Electronic fax? Really. Doing the time-warp with J2Global.com

Efax is yesterday. You know the fax machine you have out there in the cloud where you receive a fax (with a dedicated line) and they send you the fax via email. And you send the fax via email - you post it to your electronic fax provider and they fax it for you.

Electronic fax is so yesterday that when I think about it I also think of dial-up internet, I am working in the Australian Treasury, I had an American girlfriend with a PhD in economics and the Spice Girls are the hottest band in the world. (And my girlfriend objected to the Spice Girls which did not seem sporting...)



Actually electronic fax does not figure very much in my life at all. I have sent only one or two faxes in the last decade and I have received none. The closest I get to faxing is scanning a document and emailing that.

So it was a great surprise to come by J2Global.com (JCOM:NASDAQ). You see J2Global is an electronic fax company - it is the old e-fax. It is the only brand in electronic fax I remembered.

And I could not imagine that it possibly had about 300 million revenue and a market cap of almost $1.5 billion.

Like really? Like who are you kidding?

And note this was a price to sales ratio of five - a number consistent with the most profitable or highest growth companies in the world. I mean there are not many companies in established businesses with a price to sales ratio of five.

And very few businesses that should be in such obvious decline as electronic fax would ever deserve such a ratio.

But there it was, listed, with a big cap, fairly transparent looking accounts and a stock that slowly levitated over the decade in much the way that bricks don't.

This was so unexpected a find that I really did double-take.

There was a bull-story relentlessly promoted of course - which was that J2Global was a "cloud company" in the sense that internet-fax was one of the first applications out there "in the cloud" but it was a cloud company a little less sophisticated than Hotmail or the AOL "walled garden".

I had to find a customer

I was wondering whether my experience with fax machines (they have rapidly become irrelevant) was the universal one. I could not imagine being a subscriber (at $16.95 a month no less) to efax and wondered why anyone else was.

I rang our foundation client - an industrialist about 15 years older than me who is on the road quite a bit. I thought he might be a subscriber - but he can't imagine wanting to join. He wondered where I found companies like this.

So I kept asking people whether they would subscribe to an electronic fax person - and I found one - a fund manager who thought he paid $3 a month and it was before MyFax purchased his supplier (MyFax is owned by Protus - more about them below). My friend now pays $6 a month even though the cheapest price on the MyFax website is $10 and has been for some time.

The price differential was so large ($3 a month versus $16.95 per month) that I wondered why anyone would pay it. It is fairly easy to find suppliers at $8-9 a month. Faxage.com and others have prices for very light users down to $3.50 per month. And lets face it - most people who use faxes are very light users...

The first explanation for the continuation of the business was inertia (which is the same reason why some people still use dial-up internet).

Inertia or ripping off your customers?

YouTube is a valuable resource - you can usually find someone complaining about or proselytizing for a product.

In this case it was complaining. You see it is very hard to cease being a efax client. The video below shows you how when you dial up they tell you that you should cancel your account on the net. On the net it gives you a number to dial up (with a long wait). That gives you another number (with a long wait) and that tells you to cancel on the net.

You get the idea: phone center hell.



I wondered whether this was typical: whether the modus-operandi of this business was to keep ripping people off even when they wanted to cancel.

Alas there is strong evidence that it is. One of my colleagues found that the Better Business Bureau gave the company an F rating (on an A+ to F scale). The Better Business Bureau had closed 419 complaints against the company in the last year. Here is a summary:

Most complainants allege billing disputes or difficulty canceling accounts. Many customers complain of excessive hold times, anywhere between 10 minutes and up to several hours, when attempting to speak to a customer service representative. Other complainants allege the fax service does not work or fax numbers are reassigned without notice or justification. A few complaints allege the company does not disclose the fact that the number of faxes you can send is limited or that there is a per page charge for every outgoing fax. The company responds to some complaints by canceling accounts, issuing refunds, and apologizing for the interruption of service. In a few cases, the company retrieves and reactivates fax numbers or verifies the service is operational. The company further responds by claiming customers have more than one account or that they have no evidence of cancellation.

