- 0:55 - How the fallout from FTX led CashFlow Hunter to presciently short Silvergate (OTC:SICP) and Silicon Valley Bank (OTCPK:SIVBQ)
- 8:00 - Rules for shorting stocks; never short based on valuation
- 14:00 - Banks tightening; harbinger of recession?
- 24:00 - Iris Energy (NASDAQ:IREN), renewable energy and Bitcoin mining
- 35:00 - 3M (NYSE:MMM) as a high conviction play
- 47:00 - Energy picks, pipeline companies
Recorded on May 20, 2023
Check out Kirk Spano and CashFlow Hunter's Investing Groups:
Kirk Spano: Hello. This is Kirk Spano with Margin of Safety Investing on Seeking Alpha. And I'm here interviewing CashFlow Hunter today, who has had some very interesting calls over the last year. He currently works at a hedge fund, and is sharing his picks and some of his trades with folks in his service, CashFlow Hunter [Catalyst Hedge Investing]. And I'd like to welcome him today. How are you doing?
CashFlow Hunter: I'm doing great. Thank you for having me.
KS: Fantastic. So I want to jump right in here with banks. You had a short on SVB about three or four months before it tanked. And a lot of people noticed that, especially when it got into the news. Why don't we do a quick review of that before we move into a whole bunch of other exciting topics? Why don't you breakdown how you had an idea that it was going to have some problems?
CH: So I was following bitcoin's demise last year pretty carefully. And when FTX blew up, I was looking for what some of the fallout from that would be. And I saw that they had a very large account of Silvergate (OTC:SICP). And I said, okay, that's bad for Silvergate. And Silvergate also had a big network that they call the exchange network for trading cryptocurrencies, which I thought would also decline in value. So we're actually -- I was actually short Silvergate.
And I started looking around -- and one of the things that was good about Silvergate as a short is that they'd had this very rapid growth in deposits, thanks to that crypto currency exchange network. And not only were they going to lose a deposit from FTX, but I thought that they could lose a lot of deposits coming out of this crypto exchange network.
And what they had done with that rapid growth in deposits -- when I say rapid growth, I think they've gone from like $2 billion in deposits to $14 billion over the course of like two years or something, like insane growth in deposit base for a bank, is that they bought mortgages, mortgage-backed securities, and they bought duration. And so with the increase in interest rates that had occurred, by the time FTX blew up, you had quite a bit of loss in that mortgage portfolio, which if they were forced to monetize, was going to create problems because the losses exceeded book value.
So I said, all right, well, let me see if there's anyone else like this. And lo and behold, Silvergate Bank -- I mean Silicon Valley Bank (OTCPK:SIVBQ), I still get those guys confused are - was basically the same thing. You had this massive ramp in U.S. venture investing between 2000 and call it, the end of 2018 and the end of 2021. And Silicon Valley Bank’s deposit base went bananas. And it went bananas with start-up companies who burn cash. And by the end of 2022, the venture-backed business, venture-backed investment had declined quite a bit.
So these were companies that had – there were cash flow, they were loss-making companies or companies that burn cash that their deposits were going to start shrinking just organically. And Silicon Valley Bank had made the same mistake that Silvergate had made, and that rather than investing this very quick ramp of deposits into short dated highly liquid securities. They went out an extra like eight years or nine years on the duration curve for an extra 40 basis points of yield. And because of their duration in their hold to maturity portfolio, that - and they also had their available-for-sale portfolio, they had a lot of losses. And the losses there were going to basically wipe out book value, if they ever had to be monetized, crystallized.
And the other -- but you had another shot on goal with Silicon Valley Bank, which I really liked from the short perspective. And you want to try to have as many shots on goal with shorts as possible because one might not always play out so fast. And so the other shot on goal was that they had a loan portfolio that was $70 billion, 21% of what – of which was to start-up companies or early-stage companies. And I thought in the new dynamic of the venture lending or venture funding world, that those loans could be very impaired, if not zeros. And so 21% of $70 billion is right around $15 billion, or $14.5 billion. And so that would have wiped out book value too.
So I said, oh, wow, you actually have two potential losses to wipe out book value here. I actually thought the losses in the loan book were going to come out faster than the losses in the hold to maturity portfolio would be recognized. But you started having a bank run. And that was precipitated by the company, actually is the deposits started bleeding. And they had to sell their available for sale securities.
And the available for sale securities they sold, they took a very big loss, and I think it was $1.8 billion. And that $1.8 billion was a 50% impairment to book value. And they did a very stupid attempt to finance that with an equity raise that they didn't get committed. And so by the time they woke up the next morning, after they announced that, the stock was already down 25%, and then it just built on itself very, very quickly.
So it was a very hard short to hold on to, from an equity perspective, because when I first wrote about it, I think the stock was right around $210. They missed badly on their report in the fourth quarter in January. But I think, a lot of people expected them to miss badly, and then they didn't miss badly enough or whatever, or they talked a good game for 2023, which I knew was baloney. But the stock went up to $330. So I actually had options that it went to heaven. To my credit, I reloaded on them.
But the other part of the short where I made significantly more money was being short to bonds. Earlier I had short to bonds at -- bond trade is spread over treasuries, investment-grade bonds trade at spread over treasuries, right? So they were trading at 2% over the ten-year, the ten-year bonds. And that was in the context where Bank of America was trading about 1.7% over the 10-year.
