Monday, January 10, 2011

Logitech and a divergence into days payable outstanding, Dell, Apple, and macroeconomic conditions in China

Stableboy Selections (a blog I should read more often) provides us with a fairly simple case for shorting Logitech.  After joking about their domicile (Apples Switzerland) he points out the obvious - laptops are replacing desktops - pads and phones are replacing both of them.  Logitech sells peripherals.  The new technology (along with things like Google speak-to-search) will reduce the need for peripherals.  Peripheral sales should fall year-in-year-out - they have done so at Logitech.

Eventually this suggests Logitech will look like Radio Shack - a company that got rich selling cables for your computer and TV and eventually shrunk into (near) oblivion.  The first of two bottoms (in the stock at least) was marked by The Onion doing a mock interview where the CEO could not figure out why they were still in business.

If the desktop is doomed so are its peripherals - and along with my absurd collection of cables (firewire anyone) I now have a collection of mice, keyboards, video-cams and the like.  My shop is my attic.

Given Logitech trades at a trailing PE of 22 it looks like an attractive valuation-business obsolescence short.

Alas if this business were as easy as ripping off other people’s ideas we would all be rich.  So I went to work reading Logitech’s accounts.  There are some upsides - first and foremost is Google TV (“the most important product launch in our history”).  I am not sure Google TV is getting much traction (but they have a really complex remote control to sell and even that will become another Android app).  More notably they had a really good quarter - enough of a good quarter that it spelled "turnaround".  Just as The Onion marked a bottom in Radioshack I was worried that Stableboy would mark a (the?) bottom in Logitech.

I just could not work out why peripherals would have a good quarter.  And if it was a good quarter I could not figure any reason why sales should start motoring upward.  The trend towards lower peripherals sales plain - and the company's contrary prediction is strange.  However the company does predict turnaround.

My first reaction was that the company was channel-stuffing.  (Increasing the speed at which you deliver to just-in-time retail can produce sharply rising sales at the expense of annoying your customers and sharply falling sales next quarter.)  Channel-stuffing would have been a great short thesis (and Stableboy hints at it) but it does not look supported by the data.  Days receivable rose - but only in proportion to sales.   (They rose from $260 to $305 million - both 47 days.)

Inventory turns dropped (why I do not understand).  But what really jumped out at me was that payables rose to 90 days from 71 days.  This company was not paying its suppliers.  Ninety days outstanding almost destroyed David's Holdings (as per my last blog post).  Its a pretty big tell - or so it seems to someone who is used to the 35 days of retailers.

But alas 90 days is not so startling.  Apple is at 80 days at the end of year (and has been higher).  Dell is at 81.  And the disease is widespread - for instance the Japanese optical companies (Canon, Nikon) are at 80-90 days.

Dell is particularly instructive.  The company collects its cash in advance from customers and runs on negative working capital.  The business has always been funded by borrowing from suppliers.  Its just that the scale of the loan has increased with monotonous regularity.  Days payable outstanding was 56.1 days a decade ago - then 66.9, 69.4, 71.3, 73.4, 74.8, 77.1, 80.1, 71.8 and 81.2 days.  Dell just screws its suppliers a little bit more every year.  It shows more cash generation than is real.  It makes itself look better than it actually is.

Dell however is a declining business.  Apple which is clearly not declining does it too. 

Ultimately this is bad business practice.  It stresses suppliers - it costs them money chasing you up.  It builds distrust.  Yet Apple does it - and the reason is obvious.  Because it can.  Apple has power and it is not afraid to (ab)use that power.

By contrast Cisco (a company which tries to keep its supply chain sweet after an infamous supply chain stuff up)  is under 20 days.

Macroeconomic conditions in China

This leads me to the real point of this post.  The macroeconomic conditions in China are changing dramatically.  Labor shortages are a serious problem.  We are beginning to see press stories about difficulties in getting things produced and companies bringing production back to the USA.  What this presages is a change in power between the Western giants and their Chinese manufacturers.  Apple behaves badly because it can - but that power probably does not exist in the long run for Dell or Logitech and the loans that these companies have taken from their suppliers (loans that are a meaningful part of their cash balance in some cases) are going to have to be repaid.

