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Why Apple Should Buy Twitter

Hey, maybe eBay should buy Skype! Oh... wait...

Amazon: Dirty Little Secrets Persist

Good stuff. I like the word "sophistry." And AMZN is still probably overvalued.


On Apr 08 11:02 AM sdt993 wrote:

> First, who uses book value to measure a growth stock, or any stock
> for that matter these days? With all the write offs and accounting
> changes over the years, book value is generally meaningless outside
> the financial sector where you need regulatory capital. The value
> of a stock is the NPV of future free cash flows. BV looks backward,
> not forward. Second, AMZN may have gone public in 1997, but it lost
> money on a GAAP basis every year until 2003, as you might expect
> with what was then a start up operation. BV bottomed at -$1.4B in
> 2002 and has since grown to +$2.7, up $4.1B in the 6 years since
> it has been profitable. Third, share count has risen from 403 in
> 2003 to 436 at year end, up 8% over the period. Hardly a disaster.
> Where did the cash go? Gee, lets check the cash flow statement and
> balance sheet. Debt down from $1.945B to $.4B so thats $1.5 of debt
> paydown since 2003, Cash/Short term investments have gone from $1.3B
> to $3.7B, up $2.4B. SHare repo - just $.6B, not very much. Total
> CAPX since 2003 is just $1.1B and acquisitions about $.7B. So, total
> CFFO since 2003 is $5.5B, and i've just accounted for $5.6B. There's
> the answer to your big mystery. Your comments on fixed costs are
> borderline insane. AMZN turns its fixed assets 23.5X per year ($20B
> sales/.850 fixed assets) vs. 4.3X for WMT and 2.6X for TGT. There
> IS a short case to be made on AMZN, but this article is pure sophistry.

In Memory of Greg Newton

You will be missed!

Lessons Learned from Leverage

Great set of thoughts. Agree wholeheartedly!

Citigroup Float May Experience Dramatic Upside Velocity

Less float means "directional velocity?"
I'm not sure if the comments about this being a good theory are sincere or sarcastic.
But I agree with you. Citi's stock price will certainly have directional velocity once the reverse stock split.
However, I probably disagree on the directional part of "directional velocity."

Bank Nationalization: 5 Different Meanings

Interesting post. I think in Scenario #2, not sure that simply because the bank is 80% owned by the gov't it is consolidated (there is a different GAAP -- generally accepted accounting principles, for the gov't). More importantly, even if it is consolidated (would be weird), the Federal gov't is under no obligation to guarantee bank debt. They might, but under no obligation are they forced to simply because they own anywhere from 80% to 100%.

One thing to be cognizant of is that if the government takes over a financial institution, it can wipe out the equity holders. This constitutes the common equity and traditional preferred. Anything senior, however, like trust preferreds to bonds, to depositors, have varying degrees of legal protection that are protected by contract law and the federal bankruptcy code, namely Chapter 11 in a reorganization.

FYI, I read Fannie and Freddie prefs are still trading, but have not confirmed.

With Wells Fargo's (WFC) Friday dividend cut, 2009's total vaporized dividend income for S&P 500 firms ($40.8B) has already surpassed all of 2008 ($40.6B). "Dividend cuts make investors that much poorer, compounding the decline in their stocks' value and adding to the 'reverse wealth effect' in the economy," Tom Petruno writes.

I think the dividend cut is a good idea. After all, none of the banks are given "credit," or valuation support for dividends.

Cut 'em, and conserve tangible common equity. It commands a very high premium. I could even argue it is the patriotic thing to do. At least until the balance sheets are viewed as healthy.

We Cannot Afford to Wait to Recapitalize U.S. Banks

Astute observations in taking a look at the Trust Preferreds of the "major" US banks. I've been following these pseudo-equity instruments for some time.

The preferreds are issued by a trust. The trust then owns junior subordinated debt issued by the bank, or subsidiary of the bank (but often supplemented with a guarantee by the bank's parent company). So the actual public (or street facing) securities aren't debt per se.

Additionally, another risk, apart from bankruptcy, is that these trust preferreds collect their dividends off of any monies that are paid to the trust via their investment in the junior subordinated securites. (I realize this may sound complex, but think of the trust as a simple pass through entity). The actual risk is that the trusts do not collect the moneys because they can often be deferred. If one is investing in these securities, one should know if the dividends are cumulative or not. If they are not, it clearly explains one major reason why they are trading at a discount. (Think zero coupon bond!)

Finally, the possibility that there is no intrinsic value in these securities does exist. The value they have really is the product of a binary outcome. They are either worth par (eventually), or they have to power to drag a bank into bankruptcy. Traditional plain vanilla preferreds do not have this power. And obvious common does not have it at all either.

I've often thought that the government should purchase these securities, at a discount, and convert them into common equity. It would take care of the some of the Tier 1 equity calculations, lower interest costs, and "delever" the financial institutions.

