September 2008 Archives

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The Government Steps In

First, if you haven't read Tom's Moral Hazard post on how credit default swaps and short selling can be used in tandem to attack a stock; stop, go read it, then come back if you'd like.

Over the past two weeks we've seen unprecedented gov't intervention in the markets. Nearly complete nationalization of FNM and FRE, a Fed credit line and massive stock dilution to save AIG from probable bankruptcy, announcement of a new gov't agency to create a market for troubled mortgage backed securities, a new Treasury insurance plan for money market funds, an SEC ban on short selling financial stocks and an SEC investigation into market manipulation. I'm sure I missed some things, but that's more than enough highlights for two weeks.

Like most, I have no idea what the ramifications of a FNM, FRE, or AIG failure would have been or even if they would have failed had the market been left to play out. To put the scope of the AIG dilution into context, if the Fed were to exercise the warrants and divide the new shares equally among all 300 million Americans, we'd each get just under 9 35 shares. If you're curious, the Fed's authority for deals like the AIG credit line comes from section 13 (3) of the Federal Reserve Act. It basically states the rules are whatever five members of the Fed Board of Governors say they are.

I want to focus on the SEC short sale ban and the investigation into market manipulation. I've read a number of blogs and articles over the weekend basically saying the SEC is just trying to blame short sellers for all the problems in the financial stocks while ignoring root causes like lax mortgage lending standards. Some point to LEH and claim the short selling had nothing to do with its collapse. Probably true. But AIG is another story. It's entirely possible that bidding up the CDS premiums while aggressively shorting the stock were key factors in their debt downgrades. Without those debt downgrades, AIG may very well have been able to raise enough capital to survive. We don't know the whole story and I don't think the SEC does either - that's the point of the investigation.

I don't think it's a coincidence that the short sale ban and the investigation news releases are adjacent to each other on the SEC website. I don't know anything beyond what's in the press releases, but I believe the SEC has taken an initial look at connections between CDS premiums and short interest and concluded there's a possibility of market manipulation. The short ban indicates they felt there was enough risk of market manipulation to take immediate action. Since they don't have any means of regulating CDS trading right now, the only circuit breaker available to them was a ban on short selling.

The press release makes it clear the SEC ban on short selling is temporary and even states, "Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets." All I can say is welcome to the party SEC.

Thanks for reading.

Disclosure: At time of posting I believe I have a beneficial interest nearly 9 35 shares of AIG.

Edited to correct bonehead math error.

Comments: View Comments |  Sunday September 21, 2008

Free beer??? BUD Price Spread (BUD)

Back in July, InBev launched a $65 per share take over offer for Anheuser Busch (BUD). After negotiating, the offer was bumped to $70 and accepted. Both boards agreed to the takeover, InBev had financing lined up and the deal looked good to go.

The chart below clearly shows how BUD stock price reacted as the story developed.


As rumors about a deal spread, the stock traded in the low $60s. After the $65 offer hit the news, the stock traded up above that price indicating expectations of a higher priced deal. When the deal was finalized at $70, the stock price quickly ran up to trade within a few percent of the deal and stayed in a very narrow range until a couple days ago. The spread between the offer price and market price has now widened considerably.

For someone willing to take the risk of the deal falling apart, there's a 6.5% gain from Thursday's closing price. A deal closing date hasn't been announced yet, so there's no way to annualize the rate, but I can't imagine it would take longer than a few more months to close. BUD hasn't announced whether or not they'll make the next dividend payment should the deal drag out that long. That would up the return just a bit more.

The downside risk if the deal were to fall apart is substantial. BUD was trading in the high $40's before deal rumors started swirling and if the buyout doesn't materialize, there's nothing to keep the stock from taking a nearly $20 haircut.

This could just be the result of the market's high volatility over the past few days. Or it may signal that investors are starting to have some doubts about the deal. One possibility is tight credit markets may be causing some concerns about the $50 billion in financing InBev has lined up.

There's nothing in the news and the risk/reward ratio still indicates high expectations of this deal closing as announced. However, the widening spread is indicating there may be a few doubts developing about hitching the Clydesdales to InBev.

Comments: View Comments |  Thursday September 18, 2008

Is There Peril in Merrill? (MER)

Last week's big decline in Merrill Lynch (MER) share price makes it worth a look. Significantly, it is now trading nearly 25% below the last 'smart money' issue price of $22.50. So far, I believe every financial firm that's raised capital by selling common stock has gone on to trade below the issue price. Please comment if you're aware of an exception. To summarize Merrill's capital raise, I've copied the pitch from my Motley Fool CAPS underperform rating entered in late July.

