participants break even at underwriting, the investment side of the business can be critical to success.

Bancinsurance (BCIS)
The Industry: Insurance. Barriers to Entry: Capital.
The Price: Bancinsurance is currently trading at 85% of book value.
Qualitative Aspects: Bancinsurance is a microcap company that serves a small niche market, and it has a history of generating very profitable underwriting income.

SFK Pulp Fund (SFK-UN.TO)
The Industry: Pulp. Barriers to Entry: Capital.
The Price: At an enterprise value of 600 million, SFK is trading below the replacement cost of their businesses, which i calculate to be 750 to 850 million.
Qualitative Aspects: A globally growing industry protected by the limited nature of softwood fibers. The company has one of the lowest manufacturing costs in the business and can benefit greatly from a rationalization of fibre prices in the Quebec region. Finally, the company has a very great management team and does not have to pay taxes until 2011.

Delta Financial (DFC)
The Industry: Subprime Mortgage Origination. Barriers to Entry: Capital.
The Price: The price paid for Delta was in excess of the 150 million in equity of the company. However, this understates the income the company expects to generate from its 7 billion securitized mortgage portfolio. When you look at the fair value of this portfolio, which should approximate the economic reality behind the present value of this portfolio, the "true" equity is approximately 350 million.
Qualitative Aspects: One of the only subprime originators that maintained its strict quality standards and avoided the loan volume frenzy of its peers.


I left out Brick because I have treated it as a quality company and hence I am valuing it based on earnings power instead of replacement cost. It is interesting to note however, that many of my most successful past holdings, such as Posco, Sino-Forest, and KHDH, were trading at "marginal investing" prices while still having some respectable qualitative aspects to them. Conversely, Most of my losing investments have occured when I overestimated the quality of a company and paid an exuberant price. So, I should probably look over my investment in Brick one more time to see if I am not making this mistake again. I think the message is that it is much more difficult to understand quality than value, and that the growth of a value investor involves a sharpened ability to assess the qualitative merits of a company. Until that ultimate stage is reached, it is best to look for companies trading at a "marginal investing" prices and to treat most qualitative aspects as just potential bonuses.

The Investing Framework for Marginal Companies:

Today I will theorize a bit on the considerations that should be made when investing in marginal companies. A brief side conversation to define a marginal company because it is important to understand. A marginal company is any company that has a weak or no moat. I have a very strict criteria behind moat- it must be a clear and unassailable advantage. A good advertising campaign would be a weak moat. Apple has done a great job improving its image and increasing its sales of its products, but it is difficult to say whether this image will improve and pass on to other products, or if it will fade away. But at its current price, a continued image growth would be needed to justify its valuation. Other examples of weak moats are management(are they really better, how long will it last, can a competitor match it) and size(in most industries, owning more doesnt mean better), etc. Low cost advantages that can be toppled by capital are also weak. Management's in general will make a huge list of competitive strengths, but in the end a vast majority (95%+) of stocks will fall into the marginal category. Cars, steel, paper, finance, electronics... the list is endless.

The best way to evaluate marginal companies, and by extension most companies, is with a deep Ben Graham approach. An interesting Economist article i recently read discussed Hanson, a famous corporate buyout firm. "The firms they bought had to meet just two criteria: they had to be able to generate enough cash to pay the interest on the debt needed to buy them; and they had to cost less than the total value of their assets. Closures of head offices and mass sackings often followed."

Underlying this simple philosophy are the ideas of economics and Ben Graham. Buying below replacement cost means there is a disincentive for competitors to come into the market because the returns will be weak. Also, it would be cheaper to buy a competitor then to do a direct investment in the industry. In most cases, economics will eventually rationalize the industry and lead to a situation where competition has the incentive to come back in the industry. But at that point, returns have increased and you are making a sizeable return on your original investment cost. You are buying something for less than it is potentially worth under normalized industry conditions or better operation/management.

SFK's management has shown their understanding of this philosophy. They purchased their two RBK mills for a total of about 150 million, when each mill had a replacement cost of 250 million. That is a 70% discount to the cost for a competitor to enter the market. You can, and should, take the analysis much farther than just looking at the cost of assets, and this blog will go much deeper into the additional considerations that should be made. Currently, the Forest industry has many companies that are trading below replacement costs, but I would pass on a vast majority of them. Expect a write-up about a combined Abitibi-Bowater shortly. But for now, hopefully this article will spur you to take a second look at your investment portfolio. With the market average approaching almost 4x book value, chances are that you have not paid a market price below replacement cost for your investments. So you have to truly ask yourself, "How strong are the competitive advantages of your companies, really?"