You see these guys are appear a little sharp (at least in the view of the Better Business Bureau). You cancel an account and they will keep billing you claiming no evidence of cancellation or that you have more than one account (as if anyone would have more than one electronic fax number).

This sort of business behavior is harder to pull off outside the US. The US seems to have a culture that accepts consumer rip-offs (predatory lending for example). Other cultures think of unconscionable conduct. This is unconscionable. In the US I guess it works until they get a class-action lawsuit.

Anyway it is worse than just relying on inertia. The company raises rates regularly and rely on inertia not to object to or shop higher rates. Here is a blog post which complaints about their rate raising:

eFax today announced that they are raising their already gouging rates from $12.95 a month to $16.95 a month, unless you want to “lock in” the $12.95 a month rate by paying it annually (i.e. pay the $12.95 x 12 up front to the tune of more than $150.00 a year).

I call it “gouging” because eFax originally started out with this model: you could either pay to get a fax number that was local to you, or get a free fax number which could have an area code in any part of the U.S. except local to you. 

At that time it cost a mere $4.95 to have the local number, which was part of a service called “eFaxPlus”. So eFax Plus was only $4.95 a month, and that was as recently as the year 2000. 

However, once they got you hooked (and having distributed your fax number far and wide) they boosted their fees to $12.95 a month - more than double what you’d signed up for - and you were stuck, unless you were willing to lose the fax number you’d given out to everyone. Still, it was month-to-month so you could make a decision each month as to whether it was worth it. 

But now they are doing it again, saying either pay that $12.95 a month up front for a full year (a total of $155.40 a year), or pay the exhorbitant rate of $16.95 a month. And, if this prompts you to decide to cancel the service, let me tell you up front that there is no easy way to cancel your account [the blog post purports later - not quoted - to tell you how to cancel the account]. 

Here is the relevant portion of the email that I myself received today:

“The monthly subscription fee for all eFax Plus numbers on your account will be changing.
Starting on your next billing date, the monthly fee for each of your eFax number(s) will be $16.95. 

You will also receive an enhanced level of eFax service. 

Receive up to 130 fax pages and send up to 30 fax pages free each month. Store faxes up to one year with your eFax Message Center. Get 24/7 live phone support. 

To lock in the old $12.95 rate for the next year, switch to annual billing by clicking here.
Please respond by October 01, 2006.” ...

But here is the nub of it. They raised the rates to $16.95 per month in 2006. They have not raised them since... there is a limit to how much you can gouge - even if you make it so hard to exit that people have to stay in a phone center queue for three hours or take you to the Better Business Bureau just to exercise their rights...

And nobody would rationally sign up - as the same blog post makes clear this service is at least twice as expensive as the competition. If you do a simple internet search you would find that efax is poorly rated, and actively disliked by consumer groups. This is a dumb product to sign up to.

But the revenue is still growing. Why? Why the hell would anyone want to sign up to this?

My first thought was that the accounts were a lie.

Falsifying the fraud theory

I see a lot of stock fraud - and I immediately thought that they were just making the rising revenue up. After all I could not see why revenue from electronic fax should be rising. It just seemed so unlikely.

And they really are (at least in the words of their complaining customers) nasty. Customers just say the company is a scam. Just the sort of people who would fake accounts - or so I incorrectly thought.

Bolstering my theory that they were faking their accounts was their less-than-mainstream auditor. They use Singer Lewak LLP. The SEC database allows us to see all the other companies audited by them. It is not a list of known frauds - but it is hardly inspiring.

So I tried to puzzle how they did it. The company generates lots of cash but pays no dividend which makes it hard to confirm the cash is real. But if the cash is real the profits are real. And if the cash is not real the profits are not real.