So that 30 basis points of yields, of spread difference, 0.3 -- 30 basis points, that equaled about 3 points difference. And so I said okay, well, if this thing trades to Bank of America's spread, I can lose 3 points. And that was -- I shorted the bonds at 92 points, and I covered them at 41 points. So risking 3 points to make 50 was a very, very compelling risk reward trade.
KS: Right. You're looking for the asymmetry there.
CH: Yeah. I mean, in bond language, you call that negative convexity, right?
KS: So we were also short Silvergate last year. And got to be honest, I don't even remember who it was that put us on to that. It was somebody on Twitter that hated it. And my trader started looking into it, because I'm a registered guy. So I'm basically long only. But in the chat rooms, we can talk shorts. And Silvergate was one of the shorts that they put on. And that worked out pretty well. And we were looking for other banks to short. Our question was, how fast could things happen? And because being short is not just being accurate, but you have to be precise with shorts, right, because it's expensive to short. So…
CH: It can be. One of the things about shorting is you really have to see -- I think you want to have more than one shot on goal in terms of what's going to potentially hurt the company. Two, you can't have -- you have to be very careful about the company having something that can come along that can just rip the stock much higher. And three, you need to have a catalyst, a short, relatively short-dated catalyst that's going to play out, that's going to destroy, that's going to hurt the value. It's going to beat value destructive. And so yeah, that speaks to your point. You have to see it coming.
KS: Right. One of the things that I tell investors all the time is don't short a good company just because you think it's a little overvalued.
CH: Yeah, you can't short on valuation. Valuation shorts are killers.
KS: Right. And I tell them that over and over again because well, the way that I put it is that there's so many shit stocks out there, short shit stocks. You don't have to go out and say, well, I think Apple is overvalued, so I'm going to short it. I mean, that's just a horrible trade. And we have to repeat this over and over again. We get new subscribers every month. So it's a lesson that we have to repeat. And if you forget to repeat it often enough, somebody goes and does it, and then they yell at you. So we have to be careful. So…
CH: The operative word is catalyst. And that's why my investment group, Catalyst Hedge Investing, to make sure that -- because I like shorting. I'm fairly good at it. And I - but you have to have the catalyst there.
KS: Well, maybe you'll end up being the big short guy on Seeking Alpha.
CH: I think I might already be one of the few. There aren't too many people who write short articles on SA.
KS: I tell you, I have and I get yelled at for it. So it's not easy to be a short because the longs really take it to task.
CH: They do. And frankly, I actually -- I like when I write short articles. I like to hear the other side. It's actually one of the main reasons why I write these articles at all is to hear the other side. And you know you're onto something when the people are coming after you and they're just telling you, oh, you're an idiot. Okay, well, explain to me why I'm an idiot. And they just say, oh, it's just a great company. You're like, okay, well, just give me a -- tell me where I'm wrong. Tell me what is -- what I'm missing in my thesis. And if they can't do that, then you know that you're potentially onto something.
KS: Right. So for folks who haven't picked up on it yet, Cashflow Hunter and I are both [Gen]Xers. And one of the traits of Xer apparently is that we have pretty thick skin, because we had to figure out a lot of stuff on our own in life. And so whenever I come across another Xer, I know that there's going to be some things that get pretty interesting, because talking to other generations, every generation has their own traits that become a little stereotypical, but us latchkey kids, you could tell us, we're stupid or anything else. But just tell us why we would appreciate that.
So let's move on from Silicon Valley Bank and Silvergate, and how you thought about those short investments -- and catalysts, by the way, I use the word catalysts all the time, because it's important for not only managing investment, but managing psychology. If the investor knows that this is what we're looking for, they can conceptualize it, and they'll patiently wait it out, right? When people don't understand what could be coming and the stock price maybe moves against them, sometimes they do the wrong thing. Because they don't know well, this domino and this domino, and this domino could all tip in this particular timeframe.
So I think it's important to use the word catalyst, because if you're looking for more than a grinded out gain, right? If you're really looking to have alpha, you have to understand what the catalysts are and then roughly the timeframe that they could play out. So how do…?
CH: I mean, look, there are certain -- particularly with law, I mean, I - catalysts are incredibly important for shorts. They're a little bit less important with longs. So maybe with longs, you can just find wonderful franchises managed by really competent people, and then just sit back and let them do what they're going to do, create value for you every day.
KS: Right. For sure.
CH: My favorite longs, I do want to hold them forever, because they're great businesses managed by great people who compound capital at high rates.
KS: Right. Yeah. Well, right. So great franchises are typically tied to great management.
CH: Typically, yeah.
KS: So we talked about that off the air. So that's something that I think people should always keep in mind if you think the management doesn't know what they're doing, take some time to explore that idea, because you might be right. There's a Warren Buffett quote about that too, right? So…
CH: Yeah. Well, he said, it's actually if you have a business with a bad reputation, meaning a management with a good reputation, the business will often win. So you don't want to buy a bad franchise that's managed by a great person. And the real magic happens is when you find a great franchise managed by a really competent manager.
KS: Right, right. And I think that Apple (AAPL) has been the poster child company for that for a long time. All right, so let's just talk about the banking sector in general, it's going to tighten up. We don't know exactly how much.