Updates Around the Table:

Delta Financial
Highlights for 1st Quarter
-Delta reported first quarter profit of 4.9 million compared to 6.6 million last year.
-Originated 1.2 billion of mortgage loans, 11% increase over 4th quarter 06.
-Sold 177 million in loans for a 3.4% premium.

These results are spectacular when you compare them to the rest of the the industry. For example:
Novastar financial, NFI, had to cut production by 21% YoY.
-NFI is selling whole-loan for less than face value.
-NFI had a comparable cost to orignate of 3.85% compared to Delta's 2.58%.
-Accredited Homelenders, LEND, had to sell 2.7 Billion in loans for a loss of 180, and entered into a forward sales contract for 400 million loans for only 100.625%.
-I believe every other subprime lender, as well as most Alt-A lenders, have reported losses for their 1st Quarter.

Notes from Conference Call
-31% YoY increase in mortgage origination increased quarterly expenses- the income from origination is retained over the life of the loan, expenses are up front. The more loans originated, the more upfront costs.
-11% sequential increase in volume, even though 4Q to 1Q is usually slower. Ability to capitalize on market opportunities, in particular in the wholesale market.
-Still recieving some of the highest pricing in the market with 3.4%, while other lenders are struggling to receive par. Miniscule repurchase risk. $235,000 and 8 loans had to be repurchased in the quarter. 1.7% total cost to originate.
-Cost of funds on securitization was 30 basis points higher, but rates were increased to compensate for that. Mortgage rates up over 40 basis points over last few months.
-8.3 billion portfolio by year end, with expected net interest margin of 1.7%
Q: Are there new entrants coming?
A: at this point market is still not on solid ground, a lot of originators considering to fail and exit market. Wholesale market offers opportunity because of so much capacity coming off. Retail not as focused on competiton, but wholesale is very competitive. With fewer lenders competing, much easier to get their loan standards.

Q: comments on growth and loan quality?
A: increased salespeople, and account executives went from 126 to 155 and loan offices grew from 464 to 500. Average FICO 4Q was 615, 1Q 621 LTV was at 79% for 1Q.

-30+ day delinquencies at 10.8%, up from 10.5% in 4Q. 5.1% 90+ day delinquencies.

Q. O/C was 3% in 2006, what are likely O/C’s going forward?
A. 918 proceeds on 950 securitization for recent securitization, 3.5% O/C. Proceeds from NIM notes was just over 30 million. Increased interest rate to offset this in future. NIMs are about a 1 year note, usually relatively easy to sell. Note peak losses for their loans are usually between 24-48 months, so these notes are relatively safe.

SFK:
Pope and Talbot, with 800,000 yearly NBSK pulp production, seems to be heading for bankruptcy and issued a going concern warning.

Brick Group:
-Same store sales up 6% over a strong quarter.
-EBITDA up 10%.
Overall, Solid quarter, more of the same.

Fairfax:
-Fairfax is getting cheap again. Mentioned on board that if you subtract ORH and NB stakes from todays price and then add net debt, you are paying 1.3 times Crum book value. That leads runoff, Fairfax Asia, rest of business for free.
-An interesting discovery: Fairfax contributed $10 million in 2000 for its 26% stake in ICICI Lombard. Today it is the largest private insurer in India, with $700 million in premiums and growing rapidly.

Other:
I've finally found the economic report I've been looking for: "Credit Expansion, 1920 to 1929". It has been difficult to find good information about the economy for this decade before the Great Depression. The report concludes that loans from the period 1922 to 1929 increased at a 25% annual rate, and it shows the dramatic distortion credit installment had on consumer sales. When you compare this with the estimate by the Economist that global money supply has increased 21% over the last 5 years for many of the same reasons, it is not encouraging.
Fairfax is positioned very well for this type of event. Brick might be adversely impacted by a decline in easy credit.
Credit Expansion, 1920 to 1929

The Chinese market is at 43 times trailing earnings, and up 45% over last 3 months.

“What happens if we get a recession and housing is still bad?” Mr Toll asked this week. The results, he thought, could be “cataclysmic”.

Nick - Still 30% Cash and Long term bonds.

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.

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

Bancinsurance
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.

