Lesson from the Bernie Madoff Ponzi Scheme

As more and more news comes out about Bernie Madoff and how he managed to defraud many very smart people out of billions of dollars, it is useful to ask a simple question; what should we learn from what happened? From my perch the answer is very basic.

The few people who avoided Madoff’s funds did so due to doubts over the highly suspicious consistent returns he claimed (many concluded he could not produce such steady profits from the strategies he claimed to be using). They avoided disaster because they lacked information and without knowledge of what their money was invested in, they were not comfortable investing with Madoff.

The others were not as fortunate, but it begs the question, does it make sense for anyone to invest money with a money manager if they are forbidden from knowing where the money is invested? I don’t think so. I know I certainly could never look one of my clients in the eye and ask them to stop receiving account statements so their holdings could be secret. Trusting someone, as Madoff’s investors have learned the hard way, is not a good enough reason to put a blindfold on and hand someone millions of dollars.

Now, many hedge funds will argue that disclosing their holdings strips them of their “edge” since many people will simply mimic top managers’ trades and thereby reduce returns for the people coming up with the ideas. To curb this concern it is certainly reasonable to allow a slight delay in the reporting of actual holdings to ensure that a hedge fund manager can establish a full position before disclosing it to the public. You could also have investors sign a contract saying they will not act on or alert anyone to the nature of the fund’s investments.

Regardless, if you are investing in any fund that does not adequately disclose where your money is allocated, I would strongly consider ceasing such an investment. It sounds obvious to many, but given what has transpired recently, it warrants mention.

General Motors Fighting Uphill Battle with Double Edged Sword

Shortly after the U.S. government lent the Big Three $17.4 billion, we learned Monday that an additional $6 billion of taxpayer money is headed to GMAC, the large General Motors finance arm. Where will this money go? Well, GMAC said Tuesday that it will immediately resume automobile financing for “a broader spectrum of U.S. customers.” That is code for “we are going to lend money to people who probably should not be getting it right now.”

If you think this sounds awfully strange given the current economic situation, you would be right. GMAC got into trouble in the first place by giving out loans to sub-prime borrowers for not only car loans, but mortgages as well (Ditech is owned by GMAC, for example). To stem bad loans, earlier this year GMAC increased its minimum required credit score to 700. This compared to the median credit score nationally of 723, so more than half the country qualified even after lending standards were tightened considerably.

Not surprisingly, auto sales sank after the new minimums were implemented, but I think it is unreasonable to attribute all of that decline to the new credit standards. The economy is bad, people are cutting back, and unemployment is soaring, so there are simply fewer people who can afford to buy new cars, regardless of what their credit score is.

As car inventories build and GM’s losses mount, the only way to boost sales is to lend to less creditworthy borrowers. GMAC said Tuesday it will modify its credit criteria to include buyers with a credit score of 621 or higher.

This appears to be a slippery slope. Lending to borrowers with bad credit as a means to increase profits is exactly how we found ourselves in a sub-prime mortgage meltdown in the first place. With the economy worsening, this hardly seems like the time to loosen credit standards. Not only that, but doing so almost ensures that increased profits earned from higher car sales volumes will be offset by higher credit losses because GM funds the majority of its car sales through GMAC, its own financing division.

While I do not own GM stock, what is going on here should matter to all of us because taxpayer money is being used. We essentially just gave GMAC $6 billion which it is using to lend to borrowers with credit scores as much as 100 points lower than the national average. Such a plan can’t possibly increase the odds that the government gets its money back on these emergency loans. Since Uncle Sam will be first in line to collect its money, GM shareholders are likely to be left with very little unless the company sincerely changes its ways. As this week’s news is more of the same, I have no interest in going near GM stock.

Full Disclosure: No position in General Motors at the time of writing, but positions may change at any time

Update (12/31): Barry Ritholtz points out that GMAC doesn’t even know what a sub-prime borrower is.

Anheuser-Busch InBev Poised To Rebound After 85% Collapse

As you may have already read in Business Week’s 2009 Investment Outlook issue (dated 12/29-1/5), I highlighted the recently formed Anheuser-Busch InBev (AHBIF) as a potentially attractive bargain pick. Despite various other mergers failing to get done in the current credit environment, Belgium’s InBev paid $52 billion in cash to acquire Anheuser-Busch. Fearing that borrowing the money to get the deal done would prove overly aggressive, InBev’s stock simply cratered in the months leading up to the deal, and shortly after it was completed.

In addition to the plan to borrow the entire $52 billion, InBev’s plan to repay $10 billion of that loan right away via a rights offering proved much more ominous than once thought. With InBev’s stock price collapsing (the stock peaked at US$95 and fell all the way to US$14), the number of new shares needed to be sold to raise $10 billion of capital greatly increased. In fact, InBev sold about 1 billion new shares which was far greater than the 600 million shares outstanding before the buyout. All of the sudden, InBev shareholders were diluted by more than 60%, which was a main reason why the bottom fell out of the stock shortly after the buyout was completed.

