Once every few years I feel compelled to republish Alan Sokal

Warning: no financial content at all

A link. Driven by a comment on a recent blog post.

http://www.physics.nyu.edu/sokal/transgress_v2/transgress_v2_singlefile.html

J

PS. For those who need an explanation of perhaps the funniest thing I have read in my life - a reasonable summary is here on Wikipedia.

Apology to CUPID PLC

Dear readers of my blog

Following correspondence received from Cupid plc's solicitors, I have removed recent blogs concerning Cupid from my website. I apologise for any factual inaccuracies contained within those blogs and I wish Cupid good fortune in its future endeavours.


John Hempton

JCPonderings

I do not do links much - let alone non-finance links. However like much of the financial world I am wondering whether Johnson can transform JC Penney before he has no liquidity left to play with. The financials are a train-wreck. But leaving a third tier retailer alone in America is also a near-guaranteed train wreck - if you left JCP untouched it would slide from irrelevance to bankruptcy over maybe a decade.

The turnaround logic looks from the outside like:

We must do something.
This is something.
Therefore we must do it.

The link below is a nuanced fashion-based examination of this issue.

http://jcponderings.weebly.com/

Enjoy.

John

PS - The link to this article in Vogue is worth the price of admission ... http://www.vogue.com/vogue-daily/article/what-price-glory-jcpenney/#1

The HP Board Changes

I want to make a comment on the HP Board changes of today. I do not know how the HP Board missed the Autonomy fraud. It puzzles me because 

(a). Autonomy accounts were superficially funky (for instance receivables were over double unearned income in a software firm),

(b). some of the press - particularly FTAlphaville (by far the best finance blog at any newspaper) were persistently but gently skeptical of Autonomy and 

(c). several short sellers (most notably Jim Chanos) were all over it.

If I were forced to blame anyone it would have been Ken Thomson - the former Wachovia/First Union chairman because Thomson over all other board members he should have had the skills to pick up the accounting fraud by noticing the superficially funky accounts. [Not everyone on a board should have those accounting skills. Some for instance are highly skilled in some aspects of technology or staff management or any of the other myriad skills a board needs.]

But that is not why I am writing. I am not in any way privy to the board discussion of Autonomy and I do not understand how the mistake was made. And it is not for me to speculate really...

I am writing to praise the departing Ray Lane.

Over the years I have written to several companies (at least a dozen) to ask/query/complain or speculate about funky things in accounts. The reaction is often hostile and usually the more hostile and the less transparent the worse the situation is. Sometimes there is some smoke and some fire but not quite in the form I surmised. [This is a problem with misleading disclosure. When disclosure is misleading you can often accurately surmise things are not right and not as they seem and be totally wrong when you take a guess at the underlying reality...]

HP however was by far the most transparent company I have ever speculated about. I wrote them a fairly aggressive letter and discussed it a little on the blog. 

I was wrong. Flat wrong in my speculations. That will happen.

However the process set in place by Ray Lane in response to my original letter was exemplary. It was transparent, thorough and efficient.

The HP board may have got many things wrong - but in my only substantial contact with them they were way better than many. 

Just saying.

John

Cupid's profile count

This post has been removed an an apology can be found here.

I apologize to my readers for any inconvenience.



John

Cupid PLC's strange balance sheet

This post has been removed an an apology can be found here.

I apologize to my readers for any inconvenience.



John

Wondering whether the social sciences are forever stuffed

(Warning: this post is written after a glass or two of wine and is about the things that concern me after a glass or two of wine. It is not about investment.)

Brian Cox (read one of his books if you want some light amusement) pointed me (via Twitter) to this abominable article in the The Times Higher Education Supplement. It is quoting an Belfast Professor arguing for a "values based" higher education in the social sciences. To quote:

“At the back of all this is my vision for the public responsibility of social science: we’re about educating global citizens for the 21st century, not just factory-like graduates with their 2:1s,” Professor Brewer said. “It’s about inculcating within our students a set of values, an attitude towards others, that realises the public value.”