So I tried to work out whether the cash was real. Here is the balance sheet:

j2 GLOBAL COMMUNICATIONS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2010 and 2009

(In thousands, except share amounts)

		2010				2009
ASSETS
Cash and cash equivalents		$	64,752			$	197,411
Short-term investments			14,035				31,381
Accounts receivable, net of allowances of $2,588 and $3,077, respectively			17,423				11,928
Prepaid expenses and other current assets			15,196				13,076
Deferred income taxes			4,096				2,657
Total current assets			115,502				256,453
Long-term investments			8,175				14,887
Property and equipment, net			13,567				13,366
Goodwill			281,848				81,258
Tradenames, net			33,396				8,760
Patent and patent licenses, net			18,102				14,955
Customer relationships, net			36,674				7,743
Other purchased intangibles, net			11,782				7,633
Deferred income taxes			12,967				8,717
Other assets			610				229
Total assets		$	532,623			$	414,001
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable and accrued expenses		$	25,112			$	15,941
Income taxes payable			1,798				1,563
Deferred revenue			16,938				11,411
Liability for uncertain tax positions			13,471				—
Deferred income taxes			573				—
Total current liabilities			57,892				28,915
Liability for uncertain tax positions			24,391				46,820
Deferred income taxes			15,293				—
Other long-term liabilities			3,302				2,094
Total liabilities			100,878				77,829
Commitments and contingencies (Note 8)			—				—
Stockholders’ Equity:
Preferred stock, $0.01 par value. Authorized 1,000,000 and none issued			—				—
Common stock, $0.01 par value. Authorized 95,000,000 at December 31, 2010 and 2009; total issued 53,700,629 and 52,907,691 shares at December 31, 2010 and 2009, respectively, and total outstanding 45,020,061 and 44,227,123 shares at December 31, 2010 and 2009, respectively			537				529
Additional paid-in capital			164,769				147,619
Treasury stock, at cost (8,680,568 shares at December 31, 2010 and 2009, respectively)			(112,671	)			(112,671	)
Retained earnings			381,145				301,670
Accumulated other comprehensive loss			(2,035	)			(975	)
Total stockholders’ equity			431,745				336,172
Total liabilities and stockholders’ equity		$	532,623			$	414,001

During 2010 cash dropped from 197 to 65 million - the difference been spent on acquisitions. Goodwill went from 81 million to 282 million and the cash flow statement reveals that they spent $249 million on acquisitions - that $249 million being cash generated over the business over time.

If that $249 million was real then the business is real - and there is no wholesale fakery in the accounts. If they bought real assets from real, unrelated people then I would conclude the accounts were probably more or less OK. If they purchased assets from parties I could not identify then they could be from fake parties or related parties. The only assets you can buy with fake cash are fake assets and you tend to have to buy fake assets from fake parties or related parties. So I went looking for the assets purchased and who they purchased them from. This was my test of fakery. [Lots of people have asked how I do this. This is as good an explanation as any though there are more than a few tricks in the Bronte arsenal...]

So I went looking for what the acquisitions were. Here is the key text from the 10K:

During 2010, j2 Global acquired eight businesses: (1) the voice assets of Reality Telecom Ltd, (2) the fax assets of Comodo Communications, Inc, (3) the unified messaging and communications assets of mBox Pty, Ltd, (4) the assets associated with the email hosting and email marketing businesses of FuseMail, LLC, (5) the assets of Alban Telecom Limited, a UK enhanced voice services provider, (6) Venali, Inc., a Miami-based provider of enterprise Internet fax messaging solutions, (7) keepITsafe Data Solutions Ltd., an Ireland-based provider of online backup services, and (8) Protus IP Solutions, Inc., a Canadian provider of Software-as-a-Service (SaaS) communication services and solutions to the business market.

Now I had a work program. I wanted to find out what I could about the acquisitions. If the acquisitions were real companies from reputable parties and over $200 million was paid I could confirm that the business was substantially real. If they were acquisitions from dodgy-brother-related-parties then I would be ringing the Longtop-type-fraud bell.

I had to work out where they spent that $200 million. Being a methodical type I did the acquisitions in order.

