Monday, September 26, 2011

Solar panel prices

Since I expressed interest in the price of solar panels form an Australian distributor I have been bombarded with sales pitch emails...

Last price - $1.30.


Dear customer

Just a quick note that the price of alex panel has been dropped to $1.20p/w (minimun purchase amount is 2 pallets).

I have no idea whether the Solyandra disaster involved anything untoward or not.

But it does not matter either way. Solyandra was doomed.


Friday, September 23, 2011

Models for a Greek Sovereign Default

I am on a plane - long-haul over the Pacific - and someone asked me to spell out what I thought would happen with a Greek sovereign default. As this is drafted on a plane it is designed to outline extreme views (you know the ones after two glasses of wine). If people want to explore more modest views that is for the comments. Still all options look bad.

I see two broad variants - both of course stick most of the losses on Germany and France. Some variants are totally disastrous.

Variant 1 - the Argentine option: Default and de-peg the currency. 

When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.

Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires  became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.

The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too - failing to replay USD debts.

The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.

The Argentine economy was doing quite nicely after the devaluation. The lesson was that devaluation worked - provided you simultaneously forced private sector default.

If you were Greece you would take this option without hesitation.

However this option has explosive implications for Europe. You see a bank deposit in Athens is going to turn your Euros into Drachma. Overnight it will lose 70 percent of its valuation.

So it has to be done quickly and with an element of surprise (as per Argentina when most people did not get their dollars over the border). Without surprise people will rush their money to Deutsche Bank in Munich.

One weekend we will just find that the Greeks have done it.

But now suppose Greece does pull this trick. The day after we have a Drachma - deposits are in Drachma. We might print a single 10 drachma note and allow it to settle against the Euro - then over time print more. This should work for Greece.

Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.

And this bank run – a run including tens of thousands of Italians driving their Fiats - will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.

If you are going to go the devaluation route you are going to have to do it all at once. Like the big-bank weekend (maybe coinciding with a week long bank holiday) in which all core European countries get their own currency back.

There is a precedent. It is not a pretty one. When the Austro-Hungarian empire collapsed there was a single currency over a huge area covering much of what is now Euroland. In this case the rather Germanic Austrians were in charge (or rather were in charge until their empire collapsed).

What they did was put troops on all the borders and made it illegal to take cash (or wire cash!) across borders. Then all Austro-Marks in each country was stamped - converted to Drachma for Greece, Marks for Germany, Peseta for Spain or whatever the currencies of the day were [If someone remembers the 1918 border splits better than me they are welcome to say...]

In this conception all Spanish debts become Peseta debts. All German debts become Mark debts. All Greek debts become Drachma debts. Unstamped currency goes worthless.

If you are going to split the currency I see no alternative to a big bang - and if you do that I see no alternative to troops at the border stopping transfers (and wire transfers) because shifting cash North looks so profitable against a sudden devaluation. Suddenly – and against all historic hope – its time again to guard the French-German (and every other European border) with troops for a week whilst the money is stamped.

Note however almost every country borrowed in hard currency (Marks) and got to repay in soft currency (Drachma). This is a scheme which shifts the loss home to Germany and with little compensating benefit except that they get their beloved Mark back. Its a scheme that is way better for the periphery because they get to keep their institutions. In two years they should bounce back like Argentina bounced back after their default.

Unilateral Greek default and devaluation without planning for the periphery to do the same - well that is a true mess. Too ugly almost to think about - and it would be unilateral for less than a week. The rest of Europe falls into that abyss with maximum movement of deposits and cash in the meantime.

The second variant on Greek default. Greece defaults and stays in the Euro 

The second variant on Greek default is the one that Germany prefers – Greece defaults and stays on the Euro. (Credit Agricole also prefers this.*)

In the second variant Greece has a huge problem after the default - which is that its banks are insolvent. They own a whole lot of Greek Paper. Moreover Hellenic Telecom does not look that great either.

The recession goes from bad to worse and the government deficit goes from bad to worse. The Germans wind up owning the banks and the telephone company as partial offset to their losses lending to them. The Greek Institutions are captured by the Germans. (All your base are belong to us.)

They also wind up getting paid a little more as Greek austerity - as long as it lasts and that might be a long time - partially reduces German losses but at huge social costs.

The Eurozone becomes really dysfunctional - with the whole periphery totally unable to work their way out and having lost all their key institutions to the Germans who neither know how to run them nor really want them.

Moreover Greece stays expensive and unproductive and becomes more socially fractious. The likelihood of them staying the the Eurozone would be pretty low. (After all what have the Germans ever done for me!)

Europe would be held together by a massive and compulsory German aid budget. If they can't get that agreed on on day dot (and Merkel and the German constitutional court are not of that mind) then my guess is that is is in Greece's interest to go the Argentine route and let the rest of Europe fend for themselves.

And for that Europe will need troops on borders. Armed and dangerous.

