Bank Investing in 2013 (1)

According to the FDIC’s Quarterly Banking Profile for the Fourth Quarter 2012, FDIC-insured institutions earned $141.3 billion, the second-highest annual earnings ever reported, after the $145.2 billion in 2006.  Average return on assets (ROA) for the industry rose to the psychologically-important level of 1.00%, a level last realized in 2006.  The number of institutions reporting financial results declined sequentially from 7,357 to 7,083 as 51 banks failed and 223 were merged into other institutions.   2012 is the first year in FDIC history that no new reporting institutions were added.

Observations: 

1.  Not one new bank was created in an entire year.  Not a single management team was bestowed a bank charter by the government to profit from the juicy spreads earned between the near zero percent that banks pay to savers and the three to five percent they earn on average loans.  The slope of the yield curve as measured by the difference between the 3-month and the 10-year Treasury yields averaged +172 basis points for the year, roughly in line with the 20-year average of +180 basis points.  On the surface, banks are nearly as profitable as they were before the financial system collapsed, while the number of banks continues to shrink.  A charter to operate a bank is now and becoming more valuable than ever because it is becoming rarer.

Banks are unquestionably better-capitalized now in 2013 than back in 2008, in terms of credit statistics across the system as a whole.  Non-performing assets are down.  Leverage is down.  Yet 651 banks remain on the FDIC’s “Problem” List.  The singular reason why so many banks are still financially-distressed is the legacy loans trapped on their balance sheets, mismarked and unable to be sold without charging-off so much UPB (unpaid principal balance) that the equity of much of the banking system would be eviscerated.  A harbinger of massive consolidation, the banking industry is in the process of bifurcating.  Thanks to interest-rate policy, well-capitalized banks are modern-day money machines while under-capitalized banks grind to a halt.  The cost of running a bank has increased, requiring scale.  The age of the small local community bank serving one MSA is over.  Community banks can’t compete anymore, so they are merging with each other and morphing into stronger regional institutions.

2.  Credit metrics across the banking system continue to improve, i.e. as reflected in nonperforming assets, but if we scratch the surface it doesn’t take much to ascertain the reality of widespread insolvency.

Noncurrent assets (as a % of total assets) remain stubbornly high at 2.20% (down from a peak of 3.367% in 2009) while loan loss reserves are down for eleven consecutive quarters.  With leverage still high at 9x, the banking system is embedded with ~20% losses, and that ignores loans that are mismarked on the books of nearly all banks across the United States.  On April 9, 2009, at the nadir of the financial crisis, FASB (2) issued an official update to FAS 157, the rules governing mark-to-market accounting, suspending the accounting of reality when market conditions are deemed “unsteady or inactive”.  Since then, it has become impossible to rely on the valuations of loans and other assets as reflected in a bank’s audited financial statements.

3.  The rich get richer while the poor get consolidated.

The bifurcation of the banking system is enabling one of the great profit opportunities of our time.  While under-capitalized banks are frozen, “zombies” in the parlance of our time, well-capitalized banks benefit from the government’s hand replacing Adam Smith’s.  Industry consolidation is governed and the rules are strict.  The banking business, like all financial services, is a human capital business, and therefore what matters most is management.  Investing in banks is about investing in people.  Therefore the quality of the management team is the predominant factor in the analysis of any financial institution.

To measure a management’s ability to operate a bank wisely and for the long term, we focus on non-interest expense relative to the size of the bank in terms of assets and revenues where revenues consist of net interest income (NIM) and non-interest income (fees).  Specifically, we   employ a metric called Efficiency Ratio (3).  Ironically, a 100% efficiency ratio means a bank is not being efficient.  The lower the ratio the better, with most banks striving for a sub-60% ratio.  Following is a list of the most efficiently managed banks in the U.S. in 2012.

In of itself, efficiency ratio means little if it doesn’t translate into a high level of profitability.  Not unexpectedly, many of the banks reporting the lowest efficiency ratios are the ones reporting the highest profitability as measured by return on tangible equity (ROTCE).  Following is a list of the most profitable banks in the U.S. in 2012.

By cross-checking efficiency ratios with ROTCE, we identify the most profitable banks where the high level of profitability is (in part) due to efficient cost management. 

All of the banks in this list trade at richly deserved valuations north of 2x tangible book value (TBV), that is, all except for Customers Bank (CUBI) led by former Sovereign Bank CEO Jay Sidhu, and the two banks operating in Washington DC.   Before explaining the situation at Customers Bank, which is our top idea, we briefly describe the attractive opportunities for investing in banks in the Washington DC market.

Like most markets in the U.S., the Washington DC market is dominated by large money center banks such as Capital One (COF), Wells Fargo (WFC), Bank of America (BAC), and Citigroup (C), along with super-regionals including SunTrust (STI), BB&T (BBT), and PNC Financial (PNC).  In terms of pure plays (relatively), we identify 4 that are investable:

1.  United Bank (UBSI) of West Virginia recently entered the DC market via the acquisition of Virginia Commerce Bank (VCBI) for a fair price of 1.8x TBV.  With $4.5 billion of in-market deposits, United Bank is now the leading independent bank in Washington DC in terms of deposit share; however, the stock is already fully valued at 2.2x TBV.

2.  Sandy Spring Bank (SASR) of Olney, MD is a $4.0 billion asset bank that under-earns its peers because of a higher level of non-interest expense and as a result a higher efficiency ratio (>60%).  Nevertheless, Sandy Spring still earned a solid 1.0% ROA and 9.7% ROTCE in 2012, and at only 1.2x is an attractive target for any bank looking to build scale or buy its way into the Washington DC market.

3.  EagleBank (EGBN) is led by the other Ron Paul, this one a community banking legend who co-founded EagleBank in 1998.  Since then, assets have grown to $3.4 billion with a consistent record of profitability through the banking cycle.  Credit quality is outstanding with an allowance for credit losses covering 104% of nonperforming assets (NPAs), and non-interest expenses are well-managed as evidenced by a 51.4% efficiency ratio in 2012.  In terms of valuation, EagleBank is easily worth 2x TBV (of $12.62) equal to $25.24.  On an EPS basis, core EPS is approaching $0.50 on a quarterly basis ($2 of EPS per year), which is again worth at least $25 per share.

4.  Cardinal Bank (CFNL) is also one of the most consistently profitable banks in the U.S.  A huge 1.7% ROA in 2012 (16.7% ROE) is the inflated result of robust mortgage banking fees driven by gain on mortgage sales.  With interest rates zero-bound and pre-payments moderating, mortgage securities trade at premiums to par and can be liquidated at a profit at any time.  ROA peaked at an amazing 2.07% in the third quarter of 2012 and have been moderating since.  As a result Cardinal Bank should report a lower ROA in 2013, however still robust in the 1.20% to 1.40% range (1.44% in Q1 (4)).   Even at this lower level of profitability, CFNL should continue to generate a mid-teens ROE, warranting a 2x multiple of TBV (2x 2014 TBV = $23.62 per share).  On an EPS basis, core EPS is likely to stagnate as a lower level of gain on sale offsets organic revenue growth.  Applying 3-Sigma Value’s proprietary target price methodology, which is based on a series of operating scenarios driven by key factors including asset and deposit yields, loan production, fee income growth, and efficiency ratio, we derive a probability-weighted target price of $20.13.

Both EagleBank and Cardinal Bank have pristine balance sheets – Cardinal, in particular, has $0 other real estate owned (OREO) and $0 loans receivable past due 90 days or more ($3.0 billion of total assets).  With virtually no legacy credit risk, the risk/reward here is extremely attractive.  However, Cardinal Bank is missing a crucial element required in 3-Sigma Value’s investment process – a clear catalyst that will narrow the gap between CFNL’s current market value ($15) and our estimation of its intrinsic value ($20+). 

While a take-out of Cardinal Bank is likely, eventually, and theoretically a stock catalyst, as far as we at 3-Sigma Value are concerned a take-out is an exogenous factor that is uncontrollable and therefore only a factor in Upside Case scenarios. 

In contrast, Customers Bank (CUBI) is on the verge of a major catalyst that will unlock value in its shares.  Currently, CUBI (formerly CUUU) trades sparingly on the Pink Sheets while its registration statement with the SEC is being reviewed in advance of a move to the Nasdaq.  When CUBI lists, volumes will increase dramatically as privately-acquired shares become freely tradeable and the stock becomes eligible for inclusion in a wider range of institutional portfolios. 

Buy: Customers Bank (CUBI)

In the middle of 2012, 3-Sigma Value was introduced to Jay Sidhu, the CEO of Customers Bank and formerly the CEO of Sovereign Bank, which he and his team built over the course of twenty years into a major financial institution with over $89 billion in assets at the time of Jay’s “retiring” in 2006.  Nine out of fourteen senior executives at Customers Bank used to work with Jay at Sovereign. 

The rapid demise of Sovereign after the 2006 change in leadership is a morality tale lost in the tragedies of Lehman, Fannie and Freddie, and the overall collapse of the financial system in 2008.  Under Jay’s leadership, Sovereign was a conservatively run bank that was under-leveraged and under-earning relative to its peers during the credit bubble until activist investor Ralph Whitworth of Relational Investors orchestrated Jay’s removal.

To boost return on equity, the new management team, pressed by Whitworth, lowered credit standards and loaded up on an alphabet soup of structured products (5), and sure enough, on October 13, 2008 what remained of Sovereign was acquired by Spain’s Banco Santander SA for a measly $2.51 per share.  In contrast, two years earlier when Jay was still CEO, Sovereign sold a 19.8% stake to Banco Santander in a strategic transaction for $2.4 billion cash ($27 per share).  Included in the deal was an option for Banco Santander to buy the rest of the bank for $40 per share for one year beginning in the middle of 2008.  Instead, they were able to pay $2.51.

Jay went on record saying about Whitworth, “Every single action taken under his leadership of the risk management committee destroyed value. You need a long-term view with prudent risk-management strategies and not the short-term view of a hedge fund manager." (6)

After watching the disintegration of his work and much of his fortune, in 2009, Jay raised $22 million of equity ($7.5 million from Jay) to acquire New Century Bank, a failed bank in Pennsylvania with $270 million of assets.  Jay and his team restructured the operations of the newly rechristened Customers Bank and worked through its non-performing assets (NPAs) before acquiring three banks in 2010/2011, two with FDIC-assistance (total assets =  $2.1 billion) (7).  Then in the summer of 2012, Customers Bank announced an $80 million Regulation D Private Placement in a Public Company (PIPE) (8) to fund two ingenious acquisitions structured with an arbitrage that upon closing would increase the total assets of the bank to over $3 billion.

The first acquisition is CMS Bank with $247 million of assets and 5 branches in Westchester New York for $20.8 million stock valued @ 125% of book value (closing expected in 2013).  The deal is not only geographically strategic but the terms theoretically establish a valuation floor for CUBI.  Jay created an arbitrage for his investors – we paid $14 per share, equal to 95% of Q2 2012 book value, while CUBI sells stock at 125% of book value. 

The second of the two acquisitions included only the performing assets ($490 million) and one branch of Acacia Federal Savings Bank for $65 million, consisting of $10.3 million cash and common stock valued @ 115% of GAAP book value at the time of closing (expected Q2 2013) (9).  The price paid as a multiple of book value (P/BV) was a very attractive 0.56x, but unfortunately the FDIC deemed it too attractive.  On Customers Bank’s April 22, 2013 conference call, management reported that the FDIC would only consider approving one acquisition at a time, and therefore management had to choose.  Because CMS Bank represents a franchise, while Acacia is simply a book of business with no intrinsic franchise value, management decided on quality over quantity.

Another important distinguishing characteristic of Customers Bank is the size and productivity of its branches.  Average deposits per branch were $174.3 million in December 2012, up from $109 million in December 2011 and $77 million in December 2010.  This compares to ~$50 million for community banks.  Part of the reason Customers Bank is able to accumulate deposits is the bank doesn’t compete on the basis of cost.  While cost of deposits has dropped from 1.76% in December 2010 to 1.19% in December 2011 to 0.79% in the fourth quarter of 2012; that is still well above the cost of deposits at most community banks (<60bps).  Management promotes a "high touch supported with high tech" model for gathering deposits based on concierge banking serviced out of sales offices instead of full service branches, a low-cost strategy that depends on experienced bankers who reach out proactively to customers.  CUBI operates in key mid-Atlantic markets along the I-95 with attractive demographics in PA (Bucks, Berks, Chester, and Delaware counties), NY (Westchester county), NJ (Mercer county), and Washington DC. 

When discussing the Bank’s acquisition strategy, Jay describes "a lot of low hanging fruit."  There are 86 “Problem” banks with $33 billion in assets in CUBI’s target markets along the I-95 between New York and Washington DC.  Ironically, the competition to acquire these banks is limited given the reality of widespread mark-to-market insolvency and the absence of new entrants. 

Finally, the Bank’s lending strategy is highly conservative with a focus on “superior” credit quality in the following lending areas:

1.  Commercial Lending – divided into three groups: (1) Small business (SBA) loans targeting companies with less than $5 million of annual revenue; (2) Mid-market business loans targeting companies with up to $100 million of annual revenue; (3) Multifamily and commercial real estate (CRE) loans with an average loan size of $7 million.   

2.  Consumer Lending – real estate secured lending with conservative underwriting standards (>720 FICO).  No indirect auto, credit card, student or unsecured loans. 

3.  Specialty Lending – warehouse lending which provides financing to mortgage bankers for residential mortgage originations from loan closing until sale in the secondary market. Many providers of liquidity in this segment exited the business in 2007-2008 during the period of excessive market turmoil, creating an opportunity to provide liquidity at attractive spreads.  For Customers Bank, the warehouse lending business diversifies its revenue streams with a lower credit risk and interest rate line of business.  These loans are short-term, usually 16 days, and therefore yield less than commercial bank loans.  However, the Bank is paid a portion of the 1% origination fee, which makes up for the lower NIM.  Management expects the mix of warehouse loans to constitute 25% of assets over time, down from 52% at December 31, 2012. 

As a result of FDIC loss sharing and prudent lending, non-performing assets (NPAs) are 1.2% for the entire loan portfolio(10) and 0% for originated loans since the 2009 acquisition of New Century Bank.  In short, this underwriting team is outstanding.

In addition, the Bank’s allowance for loan and lease losses (ALLL) is equal to 103.4% of non-performing loans (NPLs).  Therefore, even if all of the defaulting loans in the portfolio were written-down to zero, shareholders’ equity would still not be pierced.  As far as the potential for additional losses in the portfolio to manifest in the future, the amount is limited.  Given the preponderance of short-term warehouse loans, FDIC loss-sharing on legacy loans, and very conservative underwriting standards, Customers Bank stands out as one of the few banks in the United States with little-to-no balance sheet risk. 

In summary, Customers Bank has a simple formula for success: (1) superior credit quality, plus (2) revenues = 2x expenses (50% efficiency ratio), equals 1% ROA and double-digit ROE. 

Valuation

Valuation is not in the eyes of the beholder, it is neither art nor love.  It is science.  Every input must be validated; every output must be cross-checked.  Based on (1) the high correlation between return on equity (ROE) and P/TBV, and (2) comparable bank valuations, we employ a range of Price-to-Tangible Book Value multiples (P/TBV) and Price-to-Earnings (P/E) – to estimate the future value of Customers Bank.  Empirically, the higher the return on equity the higher the multiple of book value.  This basic relationship between P/BV and ROE generally holds across all banking (spread) businesses.  Based on data from SNL Financial going back to 1990, the median P/TBV of announced M&A transactions is 1.8x.  In the early 1990s, banks were sold in the range of 1.3x to 1.8x before launching above 2x in 1997 and remaining there for 10 years except during the brief recession that followed the bursting of the internet bubble.  By 2003, M&A multiples were back over 2x, peaking at 2.3x in 2006.

Customers Bank is a significantly undervalued bank.  It earns a 12% ROE compared to 9.5% for its peers yet trades at 1.2x TBV compared to 1.6x.  CUBI should trade at a premium (or at least in line) with its peer group given its superior ROE driven by superior cost management.  CUBI is one of the most profitable banks in the U.S. and has minimal credit risk.   When CUBI lists on the Nasdaq later this quarter (2Q 2013), the increase in liquidity and trading volume will catalyze the process of elevating the stock price to a level consistent with other similar publicly-traded community banks.

Ultimately, an investment in a bank is an investment in people.  While I can’t say that we at 3-Sigma Value have a spotless record investing in bank management teams, we do have an extensive one, during which time we have conducted due diligence on over 100 past, present, and potential bank management teams. 

A fellow investor in Customers Bank warned me not to be “overly-wowed” by Jay’s knowledge of banking – a contradiction given knowledge is what we are seeking.  Jay is not “shareholder friendly,” I am told over and over again – based on a version of the Sovereign tale that history has proven false.

The basic reason Customer Bank is undervalued is the so-called “Jay Sidhu discount” – a discount that we strongly believe is unwarranted and depreciating with each impressive quarter of revenue growth and cost management.  Recently, Customers Bank was ranked #1 by Bank Director magazine in terms of organic revenue growth based on data on all U.S. banks, compiled by Bank Intelligence Solutions, a subsidiary of Fiserve (FISV).  The data is overwhelming.  See for yourself:

http://www.bankdirector.com/index.php/magazine/archives/2nd-quarter-2013/who-says-there-s-no-growth-in-banking/

Final Thoughts

In electrical engineering, there is concept called losing the signal in the noise, which when applied to economics describes the failure of forecasting and misuse of statistical probabilities.  A signal is something that conveys information, while noise is superfluous, meaningless, or random.  Problems arise when the noise is as strong as, or stronger than, the signal.    In today’s interconnected world, the amount of data we have available to measure and make projections is evergreen yet our ability to extract meaning and truth from it is limited by models that are corrupted by false inputs. 

In order to salvage the U.S. banking system, the Federal Reserve perpetuates two policies that distort reality:

1.  Pegs short-term interest rates at zero percent, enabling banks to borrow at ~zero and lend at three, four, five percent, it doesn’t matter the rate on mortgages because when a bank’s cost of capital is zero (or near-zero) all balance sheet activity is accretive.    

2.  Suspends the rules governing mark-to-market accounting, making it impossible to rely on the valuations of loans and other assets as reflected in a bank’s audited financial statements.

Banks collectively continue to earn rising profits as a result of these two controlling policies, posting a healthy ROA (return on assets) of 1.00% in 2012, up from 0.88% in 2011.  2013 should be no different.  Bank charters are licenses to make money.  And a bank without legacy credit risk is one of the best investments we can think of in this era of financial repression.  Within that construct, Customers Bank is statistically the most attractive bank in the United States in terms of the combination of revenue growth, cost management, and valuation.  The noise is strong but so is the signal.  This bank is undervalued. 

For more information, please contact us at info@3sigmavalue.com.

A Brief Overview of the Pitiable State of the U.S. Banking System

On May 24, 2011, the FDIC released its Quarterly Banking Profile for the First Quarter of 2011, a grim reminder of the insolvency of the U.S. banking system and its dependence on the federal government.

The number of FDIC-insured commercial banks and savings institutions reporting quarterly financial results fell from 7,658 at year end 2010 to 7,574 at the end of Q1 2011.  One new reporting institution was added during the quarter, while 26 institutions failed and 56 were absorbed by mergers.  Total assets of insured institutions on the FDIC’s Problem List increased from $390 billion to $397 billion, and the number of institutions increased from 884 to 888, representing the largest number of problem institutions since March 31, 1993, when there were 928(1). 

At the depths of the financial crisis in early 2009, FASB(2) looked into the abyss and ceded the rules governing mark-to-market accounting.  On April 9, 2009, FAS 157 was officially updated, suspending the accounting of reality when market conditions are deemed “unsteady or inactive”.  Since then, it has become impossible to rely on the valuations of loans and other assets as reflected in a bank’s audited financial statements.

Making matters even more fictional, on January 6, 2011, the Fed announced a change in accounting that magically transforms its losses into a liability of the Treasury (a.k.a. the taxpayer) rather than a charge to its capital.  This invention of a “negative liability” to maintain solvency is a perverse idea never before applied in legitimate audited financial reporting.

When the Fed generates profits in the normal course of its business, it distributes all of it to the U.S. Treasury.  However, by adopting the newly-concocted negative liability rule, the Fed no longer is required to record a decline in its capital when accounting for a decline in the value of its assets.  Instead, it can simply subtract the amount of the loss from its liabilities based on the premise that since the Fed owes its profits to the Treasury it is merely deferring their eventual disbursement. 

The Fed’s balance sheet has tripled in size since the crisis to a record $2.8 trillion in assets(3) – many of doubtful provenance and the vast majority highly sensitive in their valuation to the level of interest rates.  Supporting this is a slim $53 billion in capital, meaning that a mere 2% decline in the value of its assets would render our central bank theoretically insolvent.

It is easy and inevitable – the Fed will disguise losses in its expanded portfolio of toxic assets until its transformation into a zombie bank is complete.  As we wonder about the constitutionality of the newly-empowered reciprocal relationship between the supposedly independent Fed and the Obama administration, we arrive at the final conclusion that the U.S. banking system has become a Ponzi scheme.  Banks sell assets to the Fed at prices that do not reflect reality, and the Fed buries the losses.  In the meantime, fiction rules as the Fed suspends reality-based accounting and prints money to artificially inflate those same asset prices.  The end game is inevitable and approaching at an accelerating pace.

While FDIC-insured banks in the first quarter of 2011 earned their highest quarterly net income since the onset of the financial crisis – due to high levels of net interest margin (NIM) and falling loan loss provisions – revenues posted a 3.2% year-over-year decline, only the second time in 27 years for which data are available that the industry experienced a decline in quarterly revenue.  Weak loan demand is the primary culprit as loan balances posted the fifth-largest quarterly percentage decline in the 28 years for which data is available.  1-4 family residential mortgages fell 3.4%, credit card balances were down 5.5%, and real estate construction & development loans dropped 8.1%.  The only major loan type experiencing growth was C&I (commercial & industrial) loans, up 1.5%.  As of March 31, 2011, net loans and leases represented 52.4% of FDIC-insured institutions’ assets, the lowest level since the early 1970s.

Sheila Bair and other employees of the FDIC have repeatedly stated their expectation of massive consolidation in the U.S. banking system.  Starting with FDIC-assisted acquisitions of failed banks – of which 888 currently toil on the Problem List – consolidation will migrate to mergers and other un-assisted transactions until the number of banks in the U.S. is cut in half, at least.  This is precisely the reason why it is next to impossible for a new management team to be granted a de novo bank charter.  The FDIC doesn’t want to insure more banks, they want less. 

Supported by one of the most profitable banking environments in modern history given the steepness of the yield curve, Net Interest Margin (NIM) of 3.57% in Q1 2011 was higher than the 3.33% earned during the peak of the banking cycle in the second quarter of 2007(4)  In comparison, the 20-year average slope is approximately 170 bps.  Since 2009, the curve has barely shifted as the short end stays pegged at zero and economic data remains mixed.  Meanwhile, legacy credit issues continue to eradicate the earnings of much of the community banking system despite the improvement in industry-wide loss provisioning in the first quarter.

In its March 31, 2011 financial report, the People’s Bank of China (the central bank of China) disclosed leverage (defined as assets divided by equity) equal to 1,223-to-1, meaning a loss of merely 0.1% would render the bank theoretically insolvent.  However, unlike the Federal Reserve Bank of the United States’ claim of independence, China’s central bank is a socialized institution.  Via the distribution networks of the four big state-controlled commercial banks(5), the government plans and manages growth in the national economy by lending freely to Chinese companies in a frantic effort to maintain ~10% annual GDP growth(6) (+9.7% in 1Q11).

Much like the state-controlled China banks, the too-big-too-fail banks in the U.S. exist to serve the state, not the stockholders.  As well, the Fed has become a socialized institution like the PBoC suppressing interest rates, manipulating yield curves, and debasing currency, all in the name of the specious wealth effect.  The idea that the U.S. government can artificially support asset prices through fiscal and monetary stimulus until the economy is healed and the banking system stabilized is nonsensical unless and until the root cause of the crisis is addressed.  How does more debt solve the problem of too much debt? 

Our government tells us with “100% confidence”(7) that the high jacking of capitalism will ultimately be short-lived, the academics will be vindicated, and the crisis that began in July 2007 will become history.  Unfortunately, capitalism is dead, as dead as it was in September 2008.   The new economy is a command and control exercise led by academics and bureaucrats, the natural interplay of supply and demand warped by the government’s hand.  And while this environment sounds dire for investors like 3-Sigma Value, we embrace the opportunities available under the new hybrid socialist-capitalist system, and we evolve.

For a complete report, please contact us at info@3sigmavalue.com.

The Student Debt Bubble (1)

According to the Consumer Financial Protection Bureau the amount of student debt in the Unied States is over $1 trillion and counting, more than the total amount of credit card debt and more than the total amount of automobile debt.  This recent acceleration in student debt is a direct result of the marketing of online degrees to working and non-working adults who are eligible for Federal Title IV aid. 

But what makes student debt so much more insidious then credit card or auto debt is its bankruptcy exclusion.  Our generation will be carrying this debt and passing it on to our children, a burden that will be shared by yet another governmental apparatchik, by more money printing and spending and regulation.

The For Profit Education (FPE) Industry is at the vanguard of the student debt bubble, they are the sub-prime originators of student debt, with fleets of recuriters and multi-million dollar marketing budgets funded by the U.S. tax payer via Military, Pell Grant and Stafford Loan Programs. 

In a Barron's Cover Story on April 16, 2012, the Senate Health, Education, Labor, and Pensions Committee, which has been investigating the For-Profit industry, says that FPEs account for 10% of the post-secondary school population yet 40-50% of all student loan defaults.  This is a slow-motion debacle that is well-covered by the media.   

3-Sigma Value identifies 14 publicly-traded pure-play FPEs (excluding Kaplan which is owned by The Washington Post (WPO)).  4 are likely to survive an enhanced regulatory regime.  7 are question marks.  3 are likely to be shut or sold.

For more information, please contact us at info@3sigmavalue.com.

Economies of Light: The LED/OLED Revolution (1)

Chapter 1:  Introduction to the LED/OLED Revolution

Chapter 2:  Sapphire

Chapter 3:  MOCVD Equipment

Chapter 4:  Universal Display and the Value of Patents

Chapter 5:  Cree is the First Solar of LED

Chapter 1

Introduction to the LED/OLED Revolution

A Light Emitting Diode (LED) is made of semiconductor materials (positively and negatively charged particles – “diodes”) placed on a sapphire substrate via a process called epitaxial deposition.  As a result of LED’s advantages over other sources of light in terms of power consumption, heat dissipation, lifetime, durability and other application-dependent benefits, the market for LED is expanding rapidly (2).

The problem, of course, is price.  According to Google, a 60-watt LED bulb costs $35+ while a 60-watt incandescent bulb costs only $1-$2.  Ergo, LED adoption in general lighting applications is still a long way off.

At the core of 3-Sigma Value’s analysis are assumptions regarding the rate of decline in LED prices.  Similar to other technology products – i.e. mobile phones, TVs (where prices have fallen between 10% and 20% per year), computing memory, etc. – we expect most segments of LED to experience year-over-year price declines in the double-digits.  In the most recent quarter (Q3 2010), white LED prices across various applications declined between 3% and 28%.

Similarly, industry reporter Digitimes recently noted that LED lighting prices are expected to drop by 15-20% each year for the next three years as vendors reduce prices to gain market share amid a glut of new capacity.  Because prices for LED are not yet competitive in the general lighting market, LED adoption has cycled through smaller markets where penetration is now virtually complete.  Specifically, LED has 100% market share in keypad illumination; and dominant market share (90-100% market share) in screens for small mobile devices – handsets, cameras, mp3 players, etc. – and IT backlighting for larger notebooks and tablet computers.  Most recently, LED has begun taking share from LCD flat-panel televisions.

The first LED-lit television was introduced by Sony in 2004 - a direct-lit model that had a significant price premium over the same-sized CFL model.  A redesign by Samsung in 2009 to an edge-lit model reduced the number of LEDs from 1000+ to 200-600, enabling the price gap to CFL televisions to shrink to $700-800, in exchange for the following advantages.

The premium of a LED 42” television over a CFL 42” television is currently ~$300, and falling, and as a direct result LED market share continues to grow.

Offsetting this growth, however, is continual improvements in technology and design that are deflationary in nature, including the forthcoming shift from 6 LED light bar TVs (600 chips) to 4 light bars (400 chips) and eventually to 1-2 light bars (100-200 chips).  Materially less LED per television will drive down its cost, driving up its market share, and ultimately leading to a rapid saturation as we have witnessed in the markets for small mobile devices and notebooks / tablets.

The final and by far the most significant cycle of LED adoption is general lighting, a global market measuring $80+ billion.  Unfortunately for the LED supply chain which ramped up in anticipation of consumer breakeven in the immediate term, pricing for LED lamps remains at a significant premium.  For example, a 60-watt incandescent bulb costs $1-$2, a 75-watt CFL is $5, and a 60-watt LED costs $35+.

Because current LED lamps have a lifetime of over 50,000 hours versus corresponding lifetimes of ~1,000 hours for incandescent and 10,000 hours for CFL, the overall lifetime cost of ownership can be lower for an LED light.  Some applications exist where a longer payback period is acceptable when combined with other factors such as the inaccessibility of the light socket.  The most prominent example of an early adopter of LED is the streetlight. 

First, streetlights are on for long periods of time: 10 to 12 hours per day; and second, governments are willing to accept longer payback periods.   Third, streetlight sockets are inaccessible, requiring labor and/or traffic disruption in order to change.  And finally, government stimulus and grant money (most notably in China) will continue to spur demand.

The current installed base of 220 million streetlights worldwide(3) has a 1% worldwide LED penetration – with 0% penetration in the U.S. and the EU.  Traditional streetlights use one of the following technologies: high-pressure sodium, low-pressure sodium, mercury vapor, and metal halide.  Using the U.S. installed base as an example, high pressure sodium (59% market share) and mercury vapor (20%) represent the two largest sources of streetlight (4).

Pricing of LED is, of course, the most significant obstacle in adoption.  Focusing on payback periods means that the case for LED lighting is a difficult one to make – the payback period is 6 years by most estimates on a new install, and even longer (~10 years) on a retrofit installation of a streetlight:

Even after prospective cost improvements, by 2013 this payback will still be roughly 2 years for new construction and 6 years for a retrofit.

Given that other applications have different payback periods (notably residential lighting, which is the largest component of the lighting market) we segment general lighting into three categories:  (1) street lighting and area lighting (2) commercial and industrial lighting and (3) residential lighting. Each of these categories has a different adoption period and usage pattern that relies heavily on when LED technology becomes economical.

In street lighting and area (municipal) lighting, penetration will grow strongly over a small current installed base as a result of numerous government initiatives in the U.S., E.U., and China.  In particular, the Chinese streetlight initiative will spur strong adoption well into 2016.

In the remaining general illumination markets of commercial, industrial, and finally residential lighting, the timing of changes in pricing will largely determine the adoption curve.  In commercial lighting, the payback calculation is a LED light versus a T8 fluorescent light. Although fluorescent lighting is already fairly efficient, an analysis of payback for commercial applications indicates that LED lighting can offer a compelling value proposition:

Some customers will accept this payback period, while others will wait for the cost to drop from $60 to $35, the mathematical result of 3 years of 20% annual price decline.  At that price, payback for a new lamp drops to 1.68 years and for a retrofit it drops to 3.29 years.  By 2013/2014 we expect strong adoption in commercial and industrial lighting.  However, similar to other LED products, a decrease in the number of chips per tube effectively reduces unit demand, mitigating a portion of  the overall industry growth.

With ~20-25 billion light sockets world-wide, and estimates that residential accounts for ~90% of this total, residential is truly the holy grail of LED adoption.  Unfortunately, residential lighting has a much longer payback period because of the fact that residential lights are typically on for fewer hours in a day. Additionally, many consumers have already made the switch to energy-efficient CFLs, rendering the value proposition for LEDs less compelling:

Retrofits are obviously not an option in most cases, leaving the market to new construction, which, as we are all well aware, is under a great deal of pressure and is not expected to grow substantially for several years.  Nonetheless, by 2013/2014, payback periods versus incandescent lighting for new construction should approach 2-3 years, and that should be enough to drive LED adoption at the high end.

Consolidating all of the LED markets (including estimates for other applications and one-off markets such as automotive, signs/displays, traffic signals) to get a sense of the overall demand for LED leads us to the following Base Case scenario for incremental unit demand:

Conclusion: LED demand is likely to be extremely weak for the next two years, and possibly longer, into 2013.  At some point, when LED prices have declined to the point where builders are willing to accept a relatively efficient payback period – 2 or 3 years is likely to be sufficient to inspire demand – then commercial and industrial applications, followed by residential new builds will adopt LED, launching incremental unit demand into the stratosphere.  Innovation manifest in the form of price deflation, however, means that revenue will progressively weaken as penetration rises.  The decreasing number of chips per application, in almost every application, along with shifts in product mix and new innovation creates winners and losers that must be discriminated in order to invest in LED.  While our demand analysis clearly shows that the LED industry will crash hard in 2012, it is entirely possible, if not likely, that demand will rebound shortly thereafter, in and around 2013 when prices have substantially declined to levels that promote demand in commercial and industrial, and residential applications. 

Chapter 2: Sapphire

Thesis: The emergence of merchant suppliers of sapphire equipment removes the key barrier to entry, leading to structural overcapacity in the commodity sapphire market. 

Conclusion: Short Rubicon Technology (RBCN)

On July 25, 2008, at the height of solar power hysteria when investors were bidding the valuations of any company in the solar supply chain up to dot com levels, a merchant supplier of polysilicon production equipment called GT Solar (SOLR) went public with a business plan disruptive to the incumbent polysilicon producers: MEMC Electronic Materials (WFR), Wacker Chemie AG (WCH.Germany), Renewable Energy Corp (REC.Norway), GSL-Polysilicon (#1 in China), OCI Company (formerly DC Chemical in South Korea) and Hemlock (private; majority owned by Dow Chemical (DOW)). 

The bellwether of the group, MEMC, closed trading on the day of GT Solar’s IPO at $45.47.  By the end of the year 2010, the stock was $11.26.

Two years after its IPO, on July 30, 2010, GT Solar announced the replication of its merchant equipment strategy in the sapphire market through the acquisition of a company called Crystal Systems.  Similar to polysilicon equipment, sapphire equipment is not unique technology.  The industry dynamic can be characterized as a rat race to build furnaces that make large diameter (6 inches and above) sapphire wafers efficiently.  The larger the size of the wafer, the lower the overall cost of a chip.  Crystal Systems’ furnaces make sapphire boules weighing 250 kilograms, which is far superior to the 35-85 kilogram boules available today using the mainstream Kyropoulos approach to crystal growth.

Sapphire capacity is expanding at breakneck speed.  GT Solar management plans to triple sapphire capacity to 7 million 2-inch wafer equivalents (TIE) "in a couple of years" while Rubicon is increasing capacity from 5 million TIE to 10 million TIE by the end of 2011.

Over the next 3-4 years, global capacity of 30 million TIE is growing 3-5x to 90-150 million TIE, and this is happening without any regard to global demand.  As described earlier in this report, incremental unit demand for LED will tumble in 2011/2012, or until the price of LED declines to a point that spurs general lighting adoption.  For sapphire producers, this scenario represents a complete disaster.  The lack of incremental demand for an extended period of time (2011/2012) always forces a rationalization of the supply chain, however, what’s different this time around is the availability of cheap merchant equipment.  Why pay Rubicon an inflated price when you can process your own sapphire for a few million dollars of equipment that can be financed.

LED supplier, Tera Xtal, who accounted for 15% of Rubicon’s sales in 2010 (17% in 2009), announced the purchase of sapphire furnaces and sapphire material from GT Solar.  In January 2011, two major polysilicon producers announced their incursion into the sapphire wafer/ingot business via purchases from GT Solar: (i) Sino-American Silicon, based in Taiwan, is planning an initial capacity of 100,000 TIE/month (1.2 million per year), and (ii) OCI Company, based in South Korea, a leading incumbent polysilicon producer announced $90 million of purchases of sapphire furnaces from GT Solar ramping up to about 2.7 million TIE per year.  With more and more new entrants to the sapphire market buying furnaces from GT Solar (and to a lesser extent a company called Thermal Technology), the barriers to entry to the sapphire industry are crumbling down.

Sapphire wafer production is a highly-cyclical commodity business deserving a highly-cyclical commodity valuation.  Rubicon went public at $17.50 per share on November 16, 2007 at the top of the market.  A year later on 11/17/08 it had crashed to a low of $3.07 before storming back to an all-time closing high of $33.17 on 7/19/10.  Recently it broke back below $20, and is likely headed further down to $10 and $6 according to our Base and Downside Case scenarios respectively.

Chapter 3: MOCVD Equipment

Thesis: The Chinese subsidy-driven build in LED capacity has pulled demand forward for MOCVD equipment, stuffing the channel, and leaving the MOCVD companies with a bleak outlook as general lighting applications remain slow to adopt LED. 

Conclusion: Short Aixtron (AIXG).

