The whole idea of using taxpayer money at the Treasury to stabilize the economy and arrest the collateral economic damage which wall street has wrought on main street is either naïve or sinister. Naïve if Paulson and congress really thought this was the most efficient and effective way to restore liquidity and viability to the banking system and thus circumvent unnecessary business failures. But sinister if Wall Street intentionally conned congress into buying an economic Armageddon (by the time the Asian markets opened if we didn’t do this) scenario so they could effectively rob the Treasury.
Although they would never admit it publicly, you have to believe that these bank CEOs were smart enough to understand that they had screwed up the risk management and leverage to a point where they were in no position to use the lion’s share of the cash they received from Treasury to make loans. Surely they knew that this capital would be used to plug holes in severely over levered balance sheets and make good on some counterparty claims rather than make new loans in a stimulative fashion or renew revolving credit to creditworthy and current borrowers reliant on bank lines to run their businesses effectively.
Most of the $80B that AIG took went to counterparties like Goldman Sachs, UBS and Merrill Lynch and statutory capital requirements that should have been met all along. And most of the rest of the TARP money has effectively gone to bail out bond investors which made bad investments in over levered financials. Recall that in most of these instances, even though equity holders can slammed (and rightfully so), bondholders got taxpayer financed guarantees. Where are the anti-socialist free marketeers when you need them?
The reason banks haven’t loaned the TARP monies as expected is simple as I understand it: when you are way over levered and under provisioned and credit losses are surging, as your revenues are collapsing, you have to shrink your balance sheet asap or risk having the little tangible equity capital disappear as a result of additional charge offs. The problem with that is that shrinking your balance sheet is inconsistent with extending incremental credit. The math is in some ways simple and in other ways complicated. Simple because a bank levered 30 to 1 has little room for error before their capital is wiped out to an extent where solvency becomes an issue. But complicated due to a lack of transparency where assets had to be marked incorrectly, which distorted book values dramatically. Either way, the balance sheet got way too big, the assets way too risky and the transparency way too murky.
So the net of it is that most of our largest banks are in no position to lend more or take more risk; and the economic ramifications of what’s happened now make virtually all lending more risky. This should be clear as despite huge capital injections, banks struggle to meet regulatory capital requirements. And if meeting regulatory capital requirements are a priority, then how do you expect that capital to get translated into credit or investment that might mitigate the economic meltdown underway. So what to do now? More of the same? I don’t think so. We must do much better.
I understand that if the banks could shed some of the garbage assets they have on their books at above market prices then they would be in better shape to lend and I understand that given the lack of transparency and a most uncertain and dire economic outlook, that serious bids from the private sector are largely absent. So I understand the temptation to rationalize taxpayer financed welfare for the banking dregs amongst us; especially when you consider the audacity of these bank managements in the first place. This is not the best way to underwrite the costs of fixing our credit market problems, and its not the best way to get liquidity to the many solvent companies that need it to maintain employment and consumption (by both consumers and businesses. We truly need more novel approaches, so I thought I’d mention a few that I’ve thought of.
Now I’m not as smart as Paulson, Bernanke and Geithner so forgive me if this sounds a bit crazy or technically unfeasible. Although I’m not an expert here, I do have a cursory understanding of how the business and the economy works so here goes. You can always do conservatorship coupled with direct lending (which as far as the goal of increased lending is concerned seems to be a better option than TARP as its been administered to date). But I think present circumstances call for a more creative approach and probably more than one.
Why not have government employed securitization experts repackage some of the less than most toxic assets and couple them with a European style put option (written by the Treasury) which exercises a couple of years out. Or I guess it could be American style by application if necessary. Encouraging a longer term holder here would seem preferable so I think it makes sense to structure and incentivize accordingly. A sort of structured product priced to offer a chance to make a better than average return for a nominal but quantifiable risk and only make this available to banks that were responsible enough not to over leverage themselves in the first place. You could also incentivize and subsidize banks that put assets into such vehicles such that making new loans with their refunding was an attractive economic option.
Why not have the Treasury and/or Fed also subsidize restructuring and refinancing of mortgages such that the Treasury and the creditor share a principal reduction while the terms are extended a number of years AND a newly formed government agency funded by TARP money also subsidizes the mortgage rate for homeowners with cash flow sufficient to finance their primary residence if only the terms were better. Make it a needs based program with stiff penalties for fraud to prevent abuse. This would not only help lenders with more cash flow and less credit losses but also stabilize home values and residential mortgage backed securities valuations – which would buy extension lift the value of assets on bank balance sheet and their book values and thus not only lift capital ratios (which ultimately improve a bank’s lending capacity) but also make it easier and cheaper to raise additional capital from the private sector.
I thought this might be necessary a year ago and I’m shocked that it hasn’t been seriously considered. The reason it hasn’t is due to political ideology related to contract law. What’s crazy is you could have made this voluntary – some smart banks would do it and others would follow if/when it proved successful. The charges wouldn’t be as great because the treasury or fed would take half the hit so the bank’s book value, capital ratios etc. would be impacted substantially less, and the banks liquidity position would be better than otherwise the case. Loan to value ratios would also improve so credit worth would improve. And the incentive to not walk away would thus also be strengthened. The irony is that by not doing something like this the damage to creditors has been magnitudes worse as cash flow has disappeared and collateral values pummeled. It’s also ironic that the only way a bank would be otherwise worse off is if borrowers became healthier quickly and/or home values surged – both high class problems in comparison.
Another option I thought of was allowing substantial holders of U.S. Treasuries to swap Treasuries at bubble like valuations for bank asset pools with puts attached that would again limit losses in return for a chance of a reasonable return commensurate with the risk that would be realized if the buyer would have to exercise their put option. This too should not be structured in a risk free way but some risk would be necessary AND this risk could also be collared in a way that the Treasury would realize upside beyond some predetermined level in the event that the structured product performed exceptionally well. This would free up capital banks could lend and transfer some re-priced risks to foreign central banks with stronger balance sheets.
All of these things can be done with more direct government lending. The direct government lending should be underwritten sensibly (such that the taxpayer cost is minimizes yet borrower capacity to remain current maximized. And any such direct government lending could be done in a way that minimizes potential competitive damage to private sector lending by allowing banks to either participate in syndication or by subsidizing the loans to some degree so that the private sector can take down such loans at say a percentage point above where the government would do it and that extra percent would be paid by the government. This would incentivize the private sector to lend more because they would get better than market terms. In instances no private sector offers came to the market, the government would do the lending. Thus more lending would occur and it would get done on better terms with or without private sector participation.
Subsidies should not be permanent -they should remain in effect only for such time as necessary to restore the banking system. Congress could set up an agency to administer this for say a 2 year period and it could be renewed if necessary. And discretion should be paramount – although increased lending is necessary the last thing we need is more “unintended consequences”. Underwriters should be compensated and incentivzed accordingly – with back end bonuses to the extent that they increase lending and the loans perform such that cost to taxpayers is minimized. One way or another we need to try to stabilize home values, support solvent businesses with credit and create jobs. Drastic times call for drastic measures; but the more creative the measures then less drastic they might be. We must do better than we’ve done thus far or we’ll face a depressed lost decade.
Thursday, January 22, 2009
Tuesday, January 20, 2009
The Ultimate Game Changer: Why 2009 Will Be Worse Than 2008 (Part 2)
I don’t want to belabor the point but wanted to stress the fact that credit, saving spending and investment will be changed for a generation. People will be forced to save more to buy stuff they could previously buy with little or no money down and low interest. Frugality will be a way of life, not just in consumer sector, but also in the business and government sector. And the government (federal that is) can not create enough jobs to mitigate the economic pain in any meaningful way b/c the private sector is likely to cut another 6 million jobs this year and state and local governments will cut more than the federal level is apt to create. I can’t see how and when consumers and businesses will be willing AND ABLE to spend more. Generation X & Y have pulled forward a lifetime of sales. Many hundreds of billions of dollars worth of stuff bought on credit in the last few years would have been bought in the period ahead if folks had to save for it. Instead, consumers and businesses alike have to retrench in order to pay overwhelming debt service burdens. And one man’s spending is another man’s revenue; and so it goes, the multiplier effect in reverse. These dynamics don’t change overnight.
