Eric Boughton_

Salesforce.com: Making Good Results Better

Marc Benioff? Take his eye off the ball? You mean the Marc Benioff who talks like a teenager selling snake oil, pronounces 'huge' 'heeee-uge', and uses variants of the word 'exciting' on a conference call 15 times? Little chance of that! :-) What a clown.

The 'Junk Stock' Rally

Speaking of a 'junk rally', here's a fact: had you purchased the lowest-priced decile of all Russell 3000 stocks as of March 9th, equal-weighted, you would have had a 423% return through September 30! No joke. Had you simply pulled all 3000 (roughly) tickers, sorted by closing price on March 9th, and bought just $100 worth of each of the 300 lowest-priced stocks, your $30,000 investment in this diversified portfolio would have been worth $157,000 on September 30. Regret, anyone? Anyone think there might be some short candidates on that list?

Why Shorting Amazon Is a Bad Idea

Richard, I am short Amazon, and I fully respect your decision not to short Amazon. However, I will take issue with one of your basic points: "Betting against richly valued stocks is very seductive, because they are so easy to find..."

Richly valued large-cap stocks are absolutely not easy to find. Let me run a question by you: How many $3 bln mkt cap US-domiciled companies have both a PE above 30 (not a really high bar) and a price-to-book multiple above 3? Answer: 29. How many $30 bln mkt cap companies have both of these characteristics? Answer: precisely 2, namely Apple and Amazon.

Why does it matter that they are large-caps? For a short in richly-valued stocks to work, the law of large numbers must come into play before, in your words, the earnings have "time to grow into the stock price". Those, like me, who short ridiculously valued large-caps have the odds overwhelmingly stacked in our favor, because the odds of the company significantly increasing its earnings BEFORE the market assigns a fair DCF value to the stock are quite low.

And a return to fair value just creates your garden variety successful short; the real 'juice' happens when the company stumbles, like so many well-regarded companies eventually do.

Plum Creek Timber Saws off Excess Supply, Grows Profits

A "$900MM liquidity base ready for the tapping", eh? Where have I heard that before? Oh, yeah, from a bunch of over-leveraged financial firms. ("We have plenty of liquidity," Mozilo said. "We're in very good shape." -9/7/07)

But, of course, since PCL is not a "financial" firm, we shouldn't worry that its $2.73 bln in long-term debt is 5.9 times its FY08 EBITDA, and 6.5 times its FY08 operating cash flow, right? Nor should we worry that PCL generates the vast majority of its "operating" earnings merely by selling land. For example, in the first quarter, PCL made $29 mln in operating profit on selling timber, LOST $13 mln in operating profit on their manufacturing businesses, and made $173 mln operating profit on selling land. That's 92% of operating profit from a completely non-recurring area! The "selling timber" profit didn't even come close to covering the quarter's $38 mln interest expense!

Given these facts, we should probably not worry about whether PCL’s profits are sustainable over the long term, right? I mean, they can continually find land which is worth a lot more than they paid for it, right? Land markets are probably grossly inefficient, and PCL execs are the smartest operators in the world, right? The fact that the majority of PCL's land was purchased in the last 5 years doesn't matter, does it?

For those thinking of PCL as a REIT, consider also that there is a major difference between the earnings reported by other REITs, and PCL. Other REITs depreciate their property (buildings), usually on 30-year schedules. Since buildings don't really depreciate that quickly (unless they are constructed poorly), and in fact can be expected to appreciate slowly as long as they are maintained, other REITs' reported EPS is arguably understated. Not so with PCL: it depreciates NONE of its land, and so its EPS is certainly not understated. This makes PCL's 29 multiple on 2010 earnings just as ridiculous as it sounds.

In a nutshell, each and every year, PCL is making less and less money (and losing money some quarters) from what I would consider its “core” businesses: a) cutting down trees and selling them to saw mills, and b) manufacturing high quality lumber products. Each year, it is desperately attempting to make up for this by selling off its best quality, highest value timberland to real estate developers. When doing so, it is cherry-picking the land it owns at the lowest cost, in order to maximize reported earnings! Eventually, there will be nothing left in this “bag of tricks": the value of PCL's forest land will be judged on its own ability to generate sustainable cash flows. Unless lumber prices once again rise to their bubble levels of early 2004 (or PCL gets lucky and finds "greater fools", like university endowment funds, to buy its land at silly prices), equity holders of PCL are likely to be unhappy with the value of their stock when that happens.