These instruments are VERY interesting currently. But because the market is giving them a 20%+ does not necessarily mean that it warranted. Or maybe it is. Time will tell.

Is It Time to Abandon the U.S. Dollar and Go for Gold?

Right now, it absolutely would be the worst move to switch to gold as the base for the USD. The USD is amazingly strong and resilient.

The proposed solution discussed only makes sense if the USD lost buying power. The reverse is happening!

I honestly don't think we are going to see inflation anytime in the short term.

Automotive Depression: Government Needs to Let the Weak Fail

Philosophically I agree with the thesis in this piece.
Practically I also agree with the thesis in the piece.
The problem, I believe, isn't the economics of the US auto manufacturers, it is the workers themselves. Since the current administration is relatively pro-labor and pro-union (vs. the previous administration), I believe propping up the US manufacturers is an attempt to ensure that the retirement/pension/hea... benefits continue. US automakers paid very lavish wages and provided the best benefits up until recently. Many of the obligations to retirees continue to be funded by GM, Ford, and Chrysler. If these companies filed for bankruptcy, they would be off the hook (i.e. they would settle these liabilities for cents on the dollar) for providing these benefits.

These benefits are just like debt. They impair the value of the US automakers' equity.

The good times are over. Let them file, and reorganize as nimble competitors, making truly great cars. There was once a time...

What to Buy: Debt

Having substantial experience in investing in debt, specifically distressed debt, I have the itch to opine on this piece.

Debt, like equity, is far from a monolithic investment class. Actually, I take the philosophical view that everything is debt, and either you get paid back your principal (i.e. initial investment) and some interest (i.e. dividends, interest payments, capital gains). There is debt that trades like equity (often distressed, and quoted out of 100 on Wall St.), and equity that has most of the characteristics of debt (think utilities that have stable cash flows, and that are not overly leverered).

This is more the case now than ever before, given how the capital markets have traded recently. The traditional moniker of "investment grade/high grade" vs. "junk/high yield" are not clear lines of distinction. Often, there is debt that is what I call "cuspy," and has an interesting yield that makes it quasi high grade/high yield. It blurs.

What has historically made these distinctions important was the class of investor, not the investment itself. There are mutual funds and insurance companies that could only invest in agency rated investment grade debt. While I could go on a whole tangent about how effective the agencies are at this, I'll refrain. (Perhaps in my blog one day!)

The names you listed above, for the moment, do not seem to be distressed, at all. They seem like sound companies that have adequate cash flows. Cash flows, in reality, are all that matter. Both for debt and equity.

Cash flows for debt, however, are a bit more important, because it tells us (according to legal documents known as indentures or credit agreements) if the debt is current, and clear of violating covenants. Basically, it is somewhat black and white -- either you are paying your coupons on time, and don't have too much debt, or you are not. Equity, on the other hand, has no such obligations. The company can increase or decrease its leverage, and the average equity holder has no say in the matter.

So how does one figure out of the corporate credit is worthwhile using cash flows? Easy (at least conceptually, the actual exercise involves a bit of analytical work). Take a companies net income (as reported), and add back non-cash items (e.g. depreciation and amortization), add back tax (because interest expense is often tax deductible), and add back interest payments. Also, for analytical purposes, add back "one time" expenses (e.g. restructuring costs, noisy/dirty/weird stuff, etc.)

This measure is often called "EBITDA" by Wall St. It was invented by Drexel Burnham in the days of high yield. It is basically the clean(est) cash earnings of a company regardless of how it is financed (i.e. debt vs. equity).

Take the EBITDA, and deduct capital expenditures (costs associated with maintaining the property, plant, and equipment -- think of the plant costs that are required to run a factory, like a new machine). Make sure the capital expenditures are "steady state" or "maintenance." This means don't include any capital expenditures required to grow the company, like an extra machine to make more widgets.

This EBITDA less Capex formula is a magic number in many ways to debt investors. This is the cash flow that can be used to make cash coupon payments. If this number is not much higher than interest expense, then there is risk. If the number is multiples higher, as they often are in investment grade companies, then the debt is often viewed as low(er) risk. This is all a rule of thumb. Bear in mind I'm only giving the basic fundamentals, not all the dirty details behind the numbers.

In addition to that exercise, other things to be on the look out for is "seniority" of the debt. The more senior it is, the more likely it is to get paid its principal back. Finally, the maturity profile is the third main component (from my perspective). It is possible to invest in junior debt that has a higher coupon than more senior debt, but have it be "safer" because it comes due before the senior debt, and hence less risky in some ways.

Anyway, investing in debt is great if one picks up these things first. The nuances are what makes it an art vs. a science. Just like stock picking... but in some ways the requirements to be precise invite greater demands on the analysis.

I agree now is a fantastic time to be looking at debt. Barring WW III or some nuclear devastation, we are looking at some fantastic yields. I understand that risk free rates will rise in the future in order to keep inflation in check, but I'd imagine the prices of these debt securities will risk, dropping the yield, but increasing the capital gains (which is VERY nice).