This press release covers (1) Reality Communications, (2) Comodo and (3) and something called Quexion which is not on the list of acquisitons. The total consideration is not material.

Mbox (3 above) is a small Australian supplier. It is hardly the use of $200 million. Nor was it Fusemail (number 4 above) as that had only 6000 subscribers and the price was not disclosed. Alban telecom (number 5) was also specifically described as not material.

Venali inc (number 6 above) was the first with a material purchase price ($17 million). It also had $10 million of revenue and the purchase involved the settlement of some patent disputes.

By this time I was getting excited. Nothing here came close to being a real purchase using over $200 million in cash. For number 7 on the list (KeepItSafe.com) I went to the Irish companies office and pulled the balance sheet. This was a trivial purchase:

KeepItSafe.com is a remote-drive business a bit like Amazon Cloud Drive but with much higher and opaque pricing. They do not tell you their pricing on the website but I wrote to them for a quote:

50G - $75 per month
100GB - $100 per month
Additional GB is .80cent per month

This is approximately 12 times the pricing of Amazon leaving me wondering what this business does at all. (If you wanted to protect your data would you sign up for this company or Amazon with the better balance sheet and only one twelfth of the subscription price?)

I further looked up the directors and they are not key contributors to the tech world.

Whatever - it is, the pricing (opaque and outrageously expensive) and its lack of transparency or even an obvious competitive offer made me fairly sure this was a nonsense business. (It may have a product - but whatever - you can get it elsewhere cheaper...)

Now I am getting really excited. I have checked the first seven out of eight acquisitions and with one exception (Venali Inc) they are either not material or nonsense acquisitions.

I think I have my next Longtop Financial Technology. I was actually dancing around the office. (It happens - and you do not want to see it...) We already had a small short on this stock but I was going to make it a huge put-option position and see what I could do to make it pay. That sort of money-making opportunity gives me goosebumps in excitement - not quite like a 15 year old boy going on a date - but it is up there... (It is also a very large proportion of Bronte's cumulative returns.)

But I am a thorough guy and so I checked the last one - Protus IP Solutions. And my "its a Longtop" thesis collapsed. Simply collapsed. You see they purchased Protus for $213 million. If that $213 million were paid to dodgy parties or related parties I could hazard a guess that the $213 million and the purchase was a fiction. But the vendors were highly reputable venture capital funds: Bank of Montreal Capital Corporation, Edgestone Capital Venture Fund, L.P., B.E.S.T. Discoveries Fund Inc. and New Millennium Venture Fund Inc. And the number was reported in the Canadian press.

So we can conclude the $213 million was real.

And that $213 million had to come from somewhere - and the company did not raise it in the market. So we know the company actually generated that money. Protus is billed as a "software as a service" offering but it is in fact another electronic fax company. MyFax - the service my friend subscribes to - is a Protus product.

What you are seeing here is my thesis (that this was a Longtop style fraud) collapsing around me. I danced around the office prematurely - and the huge option position I was considering: well we never put it on.

I went home thinking I had done a decent two days work and achieved not very much. This is - of course - the lot of a fund manager. (Most days we achieve very little...)

But I am still left pondering the business.

So what J2Global really is

Much to my chagrin we now know that J2Global really is a fax company. And it really generates a lot of cash which means that there really are suckers (ahem customers) who pay $16.95 per month for a fax line from a company that it is very hard to unsubscribe from.

But over time the company builds up cash and then buys something - another fax company.

We also know that it puts up the rates. My friend above who had the fax at MyFax.com originally had it at another provider (and he remembers it as $3 per month). That company was acquired. Now $6 a month. Now it is inside J2Global the price will push up and up - and may eventually reach $16.95 - a price where J2 seems to stop.

And this really is a business about yesterday: he sends less and less faxes each year and so does everyone else. But J2 Global will raise his rates bleeding him for as much cash as they can before he gives up (analog) fax as an antiquity like dial-up internet.