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

Quotes
"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 Economy.com 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,…

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)

Brick
‘96
420 million revenue
27 million ebitda
??? invested capital

‘06
1.33 billion revenue
69 million ebitda
ROI -100%++

505 market cap +57 million net debt = 562 EV
8.1x EV/EBITDA

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

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

Leon’s Furniture
‘96
289 million revenue
37 million ebitda
79 million invested capital
47% ROI

‘06
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
‘96
423 million revenue
22 million ebitda
74 million Invested Capital
30% ROI

'06
835 million revenue
70 million ebitda
114 million invested capital
61% ROI

700 market cap - 109 net cash = 591 EV
8.4x EV/EBITDA

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.

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."

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.

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.

DFC
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.


SFK
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.

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

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

SFK 4Q Results:

Highlights
-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.

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

Outlook
- .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.

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.

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

Highlights:
-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.

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

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

NFI
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.

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
U.S.?

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."
-2004

SFK Pulp increases dividend:

SFK increased its monthly dividend to .05 from .03, based on "Good market conditions, the acquisition of the Fairmont and Menominee mills and the reduction of our level of indebtedness." Also, Canfor Pulp reported great earnings based off better pricing, although they warned that fibre costs were rising. This is an important aspect of the SFK investment that differentiates it from its western pulp mill competitors. Since SFK already pays $150 per tonne of woodchips compared to $60 in western Canada, the risk of increasing fibre costs for the company is minimal- in fact, an improvement is even likely. For great notes regarding the Canfor Conference call, please refer to :
Canfor Conference Notes on BHS forum

SFK's annual distribution is now at C$.60. But based on our analysis, the company will be generating far more cash than this, so look for further increases in the future. C$ 1.00 annual dividend seems very likely in the next 12 months.

Investment Analysis on SFK

Analyze This:

Every time you realize a mistake has been made in your analysis of a company, it is good to step back and try to figure out what you did wrong and what you missed. It can also be a good time to analyze your overall performance. Over the past 3 years, I've sold out of 13 positions. Of these, there have been 8 successes, 2 marginal performances, and 3 realized losses, and my overall returns have been 25% annually. All 3 losses involved mistakes that were avoidable and I believe the lessons will be a great help to readers in their endeavors. The losses were in WHI, BIOS, and TRXI, and over the next few days I will discuss what I have learned.

As for my current portfolio breakdown, there is:
26% SFK
21% FFH
12% BCIS
5% DFC
9% Others
27% Cash

Check-up on Fairfax Financial (FFH) :

Every now and then, it is good to re-visit your investments to refresh the intrinsic value in your head and to keep yourself from falling victim to your own fear or greed. Fairfax Financial is my second largest holding, and is run by- in my opinion- one of the greatest value investors today, Prem Watsa. His track record speaks for itself though, as he has averaged over 20% annually on common stocks over a period of greater than 20 years. In a field such as insurance that throws off tons of cash to invest while claims are being settled, this gives a small moat in an otherwise highly competitive industry. Fairfax has appreciated considerably since my original purchase- is it still cheap?

Fairfax at Sept. 06

473 million cash at holding co level
-1273 holding co. debt
-292 Crum (100% owned subsidiary) debt
+340 Public offering of 10,165,000 ORH shares
+1806 Odyssey Re(ORH) at market value - 45,300,000 shares
+923 Northbridge(NB.to) at market value - 30,311,300 shares

= 1.977 Billion

In addition to this, you have:

Crum & Forster- with a 99% combined ratio on 1 billion in premiums, a 2.6 billion portfolio, and 1 billion in equity. (Note: Since we included the Crum debt above, the equity here should really be 1.3 billion) To be conservative, I value this business at book-
= 1 Billion

Runoff- This business has a 4 billion portfolio and over 1.7 billion in shareholders equity. The provision for claims seems to finally have stabilized for this business after years of additional charges. It is important to note a defunct feature of insurance accounting- that reserves are provisioned on a "notional" basis. So, even though this runoff business has mostly asbestos and other long-tail liabilities that will not be paid out for several years, the reserves on the balance sheet are not discounted to reflect this. So basically, the reserves account for everything they expect to pay in the future, but in reality they are earning investment returns on a portfolio of over 4 billion for the time being. If you believe the reserves have finally been settled based on the "quiet" activity recently seen in runoff, then this business should be worth more than its equity. If you think reserves are still inadequate, then you need to discount equity. Conservatively, i assume some additional unforeseen provisions coming up and discount equity.
= 1 Billion

