Risk management and sounding crazy

In early June Carson Block and his firm Muddy Waters research published a report which made outrageous sounding allegations against Sino Forest - then a highly respected Canadian listed Chinese forestry company that had borrowed well over $2 billion to develop and expand forestry operations in China.

The base allegation in the report was that most the forests did not exist and by implication the (more than) $2 billion borrowed was stolen. Presumably many more shares have been sold too taking the total theft well above $2 billion.

It was an outrageous jaw-dropping allegation and Carson made no attempt to soften the blow. His language was inflammatory because his message was inflammatory. When $2 billion is stolen by reputable people I can't see how you can say that without appearing inflammatory. Some people, understandably, refused to believe it.

In response I set about reading ten years of Sino Forest accounts and decided Ocham's Razor style that Carson being right was the only explanation that I could think of (and probably the only simple explanation) consistent with the facts. And I shorted some, and then shorted some more. The two main posts that outlined my thinking were here and here.

Still I am obsessed about discovering the ways my positions can be wrong (and my business partner is even more obsessed) and we followed the reports of everyone (and there were many) who doubted Mr Block's research.

Dundee Securities was the most prominent Sino-supporter labeling Muddy Water's research a "pile of crap". Somewhat more considered sounding (but also flat wrong just more reasonable sounding) was Metal Augmentor who found Carson "loose with the facts and somewhat breathless". On the naive-sounding side was Susan Mallin whose complaint was that she had "never seen a research report written in this manner". More prominent people were fooled too. I have heard Richard Chandler is not an idiot (but he seems to like losing money - I keep finding him invested in frauds and he does not answer my emails). He dropped $150 million on Sino Forest.

The analysis of these people was staggeringly weak and self-referential (I can't speak for Chandler because I never saw his analysis). They judged Sino Forest against data provided by Sino Forest or people associated with Sino Forest. This is an elementary mistake in assessing fraud. To find fraud you need to be able to judge against things you are fairly sure are not fraudulent.

Everything the Carson Block doubters said sounded reasonable. Certainly more reasonable than Carson Block sounded because Carson Block held the radical position. Sounding reasonable however was wrong.

I think what is going on here is a general problem. When someone says something - anything - that is so far from the consensus as to sound outrageous then they will be considered mad, and sometimes they will be considered mad even after they are proven right. This is iconic in the history of science from Galileo (who observed the moons revolving around Jupiter and the crescent shapes of Venus and deduced much from those) to the more minor genius of Émilie du Châtelet (who thought, contrary to Newton, that energy in a moving body was proportional to velocity squared). Galileo was imprisoned. Émilie was excused because she was a woman and from there sprung her eccentricities. Her status was as Voltaire's mistress, not as a great scientist.

The mad genius is iconic in finance too.

I have heard people say - even now - that Carson was sloppy and breathless in his allegations. He was not. He was right. Dismissing him as sloppy and breathless is in itself sloppy and breathless. Indeed siding with conventional sounding language, conventional sounding reason lost you a lot of money in the Sino Forest case. It was better to side with Carson - the seeming madman.

This happens again and again and again. If you have very non-conventional views - even if they are well supported - even if they are right - if you spell them out plainly you will be thought of as a madman because your views sound outrageous.

But a hedge fund manager has it easier than the scientist. The scientist would be ostracized for the views. A hedge fund manager just makes lots of money. If you are right and nobody believes you then there is a chance to make mega-spondulick$. Indeed by far the strongest opportunities for making really good returns come from doing something original. I shudder to think how much Carson and his backers made on Sino Forest but I think we could safely measure it in lifetimes of average earnings.

There is however a problem with this: a portfolio manager who sounds mad may indeed be mad. Even if they are not mad the market may be wrong longer than they can be solvent. Which brings me to the schizoid character of a really good money manager or money manager team. It is highly rational but it appears like controlled insanity. You need the slightly crazy idea-driven maniac who is prepared to think outside the box and you need someone to button them down, to make them appear reasonable and to act reasonable.

Sometimes the two people are in the same body (I know a few of these people and some are not pleasant people because they are so strangely strung). In Bronte's case they are in different bodies with my business partner appearing much more socially, intellectually and even politically conservative than me. We are an odd-couple rather than an odd person.

All this leads me to wondering about Warren Buffett - the greatest fund manager of them all. He is an unusual individual with strange personal predilections. But he sounds so rational. And he is amazingly self-controlled. Indeed his ability to sit on billions of dollars excess cash for years and years at a time waiting for the time to pounce is legendary and extraordinarily hard to duplicate. Buffett says that temperament is more important than brains in investing and I think this is what he means. But it is often Buffett against the world. Buffett is thought of as a has-been by many people. It doesn't matter whether he was avoiding tech stocks in 1998, 1999 and 2000. It does not matter whether he was buying Bank of America now. He is - of course - just mad.