The MOCVD market is a duopoly that will collapse in 2011/2012 as the dramatic forward demand buys related to Chinese subsidies ends.  In 2007, these two companies, Aixtron (AIXG) and Veeco (VECO) were trading at 25% of their current stock prices, and we expect them to return to those levels

MOCVD equipment (also referred to as MOCVD “tools”) is the primary reactor in which LED is manufactured.  With an average selling price ~$2 million, they represent about 50% of the cost of an LED fabrication plant.  While chemical vapor deposition technology has been around for decades and is also used in the solar, data storage and industrial equipment markets, MOCVD manufacturers have recently seen their fortunes dramatically improve as LED has ramped-up in adoption.  Despite the heavy fragmentation of the LED market, most of the purchasers of MOCVDs are the Tier 1 and 2 global suppliers, and we estimate that this constitutes not more than 40 or so total firms.  Notably, two of the tier 1 suppliers – Cree and Nichia – create their own production equipment internally (and Cree uses a different process based on Silicon Carbide instead of the Gallium Arsenide standard).  

There are only three manufacturers of these machines: Aixtron, Veeco, and Nippon Sanso.  Aixtron and Veeco together control substantially 100% of the merchant (non-captive) market, with market share breakdowns of roughly 55% for AIXG and 45% for VECO.

Conversations with both Aixtron and Veeco management teams, as well as with industry and sell-side analysts, confirm that roughly 800 machines were shipped in 2010E, 3.9x the 205 machines shipped in 2009.  This is incredible growth that is not only unsustainable but dangerous for those players that must expand capacity to meet the rush of orders or else risk losing permanent market share.  It’s a classic prisoner’s dilemma.

The Chinese government has placed a high priority on the development of a domestic solid-state lighting industry, commissioned a National Solid State Lighting program, and in October of 2009 began offering a subsidy up to 50% of the total purchase price of MOCVD equipment.  These subsidies are available both to domestic Chinese companies and to Taiwanese companies that open factories in mainland China.  According to Aixtron and Veeco, of the ~800 MOCVD tools shipped in 2010, 26% were shipped to China, a global market share that should rise to nearly 50% in 2011E.

Using our LED unit demand analysis from earlier, we calculate a Base Case scenario for incremental demand for MOCVD tools.  The key assumptions are as follows:

(1)  10% output growth per year per MOCVD machine. Improvements in yield and manufacturing are required to lower costs.

(2)  2008 chip output per machine of 48.2 million LED (across all technologies / applications / wafer sizes) is the baseline year.

(3)  80% share of MOCVD tools sold applicable to the LED market.  The rest are sold to solar and laser companies. 

(4)  5% replacement of the installed base of MOCVD tools is required each year.

130 of the machines (out of 211) shipped to China in 2010 were pure subsidy-driven demand pulled forward – a “bump” that will erode demand in future years.  Assuming the high-end of the reported subsidy ($500 million) and an average subsidy equal to 50% of the ~$2 million average price of an MOCVD (or roughly $1 million), we estimate 500 total “subsidy MOCVD units”.  If 130 units shipped to China in 2010 were subsidy-driven, then 370 units remain.  To be conservative, we assume China ends its subsidy program only in a Downside Case.

Applying this demand analysis to Aixtron and Veeco generates a bleak picture for the two companies.

Current consensus in the analyst community expects tool demand in 2012 to stay roughly even with 2011, implying a massive increase in the Chinese subsidy and/or demand from Taiwanese and Korean manufacturers to step up.  In sum, current market expectations for VECO and AIXG in 2011 and 2012 are detached from reality.

While both VECO and AIXG are attractive short candidates given the outlook for MOCVD tool demand, 3-Sigma Value concentrates its allocation in AIXG because it is the weaker player yet it trades at a crazy premium.  VECO is more diversified and sells a superior product.  The MaxBright, VECO’s latest MOCVD has higher throughput and costs less to maintain than AIXG’s competing Planetary Reactor or Showerhead product.  As a result, VECO’s equipment generates a higher gross margin for its customers and is why VECO is projected to continue gaining market share.  There is no reason AIXG should be trading at a 100% premium to VECO, when in fact it should be trading at a discount.

In conclusion, Aixtron (AIXG) is a highly-cyclical semi-cap equipment stock at an unprecedented market peak trading as if it were a sustainable double-digit growth company.  AIXG has risen from $5 to >$40 over the past 2 years.  Prior to 2009, the all-time high was $15 in the summer of 2008.  We fully expect the stock to fall back to $20 once the market accepts 2011/2012 as a peak for MOCVD orders as opposed to a new era of equipment demand. 

Chpater 4: Universal Display and The Value of Patents

Thesis: The widely-anticipated migration from LCD/LED to OLED is similar to the migration from incandescent/fluorescent to LED in the sense that there will be winners and losers.  One blatantly over-hyped and over-valued company is Universal Display (PANL), a patent-holder (5) with no operations whose core patents expire in 2017.

In Las Vegas on January 11, 2012, the breakout hit at the 2012 International Consumer Electronics Show (CES) was Samsung’s 55-inch Super OLED TV (0.3 inches thin), collecting numerous prestigious awards from media outlets including Popular Science, Stuff Magazine and G4 TV, as well as a Best of CES Innovations Award from CEA, the producer of the International CES. 

Samsung hasn’t mentioned any pricing information for its 55-inch OLED but says it will be shipped to retail before the end of the year.  Whatever its ultimate price, $10,000-plus, OLED TVs will remain a super-luxury non-discretionary item for at least the next 3-4 years, given a downward trajectory in pricing similar to what we have witnessed in LED.

At this early stage in the OLED lifecycle, there is only one customer of any significance – Samsung(6), who, in August 2011, renegotiated its supply contract with PANL, changing the key economic term.  Instead of paying a variable rate based on unit sales, Samsung now only pays a flat licensing fee, which by definition limits the potential upside for PANL. 

Management points to materials(7) sales to Samsung as a source of upside but materials (host and emitter) are a commodity business with margins that will ultimately approach zero as patents expire and the price decline curve follows the same pattern that we see over and over again, with sapphire and solar-grade silicon and computer memory, etc.

The incredible valuation premium accorded to PANL is a function of the perception of value in the OLED patent portfolio, not in future sales of commodity materials.  No matter how far we stretch the assumptions underlying the transition of the IT and TV backlighting markets from LCD & LED to OLED, PANL will never sell enough emitter materials (and host materials to a lesser extent) to remotely justify the Company's $2 billion market capitalization.  With $61.3 million of total revenues in 2011 growing to a range of $303-$644 million in peak year 2017, the stock already trades at 2.6 to 5.6x peak revenue.  On an EPS basis, while Goldman Sachs sees $10 EPS, we see at most $4-$5 in the Base Case, before collapsing after its core patents expire to $1-$2 in 2018.

It is generally and widely understood that when the core patents expire, the economics (licensing fees) will change.  Management, cleverly, redirects every question about the core patents to other patents in OLED materials that expire in 2020 (3 more years of monopoly) and later.  They say future growth will come from flexible OLED and single-layer encapsulation technology.  However, none of this will offset the collapse in core revenues in 2018.  After substantial due diligence including conversations with Samsung, we strongly believe that once the core patents expire the best case scenario is a long-term emitter (and host) materials agreement at a significant discount to current prices(8).  Under no scenario do we see Samsung paying royalties for a technology off patent.  Therefore, our Base and Upside scenarios both assume that Samsung (and LG) buy their emitter materials from PANL.  The variable is the amount paid.

Without monopolistic control over the market for key PHOLED(9) technologies, other chemical companies – Merck AG, Dow Chemical, DuPont, BASF, Fujitsu, Sumitomo, LG Chemical, to name a few – will compete on the basis of price.  Merck AG in particular is relevant because it holds a virtual monopoly in the global LCD display industry owing to legacy patents(10).  

Merck AG reports a segment called Performance Materials which is largely the production of liquid crystals for LCD.  Since one of the benefits of OLED over LCD is that it uses less than 30% of the amount of material of an equivalent-size LCD TV and therefore is cheaper to produce, we assume the OLED market available to PANL is roughly 30% of the revenues generated by Merck’s Performance Materials (PM) Division.  In 2011, that number was E1,467 million.  30% is E440 million.  Over the course of the next five years, revenues related to general lighting applications will be negligible, and therefore nearly all of the incremental growth will come from TVs.

The fatal flaw in OLED is ironically the same factor underlying its development in the first place – that is, innovation is accelerating, and as a result, the development of new technology is accelerating.  OLED will remain technologically advanced for a short window of time and preventatively expensive throughout that window.  By the time the price of OLED drops to a point of economic equivalency its technological advantages will be matched or exceeded.  The lighting business is a rat race and a terrible place to invest. 

Valuing PANL depends entirely on the value of the patent portfolio as reflected in its potential to earn high margins on sales of otherwise commodity chemical materials.  We identify 3 basic scenarios:

1.  Downside Case – PANL loses core patent protection in 2017, new entrants enter the market for emitter materials, and pricing drops to its marginal cost of production.  In this case, PANL is worth not much more than the accumulated cash on its balance sheet.

2.  Base Case – PANL loses core patent protection in 2017 but to avoid litigating at a crucial time in the OLED market’s development, Samsung and LG (and others) agree to long-term material supply contracts at reduced margins.

3.  Upside Case – PANL retains core patent protection beyond 2017 and customers continue paying royalties on top of material costs.

Projecting royalties is straight-forward given Samsung is the only customer of scale, and hence, the price setter in the market.  We utilize our Demand Analysis to establish a range of scenarios for volumes in the three primary markets for OLED: (i) mobile devices, (ii) tablets, and (iii) TVs; and then apply the terms of the Samsung contract(11) to the rest of the market.  Projecting material sales is far more complex, and far more uncertain.  In general, phosphorescent emitter materials (mainly red and green, and when mixed with other chemicals produces high brightness white light) sell for around $400 per gram; and 1 gram can produce ~5,000 small mobile devices (defined as 4.5” diagonal displays(12).

Observations & other considerations

PANL’s 10-K discloses a multitude of patent litigations in Korea, Japan, Europe, and the US.  In particular, in June 2011, certain patents were invalidated in Japan for being too broad in scope.  Similarly, in Europe, PANL has been ordered to limit the scope of one of its core patents.   While management points to the validation of the vast majority of its patents in all of these markets, the sad truth is that by the end of 2017 this will all be moot. 

LG is not using PANL’s materials (or IP) to make its 55 inch OLED TV unveiled at CES in January.  Rather, it makes its white OLED backlight by stacking a blue fluorescent OLED (from Idemitsu) on top of an orange/yellow phosphorescent OLED, a process documented by Korean scientists in 2008.

A game changer for OLED adoption (Upside Case) is the impact that Apple (AAPL) would have on demand if it were ever to deploy OLED displays.  While many investors believe this is inevitable, we find numerous issues complicating this transition including the simple fact that the only credible supplier with scale for a customer of Apple’s size is Samsung, who employs OLED to differentiate itself from its competition, most notably Apple.  It is hard to believe Apple will buy from Samsung.  Most likely, Apple will continue to use its existing Retina display technology for the next version of the iPad, and then migrate to super LCD.  More generally, the improving performance of LCD is slowing a broader adoption of OLED beyond Samsung.

Finally, the greatest long-term opportunity in solid-state lighting, the Holy Grail, is general lighting.  While general lighting is by far the largest application, it is also the one where OLED is unsuitable.  OLED produces relatively low density (light per square area) compared to LED, requiring more area to generate an equal amount of light.  A ceiling would have to be covered by OLED panels in order to achieve equivalence.   PANL will not benefit from the eventual adoption of solid-state technology (LED) by general lighting applications.

In conclusion, PANL has been hiding the details of the Samsung agreement because the economic terms do not support the Company’s $2.1 billion market cap.  LG is locked up in an IP dispute with Samsung.  AU Optronics, Chimei Innolux, and Sony are all customers that will not contribute in a meaningful way for years to come.  2018 will be a new world for PANL.  License fees and royalties will crash.  Material sales will continue but at a lower price, generating lower margins.  PANL will survive, no doubt; it has $346 million of cash and no debt ($7.38 net cash per share) and generated cash for the first time in 2011 ($8 million).  3-Sigma Value’s probability-weighted target price is $19.13, down 56% from the current price.

Chapter 5: Cree is the First Solar of LED 

Thesis: A declining price of sapphire, much like a declining price of polysilicon, benefits all LED manufacturers except for Cree.

Competing against industry giants including Samsung, LG Innotek, Philips Lumileds, Siemens Osram (the producer of Sylvania), and Nichia as well as an onslaught of emerging Chinese suppliers, Cree is the next in a long line of US innovators to succumb to the over-powering supply of Asian manufacturers.  There is nothing illegal or unfair or duplicitous about this dynamic, it is simply the natural result of supply and demand in commodity markets.  Light is a commodity.  And therefore, whoever can package it at the lowest cost wins, period.

Cree is a vertically-integrated LED chip manufacturer and the technology leader, as defined in lumens per watt (5/9/11 - announced a record-breaking 231 lumen/watt LED(12), but dollars per lumen is what matters in terms of lighting adoption, and based on channel checks Cree continues to lose market share as sapphire-based competitors price aggressively, providing better lumens per dollar at acceptable levels of brightness (lumens) and efficiency (lumens per watt).

Cree’s use of silicon carbide (SiC) in the production of LED has enabled it to generate higher gross margins (35% as of 3/31/12) than its sapphire based peers (teens%) in a world where sapphire is in short supply.  But now that merchant sapphire has flooded the global market, pricing has collapsed to its marginal cost of production and Cree must react accordingly to maintain market share.  LED prices are down 50% year-over-year, and Cree’s EPS has followed, down from $1.45 in 2010 to $0.40 in 2011, and on a quarterly basis, down to $0.08 in the latest quarter.

Recognizing the need to diversify its business away from manufacturing LED components, beginning in 2008, Cree began acquiring companies downstream in the business of manufacturing and selling lighting products and systems.  In 2011, the Company acquired Ruud Lighting, entering the outdoor lighting market and now competing against many of its own customers.  In response, many of Cree’s competitors including Acuity Brands (AYI) and Cooper Industries (CBE) attacked, sending letters to their lighting agents arguing they should no longer carry Ruud products.  A year later, in retrospect, execution of the Ruud acquisition has been miserable, agency turnover has been extreme with 80% of sales agents new to the product line, and the transition continues to be a convenient source of blame for slowing revenue growth and poor margins.  In the most recent quarter (FYQ3 2012 ended 3/31/12), lighting products comprised 30.4% of total revenue, a number expected to continue rising.

Margin Structure of LED

Most sapphire-based LED manufacturers generate lousy commodity-type gross margins in the teens, leaving not much room for research and development (R&D) and other operating expenses.  On the other hand, lighting OEMs such as Copper, Acuity, and Phillips Lighting (PHIA.AMS) enjoy seemingly stable gross margins in the low 30% range.

Cree’s gross margin plunged from 44% in its fiscal year 2011 (ended 6/30/11) to 35% in 2012E largely due to the declining price of LED.  By offsetting the secularly declining margin inherent in selling a commodity LED with acquired revenues in the design, manufacture, and sale of lighting fixtures and systems, Cree management says it can maintain its 30% gross margin - which allows it to continue spending on R&D.  Because Cree walks alone, manufacturing LED using a SiC substrate, R&D as a % of revenue is significantly higher than at its peers (13% in 2011, similar level in 2012). 

In opposition to our thesis, Cree management says a declining price of sapphire shouldn't impact Cree as much as a declining price of polysilicon impacts First Solar because sapphire (substrate cost) is a far smaller percentage (6%) of the cost of LED than polysilicon is a share of the cost of a solar cell (~30%).

Unfortunately, this over-simplified argument fails to account for the additional expenses built into Cree’s closed infrastructure, a wholly-owned supply chain designed to support a product sold at a 40-50% gross margin.  R&D equals ~10% of revenue in a steady-state (13% / 12% in FY 2011 / 2012), compared to less than 5% for most sapphire-based LED manufacturers.  SG&A was 17% in FY 2011, and will be around the same level in 2012.  Other operating expenses including amortization of acquired intangibles (acquired R&D) and impairments represent ~2-3% of revenue.

Consensus estimates for the next several years - through 2014 - are unrealistically high.  The gap between perception and reality is profound.  The back-of-the-envelope margin structure in the chart above represents an Upside Case operating scenario in which gross margin stabilizes at the current level, an assumption that is wildly optimistic in the face of LED prices plunging while the cost of packaging (41% of the bill of material) and other costs remain relatively immutable.   It is far more likely that Cree’s gross margin continues its downward trajectory.

Finally, the circumstances surrounding the recent departures of longtime executives COO Steve Kelley and CFO John Kurzwell remain shrouded.  This is a time of rapid change in Cree’s business model, an inflexion point, and arguably the right time to make personnel changes.  Nevertheless, management turnover is a bad sign, especially at a time of such import.  CEO Charles Swoboda says his company is evolving into a supplier of municipal and commercial lighting systems and is no longer an LED component supplier.  Growth is focused on the lighting products business, while LED components are an enabler.  Third party LED component sales will trend toward zero.  The business will no longer be managed as a profit center, instead, a cost center that will chase Samsung, the Chinese, et al down below its own marginal cost of production.  In sum, the silicon carbide method of manufacturing LED is fatally flawed, something that is recognized by every LED producer in the world, everyone that is, except for Cree.

For more information, please contact us at info@3sigmavalue.com.

Solar Energy is a Commodity, Not a Technology (1)

A gold rush mentality driven by expanding government subsidies and technological innovation has led to a serious near-term over-supply problem.  There are more than 60 public companies producing up and down the global photovoltaic (PV) solar supply chain, most of which have gone public since 2005 and are unlikely to survive as independent companies notwithstanding the length or severity of the global economic recession and related contraction in credit.  Herein this analysis, we attempt to separate the winners (survivors) from the losers (R.I.P.) and determine whether any of them meet 3-Sigma Value’s rigid risk-reward and total return criteria.

From a bird’s-eye view, success in solar will be achieved by any supplier (of high quality polysilicon, wafers, cells, modules, balance of system) able to contribute to a supply chain wherein both the cost of production and the cost of installation approach $1/watt (~$2/watt total cost represents grid parity in sunny areas).  These are the companies that will emerge after the boom and bust as global leaders in the production of clean energy.

Before diving deeper into the component costs of producing and installing solar panels, a few words on what it means to produce energy at grid parity.  To begin, grid parity is region specific as the amount of sunlight hours varies between regions.  Parity will first be achieved in areas with abundant sun and high costs for electricity such as in Japan and California and Hawaii.  2008 average prices of residential/commercial grid power in the United States was 11.26/10.24 cents/kwh, ranging from a high of 18.84 cents/kwh in Connecticut to 6.15 cents/kwh in Idaho, according to the EIA.  Moreover, prices on the margin can be considerably higher.  For example, in California many residential customers pay on peak rates between 30 and 40 cents/kwh. 

In order for solar to be reasonably competitive with natural gas ($0.08-$0.10/kwh) and wind turbines (~$0.09/kwh without subsidies, ~$0.07/kwh with subsidies) or in other words, approach grid parity in most markets, all of the costs involved in generating solar energy must continue falling, via advances in solar cell efficiency, improvements in solar manufacturing, and a declining price of polysilicon.  The most significant factor driving down the (fully-loaded) cost of solar energy is polysilicon.  In 2008, solar module prices averaged $3.85/watt and cost $3.10/watt, with poly accounting for $1.80-$2.20 of the $3.10 (or 60-70% of total).  Since the end of 2008, poly prices have continued their downward trajectory and module prices are following.  If poly approaches its marginal cost of production – in the $40-$60/kg range – it would reduce the cost per watt of poly to ~$0.35 and drive module prices down to ~$1.35/watt (assuming a non-silicon cost structure equal to the

leading Chinese producers and 20% gross margin) a level that would drive considerable demand because then utility-scale solar projects would have generation costs of approximately $0.10-$0.11/kwh (ITC of 30% assumed).

Polysilicon production is the logical place for us to begin our analysis; it’s the first link in the supply chain, the most capital intensive, and generates the lowest ROIC now that prices are down due to a tidal wave of supply hitting the market in 2009/2010 (2).  The first step in 3-Sigma Value’s investment process is the identification of a secular thesis driving valuations.  In other words, where and how is value being created and where is it being destroyed.  From there, we will identify those companies positively and negatively impacted by this trend, and finally we will apply our valuation framework.

Step 1: Identify Secular Thesis:  Polysilicon prices, after spiking to around $450/kg in the summer of 2008, dropped to a range of $100-150/kg in the first quarter of 2009, and have since pierced the $100/kg level.  Poly pricing will likely approach its marginal cost of production ($40-60/kg) over the next one to three years.  If not sooner.  At the end of June, Digitimes reported pricing in Asia in the $70-75/kg range.

MEMC Electronic Materials (WFR), one of the lowest cost producers of polysilicon reports a cost of goods sold (COGS) of $30/kg.  A greenfield polysilicon plant, such as the 16,000MT plant in Xinyu city, Jiangxu province, China, that LDK Solar (LDK) is building, has a $30/kg design cost as well (3).  Meanwhile, new entrants with lower yields and a lack of scale will be unable to achieve competitive economics due to their inability to absorb overhead.  The economics of the solar industry are radically changing as polysilicon becomes a smaller component of cost of goods sold (from 50-70+% to ~35%), creating new winners and losers based on relative non-silicon cost structures and technology. 

As you can see in the chart below, we estimate global supply/demand for polysilicon to turn from moderate undersupply in 2007/2008 to extreme oversupply in 2009/2010.

The only way for supply and demand to find equilibrium is for the price of poly to decline to a level at which high-cost producers (COGS >$60/kg) idle capacity.  Capacity utilization across the industry has dropped from 75% in 2007, to 68% in 2008, and will breach 60% this year; however the data is bifurcated as utilization at the Incumbent Suppliers should decline moderately to ~74% (versus 79% in 2007 and 2008) while the China-based new entrants remain a wild card.  After operating at an uneconomical 38% utilization rate in 2008, reports out of China suggest as much as 20,000MT of incremental production is coming online.  And while many analysts anticipate both China and Non-China based New Entrants to shut production as the market price falls below production costs, we believe polysilicon manufacturers are economically disincentivized to do so during the initial ramp stage, and will delay the inevitable for as long as their creditors allow them to do so.  Therefore, the 132-162% projected glut in 2009/2010 could be conservative.

While the commitment to renewables from the various governments around the world intensifies in words, the economic reality is more likely to postpone rather than accelerate demand.  Following is a brief update on the demand policies of the largest solar markets:

Germany – The largest solar market despite below average sunshine entirely due to generous subsidies.  In January 2009 the government stated its installation “target” of 1.5GW in 2009 and 1.7GW in 2010, roughly flat versus 2008’s level.

Spain – New legislation at the end of 2008 capped installations at 500MW in 2009 down from approx. 2.4GW in 2008.  This shortfall will be devastating to suppliers reliant on the once booming Spanish market.

Italy – A sensible market because of favorable sun conditions and a relatively generous feed in tariff, expected to become one of the top solar markets by 2010, although midway through 2009 only 83MW were installed (vs. 500MW full year estimate).

Japan – In January, Japan’s Ministry of Economy, Trade and Industry (METI) increased solar subsidies for residential PV systems to 20.5 billion yen from 8.6 billion, and set a (aggressive) target to increase installed solar capacity to 4.8GW in 2010, from less than 2GW in 2008. 

U.S.A. – The evaporation of home equity values combined with an overall lower appetite for tax credits is depressing demand despite an 8-year extension of tax credits and the removal of the utility exemption before last November’s presidential election.  2009/2010 projections are optimistic – only 75MW were installed in 1H09 (vs. 500MW full year estimate) – although longer-term, the US will be a huge market. 

China – In March, China announced a 15RMB/watt (US$2.20/watt) subsidy program for rooftop and 20RMB/watt (US$2.92/watt) for building integrate PV solar systems in China – comparable to the $2.20/watt lump sum payment available under California’s CSI program.  In early May, the Chinese then raised their target for 2020 installations to 10,000MW (or 10GW) from the 1,800MW goal established in 2007.  The subsidy needed for China to reach this goal is not yet established (3 trillion yuan has been mentioned as a total amount, equal to US$440 billion), and, at this point, because of limited sunlight hours and a relatively inexpensive cost of electricity (~$0.08/kWh), it is unlikely China will become a major consumer of solar systems over the next 1-3 years – only 40MW were installed in 1H09 (vs. 200MW full year estimate).  Nevertheless, given China is already the world’s largest developer of wind systems and could easily grow to become the largest developer of solar systems, it is very reasonable to assume China will reach its long-term goals.

Other factors to consider when analyzing polysilicon:

> A decline in the price of poly is unlikely to stimulate meaningful incremental demand from the semiconductor industry because poly is only a small portion of a semiconductor’s COGS – less than 5% on average.

> Due to low barriers to entry down the solar supply chain, a lower polysilicon price suggests lower pricing for all the links: from ingots and wafers to cells and modules.

> Polysilicon producers have significantly higher fixed costs than wafer/cell/module manufacturers because the equipment to make poly is far more expensive – $90-120 million per 100 MW compared to $50-80 million for wafering, $50-60 million for cell production, and $25-35 million for module assembly.  Comparing D&A as a % of 2008 COGS across the supply chain, poly producers range from 10-30% (MEMC at the low end, REC at the high end) while the cell/module makers are between 3 and 10% with Suntech and Trina Solar at the low end and First Solar, Energy Conversion Devices, and Solarworld at the high end.  In other words, the high operating leverage the polysilicon producers enjoy in a bull market crushes margins in a bear market (4).

> In response to skyrocketing polysilicon prices from 2006 through the middle of 2008, producers of metallurgical grade silicon such as Timminco (TIM.TO), Globe Specialty Metals (GLBM.L), and the Elkem division of Orkla (ORK.OL) invested heavily in an effort to refine lower grades of silicon metal into a product pure enough to meet the specifications of most crystalline wafer manufacturers (99.9999% - 99.99999%, or otherwise known as “6N” to “7N” purity).  Unfortunately the commercialization of this process remains unproven with a lack of scale making it difficult to reduce COGS down to a level competitive with the incumbent poly producers.  In fact, in March, Timminco suspended its UMGS (“upgraded” metallurgical grade silicon) production due to the reality of falling poly prices obviating the need for a “lower cost” alternative to poly.  In addition to eviscerating the business of upgrading silicon metal, lower poly prices will also severely impact cell producers such as Q-Cells (QCEG.DE) whose relative margins depend on UMGS (and thin film) to offset a bloated non-silicon cost structure.

Despite overwhelmingly bearish supply/demand data, there is an Upside Case for poly supported by the fact that a considerable portion of long-term supply contracts are set in a range of $70-80/kg, and since these suppliers account for about 80% of the global supply volume, cuts in production (reducing output or even holding back supply) may support spot prices around this level and may even cause them to rebound over the medium-term. However, the flaw in this logic is illustrated by Conergy’s recent renegotiation of its long-term supply agreement with MEMC. In April, Conergy, an important customer of MEMC-made solar wafers decided to play hardball in negotiations over the fate of its long-term wafer supply contract by announcing its intention to cancel it.  Conclusion: contracts are seriously at risk! The original $8 billion 10-yr take-or-pay contract signed in 4Q07 was subsequently cut in half to $4 billion in July 2008. Now, Conergy is seeking a new one-year “replacement” contract at terms unbecoming to MEMC. If MEMC capitulates then they open a Pandora’s Box of widespread contract renegs/cancels across its entire customer base.

Step 2: Identify Winners and Losers

While high cost polysilicon producers such as Hoku Scientific (HOKU) and the UMGS producers are obvious losers, their capitalizations are small and their cost of borrow expensive rendering them unattractive as short candidates.  One might perceive low cost poly producers with solid customer bases – such as MEMC, Renewable Energy Corp (REC.OL)(5), and Wacker Chemie AG (WCHG.DE) – as attractive long candidates – unfortunately, at this time, with pricing yet to hit bottom, utilization rates low, no visibility, and other issues such as potential inventory and accounts receivable write-downs, the risk/reward is unfavorable.

Although most solar cell/module producers benefit from a lower price of polysilicon, especially vertically-integrated producers with access to the spot poly market such as Yingli Green Energy (YGE) and Trina Solar (TSL) – there are two types of producers who do not benefit, and in fact, on a relative basis, will be seriously disadvantaged.  The first are crystalline silicon (c-Si) producers locked into long-term poly contracts at above market prices – example: Suntech Power (STP).  The second are thin film producers whose cost advantage evaporates in a world where polysilicon costs less than $100/kg, as exemplified by the industry leading $15+ billion market capitalization First Solar (FSLR) (6).

First Solar has created this enormous equity value by successfully developing a way to mass-produce solar cells using cadmium telluride (CdTe) instead of polysilicon as its raw material (a powerful competitive advantage in a poly-constrained world).  During the summer of 2008 when the price of polysilicon peaked around $450/kg, the cost of polysilicon alone was $4/watt (plus $1+/watt of non-silicon costs equaled $5+ COGS/watt for silicon-based producers) while First Solar’s total cost of production was only around a buck per watt ($0.93/watt in 1Q09).  This enormous pricing advantage enabled First Solar to dominate the industry.  However, if polysilicon prices were to drop to $40-$60/kg as expected then silicon-based module pricing will collapse as well, to approximately $1.35/watt assuming non-silicon costs(7) of $0.73/watt, equal to the 2009 guidance offered by Suntech Power (STP), China’s largest producer of solar cells and modules.

In this pricing environment, First Solar would be forced to adjust down its selling price from the roughly 1.45 euros per watt (~$1.81/watt) embedded in its long-term contracts(8) to approximately $1.05/watt in order to maintain cost parity (assumes installation of First Solar modules is $0.30/watt more costly due to their lower efficiency).

Phoenix Solar (PS4G.DE), one of FSLR’s key customers, reports discounting CdTe modules by $0.35/watt).  Channel checks additionally confirm that Yingli, followed by Trina and Suntech, were offering modules in the second quarter of 2009 in select cases of bulk shipping at 1.60-1.70 euros/watt.  Subtracting 0.24 euros/watt to account for the additional costs involved in installing First Solar modules and the resulting 1.36-1.46 euros/watt parity level means First Solar’s 1.45 contracted price has been breached.  More to the point, First Solar has no cost advantage over silicon-based module producers in a world where poly approaches $50/kg.  With no cost advantage, project developers will choose to install c-Si solar panels over First Solar panels simply because they require less surface area to generate the same amount of power.

In order to maintain a competitive cost structure going forward, First Solar must continue improving its cost of production (COGS).  Management expects COGS to decline from $0.93/watt reported in the first quarter to a range of $0.75-$0.85 by 2010 (FSLR’s major feedstock supplier is 5N Plus (VNP.TO); 5N derives ~80% of its revenues from First Solar.  At the $0.80 midpoint, First Solar’s gross margin on its long-term contracts equals 56%, a level of profitability clearly warranting a premium valuation (GM was 56.3% in 1Q09, up from 54.4% in 2008).  However, with operating expenses as a % of sales equal to 16.7% in 2008 and unlikely to materially differ in 2009/2010 (9), if and when poly drops to $50/kg, GM will compress to 24% and operating margin to around 7-9%, a crappy commodity margin warranting no more than a 6-12x multiple.

First Solar targets production capacity of 1.1GW by the end of 2009, with many in the industry believing the company will sell all the product they can produce – 100% utilization.  If this were to happen, if the bulls are right and First Solar sells everything, its global market share would jump from 9.0% in 2008 to 23.6% in 2009. 

In our analysis of global supply-demand for MW by geography, total demand for MW will be down 17% or more in 2009 compared to 2008, at approximately 4.7GW.  In contrast, the leading publicly-traded module vendors are collectively guiding Wall Street to 6.7GW of shipments in 2009, a number that excludes private companies, micro caps, and divisions of conglomerates such as Sharp, Sanyo, Kyocera, Mitsubishi Electric and BP Solar who together account for at least another 2.0GW.  With a combined 8.7GW of shipments chasing 4.7GW of demand, module pricing is certain to continue its freefall – from US$3.85 in 2008 to US$1.80-2.00 in June to a level approaching $1.50/watt in the near future (and ultimately $1/watt).  This will have devastating implications for the marginal cost producers.

The channel cannot possibility support 4GW of excess solar panels (86% of 2009E shipments).  With 1+GW in the channel during the second quarter suggesting the channel is already stuffed, any recovery in demand is unlikely to result in shipment growth for module producers until 2010 at the earliest, during which time prices will continue to plummet.  Conclusion: production growth must be slashed immediately or else pricing will collapse faster than anticipated and the industry will burn cash like the dot coms did in 2002.

Excess inventory in the channel accelerates ASP decline, resulting in additional inventory write-downs and a negative cash conversion cycle that will overshadow any prospect of global solar MW expansion.  Colexon, one of First Solar’s top five customers reported building 238 days sales of inventory (DSI) in Q1 up from 55 days at the end of the year (e42.2 million vs. e19.7 million).  Given that 85% of Colexon’s revenues are thin-film based (meaning First Solar) this means they’re sitting on $25+ million of excess First Solar inventory.  Similarly, Phoenix Solar and Conergy, two of First Solar’s other top five customers, reported DSIs surging to 273 and 484 days from 66 and 121 days respectively.  As far as First Solar’s own inventory levels, DSIs increased from 56 to 66 days, yet it’s worse than that when you consider First Solar basically dumped inventory (referred to as “late quarter sales”) by extending contracted payment terms and agreeing to accelerate price declines in exchange for more total volume.

In addition, receivables are stretched as First Solar and the other scale producers are forced to match the favorable terms offered by New Entrants desperate to ship product.  More specifically, First Solar reported DSOs (Days Sales Outstanding) jumping to 40 days in 1Q09 from 13 days in 4Q08 and 8 days year-over-year, which according to the company “was mainly due to the amendment of certain customers’ long-term solar supply contracts that extended our customers’ payment terms from 10 days to 45 days, as well as the timing of shipments to customers during the three months ended March 28, 2009.”  Making matters worse, management explains that customer defaults, which could reach 10-15% of 2009 shipment guidance (or more), are excluded from guidance (and consensus).  According to Suntech management, large customers are reportedly taking inventory but paying current market prices rather than the prices for which the panels were booked.  In SG&A, Suntech records a “provision for doubtful accounts” that’s been growing sequentially (but not fast enough).  Investors can expect more and significant A/R write-downs across industry.

Returning to inventory, write-downs already crushed gross margins across the sector in 4Q08/1Q09 and will likely continue to do so as long as ASPs continue their downward spiral.  Of the Chinese manufacturers, Suntech, Canadian Solar, LDK Solar (who supplies wafers to Canadian Solar), Trina Solar, JA Solar, China Sunergy, and Solarfun all took big write-downs.  But not Yingli Green Energy (YGE).  Yingli has defied the trend to date, ostensibly due to its vertical-integration strategy and direct access to the spot poly market offering a more flexible cost structure that when combined with silicon utilization of 6.3-6.4 grams per watt and declining (versus 9+ for Suntech) and a low non-silicon COGS (~$0.80/watt) makes Yingli and Trina Solar (TSL) the low cost producers in China.

Fully-integrated producers like Yingli and Trina arguably deserve a premium valuation when compared to companies like Suntech and Q-Cells that outsource the production of wafers – Yingli’s and Trina’s gross margins (20-30%) are superior to Suntech’s (15-20%) simply because they don’t pay as much to wafer suppliers.  Nevertheless, with DSOs expanding and inventory growing, it appears extremely unlikely Yingli will survive 2009 without a material write-down ($100+ million).

In addition to writing down the value of inventories and accounts receivable, the cell/module manufactures will inevitably break their long-term wafer supply contracts in order to avoid the large pre-payments (a substantial use of cash) commonly agreed to when poly was in short supply.  According to Canadian Solar’s 20-F filing (the foreign equivalent of a 10-K), “Under existing supply contracts with many of our multi-year silicon wafer suppliers, and consistent with industry practice, we make advance payments to our suppliers prior to the scheduled delivery dates for silicon wafer supplies.

In many such cases, the advance payments are made in the absence of receiving collateral for such payments.  Moreover, we offer some of our customers short term and/or medium term credit sales based on our relationship with them and market conditions, also in the absence of receiving collateral.  As a result, our claim for such payments or sales credit would rank as unsecured claims, which would expose us to the credit risks of our suppliers and/or customers in the event of their insolvency or bankruptcy.  Accordingly, any of the above scenarios may have a material adverse effect on our financial condition, results of operations and liquidity.”

In other words, the solar companies are extending credit to both their suppliers and their customers – an unsustainable business model commonly perpetrated in bubbles.

Manufacturing Demand Along with Solar Panels

In April 2009, First Solar’s stock price soared upon the announcement of Juwi Holding AG’s receipt of ~$200 million financing for a 53MW PV plant in Germany for which First Solar is contracted to supply 700,000 panels priced at just under 1.4 euro/watt – ostensibly evidence of the willingness of banks to finance projects in spite of the global recession.  However, upon closer inspection we find that Juwi, one of First Solar’s top 5 customers in 2008, is no longer an arm’s length customer but a “co-developer” with First Solar in this project.  And while the companies didn’t originally disclose the cost of the project, except to say that 80% of the capital has been secured from a group of banks, the equity portion, estimated at $40 million, is being financed off First Solar’s balance sheet with the expectation that a majority stake will be sold after the project is completed.  

In other words, First Solar is selling modules to itself!

Q-Cells (QCEG.DE) sells to itself through a project development subsidiary called Q-Cells International.  “Internal” sales (sales of solar cells from Q-Cells to Q-Cells International) accounted for 45% of total sales in the first quarter of 2009, leading to an e130 million sequential jump in net working capital to e446 million, representing a nearly 50% NWC-to-sales ratio.  In other words, Q-Cells is rapidly expanding its balance sheet at the same time that sales are stagnating and margins are contracting.