GDP Numbers Are Not Making Sense

I hate to have to defend government statistics, but I must.

Ed, you've made a simple, but understandable error in confusing "real" GDP with "nominal" GDP. Nominal GDP is the dollar value of final goods and services. Real GDP is this value, but adjusted for inflation (as measured, quite inaccurately, by the government).

The numbers you cite for GDP are nominal: the exact nominal numbers, per bea.gov , are:

12/31/07: $14.0312 trillion
3/31/08: $14.1508 trillion
6/30/08: $14.2945 trillion
9/30/08: $14.4128 trillion
12/31/08: $14.2003 trillion

During 2008, therefore, nominal GDP had positive growth of 14.2003 / 14.0312 - 1, or 1.2%.

However, when you factor in the idea that some portion (it turns out greater than 100%) of this apparent economic growth was simply due to the devaluation of our currency vs. "real goods and services" (aka inflation), then you come up with a different answer. This is real GDP.

What inflation numbers are used? The answer lies in another government release called the "GDP price deflator", also released by bea.gov. This deflator had the following values:

12/31/07: 120.7
3/31/08: 121.5
6/30/08: 121.9
9/30/08: 123.1
12/31/08: 123.2

Total inflation, for GDP calculation purposes, during 2008 was therefore 123.2 / 120.7 - 1 = 2.1%.

Taking 1.2% - 2.1% therefore will give you (very roughly) full year 2008 real GDP decline of 0.9%.

As for how this all gets filtered through to the quarterly numbers reported by the BEA and most WIDELY cited (for example, the "-6.3%" in the fourth quarter), they are actually reporting quarterly, but ANNUALIZED changes in real GDP. This is pretty complex, but let me lay it out for you.

First, let's get quarterly REAL GDP values by dividing each quarterly nominal GDP data point by the deflator listed above:

12/31/07: $14.0312 tln / 1.20743 = $11.6207 tln
3/31/08: $14.1508 tln / 1.21508 = $11.6460 tln
6/30/08: $14.2945 tln / 1.21890 = $11.7274 tln
9/30/08: $14.4128 tln / 1.23056 = $11.7124 tln
12/31/08: $14.2003 tln / 1.23244 = $11.5221 tln

OK so far? Next we take each sequential real GDP difference and derive a percentage change. This would be "raw quarterly change in real GDP". If positive, it would indicate the BEA believes there was more "real" economic activity in that quarter than in the immediately prior one.

1Q08: $11.6460 tln / $11.6207 tln - 1 = +0.2177%
2Q08: $11.7274 tln / $11.6460 tln - 1 = +0.6990%
3Q08: $11.7124 tln / $11.7274 tln - 1 = -0.1279%
4Q08: $11.5221 tln / $11.7124 tln - 1 = -1.6248%

As sad as it is, we are not yet done with the math lesson. For their headline report, the BEA would like to make sure they annualize the quarterly number. "If the next four quarters are exactly as bad / good as this most recent quarter, then what would be the total growth / contraction in real GDP?" is the question they are trying to answer.

Essentially this means multiplying the numbers by 4, BUT we must be more precise by adding 1, raising to the fourth power, then subtracting 1. (Compounding, you know...)

So at the end of this tortuous road we have:

1Q08: (1 + 0.2177%)^4 - 1 = +0.9% (all rounded)
2Q08: (1 + 0.6990%)^4 - 1 = +2.8%
3Q08: (1 - 0.1279%)^4 - 1 = -0.5%
4Q08: (1 - 1.6248%)^4 - 1 = -6.3%

And this is what gets reported. For the full year, the BEA believes real GDP declined by:

(1.002177)*(1.00699)*(... - 1 =
-0.8485%, even as nominal GDP increased by 1.2052%.