CH: It has tightened up quite a bit. Yeah. I wrote an article about that, which actually, for a macro article got a decent amount of reading about it. But there is a survey put out that I never really paid that much attention to before, but economists have pointed it out to me, was the Senior Loan Officer Survey. And it's starting to -- Senior Loan Officers, particularly at regional banks, are responsible for an awful lot of liquidity and credit availability in this country, particularly for small and medium-sized businesses. And to the extent that they start saying, hey, we're lending less, I think it has been predictive of the last six recessions going back to the 60s.
KS: Well, yeah, that's something that I've been following as well. As I told you off-air, I consulted some private equity firms. And we've been looking at notes and properties and well, I was just in San Francisco. And it seems that the banks are going to get really tight here, because the regional banks actually provided a lot of the funding for a lot of the construction in the last 5, 6, 7, 8, 9, 10 years. And a big batch of those loans are due this year, next year, and the value of the properties is way below what's owed on the properties.
So you're seeing properties in big cities, Chicago, San Francisco, all over the place, because the vacancy rates are so high, I believe record highs. They can't get the rents, which means that the value of the property is lower. And how are they going to refinance those notes without actually having to actually do a lot of work on the property to convert it somehow. So we're looking at that right now.
Do you think that the impact is going to be that it pushes us into recession and affects a lot of other things? Or do you think that the banks muddle through with assistance from the Fed and we try to stay close to even on lending? Or do you really see lending tailing off quite a bit for a little while?
CH: I think lending will -- it has tapered off. I think it will not rebound so fast. I think -- hold on one second. I think that it's not going to rebound so fast. And it's -- a lot of banks are going to be reluctant to lend until they really feel stability within their deposit base, which could happen sooner rather than later. But even if it does happen sooner, I don't think banks are going to be so fast to lend, because the cost of deposits is still very high with an inverted yield curve relative to what they can lend to. So their net interest margins are getting squeezed pretty hard, yeah.
KS: And that is coming right into this debt ceiling, which I think that people misunderstand. We're not going to default on the U.S. debt. However, once the debt ceiling gets raised, that's a lot of liquidity that the Fed has to raise, because that's where the government checkbook is. And that means that a lot of money is going to flow out of other places.
So we're going to see tight liquidity from replenishing the government's checkbook this summer and into the end of the year, something to the tune of $500 billion, $600 billion, $700 billion. And the banks, they've got a $1 trillion headache from the commercial loans. So we could potentially see way over a $1 trillion of tightening in the economy. Well, a trillion here, trillion there is a big deal.
CH: Yeah, I agree. And it's -- you touched on commercial real estate market. There's an awful lot of loans that are coming due, that haven't come due yet. And they're going to be problematic. And it's not just office buildings, although a lot of the real pain is going to be -- the major, major write-offs are going to be in office buildings on a percentage basis.
But I think, look, there's an awful lot of fairly crappy “Class A” that depends on your definition of Class A, garden apartment communities that were built an hour outside of Atlanta, or other Sunbelt states, or other Sunbelt cities that were financed at 70% to 80% loan to value. And those trades can be underwater fairly quickly. And a lot of people are not talking about potential losses that much in multifamily.
Look, there's also an awful lot of warehouses and distribution centers that were bought or constructed during the COVID, post-COVID surge. And if the economy slows down, those things will not be able to realize rents that will support their debt, particularly when the buildings were built at incredibly low cap rates, and they were financed at incredibly low interest rates. And so if the rents don't materialize, and the interest rates are higher on the loans, you can have pretty material losses. And I don't know if you follow that Sam Zell.
CH: And actually, I met Sam, my senior year in college. He came to -- I went to Wharton for college, and he spoke at a real estate conference. He was very good friends of professor of mine. So we had some time to meet, to speak with him. And he offered -- someone asked him, you have pieces of advice for us, as you know, going out into the world. And he just said he had two rules. He said don't buy at auction, and don't buy outdated office space. And I've never forgotten those two rules of Sam. And you mentioned the office building in San Francisco, when we were talking offline. I don't know what that's worth. What is a circa 1970s office building in San Francisco worth right now?
KS: I mean, this one was built in the last decade that we were talking about, but it's going to have to be -- I forget how many stories, it is 50 stories give or take. I mean, it's a bigger building in San Francisco, and they're going to have to make it two-thirds residential. Well, that's a huge remodel. And one of the things that people don't always remember about office buildings is the plumbing is not set up for having eight condos on a floor. So that's not cheap. And that's one of the things that the private equity firms who were in family offices I talked to, they look for investments. And they're very savvy when it comes to what is this really going to cost us to redevelop?
And there's huge money in real estate redevelopment, man, there's no doubt. I mean, we've had a President of the United States who did that for a living. And you have to be careful how you buy. I'll take this all the way down to the other end too. My daughter, who owns a salon and myself. I've been talking to her for a year about looking at commercial properties rather than renting her space.
And there was a strip mall for sale near me in a suburb of Milwaukee. That was -- had a sticker price of $1.5 million. Well, it would cost way over 2 million all day long to build this thing. But they had a couple of vacancies. The note was under stress. And we went in there and said, yeah, we'll buy it for $1.5 million. We're probably getting it for a half a million dollars off, maybe a million dollars off. And we only didn't get it because somebody with a checkbook big enough to write a cash offer, got it, so we wouldn't needed financing.
So for investors out there, I would say depending on what your goals are and whether or not you're interested in real estate investing, it's going to be a very interesting market for the next couple of years I think, as everything resets. One of the articles that I have in developments is called the Great normalization. I really don't believe that the Fed is doing anything wrong. I think that they're just trying to normalize things. And you read the article if you're interested. But I'll tell you, I think that Cashflow Hunter might find another short author at some point, maybe in a REITs or something real estate-related, I guess.
