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Sunday, September 28, 2008

Quick update

I don’t want to toot my own horn by my three calls last week would have paid off in spades: oil rallied 17%, Zion fell by 12% and was down in excess of 20% at one point, and WFC fell by 5% and was down 13% at one point (it should be noted that to profit from the downside on ZION and WFC you would have had to use short term puts which would have probably magnified your return due to the inherent leverage associated with options). That being said I am not faring well on my ZOLT short which has rallied 15%, that being said I still think a ttm P/E of 88.6 is a bit much for a materials company (I would mention its forward P/E is 18, which is based on, as previously mentioned, what I believe to be extremely lofty estimates). But enough about the past, let’s look towards the future.

I am sure you have all read that the bailout plan has tentatively passed. In its current form, it gives taxpayers an ownership stake and profit-making opportunities with participating companies; puts taxpayers first in line to recover assets if a participating company fails; (and) guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit. The $700 billion would be available in phases. The first $250 billion will be "immediately available" to the Treasury Secretary, and $100 billion available "upon report to Congress," and $350 billion "available only upon Congressional action. While the industrial cycle looks to be slowing, in the US, the aforementioned bailout plan is likely to reduce the economic risk of a much sharper credit contraction. In addition, recently announced policy initiatives clearly go beyond the US: China and Russia have also taken steps to stabilize local markets. For example, last week, China announced a 27bp interest rate cut, as well as a reserve requirement reduction, reversing a couple of years of slow tightening measures. Globally policy makers are starting to act in concert to implement economically stimulating policies in order to avert a global economic meltdown. The real question is, will all these policies be enough to stimulate the global economy, or will it as I believe shift us from depression talk back to recession talk.

For the OECD as a whole, from a starting point of nearly 2% GDP growth in the first quarter of this year, GDP growth will flirt with the zero line in 2008Q4 and 2009Q1, but should manage to stay in positive territory. Of course, it is easy to see a technical recession in the OECD, particularly if US growth is softer than expected. But there are good reasons not to expect a deep OECD recession that could drag world growth materially lower. The world economy should continue to be cushioned by the strong demand from the commodity producing areas of the world (which have reaped the benefits of the tripling of oil prices since the beginning of 2007). If we fast-forward to the trough, what type of global recovery should we expect once the low point in the cycle has been reached? As I believe it would be prudent to expect the recovery phase in the global economy to be relatively subdued compared with the previous cycles. Indeed, the expected recovery is similar to the U-shaped upturn following the US Savings & Loans crisis in the early 1990s rather than the V-shaped upswing after the tech bubble in early 2000s. There are a number of reasons why we can expect the global recovery phase to be rather anemic, with the possibility of a longer than normal period of growth stagnation:

1. Although the bailout plan will do a lot to help stimulate the credit markets, bank lending will be tight for some time. The unprecedented policy interventions that have taken place over the past two weeks have led to a relaxation of stresses from the very extreme levels reached last week (when credit markets came to a complete halt), but conditions remain far from “normal”. As part of the deleveraging process, banks are clearly tightening credit (just look at LIBOR, on a side note a safe bet would be a further widening of the TED spread (yield difference between the interest rates on inter-bank loans and T-Bills) as I think private banks will continue to tighten which will raise LIBOR (plus LIBOR is currently understated) coupled with the fact that the FED will have trouble raising rights in light of the recent economic maladies, although it should be noted that this would be a short term bet because as we have witnessed before keeping rates too low for too long is a very bad thing). That remains the key message from the latest bank lending surveys from the Fed, the ECB and the Bank of England. Therefore, the lack of lending confidence is likely to curtail the strength of the upswing (particularly in consumption and investment).

2. Although it started out as mainly a US and UK problem the global housing correction has spread. Ireland, Spain and New Zealand are at the forefront of housing weakness. But other major economies have also seen some cooling. More recently there have been signs of housing weakness in parts of China and India. One of the key ideas to understand about housing is that it is a relatively illiquid asset (i.e. by and large people don’t buy houses to immediately flip them, the vast majority of homes are purchased to live in for longer periods of time) and as such housing corrections can have long-lasting macro consequences. For example, following the average OECD housing bust, the growth slowdown lasted four years on average (measured from the time GDP growth started to fall to the time when it bottomed), or close to two years after house prices peaked.