And to the extent that you buy into the bull crap (pun intended) spoon fed to you by CNBC pundits employed by fees on your assets your net worth and quality of life will suffer for it. Understand that the Abby Joseph Cohen’s of the world will never implore you to take your money out of the Goldman Sach’s of the world because it means they get paid less or fired altogether. It’s not good business as they say; but if you ask me its bad business. Strategists putting a 1100 and 1200 targets on the S&P500 as 2009 started was flat out irresponsible at minimum and probably disingenuous as well. I say that because not only are they clueless about what the earnings on the S&P500 might have been if the constituents remained the same; but many names are being changed to protect the guilty as they say, so what does it mean to the market that the new constituents earn whatever. If I recall correctly, they mentioned $53-$55 in EPS this year (which interestingly was at the low end of the street) and $60 next but many of the top market caps have will have been replaced with companies with better balance sheets and earnings. Who in their right mind would take a skewed sample and put a high teen multiple on it and say that’s what they honestly expect. I’ll tell you who – its people with a vested interest in you not allocating capital away from equities.But that’s exactly what you ought to do.
Another reason why I doubt equities can snap back a lot anytime soon is because I can’t recall a time when equities have gotten pummeled to the extent they have and other assets are as attractive as they are. Investors that lost 50-60% in what was supposed to nimble “HEDGE” Funds (which didn’t hedge well) are going to be done with them in many cases and shift money back into the mutual funds (which have much less leverage) which never lost that kind of money for them. They will also buy debt securities, corporate bonds, munis, converts and real estate among other things. Sure there’s a lot of money that will come out of treasuries but it aint going into equities to the extent that it has historically. And that money on the sidelines is not all going back into the market either. Much of it will go to redemptions and other asset classes – I doubt many will underweight cash as much as they had in the past, regardless of what yields are.
As the market rallied a couple of weeks ago, I was shocked to see how many were sucked into the idea that the worst was over. Well educated money managers bought into the company line.
Many remain in a state of disbelief and think it can’t get much worse now. They think “I can’t sell now, it’s too late”. Wrong again, uncertainty has never been greater, our financial system is melting down and the meltdown is creating massive collateral damage. Otherwise good companies are seeing credit issues impair their operations; which are already under duress on the demand side. As corporate profits slide and the outlook for growth deteriorates so too will equity valuations. Earnings and Multiples will remain under pressure and equities will decline – if you don’t reallocate out of a long only overweight equities portfolio, the market will do it for you.
So the decline is apt to be more protracted than most think and the downside will be such that the comps can’t be easy enough. Retailers are a good example of this – things got bad retailers almost 2 years ago, they’ve been up against what should have been easy comps but still comping the high teens NEGATIVE for many. Sure we may be approaching a point where its hard to get MUCH worse (much being the key) but I think the disconnect here is that everyone is assuming that things bounce back as they did in past cycles when consumer balance sheets weren’t decimated and banks were healthy and lending. Generation X & Y have pulled forward a lifetime of sales (which would have gone to sales in the period ahead and would have been more money with interest instead of deficits and unmanageable debt service burdens. One consumer’s/business’ spending is another consumer’s/business’ revenue and the multiplier effect you heard about in econ 101 (when the butcher buys baked goods and the baker then buy candles etc.) works in reverse. That’s how a mild recession turns into a really bad one – the butcher and the baker cut back the spending and employment and the candlestick maker goes out of business.
My point in all of this is not to be doom and gloom for doom and gloom sake – I’m not trying to be Marc Faber or Jim Rogers talking my book on Bloomberg or CNBC. I’m saying all this to impress upon you how important it is to worry more about containing he risk in your portfolio than missing out on a rally that has a very low chance of happening in the first place. That Goldman Sach’s S&P500 target is now almost 45% away and the hurt is palpable. It’s not too late to reduce exposure to equities and increase exposure to cash, and high quality/much less risky debt. That doesn’t mean you shouldn’t hold equities at all, it means to hold less. Avoid the temptation to bottom-fish banks, brokers, cyclicals, industrials, transports, materials, techs and other relatively high beta, economically sensitive sectors and instead focus on well managed, well financed less cyclical names likely to survive this hell of a cycle. I think a names like DE and NUE are still good shorts. And am likely to put FSLR on short as well. I’ll be back to you soon with more names both short and long. But first I’ll tell you why I think TARP is a joke and I’ll suggest what I think is a much better way to stabilize the financial system in a much more cost effective way.
And to the extent that you buy into the bull crap (pun intended) spoon fed to you by CNBC pundits employed by fees on your assets your net worth and quality of life will suffer for it. Understand that the Abby Joseph Cohen’s of the world will never implore you to take your money out of the Goldman Sach’s of the world because it means they get paid less or fired altogether. It’s not good business as they say; but if you ask me its bad business. Strategists putting a 1100 and 1200 targets on the S&P500 as 2009 started was flat out irresponsible at minimum and probably disingenuous as well. I say that because not only are they clueless about what the earnings on the S&P500 might have been if the constituents remained the same; but many names are being changed to protect the guilty as they say, so what does it mean to the market that the new constituents earn whatever. If I recall correctly, they mentioned $53-$55 in EPS this year (which interestingly was at the low end of the street) and $60 next but many of the top market caps have will have been replaced with companies with better balance sheets and earnings. Who in their right mind would take a skewed sample and put a high teen multiple on it and say that’s what they honestly expect. I’ll tell you who – its people with a vested interest in you not allocating capital away from equities.But that’s exactly what you ought to do.
Another reason why I doubt equities can snap back a lot anytime soon is because I can’t recall a time when equities have gotten pummeled to the extent they have and other assets are as attractive as they are. Investors that lost 50-60% in what was supposed to nimble “HEDGE” Funds (which didn’t hedge well) are going to be done with them in many cases and shift money back into the mutual funds (which have much less leverage) which never lost that kind of money for them. They will also buy debt securities, corporate bonds, munis, converts and real estate among other things. Sure there’s a lot of money that will come out of treasuries but it aint going into equities to the extent that it has historically. And that money on the sidelines is not all going back into the market either. Much of it will go to redemptions and other asset classes – I doubt many will underweight cash as much as they had in the past, regardless of what yields are.
As the market rallied a couple of weeks ago, I was shocked to see how many were sucked into the idea that the worst was over. Well educated money managers bought into the company line.
Many remain in a state of disbelief and think it can’t get much worse now. They think “I can’t sell now, it’s too late”. Wrong again, uncertainty has never been greater, our financial system is melting down and the meltdown is creating massive collateral damage. Otherwise good companies are seeing credit issues impair their operations; which are already under duress on the demand side. As corporate profits slide and the outlook for growth deteriorates so too will equity valuations. Earnings and Multiples will remain under pressure and equities will decline – if you don’t reallocate out of a long only overweight equities portfolio, the market will do it for you.
So the decline is apt to be more protracted than most think and the downside will be such that the comps can’t be easy enough. Retailers are a good example of this – things got bad retailers almost 2 years ago, they’ve been up against what should have been easy comps but still comping the high teens NEGATIVE for many. Sure we may be approaching a point where its hard to get MUCH worse (much being the key) but I think the disconnect here is that everyone is assuming that things bounce back as they did in past cycles when consumer balance sheets weren’t decimated and banks were healthy and lending. Generation X & Y have pulled forward a lifetime of sales (which would have gone to sales in the period ahead and would have been more money with interest instead of deficits and unmanageable debt service burdens. One consumer’s/business’ spending is another consumer’s/business’ revenue and the multiplier effect you heard about in econ 101 (when the butcher buys baked goods and the baker then buy candles etc.) works in reverse. That’s how a mild recession turns into a really bad one – the butcher and the baker cut back the spending and employment and the candlestick maker goes out of business.