I hope this has helped you understand published government numbers better. I agree with various posters: these numbers are:
1) Subject to large revisions.
2) Increasingly divorced from reality on the inflation side, as the government increasingly attempts to hedonically erase the inflation that is happening.
3) Increasingly divorced from reality on the "value of goods and services" side, as "value" is counted quite generously... every serial bundling of a crappy mortgage into a new leveraged CDO, for example, adds to GDP!
4) Increasingly unhelpful in determining "how we are doing" as a nation.

However, the one good thing we can say about government statisticians: the math does work, and is self-consistent! You just have to take the time to figure out how everything relates.

Time to Buy the Homebuilders

A few problems with your analysis, Herb. First, the U.S. Census Bureau estimates that U.S. population grew by only 2.8 mln people between 7/1/07 and 7/1/08. (www.census.gov/popest/...)
Second, even this data is fraught with potential errors, with extremely limited data on net migration leading to reliance on extrapolative techniques.
Third, the net movement of people from single-family houses into multi-family dwellings, which may be starting and may persist on a secular basis for quite some time, could offset any population growth.
Fourth, the total number of families owning multiple houses is likely to decline for some time as well, offsetting new home construction.
Fifth, when viewed over a long period of time, the average age of houses is lower than normal.
Sixth, from about 1997-2006, the total number of new homes was far in EXCESS of the number demanded purely by population increases. So, why would we think population changes going forward over the next 10 years would be at all correlated with the number of new homes built?
Seventh, specifically related to your bullish position on homebuilders, homebuilder stocks are, by and large, already pricing in the return of demand, and the ridiculously high margins achieved at the peak of the bubble. For example, consider TOL. During its best twelve months (5/1/05-4/30/06), TOL achieved $6.4 bln in sales, $1.4 bln in operating income, and $870 mln in net income (approx $5.15 per share with adjustments). This was a 22% operating margin, and a 14% net income margin. Consider, however, that from FY94-97 ("normal years"), TOL's operating margins averaged 14% and NI margins 7%. Which is more representative of TOL's business over the coming decade? You can have your opinion, but mine is that the 14% and 7% are much more likely, and in fact that 10% and 5% would be likelier still. The opulence of the past 20+ years is gone... for good!
In any case, assume for a moment TOL generates a revenue run rate 25% HIGHER THAN its trailing twelve month sales (so from $2.7 bln all the way up to $3.4 bln). Keep in mind, that would EXCEED their average annual sales in 2003-2004! A generous assumption, to say the least! By comparison, analysts expect only $1.6 bln in sales in FY2011.
Now, apply, say, 6%, net income margins to the $3.4 bln, and you get $204 mln of net income. That's a PE of 15.8, several points higher than the S&P 500! With a bunch of generous assumptions. Clearly, the market is already banking on quite a turnaround.
I use TOL as an example simply because it is one of the least leveraged of the homebuilders. Clearly, with several other homebuilders where bondholders own more of the company than shareholders do (9 of the 17 homebuilders I follow have net debt in excess of market cap, and only 3 have investment-grade (BBB-) credit ratings.), the stock represents much more of a call option on survival. Good luck with those!

Understanding the Complexities of General Growth Properties

Todd, I appreciate your efforts in attempting to determine the value of GGP equity. However, the rationale behind your belief that assets exceed liabilities at GGP is highly flawed. Specifically, your argument rests on the extension of the price per square foot offered for a few higher-value properties to GGP's entire mall portfolio. It is unlikely that such an extension is in any sense reasonable.

The question of "ultimate value" of GGP's assets is an open one, of course. However, it would take a fairly low discount rate applied to expected rental cash flows on GGP's mall properties over the next, say, 5 years, to come up with a present value answer exceeding $30 billion. Such a low discount rate is not likely to be applied by any investor with actual cash to invest. You implicitly admit as much by saying

"The sudden supply of properties without bidders (loans still are very tough to get) would mean they would have to be placed on the market below "fire sale" prices"...

Think about what you are saying. You are saying that a LOAN would be required in order to get a bidder. But, in fact, there are many investors with "actual cash" to invest. Why aren't they offering $30 billion plus for GGP assets right now? Almost certainly because the present value of those future cash flows is, in their mind, lower than $30 billion.