3. Fiscal easing has and will continue to help, but there may be constraints (for example rates are already extremely low and to lower rates further risks starting up the inflation machine). While a second fiscal stimulus package might well be implemented in the US next year, it is unlikely to provide as much bang for a buck as the first package. Nor is the Japanese fiscal stimulus package likely to give an immediate boost to the economy, given that it did not include large-scale tax cuts. The Stability and Growth Pact also makes easier fiscal policy less viable for many European governments, particularly as it might risk stoking current concerns about inflation. That being said, this constraint is less binding in EM countries, such as China, where there is substantial scope for both monetary and fiscal easing in response to a growth slowdown.

As far as portfolio positioning is concerned I still recommend loading up on EM economies that stand to benefit from high commodity prices and potential currency gains. The particularly attractive markets are those with high growth potential currently trading at low P/Es (i.e. Brazil and Russia). I think consumer stocks will continue to be punished as commodities remain high and lending remains tight, I would be shocked if these two factors coupled with a weak job market weren’t enough to incentivize the consumer to tighten up those purse strings. Interestingly, the XHB (the housing ETF) has outperformed the market by almost 20% over the last month. These companies may be unintended beneficiaries of any eventual financials/mortgage-backed-asset plan. The XHB has clearly has run ahead of the data, where only hints of optimism exists. With the recent reading of the NAHB index essentially flat, with housing permits heading lower, and with sales down, I would be shocked if the XHB went up anymore.

On the oil front, Goldman Sachs had an interesting conference call last week in which they reaffirmed their view of higher energy prices by year end. They included a snazzy chart which I have pasted below. My only warning is tread carefully because pure play E&P will swing wildly with prices of oil while refiners will swing in opposite directions (that is one reason why I like COP because it is both, plus it trades at some crazy cheap levels and has a 20% stake in Yukos).

Sorry for the short post. I just don’t think there is much to say; currently the market is in an awkward state of purgatory. Like I have emphasized before, the real action will start once Q3 earnings season begins, then we will know whether we are headed for a turnaround or a long drawn out recession.

Sunday, September 21, 2008

Financial Hodgepodge

First off, let me apologize for being MIA for a while, with all the tumult suffusing through the global markets my job has kept me quite busy. That being said let us take a moment to internally reflect on what has just happened. Ok, now lets focus on what can be done to better position us going forward.

Financial intervention to date has come in ad hoc form, first with new Fed lending facilities, then actions to facilitate the takeover of Bear Stearns, the GSE intervention, and finally last week’s decisions regarding AIG and Lehman Brothers. Without a standardized structure, the level of federal assistance, as well as the potential compensation for bearing risk, is unpredictable appears left to last-minute decision making even when it might not be. This has two consequences. First, these efforts are bound to lead to greater risk aversion among market participants. To a certain point this can be positive in reducing moral hazard, but taken to excess it can be destabilizing. This has become an increased concern over the last week—perceptions of counterparty risk have reached extreme levels and the ability of firms to attract new capital has been limited even further by concerns over potential intervention with punitive terms. Second, the lack of an agreed-upon policy makes any single intervention more difficult politically, which could constrain the Fed and Treasury in future decisions. Thus, policy may have reached a stage where a more standardized set of rules may be announced, if not legislated (hence the recent talk of RTC-esque vehicles). The need to establish the RTC is to establish a hard floor which should in essence stabilize the system (note it will stabilize it and provide a brief rally, financials will not go back to the way they were, we will still be in an extremely tight credit environment).
However, several important differences suggest that an RTC-style entity, while appropriate, is likely to be a piece of a larger solution. First, the federal government was already responsible for the costs of the S&L crisis, since it insured most S&L deposits. In contrast, the government bears little direct financial responsibility for many holders of mortgage assets in the current situation (the GSEs are the obvious exception). Without clear federal financial responsibility, the decision to establish a new agency—presumably at taxpayer risk—is more difficult. Second, the RTC was charged with consolidating assets from several hundred small banks. In the current situation, there are fewer lenders with significant assets, and they are larger. Third, in the present case, the vast majority of lenders are still going concerns rather than failed institutions which have been taken over by the government.