The Professor (John Brewer) is aware of the obvious criticism... to quote the Times article...

Although he is well aware that many people would like to remove all talk of “values” from the social sciences, Professor Brewer said he sees himself instead in the tradition of 18th-century Scottish moralists such as Adam Smith and David Hume - “the cohort of people who gave us social science in the first place as it grew out of moral philosophy. They did not see any incompatibility between their practice as scientists and their argument that society was based on values.”

Professor Brewer tells us that David Hume - of all people - did not see any incompatibility with his practice as scientists and his argument that society was based on values. Well - only if you ignore the fact that he wrestled with it extensively. This is probably the single most famous paragraph ever written by David Hume:

“In every system of morality, which I have hitherto met with, I have always remark’d, that the author proceeds for some time in the ordinary way of reasoning, and establishes the being of a God, or makes observations concerning human affairs; when of a sudden I am surpriz’d to find, that instead of the usual copulations of propositions, is, and is not, I meet with no proposition that is not connected with an ought, or an ought not. This change is imperceptible; but is, however, of the last consequence. For as this ought, or ought not, expresses some new relation or affirmation,’tis necessary that it shou’d be observ’d and explain’d; and at the same time that a reason should be given, for what seems altogether inconceivable, how this new relation can be a deduction from others, which are entirely different from it … [I] am persuaded, that a small attention [to this point] wou’d subvert all the vulgar systems of morality, and let us see, that the distinction of vice and virtue is not founded merely on the relations of objects, nor is perceiv’d by reason.”

Hume here is quoted as "the distinction of vice and virtue is not founded merely on the relationship of objects, nor is it perceiv'd by reason".

Hume had plenty of ideas of where morality comes from but they were incompatible with the practice of a scientist no matter what John Brewer says.

John Brewer - and his attitudes - are precisely what make the social sciences useless. The social sciences can work on some entirely useful facts - and these facts can inform decision making independent of values. Try these for size for recent important arguments:

(a). Did Saddam Hussein in any way contribute to the 9/11 events.

(b). Does the Chinese political system preclude any deal including China on global warming? If so what deal?

(c). Would further regulation of semi-automatic weapons in the US actually reduce the chance of a Sandy Hook like event or are the guns irrevocably in circulation such that this regulation would not make people safer.

(d). Would a three trillion dollar expansion in the US Government debt funded entirely by expanding the balance sheet of the Federal Reserve increase inflation substantially? If so by how much?

(e). Would reducing the penalty for illegal drugs - especially cocaine - reduce violence in Mexico and ultimately would it reduce the illegal immigration pressure on the US-Mexico boarder?

All of these are questions that might concern social scientists (including economists) and in every case people who start with prior ideological commitment (an "ought statement") to one or other position disqualify themselves from the debate. If you don't start by thinking you might be wrong you are far more likely to be wrong. Being guided here by ideology (or the belief in God or John Brewer's values) will make you intellectually useless. Whether printing more money (d) increases inflation is a simple fact - and if you thought it did you might have made your bet and lost considerably...

But hey then - I should not be concerned about a(nother) generation of intellectually useless social scientists and mad classics professors coming out of the British schools. The people who think that Ernest Rutherford was not an intellectual make great trading counter-parties. The best people to trade against are people who do not devise tests for their ideas - whether the tests are as simple as chatting to a few Herbalife distributors or putting a profile up on a Cupid PLC owned dating site.

So - selfishly - I want to wish John Brewer and his ilk the best at destroying the minds of a generation. I only wish he taught at Oxbridge or Harvard (not some Belfast school) as it seems to be Oxbridge and Harvard types I trade against.



John

Alliance Resources - prices received for coal over time

Alliance Resources has - as my posts have shown - pretty ordinary operating metrics but exceptional financial metrics. Labor productivity is low and falling - profit is high and rising.