My point in all of this is not to be doom and gloom for doom and gloom sake – I’m not trying to be Marc Faber or Jim Rogers talking my book on Bloomberg or CNBC. I’m saying all this to impress upon you how important it is to worry more about containing he risk in your portfolio than missing out on a rally that has a very low chance of happening in the first place. That Goldman Sach’s S&P500 target is now almost 45% away and the hurt is palpable. It’s not too late to reduce exposure to equities and increase exposure to cash, and high quality/much less risky debt. That doesn’t mean you shouldn’t hold equities at all, it means to hold less. Avoid the temptation to bottom-fish banks, brokers, cyclicals, industrials, transports, materials, techs and other relatively high beta, economically sensitive sectors and instead focus on well managed, well financed less cyclical names likely to survive this hell of a cycle. I think a names like DE and NUE are still good shorts. And am likely to put FSLR on short as well. I’ll be back to you soon with more names both short and long. But first I’ll tell you why I think TARP is a joke and I’ll suggest what I think is a much better way to stabilize the financial system in a much more cost effective way.
Monday, January 12, 2009
The "60 Minutes" story on oil speculation was spot on - facts, not shabby conjecture
Everyone seems to be bashing the 60 minutes story about speculation causing oil to surge to $147. After reading the articles published at SeekingAlpha.com I felt compelled to see how bad this segment was, so I went to the 60 minutes website to take a look see. I expected to see a chop job; but what I saw was an excellent laymen's explanation of how speculators and investors with fiduciary duties turned speculator contributed to a bubble which helped send billions of Americans hard earned money to Saudis, Iranians, Venezuelans and others who laughed all the way to the bank. These CBS bashers either have no idea how energy markets work or are spinning the truth because they have an axe to grind with CBS. It's a shame because for people that have a cursory interest, these clowns just effectively made a very enlightening report questionable to those honestly uninformed who would like to understand the issue better. And all they say to support their position is that the EIA has a graph that sort of makes it look like price tracks demand very closely. The truth is EIA estimates change with the wind - if your memory is that short you too should check the record. The EIA makes intermediate and long term energy supply and demand estimates that are awful - they failed to anticipate the CYCLICAL market tightness and failed to anticipate the cyclical downswing.
One of the first lines in the report asserted that the oil price spike was not caused by oil company CEOs or sheiks but speculators and other so called institutional investors like Hedge Funds (like Citadel, Amaranth and Ospraie), Commodity Traders in Chicago and Europe, Morgan Stanley, Goldman Sachs, J.P. Morgan, Barclays, Sovereign Wealth Funds, Yale, Harvard, as well as, Pension Funds like CALPERS and others. That this is debatable is crazy. It is a FACT that these entities entered the oil market in a big way during the bull market in oil. The story asserted that over a 5 year period the amount of energy futures traded went from $13B to $300B - this too is a fact. It is a fact that Enron lobbied aggressively for changing the rules so they could control the market more and got what they wanted. It is a fact that Morgan Stanley owns more pipeline, storage, production and refined product than most oil & gas companies; this wasn't the case in past cycles.
You don't have to be a forensic scientist to understand they did it because the asset class was going up for a long time. You can delude yourself with rationalizations if you please but this is no different than what pension funds did when they doubled and tripled their allocations to unseasoned and excessively leveraged "alternative investment" strategies. Yale did it first and looked like genius, everyone else felt either inadequate or couldn't deal with missing out. It really is that simple. Allocations to commodities increased because they did well for a long time. MBAs, CFAs and Quants everywhere fabricated a few correlations graphs and an articulate pitch and presto the blind followed the blind.
The story mentioned that there is very little physical demand in the futures market relative to the total and by far more than there has ever been. This too is a fact, bearish oil analysts which had seen a cycle before pointed this out many times. Sell side wall street analysts talked about this in research reports, Barrons did stories about it, analysts from Sanford Bernstein, Oppenheimer and ISI pointed this out at congressional hearings on the subject. A J.P. Morgan official denied speculation played any part at the same hearing, claiming it was pure supply and demand while another JPM strategist spoke about speculation taking over the energy markets in an email the same day. 60 minutes had the email and showed it. It was obvious to anyone who bothered to check. The 60 minutes story asserted that there were 27 barrels worth of futures contracts traded for every barrel of physical demand and a fraction of those ever took delivery. This too is a FACT - "60-70% of the futures contracts which were (as the story indicated) initially created to help users hedge were held by either small or large specs - I.e. CTAs, hedge funds commodity day traders. You can look at commercials as a percentage of open interest and see how bullishly involved speculators were. Not unlike the real estate market, easy money (institutions that could borrow easily and lever themselves up 20 to 1) and a market that never seemed to go down sucked the suckers in and they got what they deserved.
People told me I was crazy when I told them that demand destruction was already taking hold and the economy was already slowing so it was a matter of time till oil collapsed. I looked like an idiot as I told my friends that I thought we'd fizzle a little past par; figuring that oil would look like it lost momentum near $100, suck some premature shorts in and then proceed to spank us on a move to $110. So I got cute and shorted some black gold at $109 and covered at $117. I got lucky there as I should have also known that we'd go parabolic before the collapse. I could have easily got smoked. But that's another story. $25/bbl increase in a day on NO significant news? $10 moves in each direction? That's not the sort of volatility you see in the middle of moves but rather at tops and bottoms of speculative exhaustion. It seems to always happen that way. Markets that go parabolic are almost always driven by speculation. Permanent supply and demand shocks are rare.
My message is that if it looks like a duck, quacks like a duck and acts like a duck, don't let some clown who cant or wont deal with the facts tell you different. If you didn't watch the story, go see it for yourself. If we were running out of oil or couldn't produce enough to meet demand, you would see the kind of lines and rationing we saw in the 70s. Anyone who was around back then recalls what shortages look like - people waiting for an hour or more in line at gas stations and couldn't even fill up. To even suggest it was all supply and demand is laughable. The crash is proof in and of itself - markets driven by fundamentals do better to sustain price advances.
Nothing in the 60 minutes story was news to anyone with a clue. I'm really shocked at how it came across and appalled at how some "professional money managers" writing here spun it - super weak arguments that by and large missed the point. So I felt compelled to try to set the record straight so others less versed wouldn't get bamboozled. The fact is that no one really knows when the world will run out of oil. Many factors influence energy prices over the long run, including production costs, the dollar, supply, demand and competition from alternatives, etc. But bubbles are usually borne of cyclical (and ALWAYS temporary) supply/demand imbalances exacerbated by analysts and pundits who con otherwise unsuspecting investors and traders with new paradigm type stories. There's a saying in the commodity markets that goes "price cures price", in other words, high prices are the cure for high prices. This has been and always will be true because of the economic sensitivity of commodities and the ability of commodity producers to always race to make hay while the sun shines. OPEC didn't cut production while prices surged. The laws of supply and demand are called laws for good reason.
One of the first lines in the report asserted that the oil price spike was not caused by oil company CEOs or sheiks but speculators and other so called institutional investors like Hedge Funds (like Citadel, Amaranth and Ospraie), Commodity Traders in Chicago and Europe, Morgan Stanley, Goldman Sachs, J.P. Morgan, Barclays, Sovereign Wealth Funds, Yale, Harvard, as well as, Pension Funds like CALPERS and others. That this is debatable is crazy. It is a FACT that these entities entered the oil market in a big way during the bull market in oil. The story asserted that over a 5 year period the amount of energy futures traded went from $13B to $300B - this too is a fact. It is a fact that Enron lobbied aggressively for changing the rules so they could control the market more and got what they wanted. It is a fact that Morgan Stanley owns more pipeline, storage, production and refined product than most oil & gas companies; this wasn't the case in past cycles.