The RTC isn’t the only options there are at least two other viable options: Home Owner’s Loan Corporation (HLOC) or a Reconstruction Finance Corp (RFC).
The HOLC was established in 1933, under the Federal Home Loan Bank Board, to purchase and refinance mortgages. The HOLC acquired loans for two years and was wound down 18 years later. HOLC has several similarities to the refinancing program the Federal Housing Administration (FHA) is currently implementing. These programs were meant to support borrowers who could not refinance their mortgages, many of which at the time consisted of 5-year balloon loans. However, the HOLC exchanged a government-backed bond bearing 4% tax-exempt interest (less than prevailing mortgage rates) in return for mortgages, so that banks received an interest-bearing asset to replace the mortgage, albeit at a discount to the original value of the loan. By contrast, the current FHA program simply provides an outlet for borrowers to refinance into a government guaranteed loan once the previous loan has been voluntarily extinguished, also at a discount to the original value of the loan. While the risk borne by the government may be similar, the ability to purchase the loans would avoid some obstacles posed by loan-by-loan refinancing, though securitization is still likely to pose challenges.

The RFC was established in 1932 and by 1934 had purchased preferred stock from over four thousand banks. Unlike most preferred shareholders, the RFC also gained voting rights. The idea of an RFC-like approach would be to increase the level of capital in the banking sector and thereby expand the sector’s lending capacity. While most of the public discussion of remedies to the current situation has centered on how the government might purchase assets, the provision of capital to lenders may be just as important. To the extent that a program to purchase mortgage related assets is established, the sale of these assets is likely to crystallize losses and reduce regulatory capital. Some institutions would be able to absorb these losses, but others would either fall below regulatory minimums unless they are able to raise additional capital. Either way, the amount of credit these institutions would be able to extend would be diminished, with adverse consequences for growth. Providing capital would offset the significant slowing in lending now underway. From the standpoint of total credit available in the economy, providing capital that could be leveraged by ten times or so would allow the government to lend significantly more—through banks—than simply borrowing in the Treasury market and purchasing the assets directly.

Each of these three solutions presents an interesting alternative. The key in my mind is the process and structure the government uses to acquire these so-called assets. The most logical method would be to implement a reverse auction whereby the government could present a maximum bid (which should be something really low like $0.65 on the dollar) on a given type of asset, and accept bids starting with the lowest first until the predetermined capacity of the program is reached or the cap on bids is hit. I am a big believer that something needs to be done, something analogous to cutting off the leg to save the man type of thing.

Even though the pain in financials has been severe we must remember that financials are only a part of the bigger picture. The economic and market landscape has changed in some very important ways in the last few months. Much clearer signs of slowing in the non-US economies (particularly in the developed world) have turned what still looked at the start of the year like an environment where US weakness was dominant, to one with much more of the flavor of a global slowdown. The market has responded in two ways. First, it has downgraded non-US growth views relative to the US, pushing rates in many of the majors down relative to the US, fuelling a dollar rally and punishing equities with greater non-US exposure. Second, it has also for the first time traded across assets in ways traditionally consistent with a broad global slowdown, with commodities falling, equities underperforming bonds, cyclical stocks being hit hard, inflation breakevens dropping sharply, growth sensitive currencies being hit, and bonds doing well. My view has long been that what determines the resilience of non-US economies in US slowdowns has much less to do with the direct transmission of US weakness to the rest of the world and more to whether the underlying shocks that are driving weakness are local to the US or global in nature. And it is on that front that things have really changed.