Now, there may indeed be a rational investor who believes the present value of GGP property cash flows over the next TWENTY years exceeds $30 billion. Ackman may be one of them. But, consider that his ownership of GGP debt means that he can win (and win big) even in a Chapter 11 scenario which completely ELIMINATES the equity!

Ultimately, I agree with throbulator: The debtholders will own GGP in (essentially) its entirety within a year. The size of the bone they throw to current equity holders does not have to be large, and could be zero depending on the opinions of the bankruptcy judge. Debtholders who bought the bonds at $.25-.30 on the dollar will therefore experience a positive return IF the value of GGP mall properties turns out to be greater than $10 billion. I think that is a (relatively) safe bet, which is why I have made it.

What the Economy Needs Is a Helicopter Drop

"The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government."...???????...

I have a proposal: "NFL's Detroit team is atrocious this year. Why don't they simply trade all their bad players to the Lions?"

What exactly is your fairy tale conception of "the government"? Is "the government" some kind of disembodied entity floating above the troublesome entanglements of debt and solvency? Isn't the government, at the end of the day, all of us, and all of our descendants? Isn't the government merely the sum total of all the consumers, present and future? The proposal you make, like ALL the proposals of the past several decades, would accomplish, simply and precisely, the transfer of what should be our own debt burden, with its simultaneous augmentations (via interest and foregone investment), to our children and grandchildren. Along with Bernanke, Paulson, etc., I say you are making an IMMORAL proposal: one that only a chicken, only a whining, sniveling worm of a person, would make consciously. I don't know you, and I hope that you are motivated by ignorance, not by a desire to foist your own obligations onto others, but I also hope you come to understand your proposals in this proper light. America can not long survive with proposals like yours.

Bernanke's 'Shock and Awe' Monetary Policy Less Than Convincing

You imply this is another "bubble clean up mission"? Since when did providing more booze help a drunk clean up?

NAR Existing Home Sales Report: Bait and Switch Headline

This is the same NAR which has sponsored TV ads recently touting homes because "prices double every ten years". Even leaving aside recent housing market weakness, none of the data I have seen agrees with this claim. I have e-mailed NAR for support, have been promised a response, and have yet to hear back.

Bill Miller on Crises, Past and Present

Market observers who failed to recognize any sort of "top" (like Miller) are unlikely to have any valuable insight into a "bottom". Fundamentally, Miller does not understand the business and financial environment in which he is "investing" today, which means that his estimates of the long-term intrinsic value of securities are likely to have little relation to the true intrinsic value of these securities.
In a way, his apparent lack of understanding is surprising, given his obvious intelligence and investing experience. However, it seems to me that one of his key weaknesses has been his inability to recognize that the twenty-five year cycle of continuously expanding credit (engineered by the Federal Reserve, and by cooperative public companies and the American people) contains within it the seeds of its own collapse, and that there is a high probability that it is now irreversibly collapsing.
Unfortunately for Miller, whether this probability plays out over the next few years, or whether further profligacy by our politicians and central banks manages to reflate the credit bubble for a last hurrah, he will probably not survive through the turbulence. I anticipate his various funds will experience dramatic outflows, forcing him to sell into a falling market, and further harming his mark-to-market performance. It will be a little sad to watch, actually, but I will enjoy shorting Amazon as he is forced to sell it.

Corporate Bond Spreads Nearly at All-Time Highs

"All-time highs"?! Applying the moniker "all-time" to data going back only ten years is akin to declaring yourself the "world champion" after winning your school's spelling bee. Let's be accurate here: corporate bond spreads have been quite a bit higher during periods prior to the past decade.

Last 25 Years - Most Stable Economy in U.S. History

Thanks for this extremely interesting chart. I believe that a fair portion of the noted decline in economic volatility is due to the fact that the methods of measuring economic activity have changed steadily since 1900. Many indexes (most notably CPI, but also many other indexes of economic activity) which go into the calculation of GDP are now "seasonally adjusted", "hedonically adjusted", and otherwise "smoothed". The farther you go back in the history of economic measurement, the fewer such adjustments you will find have been made. Therefore, regardless of the underlying volatility of the economy, one would "discover" reduced volatility today.

That having been said, I do think the general trend is correctly identified: economic hard times are less frequent today, as evidenced by non-adjusted factors such as bank failures, (certain) unemployment measures, etc.