Holdco Discount- Since Fairfax would realize taxes if it monetized its shares in ORH and NB, some like to take this into account in their valuations. Others see this as wrong because they could also fully buy back the company and hold onto something the market believes has an intrinsic value of the current market price. I'll discount it, and assume Fairfax cannot come up with anything creative to lower their tax cost. Fairfax's cost basis is 700 million ( I believe? If anything, this number is wrong and way too low), while the value of ORH+NB+the offering is 3 Billion. (3,000 - 700) x 35% tax ...
= -800 million

Overall, this gives Fairfax a safe value of 3.2 Billion, compared to the market price of 3 Billion. Upside potential exists with our valuations for Crum, Runoff, and the tax discount. I'd also make a case that ORH is still undervalued, and that the dramatic improvements in the company's financial position should lead to increased credit ratings, which boosts their underwriting profitability. And in the meantime, you have a great value investor managing over a 15 billion portfolio, leveraging the investment gains compared to your market price by 5:1. It's still too early to sell.

SFK Pulp Fund- My Top Holding:

Ticker: SFK-UN.TO
Price: 4.90 CAN
Shares Outstanding: 101 Million
Debt: 114 million
Market Cap: 495 Million
Note: All above figures take into account recent acquisition and share offerings, to show position today, and all numbers will be in Can$, unless otherwise noted.

Investment Thesis Summary: SFK operates some of the most efficient pulp mills in a depressed industry and has a yield of 20% under these depressed conditions, and there are several significant sources of potential surprises. (phew, got that all in one sentence )

Business Description:
SFK Pulp Fund("SFK") is a Canadian income trust that now operates several pulp mills and is finally recieving some upswing in an industry that has been severely depressed. For those completely clueless to the pulp industry, i recommend reading the 2005 SFK annual report available at www.sedar.com. But basically, pulp is the product of processing trees, and it is the matierial used to make paper. For sake of this analysis, I will split the business into two parts: the NBSK business ("NBSK") which has been historically operated by SFK, and the AFRI mills ("AFRI"), which SFK recently acquired.

The NBSK business
SFK operates one of the lowest operating cost pulp mills before and even after accounting for fibre costs. See Exhibit A. There has been a large divergence between the fibre costs for Western and Eastern Canadian pulp companies. Western Canada has been plagued with a pinebeetle infestation that has forced them to excessively cut down trees in order to stop their spread. The result has been a huge divergence between the fibre costs for Western and Canadian pulp companies- Fibre accounts for about $125 per ADMT (ton of pulp) of the cost in the West, compared to about $310 ADMT in the East - and the selling price for an ADMT of pulp is only $784. Obviously, this has had a huge effect on Eastern Canada, and several Eastern pulp mills have had no choice but to close. SFK has been able to survive this due to its low operating costs.

The NBSK mill has production volume of 356,000 ADMTs.

NBSK Industry
The NBSK industry, as well as Pulp and Paper in general, have been plagued with losses and overcapacity for several years now as a result of very excessive investment in the 90's. However, the NBSK pulp industry in particular has several attractive characteristics to it. NBSK pulp is essential in several types of paper because it is the only way to add considerable strength. Importantly, NBSK pulp can only be produced from certain tree types that exist only in Canada, Scandinavia, and Russia, with 50% of the production coming from Canada. Thus, there is no threat from low cost countries. In addition, it is much less cyclical than some of your other commodities- the derived demand for their pulp stems from newspapers, specialty papers, etc.

Second, there has been no addition to supply for several years and little money is being reinvested in the industry because conditions and returns would of been poor for so long. As an example, a mill with similar production to SFK's would now cost about 600 million to set up, while EBITDA for SFK was only 30 million last year. In fact, the opposite has been happening- over 1.6 million ADMT production has been shut down over the last year and a half, in an industry with production of 14 million ADMTs. Meanwhile, Demand has steadily grown over the last 15 years at about 2% annually.

The AFRI Business
The AFRI business consists of two mills that were recently acquired. These mills sell RBK, or recycled pulp, which competes and prices similarly to BHK pulp. I believe managements statement does the best job of discussing the rationale for the acquisition, and this can be found at the bottom. See Exhibit B. They have a production capacity of 360,000 ADMTs of RBK.

Investment Opportunity
The market has not yet adjusted the price for the currently improved conditions or the acquisition for SFK. For the 3rd Quarter of 2006, SFK generated EBITDA of 15 million. Note: this doesnt include the acquired mills. Also, this business is not seasonal. Furthermore conditions have improved since this point.