On its first quarter conference call, Suntech (STP) revealed that a project development customer called Global Solar Fund (GSF), in which Suntech owns an 86% stake, accounted for 35MW shipped in Q1 or more than 30% of sales (31.9%).  When questioned about the arrangement, Suntech’s CEO said Union Credit and other banks were lined up to finance these Italian-based projects, and investors should expect a large equity investor in the third quarter to lower Suntech’s stake “closer to 50% or even lower”.

Like Q-Cells and Suntech, First Solar (FSLR) must run its fabs at elevated utilization rates in spite of the weak demand environment in order to spread fixed costs across the maximum amount of volume, keeping cost per watt low and maintaining margins.  Despite the obvious fact that this so-called demand is not real-time market demand, it enables First Solar to control inventory by “shipping” modules – literally to itself.  In other words, this transaction is purely about First Solar circumventing margin deterioration (which is inevitable) and protecting its premium multiple (which is unsustainable).

All three of these companies, First Solar (FSLR), Q-Cells (QCEG.DE), and Suntech (STP), as well as many others, refer to this strategy as “downstream integration”, and while in theory a captive source of demand sounds like a prudent vertical-integration strategy, in this case, these companies are merely increasing financial leverage (debt-funded working capital) and increasing execution risk.  Visibility is drastically reduced while cash earnings become more volatile on a quarterly basis.  Whereas polysilicon, wafers, cells, and modules are generally marketed on a long-term contracted basis, installations are more project-oriented and directly dependent on the financing/regulatory environment.

Balance Sheet & Other Considerations

First Solar (FSLR) has a pristine balance sheet, only recently tainted by shenanigans like the business with Juwi – the company has $228.2 million of debt as of 3/31/09 mostly consisting of euro denominated loans due 2012/2015.  Although working capital issues are expected to negatively impact free cash flow, the short thesis on First Solar has less to do with immediate credit risk than its aggressive pursuit of a transient business plan dependent on elevated polysilicon costs. 

Suntech (STP), on the other hand, is highly levered with consensus 2009 EBITDA ~$200 million versus $1.5 billion of total debt ($1.1 billion net), however, the company benefits from very favorable banking relationships.  As a large employer and exporter of high technology products in China, Suntech benefits from several forms of direct and indirect government assistance, including a low marginal tax rate (10-13% due to classification as a "high or new technology" company), rapid regulatory approvals for facility expansion, and low cost borrowing (most of Suntech's bank borrowings are from the 4 large state-sponsored banks in China).  These banking relationships make the Chinese government the largest creditor to Suntech, giving the company a decisive advantage of continued access to cheap and flexible capital. 

To finance its growth, Suntech has issued two convertible bonds ($686.3 million) and has drawn down on its lines of credit ($809.2 million; approx. $1.2 billion available at favorable rates).  Liquidity is a risk, but only if the company falls out of favor with its government.  Nevertheless, over the medium term, repurchasing debt (and funding negative cash flow) will likely entail serial equity dilution.

Suntech reported negative free cash flow of $75 million in Q1 – full year results are difficult to project with any confidence due to potential working capital impairments – Suntech’s balance sheet lists $441 million of “investments and advances to related parties”, $321 million of “prepayments and loans to suppliers” and $244 million of “intangibles and goodwill”, dubious assets requiring a haircut in spite of management’s claim of fair value accounting

In general, across the entire solar supply chain, cell makers such as Q-Cells (QCEG.DE) appear to be in the worst competitive position.  Prior to the recent flood of supply, cell makers earned gross margins in the 15-20% range and supplied a variety of module makers.  Barriers to entry were low (somewhat higher now due to a tighter financing environment) and there was a boom in module manufacturing.  Now, however, the larger and more successful module makers such as Suntech, Yingli, and Trina have built their own cell processing capabilities, thereby shrinking the supply chain and pressuring independent cell makers whose margins are already contracting as pricing continues its downward spiral.  A prime example of this is JA Solar (JASO) who missed its consensus 1Q09 revenue estimate ($112.3 million) by a staggering 70% ($33.9 million; 24MW shipped). 

JA Solar has a low non-silicon cost structure similar to Yingli and Trina but limited brand awareness – 77% of Q1 sales were to regional Chinese module manufacturers including Canadian Solar (CSIQ), Shanghai Chaori, Jiangsu Aide, and Shanghai Solar Energy who use their own brand names.  The problem with this strategy is that these second-tier module makers are losing share and leaving the industry – it’s been reported that more than half of China’s 300+ module makers have shut down since late 2008.  Similarly, China Sunergy (CSUN) is another cell maker reliant on its domestic module market (76% of 1Q09 sales) and disadvantaged by limited brand recognition and limited scale.

The Taiwan-based solar cell makers (17-18% cell efficiency) generally have higher operating costs than their Chinese peers.  Motech Industries (6244.TT) is the largest cell maker in Taiwan and with a net cash position; Gintech (3514.TT) is second but it’s levered up; and E-Ton (3452.TT), playing catch up, is the most highly levered and faces near-term re-financing risk with NT$583mm and NT$1,615mm maturing in 2009 and 2010 respectively.

Of all the publicly owned cell makers, Q-Cells (QCEG.DE) appears to be the most at risk, facing the prospect of a liquidity crisis in both our Downside and Base Case Operating Scenarios.  In addition to suffering from a high non-silicon cost structure compared to its Chinese competition, Q-Cells finds itself in the common position of being contracted to buy polysilicon (primarily from REC, but also from LDK and supposedly, Elkem and Timminco) at levels above current spot prices, while selling modules with variable pricing in approximately 65% of contracts (35% fixed price, 40% variable with a floor and a ceiling price, 25% market-based).

Furthermore, Q-Cells’ customer base consists of independent project developers and installers who are less financially stable than the Phoenix Solars of the world(10) and who are no longer willing to pay a premium for Q-Cells over the Chinese. 

To illustrate the conservatism of our Base Case Operating Scenario, the most significant assumptions underlying the analysis are as follows: (1) Q-Cells produces at the midpoint of management’s 600-800 MW guidance for 2009 (a relatively bullish assumption considering management has already lowered guidance twice this year and the year’s only half over); (2) ASPs average e1.35/watt in 2009, equal to the reported spot price in June; (3) wafer costs drop 20% in 2009 (-25% in 2010) as long-term contracts are renegotiated (mainly with REC); however, Q-Cells’ average 2009 wafer cost of e0.85/watt is still higher than the e0.80/watt spot price reported in June; and (4) non-wafer production costs (also called conversion costs) decline linearly from e0.39 to e0.30/watt in 2011. 

In this highly plausible scenario, gross margin plummets from an inflated 32.5% in 2009 to a more in-line 16.8%; and operating margin approaches breakeven.  Q-Cells burned e621 million of cash in 2008 and despite recent efforts to conserve cash including slashing 2009 capital expenditures to e400 million – from e500 million previously, and what was originally an e800 million target – the company will likely burn in excess of e400 million this year.  To fully finance 2009, Q-Cells recently (1) sold an e250 million 5.75% convert maturing in 2014 (their first convertible matures in 2012); and (2) reluctantly monetized its 17.2% interest in REC for e525 million of net proceeds – REC is a much more attractive long-term investment than Q-Cells.  And while these actions have succeeded in delaying the inevitable liquidity crisis requiring a highly dilutive transaction – e.g. 300 million euros raised at 10 euros/share implies roughly 30% dilution to the share count – Q-Cells is a market share loser with a leveraged capital structure.

In addition to Q-Cells, its European peers Solarworld (SWVG.DE) and Solon (SOOG.DE) are burdened by a high non-silicon cost structure relative to Suntech and the other Chinese producers.  Solarworld, in comparison to Q-Cells, is relatively conservative in its growth ambitions and fully integrated from poly production to installation, while Solon is over-leveraged, small cap and the stock has been un-borrowable since 2008. 

As of June 30, 2009, 3-Sigma Value was short First Solar (FSLR), Q-Cells (QCEG.DE) and Suntech (STP).

We focus herein on First Solar (FSLR), rather than Q-Cells (QCEG.DE) or Suntech (STP), mainly because of its market cap. 

Step 3: Evaluate Total Return & Risk vs. Reward in the Context of our Scenario Analysis

In an Upside Case Operating Scenario whereby First Solar (i) produces at a 100% utilization rate in 2009 with no customer defaults (1.1GW); (ii) aggressively expands production to 2.7GW by 2011 ($296 million capex in 2009, near the high end of management’s $270-300 guidance); (iii) improves COGS/watt 2.5% sequentially until reaching $0.77/watt by the end of 2010 (management’s target is $0.80/watt over that time period) before continuing down to management’s longer-term target of ~$0.60 COGS/watt by 2014; (iv) operating expenses as a % of revenues decrease due to fixed-cost leverage; (v) working capital issues (A/R, inventory, other liabilities) become non-issues; and finally (vi) polysilicon stabilizes at $100/kg, 2009 operating (EBIT) margin equals 40%, which is well above management’s guidance of 31-33% (versus 40.2% actual in 1Q09 implying management expects margins to deteriorate more quickly than the model suggests).

On April 30, after First Solar reported Q1 results, the stock jumped nearly 25% to above $190 based on strong GM (COGS down sequentially from $0.98/watt to $0.93/watt) coupled with better than expected ASPs ($2.12/watt down from $2.35/watt in 4Q08 but above consensus ~$2/watt) largely due to FX hedging.  However, the earnings were hardly clean with an abnormally low tax rate and huge jump in working capital, and meanwhile, with several customers renegotiating contracts during the quarter, ASP is sure to drop further this year to at best the level embedded in the company’s 16 long-term contracts.  When analyzed on a customer-by-customer basis, the high concentration raises serious questions about the durability of the company’s existing customer base.  In June, for example, Ecostream, an approximate 7% customer in 2008, failed to make payment on modules produced by Ubbink Solar, a 100% subsidiary of Centrosolar Group AG (C30G.DE), a systems installer whose debt-financed plan to integrate upstream will likely bankrupt the company. 

Furthermore, as discussed earlier, Juwi and First Solar are now “co-developing” projects financed off First Solar’s balance sheet, while Colexon, Conergy, and Phoenix are all facing significant working capital issues.

New contract announcements are indeed bullish catalysts and currently there’s widespread speculation that Sempra Energy and Southern Company will announce utility-scale solar projects this summer (~350MW from Sempra and ~700MW from Southern).  These and other opportunities offset some of the risk that 63% of First Solar’s shipments are yet to be financed, and therefore, in our Base Case Operating Scenario we still assume the company produces at 100% utilization and ignore management’s expectation that 10-15% of contracted volume will default. 

Other key assumptions include: (i) production expands at a more measured (and realistic) pace to 1.6GW in 2010 and 2.0GW in 2011; (ii) poly stabilizes around the current spot price of $75/kg and the company prices its modules at cost parity; and (iii) COGS/watt declines at a sequential 2% rate to $0.67 by 2014.  In this scenario, First Solar still generates $2.0 billion of revenue – at the high end of management’s 2009 guidance of $1.9-2.0 billion; and earns a healthy 53% gross margin and 35% operating margin – near the high end of management’s 31%-33% guidance.  This produces EPS of $7.49 (consensus = $7.20).  In 2010, however, although production increases to 1.6GW, margins squeeze, largely because the full year of production is priced at cost parity with c-Si modules resulting in gross margin of 44%, EBIT margin of 24.5%, and EPS of $5.10.

In a Downside Case Operating Scenario whereby First Solar prices its modules at cost parity assuming poly approaches its marginal cost of production in 2010 (we assume $50/kg despite bearish analysts who expect poly to breach cash costs below $30/kg for Tier 1 producers like MEMC, Wacker, and REC).  We further assume that in response to the pressure on margins management slashes operating expenses.  EPS is nevertheless eviscerated.  $6.21 in 2009 collapses to $1.22 in 2010 and then a loss of ($0.11) in 2011.

Assuming management is able to lower COGS/watt to the low end of their long-term target range of $0.52 - $0.63/watt, then even if poly settles at $50/kg, First Solar should be able to generate positive EPS and free cash flow -- $0.47 and $332 million in 2011 based on 1.2GW and an ASP of $0.92/watt.   In this very plausible adjusted downside scenario, representing a competitive ASP near grid parity, applying a 10% FCF yield (back-of-the envelope valuation metric) produces at $40 target price.

Catalysts: (i) the renegotiation of long-term contracted prices; (ii) the subsequent margin collapse – happens in 2010 in our Base Case; (iii) significant customers (e.g. Ecostream) default causing A/R and inventory write-downs; (iv) polysilicon indeed approaches its marginal cost of production.

Other Factors to Consider: The company discontinued quarterly guidance citing limited visibility through the remainder of 2009; widely-admired CEO Mike Ahearn is stepping down to focus on US policy; the estate of largest shareholder, Wall-Mart heir John T. Walton, who bankrolled the company sold more than $425 million of FSLR stock in April/May 2009.

Final Thoughts

First Solar’s $15+ billion market cap is ludicrous, any way you slice it.  This is a company facing the elimination of its one and only competitive advantage – cost.  This is a company that produces a commodity, yet earns the same margin as Cisco.  This is a company whose market cap on any given day is greater than the combined market cap of the next 10 solar panel makers combined (SPRWA + ESLR + ENER + QCEG.DE + SWVG.DE + STP + YGE + TSL + JASO + CSIQ). 

And while longer term, we might find ourselves owning one or more of the likely survivors, such as Yingli or Trina, Sunpower, REC, MEMC, or maybe even First Solar, at this point in time, in the middle of 2009, the solar industry is burdened by such an enormous supply-demand imbalance, from poly through modules, that no company is immune, and more importantly no company offers us the downside support we generally require in the form of asset coverage - these assets could easily trade for cents on the dollar - or durable cash earnings power - most if not all of the solar companies will burn substantial cash over the 2009/2010 timeframe owing to significant inventory and accounts receivables write-downs, margin compression, contracted polysilicon prepayments, capex, etc.

For more information, please contact us at info@3sigmavalue.com.

Creative Destruction in the Payments Industry (1)

MasterCard estimates ~85% of the world's retail transactions are still conducted via cash and checks.  Even in the US, a little less than half of merchant payments are still paper-based.  In the case of developing economies, mobile payments overcome the infrastructure challenges of deploying retail Point-of-Sale (POS) hardware.

The global evolution from paper-based to electronic payments is accelerating with the adoption of mobile payment technologies.   The benefits are many, including lower cost, reduced fraud risk, targeted real-time marketing, and big data.  3-Sigma Value identifies two powerful secular trends that are driving valuations and determining winners and losers in the payments industry.

Secular Trend Number 1:  The magnetic swipe card will be extinct within the near term, replaced by mobile wallets with your financial information pre-loaded and protected.  Consumers will no longer have to share their personal information with merchants, who are cut out of the payment process altogether.  The benefit for merchants is lower cost.  Merchants pay on average somewhere between 2.5% and 3.0% of sales (called the merchant discount rate) and are eager to shrink that vig.

Secular Trend Number 2:  Checkout lines will be obviated by mobile payments technology within the near term.  Merchants are eager to adopt technology that eliminates the lag between placing a product in a checkout cart (virtual or otherwise) and actually paying for the product.  You like four shirts, decide to buy two, and ultimately buy one.   Maybe you would have bought two if it didn’t take so long and wasn’t such a hassle to pay.  Customer support in all stores will follow Apple’s lead and carry mobile devices that access a payment processing app hosted in the Cloud.  Consumer self-checkout is the end game, and the end is coming fast.

Identifying the winners is less obvious than the losers, with technologies embedded in giant companies such as Google (Google Wallet), Ebay (PayPal), AT&T/Verizon/T-Mobile (Isis Mobile Wallet), Intuit (GoPayment), and Amazon (Price Check) competing against newer technologies developed by hungrier entrepreneurs at Square and Payair, mPower, AisleBuyer, GoPago, LevelUp, Paydiant, and dozens of others.  It’s creative mayhem.

No matter which virtual wallet gains enough market share to sustain in the new electronic world, there are companies in the payments supply chain who are scrambling to replace revenue streams in secular decline.   The first company we focus on is one of two remaining in the business of manufacturing point-of-sale (POS) card swipe terminals.  The second is a Title IV financial aid disbursement card provider that earns 30% operating margins by skimming taxpayer money. 

For more information, please contact us at info@3sigmavalue.com.

Searching for Autonomy

When we heard that Hewlett-Packard (HPQ) was writing down the value of its $11 billion acquisition of the software company Autonomy Corp Plc. by $8.8 billion (or 80%) I immediately thought back to the first time I heard the short thesis on Autonomy.  It was March 2010 and I was interviewing a technology analyst for a position at 3-Sigma Value.  His short idea, which he was very passionate about, was Autonomy. 

He raised a number of red flags that suggested aggressive and maybe even improper accounting.  Specifically, he pointed out the following:

1.  A large gap between earnings and free cash flow;

2.  No organic growth in deferred revenue despite strong reported “organic” revenue growth of 20% per annum over the same period;

3.  An unexplained sequential decline in PP&E despite an increasing amount of capital expenditures;

4.  Volatile working capital trends, especially around the time of acquisitions; 

5.  Changes in reporting that eliminated detailed segment data.

Ultimately, we passed on shorting Autonomy because of the acute risk of a take-out.  The CEO, Mike Lynch, was rich and famous and itching to sell.  The balance sheet was solid with no net debt, and after more than 100 acquisitions(1) there had to be some valuable IP in there.  In sum, the risk versus reward was not attractive.    

When H-P announced in August 2011 it was paying 10x revenue for Autonomy we were stunned.  When the 80% write-down was announced a year later we were not.  Autonomy was a roll-up of software companies with a complex structure that made it difficult to measure “organic” revenue growth.  In terms of valuation, the discrimination of organic and acquired growth makes all the difference.  Because if there is no organic growth than there is no sustainable growth.  A consolidator of mature software companies does not warrant a high multiple of free cash flow.  It is akin to a run-off business, not a dot com.  In other words, Autonomy was never worth more than 2x revenue (vs. 10x) – a relativity that matches the 80% write-down.

Autonomy’s management team used and abused the complex accounting for acquisitions to obfuscate weak performance in its core “organic” business of licensing software that manages unstructured data(2) in an enterprise.  The Bayesian-based technique that Autonomy employs for searching data is ubiquitous in large enterprises, and commoditized, leading to Autonomy’s constant need to buy companies to further growth.  

Autonomy pretended to be a growth company despite being mature.  Autonomy pretended to earn 40% operating margins despite making those numbers only by adding back amortization of acquired intangibles, restructuring costs, and stock compensation.  Ultimately what fooled Meg Whitman and the rest of H-Ps board of directors was the Company’s flagrant use of pro forma financials that are non-GAAP and non-reality.  While the fine print of an SEC filing may detail the differences between GAAP and non-GAAP numbers, Autonomy’s management team never acknowledged the difference in a quarterly conference call.  They waxed poetic on non-GAAP profits when there were GAAP losses.

Around the time of H-P’s 2011 acquisition of Autonomy, Apple introduced Siri, a voice recognition application to answer questions, make recommendations, and perform actions by delegating requests to a set of Web services.  Investors drove up the price of the company that licenses the underlying technology, a company called Nuance Communications (NUAN), from $16 in August 2011 to $30 by January 2012.   During this time 3-Sigma Value learned that Apple pays Nuance a fee that is immaterial relative to the size of Nuance’s revenue base(3).

$36 to $50 million of (temporary) revenue, just because that revenue is from Apple, caused the market capitalization of Nuance to increase by $4.5 billion.  That is $100 of valuation for every $1 of incremental revenue, an absurd reaction to headline news.

Nuance is a roll-up, just like Autonomy, which in of itself is fine but which nonetheless raises a red flag.  The balance sheet is weak with $870.4 million of net debt and a negative $1,037.3 net worth.  Acquisitions boost short-term revenue growth but generate negative return on invested capital (ROIC), contributing to negative book value.  Furthermore, there is a large and growing discrepancy between GAAP and non-GAAP results, just like at Autonomy.  The more we researched Nuance the more irregularities we found.  And then the event happened, an event that shed enough light on the corrupt mindset of this management team to warrant a short position.  It was the tipping point. 

On October 19, 2011, Nuance priced $600 million (+$90 million over-allotment) of 2.75% senior convertible debentures due 2031 (first put date is 11/1/17) with a conversion price of $32.30.  Net proceeds of $587.7 million (ex. over-allotment) were used to repurchase $200 million of shares, to make acquisitions, and for general corporate purposes.

Why did they sell this debt?

1.  Nuance doesn’t generate organic revenue growth, and needs to buy companies with deferred revenue (just like Autonomy) to satisfy expectations of a market valuing a $1.5 billion revenue company at $8.5 billion;

2.  Nuance uses the proceeds to support its stock price by buying back stock – a short term benefit only to traders and other shareholders who know to sell before the house collapses.

Sell Nuance Communications (NUAN)

Incorporated in 1992 as Visioneer, the Company changed its name to ScanSoft in 1999, before settling on Nuance Communications in 2005.  Nuance sells products grouped into four segments:

1.  Healthcare (~40% of 2012 revenue) – automates manual processes such as the dictation and transcription of patient records; sold under a traditional software perpetual model and/or an on-demand model charged as a subscription and priced by volume of usage (e.g. number of lines transcribed).

2.  Mobile and Consumer (~30% of 2012 revenue) – Dragon suite of applications embedded in auto and device OEMs generally sold under a royalty model priced per device sold, and sometimes under a license model.   Desktop and portable computer dictation solutions are generally sold under a traditional perpetual software license model.

3.  Enterprise (~20% of 2012 revenue) – customer service – automating call centers, directory assistance – charged as a subscription and priced by volume of usage (e.g. number of minutes callers use the system or number of calls completed in the system).

4.  Imaging (~10% of 2012 revenue) – PDF applications designed specifically for business users licensed to OEMs such as Brother, Canon, Dell, HP, Xerox on a royalty model, priced per unit sold.  Compete against Adobe, ABBYY, I.R.I.S. and NewSoft.

Three of Nuance’s four segments are loosely related – software that transcribes patient records (the healthcare segment) is akin to software that transcribes customer service requests (the enterprise segment) is akin to software that transcribes requests for autos or phones or other electronic devices.  The imaging segment on the other hand represents an effort to diversify away from the business of speech.  A series of small acquisitions has increased imaging revenue from $80 million in 2008 to over $200 million in 2012.  However, with a dominant competitor in Adobe virtually giving a comparable product away for free, Nuance’s imaging business is niche at best.

As described in 3-Sigma Value’s 2012 report titled Software Economics – Volume II, we evaluate software companies in terms of the quality of the underlying technology and the sustainability of cash flow, if any.  What is striking about Nuance is the fact that there is no unifying code, no unifying core speech recognition or even text-to-speech software code.  Nuance is cobbled-together and complicated.

Just like at Autonomy, the Nuance team mixes together non-GAAP and GAAP accounting, acknowledges the complexity, and ultimately communicates to investors in terms of non-GAAP numbers.  It’s a sly move.  They make the financial reporting so complex that they have to simplify it.  When simplifying, they eliminate certain expenses (i.e. acquisition-related).  The result is pro forma numbers that – as described in 3-Sigma Value’s report titled The Artifice of Contribution Margin – are misleading and apt to create another Autonomous debacle.

It doesn’t matter whether a technology company builds or buys its intellectual property as long as both forms of expenditure are accounted for properly and consistently when comparing earnings quality and growth.  By ignoring acquisition-related costs when acquiring deferred revenue, management’s effort to focus investors on non-GAAP numbers obfuscates Nuance’s true relative earnings power.

Non-GAAP costs exclude stock compensation, acquisition-related costs, amortization of acquired intangible assets, costs associated with IP collaboration agreements, and other non-cash and cash expenses.  These are recurring costs for an acquisitive firm like Nuance.

Exactly like at Autonomy, revenue recognition has become more complex due to the increasing sale of bundled technology, combining licenses, services, on-demand, and yes hardware.  While management acknowledges gross margin pressure due to a higher proportion of services and hardware, they deny it is a trend.

When recognizing revenue from the sale of bundled products, margins become fungible.  Low margin services revenue (or hardware) is packaged with high margin license or subscription revenue and a decision has to be made.   Accounting is supposed to be rules-based, consistent, but, with so many moving parts, so many acquisition-related accounts with so many reserves and so much restructuring it becomes standard to over-earn today and write-off tomorrow.

The notion of “organic” growth at Nuance is specious, misleading, and ultimately culpable.  Exactly like at Autonomy, Nuance management concocts an organic revenue number that is bunk.  Acquisitions by Nuance share a common tendency to underperform expectations.  The reason is because Nuance often bundles its acquired technology with its core technology and calls the whole thing organic.  While top line revenue looks solid, deferred revenue stalls, gross margin contracts, acquisition-related expenses persist, and the net worth of Nuance continues its decent into deeper negative territory. 

Nuance is a mature technology vendor making serial acquisitions to fuel its revenue growth and maintain its elevated valuation.  The automated call center business is not a high growth business.  The medical transcription business is not a high growth business.  The mobile business is mortally-competitive and revenue from Siri temporary.  The imaging business is small and mismatched.

The result is a low-margin model with limited operating leverage.  5-10% GAAP operating margin (OM) is under constant pressure from restructurings, charge-offs, and other acquisition-related costs.  With nearly $3 billion of questionable goodwill on the balance sheet, Nuance will be writing this stuff off, eradicating earnings, for years to come.

Nuance is a serial restructurer.  Acquiring and restructuring companies is Nuance’s core business.  Therefore, to eliminate acquisition-related expenses from earnings is to eliminate research and development (R&D).  Acquisition-related expenses amount to approximately $160 million in 2012, or ~10% of revenue.  Similarly, Nuance spends ~10% per year on stock-based compensation.  These two recurring expense should not be eliminated when calculating Nuance’s earnings.  These are not one-time items.  To calculate earnings without including these items leads to over-valuation which leads to Autonomy.

Nuance is overvalued by any measure.  The core of 3-Sigma Value’s valuation is a scenario-based, probability-weighted discounted cash flow (DCF) analysis.  This is sanity-checked by a P/E analysis.  The average of the two methodologies renders a target price of $7.50.

In July 2012, M*Modal (MODL), a company that develops voice recognition software for doctors was acquired by JP Morgan's One Equity Partners private equity arm for $820 million plus the assumption of $300 million of debt.  Revenues at MODL have been flat for the past three quarters at ~$116 million, which translates into a $664 million revenue run-rate, equal to 1.6x revenues.  Operating Income is depressed, ranging between $2 million and $12 million in recent quarters.  With $12 million of quarterly D&A, run-rate EBITDA is somewhere between $56 million and $96 million.  At the high end, the multiple paid equals 11.66x.  We use this multiple as the terminal value multiple in an Upside Case operating scenario in which Nuance is acquired at the end of 2014.

In the aftermath of the M*Modal acquisition, on July 30, 2012, celebrated New York Times reporter Andrew Ross Sorkin wrote a column titled Suggestions for an Apple Shopping List.  Guess his first pick? 

Sorkin writes, “A year before Mr. Jobs died, he strongly hinted that Apple would consider a big deal. “We strongly believe that one or more very strategic opportunities may come along, that we are in a unique position to take advantage of because of our strong cash position,” Mr. Jobs said in a call with analysts in 2010.  Having all that money can be daunting, so to help Mr. Cook, here is a potential shopping list — some must-buys and some pie-in-the-sky targets — that he may want to consider:

NUANCE This is the one no-brainer on the list. Nuance, based in Burlington, Mass., provides much of the speech recognition technology behind Apple’s Siri and dictation functions. Right now, Apple has merely licensed it and integrated it into both its mobile devices like iPhones and iPads as well as its new Macintosh operating system. Most users think it is Apple technology, but those services wouldn’t work without Nuance.

It should go without saying, but the importance of speech recognition is only going to increase in the future. Nuance has more patents for it and has developed the technology further than just about any firm in the world. At some point, Nuance will be able to hold Apple for ransom. Google and Microsoft are steadily building their own speech recognition technologies and they are catching up quickly. Nuance’s market value is $6.3 billion. Even if Apple paid twice as much, it would be a worthwhile investment.”

Because of conventional wisdom broadcasted by reporters(4) there is a real possibility Nuance will be acquired.  This time however, unlike when Frank Quattrone justified the price of Autonomy to H-P, the Board of Directors of any potential acquirer will have no defense for the acceptance of pro forma financial statements as reflections of reality. 

As far as the potential for Apple to acquire Nuance, we find the prospect highly unlikely.  In fact, it is only a matter of time until Apple replaces Nuance with its own in-house automatic speech recognition (ASR) technology.  Patents are filed.  The Siri halo effect is evaporating and what Nuance shareholders are left with is a pile of old software that is more a deferred revenue run-off story than a growth story.

For more information, please contact us at info@3sigmavalue.com.   

Where are the GlenGarry Leads?

As described in 3-Sigma Value’s separate report titled Software Economics – Volume II, we measure the value of technology and discriminate between (1) innovative technology companies with intellectual property (IP) and sustainable business models, and (2) companies that market themselves as innovative technology companies but in truth sell someone else’s technology.  The issue is not whether a company is a reseller or wholesaler or retailer or developer, the issue is that the company is what it presents itself as.  We see this all the time when companies are pumped up with hyperbole in the marketing of IPOs.

An entire segment of internet services fails every test in terms of intellectual property, margin sustainability, and cash flow generation.  The inevitable consequence of burning cash is the issue of the day, and the issue of all-time, the same issue that drives much of 3-Sigma Value’s focus on the short side of the equation in a market agnostic strategy.  It seems obvious at this point but bears repeating: as companies continue to burn cash they will continue to lose value.

Online marketing services is a broad segment of business on the Internet with valuations so robust that dozens of unproven companies have gone public in recent years, all with a singular goal:

These are the new leads. These are the GlenGarry leads. And to you they're gold, and you don't get them. Why? Because to give them to you would be throwing them away. They're for closers.

-Blake

The classic strategy for generating leads is the cold call.  Thankfully, our children won’t have to know what that means.  In the age of technology, access to potential customers has fragmented into a panoply of channels including email, websites/digital storefronts, deals/coupons, mobile, and social networks, with value added analytics and pre-packaged solutions further differentiating the vendors.

The list of companies on the following pages represents Segment 1 of 3-Sigma Value’s online marketing service provider universe (1).  Excluded from this analysis are digital advertising platforms (2), marketing automation software providers (3), market research and consulting firms (4), advertising agencies and various other integrated service providers.  All of the companies included in this analysis share a common business model – leads.  Whether it is via email, websites, social networks, or mobile applications, all of these companies make money the same way, by selling services that generate leads for their customers.

The principle conclusion drawn from our research into online marketing service providers is these are not technology companies.  Not one of these 20 companies has a credible path to sustainable profitability.  Over the long term, the only hope for any of these companies is a take-out by a larger company with greater financial wherewithal.  Therefore, the principal risk in shorting any of these companies is the risk of a take-out.

Feet-on-the-Street & the Absence of Operating Leverage

Because online marketing is a services-based model as opposed to a software-based model, the same opportunity for operating leverage does not exist.   For most of these companies, revenue growth is tightly correlated to sales & marketing (S&M) expense growth.  R&D is negligible in comparison.  Whereas a typical software vendor should generate 80-90+% gross margin (GM) and 30-40+% operating margin (OM), a services-based provider will struggle to reach 20% OM. 

With negligible EPS and negligible free cash flow (FCF), the valuations in this sector not only presuppose M&A, they also suggest these companies own valuable intellectual property (IP), something that is obviously not the case given low cumulative R&D, low margins, and zero EPS.

For this analysis, we focus our attention on one particular Internet company, chosen because it is a microcosm of the whole sector.  It is not unique.  It should not even be public.  There is no technology.  No intellectual property.  And without irony, this Internet company’s strategy is something they call Feet-on-the Street.

ReachLocal (RLOC) is a search engine advertising (SEA)(4) company that went public in May 2010 at $13 per share with a singular goal of delivering leads to its 20,400 active advertisers (30,100 active campaigns; 1.5 campaigns per advertiser).  90% of revenue derives from ReachSearch, a search engine advertising platform that generates a list of keywords and decides what search engines / local directories to pay for.

Because all they do is generate a list of keywords, barriers to entry are low and churn is high.  SEA/SEO/SEM is integrated and automated and widely available in free/freemium offerings.   This is not high technology.  Gross margin is below 50%.  R&D as a % of sales is a piddly ~4% while S&M is closer to 40%.  In other words, ReachLocal spends 10-times as much on sales and marketing as it does on research and development.

The S&M effort, which the Company calls Feet-on-the-Street, employs so-called Internet Marketing Consultants (IMC) with no previous experience required, and classifies them as "upperclassmen” or “underclassmen" depending on tenure.  The key to success, according to management, is “graduating” IMCs from underclassmen to upperclassmen because only after a period of training (defined as one year) are salespeople accretive.  In other words, upperclassmen are revenue while underclassmen are cost.  Management expects the number of underclassmen to remain flattish while the number of upperclassmen to accumulate, driving sales growth.

Because revenue growth depends on growth in the number of Upperclassmen, S&M expense rises at a similar rate to revenue.  With no S&M leverage and therefore no path to profitability (and no IP), ReachLocal must figure out some other way to make money before they run out of cash.  It’s dot com déjà vu all over again.

On ReachLocal’s first quarter 2012 earnings conference call, management introduced the latest strategy to combat the absence of operating leverage – telesales.  A business practice seemingly at odds with ReachLocal’s high-touch Feet-on-the-Street Internet Marketing Consultant (IMC) strategy, it shows just how non-tech this company is.

One final and massive risk is ReachLocal’s dependence on Google's ever-changing algorithms (and Bing to a lesser extent).  While management touts its global reseller deal with Google (covering eight countries), the Company is nothing more than a commoditized middleman that will eventually get squeezed out of the supply chain.

What is $8-$12 million of EBITDA worth?  5x = $40-60 million, plus $90 million of cash equals $130-$150 million, or $3.57 to $4.12 per share.  3-Sigma Value’s scenario-based discounted cash flow (DCF) methodology generates a probability-weighted target price of $3.26.

Final Thoughts

While we focused this analysis on ReachLocal’s services-based approach to generating leads via search engine advertising, most of the companies in 3-Sigma Value’s online marketing services segment analysis share the same fundamentally flawed characteristics:

1.  Unsustainably high level of sales and marketing (S&M) as a percentage of revenue – ReachLocal in fact is near the low end of the range at 40%.  Angie’s List (ANGI) and Yelp (YELP), for example, are user-generated ratings and review websites that spend 80%+ and 60%+ on S&M respectively (5).

2.  No technology advantage or intellectual property (IP) – at least ReachLocal spends about 4% of its revenue on research and development (R&D).  Groupon (GRPN) spends so little on R&D that it doesn’t even bother reporting it as an expense on its income statement (6).

3.  Misleading investor and corporate communications – the fact that ReachLocal derives 90% of its revenue from generating a list of keywords for its customers is obfuscated by a communications program featuring cross-channel claims of web marketing and brand building, display advertising and ad tracking, live chat, banner ad design, and video production that all add up to little more than nothing.  The same can be said of the email marketers – Constant Contact (CTCT), Exact Target (ET), and Responsys (MKTG) – who all of a sudden sell integrated cross-channel marketing platforms that include websites, social, and mobile in addition to their core email marketing services.  Prior to November 2011, 100% of Exact Target’s revenue came from sending emails on behalf of large Internet customers including Angie’s List (ANGI) and Groupon (GRPN) (7).  

In conclusion, the three flaws identified above – high expenses, low investment, and misleading communication – make a recipe for failure.  Within the vast universe of technology companies, Internet marketing services is a rapidly commoditized, intensely competitive sector that meets much of 3-Sigma Value’s criteria for potential inclusion on the short side of a hedged portfolio.   The sector is reminiscent of IPOs during the Internet Bubble (dot com 1.0), with business models changing so rapidly that the inevitable consequence is excessive vicissitude. 

For more information, please contact us at info@3sigmavalue.com.

The Artifice of Contribution Margin(1)

In this era of  hyperbole, echoes of the internet bubble reverberate in the accounting of technology companies.  We at 3-Sigma Value remain as skeptical of the merits of pro forma accounting as we were back in the twentieth century.  In fact, financial reporting has become even more obtuse since then.

The qualifier pro forma is a scourge on financial analysis, enabling a management team to manipulate financial reporting to serve its needs.  In Latin it means “as a matter of form” or “for the sake of form” and is applied to practices or documents that are done as a pure formality.

In accounting, pro forma is traditionally employed in advance of a planned M&A or other capital structure transaction to project the financials of the new company.  When I was an investment banking analyst at Bear Stearns in the mid-nineties we were told that pro forma means as if.  I was asked to produce pro forma financial statements for senior investment bankers covering client companies such as Cablevision (CVC) and Time Warner (TWX) as if potential mergers or acquisitions or recapitalizations were transacted.  This seemed perfectly normal until I began to notice in the years after I left Bear Stearns that many of the Internet IPOs were pitched to investors using pro forma to turn losses into profits – as if certain types of expenses were excluded.  Rather than use the words pro forma, some management teams chose a different, more benign qualifier to exclude expenses such as adjusted, as in adjusted EBITDA or adjusted net income.

One financial metric that is especially misleading is contribution margin.  Contribution margin is pro forma because it measures profitability as if certain costs were excluded. 