Some numbers

Protus says they had revenue at about $72 million per annum. The other significant acquisition (Venali) had $10 million revenue per annum. Acquisitions thus added revenue of about $80 million per annum or $20 million per quarter. The other acquisitions had to be a few million more.

I looked at the first quarter of this year (the first full quarter with those acquisitions which can be compared to a PCP without those acquisitions). Revenue goes from $60 million to $73 million. That is a nice rise - but not quite enough to account for the acquisitions. There is a pretty sharp underlying decline.

The next quarter they seem to have put some prices up (which is what they do) and revenue growth resumes. But you have to imagine that the clients are kicking back - slowly fading away even if it does take 3 hours on hold to cancel your account.

So what we have here is actually pretty straight forward. It is a business in decline - but it is dressed up as a cloud computing company which I guess makes people happy. It can't be much of a cloud computing company because property, plant and equipment is only $13 million and is not growing and cloud computing is capital intensive.

Because it is (at least from an equity-marketing perspective) a cloud computing company it sports a respectable PE multiple and a reasonable stock price. But revenue growth comes from two places (a) buying the competitors and (b) raising prices - and that is offset by the general decline of the electronic fax industry.

They slow that decline by making sure that customers have a really hard time unsubscribing.

Sure it generates cash - but it spends the bulk of that cash over time on acquisitions - necessary to actually get revenue growth.

The management behave as if the stock is expensive. They are selling their shares at a pretty good clip. The management at Salesforce.Com are also selling shares at a pretty good clip and that seems not to hurt them. I have sometimes purchased shares from management and done well.

And I could be wrong in the core thesis. Electronic Fax may really have a future. Maybe they can crank the rates to $30 a month and the customers will continue to love them. It seems unlikely to me - but no more unlikely that some hip 18 year old could do a Spice Girls cover on YouTube and get millions of views.

And that happened. And to complete the homage they repeated the Spice Girls trick of doing the video in one continuous take.






John

PS. Disclosure: I still have my small short on. It will stay small - technical obsolescence is something we generally short. Hyping old industries with fashionable words (like "cloud" and "software as a service") is also something we generally short. But my excitement: that was misplaced.

Repost: My old notes on Northern Rock

This is a post I made fairly early in the history of the blog - and a post I think should have got more attention. (The original post had no comments and nobody much link to it.) I re-read it today (because it came up in conversation). I am kind of proud of it - so allow me the luxury of a repost.

Reposted

In 2005 I travelled to the UK to study the UK banks. I should have shorted the lot of them. But I didn’t. But for the record here are my notes – written on a slow English train – about Northern Rock – and never finished. I have edited it only to remove references to my actual sources.

I put this up not to gloat (but its nice). Rather I am going to do an expose of another UK bank shortly.

I cannot gloat too much - because whilst these notes are amazingly prescient I did not make a fortune on the stock. I predicted rain - but its making an ark that counts!

===================================================

Quote:

Northern Rock – leverage mortgages to the max

Northern Rock is a very simple bank. It has only one strategy and it makes no bones about taking this strategy to its absolute limit. They are completely non-forthcoming about where the limit of this strategy might be – but we will see that later.

The strategy of Northern Rock is to grow the mortgage book. Fast. All decline in margin is to be made up by volume growth. They are absolutely explicit about this – the corporate objective is:

• Grow the asset base by 25 per cent per annum plus or minus 5 per cent
• Grow earnings by 15 per cent per annum plus or minus 5 per cent.

It is pretty clear that they have even de-emphasized the old building society funding base which is I think might be actually shrinking before “hot money” high rate deposits and foreign deposits[1]. At the conference they told us how they were still concentrating on the deposit base but it had the tone of protesting too much. Besides its clear that rating agencies and bond markets want some deposit based liquidity.

I am also not exaggerating in the slightest about what the corporate strategy actually is. The management must have used these two bullet points five times in my presence (and I was not with them long).