3Q06 EBITDA 15 million x 4 = 60 million
Yearly Maint. Shutdown - 10 million
Pricing Improvement +38 million
Exhange Rate Improvement +13 million

Forward EBITDA = 101 million

Let me explain the above. I 4x EBITDA of 3Q06 because the business is not seasonal, but there is a 14 day shutdown of the business for yearly maintenance, so i subtract the 10 million from that lower output and those costs. (VERY conservative, its probably closer to 5) Next, the pricing improvement. In 3Q06, SFK realized prices of $671 US/ADMT of NBSK pulp, but NBSK in the US is currently at $784 US. The reason for the huge difference is because there have been significant price improvements since the 3rd Quarter (+74$), and because there is a small lag between price increases and when SFK can pass them on to its customers(+39$), partially offset by 20% of their sales in Europe, where there is less favorable pricing(-6$). Its also important to note that historically SFK has actually charged about $30 premium to the market rate of pulp because it uses a higher cost black fir tree which has greater strength properties, but I left this out to avoid confusion and add conservatism. The reason this premium is not showing is again, because prices for pulp have gained significantly recently from their very depressed levels and SFK still hasnt fully passed these along. Finally, the exchange rate has improved from an average of .896 in the 3Q to the current .8462 . According to management, this adds 2.6 million per .01 change. Thus, we end up with 100 million in EBITDA for the NBSK business, and after subtracting annual maintenace of 6 million (managements statement, found in Annual Report 05) we get Free Cash Flow for "NBSK" of 94 million. (please also remember I havent subtracted interest yet and this is only "NBSK" so far)

Next, the AFRI Business.
For the Twelve month ended on June 30, 06, the business generated EBITDA of 36 million. (See short form prospectus dated Aug 23, 06 at sedar.com- direct link isnt possible)

EBITDA = 36 million
Pricing Improv. +21 million

Forward EBITDA = 57 million

At dec05, the price of BHK was at $570US in Europe, compared to the current price of $670US in Europe. The US usually gets better pricing than this. I cant find price at June 06, but lets assume the average price AFRI realized over the 12 months ended june 30 06 was $620 US. This $50 improvement would translate into $50 US x 1.18 US/Can x 360,000 ADMTS = 21 million more.

Finally, Lets Put it all together
Consolidated

trailing EBITDA's = 86 million
Pricing Improvs. + 59 million
Exchange Rate +13 million

Total Forward EBITDA = 158 million


Capital Structure
Pre-acquisition, there was 59.2 million units outstanding.

Immediately after the acquisition, there were 72,072,500 units outstanding plus 51 million in debentures convertible into 10.7 million units, and 200 milion in debt.

And finally, they recently issued 18.4 million units for proceeds of 86 million.

So, you have 114 million in debt (probably 100 now after the past few months of saving up money), and 101.2 million units outstanding.

Put it together:
There is a market cap of 495 million and net debt of 114 million.
EBITDA was 86 million to 158 million depending on trailing or forward figures.
NBSK capex is -6 million
AFRI capex is -4 million
Interest Expense is -10 million (114 million x 9%)

This leaves you with free cash flow of 66 million to 138 million after all is said and done on a 495 million market cap, with the 138 million assuming nothing but current market prices and rates.

Other Potential Upsides
Fibre
As i mentioned earlier, fibre accounts for $310 per ADMT of the cost for SFK compared to about $125 of the cost in Western Canada. There is no long term reason for this discrepency- rather, it has been exacerbated as a result of the pinebeetle infestation in the West and the a 20% cutback in cutting in Quebec. Simple economics tells us this will eventually balance out, as Eastern pulp mills have been forced to shut down while Western mills have prospered. Any reduction in cost will be multiplied by the 365,000 NBSK production. I see a reduction in their fibre costs as VERY likely.

Pulp Pricing
The Pulp industry has not added production in ages, and even current prices barely justify the high costs of starting up a pulp mill. If demand continues to increase and new capacity isnt built soon, there is good potential for pricing to continue to increase. Regardless, there is little downside to prices as marginal cost of production is barely lower and new capacity won't be built if prices fall. (1.6 million in capacity shut down when NBSK pulp was around $660)

Synergy + Recylced Pulp Benefit?
Management sees 5 million in costs they can cut out from the acquisition. But also, the AFRI business has a 45% market share of the recycled market, and if the eco-friendly crazy continues, you might see increased volume and pricing from this segment.