Traditionally, contribution margin is equal to revenue less fixed costs and is used in management accounting (not financial accounting) in cost-volume-profit analysis to measure operating leverage as reflected in the marginal profit per sale.  Typically, labor-intensive industries generate high contribution margins while capital-intensive industries generate low contribution margins.  However, similar to the misappropriation of the term pro forma, many of today’s high growth/no-profit technology companies misapply contribution margin, pretending there are profits when there are losses.

The poster child for misleading investors with the artifice of contribution margin is Netflix (NFLX), a company that is ironically lauded for its investor communications.

While we find much to criticize about Netflix’s misleading corporate communications and amateurish attempts to obfuscate deteriorating economics (2), for the purpose of this analysis we will focus on one issue of artifice – management proudly targeting 17% contribution margin in Q4 2012, up from 16.4% in Q3.

In fact, management is so proud of its achievement that contribution margin is the only profitability metric in the whole of management’s discussion and analysis (MD&A) of the Company’s quarterly results.  There is no mention, not once, of the more common and accepted measures of profit such as operating margin (1.8%), net margin (0.8%, will remain negligible through 2013 at least), and free cash flow (negative $20 million, will remain negative through 2013 at least) (3).

Contribution margin allows for the kind of optimism that supports over-valuation.  Despite negligible earnings and negative free cash flow burning through a diminishing $400 million of net cash ($798.4 million cash minus $400 million debt), management continues to sell investors on the false notion that contribution margin is a precursor to net margin.  Witnessing dot com after dot com run out of cash unable to convert contribution to net, the flaw in logic becomes obvious.  Contribution margin is misapplied.

According to Netflix’s Form 10-Q for the period ended 9/30/12, contribution margin is defined as revenues less cost of revenues and marketing expenses. 

Netflix employs contribution margin to discriminate the profitability of its mature domestic streaming business from the losses in its roll-out of international streaming.  The idea is to show the incremental profitability of streaming.   In other words, to show potential   operating leverage.  Operating leverage is a measure of how revenue growth translates into growth in operating income.  While contribution margin is a measure of operating leverage, its exclusion of recurring expenses renders the metric meaningless in terms of actual profit and cash flow.

Netflix’s strategy is to reinvest the profit from the DVD business (48.2% contribution margin) into international expansion of the streaming business (negative 118.8% contribution margin).  It’s a race against time as the DVD is no different than the VHS tape.  It’s not a race against Amazon, Verizon, HBO and whoever else.  Netflix must convert contribution margin to net margin (combined domestic and international streaming contribution margin is zero) before the DVD is extinct.

The major competitive disadvantage for Netflix in comparison to its competition is a material lack of financial wherewithal.  Netflix is a standalone company with a measly $400 million of net cash that is likely to be burned off by 2014, forcing the company to raise new equity (or a disressed sale) at a substantial discount to today’s stock price.     

To prove our thesis, we apply 3-Sigma Value’s proprietary scenario-based valuation framework, the first step of which is the identification of Netflix’s key drivers of value:

3-Sigma Value’s Base Case Operating Scenarios for Netflix consolidate revenues around $4 billion in 2013 rising at a decelerating pace.   Management acknowledges the lack of gross margin expansion as the cost of content is inflationary, implicitly guiding the investment community to stable gross margins around 25% (equal to ~$1 billion of gross profit).  Subtract $940 million to $1 billion of expected operating expenses in 2013 and the result is $0 to $60 million of operating income (equal to 0% to 1.5% operating margin).

On the surface, these results are terrible.  Reality is even worse.   We evaluate each of the Key Drivers of Value, and where our Base Case assumption diverges from the assumption implicit in the Company’s stock price is Driver of Value #4 – Content Cost per Streaming Subscriber.  In order to avoid a cash crunch in 2014, Netflix must grow its subscriber base in line with consensus estimates while slashing the amount it spends on streaming content (subscription expenses) – an incongruous proposition.

As revenue decelerates in the low $4 billion range, total subscription expenses will inevitably continue to increase, driving gross margin below 25%.  In fact, assuming no change in content cost per streaming customer ($90.55 per annum as of 3Q 2012), a reasonable Base Case assumption, gross margin still declines below 20%.

In order for Netflix to maintain gross margin at or above 25%, they must slash the amount of content they pay per streaming customer.  If they don’t then the Company will run out of cash in 2014.

There are many reasons why Netflix will be unable to cut costs enough to avoid running out of cash in 2014.  They are in the process of expanding into 51 international markets by year end in a land grab with no land.  They are producing original content that is a longer-term value proposition than licensing content – cash production costs for original content is realized upfront.  They are building out OpenConnect CDN, representing ~10% of traffic in 2012.  Netflix has expensive plans all over the world, plans that are not adequately funded by $8 per month all you can eat pricing.

The fatal flaw in Netflix’s business model is the unprecedented notion that content cost inflation will abate.  OTT (over-the-top) distribution is not king.  Content is king, once and always.

For more information, please contact us at info@3sigmavalue.com.

The TAM Fallacy

In a virtual redux of the Internet bubble, cloud/social/dot com 2.0 companies are peaking in terms of perceived valuation.  The worm has turned for many of the new bellwethers, with stock prices already cut in half.  Turnover in management suites are accelerating as stock options lose value and the venture capitalists want out.     

The CTO of a leading online reservation system for doctors was explaining his business plan.  “We only need 3% of the total addressable market to drive revenues and operating leverage to a level at which we can sustain cash flow."  Immediately upon hearing the words "total addressable market", I thought of one of my favorite short positions, OpenTable (OPEN), the leading promulgator of The TAM Fallacy, as featured in 3-Sigma Value's First Quarter 2010 Letter.

OpenTable (OPEN) sells old technology to restaurants at an unnecessarily-high upfront and recurring cost.  Mobile technologies are breaking down whatever barriers to entry remain in the reservation business.  OpenTable has no IP of any significance, and the value of its database is questionable at best - it's never been monetized, and no plan to monetize has ever been dislosed.

Since the end of 2010, the stock price launched to a high of $115 in April before plummeting to $46 by the end of September 2011.  We continue to hold a short position in OPEN. 

Despite the steep drop in OPEN's stock price, the valuation still evokes the internet bubble, any way you look at it.  In fact, OPEN trades on a multiple of TAM (2.0x using management's guidance), not a multiple of EPS or EBITDA or other measure of profit. 

While management’s estimation of its total addressable market in North America sounds conservative (35,000) when compared to the approx. 945,000 restaurants operating in the U.S., reality is smaller.  OpenTable initially focused on major cities such as San Francisco, New York, and Chicago because of the density of restaurant clustering and high-touch sales approach.  One sales person can cover a larger number of restaurants in these metropolitan areas, and therefore, sales productivity (per sales rep) is already and inevitably in decline.  Furthermore, the restaurants that are the most reliant on reservations and generating the most reservations per restaurant have already adopted technology, and therefore, OpenTable faces diminishing returns when adding new restaurants.

OpenTable (OPEN) is a prime example of The TAM Fallacy as the Company is far more limited in its capacity to grow than management would have you believe, and more limited than typical internet business models (limited by the number of seats available in physical restaurants).  CEO Jeff Jordan, the loudest proponent of TAM, recently resigned from both his executive position and the Board of Directors.  Growth has flattened while competition has intensified.  Yet the market still ascribes the Company a premium unsustainable billion dollar valuation (equal to 7x 2011E revenue of $140 million). 

For more information, please contact us at info@3sigmavalue.com.

Transitional Technologies

One of the areas where 3-Sigma Value repeatedly finds success is in the identification of companies whose perceived value is based on a transitional technology.  Where the market sees a high-flying growth stock we see a clock ticking, a discounted cash flow valuation with a finite number of inflows.  When there is no perpetuity growth rate, equity value will eventually approach cash value. 

Entropic Communications (ENTR)

Entropic is the market share leader in MoCA (Multimedia over Coax Alliance)-compliant chipsets used in customer premises equipment such as set-top boxes, broadband home routers and ONTs (optical network terminals) allowing network video within a subscriber's home.

The killer app for in-home video networking is multi-room DVR service.  A multi-room DVR using MoCA protocol consists of one main DVR accessed by other televisions over a home network.  Given ~100 million pay-tv households in the US alone, and MoCA penetration of ~7 million at the end of 2010, the potential market opportunity appears huge, however misleading.   Set-top-box (STB) conversions are long-tail transitions; subscribers don't proactively change their STBs; it's at the behest of the service provider.  Therefore, sales of Entropic chipsets are driven by subscriber additions.

Verizon FiOS TV was the first North American service provider to roll-out multi-room DVR utilizing the MoCA networking standard.  Followed in 2010 by DirecTV (DTV), Comcast (CMCSA), Cox (COX), and Time Warner Cable (TWC), each announcing a multi-room DVR roll-out.  Notably absent from the list is Cablevision (CVC), who is trialing DVR-Plus, a multi-room DVR service allowing subscribers to record programming on shared servers located at the cable operator's head-ends.  This configuration eliminates the need to stream video throughout a home using the MoCA protocol.

Cablevision has long been the technology vanguard of the cable industry (always the first to upgrade infrastructure, first to offer triple-play, invented HBO, etc.) and its cloud-based solution to multi-room DVR service is the long term solution.  DVR Plus has been years in the making, first introduced in 2006, it wasn't until 2009 that the U.S. Department of Justice approved its use in the wake of a legal challenge brought by certain content providers claiming copyright infringement.  During the period of injunction, MoCA emerged as an alternative, albeit a temporary one.  Cablevision’s CEO pledged to "stop buying set-top boxes" at the launch of DVR Plus in the Bronx on January 18, 2011.

The $10.95-a-month DVR Plus service comes with 160GB of storage - the same as its set-top-box based iO DVR service - enough to store up to 100 hours of standard-definition programming or 25 hours of HD programming.  Referred to as a whole-home DVR, any qualified digital box in the home can access programming recorded on the MSO's network, and set and manage DVR recordings.  DVR Plus lets subscribers record up to four shows at the same time, while watching a fifth already-recorded show.  Unlike other whole-home DVRs that use the MoCA networking protocol, DVR Plus doesn't rely on a master DVR to share content with other boxes on the home network.  Instead, all content is stored on, and played back from, the MSO's cloud-based storage banks.  Customers access and manage DVR Plus on channel 1001.

Revenue at Entropic will plateau year-over-year by 2012 due to the roll-out of cloud-based DVR services by the cable MSOs, ASP erosion for MoCA chipsets, and market share losses to Broadcom (BCOM) who shipped MoCA in its SoC (System-on-a-Chip) in Q1 2011.  Even prior to Broadcom's launch, in Q4 2010, according to JP Morgan 2/3/10, Entropic's market share was down to ~90% (of an estimated total Q4 market of 6.1 million chip sets).  STMicro (STM), the other major STB chip maker is developing an integrated MoCA on SoC as well.   Additional threats to MoCA’s share of home networking include wireless solutions and other over-the-top (OTT) solutions that bypass traditional pay tv.  In sum, Entropic is not a growth stock as Wall Street would have us believe.  It is a transitional technology that will be obviated by cloud-based services.

For more information, please contact us at info@3sigmavalue.com.

Software Economics - Volume II (1)

Introduction

Chapter 1:  The Paradox of Efficiency

Chapter 2:  Dot Com 2.0: We've Been Here Before

Chapter 3:  Jive Software (JIVE) & the Social Business Software Category

Chapter 4:  The Highest Margin Software Company in the World

Introduction

Since publishing Software Economics – Volume I in 3-Sigma Value’s Q2 2010 Quarterly Letter, the software industry’s evolution to a cloud-based delivery model (versus the traditional license/maintenance model) has accelerated as the major technology vendors focus on building and buying cloud-based applications and infrastructure. 

3-Sigma Value identifies seven major consolidators – Cisco (CSCO), Hewlett-Packard (HPQ), IBM (IBM), Juniper (JNPR), Microsoft (MSFT), Oracle (ORCL), and SAP (SAP) – who collectively spend billions of dollars annually acquiring software companies that deliver applications and infrastructure on an on-demand basis via the internet (the cloud).

Often referred to as software-as-a-service (SaaS), customers pay monthly or quarterly or sometimes annual subscription fees instead of purchasing a software license the old fashioned way (80% upfront license fee / 20% annual maintenance).  Because GAAP accounting (and common sense) dictates that revenue is recognized ratably over the course of a subscription, a SaaS company reports less revenue at the time of sale.  Instead, deferred revenue accretes (or depletes) on the balance sheet and is therefore a more accurate indicator of future revenue or lack thereof.  Additionally, SaaS vendors report billings, which is revenue plus the change in deferred revenue.  Revenue by itself is a lagging indicator, representing sales from quarters or even years ago.  Billings is the metric most highly correlated to future revenue.

Valuations for companies that deliver software on an on-demand basis via the cloud have risen to dot com heights because of the high multiples paid by the major technology consolidators.  Strategic considerations drive valuations above levels supported by underlying fundamentals.   Without M&A potential, much of the software industry is overvalued.  That being said, 3-Sigma Value never shorts a stock simply based on valuation, and more broadly we never short the stock of a great company selling a great product.

On the flip side, 3-Sigma Value never buys a stock based on the potential for a take-out.  M&A is never a consideration in a Base Case operating scenario.  The possibility is only reflected in the valuation derived from an Upside Case scenario.

The Paradox of Efficiency

In a cloud-enabled world in which companies can deliver software and services without having to buy servers and load software and build a physical infrastructure, it has become more difficult for the securities markets to discriminate between those companies that develop and own intellectual property (IP) and those that merely resell someone else’s.   A reseller of technology may be able to sustain a profitable business model and there is nothing wrong with that.  The problem is when a reseller of technology is misunderstood as a unique technology provider and as such is over-valued by the market. 

We begin our analysis of The Paradox of Efficiency by asking the question, what constitutes a technology company?

Answering qualitatively is an exercise we leave for marketing departments.  The only way we as financial analysts can gain 3-sigmas of confidence in any investment thesis is by proving it quantitatively.  Therefore, we identify three operating metrics that, taken together, measure the quality of technology sold:   

1.  Gross Margin (GM) shows how much technology content is in each sale.   A lower gross margin means the vendor is paying someone else, generally in the form of a license or royalty.  The most efficient software companies that develop all of their technology in-house report gross margins above 90%.    On the other end of the spectrum, vendors that license or pay royalties on technology developed elsewhere report gross margins closer to 60%.

2.  Cumulative R&D shows the value of the underlying intellectual property (IP).  While plenty of companies waste money developing technologies that don’t work or aren’t wanted, if a company doesn’t spend any money at all on research and development (R&D) then how can it purport to be a technology company?  Groupon (GRPN) is a prime example.  Groupon doesn’t report R&D expense on its income statement – because the amount of in-house technology development is immaterial. 

3.  Operating Margin (OM) shows how efficiently a company is managed.   Technology is scalable and the cost of technology deflationary due to innovation and Moore’s Law.  R&D expenses tend to be relatively consistent over time while operating leverage is earned in sales and marketing (S&M), and general and administrative (G&A) to a lesser extent.  The highest margin software company of significance is Check Point Technologies (CHKP), a leading IT security vendor based in Israel that reports operating margins approaching 60%.   After Check Point, leading software vendors reporting 40%+ OM include Oracle (ORCL) and Microsoft (MSFT).

It doesn’t matter whether a technology company builds or buys its intellectual property as long as both forms of expenditure are accounted for properly and consistently when comparing earnings quality and growth.  Unfortunately, the widespread acceptance of non-GAAP financial reporting obfuscates the true relative earnings power of companies across the technology spectrum.  Some companies report non-GAAP earnings when there are GAAP losses.  When a CFO or CEO talks of “margins” without qualifying it as “non-GAAP” he/she is being disingenuous because when non-GAAP earnings diverge from GAAP earnings, expenses are being excluded (or more accurately, hidden).    

Non-GAAP numbers typically exclude stock compensation, acquisition related costs, amortization of acquired intangible assets, costs associated with IP collaboration agreements, and other non-cash and cash expenses.  These are recurring costs for an acquisitive firm.

Ultimately, cash is what matters, not earnings(2).  Normally, a software company with a ratable revenue recognition model will report cash flow well in excess of earnings.  Because revenues are reported with a significant delay relative to cash collections under GAAP accounting, operating and net income will also generally lag cash flow from operations (CFFO, on the cash flow statement).  Therefore, a decline in cash flow generally indicates a problem in a software company’s strategy despite potential earnings growth that is more cosmetic (and backward-looking) than indicative.

Dot Com 2.0: We’ve Been Here Before

Given the ultimate requirement of cash flow profitability for any sustainable company, it is axiomatic that companies that continue to burn cash will continue to lose value.  Therefore,  3-Sigma Value focuses a part of its research effort on finding software companies likely to continue burning cash through our investment time horizon of one to three years, thereby calling into question the sustainability and quality of the underlying software.

As of May 30, 2012, 3-Sigma Value identifies five (5) over-hyped dot coms with negative operating margins through 2013 based on consensus estimates.  For all 5 companies, when analysts report 2014 projections, we expect those margins to be negative as well.  Perhaps, one or more of these companies can squeeze out a few cents of profit but that hardly matters given the extreme valuations attributed to these superficial growth stories.

With no earnings or cash flow to analyze and with revenues a completely unreliable measure of value, it would seem impossible to confidently value these companies if it were not for the fact that we lived through the Internet bubble.  That being said, we focus on sustainability of the business model, margin structure and path to profitability, and the uniqueness and underlying value of the technology.

Applying our framework for analysis of the relationship between GAAP and non-GAAP margins, while the difference is mostly due to the exclusion of stock-based compensation and amortization of acquired intangibles, one company stands out.

Jive Software (JIVE) & the Social Business Software Category

On June 25, 2012, Microsoft (MSFT) announced the acquisition of Yammer for $1.2 billion cash.  The valuation is irrelevant from a comparable company standpoint as Yammer only generated $15-$20 million of revenue in 2011 according to reports.  And by all accounts Yammer is not a category killer on the cusp of dramatic adoption.  Therefore, the valuation paid by Microsoft is strategic, not financial.  It fills a widening gap that Microsoft was struggling to fill as its SharePoint application for creating private websites for intra-company projects was losing clients to the new collaboration platforms that integrate social and mobile in addition to web sites.

Collaboration software for enterprises has attracted big technology vendors such as Cisco Systems (CSCO), which has a similar offering to Yammer called WebEx Social, and International Business Machine (IBM) with a rival product called Connections.  In addition, Yammer competes against Asana (founded by Dustin Moskovitz), Salesforce.com Chatter (CRM), and VMWare/SocialCast (VMW).

On December 13, 2011, Jive Software (JIVE) went public at $12.00 per share, and closed its first day of trading at $15.05.  Jive, founded in 2001 by a dot com redux management team led by CEO Tony Zingale is changing the world.  The pitch, which is valid, is that collaboration increases productivity, produces fewer emails, decreases support calls, and overall lowers cost.  The problem is that workplace collaboration software is already the most popular and commoditized SaaS application (by function) with low complexity and low IP value.  According to IDC data,

$3.5 billion was spent (in 2010) on subscription-based collaboration software, followed by Content ($1.8B), CRM ($1.6B), Engineering ($1.2B), ERM ($1.1B), Operations / Manufacturing ($0.7B), and Supply Chain Management ($0.4B).

Competition in collaboration software (re-named social business) is free/freemium and fierce.  Salesforce.com's Chatter is offered for free, at the entry level.  Yammer is freemium and sold via integration partnerships with channels including Netsuite (N) and Microsoft Dynamics.  IBM – enterprise collaboration products include Lotus Quikr and Lotus Live, and IBM Connections products, EMC/Documentum – eRoom, CenterStage, and TIBCO (TIBX) – enterprise social collaboration tool called Tibbr launched Jan 2011, give it away to customers at no incremental cost.  Telligent ($32M in 2010), Socialtext ($26M), and Lithium ($22M) are independent social vendors that have also achieved similar critical mass (Jive was only $38M in 2010).

In May 2012, Jive formally launched Try Jive, a fully-loaded edition of Jive's platform that prospective clients can trial for free for 30 days.  This is the first step of a 2-step transition to the pitiable freemium model which is always more free than premium.

Clients access the platform via cloud, hosted or on-premise deployments.  Hosted services are outsourced to SunGuard Availability Services (SunGuard).  Jive is in the process of transitioning a portion of its hosting services to a Jive managed hosting facility, but has no plans to transition entirely.  As a result of the outsourcing of a large portion of its cost of goods sold (COGS), Jive reports lower gross margins than its SaaS peers, in fact, Jive is near the low end of the software universe ~60%.  In contrast, Check Point Technologies (CHKP) reports 60% operating margins.

In addition to the lack of a proprietary back-end and reliance on 3rd-party providers, Jive's product architecture is not based on a single base of code; it is not multi-tenant software that is shared by its customer base enabling operating leverage.  Instead, Jive's customer base uses several different versions of the technology, including Jive Express, v3, v4, and v5 of the core product, and now Try Jive.  Supporting multiple versions of code adds complexity and cost.  Excluding the 100 or so clients on Jive Express rolling off throughout the remainder of 2012, the majority of Jive clients are still using v4 and face an uncertain upgrade decision – allow Jive to retrofit legacy on-premise deployments or use new, multi-tenant architecture designed for the cloud – e.g. Yammer, Salesforce.com (CRM).  As of December 31, 2011, Jive had 667 Engage Platform customers with over 20 million users within these customers and their communities.  The top 10 customers by annual contract value include ACE Group, H-P, SAP, T-Mobile, and UBS.  Top line growth is tied to sales execution, and therefore the Company is doubling the size of its sales force by the end of 2012 versus 2010.

Following is a summary of the significant assumptions underlying 3-Sigma Value’s scenario analysis:

1.  Billings (new customers, net of churn + upsell of customers above the amount of renewal) is a leading indicator of growth, while revenue is a lagging indicator.   In the first quarter of 2012, upsell was strong within Jive’s customer base (65% of billings are attributable to upsell according to management, up from 62% in Q4 2011), but this data is misleading because expansion in upsell as a % is the natural result of deceleration in new customer growth.  Management says attracting new enterprise customers is difficult, and growth is dependent on the upsell - they say upsell within the customer base is 6x the initial purchase, on average, driving an incremental share of new billings.  In fact, Q1 2012 was horrible with respect to revenue from new subscriptions, declining from $6.8 million to $4.7 million (down 32%).

Billings is determined by (1a) new customers, gross; (1b) new billings per new customer; (1c) upsell rate; (1d) churn – high at nearly 20% per annum is a red flag.

Billings deceleration is a certainty, undermining the consensus view that Jive is a growth stock.  Jive is not Facebook with 900+ million individual customers.  It has 667 enterprise customers at the end of 2011, up only 13% from the 590 customers reported at the end of 2010.  Collaboration is an intensely competitive market, one that will restrict the ability of Jive to become a dominant vendor like Facebook.  Instead, Jive will be a niche provider that is roughly breakeven on an operating basis.  The best case scenario for Jive is obviously a take-out.

2.  Retention (renewal billings as a % of total billings) – moving up from 35-36% in Q2/Q3 2011 to 42% in Q4, and 46% in Q1 2012.  Management expects the percentage to rise as new billings growth decelerates.  This assumption is tied to upsell rate.

3.  Professional Services Attach Rate – the mix of subscriptions versus services impacts margin as services is a zero margin business.

4.  Gross Margins – subscription gross margin of ~70% is low by software standards, suggesting a lack of IP in the products being sold.  Services is a zero margin business, and has been in negative territory for the past two years (-17% in 2010, -5% in 2011).

5.  Operating Expenses - Management is doubling the sales force (S&M) off a Q1 2011 base of $8.5 milli1on by the end of Q4 2012 (Q1 2013 S&M = $17 million).  Increased spending in R&D and G&A is expected as well.

6.  No taxes because no profits.

7.  WACC & Terminal Value Multiple – WACC is elevated at 16% due to a high 2.25 beta.  The multiple is based on comparable M&A transactions.  Valuations paid in M&A are all over the place, largely based on the quality of the IP and strategic rationale for the acquisition.

At the high end, on June 4, 2012, Salesforce.com (CRM) announced the $689 million acquisition of Buddy Media (14x $50 million run rate revenue), a company that helps more than 1,000 marketers including Ford Motor and L'Oreal, to manage their presence on Facebook and other social networking sites.  This comes two weeks after Oracle acquired Vitrue, an Atlanta-based social marketing platform for $310 million ($10-$25 million of revenue).  Vitrue clients include MCD, YHOO, AXP, and LUV.  Consolidation will leave the weakest players to fend for themselves.

At the low end are take-outs of commoditized / low tech SaaS vendors including iContact, an email-marketer that was acquired by Vocus (VOCS) for 3.5x revenue (on 2/28/12), and Convio, an internet marketer tailored for non-profit organizations that was acquired by Blackbaud (BLKB) for 3.4x (on 1/17/12).

In an Upside Case operating scenario in which Jive is acquired, we believe the multiple will depend on the timing, strategic value, and wherewithal of the acquirer.  This results in a broad range of valuations between 3.4x and 10x billings (consolidation around 5x). 

Our Base Case operating scenarios are not dependent on M&A, and therefore the valuation is a direct function of the underlying fundamentals.  Although Jive generates no EPS, EBIT or EBITDA, it does generate positive free cash flow in our Base Case scenarios.  That is because deferred revenue is not reflected in the income statement and therefore revenues are less meaningful when valuing a subscription-based software company.  Billings is more significant because it more accurately captures the current state of the business and its momentum.  In addition, we incorporate a free cash flow model into our valuation work.

Conclusion:  Jive is jive.  Jive is still jive.  And jive will always be jive.  According to the dictionary, jive means glib, deceptive, or foolish talk.  It can also mean deceitful or worthless, as well as it refers to a lively style of dance popular especially in the 1940s and 1950s.  In the case of Jive Software, it is collaboration masking as social, the old pretending to be new.  Jive is not Facebook, although it was priced in the immediate lead up to The Social Network's epic IPO.  Instead, it is a standalone copy of Salesforce.com Chatter, competing against Microsoft Sharepoint/Yammer, IBM, Oracle and the other incumbent enterprise software vendors.  Jive is an old idea regurgitated as new.  Jive is a turd, what we refer to here at 3-Sigma Value as a polished turd.

The Highest Margin Software Company in the World

On the flip side of our discovery and analysis of software companies projected to remain in negative operating margin territory through our investment time horizon, is a return to our research favoring the business of IT security, first published in 3-Sigma Value's Q2 2010 letter.  The actionable conclusion from that analysis was to BUY MacAfee (MFE), which was subsequently taken out by Intel for 11.5x EBITDA.  

In addition to MacAfee, 3-Sigma Value built long positions in Blue Coat Systems (BCSI) and Check Point Technologies (CHKP).  In December 2011, Blue Coat was taken private by private equity firm Thoma Bravo for 12x EBITDA, a multiple inflated by underperformance.  Check Point on the other hand remains in the 3-Sigma Value portfolio at a bargain valuation that is completely disconnected from the fundamentals underlying the most efficient software developer in our universe.

Superlatives notwithstanding, evidence of Check Point's mastery of its business is in its peerless operating margin around 60% (55-60% on a GAAP basis).

Observations:

1.  The underlying financial performance of recent IPOs is terrible compared to the performance of leading companies

In general and across all industry we find this to be the case, and therefore recent IPOs are a fecund arena to find over-hyped and over-valued companies.  Sacrificing profits (margins) today for growth or market share is a valid early-lifecycle strategy for some (a few) companies, but most companies have to generate profits in order to sustain.  For those companies that are not rapidly expanding like Amazon, the strategy of sacrificing profit becomes an unsustainable rationalization.   

3-Sigma Value is not short any of the recent IPOs in the IT security industry as none of them meet our criteria for risk/reward, principally because of the upside risk of a take-out at a premium strategic valuation.

2.  The continuing evolution of the customer base from best-of-breed point solutions to all-in-one solutions is driving vendor consolidation

The continuing saga of and inevitable consolidation of the software industry revolves around the appetite of the seven major technology consolidators, which 3-Sigma Value defines as CSCO, HPQ, IBM, JNPR, MSFT, ORCL, SAP.  Microsoft, Oracle, SAP, and IBM are particularly relevant because they are principally software companies and therefore act as benchmarks in terms of margin structure and valuation.  These Big 4 Software companies report an average operating margin of 39%, ranging between 25% and 50% based on the amount of technology content and the percentage of revenue coming from high margin software maintenance.  Oracle is at the high end at 50% OM, followed by Microsoft and SAP.  IBM, on the other hand, is at the low end at 25% because a higher portion of its business is lower margin technology (36% gross margin) and business services (30% GM). Only $25 billion out of a total $105 billion in estimated 2012 revenue at IBM is software (88% GM).

The next-generation of security platforms integrate network security (Layers 2/3), application security (Layers 4-7), and cloud security all in one box (called an appliance).  As security vendors rush to buy/build integrated functionality, those vendors that are already selling advanced technologies to enterprises should have an advantage creating a simplified, cheaper version of its product then a low end vendor has of building a more advanced, complex version of its product.  A prime example of this is the predominance of VPN/firewall sales as a percentage of total enterprise network security sales.  In 2011, $4.5 billion out of a total $6.2 billion spent on enterprise network security was spent on firewalls/VPNs (3).  Other network security products include intrusion detection and prevention (IDS/IPS), data loss prevention (DLP), web gateway/URL filtering, and application control.
 

It is the VPN/firewall sale that drives adoption of enterprise security, and therefore it is the leading VPN/firewall vendors that warrant incumbent status.  They are the companies most likely to be long-term winners in the securing of global IT infrastructure.

Cisco, Juniper, and Check Point are the big 3 in terms of network security.  The difference is that Check Point is a virtual pure-play software company while Cisco and Juniper are hardware companies.  Which leads us to a powerful secular trend in technology that will drive valuations and determine winners and losers over the next generation of network infrastructure, that is, the advent of software-defined networking (SDN).

From a network architecture standpoint, SDN separates the control plane from the data plane in switches and routers (4).  Because the control plane is implemented in software, the data plane can be implemented using commodity network equipment.  This lowers the overall cost of implementation while enabling external access to the inner workings of switches and routers that were formerly closed and proprietary.  The process of optimization is accelerated and so is the ability to fix, change, and experiment in real time. 

For example, Cisco is enabling Application Interfaces (APIs) across its switch and router portfolios (5), integrating best-in-class IT partners including EMC (EMC) and NetApp (NTAP) storage, VMWare (VMW) vCenter and vCloud, Citrix (CTXS) NetScaler and Xen Desktop, and potentially F5 Networks (FFIV) Big-IP application delivery controller (ADC) given Cisco’s decision to discontinue further development of its own ADC product (6).  SDN is the key to Cisco’s strategy to sell “architectural platforms” instead of point-to-point products.  It defends the Company’s core layer 2/3 platforms while expanding its total addressable market.  Juniper, Brocade (BRCD), Hewlett-Packard (HPQ) via its 3-Com acquisition, and F5 Networks are also pursuing API strategies.

Not long ago, security was a discrete software application sold in license form to companies whose IT professionals would load it themselves on servers, in server rooms, onsite.  More recently, the technology industry has determined that security is more important, maybe the most important application, and therefore deserves its own dedicated appliance (hardware box sold with pre-loaded software).  Check Point sells a series of appliances for large data centers (the 61000 Security System) and large and small businesses (the 12000 Appliance, 4000 Appliance, or 2000 Appliance, depending on throughput requirements), all of which run a single unified security operating system called GAiA.

Converting clients from traditional software licenses to new appliances with a new OS based on new software blade architecture (annual subscriptions) is driving a shift in revenues at Check Point from license revenue (on the Company’s income statement) to deferred revenue (on the balance sheet).  Deferred revenue amortizes over the course of a contract, eventually becoming subscription revenue (income statement).  As a result, growth in licenses is decelerating, to 5% YoY in 1Q12 and 3% in 2Q12, down from double-digit historical rates.  Cosmetically, this deceleration implies market share loss to new entrants (e.g. PaloAlto Networks) as the overall market continues to grow in the double-digits.   However, in reality, as Check Point’s business model changes, the accounting of revenue recognition changes, and new metrics are required to determine growth.  In Check Point’s case, deferred revenue was up 18% YoY, indicating a future base line of growth into 2013.

After the top 3 vendors (Cisco, Check Point, Juniper), the enterprise network security industry fragments with no other vendor garnering more than 5% market share.   However, there are a few notable comers with rich valuations implying a continuation of recent and rapid success.

Fortinet (FTNT) introduced Unified Threat Management (UTM) security appliances that scale to the 100s of Gigabits of throughput required by enterprises, effectively moving upstream to compete against the top 3.   The term UTM refers to the integration of all basic security technologies into a single appliance, and was pioneered by Fortinet at the low end for small businesses on budget.  Other UTM vendors attempting to challenge the top vendors include SonicWALL (acquired by Dell in May 2012) and WatchGuard (owned by Francisco Partners / Vector Capital), while established endpoint security vendors such as Symantec (SYMC) and Intel/McAfee (INTC) are offering UTM as well.

F5 Networks (FFIV), the leader in application delivery controllers (ADC) (7) is re-positioning its flagship Big-IP and Viprion Application Delivery platforms into next-generation security platforms, following the lead of Radware (RDWR), whose ADC has gained traction due to the integration of network security solutions including firewalls, IDS/IPS, and deep packet inspection (DPI). 

Numerous private security companies chase the leaders in the pursuit of scale, because it is scale and not profitability that leads to an IPO.  Notable private companies building enterprise security products include Barracuda Networks, Crossbeam Systems, Kaspersky Lab, SafeNet, Sophos (formerly Astaro), Stonesoft, and WatchGuard.

One company, in particular, has captured the public’s attention and rocketed to IPO success.  That company is PaloAlto Networks (PANW), and its euphoric valuation and sentiment illustrate the incredible undervaluation and disconnect between Check Point and the market.  PaloAlto has a $5 billion enterprise valuation, compared to Check Point at $7 billion.  Over the next two years, Check Point will grow EBITDA from ~$800 million to $1 billion (7x EBITDA, Base Case Operating Scenario), while PaloAlto grows EBITDA from ~$33 million to $100 million (50x EBITDA, consensus).

The acronym “NGFW” is the latest platitude added to an evergreen list.  It stands for “next-generation firewall”, and it is the basis for the hype surrounding PaloAlto’s dot com IPO road show.  What makes it the “next generation” is the integration of application visibility and control within the firewall (8).  PaloAlto is a pioneer not of the NGFW, but of the self-proclaimed.  Check Point’s new unified security operating system (called GAiA) enables the same integration of applications via software blade architecture.  Furthermore, Check Point’s high end 61000 Security System for data centers is capable of an unprecedented performance of more than 1 Tbps of firewall throughput, and achieves over 200 Gbps today.   In comparison, PaloAlto’s PA-5000 Series of next-generation firewall designed for data centers provides protection at throughput speeds of up to only 20 Gbps.

Why is market perception of Check Point so different than reality? 

One reason is the Company is based in Israel, and not only that but Check Point is the apogee of Israel’s vaunted technology industry, representing the engine of growth for the Israeli economy as a whole.   This stature might prohibit acquisition, although the Company has never expressed such a reservation on an earnings call, or in a public forum.  On the other hand, Israel maintains a very favorable corporate tax rate (2012 guidance = 19-20%) and newly relaxed restrictions on stock buybacks (On July 18, 2012, Check Point a announced new $1 billion expansion of the on-going stock repurchase program, to be deployed over the next two years).

The second reason is the perception that the deceleration in product/license revenue is a function of new competition from PaloAlto and others, and not merely a function of the shift in business model from traditional software licensing to blade software subscriptions.  As discussed earlier, deferred revenue has accelerated to 18%.  This is future revenue, it is not lost.   Typically, a traditional software license accounts for 80% of a sale with annual maintenance accounting for the remaining 20%.  A subscription flips that ratio on its head as only 20% of a sale is recognized as revenue while 80% is deferred.  Therefore, product/license revenue will decline by 75% when a customer migrates to the new operating system.  This is not an accident.  This is not a mistake.  This is a natural result of the shift in business model.     

The third and final reason is Europe accounts for 38% of sales.  Self-explanatory.

3.  Check Point’s superior margin structure (60% OM vs. 30% industry average) is a sustainable competitive advantage

As described earlier, we identify three operating metrics that, taken together, measure the quality of technology sold, and therefore the sustainability of the business:  

I.  Gross Margin (GM) shows how much technology content is in each sale.  Check Point reported 88.5% GM in the most recent quarter.  Since the first quarter of 2009, GM has ranged between 85% and 90%.  As the business mix shifts from licenses (~85% GM) to subscriptions (~92% GM (9)), GM should incrementally rise above 90%.  

II.  Cumulative R&D shows the value of the underlying intellectual property (IP).    Check Point spends around 10% of its total revenues on R&D, a level that understates its economic contribution given the Company’s access to low-cost engineering talent via Israel’s vaunted technology industry.   

III.  Operating Margin (OM) shows how efficiently a company is managed.   Check Point earns peerless OM due to its efficient R&D spend (~10%), and low level of G&A (~5%).  The only potential expense variable is Sales & Marketing (S&M).  However, like everything else they do, Check Point manages S&M very tightly around 20%.  Total operating expenses have been and will continue to approximate 35% of revenue, although in our Upside Case operating scenarios we do allow for incremental operating leverage – operating expenses (opex) as a % of revenue decline to ~30%.  With gross margin likely to remain around 90%, and opex around 30-35%, the current range of 55-60% operating margin is likely sustainable over 3-Sigma Value’s investment time horizon of one to three years.