You don't have to be a forensic scientist to understand they did it because the asset class was going up for a long time. You can delude yourself with rationalizations if you please but this is no different than what pension funds did when they doubled and tripled their allocations to unseasoned and excessively leveraged "alternative investment" strategies. Yale did it first and looked like genius, everyone else felt either inadequate or couldn't deal with missing out. It really is that simple. Allocations to commodities increased because they did well for a long time. MBAs, CFAs and Quants everywhere fabricated a few correlations graphs and an articulate pitch and presto the blind followed the blind.
The story mentioned that there is very little physical demand in the futures market relative to the total and by far more than there has ever been. This too is a fact, bearish oil analysts which had seen a cycle before pointed this out many times. Sell side wall street analysts talked about this in research reports, Barrons did stories about it, analysts from Sanford Bernstein, Oppenheimer and ISI pointed this out at congressional hearings on the subject. A J.P. Morgan official denied speculation played any part at the same hearing, claiming it was pure supply and demand while another JPM strategist spoke about speculation taking over the energy markets in an email the same day. 60 minutes had the email and showed it. It was obvious to anyone who bothered to check. The 60 minutes story asserted that there were 27 barrels worth of futures contracts traded for every barrel of physical demand and a fraction of those ever took delivery. This too is a FACT - "60-70% of the futures contracts which were (as the story indicated) initially created to help users hedge were held by either small or large specs - I.e. CTAs, hedge funds commodity day traders. You can look at commercials as a percentage of open interest and see how bullishly involved speculators were. Not unlike the real estate market, easy money (institutions that could borrow easily and lever themselves up 20 to 1) and a market that never seemed to go down sucked the suckers in and they got what they deserved.
People told me I was crazy when I told them that demand destruction was already taking hold and the economy was already slowing so it was a matter of time till oil collapsed. I looked like an idiot as I told my friends that I thought we'd fizzle a little past par; figuring that oil would look like it lost momentum near $100, suck some premature shorts in and then proceed to spank us on a move to $110. So I got cute and shorted some black gold at $109 and covered at $117. I got lucky there as I should have also known that we'd go parabolic before the collapse. I could have easily got smoked. But that's another story. $25/bbl increase in a day on NO significant news? $10 moves in each direction? That's not the sort of volatility you see in the middle of moves but rather at tops and bottoms of speculative exhaustion. It seems to always happen that way. Markets that go parabolic are almost always driven by speculation. Permanent supply and demand shocks are rare.
My message is that if it looks like a duck, quacks like a duck and acts like a duck, don't let some clown who cant or wont deal with the facts tell you different. If you didn't watch the story, go see it for yourself. If we were running out of oil or couldn't produce enough to meet demand, you would see the kind of lines and rationing we saw in the 70s. Anyone who was around back then recalls what shortages look like - people waiting for an hour or more in line at gas stations and couldn't even fill up. To even suggest it was all supply and demand is laughable. The crash is proof in and of itself - markets driven by fundamentals do better to sustain price advances.
Nothing in the 60 minutes story was news to anyone with a clue. I'm really shocked at how it came across and appalled at how some "professional money managers" writing here spun it - super weak arguments that by and large missed the point. So I felt compelled to try to set the record straight so others less versed wouldn't get bamboozled. The fact is that no one really knows when the world will run out of oil. Many factors influence energy prices over the long run, including production costs, the dollar, supply, demand and competition from alternatives, etc. But bubbles are usually borne of cyclical (and ALWAYS temporary) supply/demand imbalances exacerbated by analysts and pundits who con otherwise unsuspecting investors and traders with new paradigm type stories. There's a saying in the commodity markets that goes "price cures price", in other words, high prices are the cure for high prices. This has been and always will be true because of the economic sensitivity of commodities and the ability of commodity producers to always race to make hay while the sun shines. OPEC didn't cut production while prices surged. The laws of supply and demand are called laws for good reason.
Wednesday, January 7, 2009
The ultimate game changer – why 2009 will be worse than 2008 (part 1)
In the last 2 weeks it seems that the bulls are coming out of the woodwork. Don’t get sucked into the idea that you should chase this rally! What may appear to be a light at the end of the tunnel is probably a train. No one seems to have a good idea of what earnings might be, yet all of a sudden, bullishness abounds. Very well managed companies are guiding down multiple times early in a quarter, with no improvement in sight, yet the fast money crowd doesn’t seem worried.
I’ve watched the credit bubble popping events unfold in the context of a volatile history. I’m cognizant of the fact that is has never paid to stay very bearish for long as America is a remarkably resilient nation – we’ve overcome Herculean challenges like the depression and WW1 and Korea and Vietnam and oil embargoes and gulf wars and internet bubbles and more. However, none of these challenges compare to what decimation this credit bubble popping has wrought.
I view the stock market game as a probabilistic field of sorts. We effectively consider what’s known and unknown and try to estimate the expectancy of the potential outcomes with our incomplete information. Looking at what’s happening economically is scary – the pace and magnitude of decline in economic activity and leading indicators has been historic.
Perhaps an arguably crude analogy can put this in the proper light. The first analogy I could think of is the initial phase of hurricane Katrina. Strong winds struck and rattled a lot but the damage appeared to be well contained and surmountable initially. It wasn’t until the insurance in the form of a levy failed that we realized that we were in a heap of trouble and needed to do something about a potential catastrophe turning probable, however, we had no reference point to help us understand the magnitude and the duration of the destruction and its painful aftermath.
Today the big question revolves around how bad earnings will get and what the nature and timing of a recovery might be so we can decide whether the market is cheap or expensive relative to such a base case scenario so we know how aggressive we should be and how much market risk we should take on. The idea being that if we reasonably estimate/approximate what the next 12 months earnings yield and longer term growth rate might be, we can also craft reasonable expectations of what the central tendency of stock prices might be in the year or two ahead.
What’s more is that none of the bulls seem to have a clue as to how and when the personal incomes and corporate earnings (which I assume would support a sustainable stock market recovery) is likely to manifest. And it also seems as if everyone is expecting that multiples should be similar to what we’ve experienced in recent history, despite the glaring fact that the game has changed such that when the growth needle moves noticeably it wont be very significant unless we start from lower bases still.
In prior bear markets and recessions, much damage was done but the lifeblood of markets, (ie. Liquidity and credit) remained in tact. Credit markets remained functional and countercyclical monetary and fiscal policy acted upon the supply side and demand sides of the economy and helped get the cogs of capitalism turning again. Textbook Keynesian dynamics – when consumers and the private sector lack the will or ability to spend, Uncle Sam increases everyone’s allowance and the Fed makes financing your spending easier and cheaper.
Meanwhile, the banking system facilitates stability and an eventual recovery as enterprising Americans take advantage of apparently depressed asset prices, goods and services prices, labor prices and capital prices. That, more or less, is how the cycle plays out and a new growth cycle is born in the ashes of the last bust. The key here is that the banking system is willing and able to facilitate commerce and inject the lifeblood of the economic growth to markets. It’s not only about keeping otherwise viable businesses solvent with the help of credit; but also sowing the seeds of economic expansion which yields jobs, income, wealth creation, and improved asset prices.
The credit bubble that has popped changes the game more than most appreciate. Many think it is a matter of time that things return to whatever normal they thought was in the markets but I’m afraid that is more than a tad presumptuous. Our economy is in a literal downward spiral and the conventional countercyclical remedies are either impotent or insufficient to mitigate the seemingly exponential headwinds because the banking system has become dysfunctional and permanently impaired. Life as we knew it is over because the real pie is actually much smaller than anyone thought and it will not grow like it did in the past because credit, lending, saving, risk taking and investing behaviors will change for a generation. You are likely to see less, more costly credit, more saving itself constrained by real income, less risk taking and less, and more conservative investing.
