Monday, December 15, 2008

Talk about TLK!

The largest telecommunication company in Indonesia, PT Telekomunikasi Indonesia (NYSE:TLK), with $6B+ in revenue and over $1.2B in profit per year. Growth is measured at 20% YOY right now but will likely reduce with the on coming global recession. The balance sheet is strong with $1B+ cash and less than $900m in total long term debt. No need to go to the debt markets for handouts here. The current market cap is $9.82B with $1.2B in free cash flow. Thus the stock is selling at less than 9x cash flow with over 50% market share of the Indonesian cell phone market. Growth prospects are tremendous for this firm, considering that market penetration stands at only 40% of the Indonesian cell phone market.

What could go wrong? Excluding the major Asian meltdown of 1990s, the Rupiah has traded at most at a 30% discount todays value. Also assume a major slowdown in growth due to global pressures, reducing the growth to nil YOY. Even then, the stock would be trading at approximately 11.7x last years cashflow (9.82B / .84B = 11.7). I'll take it! At least I will buy a piece, and hope that something unfortunate and unrelated does not happen so that I can buy A LOT MORE at a lower price. :)

Transparency: The author purchased TLK at $20.12/share on November 20th and will buy again when it reaches that price point in the future.

Tuesday, December 9, 2008

Playing the Spread: Income Investing in a Treacherous Market

Nowadays I am enamored with income investing. It may be a case of the the Stockholm syndrome due to my FRE preferred positions. But who says market investing is not a case of constant flogging anyway, up or down.

Soooooo here is what we have learned over the year...

BSC preferreds were a great bet...
WM preferreds got wiped out...
C preferreds are hanging on and continue to pay...
WB preferreds, after much stomach flipping turmoil, were also a good bet...

My rational attraction to preferreds and income trusts stems from the low yields available in the market. It appears to me that there are some very stable companies being treated like they have serious default risk. Thus the spread between risk free income and corporate investment grade yields is very wide. Moreover, in the case that the economy is deflating at 3% this year, then the DUK debt will a real 12% yield. Not to mention the comparison between the income and general market performance.

10 year Treasury - 2.5%
Duke BBB Junior Debt (JBI) - 8.5%
BMY Debt Notes (XFR) - 8%
BAC Preferred Floating (BAC-PE) - 11%

Transparency: The author has established a position in JBI (Duke Energy Debt Trust) at 21 (8.5% real yield) and a position in BAC-PE at $8.1 (10% real yield).

Tuesday, December 2, 2008

8 Good Reasons to Short HSBC

1) Primary real estate exposure is Hong Kong residential mortgages

With the slowdown in China, demand for Hong Kong real estate should fall steeply.

2) Large US subprime exposure

Yes, it is still there. HSBC Finance, formerly the Household Finance Inc subprime lender, holds many loans with the expectation of holding until maturity. In fact it was one of the largest US subprime lenders until late 2007. Reading the annual report and related news articles, there are multiple mentions of securitized mortgages that were sold to HSBC affiliates or other subsidiaries. This allows HSBC to move the securities off balance sheet and avoid marking the securities to market. As a result, there is a significant chance that within months HSBC will need to raise capital in this increasingly unattractive capital raising environment.

3) Very large US consumer revolving credit exposure

The HSBC USA subsidiary is one of the largest credit card lenders in the US market.
[I will add facts to support this later.]

4) Global slowdown in key HSBC markets

US is already in a recession. UK is very close to admitting it is in a recession. China is slowing seriously and cannot see the bottom of the downturn. Thus HSBC will be pushed to recapitalize in at least two of the three major markets.

5) Madoff Discount

Thanks to Mr. Madoff's astute business model, you can erase $1B in market valuation in HSBC just due investments in Madoff managed funds alone. HSBC is now facing lawsuits due to alleged negligence advising it's clients.

6) Large Chinese manufacturing exposure

All consumer loans, industrial loans, and real estate loans made in China by multinational companies are at risk because of the huge slowdown export related manufacturing in the Greater China region. HSBC is heavily exposed to China in this manner.

7) $1T Credit Default Swap exposure

Credit default swaps, even if no default events occur, drain precious capital because of the counterparty collateral requirements. With a few potential major credit events on the horizon, CDS are a toxic security to hold.

8) Large Middle East Commercial Loan exposure

HSBC is pervasive in all areas of the former British Empire, the Middle East is no exception. But with the drop in the price of oil and the deflationary effects of the credit crisis, many of their commercial outlays in this region will be at risk or at least deserve to be marked down.

Transparency: The author is long HSBC JUN 09 $40 put options at $6.3 and
long HSBC JAN 10 puts at $3.1

Friday, November 21, 2008

If I could Ultra Ultra Short Financials, I would be RICH!!!

Let’s say you saw the credit crisis coming, and wanted to short the financials.

You see two different securities that you are interested, XLF and SKF. XLF is an index that covers many of the financial companies, and SKF is an index designed to give twice the inverse return of XLF. You think about shorting XLF, but you want more return for your future predicting powers, so you buy SKF instead expecting to get double the performance. Over three months, which return is better?

Shorting XLF.

The chart above shows XLF vs. SKF over a three month period ending Nov 14, 2008.