Well it is pretty clear that growing the balance sheet by 25 per cent per annum grows risk by something near 25 per cent per annum (the company will deny this – more on that later). Growing profits by 15 per cent per annum means that capital will wind up growing by 15 per cent per annum (give or take a little).

If you grow risk by 25 per cent and profits and capital by 15 then either

• You will run out of capital and the regulators or rating agencies or bond markets will not allow you to fund your growth – in which case the growth fizzles out at best, or
• You will eventually be taking so much risk that the return on capital will not be rational in an ex-ante basis. Some point ex post you will blow up, possibly spectacularly.

If you think I am exaggerating what this strategy is then here are the five year summary numbers from the annual report. Ten year numbers were reported at the conference and they had pretty well the same appearance.

INSERT [sorry I wrote this on the train and had a hard copy of the annual. I never bothered putting the actual table from the soft copy in the report]

Note there is no credit data here. Nowadays credit losses are negligible in UK mortgage banking.

Obviously you should notice the massive expansion of leverage in this book. The asset number to look at is the “total assets under management”. This number includes securitised mortgages where the residual credit risk is at Northern Rock. (The main buyer of this paper are Japanese banks both major and regional.[2]) The total leverage of book has moved from 27 times to 42 times. Obviously this can’t go up for ever but I suspect it can go for quite some more time. (You will see that 43 times leverage is not unusual for a UK bank.)[3]

When I was with the company I tried to explore the limits to the strategy and got nowhere useful. It would be nice to know though because when the company reaches the limit of its leverage it would be a safe short (unable to grow and possibly facing further margin erosion). Until then its probably a better long then a short as there seems no impediment to earnings increasing at at least the teens and the PE is only XXX now.

That said – here goes for my discussion about the limits to Northern Rock’s growth. The company told everyone at the conference that mortgages were safer than conventional loans probably deserving a 33 per cent risk weighting. In Australia and the US the standard is 50 per cent risk weighting for mortgages with no insurance less than 80 per cent loan to value (LTV ratio) so by international standards 33 per cent is aggressive.[4] That said Northern Rock suggested that there mortgages were substantially safer than the average (measured delinquency at about half the market rate) and hence they should have half the risk weighting – call it 17 per cent. They even went as far as to say that the regulator agreed with them. [Some comments have been removed here because they report indirect comments from regulators.  I cannot vouch for them on this blog.]

Now if your mortgages require only a 17 per cent risk weighting then you can be 84 times levered with a Tier One ration of 7 per cent. [Figures: 1/(.17*.07)]. If a third of your tier one capital is subordinated debt (not uncommon in banking these days especially in the UK) then your total leverage ratio might be well over 100. I did this calculation for them and they were quite uncomfortable – because they are hardly wanting to telegraph to the rating agency that they will one day be 100 times levered. (It would increase the cost of their funds now and hence further compress their margin.)

I did not get any useful feed on where the limits to growth are. However looking at the other banks (discussion later) I suspect that the limit is roughly 60 times levered. That would suggest (growing capital at 15 and earnings assets at 25) that there are four to five years left. However by that point the bank has almost ₤200 billion in assets – large compared to the UK mortgage market. Its funding would be totally ridiculous. [Comment deleted because a senior executive of another UK bank thought Northern Rock would go bust in 2007. I just do not want to dump him in it.] Something will crack – but in five years earnings could double again and the stock could be an abysmal short.

If you look at the five year summary above you will notice that the mortgage originations in any year the gross lending is substantially larger than the net lending. In 2004 gross lending was GBP23 billion - about 45 per cent of the total managed book at the end of 2003. Asset growth is only about 45 per cent of net lending.