It is logical when you think about it.  Inflation in the US is 1 percent plus or minus 2 percent.  Its probably over 10 percent in China.  Slow payment thus benefits the Americans relatively little but costs the Chinese counterpart a lot.  Chinese inflation and labor shortages should cause supply chains to speed up.

Cisco, Samsung and other companies that have kept the supply chain sweet should be fine.  Apple should be fine too - its bills to suppliers are trivial compared to cash balances or profits.

But hey - we did short some Logitech.  It really is not so good for them.  90 days really is a problem - even if they don't know it yet.  Their business practice stinks and it will come back and bite them.  And it will bite many other companies too.


(All days payable numbers sourced from Factset.)

Tuesday, January 4, 2011

How dope smokers with the munchies at 2AM almost destroyed the number three wholesale grocery distributor in Australia

I have a post coming about days payable outstanding (DPO) in by various mega-corporation - and the uses and abuses of corporate power.  However before that I have to tell a story - the details of which have probably been embellished in my memory - but which mixes high finance with marijuana, chocolate biscuits and the munchies.  It all happened twenty years ago - so the story has had time to embellish.

Anyway you need a bit of background.

There are two dominant grocery market chains in Australia - Woolworths and Coles.  The latter is now owned by Wesfarmers.  These chains have enormous market power - far more than say Wal-Mart in the US because the concentration here is so high.

These chains own their own distribution businesses.

When I first started investing seriously there was a third-player distributor in most states of Australia.  The third player in the biggest state (New South Wales) was David’s Holdings - owned by John David.  I met John David once - he was a very nice man.  He was also ambitious.  He wanted to consolidate all the number three players - something that was probably necessary if the third player was to survive.

So David raised some of the necessary capital by listing his company.  He then one-by-one purchased the wholesalers in the other states.

But he did not raise enough money by simply listing.  He started to raise money by playing around with payment terms.  After all a wholesaler turns over an enormous amount of merchandise on margins that are below 2 percent.  If a wholesaler is vehement about collecting from their customers rapidly (30 days or less) and starts paying its suppliers slowly (60 days or more) it can generate a lot of cash - a free loan if you will from the suppliers.

And that is what John David did.  Payments to suppliers became increasingly tardy - and DPO edged towards 80 days.  (By contrast well Wal-Mart DPO is 35.7, Tesco is at 34.3, Wesfarmers is at 35.7 and Woolworths is at 30.8).  Suppliers might not like it - but it generated Davids a large cheap float - and kept the third-force in wholesaling alive.

Woolworths however kept growing and kept destroying mom-and-pop corner grocery stores.  It was awfully difficult staying open as an independent against the large chains.  And every time one of those stores closed Davids lost volume.  And when it lost volume it lost the float associated with that volume.  Negative working capital employed in a business is wonderful until your business shrinks.

David’s - which had levered itself up for its acquisition spree - dealt with this cash drain the only way it could - which was to allow payment terms to blow out even further.  Now Davids was operating above 100 DPO.

Woolworths however smelt blood.  It started using its wholesale operations to supply third parties - mom and pop stores, shops at gas stations and the like.  These shops were reluctant to go to Woolworths because - well frankly - Woolworths was the enemy.  But some left and David’s had to increase its DPO even further.

Now enter Arnotts.  Arnotts is the dominant biscuit maker in Australia.  It is now owned by Campbell’s soup and is one of their best assets.  Arnotts however have a biscuit which figures above all others in the Australian psyche - the Tim Tam.  The Tim Tam is a desperately rich biscuit - beloved by teenagers and twenty-somethings and an iconic part of getting fat in Australia.

They are sold by gas stations (open all night) at ridiculous markups - a couple of dollars a pack being a common mark-up.  And the only person that buys them at 2am is someone who has the munchies.  (Irrational hunger - known colloquially as the munchies - is a side-effect of smoking marijuana.)  And Tim-Tam’s at 2am are the mainstay of the (overpriced) grocery shop attached to an all-night gas station.  They are an important product.

And Arnotts, sick of David’s tardy payments, supplied David’s with their entire product range except Tim-Tams.

This annoyed the gas stations who would put signs up on the vacant area where the Tim-Tams should be - saying “supplier out of stock”.  This convinced some gas stations to shift their supplier to the enemy - the dreaded Woolworths.  At least they could get Tim-Tams.