This is the problem with the new world of leveraged ETFs. The profile states “The investment seeks daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Dow Jones U.S. Financials index.” But what it does not say is that it is only accurate at certain times. Looking at the chart, it seems that huge moves short for XLF were accurately captured by SKF (Oct 4 – Oct 10), but long moves by XLF proved to be overcompensated to the downside by SKF (i.e. Oct 10 – Oct 15 and Oct 23 – Nov 3).

Moreover, over time, for reasons not explicit to the end user, the SKF index does not continue to hold the NAV over time. Thus instead of getting the inverse result, the investor only gets the inverse result “for a short duration of time” before the index falls apart again on a bear (XLF bull move) move and waits for the next XLF short surge.

For a retail investor like myself, this is disheartening. I am not sure that I have ever seen the disclaimer for this poor correlation in the index. At least their should be some standard of correlation or grading system that should be applied to all indexes that use leveraging techniques.

On the other hand, better to just keep playing than crying about the rules of the game. In any case, I plan to use this information to my advantage. As of Nov 22, SKF is now trading at $280 after one of the biggest drops in NYSE history. Will it continue? Well, even if this is the onset of the Greater Depression, the XLF index can only go to zero folks. And the market NEVER goes straight down. Thus a purchase of SKF puts based on the observations mentioned here will most definitely yield a large return as the index swap agreements are rolled over and the bounce commenses.

Transparency: The author bought JAN 09 $80 SKF PUTS at $2.4 / contract and similar positions at similar strikes and prices and closed the JAN 09 $80 SKF puts at an average of $2.85 yielding a 19% gain.

Monday, November 10, 2008

Competing Shorts : Capital One or American Express?

Assume credit cards are the next crisis. Also, assume the crisis comes because the charge off rates go to historical levels that no wants to buy credit card bonds. Not a stretch of the imagination in any regard, considering the state of the US consumer. Where is the best place to be short?

Looking at options, both Capital One (COF) and American Express (AXP) charge close to the same amount on their JAN 10 $20 puts ($5.2 and $4.8 respectively).

But looking at their market situations, there is a clear advantages to both.

Capital One
• Pro: Lower average credit score to AXP customers
• Pro: Lower average income to AXP customers
• Pro: Large auto lending component to the business
• Con: Has substantial commercial lending deposits from it’s commercial bank

American Express
• Pro: Higher customer balances than COF customers
• Pro: Travel Services department (business credit cards) income is largely influenced by business capital spending in general, clearly in decline
• Con: No commercial bank to fund lending activities (used the Fed commercial lending facility early in November)


If you look at in terms of product, COF vs. AXP is like Ford vs. BMW, AXP has a more affluent, and privileged clientele. This may provide a more orderly deleveraging and is currently reflected in the lower charge off rates for AXP customers compared to COF customers.

But if you look at it in terms of capital position, COF vs. AXP is like C vs. LEH, COF has internal capital it can use as a cushion when no one wants to buy it’s short term financing facilities. Whereas AXP, like the now defaulted Lehman Brothers, had minimal internal capital and lots of leverage that relied on securitization and commercial paper markets for operation.

Both are solid short candidates, but despite it’s pedigree, AXP is more exposed to credit market freeze and thus appears in a more precarious position.

Supporting Research:

“Capital One said this month it's restricting credit card issuance after charge-off rates spiked to 6.34% in the third quarter from 3.96% in the same period last year.”

“Banks, in turn, are trying to wean themselves from the securitization markets. They're turning to other financing such as certificate of deposit programs, but those can be costly.The market shutdown is particularly bad news for non-bank finance companies. The ability to sell off car, education and auto loans is critical to companies such Ford Motor Co.'s Ford Motor Credit, American Express Co. and student lender SLM Corp., or Sallie Mae. Without securitization markets, they have less capital to make new loans to consumers.”

“… approximately 50% of [American Express] funding was unsecured and 50% was done through securitization.
Moving to slide eight, metric performance for international consumer, we continue to have strong metrics in international consumer although we did see some slowing in billed business in the third quarter. FX adjusted growth in the first and second quarter was 10% compared to the 8% in the third quarter.” American Express CFO, Daniel Henry – EVP & CFO

“In the US while the write-off rate in the quarter was 5.9% the write-off rate in September was 6.1%. We expect the fourth quarter to be higher then the third quarter and we expect the first quarter of 2009 to be higher then the fourth quarter of 2008.” American Express CFO, Daniel Henry – EVP & CFO as reported in the American Express 3Q conf call...

Transparency: The author owns both AXP Apr 09 puts at $3/contract and COF JUN 09 $25puts at $5.58/contract.

Thursday, October 30, 2008

Credit Default Swaps are supposed to be Weapons of Mass Destruction, so where is the Mass Destruction???

Recently the financial markets were shrieking in fear of the settlement of Lehman and Washington Mutual credit default swaps. Yet the settlement dates have past and there seems to be no impact apparent to the market. What happened? Is the CDS question overblown? Are the risk controls in place that the market is discounting?

There a few reasons to believe that the issues are still looming large in the market…

1) Just like the LTCM meltdown, it is not the settlement but the collateral requirements that will kill you

The OCC reports that investment banks believe they are hedged up to 85% of notional value of CDS.