On an operating level this looks very like the (bankrupt) Patriot Coal. On a financial level it is world-beating.

Bluntly this is strange.

So far though I have shown only one explanation - and it only explains about 140 million pre-tax in cumulative profits. Alliance Resources seems to systematically under-reserve for (self-funded) workers compensation.

That is important - it invites a class action for instance - but the amounts of money are nowhere near sufficient to account for the differences in performance. There has got to be more to it.

One of the main differences between Alliance and its competitors is the price it receives for its coal. Alliance sells almost entirely high sulfur Illinois Basin coal. There is no price series for Illinois Basin coal in Bloomberg any more. When the series ended in 2007 high sulfur coal traded at a $5 per ton discount to mid-sulfur coal. If you look at Arch Coal's numbers their high sulfur coal trades at a $3.50 discount. The closing discount makes sense because more of the power stations have scrubbers.

Anyway here is the price series for Alliance Coal (by source) versus the mid-sulfur index.

What you see is remarkable. There was a period where ARLP sold coal under contract at prices quite a bit lower than spot.

However the price they receive is now rising and well above spot.

In particular ARLP is now obtaining about $8 of premium per ton for their coal over Illinois Mid Sulfur coal. Whilst Bloomberg no longer have a price series for Illinois Basin high sulfur coal my contacts (and comparison with Arch Coal) say that ARLP coal instead of trading at an $8 premium it should trade at a $3.50 discount.

That $11.50 makes a huge difference. Alliance produces about 30 million tons of high sulfur coal - so the difference equates to $345 million in pre-tax earnings or EBITDA.  Income from operations in 2012 were $334 million - so the higher prices accounts for all of it.

This price comparison has quite strong backing. Here is the price disclosure from the last Arch Coal annual:

Arch sells Illinois Basin coal at $42.50 under contract. That is almost $14 below ARLPs latest blended received prices - however I think on a like-for-like basis [stripping out a some Appalachian coal] the difference is closer $11.

If prices were reset to market (that is $10-11.50 lower) then the ability of this MLP to make distributions goes away. Indeed it is hard to see how they pay their debts. Bankruptcy is the likely outcome. If the prices go towards the $42.33 that Arch Coal is contracted to (in 2014) for Illinois Basin coal then Alliance debt holders will wind up extremely short.

This is by far the main explanation I have found for the superlative financial performance of Alliance Resources. Alliance has just contracted at far higher coal prices than the opposition.

Without these high prices Alliance would look like another very stretched coal mine with mediocre operating performance - but with a lot of debt - and it will probably go bankrupt.

The stunning performance of Alliance is a little from under-reserving workers compensation but mainly because the management team have extracted contract prices massively better than the competition... this is a company where the successes have been by senior management and white collar employees (those who sell the coal) rather than the workers who mine it.

The chart itself suggests the explanation: the prices in the contract look like they are regularly escalating. They were way below market for a while and are now a fair bit above market. It looks like the company entered some escalating price contract when its bargaining power was very strong. 

My first take: the contracts will adjust

This is what the last 10-K said about contract resets:

Virtually all of our long-term contracts are subject to price adjustment provisions, which permit an increase or decrease periodically in the contract price to reflect changes in specified price indices or items such as taxes, royalties or actual production costs. These provisions, however, may not assure that the contract price will reflect every change in production or other costs. Failure of the parties to agree on a price pursuant to an adjustment or a reopener provision can, in some instances, lead to early termination of a contract. Some of the long-term contracts also permit the contract to be reopened for renegotiation of terms and conditions other than pricing terms, and where a mutually acceptable agreement on terms and conditions cannot be concluded, either party may have the option to terminate the contract.

These are not reset to spot prices. These are reset in prices due to changes in operating costs and the like. Still resetting of the prices for this company to anything akin to market means likely bankruptcy - so the contract resetting terms are critical.

I figured that I have to look at more detail at the contract terms, price and volumes.

And what I found made left me with a few options - all ugly.