This drove David’s almost bankrupt.  The stock plummeted (it traded as low as 40c).  Eventually it sold itself in distress to a South African group (Metcash) who injected enough capital to fix the DPO problem.

And so in my memory we almost lost the third biggest grocery wholesaler in Australia because dope-addled kids with the munchies could not buy chocolate biscuits.

And I learnt to watch DPO as an important indicator of corporate health.

Till next time.


Monday, January 3, 2011

The party is not over in Australia

Mike Shedlock has declared the party to be over in Australia for about the fifth time.

He is dead right that the Australian economy is a party and that it will end.

He is wrong that it is over now.  The property market is more illiquid than usual.  It has got illiquid a few times (and essentially flat) and every time it has I have thought that we were in Wile-E-Coyote country.  (You know the type - the Coyote has run off the cliff - but he has not looked down - and only when he looks he starts to fall.)  It just never fell.

The beaches are crowded and people are still buying lots of $6 ice-cream cones.  You still meet plenty of people who are purchasing houses for more than can afford whilst driving his-and-hers BMWs.

I have thought the party was going to end for a while.  (Like Mike Shedlock I am wanting to run fast from this bubble.)  But early is wrong.

I have done very nicely with my offshore money.  I have managed to keep up with the Australian dollar and then some.  For that I am thankful.  It would have course been easier to just buy Aussie bonds.

Oh well...

Friday, December 17, 2010

Looming excess capacity in getting you smashed and Chinese statistics

A few years ago I travelled by local transport (mostly boats along the Mekong) from Saigon to Siem Riep. I traveled with my wife and my then seven year old son. Hotels ranged from about a dollar a night to 170 dollars a night. (We splurged at the Victoria Chau Doc which felt like the best hotel I had ever stayed in - but probably was only in contrast.)

We hired locals to show us what they did for fun - which largely revolved around cock-fighting and any other form of gambling they could find and moonshine. They even bred fighting fish for gambling.

I sipped (small amounts of) moonshine and watched Cambodian soldiers play poker and boules.* The soldiers left their machine guns in a pile whilst they gambled. They would not let me photograph them because they were on duty. (They had machine guns - so I went along with that request.)

The moonshine was bad. Really bad. Kill-people sort-of-bad. Drinking it in quantity would be like having your brain smashed around a gold brick and then twirled with some slightly rotten pineapple chunks. It told me that the real game in alcohol in developing countries is to get people off the (literally) poisonous once-distilled moonshine and get them onto double or triple distilled stuff that comes in bottles. The biggest selling liquor label in the world used to be Johnny Walker Red Label. Now it’s Bagpiper - a genuine Indian whiskey. Bagpiper is one of the few liquors I would argue saves lives. The alternative is moonshine and with regular and sometimes very large death-tolls.

In China they didn’t take to whiskey like the Indians. Instead they drink Baijiu. The alcohol is usually sold as a wholesale ingredient - and blended under lots of brand names. The commercially made (and multiple distilled) grain alcohols will be displacing moonshine for years to come. There is good quality growth there.

Which brings me to China New Borun (BORN). BORN is a controversial stock floated on the US exchange earlier this year. It had reputable brokers backing the IPO.  [The prospectus is part of my holiday reading!]

The prospectus tells us that edible alcohol is sold by grade (A, B, C) with A grade being more refined and hence tasting better. This company produces B and C grade with increasing focus on the B grade. Absolut Vodka it is not - but whatever - it is likely far better than the vat of rice and rotten pineapple by the Tonle Sap I tried. Here is what the company says about its production.

We currently own and operate two facilities: one in Shouguang, Shandong Province and the other in Daqing, Heilongjiang Province. Our Shouguang facility has an annual production capacity of 160,000 tons of corn−based edible alcohol (90,000 tons of Grade B edible alcohol and 70,000 tons of Grade C edible alcohol). Our Daqing facility currently has an annual production capacity of 100,000 tons of corn−based edible alcohol (70,000 tons of Grade B edible alcohol and 30,000 tons Grade C edible alcohol). We are constructing an additional 120,000 tons of capacity (all Grade B edible alcohol) at our Daqing facility, currently expected to commence commercial production in December 2010. According to the Frost & Sullivan Report, we are the largest privately−owned corn−based edible alcohol producer operating in Shandong Province and Heilongjiang Province. Our Daqing facility is licensed to build up to 330,000 tons of production capacity of edible alcohol. Based on data from the Frost & Sullivan Report and our knowledge of our industry, we believe we will be the largest producer of corn−based edible alcohol in China, in terms of current known production capacity, following complete development of the Daqing facility.