Management
Management is one of the greatest in the industries, and they're bonuses are tied very closely to operational success. It is one of the better compensation plans I have seen, but you can read for yourself in their annual proxy. They've done an excellent job of ranking amonst the lowest costs in the industry, while improving productivity from 950 ADMTS/day to 1050 over the last 4 years.

At these prices, it is no surprise that SFK is my largest position. (Disclosure: I own shares of SFK... duh)

Exhibit A - Comparison of Operating Costs

Canfor Pulp Operating Cash Costs 2003
Fibre Cost 183
Other Operating 310
Total 493

SFK Operating Cash Costs 2001
Fibre Cost 251
Other Costs:
Labor 75
Chemicals 68
Reg Maint. 35
Energy 26
Major Maint. 19
Other 18

Total 492

Note: Total other costs equals $241 for SFK, compared to $310 for Canfor. Also, SFK expenses $54 in other costs which are actually maintenance, which has resulted in significant capex savings over Canfor. In all, this makes the operating cash cost difference 187 to 310, or $123
per ADMT.



Exhibit B- Management Rationale for Acquisition

Rationale for the Acquisition

Management believes that the Acquisition is consistent with the Fund’s objective of generating sustainable

cash distributions in a manner consistent with the Fund’s acquisition and investment strategy and believes that

the Acquisition will position SFK Pulp as the owner of a premier NBSK and RBK market pulp operation in

North America. The rationale for the Acquisition is as follows and is described in greater details under ‘‘The

Acquisition — Rationale for the Acquisition’’.

• Business Strengths of the AFRI Mills. Management expects to benefit from the following business

strengths of the AFRI Mills:

• The AFRI Mills benefit from a well-protected market share (as capital costs are a significant barrier

to entry) in a growing market for recycled and environmentally friendly content. The AFRI Mills

hold a market share of approximately 45% in the North American RBK pulp market and are the

only two air-dried RBK market pulp producers in North America;

• The AFRI Mills are among the newest facilities of their type in North America and were constructed

between 1994 and 1996 at a total cost of approximately US$462 million. Management currently

estimates that capital expenditures should be limited to US$4.0 million per year in the foreseeable

future;

• As a result of their technology and process capabilities, the AFRI Mills are capable of producing an

RBK market pulp comparable in quality to pulp produced from virgin hardwood fibre, at production

costs which are among the lowest in North America;

• The AFRI Mills currently supply approximately 63% of their pulp on a contractual basis with terms

up to three years on average (see ‘‘Description of the Business of the AFRI Mills — Sales and

Marketing’’);

• In 2005, approximately 74% of the AFRI Mills’ wastepaper was purchased under long-term

contracts with suppliers; and

• The AFRI Mills can count on an experienced team of managers and employees.

• Accretive to Distributable Cash per Unit. The Acquisition would have been 77% accretive (91% fullydiluted)

to the Fund’s Distributable Cash per Unit on a pro forma basis for the twelve months ended

June 30, 2006, without accounting for synergies but including potential savings. See ‘‘Summary of

Distributable Cash of the Fund’’.

• Potential Savings. Management believes it has identified sources of cash flow improvement totalling

approximately $6.5 million within the AFRI Mills, which Management expects will help to reduce costs

and avoid duplication of certain management and administrative functions. See ‘‘Summary of

Distributable Cash of the Fund’’.

• Reduced Risk Profile. The Acquisition is expected to reduce the risk profile of SFK Pulp by diversifying its

operating base through the acquisition of two high-quality pulp assets (thereby reducing operating and

financial risks inherent to a single-mill operation, including those related to fibre supply, labour related

issues and equipment breakdown) and reducing exposure to volatility in the CDN$ / US$ exchange rate.

• Business Opportunities. SFK Pulp supplies NBSK pulp throughout North America and Europe to leading

printing and writing paper producers. With the acquisition of the AFRI Mills, Management will be able

to offer more than one product to the same buyer and intends to take advantage of cross-selling

opportunities with customers not previously served. In addition, Management believes that with a

consistently high-quality product (comparable to virgin pulp), opportunities currently exist to deepen and

broaden the customer base of the AFRI Mills.

A Few Interesting Ideas:

As stated before, value is rare these days- at least by my standards. Below is a list of companies that seem potentially compelling and would be a good place for readers to start researching:

Delta Financial (DFC)- report coming soon(see below)

SFK Pulp Fund (SFK-un.to) - high yield, very low cost operator, limited downside, potential for huge gains from normalization in eastern Canadian fiber costs.