The madness is an important part of how Buffett made all that money. But the self control is - I think - more important.

When we meet clients I do all the talking. Some people have even wondered why I am with Simon (my business partner). We fundamentally have nothing in common. But there is a reason... he is the best control mechanism I have ever found. It took me a long time (and some losses) to realize I even needed one - he has the temperament. But if the career of Warren Buffett is a guide (and I think it is) then to make money over very long periods you need an ability to think right outside the box and a lot of self-control. The self-control is what most people think of as the risk management.

I don't know how you judge the yin-and-yang of this - and I don't know how you pick the individuals or the teams that have it. But when you see two guys who present themselves as partners but one is voluble and one is quiet then make your assessments of the quiet one. Our record at Bronte is fabulous: if it stays fabulous (and I think it will) then it will be control of Simon rather than idea generation of me that keeps it that way.


John

PS. I often run my blog posts through Simon. This one is in praise of the mad-guy (Carson) and the sane-guy (Simon). I think they should just see it when it pops up.

PPS. The best fund managers hire the misfits who work hard, don't belong in suits and often put them in suits to make them seem more reasonable. (We skip the suits.) This famous letter to a job-applicant by Dan Loeb is a gem.

PPPS. John Paulson is a mad genius. His problems at the moment are as much as anything a function of risk control. His positions were too large and when he was wrong (and everyone is wrong sometimes) his wind-down was horrible. He should hire Simon but I am not going to let him!


J

The retail price of solar panels

I just googled "Trina Solar". Here is the Google results page (from Sydney, Australia).

Note the second advert which gives retail prices. AUD1.40 per watt for monocrystalline, $1.30 per watt for polycyrstalline. German modules.

The blended price from the last Trina Solar conference call (presumably a wholesale price which is lowe than a retail price) is $1.46 per watt. They told us that they had seen their prices stabilize.

Sorry. No dice. This gets worse. Much much worse.



John


Can't resist a follow up. Within two minutes of posting this the salesman who cold-called me trying to sell solar panels emailed a follow-up:

Just a quick note that the price of alex panel has been dropped to $1.30p/w (minimun purchase amount is 2 pallets). 

 The price of Ever-Solar inverter is also decreased:

Trina Solar was burning well over 100 million in cash per quarter whilst expanding its output. Discounting pressure is now increasing so it is going to get worse. Survival is not assured.

Weekend edition: Hempton vs the Hurricane in a blow-off launch of "The Business"

The cooler Mr Hempton and the Nick Hempton band are launching their second CD "The Business" in New York on Saturday Night.

Smalls Jazz Club
183 W10th Street @7th Ave
New York, NY
7.30 - 10pm

Not only is Nick better looking than me but he blows almost as hard as Irene and much much cooler. The reviews have been universally good - but I will understand if you think you need to be home sandbagging...



J

PS. Apart from Irene I wish I was in New York for this. I will be in Early October (client visits). By then the wind might have died down...

Bank of America: some comment on the Buffett deal

Warren Buffett got a sweetheart deal.

The deep discount on Warren Buffett's investment proves Bank of America was desperate.

All lines I have heard this morning. And I think they are mostly wrong.

Clearly the deal involves dilution - about 7 percent according to some of best specialist analysts on banks I know. But I thought I would try to quantify on the back-of-an-envelope just how much of a sweetheart deal Warren got and how much it will cost Bank of America.

The analysis surprised me and will probably surprise you.

The deal has two parts. 

• Buffett has purchased $5 billion of perpetual tier-1 equity that yields 6 percent, can have its dividend suspended at any time (whereupon it accumulates at 8 percent) and can be repurchased at any time at a 5% premium. 

• Buffett also received gratis options to buy 700 million shares (5 billion dollars face value) at $7.14 per share.

Lets try and back-of-the-envelope work out what each part is worth. I want to judge this against the market prices that prevailed before Buffett did the deal ... I want to work out how much of a discount Bank of America gave Warren Buffett.

The Tier 1 equity is not worth anything like 5 billion dollars. Bank of America preference share class X (a 7 percent coupon) was trading at about $21 (against par value of $25) the day before the Buffett deal. In other words it had an 8.3 percent yield. And it had slightly better terms than the Buffett deal (it is Tier 2 equity, not Tier 1 equity). Adding another 70bps to that yield to compensate for the worse (Tier 1) terms and you get my guess as to the market yield for the fixed coupon part of the deal. To be worth par it had to carry a 9 percent coupon.

Its a perpetual and it only yields 6 percent when the going market yield at the time was 9 percent. So it worth two thirds of par. So $5 billion of it was worth $3.33 billion at then market.