Monday, 28 July Merrill Lynch (MER) announced they were raising $8.5 billion of new capital in a stock offering and selling off a portfolio of CDO securities for $6.7 billion.

The CDO's had been carried on the books at $11.1 billion, that was after being marked down from an original value of over $30 billion. Merrill also financed 75% of the sale, so they netted something like $1.7 billion with some type of paper for the balance.

The stock placement will be 380 million shares priced at $22.50. There are 985.4 million shares outstanding before the new issue. That's nearly a 28% dilution for current shareholders. There is also a conversion of some convertible preferred stock from earlier capital raise that's tossed in the mix, so the dilution may even be a little higher.

As part of the new stock deal, Temasek, a Singapore sovereign wealth fund, is in for $3.4 billion worth. But because of provisions from an earlier investment in MER, that breaks down to $900 million purchased and $2.5 billion to make good on anti-dilution provisions from the last go 'round. Too bad average investors can't get those kind of guarantees.

This red-thumb is based on the track record financials have had after issuing shares to raise capital. There's typically some cheering and positive reaction because the company's been able to raise money, but then the stocks have nearly always gone down to trade below the secondary price. If that track record holds, MER should trade at least 10% below my pick point before too much longer.

Particularly disturbing in this case is that the CEO had stated that Merrill was in good shape and wasn't going to need to raise capital fairly recently.

Analysts expect MER to return to profitability next quarter, however MER has under performed expectations for the last two quarters. Yahoo shows 1.53 billion shares outstanding and the company listed tangible assets of a little over $16 billion at the end of Jun. Factoring in the new capital raise and loss on the CDO sale announced in July, tangible assets would bump up to about $20 billion. The share count appears to include the dilution. That gives a tangible book value of $13 per share and would have MER trading at a price-to-tangible book value ratio of 1.3. I believe Merrill's assets are in better shape than many other financial firms because they did go ahead and sweep out a lot of the trash; that doesn't mean the trash is all gone.

MER is paying a high yielding dividend, but if they don't start logging profits soon the payout will need to be cut.

If I did the math right, MER is trading at a premium for a company with uncertain prospects. Financials that are weathering the credit crunch well and are positioned to make fire sale acquisitions deserve premium valuations; I don't think MER is in that category. At the other end of the spectrum, MER is too expensive to attract high risk, speculative investors or deep value hunters.

Bottom line, I think MER is expensive for a company with an uncertain future. I also don't like that they announced the last capital raise so soon after Mr. Thain had publicly stated they wouldn't need one. The smart money track records in financials have not been good to date, so I'd like to see either some profitable quarters or a much larger discount to Temasek's purchase price before considering joining them as a MER shareholder.

Edited to add: Never mind; disregard this post. Just saw the news that BAC is buying MER for the ridiculous price of $29 per share. Overpaid for Countrywide, now over paying for Merrill Lynch.

Comments: View Comments |  Saturday September 13, 2008  |  Stocks: ,

A Numbers Play with Fannie Mae (FNM)

Last fall in Strategy Lab Open 1, we were asked about Fannie Mae. We said no way with the stock in the mid-40's. We were asked about it again in Strategy Lab Open 2 a few months ago. We said no way with the stock at 27. Now that it's below a buck, it's time for another look.

The turmoil from the bailout ('scuse me government assisted program) of FNM and FRE was worth a look to see if things might be overdone. Given the huge number of unknowns, there's no way to come up with a solid valuation, but the problem can be bounded to add some color to the risk/reward potential of scooping up some cheap shares.

To summarize what we know:
- Treasury is buying a new class of super senior preferred shares for $1 billion.

- The common stock and preferred stock dividends have been eliminated.

- The deal comes with warrants good for shares representing 80% of the common stock, the exercise price of the warrants is one-thousandth of a cent each, so there's no more money coming when the warrants get exercised.

- Treasury has the authority to purchase mortgage backed securities (MBS) from FNM and FRE. They will be purchasing $5 billion now and have authority to buy up to $100 billion.

- The plan establishes a direct secured credit facility for FNM and FRE at the Treasury.

- FNM closed at about $7 on Friday before the deal was announced.

- As of 30 June, FNM reported net tangible assets of $41.2 billion on the balance sheet and long-term assets of $774 billion.

- The trading range on Mon 8 Sep was $0.65 - $2.05 with a close of $0.73.

What we don't know:
- How much of the long term assets will be written off.

- What the book value would be if everything was valued at market prices.

- Whether this is the last capital injection and share dilution by Treasury.

- Unknown unknowns.