TRX, Inc. (TRXI)- speculative, commands a giant share in travel processing software and has a recurring revenue structure.

Cryptologic (CRYP)- check Value Invesor's Club for investment thesis.

Mills Corp (MLS) - large position by Seth Klarman, havent begun research.

Freddie Mac (FRE)- large position by Pzena, haven't begun research.

Of the above, i hold positions in DFC, SFK, and TRXI. Im currently working on a detailed writeup on Delta Financial to post, although it is taking me longer than expected to get in contact with the management. However, look for this report shortly.

Delta Financial Corp (DFC):
Price: 10.89
Shares Outstanding: 23.7 million
Market Cap: 260 million

As far as investments go, this is definetely an 8 foot hurdle. But that doesn't take away from the fact it is still a value- here goes.
The Business
Delta Financial Corp. is a subprime lender in the United States, which basically means they make loans to people that typical banks will not due to poor credit or lack of documentation. These loans typically have higher default rates but also have higher interest rates. Delta originates about half of their loan volume themselves, while they buy the rest wholesale (from other brokers). They then in turn either sell these loans, or put them together into a securitization trust and sell it to the public. A securitization trust holds claim to a certain pool of mortgage loans and it pays a certain interest rate from this pool. Once sold to the public, Delta is not responsible for any defaults arising on these loans. They have usually securitzed a majority (85%) of these loans, and they profit from this structure by recieving any excess interest left over after paying the securitization's interest. If there are defaults, the excess interest is first used to make up for the lost capital in the securitization before making its way to Delta. The rest of their loans are sold to other financial institutions, and they profit from the premium they recieve on the loan value.
This business does not require much to run- A warehouse credit facility which provides the capital for the loans made but not yet sold/securitized, 1300 employees, and about 40 million in working capital. Thus, the moat is minimal, although one can make a case that scale and management expertise are important. ( more on this later) The market cap is currently at 250 million, and Enterprise Value is 150 million. (also, later)

The Investment Opportunity
The investment opportunity arises by taking a step back and looking at the true economic reality of this company. This business requires expenses to be made upfront in the form of payroll, administrative, etc., while the income from this shows up over time as the portfolio generates more interest income than it has to pay out to the securitization trusts. I have done my analysis by seperating the company into three parts- Origination business, the portfolio, and excess equity. I assume that instead of securitizing, Delta instead chooses to sell all of its loans to the market. This means the portfolio will slowly dwindle as loans expire and new loans are not added (they're all being sold). The excess equity refers to the capital the company has that it does not need to run the business. These sections are discussed more thoroughly below.

Origination Business
Delta will originate approximately 4 billion in loans this year. 700 million of these loans will be sold (for a premium of about 3.7%), while the rest are packaged into securitizations which will be sold to the public. These loans are able to sell for a premium because the market expects the greater interest from these loans will more than make up for the increased credit risk. Delta in particular has been able to command greater premiums than its competitors because it focuses much more on the quality of their loans, compared to the volume approach of their competitors. 87% of Delta's loans are fixed vs adjustable rate, while their competitors' ratios are often reversed. Delta also publishes many of their underwriting criteria, something their competitors do not. I assume this speaks to the strength of their origination, but the numbers speak for themselves- Delta was able to recieve a 3.7% gross premium on sales while competitor New Century only recieves 1%.

Our first major assumption comes from what premium the company would recieve if they sold the entire portfolio. There is a lot of leeway in this area, depending on what gross premium you want to give for the entire volume of business. Meanwhile, the cost of origination for the company is 2%, and the company has remained focused on continuing to automate and reduce these costs (so far, bringing the cost down from 3% 2 years ago). Also, the company immediately expenses "deferred origination fees" - about 10 million a year of fees it expects to incur over the lifetime of their loan portfolio. Since are assuming loans are immediately sold, this would have to be added to gross premium to get the net gain on sales.

4 billion loan volume
Gross premium - cost of origination + 10 million (DOF) =
3% - 2% + 10 million = 50 million (optimistic)
2.5% -2% + 10 million = 30 million (probable)
2% - 2% + 10 million = 10 million (worst case)

Remeber, the company will actually sell 700 million for a gross premium of 3.7%. So to get an average of 3% for the total volume, this implies a 2.8% premium for the 3.3 billion not already sold. To get the worst case of 2% gross premium, the company would have to recieve 1.6% on the 3.3 billion in loans it does not sell. I believe this is a very unlikely given that 90% of the loans fall under their A-category standards.