If you further consider that the government sector may not spend as much as everyone thinks; the outlook dims even more. It seems that everyone thinks that the federal government will spend without limit and backstop anything and everything such that a recovery is likely to come much sooner than leading economic indicators seem to suggest. I hate to burst your bubble but I think that as conditions deteriorate further in the next 3-6 months, it will become increasingly clear that government spending levels are also unsustainable and the focus is thus likely to turn to smarter/more efficient spending which will “shift priorities” and “limit waste”. So a lot of the incremental new deal type spending is likely to be offset but budget cuts elsewhere. Additionally, I think many are underestimating the extent of belt tightening at the state and local level.
At the same time individuals are likely to voluntarily and involuntarily curtail spending because the game of lending anything to anyone is also over. A great deal of economic activity happens because credit is available – no credit means that business, spending or investment doesn’t get done. A generation that was enabled to spend well in excess of its means will have to learn how to save. People will still want to buy houses, cars and other big ticket items but the no money down game has changed such that saving will increase which is good longer term but obviously will defer consumption accordingly. Surprisingly few Americans have the ability to put 20% down on a $300,000 home. One of the scariest things (because I don’t know how to quantify it) is the idea that in order to manage the massive credit expansion from a personal balance sheet perspective, the pie must continue to grow meaningfully. This generation has accumulated very significant debt service burdens which are obviously unmanageable from a cash flow perspective but also will act to crowd out future spending and investment. This is likely to act as an another albatross of sorts; especially if baby boomers try to salvage whats left of their retirement nest eggs/prospects by saving more.
Yet market pundit after market strategist after CNBC guest seems to think the “THE” bottom is in. Very oversold in the context of time such that a very sizeable rally on the order of a good stock market years returns sure, but “THE” bottom? I doubt that very much – it’s possible but highly unlikely in my view. I certainly wouldn’t bet on it because I think it’s much more likely that the next big move from here is NOT up. Don’t believe the hype! Focus more on managing your risk instead of missing out on something unlikely to happen. Stocks don’t typically do well when guidance and estimates are being missed.
I’ll be back soon with some more ideas which I hope make my points clearer and also a few ideas both long and short that I think can do well to make your stay in the house of pain more comfortable. To be continued (in part 2)….
I’ve watched the credit bubble popping events unfold in the context of a volatile history. I’m cognizant of the fact that is has never paid to stay very bearish for long as America is a remarkably resilient nation – we’ve overcome Herculean challenges like the depression and WW1 and Korea and Vietnam and oil embargoes and gulf wars and internet bubbles and more. However, none of these challenges compare to what decimation this credit bubble popping has wrought.
I view the stock market game as a probabilistic field of sorts. We effectively consider what’s known and unknown and try to estimate the expectancy of the potential outcomes with our incomplete information. Looking at what’s happening economically is scary – the pace and magnitude of decline in economic activity and leading indicators has been historic.
Perhaps an arguably crude analogy can put this in the proper light. The first analogy I could think of is the initial phase of hurricane Katrina. Strong winds struck and rattled a lot but the damage appeared to be well contained and surmountable initially. It wasn’t until the insurance in the form of a levy failed that we realized that we were in a heap of trouble and needed to do something about a potential catastrophe turning probable, however, we had no reference point to help us understand the magnitude and the duration of the destruction and its painful aftermath.
Today the big question revolves around how bad earnings will get and what the nature and timing of a recovery might be so we can decide whether the market is cheap or expensive relative to such a base case scenario so we know how aggressive we should be and how much market risk we should take on. The idea being that if we reasonably estimate/approximate what the next 12 months earnings yield and longer term growth rate might be, we can also craft reasonable expectations of what the central tendency of stock prices might be in the year or two ahead.
What’s more is that none of the bulls seem to have a clue as to how and when the personal incomes and corporate earnings (which I assume would support a sustainable stock market recovery) is likely to manifest. And it also seems as if everyone is expecting that multiples should be similar to what we’ve experienced in recent history, despite the glaring fact that the game has changed such that when the growth needle moves noticeably it wont be very significant unless we start from lower bases still.
In prior bear markets and recessions, much damage was done but the lifeblood of markets, (ie. Liquidity and credit) remained in tact. Credit markets remained functional and countercyclical monetary and fiscal policy acted upon the supply side and demand sides of the economy and helped get the cogs of capitalism turning again. Textbook Keynesian dynamics – when consumers and the private sector lack the will or ability to spend, Uncle Sam increases everyone’s allowance and the Fed makes financing your spending easier and cheaper.
Meanwhile, the banking system facilitates stability and an eventual recovery as enterprising Americans take advantage of apparently depressed asset prices, goods and services prices, labor prices and capital prices. That, more or less, is how the cycle plays out and a new growth cycle is born in the ashes of the last bust. The key here is that the banking system is willing and able to facilitate commerce and inject the lifeblood of the economic growth to markets. It’s not only about keeping otherwise viable businesses solvent with the help of credit; but also sowing the seeds of economic expansion which yields jobs, income, wealth creation, and improved asset prices.
The credit bubble that has popped changes the game more than most appreciate. Many think it is a matter of time that things return to whatever normal they thought was in the markets but I’m afraid that is more than a tad presumptuous. Our economy is in a literal downward spiral and the conventional countercyclical remedies are either impotent or insufficient to mitigate the seemingly exponential headwinds because the banking system has become dysfunctional and permanently impaired. Life as we knew it is over because the real pie is actually much smaller than anyone thought and it will not grow like it did in the past because credit, lending, saving, risk taking and investing behaviors will change for a generation. You are likely to see less, more costly credit, more saving itself constrained by real income, less risk taking and less, and more conservative investing.
If you further consider that the government sector may not spend as much as everyone thinks; the outlook dims even more. It seems that everyone thinks that the federal government will spend without limit and backstop anything and everything such that a recovery is likely to come much sooner than leading economic indicators seem to suggest. I hate to burst your bubble but I think that as conditions deteriorate further in the next 3-6 months, it will become increasingly clear that government spending levels are also unsustainable and the focus is thus likely to turn to smarter/more efficient spending which will “shift priorities” and “limit waste”. So a lot of the incremental new deal type spending is likely to be offset but budget cuts elsewhere. Additionally, I think many are underestimating the extent of belt tightening at the state and local level.
At the same time individuals are likely to voluntarily and involuntarily curtail spending because the game of lending anything to anyone is also over. A great deal of economic activity happens because credit is available – no credit means that business, spending or investment doesn’t get done. A generation that was enabled to spend well in excess of its means will have to learn how to save. People will still want to buy houses, cars and other big ticket items but the no money down game has changed such that saving will increase which is good longer term but obviously will defer consumption accordingly. Surprisingly few Americans have the ability to put 20% down on a $300,000 home. One of the scariest things (because I don’t know how to quantify it) is the idea that in order to manage the massive credit expansion from a personal balance sheet perspective, the pie must continue to grow meaningfully. This generation has accumulated very significant debt service burdens which are obviously unmanageable from a cash flow perspective but also will act to crowd out future spending and investment. This is likely to act as an another albatross of sorts; especially if baby boomers try to salvage whats left of their retirement nest eggs/prospects by saving more.
Yet market pundit after market strategist after CNBC guest seems to think the “THE” bottom is in. Very oversold in the context of time such that a very sizeable rally on the order of a good stock market years returns sure, but “THE” bottom? I doubt that very much – it’s possible but highly unlikely in my view. I certainly wouldn’t bet on it because I think it’s much more likely that the next big move from here is NOT up. Don’t believe the hype! Focus more on managing your risk instead of missing out on something unlikely to happen. Stocks don’t typically do well when guidance and estimates are being missed.