This means the last 15% can swing in as a profit or loss, assuming no counterparty risk. For many of these hedge funds and banks, particularly for AIG, as market falls the collateral requirements on their positions must raise parabolicly. In the case of 123B loan from the US government to AIG, “tens of billions of dollars to post collateral with other financial institutions, as required by A.I.G.’s many derivatives contracts”. The "assets in a box" with the clearing bank will need to be replentished. But where will that come from in an environment like this? I am sure there are firms that are dead right now but just waiting on the banks to come seize assets on loans that are not performing.

2) Creditor will vampire the dead firms rather than kill them

The last thing any prime broker or bank needs is exposure that another client is not performing. Thus any attempt will be made to defer the inevitable while doing everything they can to obtain as much collateral before the fall. Look at how the home builders like Beazer have continued operations with no prospects of returning to profitability in the next few years. In the book Traders, Guns, & Money, the Das recounts how mid sized Indonesian firm, facing huge losses, created follow on agreements to amortize the debt with interest over longer periods of time. Whenever possible, this deferred payment plan disguised as an additional trade will be the best option for many of the major banks if they think the party will be able to last through the crisis.

3) The counterparty risk makes hedging calculations dubious

Take the UBS vs. Paramax court case where we find that UBS propped up a hedge fund and then bought CDS protection from them. The idea that hedge funds, as leveraged parties, can hold significant quantities of these securities creates a systemic risk. So if banks have 15% directional exposure, and additional 10% risk due to possibility of counterparty failure, then what are the real capital requirements that the banks need to call themselves solvent? I don't think any of the major credit default swap brokers have achieved this level of captial safety.

4) Lack of transparency to risk concentration is a riddle in itself

Yes, there were only $72B of Lehman CDS to be settled, and only $5B of that changed hands. But we do know there are 63T CDS outstanding amongst all banks. JP Morgan, BofA, C account for 15T by themselves. The 15% exposure of this notional value is worth more than the market cap of all of these banks combined. So what that we turned over one shell in this shell game and there was less than what we expected? Later we might turnover a shell and find more than what we expected. Or we find a case like AIG where they took only the side of writing protection?

The risk is very real.

In conclusion: Stronger transparency to collateral requirements will make the CDS market viable in the future when risk assessment criteria is formalized and enforced. But over 90% of existing CDS contracts span in length from 1 to 5 years. Thus there will be tremendous risk that will need to be flushed through the market that will keep the environment tenuous until industry can be considered viable, stable corner of the capital market.

This article is written in response to Felix Simon’s article “CDS the less you know the worse they look?”

Tuesday, October 21, 2008

Where do we really need the bailout? Hint: It is not the banks

All over the world $1.3T has been provided by governments to bolster the balance sheets of banks. Although this averts any immediate crisis by providing padding to the capital base of many of the most leveraged banks, it is a knee jerk reaction that does not address the root of the cause. It has been observed that the problem with banks is that the value of assets continues to go down in relation to leveraged balance sheets.

But if you gave the banks an infinite amount of money, would the issue be resolved? I contend no, because the real leverage is not tied to the lending institutions, but instead the consumers who provide the collateral to the transactions that the banks perform. The banks, for years, have tried to monetize the value of the undercapitalized consumer through interest rate hikes and extending the length of repayment. Now, with credit unavailable to finance these undercapitalized (regardless of credit rating) commitments long term, the banks are now starting to reflect the same financial situation that has been the case with the American consumer for years. Too many commitments served by way too little actual capital.

Thus before any type of resolution can occur in the credit markets, there will need to be a recapitalization of the American consumer. No more zero collateral purchases of cars, boats, homes, etc. A simple stimulus check providing $1200 is just one month worth of the payments that will need to be provided to float the American consumer. It will require at least 20 of these stimulus packages to get American family to stable balance sheet. What is the lesson in the temporary boost?

In conclusion, I approve of the use of $750B to recapitalize banks to avert an immediate destruction of the financial system. But I also approve a middle class tax cut bigger than what Obama is proposing and lots of personal bankruptcies as steps necessary for Americans to find their footing in a new, disciplined credit environment. The real "Bank of America", the wallets of the American consumer, will never truly be solvent until the people of America realize what fiscal solvency really requires.

Monday, October 20, 2008

10 Good Reasons to Short Bank of America

Bailout or no bailout, banks need to be profitable to survive. Bank of America has tremendous resources and connections to stay viable in the long term. But here are 10 good reasons to assume the BAC common stock will continue to fall through 2009 before the crisis abates.

#1 Bank of America also has a huge book of loans to homebuilders. It is time for at least a few to go bankrupt, this will be another severe dent in their portfolio. (Mish Shedlock quotes a minimum 7B+ in writeoffs coming)

#2 Bank of America must buy back $5B of auction rate securities. This is a cash transaction that takes away from their ability to lend in other areas, crimping income.

#3 Bank of America bought MBNA credit cards at the top of the market (2004). Thus Bank of America holds a very large exposure there to consumer spending decreases or increases in unemployment.