The equity option is harder to value - but we have some market indicators. The day before Buffett purchased Bank of America $13.30 warrants were trading at about $3.30. These were the warrants created as part of TARP and have fairly nice terms.

Buffett got $7.14 warrants with slightly longer albeit less nice terms. They are clearly worth more than $3.30 per share. But they are clearly worth less than $6.88 per share because BofA was trading at $6.88 in the middle of the day before the warrants were issued and you could actually own the stock at $6.88 which is obviously better than a warrant at $7.14.

So we have a lower bound for the warrants ($3.30) and an upper bound ($6.88). You can use fancy financial maths and the like - but I think a round number of $4.50 per warrant seems about right. Buffett received 700 million warrants - $3.15 billion dollars worth. That number - picked by my usual "scientific method" is very close to estimates made by Linus Wilson an assistant professor of finance. His number was 3.17 billion. 

So I pick a total value that Buffett received versus market prices the day before the transaction as $6.45 billion. If you want to phrase that differently Bank of America gave Buffet a $1.45 billion "gift". Or a 22.5 percent discount on his investment.

That number is quite a bit lower than the estimates in the press. Reuters for instance estimates it as $3 billion "gift". They are wrong - they have not figured on the low coupon for the preferred.

Now lets work on the 22.5 percent discount. If you had purchased Bank of America at a 22.5 percent discount to the price the day Buffett did the deal (that is a 22.5 percent discount to $6.88) then you would have got a deal just as good as Buffett. That would be a price of $5.32. BofA stock price bottomed at $6.01. If you could (miraculously) pick the bottom you had an opportunity to buy on terms nearly as good as Buffett. My best purchase was within about 30c of that but my average purchase - well that sucked.

Its a sweetheart deal no doubt - but less outrageous than it looks.

I think it will make Buffett a fortune. Why? Because the deal was cheap - but it was cheap primarily because the stock is cheap and not because of a 22.5 percent discount.

Now lets look at it from Bank of America's side.

It is fair to say that over the next couple of years Bank of America will roll over or issue more than 100 billion dollars of debt with maturities of 2 years (or some variant thereon - say larger debt shorter maturities or smaller debt longer maturities).

If the Buffett imprimatur lowers the funding cost by 70bps then Bank of America will save $1.4 billion - roughly the discount they gave to Buffett. That seems highly likely - indeed it seems a low-ball estimate. So from Bank of America's perspective the deal saves them money versus say just issuing $5 billion of equity at market.

There is of course dilution. You will earn less on your shares because the total shares outstanding are higher.

But dilution only matters if they issued the shares to Buffett cheap. They did I think but you could have had within 22.5 percent of the price issued to Buffett and if you really think that the dilution matters - that is if you really think the shares are cheap then there is a solution: buy more.

So for all those people complaining about the dilution put your money where your mouth is and buy. The stock is still only about 35 percent more than the deal Buffett got and the deal Buffett got came with ancillary benefits such as cheaper funding and regulatory cover.

Finally I can't go past a comparison with the deal Buffett struck with Goldman Sachs. That deal had more value in the fixed coupon and less value in the equity. Buffett could have structured the deal either way and he chose to take the value in the equity upside. I think that might be saying something.

Just for thought.

J

PS. In full disclosure I trimmed some shares before market about at about $8.30. These were roughly the same number of shares I purchased below $7. Its just that the position was too big - so risk management rules apply. And we are still losing on Bank of America - just not as much as before.

PPS. David Reilly at the Wall Street Journal made the same valuation error as Reuters. Peculiarly they also quote an analyst who thinks the warrants were worth "conservatively $4.40 to $5.60". The upper end of that range is a bit peculiar. 

Bank of America: time everyone took a long cold shower and sobered up

Forward: this was printed about four hours before Berkshire Hathaway took a $5 billion stake in Bank of America under sweetheart terms. Firstly Buffett got better terms than me - it helps being known as the world's greatest investor. Second, the rapid appreciation in my position is dumb luck.

I am long Bank of America on my own behalf and on the part of my clients. It has not been a fun experience. (We have had great returns at Bronte but) Bank of America is one of two stocks on which Bronte has lost more than 3 percent of the portfolio.* So you can see this note as written from the perspective of a Bank of America loser.

Still I am bullish on BofA at these prices. Very bullish. I think the politically driven finance bloggers (Yves Smith at Naked Capitalism) should be seen for their (I think justified) anti-bank agenda. Most of the rest are fitting their analysis around the stock price.** There is an awful lot of stock-price doing the analysis here.