4.  Check Point is undervalued any way you look at it. 

3-Sigma Value employs a discounted cash flow (DCF) methodology, sanity-checked with an earnings analysis to arrive at a probability-weighted target price range of $65 to $75 per share.

For more information on software economics, please contact us at info@3sigmavalue.com.

Software Economics - Volume I(1)

Introduction

Chapter 1:  General Characteristics of Software Companies We Invest In 

Chapter 2:  IT Security - The Number and Complexity of Threats are Growing Geometrically

Chapter 3:  Buy McAfee (MFE)

Introduction

Unlike most other goods produced in the economy, software is produced once and can, in theory, be sold an infinite number of times without incurring additional production costs (COGS).  In other words, there are virtually no marginal production costs for incremental sales of a software license.

For many software companies, sales and marketing expenses equal license sales.  This means margins earned on license sales are negligible and the license business as a whole is a loss leader.

In contrast, since relatively little sales and marketing effort is spent on maintenance renewals, maintenance revenue (product updates, technical and customer support) is hugely profitable (most software vendors report maintenance margin > 85%).  Moreover, licenses are generally more discretionary than maintenance.  As long as the power is on, most maintenance will be paid.  In fact, the maintenance model for a software company is so powerful that even if license sales were to significantly decline (i.e.  down 25% in a recession) and then continue to decline (for two more years(2), overall operating margin for the software company should continue to expand.

In a recessionary environment for IT spending, software license revenue will decline, however, because of high margin maintenance, profits at well-established, well-run software companies will sustain.  This is the power of the software model and why one dollar of profit at a software company is worth more than one dollar of profit at an economically-sensitive cyclical company(3).

General Characteristics of Software Companies We Invest In

1.  Maintenance Revenue as a % of Total Revenue must be meaningful

Maintenance revenue is sticky and largely cumulative given renewal rates across the industry generally greater than 85%.  More mature software companies typically generate higher maintenance revenue as a percentage of total revenue and therefore, all things equal, we prefer software companies with long operating histories.  Moreover, consumer-oriented software companies generally have less maintenance and therefore we tend to focus on software providers to companies (a.k.a. enterprises) as well as to consumers. 

2.  Maintenance Renewal Rates > 85%

Holding pricing pressure constant at 0%, maintenance revenue will only decline if renewal rates decline below 85%(4).  Therefore, in general, we prefer investing in software providers with sustainable (sticky) renewal rates greater than 85%.

3.  Pricing Pressure on Maintenance < 5%

Holding renewal rates constant at 85%, maintenance revenue will only decline if pricing declines at a rate greater than 5%.  Therefore, in general, we prefer software providers with sustainable pricing power such that pricing will not decline at a rate faster than 5% over the foreseeable future.  More specifically, we prefer vendors selling a high end rather than low end product, in a consolidating segment of the market

4.  Deferred Revenue Highly Correlated to License Sales

When software licenses are sold, maintenance is generally prepaid at the same time.  Because maintenance revenue is high margin, a rising deferred revenue balance (recorded as an asset on the Balance Sheet) is an important leading indicator of the health of a software business.  Red flags are raised if deferred revenue fails to reflect new license sales(5).

5. 3-Sigma Value’s Estimation of Intrinsic Value must be 150% or more of Current Market Value and there must be five points up to the valuation derived from our Upside Case Operating Scenario for every one point down to the valuation derived from our Downside Case Operating Scenario (5-to-1 Risk/Reward Ratio)(6) 

Because the software model is resilient during a downturn in license sales, software companies are generally worth more than cyclical companies, and therefore, software generally trades at a premium to the overall market on the basis of revenue, EBITDA and free cash flow generation.   In the private market, valuations diverge widely based more on strategic fit than market or macro timing.  For instance, SAP recently acquired Sybase for 15.7x EBITDA, 12.2x maintenance, and 4.8x revenue, valuation levels not inconsistent with strategic transactions going all the way back to Oracle’s celebrated acquisition of PeopleSoft in 2003.

Software vendors with meaningful maintenance sell in a range of 6.1x to 10.3x maintenance revenue with a tighter grouping between 6.5x and 9.5x.  In the case of SAP’s recent acquisition of Sybase, the huge valuation (see chart above) reflects the strategic nature of the deal.  SAP is the largest reseller in the world of Oracle databases and Sybase was the only independent database provider with any meaningful global market share (2009 database market share: Oracle = 43%, IBM = 24%, Microsoft = 19%, Sybase = 3%).

Much like the database business, the software industry as a whole is in the process of consolidating around five global technology vendors: Cisco (CSCO), Hewlett-Packard (HPQ), IBM (IBM), Oracle/Sun (ORCL), and Microsoft (MSFT).

Creative Destruction and Moore’s Law define opportunity oblivious to the cycle.  We find the best investment opportunities in those segments of technology where competition is the fiercest, where consolidation is a strategy not a history.  The global technology consolidators -- Cisco (CSCO), Hewlett-Packard (HPQ), IBM (IBM), Oracle/Sun (ORCL), and Microsoft (MSFT) -- all seek to offer more complete solutions, to better leverage their sales and support infrastructure, and to accrete as much high margin maintenance as possible.  While small vendors that drive innovation with specialized offerings in high growth segments continue to demand premium valuations.

IT Security – The # and Complexity of Threats are Growing Geometrically

Security threats are constant and proliferating and therefore, in general, spending on security is non-discretionary (less economically sensitive) compared to project-based IT spending.  While not all segments within the IT security market are growing as fast as mobile security or web security, as we illustrated earlier, it doesn’t take much growth to support a business model based more on retaining high margin maintenance revenue than racing to sign up new licensees. 

Many security software companies are trading at low valuations implying a deterioration in margin structure that calls into question the durability of the maintenance model.  Security maintenance is sticky and substantial, renewal rates are among the highest in software.  Nothing in the network stack is more important than securing data.

Pricing pressure varies across segment.  For example, free consumer anti-virus software offered by internet service providers (ISPs) serving the low end of the market is bound to infiltrate pricing at the high end.    In contrast, internet security, which generally refers to Web Security Gateways, or URL filters, that control a company’s access to the internet, is growing at a mid-teens CAGR, with inflationary pricing more characteristic at the high end.

Similar to other sectors within the software universe, security is consolidating; however, at this point in time, the major software vendors remain minor players, forced to partner with security specialists like Check Point (CHKP), the market share leader in firewalls and VPNs(7), or Websense (WBSN), the market share leader in Web Security Gateways.

Segmentation

While ETFs have popularized the specious notion that alpha is generated at the industry or macro level rather than at the company-specific or micro level, we here at 3-Sigma Value find that employing ETFs or other broad-based indices is akin to using a blunt instrument when surgical precision is required.  Technology is not a commodity business.  Technology succeeds on the basis of innovation.  In fact, an investment in Microsoft, or any of the Big 4 for that matter, is an investment in stasis.  Investing in Microsoft means betting against innovation.

On the other hand, there is an alternate path to success in the business of technology: strategy.  In fact, the Big 4 are the Big 4 because of strategy.  Because of great management teams and the efficient and successful integration of acquisitions.  Growth through M&A is no less valid a contributor to value than organic growth.  Vertical and horizontal integration.  Acquiring an experienced sales force.  A distribution channel.  Acquiring high margin lines of business that are typically accretive to EPS in year one.  There are many ways to create value in the business of selling technology, and understanding exactly where a company fits in its environment is the first step in understanding a company’s value.

The IT security market is broadly split based on product.  Most vendors are global, and therefore market share is posted on a global basis:

Consumer End-Point Security (a.k.a. anti-virus) vendors such as market leader Symantec’s Norton (52% market share in 2009), and McAfee (18%) continue to enjoy high renewal rates in spite of the proliferation of free anti-virus software offered by ISPs(8).  On the surface, consumer end-point appears to be in secular decline, but in reality, many consumers, those reliant on their computers, are price inelastic, willing to pay for a stronger guarantee.  While we believe premium pricing will persist at the high end, the low end is terminal.  Taken together, we view the consumer market opportunity as saturated, which translates into zero percent growth and pricing that ranges from flat to negative.

More specifically, McAfee (MFE) has aggressively expanded its PC OEM market share in recent years to over 50% of PCs shipped by the top 10 global PC OEMs(9), taking share primarily from Symantec (SYMC).  They’ve accomplished this by offering PC OEMs a greater share of on-going renewals, sacrificing margin for market share (McAfee 2010 consensus EBITDA margin is 33.1% compared to 35.9% for Symantec), resulting in market share loss for Symantec and deteriorating margins for both.

Corporate End-Point Security vendors are split between specialists such as Symantec (36% market share in 2009), McAfee (27%), and Trend Micro (19%), and major corporate technology vendors, namely Cisco and IBM(10).        

Symantec is the market leader in corporate end-point but offers nothing serious in terms of firewalls, VPNs, or gateways.  Instead, they sell storage and server management solutions to an overlapping array of corporate customers.  In 2005, Symantec made the most value-destroying acquisition in the history of software, paying $14.7 billion(11) for Veritas, the market leader in back-up, recovery, and storage software, software that simplifies data centers and reduces storage costs through improved utilization and virtualization(12).  Simply put, Veritas’ direct sales model (more than 3,500 strong) didn’t fit well with Symantec’s channel-centric sales model (value-added resellers, large account resellers, distributors, and system integrators), leading to a series of channel conflicts and much confusion.

McAfee, on the other hand, has effectively built a one-stop security shop through a combination of organic development and acquisitions – e.g. the 2008 acquisition of Secure Computing gave McAfee a competitive suite of network security products that on a standalone basis is inferior to Check Point’s, but when bundled with McAfee’s competitive End-Point and Web Security products makes for a compelling sale to any CTO who cares about lowering his costs.

Network Security vendors sell products including firewalls / VPNs, unified threat management UTM(13), and intrusion prevention systems IPS(14).  Check Point (CHKP) is the market share leader in VPNs at 15% (vs. CSCO at 11%) and number two behind Cisco in Firewalls at 20% (vs. 34%).  Check Point is a great franchise any investor would want to own at the right price.  It boasts the highest margins in the industry (51.7% EBITDA margin according to consensus estimates for 2010) and for the first time ever trades below 10x EBITDA.

Check Point largely competes against vendors bundling security into their core networking products (switches and routers).  For example, Cisco and Juniper are #2 and #3 behind Check Point in combined firewall / VPN market share respectively.  Microsoft is the only other vendor with meaningful share in firewalls (9%) and VPNs (3%), otherwise, F5 Networks (FFIV), Citrix (CTXS), Akamai (AKAM), Alcatel-Lucent (ALU), and others all offer integrated network security of dubious quality.

Web Security vendors sell products that include URL filters, content filters, and web anti-malware that is increasingly being bundled into networking products.  However, web security remains a fragmented marketplace, one expected to continue growing at a low-to-mid teens double digit CAGR over the next three years.  Furthermore, the web security marketplace is characterized by partnerships with major technology vendors, and therefore, web security is a likely battleground for consolidation sooner or later. 

Websense (WBSN), with 20% market share, is the leading provider of gateways at the low end, hence its business is more vulnerable to eventual pricing pressure, a prognosis reflected in its depressed 7.8x multiple of 2010 EBITDA.  Other major vendors of gateways include Trend Micro (11% market share), McAfee (7%), Microsoft (7%), Blue Coat Systems(15) (3%), CheckPoint (2%), and IBM (2%).

Mobile Security is a burgeoning marketplace still in its initial stages of development.  While mobile applications are a development priority at virtually all software companies, more often than not, as we know, the leading vendors will buy in addition to build.  For example, in May 2010, McAfee announced the acquisition of privately-held Trust Digital, a developer of mobile device management and security software for corporate mobility.  Through our investment in Smith Micro Software (SMSI), as profiled in our Fourth Quarter 2009 Letter, we were made aware of the Trust Digital acquisition and its strategic rationale – “The Triple Play”.  An oft-used metaphor, especially in the cable / telecom wars, it nonetheless strikes fear in the hearts of those who can only turn two.  PC + Mobile + Web = Triple Play.  Moreover, in a tough economy, cost containment remains paramount.  A bundle of software offering simplicity in terms of integration and interoperability, and a lower overall cost from bundled pricing, will continue to gain share from specialized point solutions.

Buy McAfee (MFE)

Software has never been this cheap.  Recurring streams of high margin maintenance revenue have never been this cheap.  Notwithstanding the fact that McAfee’s consumer anti-virus business will continue experiencing pricing pressure arising from the proliferation of free, and bundled, low-end software, McAfee’s investments in the PC-OEM channel in recent years (i.e. Dell and Acer) will generate increasingly higher margins as these contracts enter their harvest phase.  Typically, greater than 70% of the first year of a customer’s gross revenue is paid by McAfee to the OEM; after that, the percentage declines over time as the value of customer retention exceeds the value of the license sale.  After assuming a declining maintenance stream based on 0% billings growth (for both corporate and consumer), the free cash flow generated from maintenance alone is still worth at least $30 per share (Downside Valuation).

3-Sigma Value approaches the valuation of software companies consistently, using two approaches:

(1) Discounted Cash Flow (DCF) is logical given the recurring, cash generative nature of the software business;

(2) Sanity check with a valuation based on maintenance revenue, the preferred metric for software investors and acquirers.

We apply a range of EBITDA multiples, from 7x to 9x, approximating the valuations of the large global software consolidators, a level well-below the current and historical range of valuations for pure-play IT security companies.  While SAP trades at an unjustifiable 10-12x, its peers, Oracle, IBM, and Microsoft all trade between 7 and 9x.

On the basis of maintenance revenue, the low end of the comps approaches 6x, a multiple that is arguably generous in this case considering the services and support revenue embedded in maintenance is lower margin than pure subscription revenue.  Maintenance revenue of $1.7 billion in 2009 was split roughly 57/43 between services and subscription, and even though the combined margin was and continues to be a robust 80%+, we haircut the multiple to account for the lower margin contribution of services.

The maturing of a software business is tough to predict.  In the case of McAfee, 50% of its installed base has yet to convert from using standalone anti-virus software(16).  McAfee can generate above market organic revenue growth because McAfee has transformed itself into a platform company with tight product integration and extremely high switching costs for its corporate customers, a formula sustaining high maintenance and high margins.

Finally, to address the consolidation question, H-P, Dell, Acer, Toshiba, and Lenovo all resell McAfee.  By acquiring McAfee, any of these PC OEMs would be able to offer a superior security experience, well-integrated across PCs and other devices.  Also, Cisco has been aggressively pursuing the consumer through recent acquisitions of Pure Digital Technologies (Flip Video) to bolster its Linksys suite of home networking products; offering security software and services is logical.  Otherwise, McAfee’s enterprise value is only ~$4 billion, a small bite for one of the Big 4 software companies or IBM or any number of other global IT companies.

Downside Analysis – What is the Risk?

To begin, we exclude our valuation work based on maintenance revenue.  We ignore M&A comps and any notion of selling the company.  Therefore, what we are left with is a going concern generating around $450 million to $550 million of free cash flow in a Downside Case Operating Scenario.  More specifically, we assume:

(1) 0% billings growth;

(2) Maintenance (as a % of revenue) declines from 90% to an all-time low of 88%;

(3) Gross margin on maintenance drops from 82% to an all-time low of 78% (versus gross margin on licenses ~50%);

(4) Operating Expenses (as a % of revenue) report at the highest run-rates since 2008.

All other assumptions – e.g. capital expenditures, amortization of purchased technology, capital structure, etc. – remain consistent with LQA/LTM financial results and management guidance.

Synthesizing all of these negative assumptions, and then applying a 10% discount rate, results in a valuation of $30.32 per share, a mere 1% below the current share price of $30.72.  While 1% downside sounds phenomenal in theory, we all know the real risk is more severe.  Technical factors alone can drive the stock price well below our estimation of risk.  Anyone awake during September 2008 knows this.  Nevertheless, the point is that McAfee is a leading software company in terms of high margin maintenance whose stock is cheap based on any measure of value.  Market turbulence opens windows for patient investors.  McAfee is not speculative.  In fact, McAfee, along with CA are the best-positioned vendors if delivery of security software continues to migrate to the ISP channel, a trend that pressures margins because ISPs pay a nominal fee.  McAfee was the most aggressive to embrace this channel and entrench itself, and while this accounts in part for the sustained margin discrepancy between McAfee and Symantec, it eliminates arguably the major risk to software margins.

For more information on investing in software, please contact us at info@3sigmavalue.com.

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Bank Investing in 2013 (1)

According to the FDIC’s Quarterly Banking Profile for the Fourth Quarter 2012, FDIC-insured institutions earned $141.3 billion, the second-highest annual earnings ever reported, after the $145.2 billion in 2006.  Average return on assets (ROA) for the industry rose to the psychologically-important level of 1.00%, a level last realized in 2006.  The number of institutions reporting financial results declined sequentially from 7,357 to 7,083 as 51 banks failed and 223 were merged into other institutions.   2012 is the first year in FDIC history that no new reporting institutions were added.

Observations: 

1.  Not one new bank was created in an entire year.  Not a single management team was bestowed a bank charter by the government to profit from the juicy spreads earned between the near zero percent that banks pay to savers and the three to five percent they earn on average loans.  The slope of the yield curve as measured by the difference between the 3-month and the 10-year Treasury yields averaged +172 basis points for the year, roughly in line with the 20-year average of +180 basis points.  On the surface, banks are nearly as profitable as they were before the financial system collapsed, while the number of banks continues to shrink.  A charter to operate a bank is now and becoming more valuable than ever because it is becoming rarer.

Banks are unquestionably better-capitalized now in 2013 than back in 2008, in terms of credit statistics across the system as a whole.  Non-performing assets are down.  Leverage is down.  Yet 651 banks remain on the FDIC’s “Problem” List.  The singular reason why so many banks are still financially-distressed is the legacy loans trapped on their balance sheets, mismarked and unable to be sold without charging-off so much UPB (unpaid principal balance) that the equity of much of the banking system would be eviscerated.  A harbinger of massive consolidation, the banking industry is in the process of bifurcating.  Thanks to interest-rate policy, well-capitalized banks are modern-day money machines while under-capitalized banks grind to a halt.  The cost of running a bank has increased, requiring scale.  The age of the small local community bank serving one MSA is over.  Community banks can’t compete anymore, so they are merging with each other and morphing into stronger regional institutions.

2.  Credit metrics across the banking system continue to improve, i.e. as reflected in nonperforming assets, but if we scratch the surface it doesn’t take much to ascertain the reality of widespread insolvency.

Noncurrent assets (as a % of total assets) remain stubbornly high at 2.20% (down from a peak of 3.367% in 2009) while loan loss reserves are down for eleven consecutive quarters.  With leverage still high at 9x, the banking system is embedded with ~20% losses, and that ignores loans that are mismarked on the books of nearly all banks across the United States.  On April 9, 2009, at the nadir of the financial crisis, FASB (2) issued an official update to FAS 157, the rules governing mark-to-market accounting, suspending the accounting of reality when market conditions are deemed “unsteady or inactive”.  Since then, it has become impossible to rely on the valuations of loans and other assets as reflected in a bank’s audited financial statements.

3.  The rich get richer while the poor get consolidated.

The bifurcation of the banking system is enabling one of the great profit opportunities of our time.  While under-capitalized banks are frozen, “zombies” in the parlance of our time, well-capitalized banks benefit from the government’s hand replacing Adam Smith’s.  Industry consolidation is governed and the rules are strict.  The banking business, like all financial services, is a human capital business, and therefore what matters most is management.  Investing in banks is about investing in people.  Therefore the quality of the management team is the predominant factor in the analysis of any financial institution.

To measure a management’s ability to operate a bank wisely and for the long term, we focus on non-interest expense relative to the size of the bank in terms of assets and revenues where revenues consist of net interest income (NIM) and non-interest income (fees).  Specifically, we   employ a metric called Efficiency Ratio (3).  Ironically, a 100% efficiency ratio means a bank is not being efficient.  The lower the ratio the better, with most banks striving for a sub-60% ratio.  Following is a list of the most efficiently managed banks in the U.S. in 2012.

In of itself, efficiency ratio means little if it doesn’t translate into a high level of profitability.  Not unexpectedly, many of the banks reporting the lowest efficiency ratios are the ones reporting the highest profitability as measured by return on tangible equity (ROTCE).  Following is a list of the most profitable banks in the U.S. in 2012.

By cross-checking efficiency ratios with ROTCE, we identify the most profitable banks where the high level of profitability is (in part) due to efficient cost management. 

All of the banks in this list trade at richly deserved valuations north of 2x tangible book value (TBV), that is, all except for Customers Bank (CUBI) led by former Sovereign Bank CEO Jay Sidhu, and the two banks operating in Washington DC.   Before explaining the situation at Customers Bank, which is our top idea, we briefly describe the attractive opportunities for investing in banks in the Washington DC market.

Like most markets in the U.S., the Washington DC market is dominated by large money center banks such as Capital One (COF), Wells Fargo (WFC), Bank of America (BAC), and Citigroup (C), along with super-regionals including SunTrust (STI), BB&T (BBT), and PNC Financial (PNC).  In terms of pure plays (relatively), we identify 4 that are investable:

1.  United Bank (UBSI) of West Virginia recently entered the DC market via the acquisition of Virginia Commerce Bank (VCBI) for a fair price of 1.8x TBV.  With $4.5 billion of in-market deposits, United Bank is now the leading independent bank in Washington DC in terms of deposit share; however, the stock is already fully valued at 2.2x TBV.

2.  Sandy Spring Bank (SASR) of Olney, MD is a $4.0 billion asset bank that under-earns its peers because of a higher level of non-interest expense and as a result a higher efficiency ratio (>60%).  Nevertheless, Sandy Spring still earned a solid 1.0% ROA and 9.7% ROTCE in 2012, and at only 1.2x is an attractive target for any bank looking to build scale or buy its way into the Washington DC market.

3.  EagleBank (EGBN) is led by the other Ron Paul, this one a community banking legend who co-founded EagleBank in 1998.  Since then, assets have grown to $3.4 billion with a consistent record of profitability through the banking cycle.  Credit quality is outstanding with an allowance for credit losses covering 104% of nonperforming assets (NPAs), and non-interest expenses are well-managed as evidenced by a 51.4% efficiency ratio in 2012.  In terms of valuation, EagleBank is easily worth 2x TBV (of $12.62) equal to $25.24.  On an EPS basis, core EPS is approaching $0.50 on a quarterly basis ($2 of EPS per year), which is again worth at least $25 per share.

4.  Cardinal Bank (CFNL) is also one of the most consistently profitable banks in the U.S.  A huge 1.7% ROA in 2012 (16.7% ROE) is the inflated result of robust mortgage banking fees driven by gain on mortgage sales.  With interest rates zero-bound and pre-payments moderating, mortgage securities trade at premiums to par and can be liquidated at a profit at any time.  ROA peaked at an amazing 2.07% in the third quarter of 2012 and have been moderating since.  As a result Cardinal Bank should report a lower ROA in 2013, however still robust in the 1.20% to 1.40% range (1.44% in Q1 (4)).   Even at this lower level of profitability, CFNL should continue to generate a mid-teens ROE, warranting a 2x multiple of TBV (2x 2014 TBV = $23.62 per share).  On an EPS basis, core EPS is likely to stagnate as a lower level of gain on sale offsets organic revenue growth.  Applying 3-Sigma Value’s proprietary target price methodology, which is based on a series of operating scenarios driven by key factors including asset and deposit yields, loan production, fee income growth, and efficiency ratio, we derive a probability-weighted target price of $20.13.

Both EagleBank and Cardinal Bank have pristine balance sheets – Cardinal, in particular, has $0 other real estate owned (OREO) and $0 loans receivable past due 90 days or more ($3.0 billion of total assets).  With virtually no legacy credit risk, the risk/reward here is extremely attractive.  However, Cardinal Bank is missing a crucial element required in 3-Sigma Value’s investment process – a clear catalyst that will narrow the gap between CFNL’s current market value ($15) and our estimation of its intrinsic value ($20+). 

While a take-out of Cardinal Bank is likely, eventually, and theoretically a stock catalyst, as far as we at 3-Sigma Value are concerned a take-out is an exogenous factor that is uncontrollable and therefore only a factor in Upside Case scenarios. 

In contrast, Customers Bank (CUBI) is on the verge of a major catalyst that will unlock value in its shares.  Currently, CUBI (formerly CUUU) trades sparingly on the Pink Sheets while its registration statement with the SEC is being reviewed in advance of a move to the Nasdaq.  When CUBI lists, volumes will increase dramatically as privately-acquired shares become freely tradeable and the stock becomes eligible for inclusion in a wider range of institutional portfolios. 

Buy: Customers Bank (CUBI)

In the middle of 2012, 3-Sigma Value was introduced to Jay Sidhu, the CEO of Customers Bank and formerly the CEO of Sovereign Bank, which he and his team built over the course of twenty years into a major financial institution with over $89 billion in assets at the time of Jay’s “retiring” in 2006.  Nine out of fourteen senior executives at Customers Bank used to work with Jay at Sovereign. 

The rapid demise of Sovereign after the 2006 change in leadership is a morality tale lost in the tragedies of Lehman, Fannie and Freddie, and the overall collapse of the financial system in 2008.  Under Jay’s leadership, Sovereign was a conservatively run bank that was under-leveraged and under-earning relative to its peers during the credit bubble until activist investor Ralph Whitworth of Relational Investors orchestrated Jay’s removal.

To boost return on equity, the new management team, pressed by Whitworth, lowered credit standards and loaded up on an alphabet soup of structured products (5), and sure enough, on October 13, 2008 what remained of Sovereign was acquired by Spain’s Banco Santander SA for a measly $2.51 per share.  In contrast, two years earlier when Jay was still CEO, Sovereign sold a 19.8% stake to Banco Santander in a strategic transaction for $2.4 billion cash ($27 per share).  Included in the deal was an option for Banco Santander to buy the rest of the bank for $40 per share for one year beginning in the middle of 2008.  Instead, they were able to pay $2.51.

Jay went on record saying about Whitworth, “Every single action taken under his leadership of the risk management committee destroyed value. You need a long-term view with prudent risk-management strategies and not the short-term view of a hedge fund manager." (6)

After watching the disintegration of his work and much of his fortune, in 2009, Jay raised $22 million of equity ($7.5 million from Jay) to acquire New Century Bank, a failed bank in Pennsylvania with $270 million of assets.  Jay and his team restructured the operations of the newly rechristened Customers Bank and worked through its non-performing assets (NPAs) before acquiring three banks in 2010/2011, two with FDIC-assistance (total assets =  $2.1 billion) (7).  Then in the summer of 2012, Customers Bank announced an $80 million Regulation D Private Placement in a Public Company (PIPE) (8) to fund two ingenious acquisitions structured with an arbitrage that upon closing would increase the total assets of the bank to over $3 billion.

The first acquisition is CMS Bank with $247 million of assets and 5 branches in Westchester New York for $20.8 million stock valued @ 125% of book value (closing expected in 2013).  The deal is not only geographically strategic but the terms theoretically establish a valuation floor for CUBI.  Jay created an arbitrage for his investors – we paid $14 per share, equal to 95% of Q2 2012 book value, while CUBI sells stock at 125% of book value. 

The second of the two acquisitions included only the performing assets ($490 million) and one branch of Acacia Federal Savings Bank for $65 million, consisting of $10.3 million cash and common stock valued @ 115% of GAAP book value at the time of closing (expected Q2 2013) (9).  The price paid as a multiple of book value (P/BV) was a very attractive 0.56x, but unfortunately the FDIC deemed it too attractive.  On Customers Bank’s April 22, 2013 conference call, management reported that the FDIC would only consider approving one acquisition at a time, and therefore management had to choose.  Because CMS Bank represents a franchise, while Acacia is simply a book of business with no intrinsic franchise value, management decided on quality over quantity.

Another important distinguishing characteristic of Customers Bank is the size and productivity of its branches.  Average deposits per branch were $174.3 million in December 2012, up from $109 million in December 2011 and $77 million in December 2010.  This compares to ~$50 million for community banks.  Part of the reason Customers Bank is able to accumulate deposits is the bank doesn’t compete on the basis of cost.  While cost of deposits has dropped from 1.76% in December 2010 to 1.19% in December 2011 to 0.79% in the fourth quarter of 2012; that is still well above the cost of deposits at most community banks (<60bps).  Management promotes a "high touch supported with high tech" model for gathering deposits based on concierge banking serviced out of sales offices instead of full service branches, a low-cost strategy that depends on experienced bankers who reach out proactively to customers.  CUBI operates in key mid-Atlantic markets along the I-95 with attractive demographics in PA (Bucks, Berks, Chester, and Delaware counties), NY (Westchester county), NJ (Mercer county), and Washington DC. 

When discussing the Bank’s acquisition strategy, Jay describes "a lot of low hanging fruit."  There are 86 “Problem” banks with $33 billion in assets in CUBI’s target markets along the I-95 between New York and Washington DC.  Ironically, the competition to acquire these banks is limited given the reality of widespread mark-to-market insolvency and the absence of new entrants. 

Finally, the Bank’s lending strategy is highly conservative with a focus on “superior” credit quality in the following lending areas:

1.  Commercial Lending – divided into three groups: (1) Small business (SBA) loans targeting companies with less than $5 million of annual revenue; (2) Mid-market business loans targeting companies with up to $100 million of annual revenue; (3) Multifamily and commercial real estate (CRE) loans with an average loan size of $7 million.   

2.  Consumer Lending – real estate secured lending with conservative underwriting standards (>720 FICO).  No indirect auto, credit card, student or unsecured loans. 

3.  Specialty Lending – warehouse lending which provides financing to mortgage bankers for residential mortgage originations from loan closing until sale in the secondary market. Many providers of liquidity in this segment exited the business in 2007-2008 during the period of excessive market turmoil, creating an opportunity to provide liquidity at attractive spreads.  For Customers Bank, the warehouse lending business diversifies its revenue streams with a lower credit risk and interest rate line of business.  These loans are short-term, usually 16 days, and therefore yield less than commercial bank loans.  However, the Bank is paid a portion of the 1% origination fee, which makes up for the lower NIM.  Management expects the mix of warehouse loans to constitute 25% of assets over time, down from 52% at December 31, 2012. 

As a result of FDIC loss sharing and prudent lending, non-performing assets (NPAs) are 1.2% for the entire loan portfolio(10) and 0% for originated loans since the 2009 acquisition of New Century Bank.  In short, this underwriting team is outstanding.

In addition, the Bank’s allowance for loan and lease losses (ALLL) is equal to 103.4% of non-performing loans (NPLs).  Therefore, even if all of the defaulting loans in the portfolio were written-down to zero, shareholders’ equity would still not be pierced.  As far as the potential for additional losses in the portfolio to manifest in the future, the amount is limited.  Given the preponderance of short-term warehouse loans, FDIC loss-sharing on legacy loans, and very conservative underwriting standards, Customers Bank stands out as one of the few banks in the United States with little-to-no balance sheet risk. 

In summary, Customers Bank has a simple formula for success: (1) superior credit quality, plus (2) revenues = 2x expenses (50% efficiency ratio), equals 1% ROA and double-digit ROE. 

Valuation

Valuation is not in the eyes of the beholder, it is neither art nor love.  It is science.  Every input must be validated; every output must be cross-checked.  Based on (1) the high correlation between return on equity (ROE) and P/TBV, and (2) comparable bank valuations, we employ a range of Price-to-Tangible Book Value multiples (P/TBV) and Price-to-Earnings (P/E) – to estimate the future value of Customers Bank.  Empirically, the higher the return on equity the higher the multiple of book value.  This basic relationship between P/BV and ROE generally holds across all banking (spread) businesses.  Based on data from SNL Financial going back to 1990, the median P/TBV of announced M&A transactions is 1.8x.  In the early 1990s, banks were sold in the range of 1.3x to 1.8x before launching above 2x in 1997 and remaining there for 10 years except during the brief recession that followed the bursting of the internet bubble.  By 2003, M&A multiples were back over 2x, peaking at 2.3x in 2006.

Customers Bank is a significantly undervalued bank.  It earns a 12% ROE compared to 9.5% for its peers yet trades at 1.2x TBV compared to 1.6x.  CUBI should trade at a premium (or at least in line) with its peer group given its superior ROE driven by superior cost management.  CUBI is one of the most profitable banks in the U.S. and has minimal credit risk.   When CUBI lists on the Nasdaq later this quarter (2Q 2013), the increase in liquidity and trading volume will catalyze the process of elevating the stock price to a level consistent with other similar publicly-traded community banks.

Ultimately, an investment in a bank is an investment in people.  While I can’t say that we at 3-Sigma Value have a spotless record investing in bank management teams, we do have an extensive one, during which time we have conducted due diligence on over 100 past, present, and potential bank management teams. 

A fellow investor in Customers Bank warned me not to be “overly-wowed” by Jay’s knowledge of banking – a contradiction given knowledge is what we are seeking.  Jay is not “shareholder friendly,” I am told over and over again – based on a version of the Sovereign tale that history has proven false.

The basic reason Customer Bank is undervalued is the so-called “Jay Sidhu discount” – a discount that we strongly believe is unwarranted and depreciating with each impressive quarter of revenue growth and cost management.  Recently, Customers Bank was ranked #1 by Bank Director magazine in terms of organic revenue growth based on data on all U.S. banks, compiled by Bank Intelligence Solutions, a subsidiary of Fiserve (FISV).  The data is overwhelming.  See for yourself:

http://www.bankdirector.com/index.php/magazine/archives/2nd-quarter-2013/who-says-there-s-no-growth-in-banking/

Final Thoughts

In electrical engineering, there is concept called losing the signal in the noise, which when applied to economics describes the failure of forecasting and misuse of statistical probabilities.  A signal is something that conveys information, while noise is superfluous, meaningless, or random.  Problems arise when the noise is as strong as, or stronger than, the signal.    In today’s interconnected world, the amount of data we have available to measure and make projections is evergreen yet our ability to extract meaning and truth from it is limited by models that are corrupted by false inputs. 

In order to salvage the U.S. banking system, the Federal Reserve perpetuates two policies that distort reality:

1.  Pegs short-term interest rates at zero percent, enabling banks to borrow at ~zero and lend at three, four, five percent, it doesn’t matter the rate on mortgages because when a bank’s cost of capital is zero (or near-zero) all balance sheet activity is accretive.    

2.  Suspends the rules governing mark-to-market accounting, making it impossible to rely on the valuations of loans and other assets as reflected in a bank’s audited financial statements.

Banks collectively continue to earn rising profits as a result of these two controlling policies, posting a healthy ROA (return on assets) of 1.00% in 2012, up from 0.88% in 2011.  2013 should be no different.  Bank charters are licenses to make money.  And a bank without legacy credit risk is one of the best investments we can think of in this era of financial repression.  Within that construct, Customers Bank is statistically the most attractive bank in the United States in terms of the combination of revenue growth, cost management, and valuation.  The noise is strong but so is the signal.  This bank is undervalued. 

For more information, please contact us at info@3sigmavalue.com.

2012 Review / 2013 Outlook

Introduction

Chapter 1:  Portfolio Construction

Chapter 2:  Winners and Losers

Chapter 3:  Penetrating the Macro Through the Micro

Chapter 4:  Nitrogen Economics

Chapter 5:  Buy CF Industries (CF)

Final Thoughts

For the year ended December 31, 2012, 3-Sigma Value, LP (the “Partnership”) had an estimated gain of 32.3% (net of management fee and expenses) with average gross exposure of 138.4% and net exposure of negative 14.1%.

The Partnership’s portfolio, both long and short, focuses its investment efforts in three industries – Technology, Media & Telecom (“TMT”), Natural Resources, and Financials – chosen based on the experience of our investment professionals.  In total, 3-Sigma Value, LP is invested long in 13 companies, and short 30 companies.

Our investment approach is global in scope, yet, at this time, North American equities constitute the vast majority of our gross exposure.  We are market-cap agnostic. 

Last year when I sat down to reflect on 2011 all I could think of was the passing of my father who began working as a stockbroker at Oppenheimer & Co. in 1960.  The other day I had lunch with one of my father’s oldest friends, at PJ Clarke’s on the corner of 55^th street and 3^rd avenue, sitting at the same table he sat at fifty years earlier, having the same conversation about risk versus reward, the sizing of positions and dollar-cost averaging, and the necessity of diversification.  My father loved the challenge of the stock market and its potential.  He studied it every day.  Even when he was in the hospital, in his final days, unconscious, my mother insisted the tv stay on, tuned to CNBC. 

Reflecting on 2012, my predominant thought is of my newborn son, named after my father.  In the mornings I cradle him in my arms before leaving for work, the tv is on, of course to CNBC, and we watch together for news that could impact the investment portfolio.  My son is rapt by the flashing lights on the screen – green and red – and I imagine him soaking up all the data via osmosis.  His eyes are wide open and I can see the numbers and charts and graphs reflecting in his baby blues.  I see it myself, and feel it and experience the challenge and the potential of the stock market every day of my life.  I believe I am the youngest person in the world to be profoundly impacted by the 1987 stock market crash, a.k.a. Black Monday.  Information is cumulative yet whether or not my son is actually retaining anything is beside the point.  Sharing my passion for investing in the stock market with my children allows them to know me better, and allows me to teach them the math and statistics and game theory that forms the foundation of all applied learning.

Portfolio Construction

As of December 31, 2012, the 3-Sigma Value portfolio had gross long exposure of 66.8% and gross short exposure of 84.4%, for net investment exposure of negative 17.5%.  Going forward, we expect net exposure to revolve around zero.  We seek overall market agnosticism in the construction of the portfolio as reflected in a target range of net exposure between negative 25% and positive 25%.