I’ll be back soon with some more ideas which I hope make my points clearer and also a few ideas both long and short that I think can do well to make your stay in the house of pain more comfortable. To be continued (in part 2)….
Wednesday, November 26, 2008
Garpy health care ldea - MYL
Growth at a reasonable price in healthcare – Mylan on the comeback trail
By Allen Phatimer
Thinking about ideas that are somewhat countercyclical in nature but also have a good chance of support from industry specific trends and/or company specific dynamics which can yield cash flow and earnings acceleration lead to me like Mylan (MYL). I view this as an out of favor name in an out of favor sector; a contrarian idea which would effectively surprise positively if they simply met guidance or a consensus) of non-belief) below management's guidance. Expectations are very low in my opinion, and its understandable given the history; but Mylan suddenly appears positioned to beat expectations and gets no credit for that prospect. Management sounds very confident regarding their financial prospects yet the street says single digit forward multiple until Mylan shows us the money.
The history for those of you that don't know is that a couple of years ago the company had improving new product momentum, was valued cheaply and primed to fly as they blew out estimates for the first time in a while. Instead of leaving well enough alone, they did a pharmaceutical ingredient co. acquisition which made sense strategically and was bought at an arguably fair price but then quickly got into a bidding war for Merck KG's generic drug business. Merck KG was more than twice their size and also made sense from a longer run strategic perspective as it gave MYL access to new faster growing markets in Europe and Asia and effectively would make them a global player which would leverage the new ingredients, lower cost manufacturing capacity and distribution.
It could have been brilliant; if only Mylan didn't over pay. As it turned out Mylan got into a biding war with all the big global generic guys AND about 4 private equity investors. The bidding got too rich for the publicly traded companies involved and private equity investors gave up shortly thereafter. MYL won and went from a company trading at 9 times earnings with sales momentum and operating leverage positioned to beat estimates for the first time in years, to one paying a big premium and diluting the hell out of its shareholders as they financed the deal (with stock and debt) after they stock went down significantly.
The company has since put up weak results and guided down a couple of times but now guides to significant improvement which no one seems to believe. That now appears poised to change. Earnings out a couple of weeks ago look much better than expected and MYL reaffirmed guidance for both 2009 and 2010. Sales, margins and net income were substantially better than expected and synergy potential still lies ahead of them. Management said they've realized $100M of the $300M in synergies they plan and expressed confidence that they achieve their target of $300M by year end 2010.
Furthermore, the co. detailed the pipeline; which includes 93 ANDAs related to about $65B in branded sales of which 22 are potential first to file opportunities related to roughly $12B in branded sales. First to file opportunities are a boon to generics, where companies have 180 day exclusivity and not only price much higher than competitors that join the fray on day 181; but also work to cement sales relationships in these new products before competition arrives.
The pipeline is key because new product momentum is what will offset pricing pressure which is a fact of life for generics. In the quarter recently reported Mylan posted better sales and margins, mainly due to a improved mix of higher margin U.S. sales which more than offset pricing pressure in Europe and to a lesser extent Asia. Mylan is very well positioned on this front; and the share price gets no credit for this in my opinion
Another key part of the investment case is that utilization increases at the same time that a lot more drugs go off patent in the next 3 years. In 2009, 2010 and 2011, more branded drugs will lose patent protection than ever before. And as more people across the globe have access to cheaper medicines and payers and governments push moves to generic alternatives to cut costs, utilization can also grow. So this is really a long term investment call.
The idea is to be there in front of the potentially big earnings momentum in 2010 and 2011, when Mylan is launching new blockbuster generics and fully leveraging its leaner cost structure. If spending is kept in check, free cash flow should grow nicely over that time and can really explode in 2011. The few bulls in the name talk about opportunities in biologics although that can be another significant growth driver post the patent expiration bolus in 2011; that's too far out and too uncertain to hang your hat on in my opinion.
The company is looking for mid to high single digit revenue growth for both 2009 and 2010 and if you conservatively extrapolate what the co. expects in terms of R&D investment and SG&A, you get to roughly 200 basis points of operating margin expansion in 09' vs. 08' and another 100 basis points in 2010. That translates into huge operating leverage as pre-tax earnings grow 40-50% in 09' and another 20% in 2010. If you assume a constant 34% tax rate, you can get to $1 in 2009 and $1.40 to $1.50 in 2010.
It's worth noting that management guides to a range of $0.90-$1.10 in 2009 and $1.50-$1.70 in 2010. So, good execution and a modicum of pipeline success can easily make EPS $1.50-$1.60 or more in 2010. If Mylan can do $1.50, I think its reasonable to expect a market multiple by year end 2010 (let's assume a conservative 12X's) and that gets you to $18. That's a double ladies and gents.
On the flip side, there's little reason to expect any less than 10 times on a $1.40 number if execution is solid, so the margin of safety is substantial. If on the other hand, estimates are topped and the number is closer to $1.60, investors are apt to get really excited and bid the multiple to 13 or 14, which would get you north of $20/share.
On a shorter term basis, I think a couple of marginal earnings beats can get this name 11 times the $1 expected in 2009. That would amount to a 20%+ gain from here in the next 6 months and the street would likely look to roll that target multiple forward to a $1.40ish number for 2010 – which would get you north of $15 a year from now.
So the net-net here is that you have a decent company in an out of favor sector and industry that has stumbled and appears to be regaining traction at a time when secular trends are poised to improve and mitigate cyclical pressures in the years ahead. Sentiment is bearish, management has a credibility issue and valuation at 9 times 2009 EPS reflects. Several things can go right in the next 2 years and MYL can standout as a margin and earnings growth story in a world where few exist. Estimates appear to have stabilized, expectations are positioned to bottom and valuation multiple have minimal risk in my view, IF Mylan can simply hit its targets.
Meanwhile, huge amounts of patent expirations in the industry, a record number of first to file opportunities and yet to be realized merger synergies are reasons to be optimistic that Mylan can deliver better results. Some might question its balance sheet as the company put a lot of debt on to pay for the Merck KG assets. Fair concern but the cash flow is relatively visible and stable and the interest expenses well covered in even a very bearish scenario for profitability in 2009 and 2010. Thus I think the debt service burden very manageable and if the balance sheet is delivered faster than expected, which is quite possible; it would add additional support to EPS growth in 2010.
The shares are well off their recent lows and thus apt to give a little back in the days ahead. So you have time to build a position by buying a little here and adding on any meaningful pullback. The recent trading action and very short run chart pattern seems to indicate that the shares are under accumulation so I doubt a big pullback is coming. I'd expect pullback to find support in the $8.40 to $8.50 area and better support near $8. If your approach requires one, I'd suggest using stop at $7.80. If you can take a longer term view, I would look to buy a third here and third at $8 if it ever gets there and another third at $7 if that happened, all else was equal. At an average cost of $8, I think you'd be getting well compensated for the risk and would stand to do very well if anything went right.
By Allen Phatimer
Thinking about ideas that are somewhat countercyclical in nature but also have a good chance of support from industry specific trends and/or company specific dynamics which can yield cash flow and earnings acceleration lead to me like Mylan (MYL). I view this as an out of favor name in an out of favor sector; a contrarian idea which would effectively surprise positively if they simply met guidance or a consensus) of non-belief) below management's guidance. Expectations are very low in my opinion, and its understandable given the history; but Mylan suddenly appears positioned to beat expectations and gets no credit for that prospect. Management sounds very confident regarding their financial prospects yet the street says single digit forward multiple until Mylan shows us the money.