You might ask if I am putting my money where my mouth is – and I am a little. We purchased some more BofA below $7 but not much. Why not much? Risk control. Nothing else. Like most “value investors” we believe the right response to a stock we like going down is to buy more of it. As people who are (sometimes painfully) aware of our fallibility, we know repeatedly doubling up on a stock with tail risk is a way of getting pole-axed. So we added but did not pile in.

That said, I should explain how I think about Bank of America right now.

The problem everyone is talking about is liability for fraudulently originated mortgages – mostly mortgages originated at Countrywide. Bears argue (correctly I think) that BofA has under-reserved for liability problems associated with past mortgage origination. Some bears suggest large numbers ($50 billion is often quoted) for the real liability. They argue that BofA will be forced either to insolvency, a further bail-out or to raise a lot of capital under highly unfavorable terms (thus crunching the existing equity holders).

There are other bear cases – and I will get to them – but I want to deal the the main bear case up front.

First lets get the capital argument sorted out. Bank capital can't be accurately measured. There are just too many estimates. Steve Randy Waldman (at the indespensible Interfluidity blog) says it better than me when he points out just how many estimates go into measuring bank capital and how large those estimates are relative to the stated equity.

Over a decade or more you know whether you got it more or less right or not. Canadian and Australian banks have simply spat out money – great gobs of it – for twenty years. I do not know whether the capital or profits are stated right (and nor does anyone else) but I can be certain that these banks have been very profitable. Japanese banks by contrast don't seem profitable on a decade-long view.

But on a day-to-day basis capital can't be measured and it is meaningless to say that the bank has $50 billion too much or too little capital because you can't measure that either.

We can find out ex-post (that is after a liquidation) whether the bank was egregiously under-capitalized or not but it is very hard to tell on a day-to-day basis. I thought Lehman was insolvent in 2006. Ex-post it probably was insolvent in 2007 – it operated for quite a while after that. I never thought WaMu was insolvent but the regulator disagreed with me. Ex-post in that case I think I was right on the regulatory capital but was not right on stock.

That doesn't mean banks don't get themselves into trouble by having too little capital. They blow up with alarming frequency. But it is not actually too little capital that is the problem. Banks can operate with negative capital for years (as per Japan). It is one of two related problems:

(Type A Problem) the bank suddenly has losses so large and so unavoidable and generally so fast that any regulatory capital amounts are just smashed and the bank goes regulatory-insolvent or is forced to raise capital under disadvantageous terms or to find a “bridegroom or a suitor” or the regulator takes them over.

(Type B Problem) the market loses faith in the bank and the funding dries up which causes the bank to have liquidity troubles.

Type A problems are rare, Type B problems are much more common.

The archetypical sudden-death of a bank problem is Barings. Nick Leeson lost US$1.4 billion in the Singapore Futures Market and the loss was revealed in a single day. This was twice the bank's stated capital and Barings was forced to find a suitor. They sold themselves for a dollar.

This sort of loss is rare for large institutions (though more common for smaller institutions with government guarantees). Large institutions reveal their losses over time. That is important because operating income (in the context of a bank income before provisions and tax) can be used to shield the loss. If a bank takes its losses slowly enough it can shield very big losses this way (albeit at the cost of appearing zombie-like for years). The champions in slow-loss revelation are Japanese banks who spread losses over more than fifteen years and never breached stated regulatory guidelines on their accounts.

Because banks have quite a lot of discretion about how they book their losses and most losses can be spread over-time just running out of stated capital is not the common way for a bank to get into trouble. [The exception is small banks with guarantees as per the US and the only way they ever seem to leave is by rolling losses until they are comically enormous compared to stated capital.]

You see banks deferring losses every cycle. When the crisis hits everyone screams the bank is under-reserving and guess what – everyone is right. But the bank gets to take its losses over time and that suits the bank because the bank tends to have high pre-tax pre-provision earnings in a crisis and time cures things. When you take losses is subjective most of the time. In bad times banks lie about losses because they can and it is their interest to lie. This is – as Buffett has noted – a self-assessed exam where the penalty for failure is death.

Of course if the losses are too fast and too sudden the bank can't spread them. When someone is not paying their mortgage extend and pretend is an option. When someone actually throws back the keys and walks out you have to take the losses. Enough of them at once and you get the Nick Leeson situation, big losses which you have to book now. But it is easy to extend and pretend so banks do.

The more common way banks get into trouble is when people don't trust them any more and they can't fund themselves. This happened a surprising amount in the crisis. Sometimes we discovered the “bank” was grotesquely insolvent (Lehman Brothers). Sometimes it was only marginally problematic (Bear Stearns). I still believe Washington Mutual was solvent and the run was a panic.

You can't measure bank capital accurately but there is a way in which banks can have too little capital. They have too little capital when they can't convince regulators or creditors that they are themselves a good credit.