Defining the lower bound is simple. The stock is still trading, but if business deteriorates to the point where there's another capital injection, share value will quickly approach zero.

There are a couple of approaches to an upper price range.

The only thing that's changed since Friday's closing price is the bailout plan. At $7 per share, the market cap was about $7 billion. Treasury's plan brings the diluted share count to four billion shares. $7 billion/4 billion shares = $1.75 per share for one plausible stock valuation. Friday's closing price would have included some risk discount for a possible gov't wipeout of the common stock.

Another company with heavy mortgage exposure and questions about its future is Washington Mutual. As of 30 June, WM reported net tangible assets of $18.5 billion which works out to a P/B value of 0.38 based on Monday's closing price of $4.12. Applying that P/B value to FNM using the fully diluted share count would value FNM at $3.65 per share.

Anyone with other valuations on FNM, please feel free to comment.

In addition to massive dilution, the gov't intervention takes several measures that should help FNM business prospects going forward. Treasury's authority to buy MBS provides a market for those securities that didn't exist before, the credit facility offers financing at low spreads and the gov't action to back FNM and FRE debt should improve demand and lower spreads for their regular debt auctions.

The gov't intervention's impact on the housing market is unknown, but lower rates and an improved credit market should help stabilize the market, even if it just slows the rate of price declines. Any stabilization of housing prices helps limit foreclosures and should reduce the amount of write downs FNM will need to take.

IF (there aren't big enough letters for this if) FNM can survive without further dilution of the common or massive loss of tangible book value, buy back the gov't super preferred and move to a private sector company; it's reasonable to assume it could eventually trade at P/B of something like 2. That would be a way in the future, everything's wonderful share price of $19 based on the 30 June net tangible book.

On the downside, it would only take a little more than a 5% write down of the assets to totally wipe out the net tangible book. That's a big charge-off number, but well within the realm of possibility.

This doesn't look bad as a very, very high risk investment or a trade. At 73 cents a share, there's a plausible near term upside of between 140 and 400% if the market decides Friday afternoon's value for the company was reasonable or gives it a multiple similar to WM. Longer term, the upside is huge IF all that stuff listed above happens. Of course, there's a strong possibility of a total or near total loss of the investment.

I tried this today with a small piece of my virtual portfolio at Marketocracy and am well under water with it (entry point ~1.22). After running the numbers, I'm considering it with a tiny slice of my real portfolio, but will most likely leave this to the pros.

Comments: View Comments |  Monday September 8, 2008  |  Stocks: ,

Value Dining in a Tough Market: Sysco (SYY)

Sysco (SYY) supplies food products and supplies to restaurants, cafeterias, and institutional dining facilities. You've probably seen their trucks on the road.

The company reported 4th quarter FY 2008 earnings on 11 August. Sales were up 5.4% from the 4th quarter of 2007 and up 7.1% for the full year compared to '07. Earnings per share were also up from the previous year; 12.2% for the quarter and 13.1% for the full year. SYY has beat analysts earnings estimates three of the past four quarters and met the estimates once.

SYY has 9000 trucks, the largest private fleet in North America, so controlling fuel costs is critical. During the conference call, President and Chief Operating Officer Ken Spitler explained part of the success story, "...we continue to manage increased fuel costs by reducing the number of stops, increasing cases per truck, reducing idling time and placing governors on portions of our fleet that prevent trucks from exceeding 60 miles per hour, which not only helps save fuel but improves safety." Even with the conservation approaches, fuel costs hit operating expenses. However, the company was able to recover about 75% of the expense increases for the year with surcharges to customers. They expect to recover about half the fuel cost increases for 2009 and have entered in to forward pricing agreements for about 30% of their fuel through the first two quarters of 2009.

A risk to the business is inflation in both fuel and food commodity costs. For food, SYY estimated inflation running about 6%. Between passing costs along to customers and working to increase productivity, SYY has been able to absorb the higher commodity costs without taking a big hit to earnings. SYY has also been growing market share.

With energy costs coming down a bit recently, Sysco's productivity increases should work to improve margins. When business improves for the restaurant industry, SYY should do quite well. I don't know when that will happen, but the company pays a decent dividend while you wait and has increased the payout every year they've been public.

The stock rates 5-stars in Motley Fool's CAPS. At a little over 16 times 2009 earnings estimates, SYY trades at a discount to the S&P 500's PE of about 19 for the same period. For a company that's managing costs well, actually making money and growing earnings at a double-digit rate, that seems like a bargain.

All conference call quotes are from the transcript at SeekingAlpha.

Comments: View Comments |  Saturday September 6, 2008  |  Stocks: ,

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