Each position in the 3-Sigma Value portfolio is analyzed individually, and the portfolio is constructed from the bottom up.  We are never bullish or bearish on the overall market; or, if we are on a personal level it never dictates the construction of the portfolio.  Our short positions are not designed to hedge our long positions.  Every position, long and short, must meet 3-Sigma Value’s requirements for total return and risk versus reward, and therefore every position, long and short, represents an exceptional investment opportunity on a standalone basis.  We apply a conservative algorithm to sizing positions, beginning with 25% to 33% of the target allocation – e.g. 1%, 2.5%, 5%, or 10% depending on risk as quantified by 3-Sigma Value’s proprietary scenario-based valuation analysis. 

During a year in which the S&P 500 climbed 13.4%, the 3-Sigma Value portfolio was net short throughout, and in fact became increasingly so – although not linearly.  The monthly volatility in net exposure is not a judgment on the market but a natural result of market movements and the sizing of individual positions.  Net exposure in 2012 ranged from a high of positive 2.8% to a low of negative 26.0%(1).

Profit contribution was relatively balanced in 2012, with longs contributing 59% of trading profit and shorts accounting for 41%.  The breadth of winners, however, was much more limited in 2012 compared to 2011, as can be seen in the smaller list of winners that follows.  While only a few of our best short ideas generated profits in 2012, many more are poised to contribute in 2013 and 2014.  In sum, it doesn’t matter whether the market is up 15% or down 15%, we expect the 3-Sigma Value portfolio to generate profit either way.

Winners and Losers

15 positions in the 3-Sigma Value portfolio accounted for 100 basis points or more of profit in 2012, 4 of which were long and 11 short.  On the opposite side of the ledger, only 2 positions contributed 100 basis points or more of losses in 2012.  3 other positions accounted for between 50 and 100 basis points of losses.  Of the 5 losers, only one was new to the portfolio, that is ReachLocal (RLOC) featured in 3-Sigma Value’s Second Quarter 2012 report titled, Where are the GlenGarry Leads? 

Four long positions contributed significantly to performance in 2012.  They are:

1.  Hamni Financial (HAFC) as featured in 3-Sigma Value’s report titled, 2011 Review / 2012 Outlook;

2.  Checkpoint Technologies (CHKP) as featured in 3-Sigma Value’s report titled, Software Economics – Volume II;

3.  Covanta (CVA) – the low cost producer of energy (via waste) due to negative input costs (tip fees for disposal);

4.  Cozan (CZZ) – the low cost producer of Brazilian sugarcane ethanol due to vertical integration.  

Covanta and Cosan are two of six natural resource companies that 3-Sigma Value is invested long as of December 31, 2012.  What they have in common is what all of our natural resource investments share – they all operate at the low end of their respective cost curves.

Penetrating the Macro through the Micro

The way we begin every study at 3-Sigma Value is by focusing on something very small.  If studying an industry then we begin by studying a company.  When studying a company we begin at the very top of the income statement (revenue) and work our way down line by line.  We begin with pricing and volumes (price x volume = revenue).  Is pricing negotiated or market-driven?  Are volumes contracted, and if so, for how long?  By focusing on the way one company makes money, modeling its financial statements down to the factors that determine value, we gain incredible insight into the industry at large.   The concept is depth over breadth.  It is not an unknown or secret skill set that determines success in investing but a profound mastery of the most basic elements.

The reason 3-Sigma Value is able to consistently generate alpha is because we know what we don’t know and we are experts in what we know.  As Peter Lynch, former Portfolio Manager of Fidelity Magellan Fund recommends in his seminal books One up on Wall Street and Beating the Street, “invest in what you know.”  We are specialists here at 3-Sigma Value, not generalists.  We invest in three industries chosen based on the experience and expertise of our investment professionals: Technology, Media & Telecommunications (TMT), Natural Resources (NR), and Financial Services (FS). 

The first and one of the most important steps in analyzing any industry is defining a universe of investable companies as broadly as possible and then segmenting that universe as finely as possible.  With over 1,000 companies in each of our three industries segmented into dozens of sub-segments (there may be only two public companies in a sub-segment) we are able to identify trends (secular and cyclical) by indentifying change in a small subset of companies.

The Identification of Powerful Secular Trends Driving Valuation

Despite the significant research leading up to this point, we often describe the first step in the 3-Sigma Value investment process as identifying a powerful secular trend that drives valuation.  For the purpose of this analysis, we will focus on the Natural Resources industry, and specifically on what we believe is an incredible opportunity to make money in an era of low cost natural gas prices. 

The underlying supply and demand data is widely available on the Internet so we will keep this part short – advances in drilling technology – horizontal drilling and hydraulic fracturing – have created a glut of available natural gas in North America.  The price of natural gas (Henry Hub, Louisiana) has collapsed from a high of $14 per million Btu in 2005 to $2 in 2012, and finished the year at $3.40, a level that is near the midpoint of our expected natural gas pricing range of $2.00 to $5.00 per MMBtu.

A striking example of low cost drilling is in the Marcellus Shale(2) basin located across multiple Northeastern states including the Southern Tier and Finger Lakes regions of New York, in northern and western Pennsylvania, eastern Ohio, through western Maryland, and throughout most of West Virginia extending across the state line into western Virginia.

(2) Other key shale gas basins include Barnett, Eagle Ford, Fayetteville, Haynesville, and Utica.

According to Reuters(3), more than 1,000 natural gas wells in the Marcellus are waiting to be hooked up to unfinished pipelines.  Meanwhile, more natural gas wells are drilled all the time.  While some companies are profitable at the current low level of natural gas prices, many companies are forced to drill in order to meet lease requirements.  As the Marcellus Shale comes online, the global natural gas cost curve will continue to shift down and to the left.  In 2011, U.S. natural gas production totaled 53 Bcf/day, up from 51 Bcf/day in 2006.  By 2016, the number will reach 80 Bcf/day (20%+ of total from Marcellus).

One of the amazing pricing anomalies in the world today is the discrepancy between natural gas prices in North America and prices elsewhere in the world reaching $13 to $16 per MMBtu.  That is 4x or even 5x the price of natural gas in North America.  This differential is attracting significant foreign investment looking to take advantage of low cost feedstock for petroleum-based products, and the U.S. is in the process of building the infrastructure to become an exporter of energy sourced from natural gas.

One recent example of this phenomenon is Sasol (SSL), the chemical and synthetic fuels giant based in South Africa who announced in December 2012 it would spend $14 billion to build the first gas-to-liquids (GTL) plant in the United States, in Louisiana, supported by more than $2 billion in state incentives.  Only a handful of GTL plants operate commercially in the world, only in Qatar, South Africa, and Malaysia, areas where natural gas is cheap and abundant. 

Another example is Orascom Construction, Egypt’s largest company, who in September 2012 announced it would spend $1.4 billion building a nitrogen plant in Lee County, Iowa in order to access low cost natural gas feedstock.  At least 21 nitrogen plants/expansions in North America are in various stages of planning.   

The glut of natural gas supply in North America appears to be (nearly) matched by a surge in new demand from energy companies and chemicals manufacturers relocating and even utilities that are in the slow process of retiring coal plants and switching electricity capacity from coal to gas.   But these factors, even if they do add up to the 50% increase in natural gas production expected between 2011 and 2016 (from 53 Bcf/day to 80 Bcf/day), will not cause the price of natural gas to spike like it used to in the days before horizontal drilling and hydraulic fracturing, because the marginal cost of production has collapsed.

The Identification of Companies, Both Positive and Negatively Impacted

Who are the winners and who are the losers?  We begin with the losers, grouped into three categories: (1) High cost and leveraged natural gas producers, especially those who acquired natural gas properties at or near the top of the market; (2) Commodity service providers of traditional natural gas drilling; and (3) Coal and other alternatives including the solar and wind supply chains.  

With natural gas priced around $3 to $4, alternatives including coal are not competitive on a simple cost basis:

In particular, Central Appalachian (CAPP) coal is not competitive in the era of low natural gas prices, one major factor leading to the July 2012 bankruptcy of Patriot Coal (PCX), Peabody Coal’s (BTU) CAPP operations spun-off in October 2007.  Moreover, Northern Appalachian (NAPP) and Illinois Basin (ILB) coal are rarely competitive anymore as well.  That leaves the Powder River Basin (PRB) as the only source of coal in North America that is relatively competitive on a cost basis.

The percentage of US electricity sourced from natural gas broke the 50% mark for the first time in 2012.  However, the trajectory will slow dramatically in 2013 as coal-to-gas switching basically peaks near-term.   The issue is one of infrastructure.  Incremental natural gas utilization for electricity requires massive infrastructure expansion, especially in the gathering and processing of the commodity into refined products.

Now it’s time to identify the winners in the era of low natural gas prices: (1) Consumers of natural gas, (2) natural gas infrastructure service providers, and (3) low cost natural gas producers – all of these companies benefit in theory while in reality execution issues and lousy management teams can destroy the value of even the best laid plans.

While natural gas infrastructure service providers such as pipelines and gathering and processing systems share extremely attractive fundamentals, the stocks in general are very expensive on a relative and absolute basis(4).  The surging demand for cheap natural gas drives volumes through the supply chain.  Backlogs for pipeline projects are at record levels.  Incremental supply will be coming on line for years to come.  This is the heart and soul of America’s effort to become energy independent.  It doesn’t matter how many wells are drilled if the distribution system is bottlenecked.  3-Sigma Value closely monitors the entire natural gas supply chain – from exploration and production (Upstream) through pipelines and processing (Midstream) to utilities and service stations for sale to the end customer (Downstream) – in our pursuit of profitable investment opportunities.

The best positioned companies in the era of low natural gas prices are producers who use natural gas as a cost input.  Chemical companies come to mind.  In 2010, 3-Sigma Value owned an equity stake in Terra Industries, a North American-based producer of nitrogen-based fertilizers, when it was acquired by CF Industries (CF), creating the largest nitrogen-based fertilizer producer in North America.  Nitrogen (N) is one of the three primary plant nutrients for farming, and the only one requiring annual application.  

The timing of the Terra acquisition was incredible.  The natural gas industry was on the verge of the shale revolution, permanently altering the cost structure and improving the profitability of North American-based nitrogen production.  CF paid 7.6x EBITDA(5), a meaningful data point we use as the terminal value multiple in an Upside Case DCF-based valuation.

The other two major plant nutrients are phosphates (P=Phosphorous) and potash (K=Potassium).  Along with nitrogen, these chemicals are well-positioned to benefit from powerful global secular trends including population growth, increasing protein consumption, and growing use of bio-based fuels – driving 2-3% fertilizer demand growth annually(6).  However, phosphates and potash are somewhat discretionary in terms of application rates as farmers can forgo a year without negatively impacting crop yields.  This is untrue for nitrogen.  Due to its mobility in the soil, farmers cannot skip nitrogen fertilizer applications.  Therefore, demand for nitrogen is more stable and less elastic than demand for phosphates and potash.  Crops require nitrogen primarily for the production of chlorophyll and protein.  Plants that are deficient in nitrogen tend to be undersized and have discolored leaves.

When farmers reduce application of phosphates and potash it is called "mining the soil".  They can get away with reducing application of these two fertilizers (without a dramatic drop in yields) but only if they have been on an aggressive fertilization program in the past. Significantly reducing P and K application for more than one season has a negative economic impact on the productive capacity of land.

Nitrogen Economics

There are four major nitrogen fertilizers – ammonia (82% nitrogen content), urea (46%), UAN (32%), and ammonium nitrate/AN (15%-30%) – with ammonia containing the highest nitrogen content and serving as the base ingredient for the other three.

Ammonia is made by reacting natural gas (the primary feedstock) with nitrogen gas (a common element in the universe).  Ammonia can then be injected directly into soil as a fertilizer or processed further into urea, UAN, or AN.

Urea is made by reacting ammonia with CO2 gas, which is conveniently a by-product of ammonia synthesis.  Urea is more effective in very moist conditions, is water-soluble, and therefore can be applied as a liquid unlike ammonia which requires specialized gas-injection equipment (ammonia is stored as a liquid but applied as a gas).

Ammonia is also reacted with nitric acid to make ammonium nitrate (AN), and then AN and urea are mixed with water to make UAN fertilizer.  The main consideration for using UAN or AN is whether the application is combined with other liquids (e.g. herbicides) in order to save costs.

Ammonia is the best value per unit of nitrogen; therefore farmers will always choose to apply ammonia if field conditions allow them to do so.

In addition to being an applied nutrient and an input to upgraded nitrogen products, ammonia is a necessary input for phosphate nutrient production (DAP, MAP).  A diversified consumer base for ammonia mitigates price weakness, and therefore ammonia generally outperforms the other nitrogen nutrients on the downside.

With corn prices high (and volatile) and natural gas prices low (in a supply-induced price depression), nitrogen producers should sustain high margins. Farm economics are robust, especially for corn.  Fertilizer costs as a percentage of revenue are at lows approaching 10% (10-13% range depending on factors including geography, product mix, and scale), compared to 20% (17%-20% range) historically.  Furthermore, the widespread adoption of crop insurance reduces earnings volatility, enabling farmers to plan and apply fertilizer with confident frequency.

While shale gas discoveries have reenergized the North American fertlizer industry, the same cannot be said overseas where there are huge shale deposits that will remain untapped for years if not decades.  The issues are many, from government ownership of mineral rights, to environmental issues (hydraulic fracturing is banned in France and Bulgaria), to a lack of infrastructure, but ultimately what it boils down to is that much less is known about the geology in most foreign countries compared to the U.S. where drilling has been an industry for over one hundred years and geologic data is generally made public by state regulators.

China is believed to have more shale gas than the US.  The issue is that most of it is in arid areas where energy companies are concerned they won't be able to obtain enough water that is required in the hydraulic fracturing process.  In addition, much of China’s shale gas is located in heavily populated and urban settings.

European producers face an additional challenge in competing effectively against their North American counterparts.  Much of the natural gas in Eastern Europe is purchased under contract at prices pegged to global crude oil.  The historical relationship between the price of natural gas and oil, which has averaged 10-to-1 over the past two decades, is now approximately 30-to-1.  This divergence is even starker when considering one barrel of oil holds the energy equivalent of only 5.825 MMBtu of natural gas.  This is commonly referred to as the 6-to-1 Rule, and it shows how dramatically over-valued oil is relative to natural gas.  Therefore, in addition to the structural supply advantage that North American producers enjoy, there is a structural pricing advantage as well.  Because of all of these issues hampering the expansion of shale drilling overseas, North America will likely remain the leading, low cost source of natural gas for the foreseeable future.

Investing at the Low End of the Global Cost Curve

To illustrate the structural cost advantage of North American nitrogen-based fertilizer production, following is the global cost curve for Ammonia, the core nitrogen product.

While China is the largest global nitrogen producer with ammonia capacity representing ~30% of global production, China implemented a tariff in 2012 to limit exports.  The reasons are myriad, including the high cost of global energy and China's energy dependence.  As a result, year-to-date urea exports were down.

Globally, urea is the most widely applied nitrogen fertilizer because of the ease of its application and storage compared to ammonia and UAN, which are mainly used in North America.  Because urea in particular is a global commodity, the floor price is theoretically set by the marginal cost of production, estimated at around $350 per ton.

Several times in recent years urea prices have pierced their marginal cost (i.e. $350 per ton for urea) and the marginal producers (in Eastern European) have shut in production.  Meanwhile, at $350 urea, the gross margin for CF is approximately 60%.

The lack of a U.S. natural gas export market contributes to low natural gas prices.   Rectifying this over the long-term is the construction of LNG export terminals such as the Sabine Pass Export Terminal with completion expected in 2015.  Until then and for a long time thereafter the natural gas export bottleneck will persist.  NIMBY politics combined with runaway cost inflation renders LNG a difficult sell.  It will not be until 2016 at the earliest that exports will have any meaningful impact on demand for North American natural gas.  Meanwhile, demand from Asia for North American LNG export may never materialize because of disadvantaged logistics and long-term contracts that Asian countries (China) have with its neighboring producers such as Australia and Russia.  For a detailed analysis of the demand side of the nitrogen equation, please see Appendix 1 at the end of this report.

Supply Risk

North America has become the most economically attractive location to build new nitrogen capacity because of low cost natural gas feedstock, however, that is not the only reason.  The area is relatively low-risk politically, and near the Midwest Corn Belt, a key source of fertilizer demand where approximately 50% of the world’s corn is grown.

The following incremental supply analysis shows 21 Nitrogen plants that are either greenfield (new construction) or brownfield (expansions / debottlenecking of existing plants).  The total amount of new production that is funded is 6.0 million tons.  If we include all plants that have been announced then the amount jumps to 19.7 million tons.

Because some, if not most, of the proposed new capacity will never get built, in particular the capacity planned by foreign companies that are not currently operating plants in North America, the actual amount of new supply is likely to be somewhere around 11.8 million tons, an amount that is roughly equal to the amount of nitrogen imported to the United States in 2011. 

The United States imports 50% of its nitrogen.  Its largest trade partners are Canada and Trinidad & Tobago.  The domestic expansion of low cost nitrogen production will replace high priced imported nitrogen – it will not create a supply glut.  The total amount of supply will grow, and the market for nitrogen-based fertilizers will remain relatively balanced for the foreseeable future, excluding the impact of supply shocks such as weather and geopolitical events.

Buy CF Industries (CF)

CF is the leading producer of nitrogen fertilizers in North America, with a solid balance sheet (zero net debt).

CF’s valuation is cheap (4x EBITDA, 8x EPS) because the consensus of Wall Street expects profit to peak in 2012 – a scenario we find unlikely.

On CF's third quarter 2012 earnings conference call, management detailed its capacity expansion strategy to take advantage of the new era of low North American natural gas prices.  In addition to acquiring the 1/3 of the Medicine Hat(7) complex that it doesn’t own, CF announced a $3.8 billion expansion at two of its wholly-owned facilities – $2.1 billion at Donaldsonville(8) and $1.7 billion at Port Neal(9).  ThyssenKrupp Uhde is contracted for procurement and engineering services.  Timing is 2015/2016.  We assume 50% of new production comes online in 2015 and 50% in 2016.

In addition to the core business of nitrogen fertilizer production, CF owns related assets including several storage facilities, a 50% (non-operating) interest in KEYTRADE AG(10), and integrated phosphate operations located in Florida – includes a rock mine and rock reserves, plus a fertilizer complex and deepwater terminal facility.  Because of environmental complaints that arose during the permitting process in Florida, we do not expect CF to increase phosphate capacity.

CF's pricing strategy is to operate its facilities near capacity levels.  Therefore, CF is a price-taker.  CF reduces some earnings volatility by hedging a portion of its natural gas costs with forward contracts, and by locking in fertilizer sales via the Company's Forward Pricing Program (FPP).  Also, CF’s large storage capacity enables it to build inventory during periods of weak demand, and upgraded facilities enable it to rapidly change its production profile.

In 2011, natural gas accounted for 45% of CF’s total cost of sales for nitrogen fertilizers and a higher percentage, 75%, of cash production costs (total production costs less depreciation and amortization).  Clearly, natural gas is the single most important cost variable in determining CF’s profitability.  Moreover, the math is relatively straightforward:  CF purchased in 2012 (and will continue to purchase) approximately 255 million MMBtus of natural gas annually.  A $1 move in the price of natural gas (e.g. from $3.30/MMBtu average price in the fourth quarter of 2012 to $4.30/MMBtu) increases COGS by $255 million.

The Application of 3-Sigma Value’s Proprietary Scenario-based Valuation Framework

CF has no publicly-traded comparable company.  Agrium (AGU) is a peer in the production of nitrogen and phosphates, but it also derives a substantial portion of its revenue and profits from a retail segment.  In fact, Agrium is the largest agricultural retailer in North America, thus the drivers of AGU earnings are more diverse than for CF.

Yara International (YAR.OL) is also a significant nitrogen producer, but since its facilities are mainly in Europe (78% of capacity) it doesn't benefit from low natural gas feedstock prices, and therefore is structurally less profitable than CF.

CVR Partners LP (UAN) and Rentech Nitrogen Partners LP (RNF) went public in April and November 2011 respectively.  Because both of these companies are MLPs, majority-owned by their general partners, the economic interests of stakeholders are more complex and conflicting than common shareholder ownership.  MLPs are popular because of single-taxation and high dividend yields based on high payout ratios that are mandated; however, in terms of total returns for shareholders they underperform significantly.  Therefore, neither of the Nitrogen LPs are comparable to CF.

With no direct comparable company, we look to CF’s 2010 acquisition of Terra Industries as the basis for the 7.6x terminal value multiple used in the DCF embedded in our Upside Case Valuation Scenarios.  Base Case scenarios reflect multiples in and around the current 4-6x range.

Because natural gas has a volatile history and accounts for ~75% of the average cash costs of nitrogen production, investors typically value nitrogen operations at a discount to potash and phosphate operations.  However, in this era of low natural gas prices, nitrogen price volatility is dampened as a natural result, and margins are relatively stabilized, more so in fact than either for potash or phosphates which continue to face cost inflation and new supply.  As a result, we believe nitrogen's valuation discount will shrink.

3-Sigma Value identifies eight key drivers of value, including terminal value multiple (based on EBITDA).  These are the fundamental assumptions underlying our valuation of CF.

One final consideration before presenting CF’s Base Case financial analysis – the board authorized a $3.0 billion share repurchase program through 2016, representing 22% of the current $13.5 billion market capitalization.  This share buyback is in addition to the $3.8 billion capacity expansion project.

In the Base Case, we assume no change in natural gas prices from the $3.50 average price per million Btus realized in the fourth quarter of 2012.  Coincidentally, $3.50 is the middle of our $2.00 to $5.00 expected price range. 

Once CF’s new capacity comes online in 2015/2016, EPS will increase from a current range of $26 - $30 per share to nearly $40.  At the current share price around $200, that is 5x EPS – for a structurally-advantaged, low cost producer of necessary fertilizers.  3-Sigma Value’s probability-weighted target price is $420. 

Final Thoughts

According to Tony Will, CF Industries' SVP of Manufacturing and Distribution, "We have a view of a supply response from shale gas production that basically says it's reasonable to put new production on line at about $4.50 to $4.75 per MMBtu.  And so that creates kind of a natural window in terms of where the gas market will trade in North American between about $3 and $5."  (November 28, 2012 at Citi's Basic Materials Symposium)

The math of supply and demand is clean and straightforward.  It can be measured and confirmed.  Investing in natural resources is about data.  Forecasting is not a guessing game.  It is not magical and it doesn’t require a supercomputer.  There is no secret sauce.  When supply or demand significantly exceeds the other, the underlying price is bound to move.  The only uncertainty is timing. 

By focusing our research effort on gathering and processing data, on finding anomalies and micro trends in capital expenditures, capacity utilization, and supply chain infrastructure, we are able to formulate a view on the overall viability of the industries in which we invest.  This is the essence of 3-Sigma Value’s approach to research, what we call penetrating the macro through the micro. 

Mad Money host Jim Cramer likes to say, “There is always a bull market somewhere,” a sentiment we base our livelihood on.  The only difference is we would change it to, “There is always a bull market and a bear market somewhere”.  This is critical because whether or not the soothsayers are right and its smooth sailing in 2013 the prudent way to invest is with a hedged strategy.  To be long only is to tempt financial ruin.

Thank you for your confidence.

Benjamin Weinger                                                  Portfolio Manager                                                             3-Sigma Value

Appendix 1: The Demand Side of the Equation

In the wake of the worst drought in 110 years, farm yields in the U.S. have imploded (down 17% to 122.3 bushels per acre(11) and falling) and stocks-to-use are approaching an all-time low(12) (5.5%).

With no improvement in farm yields (bushels per acre), stocks-to-use will continue to shrink, leading to upside price risk for corn, and therefore for fertilizer.  The drought of 2012 will impact 2013-2014 because subsoil moisture will not be adequately replenished in time for the growing season.  The most likely scenario is a small increase in yields and flattish stocks-to-use.

In short, the demand outlook for fertilizer is positive.  96.9 acres planted will be the highest planted acreage since 1937, and that number is likely to be matched in 2013 as the maximum amount of plant is needed to rebuild stockpiles and improve stocks-to-use to a more normal and stable level.  Grain inventories are low around the world, resulting in continued supply tightness, especially in the global ammonia markets.  And finally, robust crop insurance programs means the drought ironically had a positive impact of many farmers' cash flow.

The most substantial risk to corn prices is a repeal of the Renewable Fuel Standard (RFS), which was created in the Energy Policy Act of 2005.  RFS mandates minimum requirements for biofuel utilization in gasoline regardless of market prices, thereby guaranteeing a market for biofuels.  In 2007, RFS was expanded under the Energy Independence and Security Act (EISA) to 15.0 billion gallons of conventional (corn) ethanol by 2015 (requiring 5.4 billion bushels of corn).

With the US very close to meeting its mandate for ethanol blending – 13.8 billion mandate for 2013 (14.4 in 2014 / 15.0 in 2015 and thereafter) versus 13-14 billion gallon gasoline demand – incremental demand for corn will require new drivers, most likely from China where corn demand growth is around 5% per year, a much faster rate than the rate of expansion of arable acreage and 2% average yield improvement.

For more information, please contact us at info@3sigmavalue.com.

Searching for Autonomy

When we heard that Hewlett-Packard (HPQ) was writing down the value of its $11 billion acquisition of the software company Autonomy Corp Plc. by $8.8 billion (or 80%) I immediately thought back to the first time I heard the short thesis on Autonomy.  It was March 2010 and I was interviewing a technology analyst for a position at 3-Sigma Value.  His short idea, which he was very passionate about, was Autonomy. 

He raised a number of red flags that suggested aggressive and maybe even improper accounting.  Specifically, he pointed out the following:

1.  A large gap between earnings and free cash flow;

2.  No organic growth in deferred revenue despite strong reported “organic” revenue growth of 20% per annum over the same period;

3.  An unexplained sequential decline in PP&E despite an increasing amount of capital expenditures;

4.  Volatile working capital trends, especially around the time of acquisitions; 

5.  Changes in reporting that eliminated detailed segment data.

Ultimately, we passed on shorting Autonomy because of the acute risk of a take-out.  The CEO, Mike Lynch, was rich and famous and itching to sell.  The balance sheet was solid with no net debt, and after more than 100 acquisitions(1) there had to be some valuable IP in there.  In sum, the risk versus reward was not attractive.    

When H-P announced in August 2011 it was paying 10x revenue for Autonomy we were stunned.  When the 80% write-down was announced a year later we were not.  Autonomy was a roll-up of software companies with a complex structure that made it difficult to measure “organic” revenue growth.  In terms of valuation, the discrimination of organic and acquired growth makes all the difference.  Because if there is no organic growth than there is no sustainable growth.  A consolidator of mature software companies does not warrant a high multiple of free cash flow.  It is akin to a run-off business, not a dot com.  In other words, Autonomy was never worth more than 2x revenue (vs. 10x) – a relativity that matches the 80% write-down.

Autonomy’s management team used and abused the complex accounting for acquisitions to obfuscate weak performance in its core “organic” business of licensing software that manages unstructured data(2) in an enterprise.  The Bayesian-based technique that Autonomy employs for searching data is ubiquitous in large enterprises, and commoditized, leading to Autonomy’s constant need to buy companies to further growth.  

Autonomy pretended to be a growth company despite being mature.  Autonomy pretended to earn 40% operating margins despite making those numbers only by adding back amortization of acquired intangibles, restructuring costs, and stock compensation.  Ultimately what fooled Meg Whitman and the rest of H-Ps board of directors was the Company’s flagrant use of pro forma financials that are non-GAAP and non-reality.  While the fine print of an SEC filing may detail the differences between GAAP and non-GAAP numbers, Autonomy’s management team never acknowledged the difference in a quarterly conference call.  They waxed poetic on non-GAAP profits when there were GAAP losses.

Around the time of H-P’s 2011 acquisition of Autonomy, Apple introduced Siri, a voice recognition application to answer questions, make recommendations, and perform actions by delegating requests to a set of Web services.  Investors drove up the price of the company that licenses the underlying technology, a company called Nuance Communications (NUAN), from $16 in August 2011 to $30 by January 2012.   During this time 3-Sigma Value learned that Apple pays Nuance a fee that is immaterial relative to the size of Nuance’s revenue base(3).

$36 to $50 million of (temporary) revenue, just because that revenue is from Apple, caused the market capitalization of Nuance to increase by $4.5 billion.  That is $100 of valuation for every $1 of incremental revenue, an absurd reaction to headline news.

Nuance is a roll-up, just like Autonomy, which in of itself is fine but which nonetheless raises a red flag.  The balance sheet is weak with $870.4 million of net debt and a negative $1,037.3 net worth.  Acquisitions boost short-term revenue growth but generate negative return on invested capital (ROIC), contributing to negative book value.  Furthermore, there is a large and growing discrepancy between GAAP and non-GAAP results, just like at Autonomy.  The more we researched Nuance the more irregularities we found.  And then the event happened, an event that shed enough light on the corrupt mindset of this management team to warrant a short position.  It was the tipping point. 

On October 19, 2011, Nuance priced $600 million (+$90 million over-allotment) of 2.75% senior convertible debentures due 2031 (first put date is 11/1/17) with a conversion price of $32.30.  Net proceeds of $587.7 million (ex. over-allotment) were used to repurchase $200 million of shares, to make acquisitions, and for general corporate purposes.

Why did they sell this debt?

1.  Nuance doesn’t generate organic revenue growth, and needs to buy companies with deferred revenue (just like Autonomy) to satisfy expectations of a market valuing a $1.5 billion revenue company at $8.5 billion;

2.  Nuance uses the proceeds to support its stock price by buying back stock – a short term benefit only to traders and other shareholders who know to sell before the house collapses.

Sell Nuance Communications (NUAN)

Incorporated in 1992 as Visioneer, the Company changed its name to ScanSoft in 1999, before settling on Nuance Communications in 2005.  Nuance sells products grouped into four segments:

1.  Healthcare (~40% of 2012 revenue) – automates manual processes such as the dictation and transcription of patient records; sold under a traditional software perpetual model and/or an on-demand model charged as a subscription and priced by volume of usage (e.g. number of lines transcribed).

2.  Mobile and Consumer (~30% of 2012 revenue) – Dragon suite of applications embedded in auto and device OEMs generally sold under a royalty model priced per device sold, and sometimes under a license model.   Desktop and portable computer dictation solutions are generally sold under a traditional perpetual software license model.

3.  Enterprise (~20% of 2012 revenue) – customer service – automating call centers, directory assistance – charged as a subscription and priced by volume of usage (e.g. number of minutes callers use the system or number of calls completed in the system).

4.  Imaging (~10% of 2012 revenue) – PDF applications designed specifically for business users licensed to OEMs such as Brother, Canon, Dell, HP, Xerox on a royalty model, priced per unit sold.  Compete against Adobe, ABBYY, I.R.I.S. and NewSoft.

Three of Nuance’s four segments are loosely related – software that transcribes patient records (the healthcare segment) is akin to software that transcribes customer service requests (the enterprise segment) is akin to software that transcribes requests for autos or phones or other electronic devices.  The imaging segment on the other hand represents an effort to diversify away from the business of speech.  A series of small acquisitions has increased imaging revenue from $80 million in 2008 to over $200 million in 2012.  However, with a dominant competitor in Adobe virtually giving a comparable product away for free, Nuance’s imaging business is niche at best.

As described in 3-Sigma Value’s 2012 report titled Software Economics – Volume II, we evaluate software companies in terms of the quality of the underlying technology and the sustainability of cash flow, if any.  What is striking about Nuance is the fact that there is no unifying code, no unifying core speech recognition or even text-to-speech software code.  Nuance is cobbled-together and complicated.

Just like at Autonomy, the Nuance team mixes together non-GAAP and GAAP accounting, acknowledges the complexity, and ultimately communicates to investors in terms of non-GAAP numbers.  It’s a sly move.  They make the financial reporting so complex that they have to simplify it.  When simplifying, they eliminate certain expenses (i.e. acquisition-related).  The result is pro forma numbers that – as described in 3-Sigma Value’s report titled The Artifice of Contribution Margin – are misleading and apt to create another Autonomous debacle.

It doesn’t matter whether a technology company builds or buys its intellectual property as long as both forms of expenditure are accounted for properly and consistently when comparing earnings quality and growth.  By ignoring acquisition-related costs when acquiring deferred revenue, management’s effort to focus investors on non-GAAP numbers obfuscates Nuance’s true relative earnings power.

Non-GAAP costs exclude stock compensation, acquisition-related costs, amortization of acquired intangible assets, costs associated with IP collaboration agreements, and other non-cash and cash expenses.  These are recurring costs for an acquisitive firm like Nuance.

Exactly like at Autonomy, revenue recognition has become more complex due to the increasing sale of bundled technology, combining licenses, services, on-demand, and yes hardware.  While management acknowledges gross margin pressure due to a higher proportion of services and hardware, they deny it is a trend.

When recognizing revenue from the sale of bundled products, margins become fungible.  Low margin services revenue (or hardware) is packaged with high margin license or subscription revenue and a decision has to be made.   Accounting is supposed to be rules-based, consistent, but, with so many moving parts, so many acquisition-related accounts with so many reserves and so much restructuring it becomes standard to over-earn today and write-off tomorrow.

The notion of “organic” growth at Nuance is specious, misleading, and ultimately culpable.  Exactly like at Autonomy, Nuance management concocts an organic revenue number that is bunk.  Acquisitions by Nuance share a common tendency to underperform expectations.  The reason is because Nuance often bundles its acquired technology with its core technology and calls the whole thing organic.  While top line revenue looks solid, deferred revenue stalls, gross margin contracts, acquisition-related expenses persist, and the net worth of Nuance continues its decent into deeper negative territory. 

Nuance is a mature technology vendor making serial acquisitions to fuel its revenue growth and maintain its elevated valuation.  The automated call center business is not a high growth business.  The medical transcription business is not a high growth business.  The mobile business is mortally-competitive and revenue from Siri temporary.  The imaging business is small and mismatched.

The result is a low-margin model with limited operating leverage.  5-10% GAAP operating margin (OM) is under constant pressure from restructurings, charge-offs, and other acquisition-related costs.  With nearly $3 billion of questionable goodwill on the balance sheet, Nuance will be writing this stuff off, eradicating earnings, for years to come.

Nuance is a serial restructurer.  Acquiring and restructuring companies is Nuance’s core business.  Therefore, to eliminate acquisition-related expenses from earnings is to eliminate research and development (R&D).  Acquisition-related expenses amount to approximately $160 million in 2012, or ~10% of revenue.  Similarly, Nuance spends ~10% per year on stock-based compensation.  These two recurring expense should not be eliminated when calculating Nuance’s earnings.  These are not one-time items.  To calculate earnings without including these items leads to over-valuation which leads to Autonomy.

Nuance is overvalued by any measure.  The core of 3-Sigma Value’s valuation is a scenario-based, probability-weighted discounted cash flow (DCF) analysis.  This is sanity-checked by a P/E analysis.  The average of the two methodologies renders a target price of $7.50.

In July 2012, M*Modal (MODL), a company that develops voice recognition software for doctors was acquired by JP Morgan's One Equity Partners private equity arm for $820 million plus the assumption of $300 million of debt.  Revenues at MODL have been flat for the past three quarters at ~$116 million, which translates into a $664 million revenue run-rate, equal to 1.6x revenues.  Operating Income is depressed, ranging between $2 million and $12 million in recent quarters.  With $12 million of quarterly D&A, run-rate EBITDA is somewhere between $56 million and $96 million.  At the high end, the multiple paid equals 11.66x.  We use this multiple as the terminal value multiple in an Upside Case operating scenario in which Nuance is acquired at the end of 2014.

In the aftermath of the M*Modal acquisition, on July 30, 2012, celebrated New York Times reporter Andrew Ross Sorkin wrote a column titled Suggestions for an Apple Shopping List.  Guess his first pick? 

Sorkin writes, “A year before Mr. Jobs died, he strongly hinted that Apple would consider a big deal. “We strongly believe that one or more very strategic opportunities may come along, that we are in a unique position to take advantage of because of our strong cash position,” Mr. Jobs said in a call with analysts in 2010.  Having all that money can be daunting, so to help Mr. Cook, here is a potential shopping list — some must-buys and some pie-in-the-sky targets — that he may want to consider:

NUANCE This is the one no-brainer on the list. Nuance, based in Burlington, Mass., provides much of the speech recognition technology behind Apple’s Siri and dictation functions. Right now, Apple has merely licensed it and integrated it into both its mobile devices like iPhones and iPads as well as its new Macintosh operating system. Most users think it is Apple technology, but those services wouldn’t work without Nuance.

It should go without saying, but the importance of speech recognition is only going to increase in the future. Nuance has more patents for it and has developed the technology further than just about any firm in the world. At some point, Nuance will be able to hold Apple for ransom. Google and Microsoft are steadily building their own speech recognition technologies and they are catching up quickly. Nuance’s market value is $6.3 billion. Even if Apple paid twice as much, it would be a worthwhile investment.”

Because of conventional wisdom broadcasted by reporters(4) there is a real possibility Nuance will be acquired.  This time however, unlike when Frank Quattrone justified the price of Autonomy to H-P, the Board of Directors of any potential acquirer will have no defense for the acceptance of pro forma financial statements as reflections of reality. 