The history for those of you that don't know is that a couple of years ago the company had improving new product momentum, was valued cheaply and primed to fly as they blew out estimates for the first time in a while. Instead of leaving well enough alone, they did a pharmaceutical ingredient co. acquisition which made sense strategically and was bought at an arguably fair price but then quickly got into a bidding war for Merck KG's generic drug business. Merck KG was more than twice their size and also made sense from a longer run strategic perspective as it gave MYL access to new faster growing markets in Europe and Asia and effectively would make them a global player which would leverage the new ingredients, lower cost manufacturing capacity and distribution.
It could have been brilliant; if only Mylan didn't over pay. As it turned out Mylan got into a biding war with all the big global generic guys AND about 4 private equity investors. The bidding got too rich for the publicly traded companies involved and private equity investors gave up shortly thereafter. MYL won and went from a company trading at 9 times earnings with sales momentum and operating leverage positioned to beat estimates for the first time in years, to one paying a big premium and diluting the hell out of its shareholders as they financed the deal (with stock and debt) after they stock went down significantly.
The company has since put up weak results and guided down a couple of times but now guides to significant improvement which no one seems to believe. That now appears poised to change. Earnings out a couple of weeks ago look much better than expected and MYL reaffirmed guidance for both 2009 and 2010. Sales, margins and net income were substantially better than expected and synergy potential still lies ahead of them. Management said they've realized $100M of the $300M in synergies they plan and expressed confidence that they achieve their target of $300M by year end 2010.
Furthermore, the co. detailed the pipeline; which includes 93 ANDAs related to about $65B in branded sales of which 22 are potential first to file opportunities related to roughly $12B in branded sales. First to file opportunities are a boon to generics, where companies have 180 day exclusivity and not only price much higher than competitors that join the fray on day 181; but also work to cement sales relationships in these new products before competition arrives.
The pipeline is key because new product momentum is what will offset pricing pressure which is a fact of life for generics. In the quarter recently reported Mylan posted better sales and margins, mainly due to a improved mix of higher margin U.S. sales which more than offset pricing pressure in Europe and to a lesser extent Asia. Mylan is very well positioned on this front; and the share price gets no credit for this in my opinion
Another key part of the investment case is that utilization increases at the same time that a lot more drugs go off patent in the next 3 years. In 2009, 2010 and 2011, more branded drugs will lose patent protection than ever before. And as more people across the globe have access to cheaper medicines and payers and governments push moves to generic alternatives to cut costs, utilization can also grow. So this is really a long term investment call.
The idea is to be there in front of the potentially big earnings momentum in 2010 and 2011, when Mylan is launching new blockbuster generics and fully leveraging its leaner cost structure. If spending is kept in check, free cash flow should grow nicely over that time and can really explode in 2011. The few bulls in the name talk about opportunities in biologics although that can be another significant growth driver post the patent expiration bolus in 2011; that's too far out and too uncertain to hang your hat on in my opinion.
The company is looking for mid to high single digit revenue growth for both 2009 and 2010 and if you conservatively extrapolate what the co. expects in terms of R&D investment and SG&A, you get to roughly 200 basis points of operating margin expansion in 09' vs. 08' and another 100 basis points in 2010. That translates into huge operating leverage as pre-tax earnings grow 40-50% in 09' and another 20% in 2010. If you assume a constant 34% tax rate, you can get to $1 in 2009 and $1.40 to $1.50 in 2010.
It's worth noting that management guides to a range of $0.90-$1.10 in 2009 and $1.50-$1.70 in 2010. So, good execution and a modicum of pipeline success can easily make EPS $1.50-$1.60 or more in 2010. If Mylan can do $1.50, I think its reasonable to expect a market multiple by year end 2010 (let's assume a conservative 12X's) and that gets you to $18. That's a double ladies and gents.
On the flip side, there's little reason to expect any less than 10 times on a $1.40 number if execution is solid, so the margin of safety is substantial. If on the other hand, estimates are topped and the number is closer to $1.60, investors are apt to get really excited and bid the multiple to 13 or 14, which would get you north of $20/share.
On a shorter term basis, I think a couple of marginal earnings beats can get this name 11 times the $1 expected in 2009. That would amount to a 20%+ gain from here in the next 6 months and the street would likely look to roll that target multiple forward to a $1.40ish number for 2010 – which would get you north of $15 a year from now.
So the net-net here is that you have a decent company in an out of favor sector and industry that has stumbled and appears to be regaining traction at a time when secular trends are poised to improve and mitigate cyclical pressures in the years ahead. Sentiment is bearish, management has a credibility issue and valuation at 9 times 2009 EPS reflects. Several things can go right in the next 2 years and MYL can standout as a margin and earnings growth story in a world where few exist. Estimates appear to have stabilized, expectations are positioned to bottom and valuation multiple have minimal risk in my view, IF Mylan can simply hit its targets.
Meanwhile, huge amounts of patent expirations in the industry, a record number of first to file opportunities and yet to be realized merger synergies are reasons to be optimistic that Mylan can deliver better results. Some might question its balance sheet as the company put a lot of debt on to pay for the Merck KG assets. Fair concern but the cash flow is relatively visible and stable and the interest expenses well covered in even a very bearish scenario for profitability in 2009 and 2010. Thus I think the debt service burden very manageable and if the balance sheet is delivered faster than expected, which is quite possible; it would add additional support to EPS growth in 2010.
The shares are well off their recent lows and thus apt to give a little back in the days ahead. So you have time to build a position by buying a little here and adding on any meaningful pullback. The recent trading action and very short run chart pattern seems to indicate that the shares are under accumulation so I doubt a big pullback is coming. I'd expect pullback to find support in the $8.40 to $8.50 area and better support near $8. If your approach requires one, I'd suggest using stop at $7.80. If you can take a longer term view, I would look to buy a third here and third at $8 if it ever gets there and another third at $7 if that happened, all else was equal. At an average cost of $8, I think you'd be getting well compensated for the risk and would stand to do very well if anything went right.
Tuesday, November 18, 2008
Hologic (HOLX) A Top Healthcare Pick for 2009
Hologic (HOLX): A top pick in Healthcare for 2009?
A quest for value and alpha in well financed, well managed defensive names with solid visibility, reasonable growth prospects and discount valuation leads me to digital mammography and Pap test leader Hologic. The shares are off to historical trough multiples at significant discounts to what appear to be lesser peers. But with a solid quarter, reset and achievable expectation and a call that detailed how upside to 09’ expectations is probable; I cant help but think about what can go right at this juncture.
The shares have been in a slide for the better part of a year in reaction to a major acquisition (Cytec) which looked suboptimal and expensive initially and proved naysayer right when the sales growth of the acquired product portfolio slowed profitability suffered and investors began to aggressively discount the expected sales and margin benefits the co. did the Cytec deal for in the first place. And then came the currency headwind. And then a sales miss. And did I mention the push out of a new sales and margin driving product?
Needless to say, the bears were vindicated and burden of proof shifted directly to management’s ability to execute on improving acquired sales growth and new product commercialization which looked increasingly difficult in the face of mounting macro and industry specific headwinds. Understandably, long time longs threw in the towel, shorts pressed their positions and the share price has gotten pummeled.
What’s the point you ask? To make a short story long, I think HOLX shares might now represent the kind of relative value associated with a stock with reasonable growth prospects and margin expansion opportunity in a world where few can grow or hold margins.
Sales were better than expected on strong organic unit sales growth. The company’s breast health sales were solid, orders were strong and management was somewhat optimistic about a rebound in acquired product sales. Gross Margin dollars were higher and operating expenses lower so operating income topped expectations. EPS was in-line.
Breast Health of sales of $221M were up 25%; guidance is for 5% in FY09’, Diagnostics revenue of $133.7M was up 11% y/y; guidance is for 15-16% growth in FY09’, and GYN/Surgical (which is essentially NovaSure) sales of $59.7M were up 2%; but that’s an improvement from the last couple of quarters and management is looking for 17-18% growth in FY09’ in that division. Management's new FY09 guidance is for 9-10% sales growth to $1.82-1.85B and non-GAAP EPS of $1.22-1.44.