In the early stages of the US housing market adjustment, the shocks hitting the global economy seemed primarily US-based – emanating from the collapse of the US housing bubble. The drag from this source has weighed on the non-US economy (the improving trade balance is a partial measure of how much the US has exported its slowdown to its trading partners). But much of the new pressure outside the rest of the world reflects the fact that over the last 12-18 months, a broader set of shocks has appeared.

In terms of housing vulnerability, the US, New Zealand, the UK and South Africa are already seeing real house price declines. Furthermore, within the Eurozone, Spain and Ireland have also seen house price depreciation. Although the price dynamics are less clear, China’s property market has also started to come under pressure after a long bull run. Parts of Eastern Europe in particular the Baltics, are showing sharp turns after having built up sizable imbalances. Much of continental Europe, Japan and many other Asian economies look less exposed.
On the terms-of-trade front, the split between commodity producers and consumers is clear. While the data does not fully account for the recent reversals in commodity prices, that conclusion over the last 12-18months is likely to hold even now. The biggest losers are most of North Asia (including China) and India, Turkey and the US. The biggest winners are Russia, Brazil, Malaysia, South Africa and the developed market commodity producers. These shifts have been dramatic in places, with a 43.6% rise in Russia’s terms of trade, and a sharp 24.1% decline in South Korea’s.

Looking at all these factors together, downside growth risk remains the most pronounced in the US, Japan and New Zealand. China and other NJA economies also face significant headwinds from a slowing global industrial cycle and negative terms-of-trade shocks, but there are important offsets from still generally healthy credit availability. For China and the Asian region as a whole, the underlying trend in Chinese domestic demand will be key, as external influences have flipped negative. On the other hand, the growth prospects look relatively better in several EM countries, including Brazil, Russia, Malaysia. Similarly, Canada, Norway and Australia may also have potential to outperform other G10 countries. The positive dynamics set off by earlier commodity rises are likely to remain supportive for growth in these markets for some time to come, even with the commodity pullback, as prices will still be generally higher than a year ago. With respect to asset prices more specifically, it is clearly important to differentiate between different asset classes. The relative growth outperformance of EM countries is likely to be most clearly reflected in FX space, where strong cyclical growth has been consistently rewarded. Local equity markets, on the other hand, and in particular those with commodity exposures, will be more influenced by spot commodity dynamics and global growth risk. This dynamic could well dominate local macro fundamentals, especially as long as we remain in a global deleveraging processing.

On the commodity front, The oil market is oversold, providing a compelling entry point, though near-term upside is now reduced Just as the market significantly overshot to the upside in the second quarter, it appears that the market has overshot to the downside and is now substantially oversold, as a combination of financial concerns, skepticism, and real and perceived demand weakness has pushed prices below the long-term economics of the industry.

The supply side of the market still remains severely constrained. As evidenced this past July at $140/bbl, oil producers raced to squeeze as much supply out of the system as possible, yet created only a very modest inventory cushion despite a substantially weaker demand environment. It is this lack of a significant inventory build in July followed by draws in August and a likely draw in September that is one of the key drivers behind a potential fourth quarter rebound in oil prices, as it leaves the market vulnerable to any type of shock. One of the more anomalous aspects of the recent market has been the deep level of contango that has persisted in the face of stock draws. The only dynamic that can explain this pricing anomaly is de-stocking, both physical (the stock of real barrels) and financial (the "stock" of paper barrels), which is just another aspect of the industry-wide de-leveraging that is taking place. The initial impact of physical and financial de-stocking is negative to prices as (1) physical players run down oil stocks to reduce working capital, they reduce their demand for physical prompt crude which creates a prompt contango in the forward curve, and (2) financial players sell out of paper positions to reduce credit exposure and/or cover losses. However, the medium- to longer-term impact of de-stocking to both price and volatility is explosive as it reduces the physical cushion and market liquidity to deal with any future supply or demand shock.