CH: Yeah, I've been looking it there. It's hard to find the ones that are with the catalyst, like you said, although the good news is very few REITs ever triple on -- or double on you. So short is not so high risk.
KS: And most of the REITs I'm taking what I call a Munger, just too hard to invest in.
CH: Yeah, it is. They're very hard. I agree.
KS: Right. For people who didn't get that reference, Charlie Munger, Warren Buffett's partner often says, look, there's just things out there too hard to figure out, so we skip them. And that's how I feel about most of the REITs. It's just too hard to figure out what the risk really is. There's only like five or six REITs I really like right now. And I stick with those. The rest of them I think are just -- they're hard. They're really hard.
So let's move on to a company that CashFlow Hunter likes, called Iris Energy (IREN). And there's a Bitcoin connection here, big Bitcoin connection obviously. You tell us about Iris Energy, why you like it? And how it even acts as kind of contrary to your general opinion, and Bitcoin or tie in your thoughts on Bitcoin because…
CH: Yeah, I mean, look, I - I'm an old school, a bond trader by training. I'm a value guy by training and by craft. I guess I'm a bond trader by craft still too. But yeah, I have a -- what I would say -- every part of my being is just looks for cash flow streams, hence CashFlow Hunter, and/or real concrete asset values that are time tested. And Bitcoin or any cryptocurrency has neither, right?
So I have had a healthy skepticism, I would say of Bitcoin for quite a while. I've watched in horror frankly, at seeing these altcoins which have a different moniker that is not for polite society, but…
KS: We used it with regards to stocks earlier.
CH: Yeah. So - and that whole crypto bro culture just irritates me, I would say, maybe I'm just cranky Gen Xer as you said. But loo, so -- and…
KS: Let me jump in there for a second. I don't think it's cranky. I think the Gen X for a lot of generational reasons, I think that we developed very good bullshit detectors.
CH: That might be true, yeah. And look, I just say that bullshit detector has served me well throughout my career. I started my -- I came out of college in the late 90s. Just as the dotcom boom was coming on full steam. And I just was looking at these companies trading on the valuation of eyeballs, remember that valuation metric?
CH: And I sidestepped a lot of that, effectively shorted quite a bit of those things. And so that was my first trial by fire. And then I really made the bowl -- my first real money in this business, being at a hedge fund that had a big short on. And it was not something that we just said, okay, let's get short the housing market in 2007. I was starting to get pretty skeptical about the housing market in 2002. And we started putting on the big short in size in 2005. So we were -- I watched that movie, The Big Short, I read the book, obviously. I actually -- I know a lot of those people. I've spoken to a lot of those people in that movie.
And so I kind of lived that space. So I guess that just sort of says my healthy skepticism/bullshit detector has served me well throughout my career. And I would say that a lot of Bitcoin traits follow that. That said -- and I wrote this in the Iris article, an awful lot has been thrown at Bitcoin over the past two years and it's still there. It's still hanging out at $25,000 per coin.
Now I think it's very, very difficult, even for the truest believer of Bitcoin to really point to concrete, intrinsic value of Bitcoin. Now a lot of people say, well, yeah, you can say the same thing about gold and it's not really the same thing. Because there are a lot of people who want to wear gold jewelry. Nobody wants to wear Bitcoin jewelry, right? I mean, there is a practical use for gold. And so -- and it's been a store of value for 5,000 years. So they're not really the same. But again, like I said, an awful lot has been thrown at Bitcoin, and it's still with us.
And so my other gripe with Bitcoin is the franchises that have been established to -- for people to invest in Bitcoin and bet on Bitcoin are, in my opinion, just horrific. I mean, they're just terrible, terrible structures. I think Coinbase (COIN) is a ridiculous business model that's -- that had a moment in time where it could arbitrage and inefficiency in the marketplace. And that time has generally gone. Now it's basically just earning interest on USDC for the most part. It's how it's making a lot of its money, other than ripping off people on too high commissions on cryptocurrency trades.
And then MicroStrategy (MSTR) is just an overlevered underwater bet on Bitcoin that was perpetrated by a guy who's had a software company that he hasn't been able to grow for 20 years. And this is a Hail Mary pass.
KS: I have followed Michael Saylor a very long time, just because he's been a purported rock star a couple of different times.
KS: And I started in the middle-90s. I've never been able to figure out why he's newsworthy. He's not a big deal from what I can tell. And maybe I'm wrong. Maybe, he was a hotshot when he got started. But I haven't seen anything, particularly credible from him in a long time. And I see that as a guy who's been convinced that Bitcoin is a thing.
Our thesis three, four years ago, and especially in 2021, was that most of the altcoins would go to zero. A handful of the project-based coins that are going to be around, and are getting adopted by the banking system, and the financial system will stick around, Ethereum, Ripple, a couple of others, Chainlink, they all have roles with big banks and World Bank and IMF, things like that.
And then Bitcoin we look at as part of a geopolitical argument that the emerging markets and a lot of our enemies, and even our frenemies, they want to hedge against the dollar, and Bitcoin is part of that, along with the new BRIC currency and things like that. So if they adopt it, it will go much higher. If they don't adopt it, it's a gambling token.