In China the numbers can bamboozle you - but I am not used to talking about 380 thousand tons of edible alcohol. That will supply an awful lot of drunks. I was trying to work out just how many - but the text of the prospectus does not make clear whether they are talking about metric tonnes or US short tons** as would be measured in America. (The spelling is different - so I would normally go with the spelling - except that China would measure this in metric and some diagrams later in the prospectus are specifically labelled as “metric tons”.)

And here is the diagram that was labelled “metric tons”. It purports to show edible alcohol consumption in China. They mean grain based stuff sold into the Baijiu market.

Lets take the 2012 estimate. 7.3 million tonnes of alcohol per annum. That is 7.3 billion kilograms of alcohol per annum. That is of course on top of the moonshine, wines, beers and imported spirits that the Chinese drink.  (The growth in this chart must be moonshine replacement.)  This is a lot of alcohol even for 1.3 billion people.  It is more alcohol than the Chinese drink according to WHO statistics.  Indeed it suggests that the Chinese are as drunk as the Russians (something that casual observation of culture makes you think is unlikely).

There is just over a quarter of a kilogram of alcohol in a (standard 700ml) bottle of Absolut Vodka. So this represents say 29 billion bottles of vodka. One company - China New Borun - is - according to its prospectus - responsible for about 1.2 billion of these bottles.

By contrast, the biggest selling liquor labels in the world (Bagpiper, Johnny Walker Red) sell about 20 million bottles (ahem: cases) each. China New Borun claims to be an absolute global behemoth in the business of getting people smashed.  (Even with the bottles-cases correction China New Borun is a global behemoth in getting people stewed.)

Of course all the consumption in this note - and China New Borun's capacity - represent 2012 estimates.  Maybe - like everything else in the world - the Chinese are building excess capacity in getting people pissed, legless, bladdered, trashed and otherwise off-the-wagon.

Lesson of all this: there are either a lot of drunks in China or the statistics are wrong. Maybe there are a lot of drunks in China and the statistics are wrong. Maybe the statistics are compiled by the drunks.  Maybe the excess alcohol capacity is supplied by drunks.  Whatever - when it comes to statistics and China you need to take them with a good stiff glass of Baijiu. If the statistics are in a prospectus trying to sell you stock - take two glasses of Baijiu.  If that does not work - resort to moonshine.


*The French left baguettes, boules and train-tracks. The train-tracks have since been converted to bamboo railways.

Wednesday, December 15, 2010

Fish and chips in Kiama

I am back in Australia after my trip to the USA and I am taking a few days break. Its lunch time – and I have been reading the annual report of a once highly valued internet company* whilst I wait for the heat to die down. It is too hot to stay at the beach – but I am cool from my most recent dip in the Pacific Ocean. I can hear waves crashing on the shore.

I write to make an observation – one for all the currency speculators out there. We stopped for a meal on the way South. South of Sydney (hence with cooler water) is the unfashionable part of the New South Wales coast. A beach-town cafe in decidedly middle class Kiama – and without water views is now as expensive as a cafe on the Upper West Side of Manhattan. (The fish and chips are better in Kiama though.)

Some of this price level is due to wage structure – but most of it is new. Australia is just expensive and getting more so – and the Central Bank (justifiably) feels the need to raise interest rates. Australia is now a very expensive place to visit and I do not recommend it except for the very wealthy.

It's hard to call the end of the Australian bubble – but the boom and prices have gone far beyond rational. I don't see what breaks it other than an end to the Chinese construction boom. These prices are the downside of being China's coal and iron ore mine. In America I saw no obvious inflation between trips. On the South Coast of New South Wales I can't say the same thing.

If you are an Australian and you are not in the process of shifting 25 percent of your asset base offshore you are probably remiss. And if you are a currency speculator liking the carry on Australian government bonds then it has been a great trade but I hope you get to the exits early.

Meanwhile you can enjoy ordinary ice-cream cones in small coastal towns at US $5.30 each.