While the dilution certainly was much more than anyone expected, the business prospects for the combined company have not really changed, which is at the heart of why I think there is a good chance they can actually pay back the loans successfully. Beer sales worldwide are not going to be dramatically affected by the global recession and lower commodity prices could even help boost margins as input costs decline.

Through the first nine months of 2008, Anheuser-Busch was on pace for annual EBITDA of about $3.9 billion, with InBev tacking on another 5 billion euros. That comes to nearly 7.5 billion euros of annual EBITDA before accounting for any cost synergies. Assuming the A-B portion could see an improvement in profitability due to cost cuts, there is reason to think the combined company could have annual EBITDA of more than 8 billion euros. To see how I get to that number, I have included the following chart:

Comparable large, dominant, global beverage brands fetch about 10 times cash flow in the public markets so an enterprise value of 80 billion euro is not an unreasonable valuation in my eyes. The catch, of course, is the tremendous debt load InBev took on to become the most dominant beer company in the world.

The companies had more than $7 billion in net debt before the transaction. Even after 20% of the $52 billion load is repaid with proceeds from the new stock sale, Anheuser-Busch InBev remains saddled with about 40 billion euro of net debt, which accounts for half of the projected enterprise value of the company. At the current point in time, that translates into a little more than $24 per AHBIF share. After rising from a low of $14 in recent weeks, the stock trades in the low 20’s already.

Is there any upside left then? Well, leverage works both ways. If you take on too much debt and your cash flow sinks, you might be left holding the bag. On the other hand, if your cash flow is strong, you can repay debt fairly quickly. There is no doubt that 40 billion euros of debt sounds like a huge number, but it is more reasonable if you are bringing in 8 billion euro of EBITDA annually.

Now, it is true that all of that money cannot go toward the debt (which would wipe it out in five years), due to ongoing capital expenditure requirements. That said, Anheuser-Busch reinvests about 20% of its cash flow into the business, so they were on pace to have free cash flow of $3 billion in 2008 after reinvesting $750 million back into the business. InBev was even bigger than A-B before the merger, so free cash flow should be immense.

Assuming AHBIF reinvests 20% of operating cash flow into the business and uses the remaining 80% to repay debt, the current 40 billion euro debt load could be reduced by half within several years. At current prices, AHBIF stock could return more than 50% in 3 years, which equates to a 15% average annual return.

I have ignored taxes in this example, but fortunately the company’s interest expense will wipe out much of their taxable income. To offset that variable, I also did not factor in any proceeds from asset divestitures that are likely to be completed to help with the deleveraging process. Anheuser’s entertainment division (think Busch Gardens, etc) as well as their packaging division are often rumored to potentially be on the selling block. Proceeds would be used for interest and debt payments. As a result, while the numbers I have used will not prove to be exact, a net debt to EBITDA ratio of 5:1, while high, seems manageable given the strength of the combined company’s business.

Note: Anheuser-Busch InBev stock trades on the Brussels exchange and recently fetched about 16 euros. Investors without access to international exchanges can buy the stock over the counter under the symbol AHBIF for around 23 dollars, but currency fluctuations will impact the dollar price, which is based on the euro quote and the prevailing exchange rate.

Full Disclosure: Peridot was long shares of Anheuser-Busch InBev at the time of writing, but positions may change at any time

Chad’s Stock Idea for the Annual Business Week Investment Outlook Issue

The annual Business Week Investment Outlook issue (dated 12/29-1/5) is out and I was asked to contribute a bargain investment idea from the currently depressed market. My pick (on page 58) was Anheuser-Busch InBev. I am on vacation through 12/27 but I will write about this newly created beer giant in more detail when I return. For those of you who do not have access to the magazine, I made a PDF file:

Business Week Investment Outlook – 12-29-08 (Page 58)

Abercrombie Chooses Fewer, More Profitable Sales Over Lower Margin Bargain Bins

Last month I mentioned I thought Abercrombie and Fitch (ANF) stock looked undervalued. A December 8th Wall Street Journal article entitled “Abercrombie Fights Discount Tide” discussed ANF’s strategy to maintain its premium brand image by choosing to accept higher rates of sales decline, relative to lower priced competitors, in order to hold up profit margins and not risk losing pricing power when the economy recovers.

The company has taken some heat on Wall Street for employing such a strategy, but it worked just fine for Abercrombie in the last recession. As an investor, I much prefer fewer sales at higher margin to higher volume (and less profitable sales) because it minimizes the risk of a retailer falling into the red.