As far as the potential for Apple to acquire Nuance, we find the prospect highly unlikely.  In fact, it is only a matter of time until Apple replaces Nuance with its own in-house automatic speech recognition (ASR) technology.  Patents are filed.  The Siri halo effect is evaporating and what Nuance shareholders are left with is a pile of old software that is more a deferred revenue run-off story than a growth story.

For more information, please contact us at info@3sigmavalue.com.   

Where are the GlenGarry Leads?

As described in 3-Sigma Value’s separate report titled Software Economics – Volume II, we measure the value of technology and discriminate between (1) innovative technology companies with intellectual property (IP) and sustainable business models, and (2) companies that market themselves as innovative technology companies but in truth sell someone else’s technology.  The issue is not whether a company is a reseller or wholesaler or retailer or developer, the issue is that the company is what it presents itself as.  We see this all the time when companies are pumped up with hyperbole in the marketing of IPOs.

An entire segment of internet services fails every test in terms of intellectual property, margin sustainability, and cash flow generation.  The inevitable consequence of burning cash is the issue of the day, and the issue of all-time, the same issue that drives much of 3-Sigma Value’s focus on the short side of the equation in a market agnostic strategy.  It seems obvious at this point but bears repeating: as companies continue to burn cash they will continue to lose value.

Online marketing services is a broad segment of business on the Internet with valuations so robust that dozens of unproven companies have gone public in recent years, all with a singular goal:

These are the new leads. These are the GlenGarry leads. And to you they're gold, and you don't get them. Why? Because to give them to you would be throwing them away. They're for closers.

-Blake

The classic strategy for generating leads is the cold call.  Thankfully, our children won’t have to know what that means.  In the age of technology, access to potential customers has fragmented into a panoply of channels including email, websites/digital storefronts, deals/coupons, mobile, and social networks, with value added analytics and pre-packaged solutions further differentiating the vendors.

The list of companies on the following pages represents Segment 1 of 3-Sigma Value’s online marketing service provider universe (1).  Excluded from this analysis are digital advertising platforms (2), marketing automation software providers (3), market research and consulting firms (4), advertising agencies and various other integrated service providers.  All of the companies included in this analysis share a common business model – leads.  Whether it is via email, websites, social networks, or mobile applications, all of these companies make money the same way, by selling services that generate leads for their customers.

The principle conclusion drawn from our research into online marketing service providers is these are not technology companies.  Not one of these 20 companies has a credible path to sustainable profitability.  Over the long term, the only hope for any of these companies is a take-out by a larger company with greater financial wherewithal.  Therefore, the principal risk in shorting any of these companies is the risk of a take-out.

Feet-on-the-Street & the Absence of Operating Leverage

Because online marketing is a services-based model as opposed to a software-based model, the same opportunity for operating leverage does not exist.   For most of these companies, revenue growth is tightly correlated to sales & marketing (S&M) expense growth.  R&D is negligible in comparison.  Whereas a typical software vendor should generate 80-90+% gross margin (GM) and 30-40+% operating margin (OM), a services-based provider will struggle to reach 20% OM. 

With negligible EPS and negligible free cash flow (FCF), the valuations in this sector not only presuppose M&A, they also suggest these companies own valuable intellectual property (IP), something that is obviously not the case given low cumulative R&D, low margins, and zero EPS.

For this analysis, we focus our attention on one particular Internet company, chosen because it is a microcosm of the whole sector.  It is not unique.  It should not even be public.  There is no technology.  No intellectual property.  And without irony, this Internet company’s strategy is something they call Feet-on-the Street.

ReachLocal (RLOC) is a search engine advertising (SEA)(4) company that went public in May 2010 at $13 per share with a singular goal of delivering leads to its 20,400 active advertisers (30,100 active campaigns; 1.5 campaigns per advertiser).  90% of revenue derives from ReachSearch, a search engine advertising platform that generates a list of keywords and decides what search engines / local directories to pay for.

Because all they do is generate a list of keywords, barriers to entry are low and churn is high.  SEA/SEO/SEM is integrated and automated and widely available in free/freemium offerings.   This is not high technology.  Gross margin is below 50%.  R&D as a % of sales is a piddly ~4% while S&M is closer to 40%.  In other words, ReachLocal spends 10-times as much on sales and marketing as it does on research and development.

The S&M effort, which the Company calls Feet-on-the-Street, employs so-called Internet Marketing Consultants (IMC) with no previous experience required, and classifies them as "upperclassmen” or “underclassmen" depending on tenure.  The key to success, according to management, is “graduating” IMCs from underclassmen to upperclassmen because only after a period of training (defined as one year) are salespeople accretive.  In other words, upperclassmen are revenue while underclassmen are cost.  Management expects the number of underclassmen to remain flattish while the number of upperclassmen to accumulate, driving sales growth.

Because revenue growth depends on growth in the number of Upperclassmen, S&M expense rises at a similar rate to revenue.  With no S&M leverage and therefore no path to profitability (and no IP), ReachLocal must figure out some other way to make money before they run out of cash.  It’s dot com déjà vu all over again.

On ReachLocal’s first quarter 2012 earnings conference call, management introduced the latest strategy to combat the absence of operating leverage – telesales.  A business practice seemingly at odds with ReachLocal’s high-touch Feet-on-the-Street Internet Marketing Consultant (IMC) strategy, it shows just how non-tech this company is.

One final and massive risk is ReachLocal’s dependence on Google's ever-changing algorithms (and Bing to a lesser extent).  While management touts its global reseller deal with Google (covering eight countries), the Company is nothing more than a commoditized middleman that will eventually get squeezed out of the supply chain.

What is $8-$12 million of EBITDA worth?  5x = $40-60 million, plus $90 million of cash equals $130-$150 million, or $3.57 to $4.12 per share.  3-Sigma Value’s scenario-based discounted cash flow (DCF) methodology generates a probability-weighted target price of $3.26.

Final Thoughts

While we focused this analysis on ReachLocal’s services-based approach to generating leads via search engine advertising, most of the companies in 3-Sigma Value’s online marketing services segment analysis share the same fundamentally flawed characteristics:

1.  Unsustainably high level of sales and marketing (S&M) as a percentage of revenue – ReachLocal in fact is near the low end of the range at 40%.  Angie’s List (ANGI) and Yelp (YELP), for example, are user-generated ratings and review websites that spend 80%+ and 60%+ on S&M respectively (5).

2.  No technology advantage or intellectual property (IP) – at least ReachLocal spends about 4% of its revenue on research and development (R&D).  Groupon (GRPN) spends so little on R&D that it doesn’t even bother reporting it as an expense on its income statement (6).

3.  Misleading investor and corporate communications – the fact that ReachLocal derives 90% of its revenue from generating a list of keywords for its customers is obfuscated by a communications program featuring cross-channel claims of web marketing and brand building, display advertising and ad tracking, live chat, banner ad design, and video production that all add up to little more than nothing.  The same can be said of the email marketers – Constant Contact (CTCT), Exact Target (ET), and Responsys (MKTG) – who all of a sudden sell integrated cross-channel marketing platforms that include websites, social, and mobile in addition to their core email marketing services.  Prior to November 2011, 100% of Exact Target’s revenue came from sending emails on behalf of large Internet customers including Angie’s List (ANGI) and Groupon (GRPN) (7).  

In conclusion, the three flaws identified above – high expenses, low investment, and misleading communication – make a recipe for failure.  Within the vast universe of technology companies, Internet marketing services is a rapidly commoditized, intensely competitive sector that meets much of 3-Sigma Value’s criteria for potential inclusion on the short side of a hedged portfolio.   The sector is reminiscent of IPOs during the Internet Bubble (dot com 1.0), with business models changing so rapidly that the inevitable consequence is excessive vicissitude. 

For more information, please contact us at info@3sigmavalue.com.

The Artifice of Contribution Margin(1)

In this era of  hyperbole, echoes of the internet bubble reverberate in the accounting of technology companies.  We at 3-Sigma Value remain as skeptical of the merits of pro forma accounting as we were back in the twentieth century.  In fact, financial reporting has become even more obtuse since then.

The qualifier pro forma is a scourge on financial analysis, enabling a management team to manipulate financial reporting to serve its needs.  In Latin it means “as a matter of form” or “for the sake of form” and is applied to practices or documents that are done as a pure formality.
 

In accounting, pro forma is traditionally employed in advance of a planned M&A or other capital structure transaction to project the financials of the new company.  When I was an investment banking analyst at Bear Stearns in the mid-nineties we were told that pro forma means as if.  I was asked to produce pro forma financial statements for senior investment bankers covering client companies such as Cablevision (CVC) and Time Warner (TWX) as if potential mergers or acquisitions or recapitalizations were transacted.  This seemed perfectly normal until I began to notice in the years after I left Bear Stearns that many of the Internet IPOs were pitched to investors using pro forma to turn losses into profits – as if certain types of expenses were excluded.  Rather than use the words pro forma, some management teams chose a different, more benign qualifier to exclude expenses such as adjusted, as in adjusted EBITDA or adjusted net income.

One financial metric that is especially misleading is contribution margin.  Contribution margin is pro forma because it measures profitability as if certain costs were excluded. 

Traditionally, contribution margin is equal to revenue less fixed costs and is used in management accounting (not financial accounting) in cost-volume-profit analysis to measure operating leverage as reflected in the marginal profit per sale.  Typically, labor-intensive industries generate high contribution margins while capital-intensive industries generate low contribution margins.  However, similar to the misappropriation of the term pro forma, many of today’s high growth/no-profit technology companies misapply contribution margin, pretending there are profits when there are losses.

The poster child for misleading investors with the artifice of contribution margin is Netflix (NFLX), a company that is ironically lauded for its investor communications.

While we find much to criticize about Netflix’s misleading corporate communications and amateurish attempts to obfuscate deteriorating economics (2), for the purpose of this analysis we will focus on one issue of artifice – management proudly targeting 17% contribution margin in Q4 2012, up from 16.4% in Q3.

In fact, management is so proud of its achievement that contribution margin is the only profitability metric in the whole of management’s discussion and analysis (MD&A) of the Company’s quarterly results.  There is no mention, not once, of the more common and accepted measures of profit such as operating margin (1.8%), net margin (0.8%, will remain negligible through 2013 at least), and free cash flow (negative $20 million, will remain negative through 2013 at least) (3).

Contribution margin allows for the kind of optimism that supports over-valuation.  Despite negligible earnings and negative free cash flow burning through a diminishing $400 million of net cash ($798.4 million cash minus $400 million debt), management continues to sell investors on the false notion that contribution margin is a precursor to net margin.  Witnessing dot com after dot com run out of cash unable to convert contribution to net, the flaw in logic becomes obvious.  Contribution margin is misapplied.
 

According to Netflix’s Form 10-Q for the period ended 9/30/12, contribution margin is defined as revenues less cost of revenues and marketing expenses. 

Netflix employs contribution margin to discriminate the profitability of its mature domestic streaming business from the losses in its roll-out of international streaming.  The idea is to show the incremental profitability of streaming.   In other words, to show potential   operating leverage.  Operating leverage is a measure of how revenue growth translates into growth in operating income.  While contribution margin is a measure of operating leverage, its exclusion of recurring expenses renders the metric meaningless in terms of actual profit and cash flow.

Netflix’s strategy is to reinvest the profit from the DVD business (48.2% contribution margin) into international expansion of the streaming business (negative 118.8% contribution margin).  It’s a race against time as the DVD is no different than the VHS tape.  It’s not a race against Amazon, Verizon, HBO and whoever else.  Netflix must convert contribution margin to net margin (combined domestic and international streaming contribution margin is zero) before the DVD is extinct.

The major competitive disadvantage for Netflix in comparison to its competition is a material lack of financial wherewithal.  Netflix is a standalone company with a measly $400 million of net cash that is likely to be burned off by 2014, forcing the company to raise new equity (or a disressed sale) at a substantial discount to today’s stock price.     

To prove our thesis, we apply 3-Sigma Value’s proprietary scenario-based valuation framework, the first step of which is the identification of Netflix’s key drivers of value:

3-Sigma Value’s Base Case Operating Scenarios for Netflix consolidate revenues around $4 billion in 2013 rising at a decelerating pace.   Management acknowledges the lack of gross margin expansion as the cost of content is inflationary, implicitly guiding the investment community to stable gross margins around 25% (equal to ~$1 billion of gross profit).  Subtract $940 million to $1 billion of expected operating expenses in 2013 and the result is $0 to $60 million of operating income (equal to 0% to 1.5% operating margin).

On the surface, these results are terrible.  Reality is even worse.   We evaluate each of the Key Drivers of Value, and where our Base Case assumption diverges from the assumption implicit in the Company’s stock price is Driver of Value #4 – Content Cost per Streaming Subscriber.  In order to avoid a cash crunch in 2014, Netflix must grow its subscriber base in line with consensus estimates while slashing the amount it spends on streaming content (subscription expenses) – an incongruous proposition.

As revenue decelerates in the low $4 billion range, total subscription expenses will inevitably continue to increase, driving gross margin below 25%.  In fact, assuming no change in content cost per streaming customer ($90.55 per annum as of 3Q 2012), a reasonable Base Case assumption, gross margin still declines below 20%.

In order for Netflix to maintain gross margin at or above 25%, they must slash the amount of content they pay per streaming customer.  If they don’t then the Company will run out of cash in 2014.

There are many reasons why Netflix will be unable to cut costs enough to avoid running out of cash in 2014.  They are in the process of expanding into 51 international markets by year end in a land grab with no land.  They are producing original content that is a longer-term value proposition than licensing content – cash production costs for original content is realized upfront.  They are building out OpenConnect CDN, representing ~10% of traffic in 2012.  Netflix has expensive plans all over the world, plans that are not adequately funded by $8 per month all you can eat pricing.

The fatal flaw in Netflix’s business model is the unprecedented notion that content cost inflation will abate.  OTT (over-the-top) distribution is not king.  Content is king, once and always.

For more information, please contact us at info@3sigmavalue.com.

2011 Review / 2012 Outlook

Introduction

Chapter 1:  Portfolio Construction

Chapter 2:  Winners and Losers

Chapter 3:  Bank Investing in 2012 

Chapter 4:  Buy Hamni Financial (HAFC)

Final Thoughts

For the year ended December 31, 2011, 3-Sigma Value, LP (the “Partnership”) had an estimated gain of 37.4% (net of management fee and expenses) with average net exposure of negative 10.8%.

The Partnership’s portfolio, both long and short, focuses its investment efforts in three industries – Technology, Media & Telecom (“TMT”), Natural Resources, and Financials – chosen based on the experience of our investment professionals.  In total, 3-Sigma Value, LP is invested long in 15 companies, and short 28 companies.

Reflecting on the global equity markets over the past year what is most evident is the natural advantage of the long-short business model.  My father, who passed away October 7, 2011, spent 30 years at Oppenheimer & Co., where he invested in the stock market on the long side only.  He was an excellent dividend yielding stock picker who outperformed the market over the long term, as measured in decades, not years, and certainly not quarters or months.  During the bull market, this was a profitable way to invest.  Unfortunately, since the internet bubble burst in 2000 it’s been a bear market with no end in sight.  The stock market could be up or down 50% in 2012, who knows?   Nothing has been solved.   

Portfolio Construction

As of December 31, 2011, the 3-Sigma Value portfolio had gross long exposure of 77.3% and gross short exposure of 71.2%, for net investment exposure of positive 6.1%.  Going forward, we expect net exposure to revolve around zero.  On a beta-adjusted basis, the portfolio is net short 8.2%.  We seek overall market agnosticism in the construction of the portfolio as reflected in a target range of exposure between negative 25% and positive 25%.

Our investment approach is global in scope, yet, at this time, North American equities constitute the vast majority of our gross exposure.  We are market-cap agnostic.

We are not economists per se and therefore we do not take directional bets on the overall economy as reflected in the performance of the overall stock market.  On the other hand, we are completely comfortable taking directional bets on specific industry segments, generally those dominated by secular decline.  Given the tendency of many market participants to assume a degree of mean reversion in the swinging pendulum of market sentiment, we find large exploitable market opportunities in the tendency of the Street to under-penalize such industries.  The fallacy of continuity between past and future underlying the premise of mean reversion in industries facing secular decline (or extinction) can yield short opportunities with unusually large breadth, depth and durability.   Examples abound in old media and old technology.

Winners and Losers

When comparing 3-Sigma Value’s Winners & Losers of 2011 to those of 2010, we find nothing that can be characterized as a pattern.  Certain investments flipped sides between 2010 and 2011 – for example, both RealD (RLD)(1) and Open Table (OPEN)(2) were losers last year only to become winners this year.  Were we wrong last year?  Yes.  Were we early?   Yes.  Early is the same as wrong. 

Unlike ReadD and Open Table, Netflix (NFLX) was a short position we initiated in early 2011.  While we had been following the company for years it was not until rumors spread that Starz was requesting a 10-fold price increase for its content (representing ~10% of Netflix content) that we decided to consider shorting the stock.  The popular notion that management made mistakes (i.e., separating streaming from DVDs, raising prices, Quikster) is the red herring of the year.  Management made these changes to its business model because they had to do something to boost revenue in the face of rapidly increasing content costs.  Unless subscriber growth doubled yet again, to 45 or 50 million subscribers, Netflix was destined for losses.

Certain investments were winners in both 2010 and 2011 – First Solar (FSLR) on the short side; AmTrust Financial (AFSI), and Checkpoint Technologies (CHKP) on the long side.

2011 Winners (14)

Short:   RealD (RLD) - don't believe the hype is a sequel; 3D glasses were introduced in 1922

Short:   Netflix (NFLX) - content costs are skyrocketing while subscription growth is declining; losses are inevitable

Short:   Open Table (OPEN) - niche business at best, more likely disintermediated by Google; ERB is old, pre-cloud technology

Short:   First Solar (FSLR) - solar energy is a commodity, not a technology

Short:   Aixtron (AIXG) - maker of MOCVD equipment for the production of LEDs faces an avalanche of Chinese competition

Short:   Rubicon (RBCN) - new entrants in the production of sapphire substrates will drive prices below marginal cost

Short:   Entropic Communications (ENTR) - MoCA is a transitional home networking protocol obviated by cloud-based services

Short:   TeleNav (TNAV) - GPS is a commoditized technology

Short:   Media General (MEG) - over-leveraged newspaper/tv broadcaster

Short:   Strayer Education (STRA) - For-profit education provider is no cleaner than any of the others

Short:   Hampton Roads Bank (HMPR) - 2010 recapitalization was insufficient

Long:    Hamni Financial (HAFC) - 2010 recapitalization was insufficient; however, 2011 recapitalization was a great bargain

Long:   AmTrust Financial (AFSI) - Highest ROE (20%+) insurance company with high frequency, low severity business model

Long:   Checkpoint Technologies (CHKP) - Highest margin (55-60% operating) software vendor with the best suite of IT security products

2011 Losers (4)

Short:   Alliance Data Systems (ADS) - subprime consumer lender masking as a vendor of data services

Short:   Bridgepoint Educaction (BPI) - For-profit online degree provider unlikely to survive enhanced regulations

Long:   Alliance Healthcare Services (AIQ) - medical imaging and radiation oncology service provider trading at ~100% free cash flow yield, implying the company is going bankrupt, which we believe is a false conclusion.

Long:   Smith Micro Software (SMSI) - the connection management software sold by SMSI is now being bundled into other technology

Looking ahead at 2012, many of our biggest winners and losers from 2011 remain in the 3-Sigma Value portfolio, although allocations rise and fall as target prices are approached, and profits and losses are taken. 

One short idea, Hampton Roads Bancshares (HMPR), is particularly relevant for bank investing in 2012 because it is a microcosm of the global financial system; it shows that even the smartest money in the room, investors who purport to be realists, certainly more realistic than government policy makers, are still vastly underestimating legacy loan losses buried in the mismarked books of banks and other financial institutions across the country.   

Making matters absurd in this case is the fact that the group of private equity investors led by The Carlyle Group, Anchorage Advisors, and CapGen Financial for some unknown reason decided to pay an astronomical price, 201% of tangible book value (TBV), for an insolvent bank with a 719% pre-money Texas Ratio on the verge of getting seized by the FDIC, and unlikely to make money for at least the next three years except in the most bullish of scenarios.   

We expect the Bank of Hampton Roads to be forced to raise more capital, and unless Carlyle et al throw good money after bad, we would expect the next round of financing to be priced at a significant discount to the previous round ($10 per share in 2010) since the bank is still unprofitable, and thus any investor unwilling to participate deserves to be diluted. 

3-Sigma Value built a short position in HMPR at an average price of $7.72, and then covered a portion of the position five dollars lower at $2.72. 

At the end of Q3 2011, tangible book value eroded to $3.81 per share, and it’s headed lower.  There are $264 million of non-performing assets (NPAs) consisting of $93 million of past due and non-accruing construction loans, $46 million of non-performing commercial real estate mortgages (CRE), $37 million of non-performing residential mortgages, and $67 million of other real estate owned (OREO).   This compares to an allowance for loan and lease losses (ALLL) of only $83 million. 

Based on sales out of OREO, which is mostly comprised of unfinished construction and land, we expect recovery in the range of 50-69% of book value for defaulted construction and land loans.  Using less draconian assumptions for the other loan types (residential, commercial, consumer), we expect total charge-offs to approximate $80-$90 million.  Over the past three quarters, the bank charged-off $132 million of bad loans while at the same time provisioning $54 million for newly-categorized bad loans (not newly-originated, these loans have been classified as substandard for years).    Assuming (1) charge-offs are recorded before the end of 2012, and (2) new provisioning maintains the current level of allowances, then we would expect the bank to continue producing losses through 2012, during which time book value will erode below $2 per share.

Operating at a negative margin on a pre-provision basis, with bloated non-interest expense of $24 million per quarter substantially higher than $17-$18 million of quarterly net interest income, it is hard to see how this bank will ever generate profits even if and when legacy credit-related expenses normalize.  An unprofitable or barely-profitable bank deserves to trade at a discount to its book value.  For Hampton Roads Bancshares (HMPR), that means the shares should eventually trade below two dollars.

Bank Investing in 2012

On December 16, 2008, the Federal Reserve lowered its targeted Fed Funds rate of 1% by 75-100 basis points, pushing interest rates down to their lowest levels since the 1950s.  The Federal Reserve then announced on August 10, 2011 that it would maintain zero-bound interest rates through the middle of 2013.  And most recently, on January 25, 2012 the Fed downgraded its outlook for US economic growth and extended its zero-bound interest rate policy through 2014. 

On September 21, 2011, the Federal Reserve announced “Operation Twist”, in which it would purchase $400 billion of long-term bonds (6 to 30 year maturities) financed by the sale of shorter-term bonds (maturities less than 3 years), intended to flatten the yield curve as long-term rates drop while short-term rates stay relatively the same.  30-year mortgage rates hit a record low recently, averaging 3.9% for the week ended January 5, 2012, ostensibly offering consumers incentive to buy houses and refinance debts.  Unfortunately, the problem isn’t the supply of credit here in the United States but the demand for it.  Loan demand is anemic, according to bank CEOs around the country.  The wave of refinancing that began in 2010 has washed ashore.  Anybody with debt has refinanced by now.  We live in an era of deleveraging.  How does more debt solve the problem of too much debt?

Whether and when the Fed will eventually raise its target for short-term interest rates depends on the economy, inflation expectations, and most importantly, the success of deleveraging balance sheets.  Interest rates cannot rise because then our government, companies, and households won’t be able to service their debts.   The government is selling ten-year bonds (~2%) below the rate of inflation (>2%).  One-year treasuries yield a measly 12 bips.  Five years out on the curve only gets you 86 bips, still less than 1% per year, and well below inflation.  What will happen to deficits when rates rise back up to normalized levels?  We can only hope that when the day arrives, the deleveraging cycle will be largely complete.  Until then we’re trapped in an era of historically low interest rates. 

Despite the Fed’s effort to flatten the yield curve, December marked the 48^th consecutive month of a historically-steep yield curve enabling banks to earn juicy net interest margin (NIM) averaging 3.56%.  However, while FDIC-insured banks in the third quarter of 2011 (latest information available) earned their highest quarterly net income since the onset of the financial crisis – due to high levels of NIM and falling loan loss provisions – revenues posted a year-over-year decline for the third consecutive quarter, unprecedented in 27 years for which data are available.  Weak loan demand is the primary culprit as loan balances rose a meager 0.3%. 

Meanwhile, legacy credit issues continue to eradicate the earnings of much of the banking system despite the heralded improvement in industry-wide loss provisioning in 2011.  At the depths of the financial crisis in early 2009, FASB(3) looked into the abyss and ceded the rules governing mark-to-market accounting.  On April 9, 2009, FAS 157 was officially updated, suspending the accounting of reality when market conditions are deemed “unsteady or inactive”.  Since then, it has become nearly-impossible to rely on the valuations of loans and other assets as reflected in a bank’s audited financial statements.   

As a result of the uncertainty created by the absence of mark-to-market accounting, bank valuations have polarized.  Banks that trade at a fraction of their book value are likely insolvent on a mark-to-market basis.  Banks that are healthy – either because they were managed conservatively during the credit bubble, or because they have been successfully recapitalized since – trade at normal valuation multiples corresponding to the returns generated on their tangible common equity (ROTCE)(4).   

For example, banks that earn a consistent ROTCE of 10% or more typically trade around 1.5x tangible book value.  A 15% ROTCE translates to approximately 2x book value.  Banks that earn an ROTCE around zero typically trade below book value.  The problem in today’s world is that the book value number is imaginary, concocted by financial re-engineers who manipulate assumptions to satisfy a conclusion derived in advance, ergo – the bank is solvent.

It’s a great time to be in the banking business, as long as the bank is solvent on a mark-to-market basis.  Which is what leads us to identifying the important factors when analyzing a bank investment in the current market environment:

(1) Quantifiable legacy credit risk.  Our preference is to invest in banks growing via FDIC-assisted acquisitions in which the government assumes a majority of (80% is normal) future charge-offs out of the acquired loan portfolio (called “covered” loans because they are covered by FDIC loss-sharing).  In FDIC-assisted deals, the legacy credit risk is fixed and known, and in many cases negligible.

In lieu of FDIC-assisted growth, we seek investments in post-recapitalization banks in which either (a) more than enough capital was raised to repair the balance sheet; or (b) not nearly enough capital was raised.  Bank of Hampton Roads (HMPR) as previously discussed is an example of b.  Hamni Bank (HAFC), featured in the next section of this report, is an example of a.  

2.  Solid core deposit base.  With interest rates pegged at zero, savers are suffering, deposits yield next to nothing.  But if you’ve been banking with a particular institution for years or even decades you’re unlikely to move your business for a few basis points.  Convenience matters.  Community banking is a local business.  Service matters.  Banks that have survived cycles tend to have sticky core deposit bases forming the foundation of a valuable banking franchise. 

3.  Management team.  Banking, like all financial services, is a human capital business.  The quality and credibility of a management team trumps all the statistical factors.

 Buy: Hanmi Financial Corp (HAFC)

Established in 1982, Hamni Bank ($2.7 billion of assets) is a wholly-owned subsidiary of Hamni Financial (HAFC) and one of the three largest Korean-American banks based in California, the state with the largest Korean-American population(5).  Like much of the banking system, Hamni Bank chased loan growth during the credit bubble and ultimately erased its own equity.  Facing insolvency, in May 2010 the Bank agreed to a $240 million investment by Woori Financial Group (WFG) for a majority stake(6).   WFG is a $264 billion financial holding company headquartered in Korea with a U.S. subsidiary, Woori American Bank (WAB).

Not coincidentally, Hamni’s current CEO, Jay Seung Yoo, was Woori American Bank’s CEO from 2001-2007.  And although we at 3-Sigma Value never invest simply because we believe in the high-probability of a take-out, given the cooperation between the two institutions, overlapping management teams, and the fact that Woori was willing to pay $9.60 per share staring into the abyss, it seems likely that Woori will eventually consolidate or otherwise cause the consolidation of Hamni Bank.  If a take-out were to price at merely 1x TBV (tangible book value) then 3-Sigma Value will earn 2.5x its investment.

To the chagrin of both Woori and Hamni management, regulators squashed the deal without a public explanation.  In its place, Hamni Bank raised $120 million at the same $1.20 per share ($9.60 pre-reverse split), mainly from investors and customers within the Korean community.  Unfortunately for them, $120 million wasn’t enough to offset the legacy losses embedded in the loan portfolio.

By the summer of 2011, Hamni Bank was back in the capital markets seeking around $80 million, this time priced at $0.80 per share ($6.40 pre-reverse split).  The deal eventually closed in November 2011, two-times over-subscribed.  Woori acquired a 4% stake.  The Fed limited them to 4.9%, and because of the over-subscription their allocation was reduced along with other participating investors.

Second Time’s the Charm – a profitable theme guiding 3-Sigma Value’s research into the banking industry is the chronic under-estimation of legacy credit risk, and as a direct result the inadequate recapitalization of banks that market themselves to investors (via Wall Street) as turnaround stories.  As of December 31, 2011, 3-Sigma Value, LP was short two banks that, similar to Hamni Bank, did not raise enough equity capital the first time and will require a second infusion at some point sooner rather than later. 

In the case of Hamni Bank, we invested as part of the second recapitalization.

Hamni finally raised more than enough capital to charge-off its remaining non-performing assets(7) (NPAs) without coming close to piercing its equity.  The Allowance for Loan & Lease Losses (ALLL) covers 171% of non-performing loans (NPLs), and 5% of total loans, well-above management’s target coverage of 3-3.25% by the end of 2012 and 2.25-2.5% by 2013.

According to management, NPAs will be charged-down to $45 million by June 2012, leaving ALLL at 194% of NPAs, a level of extreme conservatism unmatched by its peers.  This is effectively a clean bank with quantifiable balance sheet risk.  Hanmi has successfully and finally recapitalized itself.   In fact, based on management’s guidance for ALLL coverage to normalize, reserve releases in 2012 will more than offset new provisioning resulting in ~$20 million of additional profits, boosting tangible book value to ~$13 per share by the end of 2012.

The principal risk in 2012 and beyond is that the Bank originates bad loans.  As part of the ongoing diversification of the loan book away from commercial real estate (75% of total loans), the Bank hired an SBA lending team that began originating loans in 4Q 2011 with the goal of generating at least $65 million per quarter in 2012 and then $75 million per quarter in 2013.  In addition, Hamni has the highest proportion of owner-occupied (O&O) commercial real estate loans among its peer group with 62% occupied by the owner of the property.  Owner-occupied properties typically default at much lower rates then properties occupied by someone other than the owner.

To project the future performance of Hamni Bank, or any bank for that matter, we focus on the underlying assumptions that drive net income.  Net income is the principal metric by which we determine a bank’s valuation – the higher the net income as reflected in ROE, the higher the price investors will pay as a percentage of tangible book value (P/TBV). 

We begin with the basic formula:  

Net Income = Net Interest Income plus Non Interest Income minus Non Interest Expense

Net Interest Income – NIM(8) averaged 3.68% in 2011.   Longer-term, management targets NIM expansion to 4-4.25% due to the following factors: (1) increasing the loan-to-deposit ratio, (2) improving asset yields as rates rise; (3) relatively-stable funding costs with limited sensitivity to interest rates – 27% of deposits are non-interest bearing, and (4) running-off high cost CDs – $650 million of CDs are re-pricing in the first half of 2012.  CDs paying 1.8% will re-price at below 1%.  However, as long as interest rates remain at historically low levels, the loan portfolio will re-price at lower yields; and therefore, we expect NIM to remain relatively constant as long as the shape of the yield curve remains relatively steep.

Non-Interest Income – fees are depressed because interest rates are zero-bound.  Longer-term, management targets non-interest income as a percentage of assets to eclipse 1%, but for now is satisfied with 0.6% fees earned on SBA loans, the focal point of new origination. 

Non-Interest Expense – the Bank’s Efficiency Ratio(9) of 67% in 2011 was well-above management’s target of mid 50% in 2012, and 45-50% in 2013.  Overseeing this effort is new CFO, Lonny Robinson, a highly-regarded cost cutter with over 25 years of community banking experience and prior to that a CPA at Ernst & Young specializing in banks.  The improvement in operational efficiency is being driven by (1) lower SG&A, (2) lower regulatory-related fees and assessments, (3) lower resolution expenses due to lower balances of non-performance assets, and (4) the elimination of other non-recurring charges.

On the subject of taxes, the Bank has an $82 million deferred tax asset (DTA) that is 100% offset by a valuation allowance.  Under GAAP, a valuation allowance must be recorded if it is “more likely than not” that such deferred tax assets will not be realized.  However, after five straight quarters of profits, management expects the allowance to be reversed in a multi-step event beginning in 2012.  They estimate $60 million will be recoverable.

Capitalization & Other Balance Sheet Considerations – In order to generate the double-digit return on equity (ROE) required to earn a 1.5x or higher multiple of tangible book value (TBV), capitalization as reflected in the ratio of tangible common equity to total assets (TCE / TA) must be optimized.  In other words, a bank weighed down by excess cash earning zero percent doesn’t deserve a multiple much higher than 1x TBV.

At the end of Q3 2011, Hamni Bank reported a 7.5% TCE Ratio that rose to 10.4% in Q4 after the November common stock offering.  Longer-term, management targets TCE in the 9-10% range; however, the reversal of the deferred tax asset valuation allowance in 2012 combined with a restructured operation will elevate TCE up to 13.4%, a level of over-capitalization that suppresses return on equity.  ROE will stay around 8% or 9% unless management is able to prudently re-leverage the balance sheet. 

Assuming management is able to achieve its target 9-10% TCE Ratio then the Bank should generate ROE in a range of 10% to 16% based on ROA in the range of 1.0% to 1.4% through 2014(10).

Valuation – We employ a range of Price-to-Tangible Book Value multiples (P/TBV) – from 1.00x to 1.50x – to estimate the future value of Hamni Bank.  This multiple range is based on (1) the high correlation between return on tangible common equity (ROTCE) and P/TBV, and (2) comparable bank valuations.

Conclusion – Hamni Bank is a well-capitalized post-restructuring bank that accelerated through the credit cycle via two rounds of financing.  Unfortunately for investors in the first round, the amount raised wasn’t enough.  Investors in the second round however can expect to earn a 150% return on their investment based on a prospective 1x multiple of 2013 tangible book value of $16 per share.

Final Thoughts

We are not market forecasters.   We never analyze or discuss where the S&P 500 is going, or any other market-driven index for that matter.  In the aggregate, our portfolio should do well in either direction.  That is the design.  That is the whole point.   That’s what turned my father from a long-only advocate who questioned the mindset of short-sellers who choose to profit from failure.  What kind of person bets don’t pass, he asked rhetorically years ago on the floor of Caesar’s in Las Vegas.  He felt it was a negative way to bet, and he questioned the mindset of someone betting on failure rather than success.

In 2008, the year in which the financial system collapsed in September, 3-Sigma Value, LP was down 15% –– 14% of which occurred in the month of September when our longs plummeted and our shorts were squeezed.  My father was weak after the second of three aneurysm surgeries when he marveled, “I never thought it would happen.  I was born during a depression and now I’m going to die during one.”

He recovered, until his third surgery in early 2011, which proved to be the catalyst for his ultimate demise in October.  He believed that decades from now, historians and their ilk will look back at this time as a Depression, a time of high unemployment and high levels of misery and uncertainty.  A time when positive investment performance is generated in one of two ways: either by skillfully trading the market’s volatility or by investing with a zero-beta construction.

My father preached diversification and talked incessantly about high yielding stocks like Pfizer and Bristol Myers, Verizon, AT&T, Chevron, Altria, et al, but at the end of the day he was nervous.  2008 shook his confidence because there was nowhere to hide.  Money was trapped.  What was deemed cash one day became private equity the next.  He was trapped in Auction Rate Securities.  The Reserve Fund, the country’s oldest and largest money-market mutual fund “broke the buck” meaning that management was forced to face reality, to acknowledge that their assets consisting of short-term fixed income securities were worth less than 100% of NAV.  What is cash anymore?  What is a default?  

The rules change at an incendiary pace.  Strategies evolve or implode.  There is nothing in between.  The question of bull or bear is a red herring.  It is a war of attrition.  We are living history, my father said on the phone one evening while I was at my desk.  I was telling him about an arbitrage opportunity.  The FDIC-arbitrage, in which the government seizes failed “zombie” banks and pays to have them consolidated.  Generally, the government shares future loan losses (80% loss-sharing is typical) while paying the acquiring bank an amount of cash up-front that covers all or a portion of the bank’s (~20%) share of future losses.  He told me his memories of the S&L crisis and said that even in the darkest of times, especially in the most volatile of times, there is opportunity.  He told me he was proud of me. 

Thank you for your confidence.

 Sincerely,Benjamin Weinger                                                     Portfolio Manager                                                             3-Sigma Value

3, L

The TAM Fallacy

In a virtual redux of the Internet bubble, cloud/social/dot com 2.0 companies are peaking in terms of perceived valuation.  The worm has turned for many of the new bellwethers, with stock prices already cut in half.  Turnover in management suites are accelerating as stock options lose value and the venture capitalists want out.     

The CTO of a leading online reservation system for doctors was explaining his business plan.  “We only need 3% of the total addressable market to drive revenues and operating leverage to a level at which we can sustain cash flow."  Immediately upon hearing the words "total addressable market", I thought of one of my favorite short positions, OpenTable (OPEN), the leading promulgator of The TAM Fallacy, as featured in 3-Sigma Value's First Quarter 2010 Letter.