This leads into the way that the lending is done. Its TEASER RATE lending. In the UK new mortgages (especially from this bank) tend to have a “teaser rate” which applies for two to three years (mostly two years). The fashion of late is to have two year fixed rate loans on very low spreads (the yield curve is flat in the UK) and to offset the spread a little bit in up-front fees. The loans revert to old fashioned (and fat margin) standard variable rate (SVR) at the end of the teaser rate period. The profitability of this business is determined by how many of the loans you manage to keep on your books after the teaser rate wears off and on any incidental products you might sell to the mortgage holder. If the loan comes in through a branch rather than an IFA the loan might be more profitable because it does not cause a broker fee.Internet channels are also relatively profitable.

The way that Northern Rock grows so fast is that it is the king of the teaser rate. It has however very poor retention. Bradford and Bingley told me that Northern Rock would boast about their 400 retention staff (they will cut your rate if you ring up because the alternative is for you to go elsewhere and a cut rate loan is more profitable than a new brokered loan). The competition also target Northern Rock customers. Natwest (HBOS) have regular advertisements on TV showing people on a rollercoaster with very low mortgage rates about to swing up wildly (and quite graphically make them sick). They suggest that you are nuts if you take this swing up and offer you GBP100 if you are an Alliance & Leicester or Northern Rock customer (not a B&B customer) and your rates refinance and you do not want to pick a Natwest mortgage. Its clear that Natwest however is trying to get people through the (lower cost) direct channels. (This sort of competition exists in deposit pricing too.)

There is a test as to whether all this teaser rate activity produces long term customers. Just look at the implied fall off in loans versus the originations two years ago. In 2004 it appears that over GBP10 billion repaid. Gross lending two years ago was 12.5. There is clearly some but quite limited success in retaining the customers. When pushed on accurate data on this issue Northern Rock were simply not forthcoming.

There is one more thing that is quite revealing about Northern Rock – and that is the effect of International Accounting Standards (IFRS) on balance sheet and profitability. UK companies are being forced to adopt IFRS and whilst it is an issue with a lot of noise for many companies the differences are small. They are not small at the Rock. In particular IFRS requires that income and expense charged as a fee but which relates to some period gets amortised over the period. Now remember that the shift in the market has been from floating rate teaser products to fixed rate teaser products with high fees. The Rock has been booking those fees up front inflating earnings and book value. IFRS will (under the guidance given at the conference) reduce book value and earnings by about 10 per cent. (Leverage is probably closer to 47 times – and using a sixty times limit the company probably has only three years rather than five.) The company seems to think that IFRS is a bad idea (aren’t the fees cash). But I am never quite sure whether the mix of fees and spread has shifted driven by accounting considerations or whether its driven by the realisation that churn is going to remain incurably bad or get worse. (Obviously enough up front fees are a good idea if you are scared of churn.)

All of this was enough to make me pretty bearish on the stock. But it got worse. They simply stretched numbers to say what they do not. If it were not for the low standards of America I would say they lied – but I suspect just being economical with the truth was closer. I have referred above to the notion that their delinquency is half the industry average and therefore (as they argue) they deserve only half the regulatory capital charges of the competition. The problem is that a delinquency rate simply does not make sense when your growth has been as rapid as the Rock. I tried to tease out of them the notion of a “growth adjusted delinquency rate”. No luck. I tried to work out what the delinquency by age of mortgage was so I could do the numbers – no luck. They simply were not forthcoming and even attempted to mislead me.[5]

The place however they misled most blatantly was on the margins both historic and prospective. The company stressed that I should not just look at interest margin – rather I should look at fees plus margin over assets – especially as they had shifted to fixed rate low margin loans with relatively high fees.Ignoring the IFRS issue (as they did) the average margin on the book is 125bp and it has fallen every year – most notably during 2004. They wanted to tell me that the INCREMENTAL margin was 110-120bp. This is much higher than the competition tell me the margin is (40-80bps) and simply cannot be squared with the margin figures in the above table. The problem is that they will soon hit limit leverage constraints (but they would not tell me what those constraints were) and were aware that their margins (hence earnings and ROE) would continue to drop once they hit those limits.