#4 In their distress with deteriorating loans, Freddie and Fannie have said that their top priority is to find recourse with fraudulent loans that have gone sour. If fraud is found, then the loan and the loss will be sent back to the originator. Until 2008, Countrywide originated over 25% of the countries loans.

#5 Countrywide has $25B in option arms still on the books that BofA is still liable for.

#6 Countrywide has $38B in debt outstanding. When Bank of America (BofA) took over Countrywide, BofA did not commit to guaranteeing the debt would be paid.

#7 When one of the Big Three automakers goes bankrupt, directly or indirectly this will mean at least a $5B hit to Bank of America

#8 Commercial Real Estate exposure is very significant

“Now what about financing of malls, retailers, office space, etc etc. A modest 10% writeoff across the board (highly likely IMO) would mean another $33 billion in writeoffs are coming from commercial real estate.”

#9 The sheer arrogence of the Merrill Lynch purchase at $26/share for a company about to go bankrupt.

#10 Bank of America has huge credit default swap counterparty risk

Bank of America currently holds over $1T in nominal credit default swaps. With deleveraging of hedge funds, parties that took the other side of their trades may not be able to pay out the insurance. In particular, if a party cannot payout on regarding a different CDS event, then the value of that party as an insurer of any other CDS contract becomes void. This could become a huge hole for BAC on many of their commercial loans.

What kind of opportunity is available for those interested in shorting the stock???

Assume a $124B market capitalization for the stock, referring to one year revenue based on 2007 revenue.

Subtract $5B writedown for homebuilder loans
Subtract $30B writedown in commercial real estate
Subtract $10B writedown of credit default swaps due to counterparty risk
Subtract $1B net writedown for auction rate securities
Subtract $5B writedown of Countrywide option ARMs
Subtract $5B writedown on prime mortgages from BAC legacy business
Subtract $1B from boomerang loans from Fannie and Freddie
Subtract $10B writedown to defease Countrywide and Merrill Lynch debt
Subtract $3B in credit card writedowns from legacy MBNA business
Subtract $5B writedown for commercial loans (industrial and especially automakers and their auto industry supply chain partners)

All of these negative events aside, within three years, Merrill Lynch and Countrywide will start to have a positive impact on earnings. But this year, we should expect the market cap of Bank of America ($124B cap) to absorb over $75B in writedowns and losses to net a market cap of $50B, which is approximately a fair value of $13/share.

Thus Lockstep Investing is recommending initiating a short position once Bank of America crosses $26 / share, exit when the stock crosses $12 / share.

Friday, August 22, 2008

Fannie, Freddie : Beyond the Balance Sheets

1 Kings 19:11-13

“The LORD said, "Go out and stand on the mountain in the presence of the LORD, for the LORD is about to pass by."
Then a great and powerful wind tore the mountains apart and shattered the rocks before the LORD, but the LORD was not in the wind. After the wind there was an earthquake, but the LORD was not in the earthquake. 12 After the earthquake came a fire, but the LORD was not in the fire. And after the fire came a gentle whisper. 13 When Elijah heard it, he pulled his cloak over his face and went out and stood at the mouth of the cave.”

The story of Elijah is a spiritual example of how investors need to demonstrate discipline and discernment. Each of the seemingly apocalyptic events that occurred in front of Elijah could have caused him to react prematurely or fear something not worthy of fear.

On a much more worldly level, such is the case with Freddie Mac (FRE) and Fannie Mae (FNM) preferred shares. In the past few months, the din of negative assessments of the GSEs situation has been deafening. Stories of representatives of foreign sovereign financial institutions calling Paulson himself to explicitly guarantee the US government financial backing for the FRE and FNM are accepted as truth. There has been an unprecedented selling of FRE and FNM preferred share securities, over $12B worth, in just a few weeks. For any smaller or non-government entity, this would be a sign that the corporation was worth no more than junk.

Even more telling is estimates regarding the net worth of GSEs. By many mark to market measures, there is negative net worth to the organizations. No one really disputes this, but many market participants expect that this is grounds to seek bankruptcy proceedings for these entities. The roar of the critics and investors disillusioned by the state of the credit markets expecting honest reporting and vindication for predictions of this outcome of easy credit is deafening.

Yet this is all noise. The authority, the US government has completely different agenda. The US government must maintain the stability of the US and implicitly the US housing and credit markets. The calculation of the net worth of FRE and FNM completely discounts the goodwill value of having a government organ able to keep mortgage markets from freezing up completely and starting the economy in a free fall. To the government, FRE and FNM are one of the few remaining levers to keep the markets moving. How much is that worth? In a whisper, that value is beyond the value of any bailout cost in dollar terms.

Why keep value in the preferreds and even the common then? Scream any profanity appropriate about how unfair it is for investors not to pay for their faith in insolvent corporations, but what about the intangibles? The biggest currency the US government has right now is faith that it is a good place to invest and that it will pay whatever debt is owed. A tremendous amount of the preferred securities were purchase based on the implied backing of the US government. To repudiate that assumption at this point will to risk total loss of faith in the US government as debtor. How much is that worth?