CH: Yeah. So I agree. I guess my point is, look, I can be a skeptic of Bitcoin all I want. The fact of the matter is, it's still around. There are people who value it a certain way and who am I to say that they're rock? So that said, I want to have -- so I'm not going to give up on my short leanings on Coinbase and MicroStrategy. And you - but you can't just sit there being short without basically effect -- those things trade with Bitcoin, right? Bitcoin goes up, those things go up and they often go up one and a half beta to Bitcoin. And so…
KS: So you're looking for a pair trade?
CH: Looking for pair trade. And Iris is, look, Iris has a lot of the virtues that I look for. They have a clean balance sheet unlike Coinbase, and unlike MicroStrategy. They have what I consider to be a really interesting and capable management team, again, unlike Bitcoin, and unlike Coinbase and unlike MicroStrategy. And they have a pretty simple business that has some structural advantages and that comes from renewable power - renewable cheap power contracts.
So to the extent that Bitcoin can trade above -- I think I estimated about $18,000 Bitcoin. These guys are going to make some really good money every day. And they don't make any bets. They sell the Bitcoin as soon as they mine it. And they -- and so yeah, so it's a really natural pair. And to be honest, I actually kind of like the business enough that I don't even need to have the short on against it. And if you look at it versus everything else in the crypto space, be it Coinbase or MicroStrategy, or other miners, it's just night and day in terms of its capital structure, in terms of its management team and, frankly, I think in the terms of its economics.
So I like it. And the other -- the last thing is I do believe that they -- their data centers are new enough and good enough that if bitcoin disappeared tomorrow, they'd be able to repurpose those assets for something. Would you get $4 a share of value? That's hard to say. It's entirely possible that you could get more, but it's not a zero. Whereas I think that MicroStrategy is potentially just a zero, right? If bitcoin is underwater, when their debt comes due, it's a zero.
KS: Right. Yeah, we have invested in Marathon (MARA). Similar thesis, as this, a little bit Riot (RIOT), but we really pivoted to Marathon, I like Marathon better. But Iris Energy, Marathon, if you go to the Iris Energy presentation, investor presentation, they have a really good chart in there, that shows all these miners and what their debt is, and what they're generating. So it's -- I will say, for folks, you should read this article, the Iris Energy article that you put out, and then go read the presentation. And the 10-Q, because I -- like I said, I've been in Marathon, and I'm going to look at this one now, because I like what they've done in…
CH: Reset that cash balance sheet, whereas Marathon still has that big convert coming up.
KS: Right, right. So Marathon, when Bitcoin prices crashed, they got a little over their skis, and they had to finance their way out. And that's going to work against them on the -- I guess the margin side would be the way to describe it. So enough to pay off their bills. So this one being debt-free. And I look at this, and I go, well, if you want to be long a company that's in this space, that has some residual value of Bitcoin disappears, this is an interesting idea to me. It really is. I'm going to look into this one, because it may be an improvement, and the one that I've been playing with.
CH: I put a comp table in the article. So you can see that this is on almost pretty much every metric, this is cheaper than most other miners.
KS: Okay. Fantastic. All right. So you have a high conviction trade going on in 3M (MMM) right now. Why don't we pivot on over there? I know that we've talked a lot of financials. Let's get into industry.
CH: Sure. So this was -- I was actually kind of blown away by the feedback that this article got. It got, I think over 40,000 page views or something like that. It's pretty high. So 3M again, a story that checks a lot of boxes. It is a business where they have four different segments and three of them actually had negative organic revenue in the first quarter. The one business that they had, that was positive organic revenue, had 1% of organic revenue growth. And that's their healthcare business, which they were talking about spinning off in the fourth quarter -- first quarter of next year.
But with 3M, you have two shots on goal of value destruction here. The first, which I think we're probably going to get some sort of resolution on in relatively short order, is they owned -- they bought a company that provided earplugs to the military that just didn't work. And so you have over 200,000 veterans with hearing damage. So that's just -- it's a terrible thing to happen to our people who are serving our country. And it's just politically that's a disaster, right? I mean, who is to say, oh, yeah, we'll screw the veterans. I mean, it just doesn't happen.
So the company is saying they've been trying all these different legal maneuvers. They were trying to bankrupt a subsidiary, which is something that Johnson & Johnson tried to do with their talc liabilities. I think that maneuver was blocked by a lower court judge. It's in front of an appellate court panel of judges right now. They are likely to uphold the lower court decision. If that happens, and that's going to happen, I believe, in the next few weeks, then the company is going to have to negotiate some sort of settlement.
They have initially said, oh, well, we'll pay $5,000 a person or $5,000 person, a $1 billion. $5,000 for hearing damage, there's just no way that, that is going to fly.
KS: It sounds like they might need to add a zero.
CH: That's my take exactly. I think it's probably most -- more like between, I think $50,000 is probably the low end, and $100,000 per person is probably the higher end. So we're talking between $10 billion and $20 billion potential liability. Now I think there's people on the sell-side who are estimating 5,000 to 6,000. If it comes through at 5,000 to 6,000, in terms of a settlement, that'll oddly be considered a win. But that will blow out -- that destroys their free cash for a year. It's just gone.
KS: So in another life, very early in my career, I sold a lot of insurance. And people who have benefit plans at work or familiar with Aflac or anything, the benefit that you would collect on an insurance policy for losing your hearing or your sight or anything like that, way over $5,000?
CH: Yeah, there's just $5,000 is just give me a break, I mean. So I mean, most people's annual grocery bills are significantly higher than $5,000, right?