Lets look at Bank of America in this light

The credit default swap (one year, illiquid) says that BofA is having some trouble financing itself. People are willing to pay 4 percent for a one year BofA default bet.

But absent that (rather hairy) data point I lean on the fact that the “too big to fail” rules of the game are well understood at the moment whether Yves Smith or Paul Krugman likes them or not. No big bank in America is going to be let fail. Ultimately the credit of Bank of America is synonymous with the credit of the United States of America and last I looked at US bond pricing that credit was good.

In other words BofA has enough capital to raise money in the bond market because its real capital is not something on its book. Its real capital is faith and credit of the United States. And because of that the bank won't fail through a wholesale run. Besides Bank of America has a lot of short-term liquidity. Not enough to save them from a mega-catastrophic run of course but they can deal with most things and a mega-run relies on the too-big-to-fail consensus breaking down.

The only capital risk to BofA then is one that regulators find them poorly capitalized and force them to raise capital or the like. That is definitely possible but in my view unlikely.

It would happen if BofA were to book a sudden 50 billion in provisions for mortgage-fraud settlements. But that is the legendary self-assessed exam where the penalty for failure is death.

You see these are litigation losses not credit losses and the one thing that everyone agrees on about litigation is that it is slow.

For Bank of America slow is good. Very good. You see BofA has more than 10 billion dollars in pre-tax pre-provision earnings every quarter. This number is falling but it still very large.

If Bank of America really has 50 billion – no – lets get really bearish – 70 billion in additional losses to take but the litigation lasts seven years it will eat only a quarter of the pre-tax, pre-provision earnings over that period. It will dampen earnings but can't cause BofA to run short of regulatory capital.

And I am pretty sure they could stretch the litigation five years if not seven. I have seen court cases where discovery lasts that long.

So in summary Bank of America won't fail because the market does not want to fund it. It is “too big to fail” and its credit is really the credit of the US Government. And it can't fail because it needs to take too many losses too fast and runs out of regulatory capital. These are litigation losses and they offer plenty of time for deferral against future income.

In other words this Bank of America panic is just a panic.

And at the risk of sounding like Jim Cramer: Buy.

Where I can be wrong

Above I am talking my book. I own Bank of America shares. My clients own Bank of America shares. I want to explore the ways I can be wrong. After all it could cost our clients a further 5 percent if Bank of America fails.

The first way I could be wrong is if there is another big credit cycle (not old stuff, new stuff) caused by a deep, nasty double-dip recession. In that case the pre-tax, pre-provision income of the bank may be committed to paying off another round of credit losses and not be available for litigation losses.

The main defense the bank would have against that is that the litigation losses can be deferred for very long periods so the bank might deal with one fire (new credit losses) first whilst it leave the other fire (litigation losses) to simmer. It would not be nice for shareholders (no dividends or capital growth for seven years) but it is not devastating.

More worrying is my assumption that the pre-tax, pre-provision earnings are solid. They are clearly falling right now. In Japan these fell for ten straight years – and when you thought that bank margins could not get any lower they went into a bit of a decline.

I once wrote two posts on why I did not think the Japanese outcome was likely for American banks. Go back and read them (links here and here). Those posts don't look that good any more. America is looking more and more Japanese. Pre-tax, pre-provision earnings for banks is falling faster and further than I thought possible.

A small amount of inflation (surely the Fed will print money until that happens) fixes that problem – but that was my argument 24 months ago and that argument is looking less right every day.

The third way I could be wrong is if litigation is not as slow as I am guessing. There could be some kind of summary judgement along the way. But then maybe not. I genuinely do not know enough about American litigation practices to offer an informed opinion.

The fourth way I could be wrong is if the Government guarantee is called by a really skittish market. Government guarantees (implicit or explicit) are hardly what they used to be. That said America prints its own currency. And the credit markets seem to think the US government is solvent. Nonetheless I can't rule it out either.

The fifth way I could be wrong is if the regulators themselves call it. Bank of America is a beneficiary of an implicit government guarantee. That in a normal world gives the government some over-arching regulatory rights. They could determine that there really are $50 billion in provisions necessary and force Bank of America to provide rapidly. If they did so then a capital raise would be necessary because the Government forced it.

Governments have power. If they use it against existing Bank of America shareholders then I will lose. Some of the anti-Bank-of-America bloggers (and I am thinking mostly of Yves here) have that view because they believe government SHOULD use that power against banks. I suspect in that she is right – but my job is to make money for my clients – the question is not whether they should use that power, the question is whether they will. In that I think I can rely on the cravenly pro-finance Obama administration.

There is a final way I can be wrong - and it is a way that worries me more than almost any other. That is Bank of America just falls apart from a systems basis.