An interesting question is of course whether this is a sustainable development. If pressed, I would conclude that it is not: that economic activity will go through periods of higher volatility for some 25-year stretch in the next century. I may even be around to see it!

First Federal: Soon-To-Be Sub-Prime Lender?

Thanks for the post, Tim.... there is even more to the story.

At first glance, this is a sleepy community bank with 32 branches, founded in 1929. A closer look reveals dramatic acceleration in mortgage loan production between 2003 and 2005, as the bank more than doubled total assets with almost no growth in branches. What’s more, these loans have characteristics which we see as huge dangers for the company.

1) FirstFed operates in an area where home prices are at record levels, based on any metric. In many California communities, the median home price is 6-7 times the median income, compared to 3.5-4 times nationally, and 2.5-3 times five years ago. Our thesis is that many borrowers, even those deemed good credit risks, will walk away from their homes if and when home prices fall substantially.

2) 90% of FirstFed’s loans are ARMs. FirstFed has positioned itself as “the” ARM source in Southern California. As the falling originations highlight, this is great when option ARMs are popular, but can dry up pretty quickly.

3) 80% of loan originations in 2006 were 40-year mortgages, another sign of a stretched consumer desperate to minimize a monthly payment. A longer mortgage period means lower payments and more opportunity to default.

4) Many of FirstFed’s loans have negative amortization features. Aside from the increasingly evident risk that borrowers will have to default as soon as the rate resets, negative amortization in FirstFed’s case means that operating cash flows are consistently negative, even though EPS looks healthy. (BKUNA is another name we are short for the same reason.) There was $216 million of neg-am included in 12/31/06 loan balances.

5) As you point out, half of the loans on FirstFed’s balance sheet are “liar loans”, with either no income or asset information requested, or no verification of the borrower’s stated financial situation. An additional 33% are “SIVA”, with assets verified, but income not verified.

6) FirstFed gets half of their loans from wholesale loan brokers, meaning there is much more room for the “predatory lending” Congress is currently whining about, and also meaning that FirstFed can easily be misled by fraudulent brokers, who seem to come out of the woodwork in a downturn.

7) FirstFed seems to have under-reserved for problem loans. Non-performing assets jumped from 0.05% of total loans at the end of 2005 (absurdly low) to 0.23% at the end of 2006 (still lower than most banks). FirstFed also has NO valuation allowance for impaired loans, relying on SFAS 114, which they read as not requiring a valuation allowance for loans under $1 million.

8) FirstFed finances loan production with high-cost and “flighty” CD’s. In fact, they are one of the largest internet advertisers of high CD rates. This makes perfect sense—after all, one can hardly expect $1.5 billion in “sticky” customer deposits from only 32 bank branches to support $8.5 billion in loans! This may be a great business model when there is a high interest spread between CD’s and mortgages, and when defaults are low--neither is the case today.

9) The average FICO score for FirstFed borrowers in 2006 was 714, solidly in Alt-A territory. When an Alt-A borrower tries to afford a “prime” house, the borrower may as well be sub-prime.

10) To top things off, FED has seen high insider selling recently.

Full disclosure: our hedge fund is short this name.

Three Closed-End Funds of Funds

Interesting finds, George. I run a hedge fund that applies the strategy of buying closed-end funds at discounts to NAV, so I am pretty familiar with this area. Every single one of the closed-ends we bought in 2006 (about 30) saw its discount to NAV narrow (or disappear) by the end of the year. Intriguing possibility that the tail end of that could have been due partially to FOF. (Our hedge fund, Matisse Income Fund, is up 23.5% (net after all fees) since inception October '05.)

We have also seen a number of activist hedge funds purchase closed-ends at discounts, then sue the company to 1) convert to an open-end (discount disappears obviously), or 2) buy back shares at close to NAV. One typical example is Karpus, and their involvement with IMF. Our hedge fund is currently only $12 million, so we don't quite have the size to push the closed-end boards around like Karpus can.

Wanted to point out your "double discount" calculation on ADX is a bit misleading, however, given that PEO only makes up about a 5% position in ADX. Taking that into account, the net "look-through" discount on ADX only goes up to about 14%.