The argument against this vulnerability to a shock is that demand is weak and that any shocks are likely to only have a very small impact. The We weakness in demand has resulted from two transient drivers: (1) current Chinese de-stocking that resulted from forward buying in June and July ahead of both a shift in tax regime and the Olympics, which helped to create the surge in prices earlier this year (significantly overshooting even the bullish forecasts) and then the subsequent collapse to current levels, and also (2) the sharp decline in US crude oil runs due to the two back-to-back hurricane strikes on US Gulf Coast refineries. These two events, combined with financial concerns, largely explain the two-stage pullback in oil prices in the recent period. Using the diesel refinery margin as a proxy for Chinese demand for diesel, as most of the pre-August buying was in low sulfur diesel, the collapse in the diesel margin dragged oil prices from $145/bbl to $115/bbl, which was followed by a short period of consolidation. The hurricanes then struck, which knocked out a massive amount of US refinery demand, creating the second leg down from $115/bbl to $100/bbl and below that was exacerbated by the overlay of heightened financial concerns. This second leg down, however, widened refinery margins, which sets the stage for a rebound in prices once the shuttered refineries restart. While both of these events substantially reduce the current demand for crude oil, they do little to reduce end-use demand for refined products which remain much more stable. The recent sharp rise in prompt refinery margins around the world provides further evidence that end use demand remains stronger than refinery level demand.

On top of these transient negative demand factors, the market is trading with a very high level of skepticism, which has made the market moribund to nearly every bullish headline that has surfaced since early August – loss of Azeri crude oil (10 mmb), problems with Angolan platforms (15 mmb) and more recently real and substantial hurricane supply losses (a net loss of 56 mmb) and a dangerous escalation of civil unrest in Nigeria. Eventually, this string of events will be felt as demand rebounds in the fourth quarter against a small inventory cushion and very little spare production capacity; however, given the current trading bias, it will likely take a real physical catalyst that generates real physical demand to turn the market.

We are now nearly nine years into this current bull market in oil and have nearly no new supplies to show. This stands in sharp contrast to the 9th year of the bull market of the 1970s when Alaska, Mexico and the North Sea were all new projects in the ramp up phase with great prospects in front of them (see below). Today, try and name three new projects in the pipeline that have that same type of potential over the next five years (hint, it can’t be done). Without supply growth and continued economic expansion, demand will need to experience more and deeper adjustments that will only come through higher or more volatile prices in the future.

So what does this all mean for oil prices? I have not done enough research to predict with any level of confidence where prices will go, but I don’t think it will be down (or at least not much further). I know Goldman Sachs is predicted prices $125 by year end. While this could be possible it just says to me given the recent pullback in E&P players, it might be time to start acquiring (I know I have said this before, as prices have fallen further the argument has just gotten stronger). If any readers have any argument against investing in E&P players at these prices please let me know.

Not to cut this post short but I am tired of writing so I will quickly state some viewpoints:

Market will continue to be very volatile and will likely drop as crummy Q3 earnings are reported in October and November. There will be a pull back in select banking players as some have run up a little too much (i.e. WFC and maybe ZION). I would look to put money in wide-moat companies as the consumer will be dominating the news over the next few months. Pay particular attention to spending data, if the consumer pulls back we are headed for very-very tough times.

Sunday, September 7, 2008

A short tale.....

Every now and again I stumble across an interesting short. The key to good shorting starts with a top-down approach. First look around for the most hyped industry and then focus in the industry on finding the most overvalued company. Here is one example that has mostly played out but still has some room to run. One sector that I have particularly interested in lately is alternative energy. With the rise in commodity prices a ton of attention particularly in the venture capital community has been given to alternative energy companies. Let me preface this by saying I think there will be some truly great companies that come out of this recent push into alternative energy, but with all that money there is undoubtedly going to be some junk.

One piece of junk that I came across a while back is Zoltek Companies. The company makes carbon fibers that can be used in a variety of applications due to their lightweight, high-strength, conductive, and corrosion-resistant properties. Carbon fibers are most common in aircraft brakes, but Zoltek has been expanding their use by employing them in composites for wind turbine blades (i.e. alternative energy) as well as for use by the oil and gas industry. Zoltek has two segments: heat- and flame-resistant technical fibers (acrylic fibers) and carbon fibers (under the brand name PANEX). In 2007, to concentrate on its carbon fibers business, it discontinued its former specialty products unit. Founder and CEO Zsolt Rumy owns just under a quarter of Zoltek. Historically, carbon fibers have been used primarily for expensive specialty products because acrylic fibers (used as raw materials for carbon fibers) were custom made and expensive. Zoltek's process, however, uses less-expensive, textile-grade fibers, making the use of carbon fibers economical in more applications.