Why hasn’t the authority spoken to revive faith in these institutions and let all this noise come out speaking of their demise? In the financial classic “"Manias, Panics, and Crashes: A History of Financial Crises" the author, Kindleberger, explores how financial crises unfold and what is the options of those seeking to alleviate the crisis. A reviewer gives a synopsis of Kindleberger’s conclusion…

“What, in the end, is Kindleberger's moral? …. The solution, he believes, lies in having a lender of last resort. The trick, of course, is to avoid moral hazard and prevent the public from gambling due to the reassurance of a lender of last resort. The answer is ambiguity: the lender can come in and save the day but investors should never be certain that help is forthcoming."

Elijah never knew how many dramatic events would occur before he would hear The Lord speak. Such is the case with FNM and FRE, there is no motivation for the government to establish a floor because of the risk of inspiring moral hazard in the market is too great.

In the end, some time soon the cacophony of market opinions will subside and the market will realize that FNM and FRE serve a purpose much larger than just what balance sheets suggest. Then, at that grand final moment, the authority in this matter will honor the faithful.

Disclosure: Lockstep Investing is long FRE Y Series and Z Series preferreds

Lockstep Proposed Position: Buy FRE Y Series preferreds below $9 / share.

Monday, July 28, 2008

Crocodiles smile at Bank of America

“Crocodiles are ambush hunters, waiting for fish or land animals to come close, then rushing out to attack. As cold-blooded predators, they are lethargic, therefore survive long periods without food, and rarely need to actively go hunting.”

In this time of pain and turmoil, investors need to come out of their defensive positions and find easy prey. The J series preferred shares of Bank of America (Ticker:BAC-PJ) are that prey.

For investors, the recent banking turmoil is both a blessing and a curse. On one hand, castrophic losses have threatened the viability of the US banking system. On the other hand, for the surviving companies, there will be tremendous opportunities with reduced competition. This conclusion was presented during the recent JP Morgan Q2 conference call where analyst Mike Mayo, observing the opportunities of big banks to take advantage of weakened competition, approached JP Morgan CEO Jamie Dimon with a point blank question.

“You have been waiting your whole life for this environment,” Mayo asked, so what is holding JP Morgan back from growing through mergers with so many competitors hurt?

Bank of America is in a similar position. Despite the significant downside exposure of the Countrywide purchase, Bank of America deposits-on-hand is enough to weather any major storm. Although common shares may ebb and flow with the distress of the credit crisis, there are lower risk areas that pay premium amounts for capital. Thus, the recent opportunities to buy Bank of America preferred shares at reduced prices have been tremendous.

Any investor in this security will receive a 7.25% coupon with a par value of $25 a share for five years ending 2012. If the investor can buy the shares for less than the par value, then the yield on the shares will be higher. During the recent sell off in financial stocks in July, the shares dropped to $16 which meant a yield of 11.3% on any share purchased.

The J series preferred shares are non cumulative, meaning Bank of America can suspend paying the dividend at any time and will not incur any liabilities. For the investor, this is the downside risk of preferreds. Yet banks often issue their shares as non-cumulative because under accounting rules it allows them to use proceeds of the preferred issue toward their Tier 1 capital reserves. In most cases preferred share dividends are not cut unless common shareholder dividends are reduced to zero and/or bankruptcy occurs. In comparison, even the Bear Sterns non-cumulative preferred shares are still being paid out by JP Morgan without disruption. As of July 28, 2008, Washington Mutual (Yahoo! Ticker: WM-PR) is still paying out their preferreds shares at a 16% yield. Although I view dividend cuts to Bank of America common stock over the next two years very likely due to Countrywide exposure, credit card exposure, and real estate exposure, I do not foresee a total suspension of the dividend in any scenario.

There will only be a few times when high quality will be available at discount price. The turmoil that brought the shares down to $16 will happen again, probably sooner rather than later, and probably in relation to a bank bigger than Indymac. In most cases, the general market will be in fear of complete collapse or unknowledgeable about the opportunities that abound at this time. I recommend waiting until these preferred shares once again reach $16 / share before buying. In most cases, the general market will be in fear or unknowledgeable about the opportunities that abound at this time. Only crocodile investors who wait until the conditions are appropriate will be astute enough to identify this opportunity and enjoy the best returns.

Transparency: Position initiated on Oct 10, 2008 at $16 / share. On that day the security reached an intraday low of $15.50 / share.

Monday, July 14, 2008

One day the Smogbirds will come back

"I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out."- Warren Buffett in Oct. 2003 talking with Wharton MBA students

The Position of the Month

Stock: Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC)
Position: Long
Opening Price: Below $21.50
Expected Closing Price: Above $60

Sometimes it actually rains in Southern California, or just becomes overcast during January and February every year. During that time the depressed residents of this area enjoy nothing more than a trip to balmy climates just south of the border where there dollar goes a little further and the SPF 50 cocoa butter is plentiful off season. Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC) is a company that welcomes the Smog Birds of Southern California to their airports on their way to the vacation resort of their choice.

GAP is one of three airport operators (the other two are Ticker: ASR and Ticker: OMAB) concessions in Mexico created in 2005 with the privatization of the airport management entity. It has 12 airports under management in the Western part of the country including Guadalajara (third biggest in Mexico), Puerto Vallerta, Los Cabos, Tijuana and smaller locations Mexicali, Hermosillo, Agaucalientes, Bajio, Morelia, La Paz, Manzanillo.