The mathematics of Alliance contract terms...

Unfortunately, you are going to have to bear with me through a little bit of arithmetic.

The 2009 form 10-K contains the following disclosure:

Coal Marketing and Sales

...[W]e have entered into long-term coal supply agreements with many of our customers. These arrangements are mutually beneficial to us and our customers in that they provide greater predictability of sales volumes and sales prices. In 2009, approximately 92.6% and 91.1% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2010 to 2016. Our total nominal commitment under significant long-term contracts for existing operations was approximately 138.7 million tons at December 31, 2009, and is expected to be delivered as follows: 29.2 million tons in 2010, 26.9 million tons in 2011, 20.4 million tons in 2012, and 62.2 million tons thereafter during the remaining terms of the relevant coal supply agreements. The total commitment of coal under contract is an approximate number because, in some instances, our contracts contain provisions that could cause the nominal total commitment to increase or decrease by as much as 20%. The contractual time commitments for customers to nominate future purchase volumes under these contracts are typically sufficient to allow us to balance our sales commitments with prospective production capacity. In addition, the nominal total commitment can otherwise change because of reopener provisions contained in certain of these long-term contracts.

The way to think about this: 25.0 million tons were sold in 2009 – 92.6 percent under long term contracts. That is 23.15 million tons were sold under contracts. The next years – as stated – are 29.2 million, 26.3 million and 20.4 million. After that we do not really know (we only know the totals) so I have assume 20 million tons per year – but marked this in the following table in yellow [to indicated that it is a guess].

We can complete the table for 2010. Here is the relevant disclosure:

In 2010, approximately 92.4% and 89.0% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2011 to 2016. As of January 28, 2011, our nominal commitment under long-term contracts was approximately 31.1 million tons in 2011, 27.3 million tons in 2012, 24.1 million tons in 2013 and 19.0 million tons in 2014. 

Tons sold in 2010 were 30.3 million.

And the same for 2011 – here is the relevant disclosure

In 2011, approximately 92.2% and 90.5% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2012 to 2016. As of January 28, 2012, our nominal commitment under long-term contracts was approximately 33.8 million tons in 2012, 33.5 million tons in 2013, 27.2 million tons in 2014 and 19.8 million tons in 2015. 

Tons sold in 2011 were 31.9 million.

And we for 2012:

In 2012, approximately 94.2% and 94.3% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2013 to 2020. As of January 28, 2013, our nominal commitment under long-term contracts was approximately 38.5 million tons in 2013, 30.7 million tons in 2014, 23.4 million tons in 2015 and 18.7 million tons in 2016.

Tons sold in 2012 were 35.2 million.

This gives us a more complete table thus:

Just  can also work out the size of the incremental contracts sold in each year. This is in the following table.

The table has one startling implication: the company has never quite delivered the contractual amounts under contract. For example in 2009 they had contracted for 29.2 million tons to be delivered in 2010 under contract and they only delivered 28.0 million tons under contract. Incremental contracted volumes are negative in every year - though contracted volumes are positive in the out-years.

Prices in each year:

We also have the price received for each year. This is disclosed in the relevant 10-Ks.

From 2009 form 10-K

We reported Net Income of ARLP of $192.2 million, an increase of 43.2% in 2009 compared to Net Income of ARLP of $134.2 million in 2008. The increase of $58.0 million was principally due to improved contract pricing resulting in an average coal sales price of $46.60 per ton sold, compared to $40.23 per ton sold in 2008, partially offset by lower sales volumes and higher operating expense per ton sold in 2009.

From the 2010 form 10-K

We reported record Net Income of ARLP of $321.0 million in 2010 compared to $192.2 million in 2009. This increase of $128.8 million was principally due to increased tons sold and improved contract pricing resulting in an average coal sales price of $51.21 per ton sold, as compared to $46.60 per ton sold in 2009. 