*There is a blog post in that internet company – but it will have to wait for the new year. I want to talk to management to hear their side of the story first.

Wednesday, December 8, 2010

Shawn Richard of Astarra enters a guilty plea

Just over a year ago I wrote a letter to regulators detailing a fraud at an Australian fund manager (Astarra/Trio Capital).  This was the Bernie Madoff of Australia.  (This required no special genius on my part.  I was tipped off by a blog reader.)

The regulator closed Astarra within a month.  I have no complaints.

I wrote up part of my thinking for this blog.

But until recently no charges were laid and I was getting increasingly frustrated.  I even wrote a (slightly) complaining letter to ASIC (the Australian regulator) only yesterday.

But the Australian regulator rocks!  Shawn Richard (the principal malefactor) was charged  - entered a guilty plea and will go to prison (probably for five years).

I want to acknowledge the press.  The Sydney Morning Herald has kept the story alive with accurate and hard-hitting reporting.  The (financial) decline of newspapers is not a good thing.

ASIC has set a standard for the SEC to emulate.

Prosecutions are important.  Many thousands of people have lost their life savings in this mess.  A strong regulatory response will reduce the chance of repeat problems.


Saturday, December 4, 2010

Laundry lessons - a first follow up

The subject of income distribution is taboo in the USA.  On my blog readers noted a simple comparison of the price of laundry in London and New York will do to prove the point.  However when reposted on Business Insider (with a more inflammatory header) the hostile-reactometer went off-the scale.

And it did that even though I was careful to point out some of the many benefits of a wide income distribution.  There are benefits of non-strict labor laws which make certain businesses possible in America that are very difficult in Europe or Australia.

We have a friend who has a massively cyclic business.  (The business involves capital equipment for the construction industry.)  They pay their staff very well.  (Many receive $100 per hour though most receive far less.)  However their staff numbers shrink by 80 plus percent whenever business turns down (regularly enough) and rise by 500 percent when business turns up.  The volatility in the business is shared with the staff rather than being absorbed entirely by the owner.

In extrema this business could not exist in (say) France because no business owner could (or would) absorb this volatility themselves.  The owner openly says he does not know how people do business in France.  Sharing the pain works.

This applies across the whole labor market - the highly flexible working conditions of America are a strength of American business even though at times they result in amazingly large income variability and some very low wages.

Still - and carefully thinking about it - I am not sure what the real cause of low-end wages is.

Many readers thought (logically enough) that immigration levels drove bottom-end wages - after all the women washing my clothes were Chinese and the nannies were largely Hispanic.  Some on Business Insider thought me an idiot for not just accepting that.  (Australia is - they observed - becoming more closed to immigration.)

I am not so sure.

The US population is 307 million and it grows about 1 million per annum - most of which is driven by immigration - some of it illegal.

Australia has a population of 21.9 million - and the immigration rate has been over 200 thousand people per annum of late.  (Its about to drop for political reasons.)  The population growth rate in Australia is three times the USA - almost entirely driven by immigration including a lot of immigration of people who would expect to earn below average wages.

In Australia there are more immigrants to do my laundry per head of population than in the USA.

And yet bottom end wages have never been quite as pressured as in the USA - and frankly - I do not understand why.

This is interesting in the case of Australia but truly important for Europe.  Europe opened itself to massive internal immigration from poor countries and did not have a collapse in the bottom end wage structure.

The GDP per capita in Bulgaria is under $7000 USD per annum.  Bulgaria is poorer than Mexico on that measure.  And the border is open.  Romania is similar (with a larger population).  And sure the low wage workers who clean my hotel room in London are likely to be Bulgarian or Romanian but - whatever - they haven’t managed to drive down the price of laundry.

And that I do not quite understand.  It is making writing the European follow up post difficult.


Thursday, December 2, 2010

Lessons in my laundry - part 1

I am on a trip to the United States to raise money for my funds management business.  Its like an endless series of first dates.  If things go well you get a second date.  If things go poorly you get jilted - and usually you are not told why you are jilted.  One prospect however told us that they were not going to invest with us because they did not like my accent.  (I am an Australian - get used to it.)

Anyway I stayed with some friends who turned out (somewhat to my surprise) to be more prosperous than I imagined.  They lived in a three level beautiful inner Chicago house designed by a very stylish architect.  I was there getting over jet-lag and cooking in their beautiful kitchen.  (I cooked braised pork with sage, shallots, and star anise.)