The WSJ cites November same store sales drops of 28% for Abercrombie versus only 10% for Pacific Sunwear (PSUN) and 11% for American Eagle Outfitters (AEO) as evidence that markdowns boost sales in the short term, which is certainly true. But the key here is margins. While gross margin collapsed for the latter two retailers (Pac Sun from 34% to 29%, American Eagle from 47% to 41%), Abercrombie’s held steady at a stunning 66%.

Gross margins of 66% are usually reserved for software and medical device companies, not mall retailers. With retail markups of 50% above cost, Abercrombie clearly has a premium brand. It is expected that during tough economic times that many of its customers will trade down to cheaper clothes, but that does not mean the company should completely rebrand itself. ANF is debt-free with 66% gross margins, so sales can drop pretty significantly without jeopardizing profitability.

“We hear your concerns,” ANF Chief Executive Michael Jeffries said during an earnings call, but “promotions are a short-term solution with dreadful long-term effects.” Abercrombie’s general counsel, David Cupps, added that the company is “well positioned to deal with a tough market,” adding that cutting prices would be cutting the quality of merchandise. “We’re not going to follow the promotional pied piper,” he said.

Given the amount of bad news already priced into ANF shares, they look very cheap even if sales continue to drop throughout 2009. Even if you assume earnings fall 50% from their 2007 peak level, never recover at all, and the stock only fetches a 10 P/E, investors buying today will make a 30% return from current levels. That is a risk-reward scenario that looks very favorable.

Full Disclosure: Peridot Capital was long shares of ANF at the time of writing, but positions may change at any time

El Paso Debt Deal Shows High Yield Market Isn’t Dead, Just Expensive

To get an idea of how bad the high yield debt market is right now, one need only look at what price El Paso (EP) had to pay this week to issue $500 million worth of senior notes. El Paso is a solid company and should not have trouble selling debt. Their hybrid business model; energy pipelines coupled with exploration and production, makes their cash flow more predictable than more narrowly focused energy companies.

Still, El Paso is paying 12% interest and even with such a coupon rate, could not sell the notes at par. Instead they discounted them to entice buyers, who will earn 15.25% by holding to maturity. Why did EP sell such expensive debt? They have more than $13 billion of debt, with more than $1 billion coming due in 2009, and wanted to refinance until 2013.

Hopefully deals like this will continue. While they do not represent bargains for issuing companies, an increase in corporate debt offerings will be crucial for getting improvement in the corporate debt market. Once it becomes more clear that companies can issue new debt (even at high prices), the pressure on common stock prices of highly leveraged firms will abate, removing one of the largest elements of fear in today’s equity market.

Full Disclosure: Peridot was long shares of El Paso preferred stock at the time of writing, but positions may change at any time

Housing Recovery: Long Way Off

It is going to be very difficult for the U.S. economy to turn a significant corner without a housing market that is at least stable. Amazingly, the housing situation has not improved much at all during 2008, even as builders halt new construction and slash prices on newly built inventory. Increases in foreclosures have completely negated any of those builder actions. As you can see, home inventories remain elevated and have just been treading water all year, well above historical averages.

The Treasury Department is thinking about trying to get mortgage rates down to 4.5% from the recent 5.5%-6.5% range. Will that help the housing market recover? I doubt it (interest rates aren’t the problem). How many people can’t afford to borrow money at 5.5% to buy a home, but could do so with a 4.5% rate? Not many, I suspect.

Financial, Retail Weakness Mask Underlying Core Profitability

Simply judging from the stock market’s performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.

As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.

The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980’s. It is a gift for long term investors.

Citigroup: A Sell At $3.00?

I really thought we would finally see a less negative view on Citigroup (C) from Meredith Whitney a couple weeks back when the stock hit three bucks. Whitney, you may recall, is the Oppenheimer & Co banking analyst who downgraded Citigroup to “underperform” last year when the shares traded for around $40 each. Last month, Citigroup hit a fresh intra-day low of $3.05, capping a stunning 13 month 92% drop in the shares of what once was one of the most valuable U.S. companies.

What a perfect time that was to remove a “sell” rating. At $3.05, Citigroup stock likely had two possible long term outcomes; go bust or go a lot higher. Whitney could have closed the book on what would have been one of the best analyst calls of all time. It would be easy to justify upgrading Citi to “neutral” at $3 per share. After all, after a 92% drop, the risk-reward trade off is far less compelling unless you really think the company won’t survive. Whitney has never indicated she thinks Citigroup will go under, so I have to think recommending investors sell the stock at $3 makes little sense, unless she wants to remain the most bearish analyst on Wall Street and an upgrade of a large bank stock wouldn’t fit that mold.

In the past two weeks, Citigroup stock has surged by more than 150% from the ridiculously low $3 quote to $7.70 per share as I write this. If that $3 print turns out to be the low (I am not predicting that necessarily, as I have no idea where bank stocks could trade in the short term), Whitney might have to remove her “underperform” rating at much higher prices, which tarnishes the call because she would have that rating on the stock as it doubled, tripled, or even quadrupled in value.