With monopoly status, the fortunes of the company are directly indicated by the number passengers passing through their airports. The 2007 annual report for the company reported passenger growth at Guadalajara over a three year period and Los Cabos over a five year period of 11% and 14% respectively. At Los Cabos, 75% of the increase consisted in higher margin international passengers.

At the end of 2007 and early 2008, the company continued to believe traffic growth will continue at previous rates unabated. As such, the company has been investing in capital expansion projects in Guadalajara, Los Cabos, Puerto Vallarta, and Tijuana airports with the intent of capturing new commercial revenues. Overall passenger growth and commercial growth were estimated at under 10% and 13-16% respectively. Customer traffic has been increasing to GAP airports due to increased international exposure of Mexico’s resort destinations and explosion of the Low Cost Carrier (LCC) industry in Mexico over the last few years. LCC traffic represented 30% of all domestic passenger traffic in Mexico at the beginning of 2007 and over 43% by the end of 2007. Given this, management entered 2008 optimistic.

But the best laid plans of mice and men go awry. The spike in oil has caused a severe pullback in airline carrier operations at GAP airports that directly effects the amount of passenger traffic.

Airport and carriers which either ceased or significantly reduced operations at this location include…

Tijuana (Aviacsa, Aeromexico, Mexicana, Avolar and Aerocalifornia)
Mexicali – (Aviacsa)
La Paz – (Avolar and Aeromexico)
Guanjuato – (Volaris, Aviacsa)

…and there are more…

The LCCs are getting directly hit from oil and, as is prudent, abandoning the smaller airports retreating to the hubs and where their cost advantages serve them well. The discontinuation of routes and operations at smaller GAP airports due to jet fuel prices make the routes unprofitable, especially for the LCCs. Even though GAP continues to see increases in traffic at its four biggest airports from this LCC consolidation trend, the net effect is overall decrease in passenger traffic overall for GAP.

This trend is reflected in the GAP stock price. From Oct 2007, GAP has moved inverse to oil. With oil now at skyrocketing to $142 / barrel and continued stress in the energy markets for the foreseeable future, a major economic downturn in the US and particularly Southern California, the major question for GAP what will be the rock bottom price of GAP as the dust settles. Even if the downturn moderates the oil price, even $80 / barrel is a cruel and unusual punishment for well funded international carriers and low margin LCCs. Additional discontinuation of routes and failures due elevated energy costs will cause significant disruptions in passenger traffic in GAP locations. For example, the American Airlines “no fly” episode cost GAP a bundle due to the fact that AA flights make up 14% of total passenger traffic at Los Cabos airport alone.

There is no better example of the future prospects of GAP than the Smog Birds of Southern California. The company also manages the second most important international route in Mexico, the Guadalajara-Los Angeles route. The broader context of a US recession aside, focused stress in the Southern California economy is bound to particularly hit GAP in terms of international passengers to resort destinations but also as So Cal residents with family ties to Mexico are impacted by decreased economic prospects.

GAP, as a monopoly, is what Warren Buffett would describe as having a “wide moat”. Strictly from a balance sheet perspective, GAP boasts assets including the airport concessions and land valued at over $1.5B. In 2007 it improved operating margins 3.4% to 45%. The company has completed capital projects that support expansion sure to come in future years. The company earned $161m last year on $320m in revenue, a cash machine. Yet due to concerns over oil the company currently holds a market cap of $1.4B. In June GAP sunk below its IPO share price of $31/share and now stands at $26/share.

I am expecting a prolonged period of pain for GAP due to oil and a US consumer led recession, and thus my recommended purchase price is below my estimated market value for the company. Despite the energy markets run up the company will still easily meet dividend commitments which are $2.01/share for ADRs which make the company always a buy, but at a particular price. I recommend accumulating GAP at $21.50/share (1.15B market cap) will provide a 9.3% yield. At this price, an investor can stay defensive long enough addresses any economic risk, oil shock risk, or carrier risk that could occur if events similar to the 1970s energy debacle are repeated. While you wait, the grittiest of Smog Birds will continue their annual migration route until their traditional margarita watering holes filled again with chattering about the 101, the 5, the 405 and the latest Hollywood gossip.§ion=REPORTES_ANUALES&tema=579&menu=INVERSIONISTAS&lang=eng

Transparency: The author bought a long position at $21/share.

Wednesday, May 7, 2008

No credit for Capital One

The Quote of the Month

““It takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side. It took me longer to get that general principle fixed firmly in my mind than it did most of the more technical phases of the game of stock speculation.” Jesse Livermore, “Reminiscences of a Stock Operator”.

The Position of the Month

Stock: COF
Position: Short

Basic Position Opening Price:
Above $55
Basic Position Expected closing price:
Below $40
Advanced Investor Position Opening Price:
Buy COF $50 Jan 10 puts at $10
Advanced Investor Position Closing Price:
Sell to Close at $14 / contract

The Summary

Capital One is a leveraged lender with high percentage of low quality cardholders.