Go forth and invest. But invest safely!

The Future of Investing

Just wanted to add my 2 cents.
Equities won't stabilize until the banking system stabilizes, and the banks can lend again on a proper risk/adjusted basis.
Once that happens, corporate bank debt will stabilize (investment grade) along with investment grade bonds. Then leveraged debt (bank & bonds), then equities.

Absolute priority, in theory, must hold. How can you pay an owner before paying the lender? It's like saying I'd buy a house's equity while the mortgage is still underwater. It doesn't make sense to me.

What's Good for Citi - And What's Good for America

In a pure, free-market system, I would agree with the points outlined above. But the reality is that the United States is not purely free market. There are times in history, and there will be times in the future, where the gov't will have to intervene to support private enterprise during a crisis of confidence.

Do I (or any other ardent investor in the markets) like this? Well no. And yes. I realize this sounds tongue-in-cheek, but we are in a time where it practicality needs to triumph ideology. As painful as it is for me to admit, I believe the same applies to economics as it does politics.

The gov't intervention is not save shareholders or creditors, it is to save depositors and all the counterparties that would be adversely impacted by a liquidation of Citi. Many argue that the Chapter 11 filing of Lehman Brothers pushed the global economy into further weakness. Maybe it did, maybe it didn't -- but a failure of Citi would have far and wide reaching repercussions that would dwarf any impact Lehman has had on the global financial system.

I clearly don't like where we are in this nation's banking system, but it does seem to function during non-turbulent times. The problems arose from risk management (or lack of) and easy liquidity. Few, if any, foresaw what a reversal in global liquidity would do the global economy.

Now there will some that will have to pay for this. Berkshire, with its stellar and pristine balance sheet (relatively), is paying a price from a Firm (or "Enterprise") perspective, but I'm quite confident its shareholders are happier vs. Citi's shareholders. This is the equity mindset. This is where the highest risk should be.

The gov't backstop of the nation's largest banks arguably removes risk from depositors and creditors. Some of this creditors (likely the most junior) are going to benefit from this, but in the end, this is chump change compared to the value destruction seen in the sector overall.

So yes, it is not fun to be Berkshire right now competing with Citi when it comes to funding costs. But this is not for the benefit of Citi's shareholders. Clearly. A stock price chart would tell anyone that. The moves that are made by the gov't are for all Americans interests, as well as those beyond these borders.

One thing I can say, with some level of certainty, is that if Citi filed for Chapter 11, or was rushed through some liquidation process, Berkshire's stock price probably would trade down further. That's simply lose/lose. Who wants that?

The moves made by the gov't are currently the decisions they feel to be the best given the current situation. And as far as I can tell, they seem to be reasonable and sound. And they are looking to stem the loss of confidence in this nation's banking system. That, my friend, has value that isn't measured in any one company's stock price alone.

It's Not a Credit Crunch, It's a Deflation

David, excellent piece. I agree with you wholeheartedly in many, if not all, of your points. Because of this massive deflation, I believe gold is quite overvalued. (USD/Gold trading in tandem makes no sense to me.)

As far as your comment regarding intrinsic value of money... I perhaps disagree there. The intrinsic value is what it is. It buys whatever the capitalist market allows it to buy. If anything, during a deflationary period the value of this money increases.

It seems like it just comes down to basic Economics 101.

One question I have, if you believe we are in a short to mid term deflationary environment, does it make sense to go long equities? Revenues (price x quantity) are likely to decline, due to reduced pricing (deflation) and reduced quantity (higher unemployment, reduced exports due to USD strength, etc.). However, the implicit discount rate (i.e. the cost of capital) applied to these revenues has shot up sky high (which, in my opinion, is the only mitigating factor to go long equities). I do understand that the cash cost component is likely to fall for firms that have highly variable cost structures. Still, this does not portend well for equities.

Great piece, once again.

Bond Expert: Friday Wrap

The market has definitely become a lot more complicated. To be honest, I am not comfortable prognosticating on Treasuries. Could there be a bubble? I would have said yes 2 months ago. Now? Hard to tell. I understand the need for liquidity is great.

The fact that the curve has steepened makes sense. Who in their right mind would lock in a return of 3.5% for 10+ years?

Corporate debt is extremely interesting. High quality investment grade debt, while sold off, is probably a better place to "park" excess cash, given how spreads have widened. It's the reverse of 2006/2007, in my opinion. Some spreads to "risk free" rates are just too wide.

Personally, highly leveraged loans of LBOs and other highly levered companies are trading on recovery value (i.e. "equity") vs. yield. The beauty is that it is structured like a free call. If the company pulls through, great... there is substantial capital appreciation as well as collecting a nice coupon (which would have a good current yield).
Doesn't pull through? Convert to equity and enjoy ownership in a newly reorganized company with much less debt.