As for credit risk. The company told me that they had a position in the broker market as offering the cheapest loans to the best credit. I have one reason to disbelieve them. The Rock has a lower rating and hence a higher funding cost than several competitors – and hence would naturally have a relative advantage further up the risk spectrum (its hard to do good credit well with a low rating). Also they told me in another breath that they had industry leading margins (which did not reflect in the accounts).Stuffed if I know. They seem to think that they will be alright with a 20 per cent fall in the property market. They seem to get concerned when you talk about a 30 per cent fall – and they seem to think that a 35 per cent fall is impossible. I heard all the old hoary clichés: “they are not making any more land in the South East” etc. I should get the stock brokers to organise me some chats with mortgage brokers and IFAs. But I am – until that – inclined to believe that the threshold for pain is about a 30 per cent fall in the property market – and that falls beyond this range could lead to a wipe-out because the loan book is new (hence has not had the chance to get much appreciation into it) and is so levered. [Ok – I was wrong here – they went bust on funding.]

You do have to give the bank credit for one thing though. They have got their costs quite low – 38bp of assets and probably lower under IFRS. This is one of the lowest cost structures in the world. The management will point this out as almost their crowning achievement. They had to do it (had they kept their old cost structure the squeeze in margins would have wiped them out). It does however look difficult to keep reporting lower costs – this looks a lean operation.

Do I want to short it? I wouldn’t object – but I suspect we can do better with timing. The investment bankers are convinced that if something went wrong it would be purchased at 80 per cent of book on the way down. Maybe that is true now – but it will not always be so. I was staggered by the lack of sophistication of the staff – I met the CFO and he was either dumb or a liar or just assumed I was dumb.This company is totally dependent on the goodwill of financial markets. I put to them that they were dependent on the kindness of strangers – and they bristled. They thought that people invested in UK mortgages because they were good investments. Why – so they thought would you invest in Italy?

For discussion.

---

[1] The shrinkage does not show in the numbers – but the deposit base includes €2.5 billion in French deposits which are really hot-money commercial paper and some Japanese deposits. The claimed retail deposits in the five year results page I reproduce (17239) does not match the balance sheet (20342) and I am assuming the difference is roughly the above €2.5 billion and other quasi wholesale money. I can’t tell how much “hot money” there is but Northern Rock were pretty keen to advertise a 5.4 per cent rate.The shrinkage is a guess – but the company was not far from admitting the same when pushed on the issue.

[2] Amazingly the CFO was prepared to name the six Japanese banks which purchased the paper. I told him we had an interest in the Japanese banks and it would help me understand their books. He did not remember their names but he had been on a roadshow to Japan. I have virtually never had a company volunteer this sort of information. Its pretty naïve to do so as there is more than one way to interfere with a banks funding. If he had thought about it clearly it was just as likely I was short Northern Rock than long it. It was part of a general attitude I came across in Britain (nobody appears at all concerned about the vulnerability of funding bases). I pretty well floored Michael Oliver (the very experienced IR guy at Lloyds TSB) when I told him this when I took him out to dinner.

[3] The US tends to have a regulatory limit on leverage at 20 times. Any further and the informal rule is that you can expect an intrusive visit from the regulator. [Some comments deleted here.]

[4] [Regulatory footnote removed – partly because it is wrong – and I am embarrased.]

[5] On the train between Leeds and Leicester I chatted to a woman in her fifties about the banks. She had a mortgage on SVR (an old high margin mortgage) with Lloyds TSB. I asked her why she did not refinance it and she told me a story about weakened credit. Her husband no longer worked and her income paid the mortgage and supported the family. She had plenty of equity in the house but she (erroneously) thought that she could not refinance. Refinance would have saved her GBP500 per year. It was an easy decision had she been informed. Lloyds is hardly going to inform her. But there is a lesson here – the back book are going to have higher delinquency than the front book but without necessarily worse credit. It self-selects this way in part. The comparison that Northern Rock had on their delinquency rate was at best grossly misleading. (There is a possibility that they believed it though which would suggest incompetence. In this case they misled so transparently they might well just have been dumb.)

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.