The Story

Any investment related to credit cards is a bet on the American consumer. When the American consumer can hold a job, they can maintain their credit card balance. In this case, credit card companies profit on carrying fees. If Americans lose their job, then credit card costs spiral out of control. In this case, credit card companies lose money from charge offs, lost income streams, and decreased portfolio quality.

Off balance sheet securities performing poorly(1) 4/13/08 “Off-balance sheet item ($49B) has a default rate of 5.8% where the base portfolio is 3.26%.”

Credit card charge offs still at low levels considering economic outlook(2) 4/10/08 “Now, as the "almost-affirmed" recession is upon us, delinquencies will rise along with foreclosures and bankruptcies. This will surely trickle down to the lenders as the inflows they receive dwindle, outflows grow and non-recoverable debt increases. While a 6% rate may seem historically high, back in 2003, Capital One posted rates closer to 8% as the U.S. was starting on the road to recovery from a difficult 2 years of recession and the fall off from the domestic stock markets averaging near -50%.”

COF insiders are selling

(3) 3/24/08 “COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%”

Americans revolving credit increasing as economy suffers
(4) 4/25/08 “Revolving debt, which typically comes from credit cards, has increased at a faster rate than overall debt since the summer of 2006 -- right about when the housing market began to implode.
The trend seems to suggest consumers are using credit cards to patch up holes in revenue that once could be filled by refinancing or selling a home. Now that home values have dropped sharply and are predicted to fall further, at least over the short term, consumers are left without the housing crutch they once relied upon.”

The story is very simple. If you think the unemployment rate is going up, then credit card companies will suffer in direct proportion to the increase in unemployment.

To underscore the link, look at the graph below and think about how it corresponds to home equity cash out phenomenon. As equity transferred from homes to consumer spending, credit cards benefited from increased revenue and lower defaults.

Moreover, projections are that credit card charge offs will continue return toward the mean in terms of historical charge off rates.
(5) "Despite these negative macroeconomic trends, credit card delinquencies and charge-offs have just recently returned to their long-term averages following a two-year period of exceptionally strong performance in the wake of the implementation of new bankruptcy legislation in 2005," Cynthia Ullrich, a senior director at Fitch, said in a statement.
The Conclusion

This investment hinges on the pretext that the credit unwind will directly effect the American consumer in terms of economic contraction and reduced leverage in household spending. Considering the current situation, this looks like a low risk investment with many different scenarios leading to the predicted outcome.

(1) Andrew Horowitz,

(2) Andrew Horowitz,

(3) Andrew Horowitz

(4), 4/25/08,

(5) “Fitch study shows credit-card delinquencies and charge-offs rising, will pressure securities”
Wednesday, April 30th, Reuters,

Tuesday, March 25, 2008

UBS no longer a haven

The Quote of the Month

“Please, God, just one more bubble!” quoted from Warren Buffet’s 2007 Letter to the Shareholders of Berkshire Hathaway

The Position of the Month

Stock: UBS
Position: Short

Basic Position Opening Price
Above $30
Basic Position Expected closing price
Below $15
Advanced Investor Position Opening Price
Buy UBS $35 Jan 09 puts at $8.50 / contract or lower
Advanced Investor Position Closing Price
Sell to Close at $19 / contract

The Summary

UBS is overleveraged and delaying an inevitable unwind. In the meantime, it is destroying centuries old customer confidence in Swiss banking.

Currently UBS is in a state of crisis. As Jim Cramer once said "Whenever you smell smoke, behind the door there is probably a giant conflagration!" The smoke is currently seeping out of UBS in the form of desperate measures to raise liquidity.

* UBS recently dumped $25B Alt-A mortgages due to liquidity concerns

“Analysts said they believed UBS had sold its Alt-A investments -- U.S. mortgages ranked between prime and subprime – to bond manager Pimco for 70 cents to the dollar, taking a deep discount on a 26.6 billion Swiss franc ($25.7 billion) portfolio.” Chris: A sure sign of cash concerns is bulk sales of loans.

* UBS still holds $400B in repurchase agreements for funding

“Analysts also said they expected the ailing bank making further writedowns on a massive 400 billion franc portfolio of repurchase agreements as it rushes to cut its exposure to the capital markets in general and to risky assets in particular.” Chris: This just shows how many assets they are holding out to avoid liquidating in an unforgiving market.

UBS tried to sell it’s Paine Webber brokerage arm to raise cash

“Swiss bank UBS, another bank suffering from the credit crunch, recently shopped its PaineWebber brokerage unit in an effort to drum up cash but failed to find the right buyer. (BAC, Wells Fargo and Barclays all declined).”

UBS needs to raise cash in a unforgiving market. There are tons competing assets sales, but all the potential customers are overleveraged and marketing the same securities themselves or prudent and choosier by the day. UBS needs to find solutions fast, while the clock on $400B in debt deteriorating in value is ticking away.

The Story

In the movie Die Hard, the evil villain says that after stealing $20m in bonds and lock safe baubles, he planned to store them in a “Swiss bank account and sit on the beach collecting 6%”. He might want to rethink that strategy.

For much of the 20th century Switzerland was considered the world’s safe haven for banking. African dictators, European despots, and Nazi war criminals all found it an oasis for savings in tumultuous times. In the latter part of the century, Swiss banking consolidated to two names, Union Bank of Switzerland and Credit Suisse.