All in all a solid quarter with excellent unit growth in profit driving digital mammo, steady Pap test sales and a rebound in Novasure (key products acquired from Cytec). And management lowered guidance to account for recession worsening, credit tightness, currency pressure, and slightly negative mix. Management removed any considerations for new product sales. And that only lowered numbers slightly – much less I think, than was feared. Exactly what you needed to see, in my opinion, in order to begin to exit the show me stock status Hologic earned.
It appears that the share price (at roughly 11 times forward earnings) discounts a substantially worse unit growth and pricing pressure in key cash flow drivers than management or most analysts do with no help from new products – i.e. what amounts to a worst case scenario. So risk (in the company specific sense) with respect to earnings and multiple appears relatively low if can make it’s numbers because the unusually low multiple should hold provided the market doesn’t continue to slide hard.
One might also think that risk (in a margin of safety sense) is relatively low if valuation on cash flow, margin potential and returns of such franchises as Hologic’s is low – as I believe it is. One might also conclude that a company that considers pressure on unit sales growth and margins that they are yet to realize, and omits likely incrementals in its guidance is being very conservative and thus risk to their estimates is low so that sort of risk appears to be relatively low.
Management considers the macro pressure (which they still say they haven’t seen) and no new product contribution in the $1.22 guidance, when there is a high likelihood of additional revenue streams ramping by year end 2009, and 9% revenue growth that is fairly visible (strong order growth, and substantial backlog) and stable margins that can expand as sales growth accelerates.
Management seems confident that digital mammography unit sales would be up in 09’ vs. 08’. They admitted average selling prices might be under slight pressure but suggested that the guidance took that into consideration. I can’t help but wonder is management is more bullish than they let on about unit sales.
Another interesting thing about this situation is that cash flow appears to be resilient in the face some level of the aforementioned macro headwinds, while the company has a few significant growth drivers and cost save opportunities (like the new products and ramping utilization in a new low cost facility or synergy from integrating Cytec). Thus you might think that adds more flexibility to meet numbers.
So as the market grows (however slowly) and penetration increases, revenue growth can accelerate and margins can increase a couple of hundred basis points by year end 2010. The 1.22 can turn into 1.30 which might get a 12 multiple (~$17), and 15% growth rate in 2010 can get you to 1.50 for 2010 and could be as high as 1.60-1.70 on such faster, higher margin sales growth and a little operating leverage. And that 1.65 might garner a 14-15 time multiple (when the co. is beating estimates and raising guidance) and that might get you to $23-$25 12-18 months out. If anyone knows how wrong I am, please do tell.
A quest for value and alpha in well financed, well managed defensive names with solid visibility, reasonable growth prospects and discount valuation leads me to digital mammography and Pap test leader Hologic. The shares are off to historical trough multiples at significant discounts to what appear to be lesser peers. But with a solid quarter, reset and achievable expectation and a call that detailed how upside to 09’ expectations is probable; I cant help but think about what can go right at this juncture.
The shares have been in a slide for the better part of a year in reaction to a major acquisition (Cytec) which looked suboptimal and expensive initially and proved naysayer right when the sales growth of the acquired product portfolio slowed profitability suffered and investors began to aggressively discount the expected sales and margin benefits the co. did the Cytec deal for in the first place. And then came the currency headwind. And then a sales miss. And did I mention the push out of a new sales and margin driving product?
Needless to say, the bears were vindicated and burden of proof shifted directly to management’s ability to execute on improving acquired sales growth and new product commercialization which looked increasingly difficult in the face of mounting macro and industry specific headwinds. Understandably, long time longs threw in the towel, shorts pressed their positions and the share price has gotten pummeled.
What’s the point you ask? To make a short story long, I think HOLX shares might now represent the kind of relative value associated with a stock with reasonable growth prospects and margin expansion opportunity in a world where few can grow or hold margins.
Sales were better than expected on strong organic unit sales growth. The company’s breast health sales were solid, orders were strong and management was somewhat optimistic about a rebound in acquired product sales. Gross Margin dollars were higher and operating expenses lower so operating income topped expectations. EPS was in-line.
Breast Health of sales of $221M were up 25%; guidance is for 5% in FY09’, Diagnostics revenue of $133.7M was up 11% y/y; guidance is for 15-16% growth in FY09’, and GYN/Surgical (which is essentially NovaSure) sales of $59.7M were up 2%; but that’s an improvement from the last couple of quarters and management is looking for 17-18% growth in FY09’ in that division. Management's new FY09 guidance is for 9-10% sales growth to $1.82-1.85B and non-GAAP EPS of $1.22-1.44.
All in all a solid quarter with excellent unit growth in profit driving digital mammo, steady Pap test sales and a rebound in Novasure (key products acquired from Cytec). And management lowered guidance to account for recession worsening, credit tightness, currency pressure, and slightly negative mix. Management removed any considerations for new product sales. And that only lowered numbers slightly – much less I think, than was feared. Exactly what you needed to see, in my opinion, in order to begin to exit the show me stock status Hologic earned.
It appears that the share price (at roughly 11 times forward earnings) discounts a substantially worse unit growth and pricing pressure in key cash flow drivers than management or most analysts do with no help from new products – i.e. what amounts to a worst case scenario. So risk (in the company specific sense) with respect to earnings and multiple appears relatively low if can make it’s numbers because the unusually low multiple should hold provided the market doesn’t continue to slide hard.
One might also think that risk (in a margin of safety sense) is relatively low if valuation on cash flow, margin potential and returns of such franchises as Hologic’s is low – as I believe it is. One might also conclude that a company that considers pressure on unit sales growth and margins that they are yet to realize, and omits likely incrementals in its guidance is being very conservative and thus risk to their estimates is low so that sort of risk appears to be relatively low.
Management considers the macro pressure (which they still say they haven’t seen) and no new product contribution in the $1.22 guidance, when there is a high likelihood of additional revenue streams ramping by year end 2009, and 9% revenue growth that is fairly visible (strong order growth, and substantial backlog) and stable margins that can expand as sales growth accelerates.
Management seems confident that digital mammography unit sales would be up in 09’ vs. 08’. They admitted average selling prices might be under slight pressure but suggested that the guidance took that into consideration. I can’t help but wonder is management is more bullish than they let on about unit sales.
Another interesting thing about this situation is that cash flow appears to be resilient in the face some level of the aforementioned macro headwinds, while the company has a few significant growth drivers and cost save opportunities (like the new products and ramping utilization in a new low cost facility or synergy from integrating Cytec). Thus you might think that adds more flexibility to meet numbers.
So as the market grows (however slowly) and penetration increases, revenue growth can accelerate and margins can increase a couple of hundred basis points by year end 2010. The 1.22 can turn into 1.30 which might get a 12 multiple (~$17), and 15% growth rate in 2010 can get you to 1.50 for 2010 and could be as high as 1.60-1.70 on such faster, higher margin sales growth and a little operating leverage. And that 1.65 might garner a 14-15 time multiple (when the co. is beating estimates and raising guidance) and that might get you to $23-$25 12-18 months out. If anyone knows how wrong I am, please do tell.
Saturday, November 15, 2008
Don't call it a comeback
After writing my first few blog posts a good friend of mine suggested I turn it into something bigger and better than a blog full of market rambling. He suggested that incorporating technical and market timing insights and ideas to my fundamental value approach was a good idea and I agreed. Though my specialty is So I took a hiatus and started building a larger website and an almost done with the finishing touches. We hope to launch by December 1. We hope to see you back then. We'll be discussing equity, futures, options and system trades and investments. I'll be back to give you the new url soon. Thanks for you patience; it'll be worth the wait!
Subscribe to:
Posts (Atom)
Posts