I have a friend who had a tax lien put on her house because Bank of America misreported something. It took her six months to get it taken off. There are stories of houses with no mortgages being foreclosed on. There are stories about people getting free houses because the bank loses the mortgage documents.

A bank only has value if it can perform the function of a bank - and top of that list is keeping the client accounts straight - knowing who owes and who owns what and having the documents to prove it.

On that Bank of America is surprisingly inept. That is what comes of doing too many bank mergers.

And of all the things that worry me about BofA their systems failures are the ones that worry me most. You hear too many stories and the stories are from credible people without an axe to grind.

If it were not for that worry I might have added (yet another) percent to my Bank of America holding. But risk control is not lost on me - so I am sitting pat.

There you have it...

My case for Bank of America right now. It is the case of someone who has marred a very good record (about 100 percent above index in just over two years) by owning a lot of Bank of America stock. It is the case of another Bank of America loser.

Make of it what you will.



John

*Bronte has only been running just over two years. Given more time I am sure we will find more ways to both make and lose the clients' money. We are proud of our record (even if I do focus a little on the losers...)

**Incidentally I think Yves anti-bank agenda is justified. She is correct that the banks have Washington wrapped up, that real reform is off the agenda and is necessary and that the banks have behaved terribly and that BofA/Countrywide has behaved utterly atrociously. That of course does not mean BofA is insolvent no matter how devoutly she wishes it. Indeed the Washington consensus is a major reason for thinking BofA is not insolvent.

Trina Solar conference call notes

Bronte Capital is both long and short Trina Solar. If Trina Solar shares wind up at $50 we make out like bandits.

If Trina Solar goes rapidly to $2 we also make out like bandits.

We don't like sideways: a share price of $12.50 - $18 is uncomfortable and will cost us a few percentage points of our fund. Outside that range we are comfortable.  Far outside that range and we are very happy indeed.

We are weighted short: we would prefer $2 to $50 and we think $2 is more likely. But $50 would be just fine too.

The Trina results were more or less exactly as I predicted. (The earnings miss was obvious - I predicted a few cents per share worse... but that is not important.)

The balance sheet decay was more or less as I predicted it. The company burnt a lot of cash. I was wrong about one thing: the willingness of the banks to lend lots of money short term to a company where the credit default swaps are priced over 1400bps.

The willingness of banks to extend credit to a company with such weak credit profile weakens my short thesis. It is hard to go bust if you have banks that are that understanding. So I guess all-in-all the result was marginally better for the company than I expected. I expected them to be running low on cash - but they are not - they are just running up short dated debt very rapidly.

After listening to the results I listened to the conference call which I thought was dreadful: I was completely convinced the stock was going to crater and it was indeed weak in the pre-market. The doyens on the Yahoo! chat board (whoever they may be) had the same view. Instead the stock went up fast. Guess that happens with low PE ratio high short interest stocks. Longs are gloating. Shorts are puzzled.

Notes from the Trina Solar conference call

This blog is a fan of Fox News. The slogan is "we report, you decide" and then we will give you our opinion anyway.  In this light I want to extract some highlights from the call.  Some of the executives are non-native English speakers so you will need to forgive the sytnax.

Jifan Gao (CEO): In the second quarter, our sales were to some extent expanded in the market of financing and higher inventory due to the Italian solar subspace changes in earlier May. However, we experienced shipment increase due to our increased sales to Germany and U.S.

That figures. Italy was well known to be a problem. The US is growing fast off a small base. Germany however they did very well in.

Pricing however was an issue:

Terry Wang (CFO): ASP (average selling price per watt) was approximately $1.46 in the quarter versus $1.71 previously.

I guess there is more pain to come. These prices are higher than the retail price (AUD1.35) offered yesterday by a cold caller in Australia.*

Still the CEO laid out the well known bull story:

Terry Wang (CFO): The sequential decline [in margin] was primarily due to the significant decline in module ASPs, which has started in April, we realized client reductions due to renegotiations of a long-term polysilicon feedstock and wafer agreements in early June. This ASP versus cost timing differential to extend have an impact on our gross margin. In recent weeks, we have seen module ASP stabilizing as well as material prices bottoming out bring forth significant manufacturing costs reduction in the current quarter.

In other words selling price fell sharply over the whole quarter (it started in April) but they only renegotiated their supply costs in early June so they had a margin squeeze. As they have now renegotiated their supply costs they should have a margin expansion in the future.

Moreover he says that selling prices are stabilizing which - given falling input prices - strengthens the case for better margins in the third and fourth quarter.