At some point all this revere and sticky old money was not enough. The old money wanted higher returns and hedge funds came en vogue. UBS, providing the connections to the massive money of the old world, became a key prime broker to the hedge funds. Prime brokers are the home for hedge funds, housing them, executing their trades, finding investors, providing reports, cleaning up accounts, and even providing seed money and loans. This is very profitable considering 33% of volume in the market is hedge fund activity.

While times were good, the relationship was cozy. Now that the order of the day is deleveraging and the levered hedge funds, stuck in illiquid positions, are now more of a liability than an asset. The loans outstanding at UBS total more than $400B and cash on hand is $19B. Sounds impressive, but Bear had $17B on hand the day it folded. With the obvious implied leverage there is no doubt in my mind that UBS has been busy at the Fed discount window trading securities for treasuries that people will take for cash. The problem is that the Fed is lending only for 28 days. Every 28 days the value of the mortgage backed securities that UBS directly or indirectly is exposed to goes down in value. The house decline will not stop any time soon. So the predicament at UBS will continue to be more precarious as the weeks go by.

The Scorecard

Position #1: C

Direction: Short
Start Price: 27.3
Current Price: 23.78
Start Date: Jan 13, 2008

Position #2: UBS

Direction: Short
Start Price: Not reached yet
Current Price: 29.56

Start Date: TBD

Things are amiss in Gotham Citi

Quote of the Month

Proverbs 22:26-27 "26 Do not be a man who strikes hands in pledge or puts up security for debts; 27 If you lack the means to pay your very bed will be snatched under you"

Position of the Month

Position: Short
Opening Price: Above $27
Expected closing price: Below $16
Horizon: One year


Citi is unwinding leverage in the capital markets while facing a deteriorating consumer credit business.

Position of the Month:

The Citi is in trouble, and everyone knows it.

The previously largest bank by market capitalization in the world is trying to get hold of all the problems threatening the company. The unwinding of off balance sheet debt positions (think Enron) led to the ratings agencies attempting to downgrade to junk six of their seven off balance sheet companies. In the last minute before six of the seven SIV companies were downgraded to junk, the SIVs were adopted on to Citi’s balance sheet. What remains of the $100B of asset backed securities that Citi was caught holding the bag with, $43B of the securities still remain.

But that was the first issue. Citi seemed to lending to it’s citizens seems to be too lax. Citi also purchased two subprime insurers at the top of the market that continue to cause writeoffs as the loans deteriorate. In addition, Citi took positions is securities and derivatives that analyst William Tanona estimates gives the company 37B exposure to subprime mortgages. This issue will continue to haunt Citi as the market reprices homes from the top of the market.

The bottom line for Citi is that mortgage losses, credit losses, and derivative losses all draw cash away from the bank. Unhedged long term positions threaten to bring the banks capital ratios down below the capital requirement levels required. If the people of Citi think the bank cannot repay, they will be very likely to take their deposits elsewhere.

Ok things are bad, but what is next for Gotham?

From the transcript of the Citi 4th quarter conf call…

"The American consumer is losing net worth at phenomenal rate with the decrease in housing prices. The Case & Schiller index of home prices indicates we are only in the second year of five year retreat in home prices. Much of the consumer economy of the past ten years has relied on or was financed by the increase in home prices. As the prices fall companies like Citi will have larger and larger draws on it’s available cash from it’s consumer operations to fund it’s illiquid leveraged positions, managing bank capital ratios against decreasing asset values, and continuing losses from lax lending areas from auto loans to credit cards."

Economic Outlook:

“Pyramid schemes and chain letters collapse because there is no more credit to feed them. As the system of modern day levered shadow finance slows to a crawl, or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question.”

Author William Gross, “Pyramids Crumbling”, Investment Outlook, January 2008


The current unwinding of financial markets is repricing risk from historically low levels. When price trends reach the end of a cycle and start retracing prices tend to overshoot, not revert to the mean. So we can expect significant increases in the cost of consumer credit over the next couple of years.

To support the point refer to the CFO of Citibank as reported in the New York Times (1)

“Mr. Crittenden, the chief financial officer of Citigroup, had a different message on Tuesday, as Citi disclosed an $18.1 billion write-down. He told analysts that Citi was raising rates on credit cards and tightening the amount of credit it would extend. Asked by an analyst whether credit card lending was an area where Citi might want to “pull back or increase pricing,” he responded, “All of the above.”

Crittenden continues...

"Low Federal rates of turn of the century led to a credit boom with lax lending standards. Now that lenders are getting burned, the spigot is being turned the other way. This bodes poorly for overextended consumers.

Again the NYT reports…
“Citi is not alone. While the tighter credit market has not stopped credit-worthy individuals or companies from obtaining loans, it has made loans more expensive for many of them, and left those with the greatest need for cash far less able to obtain it.”
“They are parceling out credit with a keen eye on the balance sheet,” said John Garvey, the head of the financial services advisory group at PricewaterhouseCoopers. “There is a flight to quality and a renewed focus on risk.”

(1) “An Effort to Stem Losses at Citigroup Produces a Renewed Focus on Risk” by Floyd Norris