Bring out the guns.


*I have a known partiality to that stock but do not own it at the moment...

Monday, September 19, 2011

Some comments on the UBS Rogue Trader

There has been lots said about the rogue trader at UBS. The best gag was that the name for a trader who makes money breaching risk limits is "managing director". Matt Taibbi argued that rogue traders were what banks hired when they hired "risk takers".

All of that misses the point. A well organized financial institution - any financial institution - has a back-office and a front-office (and sometimes a "middle office"). The back office records and settles trades and sometimes measures risk. (The risk measurement function is sometimes at the "middle office".) If you have your systems right you can hire "risk takers" all you like. They won't kill you because the "back office" and "middle office" won't let them.

If anyone is able to break the risk limits, managing director, lowly trader, then that is a failure of the system and reflects directly on senior management who have a core function of making sure the systems work.

Oswald Gruebel (the CEO of UBS) took a different stance (hat-tip Kid Dynamite) and argued that management could not stop rogue trading. (Quoted Chicago Tribune.)

Speaking for the first time since UBS revealed the loss, Gruebel told the Swiss weekly Der Sonntag that the loss couldn’t have been prevented. 
“If someone acts with criminal energy, then you can’t do anything. That will always be the case in our business,” the former trader said in the interview published Sunday.
No Mr Gruebel: there will always be criminals, there will always be people who want to steal from your bank or go to the casino on your dime. You cannot monitor all those people but you can and should build systems that are as robust as possible to human nature and when you fail to do that you fail in your job.

But worse: your statement that "you can't do anything" is a statement that you are abdicating your duty. I hope that statement is misquoted because if I were on your board and you took that stance I would be seeking your resignation. To lose money to a determined rogue trader is an error - and all systems have holes. To deny you can do anything about it is to give up being a banker.

Still the best analysis of this trading loss comes from Macro-Man who makes a simple but clearly correct observation:
There is a really good reason why you don't promote people from back or middle office to front office: they know the systems well enough to cover their tracks. Better the norm where very few front office people have a clue what happens to a trade once they press "done". Leeson, Kerviel and Adoboli all had this in common. Note to management - if you want to hire a back or middle office guy to do a front office job, hire them from a different bank.
Alas every second back-office guy wants to be in the front office. After all front-office guys are paid more and have more decision making power. Back-office is administrative and procedural. Front-office are "risk takers" which is somewhat more glamorous. But there are good reasons for discriminating against back-office guys, especially when bank systems are not robust.

Whatever: A message to the UBS CEO. An internally discriminatory hiring policy is not as good as robust systems but it is surely better than what you are doing Mr Gruebel.


Wednesday, September 14, 2011

Welcome to day-traders anonymous (French Bank edition)

At Bronte we talk a lot about French banks. But we have not owned any of the majors since Greece started looking shaky. We used to own Credit Agricole SA - indeed when we started Bronte it was one of our largest positions. But their exposure to Emporiki (the number 5 bank in Greece) scared me. Indeed I blogged about it once.

We have an estimate of their largest possible loss at Emporiki - and it is probably a good estimate - but hey - this is a crisis and its pretty hard to trade that estimate. The main issues are found on page 70 of 236 of their results presentation (that is where customer assets, customer liabilities and other funding needs are presented). Whether the loss in Greece is 4 billion or 12 billion Euro hardly counts...

Anyway I just bit the bullet and purchased a position in Credit Agricole. My business partner didn't like it - indeed he argued strongly against it.

So we sold.

We made a profit - after commissions - of 412 Euro on the only day trade Bronte has ever done.

My name is John and I am a day trader.

Kind of makes you feel dirty...


Friday, September 9, 2011

Electronic fax? Really. Doing the time-warp with

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 (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. 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:


December 31, 2010 and 2009
(In thousands, except share amounts)

Cash and cash equivalents
Short-term investments
Accounts receivable, net of allowances of $2,588 and $3,077, respectively
Prepaid expenses and other current assets
Deferred income taxes
Total current assets
Long-term investments
Property and equipment, net
Tradenames, net33,3968,760
Patent and patent licenses, net 18,10214,955
Customer relationships, net 36,6747,743
Other purchased intangibles, net
Deferred income taxes
Other assets
Total assets
Accounts payable and accrued expenses
Income taxes payable
Deferred revenue
Liability for uncertain tax positions
Deferred income taxes
Total current liabilities
Liability for uncertain tax positions
Deferred income taxes
Other long-term liabilities
Total liabilities
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
Additional paid-in capital
Treasury stock, at cost (8,680,568 shares at December 31, 2010 and 2009, respectively)
Retained earnings
Accumulated other comprehensive loss
Total stockholders’ equity
Total liabilities and stockholders’ equity

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 ( I went to the Irish companies office and pulled the balance sheet. This was a trivial purchase: 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 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.


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.

Wednesday, September 7, 2011

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.


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!


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.)

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