KS: So I've gotten fat the last decade since I quit playing competitive sports. So I can attest to that.
CH: So that's -- and frankly, that's just a small thing that's coming after 3M. The big thing are these their polyfluoroalkyls, PFAS, where otherwise known as forever chemicals. And it's the stuff that was in scotch guard. But the real pollutive application was in a fire suppressing foam. So stuff that just got sold to fire departments all over the country got sprayed around and just went into the groundwater.
So there is a multi-district litigation that's being handled in South Carolina. There is the first lawsuit under that multi-district litigation is occurring -- starting on June 5. It's the City of Stuart, Florida, suing 3M. And so there are a couple of things with that case. One is, it's just one of like 4,000 potential litigants. So if there's going to be a settlement, it's going to have to occur somewhere either before or after that case happens. But I think that the fact -- the facts that are going to come out in that case are going to be pretty damaging to 3M in terms of what they knew when. That's always -- that's frequently sort of a nasty thing for them.
KS: And that's what triggers punitive damages a lot of time.
CH: Right. And so 3M actually already settled with the Twin Cities for $850 million. One metropolitan area with pollution for these PFAS, $850 million. So there are people saying, oh, well, 3M would have settled for like $10 billion. And my answer is, well, they settled for the Twin Cities for $850 million. And I'm not saying every city is going to be the size of the Twin Cities, but there are an awful lot of cities that are suing these guys.
The other -- but the real headshot that could come regardless of what happens with these lawsuits or any kind of settlement from these lawsuits is that the EPA has put forth two potential -- two things. One is the acceptable level of PFAS in groundwater. They put out a regulatory proposal in March of four parts per trillion. That's generally regarded as safe content of PFAS in drinking water. Most places right now are 70 parts. The Delta from 70 to 4, potentially is going to cost like $300 billion to $500 billion to clean up. I mean, the numbers are staggering.
So - and then the EPA is also trying to get PFAS labeled as a hazardous material. If they get the hazardous material designation, and the four parts per trillion regulation becomes a law, then any water system that has more than four parts per trillion becomes a Superfund site, in which case, the EPA becomes judge, jury and executioner. And there's no trial. There's no appeal. The EPA says this is a Superfund site. You guys made the chemicals that are in the Superfund site. Pay us. It's a fine, and there's no appeal. It's like appealing to the IRS, you can't do it, right? It just doesn't happen.
So I think that's the true headshot. And that is what comes through, almost regardless of what happens with any of these cases in South Carolina. But you're going to start seeing, I think, some pretty nasty stuff coming out of South Carolina. And I think the best possible situation for 3M is that they settle this litigation, this multidistrict litigation for like $30 billion, and they do it over 30 years. So it's a $1 billion a year for 30 years. I think that's really unlikely. But that's probably the best possible situation that can happen to these guys.
And again, you're talking about a $1 billion of annual expense on $8 billion of EBITDA and $4 billion of free cash. So it's going to be material. It's going to be material not to the company, and that would come on top of the earplugs. But I think it's a really high likelihood that this thing spirals over the next two years and 3M is forced into bankruptcy.
KS: So I've talked about a lot of dividend companies that I thought were zombies. And 3M has been on that list, and I've gotten chastised for it. I would just challenge any dividend investor who's looking at their dividend with 3M. And I would ask you, what do you think the risk is that they have to cut their dividend, and…?
CH: And I wrote about that in the write-off. I said, look, if you own this for a dividend, dividend is really not safe.
KS: No, not. It's not safe at all. And there's a bunch of other companies in the S&P 500. But I think this one is compelling for its immediacy. They're going to have to cut that dividend. And there's -- in my mind, there's almost no way that dividends stays intact. And when they cut it, you just saw what happened to Paramount Global (PARA), and what happened to AT&T (T) a while back. You want to maybe own those companies after the dividend cut, for the rebound in the stock price over time, but probably not too quickly. And you sure as heck don't want to own those stocks going into the dividend cut. Because you are going to lose a lot of values.
CH: I agree a 1000%. The joke of the matter is, frankly, is that they want to do this spin-off of their healthcare business, because I think that, that would unlock a lot of value. And I walked through the article how that wouldn't actually be the case. But if they do spin-off the healthcare business, the dividend is almost going to have to be cut if they do that. Now they said the spun out healthcare business might -- what might pay a dividend. But how many people add up the dividends in the two different companies and say, okay, well, I'm still okay, right? That usually doesn't happen.
KS: Well, and a similar thing happened to AT&T when they spun off Warner, right? They lost all that revenue from Warner. So they had to cut their dividend and people -- they lost their minds. But AT&T is a much healthier company now because of it. However people always look back and they're just so angry that, they can't see that AT&T is a better company now than it was before.
CH: Yeah, I agree, 100%. So yeah, so look, I think -- and that dividend cuts another shot on goal with 3M. So you have really three shots on goal there. And again, there's nothing there that's going to really rip the thing up in your face. And once again, I own longer dated puts in 3M, which are cheap, because it's a low volatility company. So there's not much volatility priced into the puts. But we're also short the bonds in pretty good size. And I think that's again an incredibly wonderful risk reward trade.
KS: Right. All right, let's finish up because I know we both have places to go on a Saturday. That's one we’re recording, folks. Let's finish up with energy. Everybody loves talking about energy. And let's take a look at some of the pipeline companies, in particular, you like Enterprise Products Partners (NYSE:EPD).