Range of Value, using a 10x PE: 100 million to 500 million

The Portfolio
Next, the portfolio. With all expenses covered by the origination business above, and no ongoing expenses from new securitizations, this leaves the portfolio practically free and clear to shareholders. As mentioned previously, Delta is not liable for any defaults that occur in the portfolio, although defaults do lower the interest income they recieve. This year, the portfolio will earn 120 million after provisions for loan losses. This number will lower as the portfolio expires, but management's guidance is that it the current portfolio will earn at least 85 million after tax in income after provisions for the next 2 years.(80 million after discounting) My analysis says that after the first 2 years, the portfolio should generate about 30 million more after tax. ( I did this by looking at the expiration of mortgage portfolio provided in the 10-Q)

Range of Value = 80 million+++

Excess Equity
As mentioned earlier, this business does not require much to run it- just 40 million in working capital and a credit facility which does not use up any capital. So, of their 140 million in shareholders equity at 9/30/2006, 100 million is not needed to run the business. Also, in a liquidated value assumption, you could use the full equity of 140 million because you no longer need the working capital.
mi
Value = 100 million

Overall, we get a sum of value from 280 - 680 million depending on the scenario, with a probable value of about 480 million. This compares with the current market cap of 260 million.

Risks
What if "All hell breaks loose", so to speak. After all, we are at the peak of a credit bubble where subprime loans have gone from 5% to 20% of the total underwritten loans over the past decade. Rather than try to say its different this time, I'm going to see what the value is if something dramatic were to occur.

-Origination Business
Contrary to first instinct, the origination business would not be in dire trouble should the economy turn into depression. Loans rarely default after they have just been written, and the company can adjust quickly to a change in market sentiment by raising standards and cutting staff. Volume would probably fall however, and probably gross premiums. Depression scenario though, the business would still maintain positive value.

-Portfolio
The portfolio of course cannot go into negative value for the company due to the securitization structure. But it probably would still have positive value too. The company gets paid its excess interest every month, and this money is not liable to pay for any future defaults. So every month until doomsday occurs, you get an additional 4 million in interest.

Also, "Doomsday" for the portfolio means a lot. Nationwide home prices have never fallen since the government has begun recording them, a timespan of over 50 years. And DFC's portfolio is very dispersed across the country, with only 3% in California. See the Fact Sheet link below. But let's assume home prices do fall 10%. DFC's loan to value ratio (ratio of loan amount to the value of property it encumbers) is at 80%. Since DFC rarely gets market price for its property sales due to how quickly it is trying to get rid of the property, they usually sell for a 20% discount to market. This would mean that DFC would only get 72 dollars of capital back for every 80 dollars of a loan made, or 90% of their money back if home prices fell 10% nationwide. In order for the interest income of the portfolio to be wiped out, the default rate would have to go up to 20%, along with the 10% drop in home prices. A highly unlikely scenario.

Given the relative safety at these prices, and the potential for huge and likely upside, I believe DFC makes an attractive investment.

References:
Delta Financial Q3 2006 Fact Sheet

Time to be Fearful:

It's been quite awhile since my last post. In truth, I wasn't exactly sure where I was heading with this blog. I originally wanted this blog to be focused mostly on investing. But recently, I have been very pessimistic on the future returns available in the market. I will save the detailed economic explanation and my entire outlook for upcoming posts, but for now I will pose this question for active investors to think about. With prices rising and yields falling quickly on all sorts of investments, (think, stocks, junk bonds, real estate) how long will it be until this mass of liquidity starts pouring into corporate investment, and as a result, increases competition and lowers corporate profitability? In 2005, Greenspan said that corporate profitability was at an all time high at about 14%. With PE's on stocks nearing 20, treasuries at 4.7%, and junk bonds not much higher, it seems coroprate investment will be the next victim of yield chasing. Just as stocks and bonds start being priced in for a lower return environment, they risk being hit by increased competive pressures. Already high prices mixed with lower earnings bodes terrible consequences for an investor.

I will try to outline my reasoning in further detail as time goes on, but in terms of investing I will still focus on individual companies. I have recently added two short positions to my portfolio. Interoil (IOC) and Silver Wheaton(SLW). These are not plays on a slower economy. Rather, I have analyzed both stocks and concluded that they are both worth slim to none. The Interoil position was not originally my idea. I urge everyone to sign up at Value Investors Club and read both reports on Interoil. The website is also a good site to check regularly for new ideas. I will post my report about Silver Wheaton shortly.