I also did my laundry.  Much to my surprise my hosts did not have an ironing board.

I told my wife by phone - and she thought they must be absurdly wealthy - but then even the wealthy in Australia have an ironing board.  Sure they were a highly motivated and extremely hard working professional couple and ironing was hardly a priority - but it was still strange.

And then in Brooklyn - a week later - I worked it out.  I dropped my laundry off at a Chinese Laundromat and got back a few pressed shirts, my jeans, socks etcetera and paid $11.75.  I figure the same basket would cost me $28 in Australia.  Why would you bother to wash and iron if you were prosperous and laundry was that cheap...  moreover there was at least two laundries between my home and the subway.  I did not need to go out of my way.

This was all because of something I knew on paper - but the price of washing made it personal.  Australia does not have large numbers of very low wage employees and - even in the days machines - laundry is a labor intensive and non-traded commodity.  Laundry is expensive in Australia because the person doing it expects to make $15 plus per hour.  Sure minimum wages are a little lower than that - but most lowly skilled workers are paid more than the minimum.  The laundries I pass in Brooklyn take the clothes to a large warehouse-type room filled with Chinese women who speak little English and who almost certainly work for less than minimum wages.  And a upper middle-class New Yorker either never sees them and can ignore them.  A large low-wage group make the (very rich) lifestyles of the American elite possible.  They make it possible to never do your washing, eat in up-market restaurants, have nannies look after your children and have a material standard of living that even very rich Australians might envy.

If you are minimum wage worker and you have a job it is clearly much better if you live in Sydney or Melbourne than Brooklyn.  At the moment of course Australia is the far-better bet - low wage workers are more likely to find a job down-under and the job is certain to pay better.   But that is not the pattern of the last twenty years.  Mostly Australia has run unemployment a percent or more higher than the United States and there has been less low-pay work.  (Of course the reason why there is less low pay work is that we do our own ironing, cooking, cleaning and child minding as a response to the high price of these services.)

I don’t want to say that this is just a result of minimum wage laws.  I was careful to note that in Australia the norm would be to pay more than the minimum and less than the minimum is common in the US.  Whatever this is an extreme society and the results are - to my eyes - often peculiar.  Lightly traded labor intensive goods and services are - at least to my eyes - startlingly cheap in America.  And whilst laundry is my case example - the one I most enjoy is berries.  Strawberries and raspberries are highly labor intensive fruit.  Picking them is backbreaking and/or prickly work and they need to be transported to very tight timetables.   Like laundry the cost in New York is about a third that in Sydney.  And whilst clean clothes are nice - raspberries are wonderful.  So a little self-consciously I literally enjoy the fruits of American inequality.

America was not always this unequal.  Australia has got more unequal in my adult life.  And inequality is not all bad - not only do I eat fine raspberries - but it makes some people more productive if there is a (financial) tree to climb.  Its just - along with the side of the road Americans drive on and the endless adverts for medical services the most visible difference between Australia and America.  I can’t help but be aware of it.


PS.  Part II will be about traded and non-traded goods in the Eurozone.  And the price of laundry...

Sunday, November 21, 2010

Hell is empty: A review of Bethany McLean and Joe Nocera on the financial crisis

There are lots of books on the financial crisis and some are very good.  Bethany McLean and Joe Nocera have entered a crowded market - but they have done what nobody else has yet done.  They have produced a book (All the Devils are Here) in which I have yet to find a single factual error.  And they have produced a book which did not start with an ideologically driven conclusion.   This is a big achievement making this book - above others - worthy of your time.

Just to make it more joyous though they have made a book that looks like it was effortless to write and it is a fun read.  The book is thought provoking not because it badgers you but because the story is laid out with nuance - all the devils, ranging from naivety to delusion to criminality are present within realistic characters sketches of many of the key players.  This was a human crisis with human causes - not a whirlwind caused by some deity.

If I have a criticism it is that the book is too narrow.  The bond insurers are barely mentioned.  (Ambac and MBIA are names that do not appear in the index.)  The crisis is placed in an American context - and it was a global crisis.  (At a minimum it was a North Atlantic crisis.)  The role of the British banks (huge players) was not explored.  You could read this book and not have an inkling of the crisis now engulfing Ireland.  That is a tough criticism though - because if the book were broadened to that it would have either been 800 pages or lost the depth of character displayed.

