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.
Monday, April 30, 2007
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
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."
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."
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)
‘96
423 million revenue
22 million ebitda
74 million Invested Capital
30% ROI
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
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.
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
1.33 billion revenue
69 million ebitda
ROI -100%++
8.1x EV/EBITDA
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
‘96
289 million revenue
37 million ebitda
79 million invested capital
47% ROI
591 million revenue
94 million EBITDA
177 million invested capital
53% ROI
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.
‘96
423 million revenue
22 million ebitda
74 million Invested Capital
30% ROI
835 million revenue
70 million ebitda
114 million invested capital
61% ROI
8.4x EV/EBITDA
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
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."
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.
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.
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.
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.
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.
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
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
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:
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.
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.
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.
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
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.
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.
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
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
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
Monday, February 19, 2007
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
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
Thursday, February 15, 2007
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
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
Monday, February 12, 2007
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.
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.
Monday, February 05, 2007
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 $123
per ADMT.
Exhibit B- Management Rationale for Acquisition
Ticker: SFK-UN.TO
Price: 4.90 CAN
Shares Outstanding: 101 Million
Debt: 114 million
Market Cap: 495 Million
Note: All above figures take into account recent acquisition and share offerings, to show position today, and all numbers will be in Can$, 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
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
• The AFRI Mills are among the newest facilities of their type in
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
• 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
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
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.
Tuesday, January 30, 2007
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.
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.
Saturday, January 27, 2007
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
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
Sunday, January 07, 2007
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.
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.
Tuesday, October 10, 2006
Liberty of Thought and Discussion:
I read a very logical and convincing work today by John Stuart Mills entitled "Liberty of Thought and Discussion". Mills makes the argument that society should promote discussion and debate, because "the only way in which a human being can make some approach to knowing the whole of a subject is by hearing what can be said about it by persons of every variety of opinion, and studying all modes in which it can be looked at by every character of mind." The biggest evil is to silence opinions or brand a differentiating opinion as "evil", because it inhibits discussion.
Sadly, several examples of this occur today in our society, especially in politics. President Bush's chronic characterization of Iraq war critics as "unpatriotic" and "weak" is prohibiting debate on the best course of action that America should take. "All silencing of discussion is an assumption of infallibility." It is wrong for any President to act in this way. It is even worse to permit this type of demeanor given all the mishaps his leadership has already committed. Unfortunately, most of politics is now ran on a similar behavior. In our world of short attention spans and 30 second media ads, are we doomed to fall prey to propoganda and ignorance?
Mills' logic is very provoking and hits the heart in today's society. I urge everyone to read the mentioned chapter by Mr. Mills. The link is displayed below as well as under the links section of this blog.
Liberty of Thought and Discussion: Chapter Two
I read a very logical and convincing work today by John Stuart Mills entitled "Liberty of Thought and Discussion". Mills makes the argument that society should promote discussion and debate, because "the only way in which a human being can make some approach to knowing the whole of a subject is by hearing what can be said about it by persons of every variety of opinion, and studying all modes in which it can be looked at by every character of mind." The biggest evil is to silence opinions or brand a differentiating opinion as "evil", because it inhibits discussion.
Sadly, several examples of this occur today in our society, especially in politics. President Bush's chronic characterization of Iraq war critics as "unpatriotic" and "weak" is prohibiting debate on the best course of action that America should take. "All silencing of discussion is an assumption of infallibility." It is wrong for any President to act in this way. It is even worse to permit this type of demeanor given all the mishaps his leadership has already committed. Unfortunately, most of politics is now ran on a similar behavior. In our world of short attention spans and 30 second media ads, are we doomed to fall prey to propoganda and ignorance?
Mills' logic is very provoking and hits the heart in today's society. I urge everyone to read the mentioned chapter by Mr. Mills. The link is displayed below as well as under the links section of this blog.
Liberty of Thought and Discussion: Chapter Two
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