Zoltek had been driving down the price of carbon fiber and racking up losses in the hope that manufacturers would choose it over other materials. Despite price decreases, the company's manufacturing capacity continued for a long while to be under-used.

After experiencing tough business conditions in the aerospace market for its carbon fibers, new aircraft production at Airbus (the A-380) and Boeing (the 7E7) spurred much growth in the industry. The new aircraft went into production in 2006 and, as a result, Zoltek's carbon fiber sales nearly doubled that year. That coupled with a marked increase in demand for wind turbines allowed Zoltek to again double its carbon fiber sales in 2007.

Zoltek also has an agreement with BMW to supply carbon fibers for the production of structural components of a new series of automobile. Still years away from completion, the project is designed to produce a lighter-weight vehicle that allows for the use of alternative fuels. Zoltek projects the automobile industry will eventually provide the largest market for carbon fibers, though it says that development is still years from fruition.

All of these developments led Zoltek to restart a manufacturing facility in Texas in 2004 and then to make plans to add capacity to all of its facilities in 2007. (It increased production from two lines in 2004 to 18 in 2007.) That year it also acquired a Mexican facility from Cydsa that will provide raw materials to Zoltek's carbon fibers manufacturing plants. The positive trends have also led Zoltek to exit some of its traditional acrylic and nylon fibers businesses.
Zoltek’s carbon fiber blades compete with those produced by Toray, and Mitsubishi Rayon (which represent some stiff competition).

Now there is no question that carbon fiber is a strong light material that is a logical fit in both planes and windmills. The issue is it is very expensive and the price differential is too great for its implementation in most applications. That is the reason in case you were wondering why we don’t have carbon fiber mass produced cars.

The current consensus estimates on this company have revenue growing more than 40% his year and 22% next year. With earnings more than doubling from $0.76 to $1.75 in 2010.

Now this may be perfectly feasible if carbon fiber wasn’t such a substitute premium product. In other words I doubt their ability to further push prices without killing demand. Take this coupled with the fact that one of their key customers is the aerospace industry which is going through troubles of its own (strike at Boeing and slowdown in demand for new aircrafts). It is the perfect recipe for a short.
Recently there was decent write up on this company by Carlo Cannell of Cannell Capital a long/short hedge fund. Here is an interesting quote from said article. “Our biggest issue with the company is that they are saying different things than their customers are telling us. Zoltek says they’re completely designed into future wind-turbine plans at Vestas and Gamesa, but we hear from those companies that they’re pursuing other solutions, such as replacing some carbon fiber with glass. The dramatic expected growth would also require making inroads at other large wind-turbine manufacturers like GE, who currently use no carbon fiber at all and doesn’t appear to have any plans to do so.”

Another hit against the company is that they currently trade at 3x EV/R which is a multiple befitting a software company not a cyclical chemical company like Zoltek. Cyclical chemical companies usually trade at a discount to revenue so being generous we will assume that Zoltek given that it’s a “green” or “alternative energy” company should trade at 1.5x-2x ttm EV/R which would give them an implied valuation of $8.50 to $11.11 which is a full 35%-50% below current levels. These are quite attractive returns.

Another interesting quote from Carlo Cannell, “There are several added party favors here. Working capital management is terrible – they have over 100 days of inventory when they should have 20. Insiders are selling. The CFO has resigned and the SEC is investigating unauthorized payments made to third parties that he (CFO) may have been affiliated with. Good companies don’t have their CFOs resign for alleged wrongdoing and then make them sign an iron-clad non-disclosure agreement.”
So take this all together and you have what could be one interesting short.