CH: Yeah. I mean, look, I - with longs, you just want to buy, really, if possible, irreplaceable assets, or irreplaceable franchises. I mean, nothing, I guess is really irreplaceable at the end of the day. But for the most part, I think energy, enterprise products has irreplaceable assets that have become only more irreplaceable as the environmental permitting process has become more unfriendly to pipe. And it's become more expensive, too, from a labor and materials perspective, to build pipelines.
And these guys, they connect to every major refinery, every major cracker on west of the Mississippi. And they also own the bulk of the natural gas liquids, export infrastructure at the Port of Houston, which is where a lot of the domestically produced natural gas liquids, such as propane and ethane, really -- mainly propane is what gets exported, are delivered. And people don't really realize this, but an awful lot of propane gets exported in this country. It goes to China in India, and this is just going to keep growing. And these guys own 1,500 acres right on the Port of Houston.
So unless you think there's going to be another major deep water port built anywhere close to the major energy infrastructure of this country, these guys have really phenomenal, phenomenal assets. And they're managed very, very well, with very good, steady mid-to -- low-to-mid teens returns on invested capital. And they didn't just -- you don't want to -- you know as well as I do. You don't want to just find an enterprise that is a one trick pony and say, okay, well, they can build a facility, and they can build a facility at 15% returns. And once they build that facility, well, I don't know if they can build another one.
These guys can just continually invest at high rates of return. And I mean, that's just a phenomenal, phenomenal and a very rare asset base. And the funny thing to me is that these businesses all trade cheaper than they did pre-COVID, even though they've probably gotten better and more valuable.
KS: Right. So I was -- a similar thesis with Kinder Morgan (KMI). And I like where they're located, right? They're very Texas, because of their Permian assets that they've built out. They made a pivot. After 2014 when the Saudis flooded the market with oil, they made a pivot to stop building anything on SPAC. If they don't have backing financing from a sponsor of some sort, they won't build it anymore. So they're doing the same thing as these guys is, look, if we can't get a high rate of return, we just won't build it.
We're not going to guess that we're going to get a client sometime or a partner down the road. Look, if you want us to build it, we will build it and we'll run it. And enterprise product partners, their product mix with the liquids. I don't think people always differentiate between oil and gas and LNG and the fuels. What you really want to be heavy in is everything but oil, right? So oil is not the most profitable one. It's the liquids, in particular, in the fuels, and carbon capture, which we're about to talk about a little bit. That's coming.
So I like Enterprise Product Partners, too, Kinder Morgan. A lot of the other pipeline companies I'm not always in love with because they're too oil heavy for me. And I don't like the regions that they serve, because as we know, it's really only the Permian that shows any growth anymore among the fracking regions. So folks should be careful about who they're picking out. And not just look at the yield first, look at the business behind the yield.
All right. So carbon capture. I'm huge on this. I have a huge trade on this right now out in California. But it's not the one that you like in California. So why don't you tell me about California Resources Corporation (NYSE:CRC)?
CH: Yeah. So I've written about California Resources in the past. Its stock really hasn't gone anywhere, but it's developed. The story is developing as much as I'd hoped. So California Resources was the original assets that formed Occidental Petroleum. It was spun-out in 2012, I think.
KS: About a decade ago.
CH: Yeah, somewhere around there, with way too much debt. They spun out like $5 billion of debt. And they filed for bankruptcy, was unsupportable capital structure. And they filed for bankruptcy, I think in 2020, if I'm not wrong, if I'm not mistaken. And they merged in 2021 with a clean balance sheet, very little debt. And as just an exploration and production company, it's a nice little asset. California is a nice little protected market. California still with all of their energy efficiency initiatives and their green initiatives, it still consumes 10% of the world's -- of the country's oil, and only produces 4%.
So a lot of California's oil, since there are no oil pipelines going into California, has to be imported, either from Alaska or from OPEC. So California Resources has very low depletion oil wells. They also produce natural gas liquids, propane and natural gas, and they have a really protected market. So it's a really nice little business from that perspective. And really, all you're paying for right now is that business.
They also though -- I think the really interesting angle is they have these caverns from -- that are -- Occidental Petroleum was founded, I think, in the 20s or 30s, by J. Paul Getty. And it was -- maybe it wasn't Getty, but it was founded in the 20s. And so these caverns are very deep. They're 10,000 feet down. They're surrounded by very hard non-porous rock, and they are empty. And they formerly held oil and gas without leaking it. And so the idea is that they - you can now pump carbon dioxide out of -- from refineries or factories of several kinds of sorts into these caverns, and it becomes carbon capture.
And I think these are the types of businesses that gain huge valuations because they're very high return on capital. And the company partnered with Brookfield Infrastructure, where Brookfield Infrastructure is going to put up all the capital to develop these caverns for carbon capture. And the old CEO, the original CEO of California Resources, who – guy was CEO when they merged, just left the California Resources CEO job to become CEO of what they call this Carbon Teravolt business. And they are waiting for a permit to come through from the EPA to start this business. And it's probably only about six months away that they'll get this permit.
And once they do, I think this entire business revalues in a very, very major way. They're talking about having the initial application for a million tons, but going up to like 5 million tons of carbon capture capacity in three years and getting paid about $250 a ton. So start doing the math on that. It starts to become a very, very big number,
KS: All right. For people who read me, you know that I'm very heavy in that California story with carbon credits. My top growth stock for the year was Aemetis (AMTX). And there they have a short interest of like 23%. And it looks like they're at the very front end of a short squeeze for a lot of the same reasons that he just discussed here with California Resources. So for folks who don't quite understand how this works, is these companies are going to get paid for providing other companies with offsets for their carbon.