If the stock goes back down in the coming weeks or months, I think Whitney would be well-served to put a neutral rating on the stock, claim victory, and cement her Citigroup call as perhaps the best sell side recommendation of all time.

It would not be an easy decision given the banking sector still has not overcome its problems, but moving on would signal to investors and her clients that she has not resorted to simply being the most bearish banking analyst on Wall Street. Just because that is what put her on the map, it does not mean staying bearish for too long could not take her off of it just as quickly.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time

Sears Holdings Has Squandered An Opportunity

The last four years or so for Sears Holdings (SHLD) and its shareholders would make for quite an interesting Harvard Business School case study. I have been writing about the company since 2005 and was an early investor in Kmart, even before Eddie Lampert used it as a vehicle to buy Sears.

The early success was very impressive. Lampert bought loads of Kmart debt as it filed bankruptcy and gained control of the company’s equity when it reemerged in 2004. In 2006 Sears Holdings earned a profit of $1.5 billion, or $9.58 per share, quite a turnaround for a retailer that had been bleeding red ink.

Lampert accomplished this not by turning Sears and Kmart into strong retailers like Wal-Mart (WMT) and Target (TGT) (sales and profit margins still lagged those competitors), but rather simply by running the companies very efficiently and milking them for cash flow. Even if you earn a 3% margin instead of 6%, that is big money when you bring in $50 billion of sales annually.

The Wall Street community was sold on the idea that Lampert would use the cash flow from Sears Holdings to diversify its business away from ailing retail brands. Maybe he would close down stores and sell the real estate, or lease it back to other retailers who wanted the space. Maybe Kenmore and Craftsman products, which are owned by Sears, would show up on other retailers’ shelves. Maybe Land’s End, also owned by Sears, would be expanded as an independent retail brand. Maybe Lampert would buy other companies outside of retail altogether. The possibilities seemed, were, and still are, endless.

And yet none of this has materialized. Sears continues to operate as a sub-par retailer and uses excess cash flow to repurchase stock. As the economy has faltered, so has cash flow. Adjusted EBITDA year-to-date has fallen to $700 million, from $1.5 billion last year. The only positive has been the reduction in share count. Sears earned $1.5 billion in 2006, or $9.58 per share. If they somehow are able to earn that much again when the retail environment improves, earnings per share would be nearly $12 per share because of the lower share count. With the stock at $31 today, you can see that the stock would trade back above $100 in that scenario.

But how will that happen anytime soon if Sears continues as is has? It won’t, which is why Peridot Capital has been steadily selling Sears stock over the last year. It used to be a very large holding, but is now one of our smallest. Eddie Lampert evidently was convinced he could do more with the retailer’s operations even after the low hanging fruit had been picked. That was a bad decision.

As long as the economy remains weak, Sears will likely use it as an excuse for its poor operating results. That is a shame, because they had a perfect opportunity to diversify out of retail and they chose not to, even when it was widely accepted as the right strategy for investors. The truth is, however, that Sears and Kmart are not strong retailers and likely never will be, at least not in their current form.

To me, Sears is in the same exact position as General Motors (GM) right now. They are operationally inferior to their competitors, but refuse to dramatically alter their business plans to adapt to the market. Today the Big 3 CEOs will testify in front of Congress and explain that the economy is the source of their problems. They need annual auto sales of 13 million units to earn a profit, far from the 10 to 11 million run rate we are now facing.

I don’t need to tell you that GM’s business model is the problem, not the economy. If the U.S. auto market shrinks due to higher job losses and tighter credit standards, managers need to make changes to ensure they can survive in such an environment. In that case, a stronger economy would mean higher profits, not just survival.

I heard a GM dealer on television complaining that he can finance customers with credit scores of 650 or higher today, whereas last year someone with a 550 could get a loan. He implied that the banks were at fault for cutting credit for people with bad credit (the average credit score in the U.S. is 680). Was it not the fact that 550 credit scores qualified for car loans in the first place that got us into this kind of financial crisis? We should give loans to low quality borrowers to save the Detroit auto industry? I think not.

The bottom line is, if your company adapts you will likely be a survivor. When times are bad the weak die out and the strong not only survive, but they come out of the downturn even stronger than they were before. In today’s market, when nearly every stock is down tremendously, there are fewer reasons to invest in Sears or GM when you can buy a stronger company like Target or Toyota on sale. When Target fetched a 20 P/E I preferred to buy the more undervalued Sears. Combine disappointing execution by Sears and a 50% drop in Target stock, and given the same choice I will take Target at a 10 P/E, which is what I plan to do.

Full Disclosure: At the time of writing Peridot Capital was long shares of Sears and Target and had no position in GM or Wal-Mart, but positions may change at any time