They quantified the costs later in the Q&A. They had 73c per watt of non-poly manufacturing costs and they think that will fall to 70c. They had 43c per watt of poly costs and the "poly costs dropped drastically". I could quantify further: they use roughly 6 grams of silicon per watt. The spot silicon price is about $50 per kilogram so they use roughly 30c of silicon per watt. If the silicon contract has been reduced to that spot price and they achieve their 70c non-poly cost they should have costs of about $1 per watt. They purchase some wafers as well and told us that that raises their average cost by 4-5 cents - so they are expecting costs about $1.04 per watt.

But that was the extent of the good bit of the conference call. From then it was weaker:

Terry Wang: As we look ahead in light of the current global economic and operating environment, our capital expenditure strategy and capital expansion decision will remain closely tied and adapted to market demand conditions.

This doesn't look right. The company has been growing capacity at a massive rate despite demand problems and falling prices and they have announced further capacity expansions.

The CFO further highlighted their ability to deal with the cycle saying:

Terry Wang: We demonstrated our ability to manage and preserve reasonable cash balance for liquidity and working capital purposes so that we can remain nimble in constantly changing market and have a buffer against any downturns or upturns.

Really? So is that why they expanded capacity into a demand downturn and relied heavily on their banks?

By this point I concluded they might be making it up. But it got worse:

Mark Kingsley (COO): as for current outlook in the third quarter, we are benefiting from several positive trends, which includes a growth recovery in Europe, increased order rates from new markets, and improved demand in the U.S. linked to the cash grant subsidy windows.

Now I am sure they are making it up. Does anyone really believe that this current quarter is showing a growth recovery in Europe? Really?

After that the Chief Operating Officer piled it on:

Mark Kingsley: Continuing our drive for geographic expansion, we recently announced our second strategic partnership in Australia with Origin Energy, which we believe can strengthen and sustain our market position as this area’s residential segment continues to expand.

This is at its kindest an exaggeration. Origin Energy recently confirmed to me in writing the nature of this strategic partnership:

Origin has not put out a release as it is simply part of our ongoing supply arrangements and not material in its own right.  Trina is one of a number of suppliers we use.

Angus Guthrie
Group Manager, Investor Relations

But it only got worse from there. The CFO started to contradict himself on selling prices:

Terry Wang (CFO): ... for the ASP (average selling price per watt) side, it’s uncertain and then now the markets are volatile and we have a – this quarter’s ASP target and because last quarter we missed it and because we didn’t realize that in June that the ASP dropped drastically, so I have to – and foresee that the potential of volatility for the ASP side. 

You see earlier the CFO told us that the ASP dropped in March and they renegotiated the Silicon contracts in early June. That was the key for the margin expansion story. Now he is telling us that the ASP "dropped drastically" in June (and if it is mid-June it is after they renegotiated their input prices). This suggests a margin contraction in the coming quarter not a margin expansion: it demolishes the bull case.

The CFO's latest statement is entirely consistent with the cold-call I received yesterday offering me bargain panels to install on my roof.

I was wondering if this call could get any more surreal. I did not need to wait long for the Chief Operating Officer to oblige. He was asked about the situation in Italy in September:

Mark Kingsley (COO): I have been waiting for Italy since I got here. So, we are actually seeing some good activity finally. And we have some pickup in activity. We see it. Obviously, our historic Italian account is at the utilities. We also see Spanish accounts that a lot of them actually served projects there. So, after much waiting and unclarity, we are seeing some pickup in demand. There is – we still have a mix of utility projects in commercial rooftop there. And so what we are seeing moved quicker was the stuff that was utility that was finishing off and now it’s blending into commercial rooftop.

Let me explain something. A solar farm is a power station lasting 25 or more years where you pay for all of your fuel costs up front. They are capital intensive beasts and they absolutely require ready access to finance.

Mark Kingsley is trying to tell us that activity in a capital intensive finance dependent business has picked in Italy right now. He is saying the same thing about Spain.

Of course the Italian (and Spanish) financing system is working just fine right now. Mark Kingsley is seeing it. We should all rejoice in the sudden turn-around.

My view versus the market

Its the job of a hedge fund manager to disagree with the market sometimes. But I have been around long enough to know that often the market spots the improvement or deterioration in a business before I do.

The market thinks the results and the conference call was good enough and they took the price up. I disagree.

The bull story was that selling prices fell in April but stabilized later and the input prices (mostly polysilicon) were renegotiated down in June. Therefore margins reached a cyclic low this quarter and should improve.

That story was contradicted later when the CFO said that selling prices "dropped drastically" in June.

Then the company said that it was "nimble" and that it could manage its growth and capital expenditure to demand but that ability was not reflected in the accounts which show a sudden massive reliance on bank finance.

They say that demand improvement is coming from Europe or so they say. Indeed they say that in the current third quarter they are "benefiting from a growth recovery in Europe".