From the 2011 form 10-K

We reported record Net Income of ARLP of $389.4 million in 2011 compared to $321.0 million in 2010. This increase of $68.4 million was principally due to increased tons sold and improved contract pricing resulting in an average coal sales price of $55.95 per ton sold, as compared to $51.21 per ton sold in 2010. 

From the 2012 form 10-K

A higher average coal sales price in 2012, which increased to $56.28 per ton sold as compared to $55.95 per ton sold in 2011, resulted from improved contract pricing for Illinois Basin coal sales offset partially by lower coal volumes sold by our Mettiki mine into the metallurgical export markets.

Prices per year were thus $46.60, $51.21, $55.95 and $56.28.

These higher prices were achieved in an era of falling prices and when older and presumably higher priced contracts were not entirely delivered.

The bull case for ARLP (and for many other MLPs) is that the revenue is ensured by longer-term contracts. But these longer term contracts appear to be priced further and further out of the money - and incremental prices achieved appear to be way-out-of-the money.

Explanations

At this point I expected to be reverting to my (late) high school linear algebra but it does not work [this can only be solved if the prices per incremental ton contracted are implausibly high]. 

The company did not even deliver its contract and yet realized price per ton kept rising despite spot prices falling.

There are only three alternatives I can see:

(a). The contracts have very large escalation clauses – clauses that are by and large not disclosed

(b). The contracts are fixed price – and as market went down the utilities paid big termination fees (which are entered as part of realized price) and after which the company entered new contracts at lower prices. However the termination fees ensured the realized price went up each year. Explanation (b) would also explain why contracted volumes are consistently not delivered or

(c). The accounting disclosures are simply fiction.

I have been around US capital markets long enough to know that you can never quite dismiss the third explanation (that the accounting disclosures are just fiction). But that is still a big step.

Explanation (a) large escalation clauses - is consistent with the price chart above. Alliance sold at prices well below market in 2008 and sells well above market now. However (a) has a very big problem. This is that none of the 10-Ks tell us about a coal price escalation clause. And the management team are promotional and would normally tell us.

Explanation (b) thus looks more plausible... The prices received are an artifact of cancelling old contracts set at higher prices. That would also explain why the company has failed to deliver its contracted tonnage in every year studied. In that case the new tons must be at much lower prices. 

We get some guidance in this matter from the accounts of the two largest customers - the Tennessee Valley Authority and LG&E (the large German owned utility). Both these companies suggest that they have derivative liabilities on coal contracts - that is they are contracted to buy coal at above market prices. However in both cases the derivative liabilities are falling fast (consistent with explanation b above).

The disclosure from the TVA is most germane:

At September 2012 The Tennessee Valley Authority had 46 million tons contracted and they were $267 million underwater on those tons. In other words their coal was $5.80 per ton overpriced.

By December they had 48 million tons contracted but were only $224 million underwater - or $4.67 a ton underwater.

At this rate by early 2014 The TVA will have rid itself of all out-of-the-money contracts. They may be doing it this fast by paying their way out. Whatever happens Alliance Resources (whose biggest customer is The TVA) will be receiving closer to market prices.

Future outcomes

If (a) is true then the contracts will wind up being reset. There is a huge contract that was there in 2009 (and still accounts for the bulk of contracted value). That contract does roll over fairly sharply now. When it rolls off prices will be much lower.

If (b) is true then the profitability of this company is going to crash because the forward contract prices are massively lower than realized historic prices. This decline will happen fairly fast in this case.

Under both scenarios (a) and (b) it is difficult to see how this partnership services its large debt. Any price close to what Arch Capital receives for its coal will result in fairly rapid bankruptcy. Debt-holders beware!

The third possibility (c) is probably the best one for shareholders. The third possibility is that this is a massive fraud. In that case it can keep going as long as the management keep lying. In the fraud possibility the stock might take a while to crash (as lies can be very long-lasting) - especially if they can - Ponzi like - continue to raise capital. They will keep paying dividends as long as lenders in particular are dopey enough to continue to lend to them.