So these companies by taking in carbon, or having renewable fuels or anything like that, that has an offset to the carbon, they can sell that. Well, the price of those credits plunged, got down to like $65. And recently, California, which sets the rules and said we're going to tweak the rules to push that back up. And their target price within two years is $250. So since they just said that they were going to do it, which they're not doing until the summer, I think, it's next month, might be July, I'm not sure it's June or July, has gone from about $65 per credit to -- it's a little over 90 right now, I believe as we speak.
So it's already moved up 30%, 40%, 50%, just on the promise they were going to tweak those rules. Once those rules are tweaked, and as we know through various legislation at the federal level, but also with the California regulations on top, companies that produce a lot of carbon are going to have to buy offsets or completely revamp their own equipment. It's going to be cheaper in many cases and faster for them to buy the offsets for companies that can provide them with the credits against their carbon.
So the upside on these kinds of stocks around the country, especially with the Inflation Reduction Act, really incentivizing them, and even the big oil companies are going to do well are Chevron (CVX), Occidental (OXY), Exxon (XOM), they can all do this in Texas. There's going to be a lot of money. The companies that probably turn the biggest gains for you though as an investor are the little companies that aren't highly valued.
So you could buy Exxon or Chevron or Occidental and I buy a lot of Occidental. I've been buying it for a couple of years, is good. However, if you're looking for a big capital gain, I think California Resources, which is one that we've looked at, and Aemetis (AMTX) and pick your company, if you can find one out there that's going to all of a sudden start dropping all kinds of money to the bottom line, in most cases, that's not priced in right now.
Almost everything in the large caps is priced in because that's a very efficient market. But small and midcaps, you're not always getting that value because - excuse me, small and midcaps, you're usually getting that value because it's not priced in. So any other thoughts about energy that you think are big themes for the next few years?
CH: Look, I mean, natural gas is in the dumps right now, and inventories are high, but there's an awful lot of LNG that's going to start being exported. Yeah, I think Europe dodged the bullet this past year - this past winter with a mild winter. And they basically shut in all of their high energy industrial industry. I don't think that Europe is going to be permanently shutting down their high energy using industry forever. And yeah, I guess you could have another couple of warm winters in a row.
But if you don't, there's going to be an awful lot of demand for natural gas coming out of Europe. And I still like -- so I still like natural gas plays and they've come down a lot. You just have to make sure like anything in energy that you're buying these things -- you make your money in energy buying when everything's gone to hell, not when prices are high. So, natural gas back at $2 or $2.50 is down to back to a relatively low level. And particularly when you start having these LNG, export facilities are going to start coming online. So I like natural gas, but you have to obviously pick your assets, pick your management teams carefully.
KS: Yeah. I agree on Europe, what you said there. And I would throw in India. I think India is a catalyst for a lot of energy growth in the next several years, because they just can't transition fast enough.
CH: No, and actually, that's a great point. And India is actually -- I think India is now the largest importer of U.S. propane right now. I think that's right.
KS: It is.
CH: And look -- they're an awful -- India has terrible pollution problems. And a lot of it is caused not by heavy industry, frankly. A lot of it's caused by people have ovens in their backyards that are fueled by coal or by dung, and a much cleaner propane is a cheap replacement for both of those fuels. And it doesn't take much to distribute propane tanks with little burners attached to them. And so that is a big initiative by the Indian government. I think it's going to continue to be a big initiative.
KS: See what they need in India is there's an Ace Hardware by me that I just bought a new propane weber grill.
Man, I tell you what, that was a super interesting conversation that we started, man, an hour and a half ago. And I will definitely have to keep a closer eye on your articles. I know you're a little newer on the platform. And, man, pretty exciting things that you're talking about. I know that short investors should be interested in you for sure. But even people who just want to double check to see if there's a lot of risk to their dividend stocks, I mean, I think that that's a vital service here, because on Seeking Alpha, there's a lot of dividend investors.
CH: An awful lot, yeah.
KS: And that's the last thing you want to be a dividend investor is to see your dividend get cut, not just because you get less income, but usually take a huge capital loss.
CH: Yeah, well, because if you, like you're the dividend investor, and you're not getting the dividend, you sell the stock. Bond traders are colorful personalities. They have a lot of sayings, most of them are again, not acceptable in polite society.
But one of them is the road to hell is paved with positive carry. And positive carry for bonds is the... is the coupon that you earn owning the bond. And I think you can translate that to dividend stocks. Hell is paved with the dividend yield. And yeah, to the extent anyone owns 3M, because of the dividend, I think is worth reexamining that strategy.
KS: Right. Another way that I would put that for people is that if you're buying a stock for the yield, without looking at the actual valuation and the strength of the business, you're taking a huge risk.
CH: A 1,000%
KS: Because a lot of these dividend stocks, in a no growth or slow growth environment, cannot possibly sustain those dividends long-term. And if they have negative catalysts, like 3M seems to have, it's just even more dangerous.
KS: All right. All right. Thank you very much. I will look forward to your newer articles.
CH: All right. Well, unfortunately or fortunately, most people are going to have to subscribe to Catalyst Hedge Investing to get the bulk of my new articles, but I'll still be putting out some onto the main site.
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