Then they simply repeated their story about their new "strategic partnership" in Australia as more support for the increased demand. That strategic partnership is just a competitive customer relationship where Trina is one of many suppliers.

And finally they told us that they are seeing more demand right now for capital intensive projects in Italy and Spain. This is not in their view a future hypothetical turnaround. It is that they are "actually seeing some good activity finally".

This was an 8 am conference call. In Alice in Wonderland the Queen says that she "sometimes believed as many as six impossible things before breakfast".

Maybe the Queen was an equity analyst.




John

*My mistake: someone cold-called me offering to sell me solar panels for my house. I took a serious interest for reasons that should be obvious to all my readers. Now the guy won't leave me alone. John Hempton is now suffering obsequious salesmen for his trade.

Trina Solar's very understanding banks...

Trina Solar is fast becoming a test-piece about just how understanding a Chinese bank can become.

They have just produced some pretty ordinary numbers (as pre-announced) but it the massive changes in their balance sheet that are really interesting.

Trina Solar Limited
Unaudited Consolidated Balance Sheet
(US dollars in thousands)
			June 30		March 31		June 30
			2011		2011		2010
ASSETS
Current assets:
Cash and cash equivalents			$            630,978		$        489,820		$          639,517
Restricted cash			53,260		64,813		45,758
Marketable Securities			315		426		443
Inventories			226,303		179,780		96,395
Project assets			43,472		42,110		23,877
Accounts receivable, net			584,046		542,967		313,042
Current portion of advances to suppliers			64,049		82,370		42,895
Prepaid expenses and other current assets, net			101,948		90,297		53,256
Total current assets			1,704,371		1,492,583		1,215,183
Property, plant and equipment			751,480		663,851		533,795
Project assets- long term			2,614		-		-
Prepaid land use right			36,661		36,854		27,139
Advances to suppliers - long-term			129,138		94,807		87,205
Investment in affiliates			320		319		-
Deferred tax assets			14,667		15,405		10,481
Other noncurrent assets			28		196		1,352
TOTAL ASSETS			$         2,639,279		$     2,304,015		$       1,875,155
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term borrowings, including current portion of long-term debt			$            342,953		$        153,286		$          161,557
Accounts payable			315,004		253,223		197,789
Convertible note payable			137,870		137,065
Income tax payable			20,139		46,656		9,436
Accrued expenses and other current liabilities			130,305		132,487		60,220
Total current liabilities			946,271		722,717		429,002
Long-term bank borrowings			382,631		295,652		331,152
Convertible note payable			-		-		134,644
Accrued warranty costs			50,205		44,194		27,508
Other noncurrent liabilities			17,223		18,454		14,740
Total liabilities			1,396,330		1,081,017		937,046
Ordinary shares			40		40		40
Additional paid-in capital			646,925		644,628		638,457
Retained earnings			579,183		567,423		291,572
Other comprehensive income			16,601		10,707		8,040
Total shareholders' equity			1,242,749		1,222,798		938,109
Non-controlling interest			200		200		-
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY			$         2,639,279		$     2,304,015		$       1,875,155

Cash went up from $490 million to $631 million - an increase of $141 million.

But that was the end of the balance sheet good news.

Short term debt went up from $153 to $343 million. They borrowed $190 million short term.

And long term debt went up from $296 to $383 million. They borrowed another $87 million.

So another way to look at it is that the company chewed through a net (190+87-141=) 136 million despite their (much lower) stated profit.

What gives? Its a widget company with stated profit but cash burn.

Actually we know what gives - the company still can't sell their product to customers that actually pay.

Inventory went up from $180 to $226 million. This company is still shipping to warehouses...

Receivables went up from $543 to $584 million. So they are selling to people who are slow to pay (but who have probably already received irrevocable delivery of solar panels and installed them into levered solar parks. (The project financier almost certainly has the collateral now!)

The rest of the cash burn wasn't really burn - it was (another) large increase in capacity. These increases are happening despite the obvious problems this company has in selling its inventories.

As I said - the banks are very understanding.

And they will need to be because the company has contracted to buy lots more silicon and it needs to increase its output substantially. They tell us that the silicon price will be lowered in accordance with the contract. That is great: they are going to need it.

Today at my office in Sydney I was cold-called by a solar panel installer. Business is quiet so they were drumming up business. They want to sell me panels at an installed price (with inverters etc).  The panel price was $1.35 per watt. Not kidding - way below where Trina is currently booking sales.

The brand was Alex Panel - another company which the salesman assured me was "planning to list on the New York Stock exchange".

Trina say next quarter will be better. At $1.35 per watt sold by retail-cold-call in Sydney I don't quite see it.



John