This is one of those rare cases where I am a short seller and I am hoping the company is not a massive fraud. If its not a massive fraud I am going to get paid fairly quickly.

If it is a massive fraud I might be waiting some time. As a short seller I hope it is not a fraud - then I get a quick fairly guaranteed collapse.

John

Vodafone news of the day

Reuters today have a piece out on the Vodafone-Verizon issue. To quote:

By Kate Holton, Chris Vellacott and Sinead Carew 

(Reuters) - Almost five years after taking the helm at the world's second-largest mobile phone company, Vittorio Colao doesn't want to be the third Vodafone boss to be stumped by its seemingly intractable U.S. 'problem'. 

The urbane Italian, who has streamlined a company built on the foundations of aggressive expansion, is exploring what to do with the one remaining asset he does not control - the stake in U.S. operator Verizon Wireless, which makes up about 75 percent of the firm's value. 

On paper Colao has several options, each with pros and cons: sell all or part of the stake to majority owner Verizon Communications, maintain the status quo in the face of Verizon's desire for a deal, or sell Vodafone in its entirety to Verizon. 

I desire problems like Vodafone's intractable "US problem".

The US problem is that they own - but do not control - an asset that has appreciated, appreciated some more and gone up a bit after that.

Most of Vodafone's shareholders would love to have that problem because Vodafone has fallen a bit, got a little depressed, then gone into a decline and - well - recovered somewhat in recent years because it got just too cheap. And it had distributions from its US operation to fund its dividend. If Vodafone did not have its US problem its stock price might resemble France Telecom by now...

But with an asking price for Vodafone's 45 percent stake in Verizon Wireless around $115 billion and a potential $20 billion tax bill on the capital gain, Vodafone investors worry that Verizon may not be willing to pay enough for a business it already controls.

No. What Vodafone investors are scared of is that Vodafone will sell its best asset grotesquely tax-inefficiently to buy inferior assets at prices two turns higher.

The inability to do that so far has been the US problem in a nutshell. The US problem is the only thing that has saved the shareholders here.

Verizon has one huge advantage in this deal. They are dealing with self-centered imbeciles rather than shareholder focused players. Later in the article they say:

Vodafone has lawyers from Linklaters, bankers from UBS and consultants from McKinsey looking at deal options and structure, and for ways to reduce the tax bill, according to three people familiar with the situation.

You bet they are. But as an American analyst points out:

It is not clear how a large proportion of any capital gains tax liability could be mitigated while allowing Vodafone to make a clean break from US. Even if a feasible solution could be found we disagree with the bull-case view that any point of tax law would be clear cut. In our view, Vodafone could face protracted debate with tax authorities, something we believe it wants to avoid.

But even this analyst is not correct. What our "urbane Italian" wants is to avoid isn't difficulties with the IRS. It is being shafted when he sells the business which belongs to shareholders (including my clients).

Personal concerns for employment for Vodafone's board and management - not tax - is the issue here.

In praise of unjust enrichment

The only deal that makes sense is to sell the whole of Vodafone to Verizon.

That is obvious.

The main people it does not make sense to are the Vodafone senior management.

So I will suggest a solution for Mr Colao.

The deal should be done with termination payments - huge ones - maybe a cumulative half a billion dollars.

So much so that the "urbane Italian" and his ilk have enough money to be pointlessly urbane for the rest of eternity.

Enough money so their heirs and successors can be dynastically "urbane" as well.

It will be unjust.

It will be a reward for a decade of failure.

But as a shareholder I would vote for it. These clowns are so bad it might be worth half a billion dollars to make them go away.

Still if Verizon want to save that half a billion dollars (and then some) they can force the issue. Go hostile. Go now. Go hard.

Go before Vodafail's startlingly inept management work out just how much the Square Mile really hates them.




John

Gonorrhoea, online dating and credit card phising scams – examining Cupid PLC

This post has been removed an an apology can be found here.

I apologize to my readers for any inconvenience.



John