But my guess is that if someone wrote that book they would find all the devils of the American crisis lurking in the European crisis.  Hell may well be empty.  Human failings are found amongst the living.  All the devils would be there too!

Monday, November 15, 2010

China Media Express: A Wall Street drama

Sorry I have not been blogging for a while.  There are a few reasons.  Firstly I have been travelling to raise money for my funds management business (now in NYC).  Also I have been working on shorts - and whenever I talk shorts I get hate mail and sometimes threats of litigation.  My experience is that the bigger the slime-bag the faster they are to call lawyers... but being on the receiving end of threats from sleazy lawyers makes blogging less fun.

Further - writing about shorts is surprisingly unprofitable.  My experience is that shorts that are widely discussed become riskier (they get crowded) and sometimes go up - whatever - they stop falling in response to bad news.  Universal Travel Group for instance is now trading above when I first blogged about it and the only substantial news has been that their fourth auditor resigned and their fifth auditor accepted the appointment.  They also got a new shareholder - an elderly retired car dealer from California’s Central Valley - who I suppose is also an expert on dot-com travel companies in China.

And so that brings me to the subject of short squeezes and one stock - China Media Express Holdings (CCME).  This is not a stock in which we have a meaningful position but which for a small-cap company seems to get more-than-its-share of attention.  When I wrote the Universal Travel post I got more than ten inquiries about this stock - another China stock listed in New York.  Why this one?  Well it is sort of attractive - indeed outrageously attractive - and unlike all the other US listed China stocks it has a reputable auditor (Deloittes) and a major shareholder with some credibility (Starr International of AIG/Hank Greenberg fame).  

CCME has a simple business model.  It places TV screens on buses in China and bombard captive passengers with adverts.  There are a lot of buses in China because China has the largest internal migration in the world.  Chinese consumers are bombarded with adverts but the really captive bus passengers are a good market.

The company is - at least according to its accounts - frightfully profitable.  In the last quarter the company had $57 million in revenue and only $13 million cost of goods sold.  Selling and administrative expenses were less than $3 million. Head office is obviously tiny.  After tax it is making $31 million per quarter.  This is the fattest margin and fastest growth media company I have ever seen.  It is pretty darn attractive.  And plenty of my smart readers own it despite rumors that it is fraudulent.  One of my smartest correspondents was long.

And a very few of my readers argued to me that it must be a fraud and were short.  Some of them were short six or more percentage points of the funds they manage.  And all wanted my opinion.

Whatever - this was a dangerous stock.  Any stock that normal non-stock-market people have never heard of but which garners this much passion is dangerous.  And at the time it was trading at a low single-digit price earnings ratio - it was either a flat fraud or the stock was going to trade up a very long way.  Indeed it was possible that it was both a fraud and going to trade up a very long way.  I had - as I stated - no opinion.  

But at least a dozen people asked me for one.  So I had a look and was left with the ambivalence which says “don’t touch this stock - long or short”.  There were only two negatives that stood out.  One was that the company once used a stock promoter that has previously been associated with some frauds.  They don’t use them any more.  The second was that the CFO was under 30 years of age, operated from a serviced office in Hong Kong and his only qualifications were a degree from a distinctly second tier Australian university.  [See correction below.  This description does not apply to the CFO but does apply to one external director.  The facts of the serviced office are however correct - the company's registered office is that serviced office in Hong Kong.]

Against this there were real positives.  Many Chinese companies listed in the US have auditors even relatively sophisticated investors have never heard of.  These guys used Deloittes.  And the major shareholder (Starr) supposedly did several weeks due diligence before they invested.  And who am I to question that?  Again I decided to leave it alone.

But the stock went up - and up - and up.  In the last three months the stock has traded between $7.58 and $22.30.  When I looked it was about $8.  

If you were six percent short at $8 - which some were - it was diabolical.  At $20 you were down 9 percent of your fund.  Moreover your position had increased by 2.5 times and your fund had reduced - so now the position would be over 16 percent of your fund.  At that point the position is threatening the existence of your funds management business.  After all it is now possible to lose 20 plus percent of your fund on a single obscure short.   This is a major drama for someone...