OpenTable (OPEN) sells old technology to restaurants at an unnecessarily-high upfront and recurring cost.  Mobile technologies are breaking down whatever barriers to entry remain in the reservation business.  OpenTable has no IP of any significance, and the value of its database is questionable at best - it's never been monetized, and no plan to monetize has ever been dislosed.

Since the end of 2010, the stock price launched to a high of $115 in April before plummeting to $46 by the end of September 2011.  We continue to hold a short position in OPEN. 

Despite the steep drop in OPEN's stock price, the valuation still evokes the internet bubble, any way you look at it.  In fact, OPEN trades on a multiple of TAM (2.0x using management's guidance), not a multiple of EPS or EBITDA or other measure of profit. 

While management’s estimation of its total addressable market in North America sounds conservative (35,000) when compared to the approx. 945,000 restaurants operating in the U.S., reality is smaller.  OpenTable initially focused on major cities such as San Francisco, New York, and Chicago because of the density of restaurant clustering and high-touch sales approach.  One sales person can cover a larger number of restaurants in these metropolitan areas, and therefore, sales productivity (per sales rep) is already and inevitably in decline.  Furthermore, the restaurants that are the most reliant on reservations and generating the most reservations per restaurant have already adopted technology, and therefore, OpenTable faces diminishing returns when adding new restaurants.

OpenTable (OPEN) is a prime example of The TAM Fallacy as the Company is far more limited in its capacity to grow than management would have you believe, and more limited than typical internet business models (limited by the number of seats available in physical restaurants).  CEO Jeff Jordan, the loudest proponent of TAM, recently resigned from both his executive position and the Board of Directors.  Growth has flattened while competition has intensified.  Yet the market still ascribes the Company a premium unsustainable billion dollar valuation (equal to 7x 2011E revenue of $140 million). 

For more information, please contact us at info@3sigmavalue.com.

Transitional Technologies

One of the areas where 3-Sigma Value repeatedly finds success is in the identification of companies whose perceived value is based on a transitional technology.  Where the market sees a high-flying growth stock we see a clock ticking, a discounted cash flow valuation with a finite number of inflows.  When there is no perpetuity growth rate, equity value will eventually approach cash value. 

Entropic Communications (ENTR)

Entropic is the market share leader in MoCA (Multimedia over Coax Alliance)-compliant chipsets used in customer premises equipment such as set-top boxes, broadband home routers and ONTs (optical network terminals) allowing network video within a subscriber's home.

The killer app for in-home video networking is multi-room DVR service.  A multi-room DVR using MoCA protocol consists of one main DVR accessed by other televisions over a home network.  Given ~100 million pay-tv households in the US alone, and MoCA penetration of ~7 million at the end of 2010, the potential market opportunity appears huge, however misleading.   Set-top-box (STB) conversions are long-tail transitions; subscribers don't proactively change their STBs; it's at the behest of the service provider.  Therefore, sales of Entropic chipsets are driven by subscriber additions.

Verizon FiOS TV was the first North American service provider to roll-out multi-room DVR utilizing the MoCA networking standard.  Followed in 2010 by DirecTV (DTV), Comcast (CMCSA), Cox (COX), and Time Warner Cable (TWC), each announcing a multi-room DVR roll-out.  Notably absent from the list is Cablevision (CVC), who is trialing DVR-Plus, a multi-room DVR service allowing subscribers to record programming on shared servers located at the cable operator's head-ends.  This configuration eliminates the need to stream video throughout a home using the MoCA protocol.

Cablevision has long been the technology vanguard of the cable industry (always the first to upgrade infrastructure, first to offer triple-play, invented HBO, etc.) and its cloud-based solution to multi-room DVR service is the long term solution.  DVR Plus has been years in the making, first introduced in 2006, it wasn't until 2009 that the U.S. Department of Justice approved its use in the wake of a legal challenge brought by certain content providers claiming copyright infringement.  During the period of injunction, MoCA emerged as an alternative, albeit a temporary one.  Cablevision’s CEO pledged to "stop buying set-top boxes" at the launch of DVR Plus in the Bronx on January 18, 2011.

The $10.95-a-month DVR Plus service comes with 160GB of storage - the same as its set-top-box based iO DVR service - enough to store up to 100 hours of standard-definition programming or 25 hours of HD programming.  Referred to as a whole-home DVR, any qualified digital box in the home can access programming recorded on the MSO's network, and set and manage DVR recordings.  DVR Plus lets subscribers record up to four shows at the same time, while watching a fifth already-recorded show.  Unlike other whole-home DVRs that use the MoCA networking protocol, DVR Plus doesn't rely on a master DVR to share content with other boxes on the home network.  Instead, all content is stored on, and played back from, the MSO's cloud-based storage banks.  Customers access and manage DVR Plus on channel 1001.

Revenue at Entropic will plateau year-over-year by 2012 due to the roll-out of cloud-based DVR services by the cable MSOs, ASP erosion for MoCA chipsets, and market share losses to Broadcom (BCOM) who shipped MoCA in its SoC (System-on-a-Chip) in Q1 2011.  Even prior to Broadcom's launch, in Q4 2010, according to JP Morgan 2/3/10, Entropic's market share was down to ~90% (of an estimated total Q4 market of 6.1 million chip sets).  STMicro (STM), the other major STB chip maker is developing an integrated MoCA on SoC as well.   Additional threats to MoCA’s share of home networking include wireless solutions and other over-the-top (OTT) solutions that bypass traditional pay tv.  In sum, Entropic is not a growth stock as Wall Street would have us believe.  It is a transitional technology that will be obviated by cloud-based services.

For more information, please contact us at info@3sigmavalue.com.

A Brief Overview of the Pitiable State of the U.S. Banking System

On May 24, 2011, the FDIC released its Quarterly Banking Profile for the First Quarter of 2011, a grim reminder of the insolvency of the U.S. banking system and its dependence on the federal government.

The number of FDIC-insured commercial banks and savings institutions reporting quarterly financial results fell from 7,658 at year end 2010 to 7,574 at the end of Q1 2011.  One new reporting institution was added during the quarter, while 26 institutions failed and 56 were absorbed by mergers.  Total assets of insured institutions on the FDIC’s Problem List increased from $390 billion to $397 billion, and the number of institutions increased from 884 to 888, representing the largest number of problem institutions since March 31, 1993, when there were 928(1). 

At the depths of the financial crisis in early 2009, FASB(2) looked into the abyss and ceded the rules governing mark-to-market accounting.  On April 9, 2009, FAS 157 was officially updated, suspending the accounting of reality when market conditions are deemed “unsteady or inactive”.  Since then, it has become impossible to rely on the valuations of loans and other assets as reflected in a bank’s audited financial statements.

Making matters even more fictional, on January 6, 2011, the Fed announced a change in accounting that magically transforms its losses into a liability of the Treasury (a.k.a. the taxpayer) rather than a charge to its capital.  This invention of a “negative liability” to maintain solvency is a perverse idea never before applied in legitimate audited financial reporting.

When the Fed generates profits in the normal course of its business, it distributes all of it to the U.S. Treasury.  However, by adopting the newly-concocted negative liability rule, the Fed no longer is required to record a decline in its capital when accounting for a decline in the value of its assets.  Instead, it can simply subtract the amount of the loss from its liabilities based on the premise that since the Fed owes its profits to the Treasury it is merely deferring their eventual disbursement. 

The Fed’s balance sheet has tripled in size since the crisis to a record $2.8 trillion in assets(3) – many of doubtful provenance and the vast majority highly sensitive in their valuation to the level of interest rates.  Supporting this is a slim $53 billion in capital, meaning that a mere 2% decline in the value of its assets would render our central bank theoretically insolvent.

It is easy and inevitable – the Fed will disguise losses in its expanded portfolio of toxic assets until its transformation into a zombie bank is complete.  As we wonder about the constitutionality of the newly-empowered reciprocal relationship between the supposedly independent Fed and the Obama administration, we arrive at the final conclusion that the U.S. banking system has become a Ponzi scheme.  Banks sell assets to the Fed at prices that do not reflect reality, and the Fed buries the losses.  In the meantime, fiction rules as the Fed suspends reality-based accounting and prints money to artificially inflate those same asset prices.  The end game is inevitable and approaching at an accelerating pace.

While FDIC-insured banks in the first quarter of 2011 earned their highest quarterly net income since the onset of the financial crisis – due to high levels of net interest margin (NIM) and falling loan loss provisions – revenues posted a 3.2% year-over-year decline, only the second time in 27 years for which data are available that the industry experienced a decline in quarterly revenue.  Weak loan demand is the primary culprit as loan balances posted the fifth-largest quarterly percentage decline in the 28 years for which data is available.  1-4 family residential mortgages fell 3.4%, credit card balances were down 5.5%, and real estate construction & development loans dropped 8.1%.  The only major loan type experiencing growth was C&I (commercial & industrial) loans, up 1.5%.  As of March 31, 2011, net loans and leases represented 52.4% of FDIC-insured institutions’ assets, the lowest level since the early 1970s.

Sheila Bair and other employees of the FDIC have repeatedly stated their expectation of massive consolidation in the U.S. banking system.  Starting with FDIC-assisted acquisitions of failed banks – of which 888 currently toil on the Problem List – consolidation will migrate to mergers and other un-assisted transactions until the number of banks in the U.S. is cut in half, at least.  This is precisely the reason why it is next to impossible for a new management team to be granted a de novo bank charter.  The FDIC doesn’t want to insure more banks, they want less. 

Supported by one of the most profitable banking environments in modern history given the steepness of the yield curve, Net Interest Margin (NIM) of 3.57% in Q1 2011 was higher than the 3.33% earned during the peak of the banking cycle in the second quarter of 2007(4)  In comparison, the 20-year average slope is approximately 170 bps.  Since 2009, the curve has barely shifted as the short end stays pegged at zero and economic data remains mixed.  Meanwhile, legacy credit issues continue to eradicate the earnings of much of the community banking system despite the improvement in industry-wide loss provisioning in the first quarter.

In its March 31, 2011 financial report, the People’s Bank of China (the central bank of China) disclosed leverage (defined as assets divided by equity) equal to 1,223-to-1, meaning a loss of merely 0.1% would render the bank theoretically insolvent.  However, unlike the Federal Reserve Bank of the United States’ claim of independence, China’s central bank is a socialized institution.  Via the distribution networks of the four big state-controlled commercial banks(5), the government plans and manages growth in the national economy by lending freely to Chinese companies in a frantic effort to maintain ~10% annual GDP growth(6) (+9.7% in 1Q11).

Much like the state-controlled China banks, the too-big-too-fail banks in the U.S. exist to serve the state, not the stockholders.  As well, the Fed has become a socialized institution like the PBoC suppressing interest rates, manipulating yield curves, and debasing currency, all in the name of the specious wealth effect.  The idea that the U.S. government can artificially support asset prices through fiscal and monetary stimulus until the economy is healed and the banking system stabilized is nonsensical unless and until the root cause of the crisis is addressed.  How does more debt solve the problem of too much debt? 

Our government tells us with “100% confidence”(7) that the high jacking of capitalism will ultimately be short-lived, the academics will be vindicated, and the crisis that began in July 2007 will become history.  Unfortunately, capitalism is dead, as dead as it was in September 2008.   The new economy is a command and control exercise led by academics and bureaucrats, the natural interplay of supply and demand warped by the government’s hand.  And while this environment sounds dire for investors like 3-Sigma Value, we embrace the opportunities available under the new hybrid socialist-capitalist system, and we evolve.

For a complete report, please contact us at info@3sigmavalue.com.

Fourth Quarter 2010

Our agnosticsm is tested in this time of economic recovery fueled by fiscal and monetary stimuli.  Nevertheless,  we continue to find the best risk/reward opportunities on the short side of the equation.  3-Sigma Value, LP enters 2011 with 58% gross long exposure and 72% gross short exposure, for gross and net exposure of 129% and negative 14%, respectively.

The Partnership’s portfolio, both long and short, focuses its investment efforts in three industries – Technology, Media & Telecom (“TMT”), Natural Resources, and Financials – chosen based on the experience of our investment professionals.  In total, 3-Sigma Value, LP is invested long in 13 companies, and short 25 companies. 

In 2010, 3-Sigma Value created a separate investment partnership, 3-Sigma Value Financial Opportunities, LP, to invest in one of the great opportunities of our time - banks that are participating in FDIC auctions of failed bank assets, in which the government is literally paying investors to take ownership of assets in an effort to stabilize the banking system. 

The Number of Problem Institutions Continues to Rise

According to the FDIC’s Third Quarter 2010 Banking Profile, the number of insured commercial banks and savings institutions reporting quarterly financial results fell from 7,830 in the second quarter to 7,760 in the third quarter.  Five new reporting institutions were added during the quarter, while 30 institutions were absorbed into other charters through mergers.

41 institutions failed in the third quarter, bringing the total number of failures through Q3 2010 to 127.  The number of insured institutions on the FDIC’s Problem List increased from 829 to 860 by the end of Q3, representing the largest number of problem institutions since March 31, 1993, when there were 928(1).

While the FDIC has not yet released its Fourth Quarter report, we do know another 30 banks were seized during the quarter bringing the calendar year 2010 total to 157(2).  The Problem List will approach 900 and in all likelihood break the all-time record in 2011.  The FDIC, despite its good intentions, is hindered by a highly subjective regulatory process requiring three agencies to approve the government’s seizure of a banking institution(3).  As a result, insolvent banks may languish on the Problem List for quarters or even years, frozen, waiting nervously for the FDIC to change the locks on any given Friday.

For more information, please contact us at info@3sigmavalue.com.

Third Quarter 2010

We are inherently skeptical analysts here at 3-Sigma Value, perhaps one reason why we focus and find success on the short side of the portfolio notwithstanding market conditions.  We accept nothing at face value – management projections, government data, sell side analyst math, all of it, as far as we’re concerned, is tainted by the agendas of those making the calculations.  We have no bullish or bearish agenda, or bias or proclivity.  We are a data-driven investment firm that does all of its own research and builds all of its own models from scratch and draws all of its own conclusions.  We invest only when we are overwhelmed by the evidence.  We separate the survivors from the doomed, the value from the junk, the good from the bad.  We strive to be agnostic but never ignore reality.  And that’s where we find ourselves today, facing reality and not liking what we see. 

Ultimately, the United States is faced with a choice, a choice between short-term or long-term pain.  The printing press alleviates some short-term suffering while creating an equivalent amount of long-term suffering.  Same goes for fiscal stimulus spending.  It is a zero sum game.  Every dollar borrowed must eventually be paid back.

While equities melt up a wall of money or wall of worry or whatever wall stands in its way, we remain more focused on preserving wealth over the long term than catching every schizophrenic movement of the stock market.  What we deliver on a short-term basis (defined as less than one year) is an uncorrelated(1) return profile, what we deliver over the long term is superior performance.  That is the very nature of a deep value with a catalyst strategy – the simplest way to define what we do.

For a complete report, please contact us at info@3sigmavalue.com.

Second Quarter 2010

German Chancellor Angela Merkel declared that governments were locked in a battle with financial markets, a confrontation she and her fellow politicians were determined to win.  "To some degree this is a battle between the politicians and the markets," she said in a speech in Berlin. "But I am firmly resolved -- and I think all of my colleagues are too -- to win this battle."  Reuters.  

Sam’s Club, the division of Wal-Mart Stores (WMT), is teaming with a company called Superior Financial Group to offer loans up to $25,000 to its small business customers(1).  Superior Financial is what’s called a “non-bank lender” and accordingly, the loan qualifying criteria are not as stringent as conventional business loans.  It takes only four days on average to fund them, according to Tim Jochner, chief executive officer of Superior Financial Group.  "It's just another way for us to reach small businesses, especially in this time where equity has evaporated,” said Jochner with irony so thick it’s a bad joke. 

Why couldn’t Wal-Mart find a bank partner?  Driving back to the city over the weekend from Salisbury CT, I noticed a highway billboard promoting Stop & Shop’s banking partnership with People’s United Bank (PBCT).  If Stop & Shop can attract a legitimate regulated banking partner, why not Wal-Mart?(2).

Is this not an indictment of our financial and banking system?  Wal-Mart is America’s #1 retailer, not some usurious payday lending machine.  If Wal-Mart isn’t willing to be a part of the solution, then, what is the solution?  More subprime debt.  More dollars printed in order to soak up the subprime debt.  The Fed’s balance sheet has multiplied by 250% over the past two years, from $877 million to $2.3 billion(3).  Is this the lesson of the credit crisis?  That big government stands behind us, check book in hand, no matter the size of the dollars lost.  No matter how many rules we bend and break, no matter how many loopholes we reverse-engineer.  The government’s in business.  And they will crush us all or support us for all the wrong reasons.

The excesses of a boom, any boom, must be cleared out by economic adjustments to the downside, or as Joseph Schumpeter said it, what we need now is an excursion into depression.  Until then, we remain mired in the great economic debate of our time – Keynes vs. Hayek, The New York Times vs. The Wall Street Journal, to stimulate or not to stimulate an economy.  Before confidence can replace equivocation in a stock market deeply scarred by the harrowing events of September 2008, the most basic questions of government need to be adjudicated – what is the role and size of our government in an age of inevitable decline. 

My father always says, “No need to be a hero and a half.”  Never before has this particular aphorism of his felt more imperative.

For a complete report, please contact us at info@3sigmavalue.com.

First Quarter 2010

Conviction in the market is evanescent and, more often lately, absent.  Even the wild bulls are equivocal in their bullishness, generally falling into one of two camps, either (a) they are momentum-based traders/investors focused more on technical than fundamental analysis, or (b) they are thunderstruck by the massive reflation in risk-assets we have experienced over the past year, a reflation that is obviously the direct result of unprecedented monetary and fiscal stimuli.  The question now, which the market has already answered in the affirmative, is whether or not these stimuli will kick-start sustainable growth in the economy.  We are not so convinced.

Thomas Gaynor, Chief Investment Officer of Markel Corp. (NYSE: MKL), a specialty insurance company, is quoted in a recent issue of Jim Grant’s Interest Rate Observer(1) as telling the audience at Grant’s recent investment conference the following, I don’t know if you remember the movie ‘Butch Cassidy and the Sundance Kid’, but to me, equities look like the choice available to Butch and Sundance as they stood trapped by the lawmen on the ledge over the raging river.  When Sundance objected to Butch’s suggestion that they jump and seize the only chance of escape, by saying he didn’t know how to swim, Butch replied, ‘don’t worry, the fall will probably kill you.’

Take a flying leap of faith my friends.  Buy multi-national blue chips, or better yet, index funds, the kind promoted by John Bogle and his ilk.  Await retirement with peace of mind.  A self-described “relentless optimist”, Gayner followed with this remarkable advice, Endless concern about what might go wrong keeps you from acting in a positive and productive manner(2).  If interest rates go up, that won’t do equities any favor.  I just think it will hurt them less than the alternatives.  Spoken like a classic long-only investor. 

He ended on this note, “I study, think, discuss ideas and ultimately force myself to retain the optimistic point of view, oftentimes…in the face of sound arguments to the contrary.”   Now we know why the market can remain irrational longer than we can remain solvent. 

I’ve never met Thomas Gaynor so I’m not going to cast aspersions at his knowledge and ability; instead, I’m using this to illustrate insanity.  The religious approach to investing.   Born again investors everywhere.  Didn’t buy and hold die in 2008?  When did the world stabilize enough?  When did the future become so clear?  The wall of worry has been torn down.  The bears have been slayed.  The shorts squeezed.  If you happen to be a born again investor then we are not the investment vehicle for you.  If, on the other hand, you are like us, and you make a concerted effort to not force yourself to retain any particular point of view, if you value objectivity and process, if you value modeling, then we are for you. 

For a complete report, please contact us at info@3sigmavalue.com.

Fourth Quarter 2009

We generally expect to be one of several allocations within a diversified investment portfolio.  Whether you’re a pension fund manager or high net worth individual, when building a diversified investment portfolio, it is imperative to understand the correlations of and between your individual investments.  In fact, in a well-diversified portfolio, it is not the absolute performance of an underlying manager that ultimately matters as much as the amount of alpha his or her portfolio generates.  To illustrate: if a portfolio is long 20+ hedge fund managers, adding or subtracting one will not generally impact the return of the overall portfolio no matter the absolute return of that marginal hedge fund manager if his or her return is largely explained by its beta.  Therefore, the only statistic with any predictive value is alpha, defined as an investment’s return in excess of what is expected by its correlation to the market (its beta).  

Simply put, if a portfolio’s beta is zero, then any positive return generated by the portfolio is pure alpha.  By separating the impact of the market on a portfolio, what you are left with is skill.

John Kenneth Galbraith famously said, “We have two classes of forecaster: those who don’t know – and those who don’t know they don’t know.  However, if you were to follow the advice of the swill merchants on CNBC or in Barron’s Roundtable(1) forecasting the equity markets to rise between five and twenty percent then everyone can sleep well in 2010.  There will be volatility, they say, but not enough to negate their liquidity and momentum-driven hypothesis for embracing beta. 

For access to the complete report, please contact us at info@3sigmavalue.com.

Third Quarter 2009

Risk management is the least understood topic in finance, even among professional investors.  And while gigabytes of data are available on volatility and correlation, liquidity and fund flows, historical information is only useful in so far as the past is a predictor of the future.  Eight years after 9-11, two years after the stock market peaked (October 2007), we face an uncertain future.  Visibility is limited.  Computers drive momentum like day-traders did at the peak of the internet bubble.  I had lunch with a brilliant quant whose models are driven by factors that are categorized as either Momentum­ or Reversion to the Mean.  In 2008, any quant fund geared toward mean-reversion got hammered, and as a result, the whole idea of mean-reversion is being challenged.  Therefore, it is momentum that rules the day, an anxious momentum that naturally follows the unprecedented volatility we’ve experienced.

The following quote from Keynes strikes me as especially relevant at this time, a time of minimum visibility and maximum equivocation.  “Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.  It is not a case of choosing those which, to the best of one’s judgment, are really prettiest, nor even those which average opinion genuinely thinks the prettiest.  We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.  And there are some, I believe, who practice the fourth, fifth and higher degrees.”

If there is anything we strive for at 3-Sigma Value (besides preserving capital), it is the objective application of scenario analysis to evaluate prospective investments in terms of total expected return and risk versus reward. 

For access to the complete report, please contact us at info@3sigmavalue.com.

Second Quarter 2009

Correlations are high, the natural result of a volatile market.  Investors become more emotional as markets become more volatile, and when they’re emotional, investors tend to herd together like sheep even more so than usual.  This creates fantastic opportunities for longer-term investors who can capitalize on the predictability that follows volatility, and the tendency of investors to sell when stocks are oversold and buy when rallies are overextended.  We agree wholeheartedly that recent events have dismantled the academic theory known as efficient market hypothesis and we remain highly cognizant that valuation disparities can persist longer than our own financial wherewithal.  However, we also know it would be a comparable mistake to assume any particular disparity will persist for too much longer. 

We are not market timers.  We do not make directional bets on the market.  We do not attempt to predict, or think much about, where the S&P 500 will be at the end of the year.  All we do, and all we know, is that if we stay disciplined to our process and intellectually honest in its application then we wield an incredible edge over most market participants. 

As discussed in previous letters, our use of scenario analyses is central to quantifying the impact of various positive and negative assumptions on valuation.  Most importantly, our research effort is (and has always been) focused on the Downside Case Operating Scenario.  In other words, what can possibly go wrong?  Or, when analyzing a potential short, what is the valuation if management delivers according to plan?  By focusing our effort first on quantifying the risk, we approach sources of information – management, industry experts, analysts – with a skeptical eye aimed primarily at finding the flaws rather than merely buying the pitch.

The lack of visibility makes this a very treacherous environment for risk-taking.  We understand why anyone would want to sit in cash or gold depending on your viewpoint on inflation.  Certainly we agree that makes as much sense as simply owning stocks, attempting to “beat the market” with solid dividend payers, the Dogs of the Dow, Wisdom Tree’s fundamentally-based ETFs, or any of the other bull market products being hawked incessantly on CNBC by long-only managers parroting each other about green shoots and early cyclicals.  We at 3-Sigma Value remain convinced the key to wealth creation over the next 12 to 24 months entails a high degree of market agnosticism supported by deep, fundamental, data-driven research.  The bull versus bear argument is a red herring.  With asset classes more highly correlated than ever before and asset allocation less relevant as a result, it is structured stock picking with an alpha-generating short strategy (as opposed to simply using the short book as a hedge) that offers the most straightforward way to profit in this market.

For access to the complete report, please contact us at info@3sigmavalue.com.

First Quarter 2009

Although we remain fundamentally pessimistic regarding the macro outlook, we don’t seek to take directional bets on the overall market (we’re not economists), and as a result, our success is not dependent on either a bull or bear market.  In contrast, we are completely comfortable taking directional bets on specific industry segments (in our areas of expertise) dominated by a secular trend that is either creating or destroying value.  In fact, this is the first step in our investment process. 

For example, one theme we are focused on is the inevitable inflation created by the unprecedented monetary and fiscal stimulus being pumped into the global economy.  What makes this cycle particularly dangerous (besides the sheer magnitude of the stimuli) is the fact that significantly improved manufacturing flexibility is allowing for a more rapid and less costly shutdown of supply than ever before.  Across the commodity spectrum, from metals to energy, shifts are being reduced and plants are being mothballed while uncertainty regarding the short-term impact of stimulus spending is obscuring the market’s ability to differentiate between low-and high-cost producers. 

And therein lies the opportunity, to invest in low-cost producers that can profit from high long-term inflation rates while remaining agnostic in the short-term.  Furthermore, the global financial crisis has squashed much of the expansion capex planned by commodity producers for 2009 and 2010, as budgets have been slashed and capital equipment purchases (e.g. deepwater drilling rigs, wind turbines) are delayed or outright cancelled.  While this situation creates immediate pain for producers and servicers that have to take special charges and write-down the value of assets, longer-term it will prove to be hugely positive for those service providers with recently upgraded asset bases.

For access to the complete report, please contact us at info@3sigmavalue.com.

Fourth Quarter 2008

It is probably no surprise that all of our top 10 winners in 2008 came on the short side of the portfolio while 8 of the top 10 losers came on the long side.  Our loss in aggregate was heavily concentrated in September and driven by the historic sell-off in commodity-related stocks.  Since then, we have more adequately hedged our sector exposure and more heavily weighted in our analysis technical factors that drove the rapid and self-reinforcing manner in which these stocks plummeted. 

If 2008 has taught us anything instructive for 2009, it has dramatically broadened for us the scope of the possible and eviscerated the normative meaning of the word “unprecedented”.  Many sacred cows were led to slaughter in 2008 – the certainty that free-market capitalism is the best path to prosperity, a depersonalized notion of markets as infinitely liquid and guided by invisible, rational hands, “risk pricing” as a science, and, perhaps most poignantly, a view that market “anomalies” are quick to correct themselves. 

2008 was a year in which prevalent market assumptions at the beginning of the year (e.g., $200 oil) proved downright embarrassing by year end, both momentum and contrarian investment strategies generally performed poorly and so-called market “anomalies” persisted long enough to bankrupt investors who aggressively wagered on their correction.  The Keynsian maxim that “in the long run, we are all dead” has never been more apt.  However, we believe it would be a comparable mistake to seize on any particular anomaly (turned normality) of 2008 as certain to persist in 2009.  We find it curious that the same pundits who deemed it unthinkable that the government would allow Lehman Brothers to fail, now appear equally confident that the Treasury has learned its lesson from the Lehman bankruptcy debacle and will never allow a repeat performance.  We simply don’t know what form government intervention will (or won’t) take, whether forced asset liquidations will persist or abate or any number of other market-moving catalysts with certainty.  We take some solace in being confident that our ignorance is widely shared.   

Consequently, our chief takeaway from 2008 into 2009 is heightened agnosticism – we pursue investment theses based on assumptions we view as credible but acknowledge their uncertainty, we aim to buy “cheap” and sell “expensive” stocks but do so mindful of the reality that valuation disparities can persist for periods long enough to render their corrections pyrrhic victories.  We pay particular attention to knowing our fellow shareholders and shortsellers.  We remain cognizant that portfolio correlation to the market can change on a dime and, consequently, reduced or eliminated our exposure at year-end to positions where catalysts appear too tenuous.  In short, we undertake the same approach we took to 2008 but do so with even greater humility and caution. 

One area in which this is playing out in practice is in our effort to capitalize on the view that so-called “defensive” investments are severely mispriced in the flight to quality following 2008’s steep market declines.  While panic generally caused a mass exodus of funds out of equities in the latter half of the year, a narrow collection of industry segments have remained immune or actually benefited from this rotation and, driven by panic, our view is that the pendulum has swung too far.  Mindful, however, that market panic can persist, we focus on the even narrower collection of companies within this universe where we judge the market’s determination of acyclicality/counter-cyclicality itself to be incorrect.  If fearful investors have disregarded valuation and indiscriminately piled into these stocks because they view them as immune to the current recession, how violent is their exodus likely to be when this assumption is debunked? 

For a complete report, please contact us at info@3sigmavalue.com.

Third Quarter 2008

We remain mindful that it is precisely in environments such as the current one where the greatest opportunities for mispricing exist.  Even under scenarios where commodity prices fall well-below their marginal cost of production and henceforth are unsustainable, many of the bluest-chip companies in the world with solid balance sheets and no external financing requirements trade at the same relative valuation levels of their more leveraged brethren.  The babies are being thrown out with the bathwater.  And while it is likely that many high cost, and heavily geared producers will be forced to go bankrupt in a scenario characterized by a multi-year global recession (our base case assumption), there are producers operating on the lower end of the cost curve with the financial wherewithal to survive even in our downside case – an extended credit crisis leading to a second great depression (GD2). 

In short, we agree with Warren Buffet who recently reiterated his famous axiom in a Wall Street Journal op-ed, “Be fearful when others are greedy and greedy when others are fearful.”  This is precisely why we’ve remained relatively fully invested.  Asset mispricing has never been more widespread. 

More than at any point in the recent history of the stock market, technical factors are overwhelming fundamentals, resulting in (i) extreme levels of volatility and (ii) a market largely disconnected from traditional valuation metrics such as discounted cash flow analysis (even using Depression-level assumptions).  Today, it is easy to find solid, cash-flow generating companies without any external financing requirements trading at low-to-mid single digit P/Es (based on consensus earnings over the next twelve months).  Either nobody believes these estimates or nobody cares.  Most likely, it’s a combination of the two.

Over the past 20 months since inception 3-Sigma Value has delivered positive returns during an extraordinarily difficult time.  And while the global credit crisis will continue to penalize overleveraged balance sheets and companies dependent on external sources of financing, the share price of many solid companies are suffering disproportionately, already pricing in a second great depression.  The stage is set for a prolonged bear market – one in which hedged strategies focused on individual security selection, once again, will distinguish themselves.

For aceess to the complete report, please contact us at info@3sigmavalue.com.

Second Quarter 2008

As long-short investors focused on delivering positive returns on your investment regardless of market conditions, we are heavily focused on managing the portfolio’s correlation to the overall equity markets (or “beta”).  In fact, we are more concerned with correlation than volatility because volatility is the natural result of any deep-value investment strategy, and therefore we accept a certain level of shorter-term volatility that is only “risky” to emotionally driven or illiquid market participants when it guides their buy/sell decision-making.

Managing the beta of a value-driven equity portfolio, in any market climate, is an inherently tricky undertaking.  Much like the disclosure maxim that “past performance is no guarantee of future results”, the historical correlation of portfolio returns with market returns is only valid to the extent future performance and perception of risk remains consistent with the recent past. 

As value investors frequently targeting companies facing rapidly changing operating performance and/or market perceptions, this continuity between the past and future is tenuous at best.  Notwithstanding this caveat, we generally seek to maintain a portfolio beta (derived from a weighted-average of historical betas of the individual securities in the portfolio) of between negative 25% and positive 25%.

Because our efforts are focused on identifying and exploiting a very scarce set of truly egregious valuation discrepancies rather than a broader set of more common (and muted) ones, we believe it inherently produces weaker long-term market correlation for two reasons.  First, the “correction” of such mispricing upon catalyzing events generally occurs irrespectively of the strength of the market – i.e. a company that is 50% or more undervalued will not remain so even in a weak market. 

Second, the downside protection we demand in the context of our risk/reward criteria is generally provided in the form of either strong asset coverage, durable earnings power or both.  Currently, while the positions in our short book share these attributes, many of them target industries facing weak macro fundamentals and, therefore, tend toward higher market correlation than those in our long book.

Consequently, although the net investment exposure of the 3-Sigma Value portfolio averaged 15.7% over the first six months of 2008, its live correlation to market returns was negative 19.3%.  Because the portfolio is constantly evolving, driven by industry and company fundamentals, we generally focus on beta using three months of trailing data to identify market risk inherent in the portfolio.  Using this methodology, beta was negative 21.6%.  Using data since the inception of the Partnership, the correlation of daily returns generated by the 3-Sigma Value portfolio versus the S&P 500 was positive 2.7%.    

Beta (vs. S&P 500)

Trailing 3 months = -21.6%

YTD 2008 = -19.3%

Since Inception = 2.7%

In short, the returns generated by the 3-Sigma Value portfolio, as a whole, are uncorrelated, and consistent with our goal of delivering absolute performance regardless of market conditions.

For access to the complete report, please contact us at info@3sigmavalue.com.

First Quarter 2008

As value investors driven by industry and company fundamentals, we consider risk to be the probability that portfolio investments fail to deliver anticipated returns over our investment horizon (generally 1-3 years).  As such, we do accept a certain level of shorter-term volatility that is only “risky” to emotionally-driven or illiquid market participants when it guides their buy/sell decision making.  We are not active traders but long-term investors; however, a significant share of our alpha generation derives precisely from being able to exploit this short-term volatility through trading around our long-term deep value holdings.  Moreover, we have come to understand that in a market as volatile as this one it pays to tighten up the rules with regards to the realization of profits and losses.    

Although the net exposure of the 3-Sigma Value portfolio averaged 20.2% over the first 4 months of 2008, its correlation to market returns (i.e. beta) was actually slightly negative.  The portfolio’s beta has ranged between negative 10 and 20%, reflecting short positions in consumer-related and other cyclical companies that more than offset the moderate amount of beta found in our long investments.  In other words, the returns generated by this portfolio are relatively uncorrelated, and consistent with our goal of delivering absolute performance regardless of market conditions.

For access to the complete report, please contact us at info@3sigmavalue.com.

Fourth Quarter 2007

In the fourth quarter, we capitalized on the market’s failure to adequately discount accelerating weakness in consumer spending, especially as it related to the holiday shopping season, and the likelihood of recession in 2008.  3-Sigma Value is short 26 companies that are highly correlated to U.S. consumer discretionary spending.  Of theses 26 names, 6 represent core short positions, defined as an allocation greater than 2% (no individual short represents more than 5% of the portfolio).  In total, as of 12/31/07, gross short exposure to this theme was 38.9%.

For access to the complete report, please contact us at info@3sigmavalue.com.

Third Quarter 2007

We remain more convinced than ever that a deceleration (or decline) in consumer spending will be one of the dominant features of the U.S. economy going into 2008.  Current market sentiment appears eerily familiar to the cognitive dissonance that preceded the brunt of the dot com implosion in 2001 – early indicators of weakness written off as isolated events, compelling metrics that a decline is inevitable, and generalized indecision intermediating between short-term momentum and long-term inevitability.  Short and longer-term drivers of such a decline in consumer spending are self-evident, including: (1) dwindling availability of consumer and mortgage credit that has fueled much of the spending to date, (2) declines in paper wealth driven by declining housing prices, (3) a weak dollar making imports more expensive, and (4) rampant inflation in food staples, basic materials, and energy not experienced since the 1970s.  Moreover, these factors impacting the consumer are doing so at a time when s/he is more stretched than at any time in recent history. 

Federal Reserve estimates of household fixed obligations-to-income are at the highest levels since 1980 (when data collection began).  A recent McKinsey study of baby boomers estimated that less than 18% have saved “adequately” for retirement (i.e., able to maintain retirement-adjusted consumption).  In short, discretionary income will continue to be unavoidably squeezed between the fallout from the housing bubble and inflation in consumer staples. 

For access to the complete report, please contact us at info@3sigmavalue.com.

Second Quarter 2007

With bank loan and public debt markets becoming more skeptical of highly-levered deals and interest rates increasing across credit classes, managers across industry must adjust to a higher cost of capital.  Similarly, the Bear Stearns’ High Grade Structured Credit Fund bailout in June exposed a layer of systemic risk that until recently has gone largely ignored.  That is, the mark-to-market risk of illiquid, over-the-counter securities in the credit derivatives markets, many of which are backed by assets vulnerable to the persistence and breadth of defaults in residential housing.  In short, it appears the markets have been undervaluing risk.

For access to the complete report, please contact us at info@3sigmavalue.com.

First Quarter 2007

In the past quarter, investors had to digest a host of issues, including a meltdown in the sub-prime mortgage market that in all likelihood will impact the overall availability of credit as spreads widen on CDOs and other riskier types of debt.  On top of the continuing problems in residential real estate, China, seeking to crack down on what it considers excess speculative activity, in late February warned banks about improper loans to finance stock speculation triggering an emerging market sell-off that has largely reversed but nevertheless refocused attention on the low levels of global risk premiums.  In short, after two relatively peaceful years, volatility appears to have returned, leading to a dispersion of returns that favors disciplined stock pickers.

For access to the complete report, please contact us at info@3sigmavalue.com.