The big short has to cover.  At the same time the stock is attracting momentum (mo-mo) investors.  To add fuel to the fire the company throws out yet another series of perfect looking financial results.  This is deeply ugly and you are forced to buy the stock back to save your business.  If you don’t eventually your prime broker will buy it back for you - because they will protect their own.  That buying fuels the upward rise - putting more pressure on shorts and attracting more mo-mo investors.  

If you are a small holder you should - of course - sell some stock into short squeezes.  After all the buying is often artificial (forced covering, mo-mo guys) and when the squeeze ends the buying pressure ends.  The mo-mo investors often become sellers.  We have a guideline at Bronte that we will short 10-15bps of the fund into short squeezes where possible.  You shouldn’t do any more than that because you run the risk of becoming a victim of the squeeze yourself.  And it may not be possible because a borrow is not always possible.  (In the case of CCME borrow is possible but the stock rents for a double-digit percent per year.)  So we are short a little CCME - but way less than half a percent of the fund - and we are hardly committed.  For those that are interested - we are losing money.

Some of my readers however can talk about little else.  It is either the best or the worst stock in their portfolio.  Short squeezes are one of many dramas of Wall Street.  This one - repeated in a few other Chinese stocks like China New Borun - is particularly dramatic for those that are involved - and totally irrelevant for everyone else.

Thinking aloud about CCME’s business

Outdoor advertising is much bigger business in Europe than in America.  Europeans watch much less TV than Americans.  Americans drive home from work (and get bombarded by radio).  Europeans take public transport.  And that is one of the best times to advertise to them.  

Jean-Claude Decaux was the pioneer of street furniture for advertising - and you can guess how the negotiation went.  He goes to a local government (I remember when it was done in Sydney) and tells them that they will install, maintain and clean bus stops and other street furniture and they will pay the local government (or bus authority or whatever) millions of dollars for the privilege.  The cash-strapped local government swoons at the sales pitch.  And JCDecaux gets a few thousand more bus stops to display their adverts at.  

You can imagine this deal was amazingly profitable for Monsieur JCDecaux. It was a naive cash-strapped local government versus sophisticated advertising executives.  And lets face it - TV advertising requires huge numbers of people including some very highly paid creative people.  Street furniture (even if you have to scrub off graffiti) looks like a relatively cheap platform to display adverts on.  Of course it is fat margin.

Fat margins do not last forever.  People - even people that run bus companies - don’t remain stupid forever.  Every time a contract renews the bus company gets a little wiser and the margin goes down.  The long dated contracts are all eventually renew - and they renew at lower spreads for JCDecaux.  And looking at the expiry of the old fat margin contracts you can guess what Mr JCDecaux did.  He listed his company.  

Ok - China Media Express is more profitable than JCDecaux ever was.  The little upstart China Media Express is now as profitable in aggregate as the global leader.  At this rate of growth they will be far more profitable than the global leader.  But what has me really perplexed is that CCME is growing fast at increasing margins.  Last year gross profits for the third quarter were 17 million on 26 million in revenue.  This year they are 44 million on 57 million of revenue.  Margin is exploding...

JC Decaux do street furniture in Chicago (as pictured in their 2002 annual report) - and even in places like Chicago the bus companies and the local governments get smarter over time.  In China they seem to get more stupid or more corrupt.  After all the Chicago local authorities are doing better at extracting the margin from advertisers than Chinese bus operators.  Unusual.

But who am I to question this?  Delloites is the auditor and there is 170 million on the balance sheet (representing past-profits) and that is a pretty easy thing for an auditor to check.  So I am just going to conclude that the people who run Chinese bus companies are stupid.

Really stupid.  Or really corrupt.


Post script:  For the avoidance of doubt the fund I know that was heavily short CCME was covering the whole way up.  They are no longer heavily short CCME.  They did however lose meaningful money.  

They would have been only a small part of the volume.  There are probably more than one party caught in this squeeze.  Whether the squeeze is over?  Who knows.

Correction:  Several people have observed that the CFO is not sub 30 and not educated at an Australian university.  I stand corrected.  There is a young director of CCME who is also the financial controller of another listed company that fits that description.  I wrote this from memory and confused my directors.  The registered office of the company however is a serviced office in Hong Kong - the same serviced office as that young director operates out of.

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.