The Big Short: Another Excellent Book from Michael Lewis

I took a few days off earlier this week and used the down time at the beach to read Michael Lewis’ latest book, The Big Short. Lewis has written some of my favorite books, not only about the financial markets (Liar’s Poker), but also baseball (Moneyball), and the inspiring story of Baltimore Ravens offensive lineman Michael Oher (The Blind Side) which was made into a hit movie last year starring Sandra Bullock (for which she won an Oscar award).

The Big Short did not disappoint and it further secured Lewis’ spot on my short list of favorite non-fiction writers. Lewis tells the story of a handful of market watchers and investors who both correctly identified the housing bubble as it was happening and made big bets based on their views. Unlike many other accounts discussing the financial crisis, Lewis follows a handful of people who most of us had never heard of before. John Paulson always gets a lot of attention, but small investors such as Michael Burry at Scion Capital and the founders of Cornwall Capital, which started as a $110,000 private investment fund of $110,000 managed in a shed, now are having their stories told and frankly they are fascinating (and they beat Paulson to the punch by 1-2 years).

The Big Short uses a different approach than most other authors have in trying to place blame on those responsible for the housing market’s bubble and bust. While some have insisted that Lewis’ focus on those who made money off the crisis does little to help regulators and politicians prevent another bubble from happening by focusing on the big issues, I find this view unconvincing.

In order to tell these stories, Lewis is forced to include nearly every detail throughout the entire process (the book focuses on chronicling the period from 2003 through 2008). It becomes abundantly clear to the reader which parties are responsible for propping up the housing and mortgage market and the problems are discussed in detail. The story works so well, I believe, because the reader can simultaneously see what all of the interested and conflicted parties are doing, rather than only getting one side of the story.

If you have either enjoyed Michael Lewis’ previous books or are interested in reading an excellent account of exactly how the housing bubble kept going for so long, bringing the nation’s banks to their knees, or both, a copy of The Big Short is definitely worth picking up. In only 264 pages, Lewis does a great job telling the story from various Wall Street perspectives.

BP Stock Reacts Well as the Obama Administration Helps Craft Framework for Spill Cost Outlays

Once the decline in BP plc (BP) stock reached 20% after the Gulf spill I was in the camp that felt that BP’s stock price drop was overdone given the oil giant’s financial strength. However, as the oil has continued to gush despite repeated efforts to stem the flow, BP shares have continued to fall, which at its worst levels amounted to a market value loss of 50% or $95 billion. While my initial nibbling in the stock was premature (I, like many people, figured BP would have better success containing the well after 2 months of trying), I still believe the stock market reaction has been excessive.

Thus far on this blog I have resisted providing specific financial projections to back up such an assertion, due mostly to the fact that the oil continues to pour out of the ruptured well, making the potential liability unlimited and unknowable. That said, Wednesday’s meeting between the Obama Administration and BP executives was helpful for value investors looking at BP. During the meeting they were able to agree on a timetable for cash outlays to cover the spill’s economic damages, which gives us a lot more clarity as to the financial impact on BP in the coming months and years.

As a result, I will run through some of these numbers and show why I still believe that BP can survive this spill somewhat easily, simply due to the size and financial strength of the entire company. We must remember that BP is one of the world’s largest and most profitable companies (we are not dealing with accounting games at Enron or 30x leverage at Lehman Brothers).

Let’s start with the costs of the containment efforts and the clean-up of the oil. So far BP has spent $1.75 billion in the two months since the Deepwater Horizon rig exploded. Industry experts expect this run-rate of expenses (about $1 billion per month) to drop once the well has been capped (evidently undersea robots drilling with diamond studded saws are pretty costly), but to be extremely conservative I have been assuming that the containment/clean-up costs continue at $1 billion per month through 2011 before the drop. This equates to $12 billion per year in containment and cleanup costs as a conservative estimate.

The White House and BP agreed Wednesday to a $20 billion escrow account to be used for economic claims from businesses. BP has announced it will pay $5 billion into the fund this year and an additional $1.25 billion each quarter beginning in 2011, until the $20 billion has been fully funded. This comes to $5 billion per year for 2010 through 2013.

It is also important to understand that BP will be subject to additional fines and penalties under the U.S. Clean Water Act, based on how much oil ultimately is determined to have been spilled into the ocean. Because the oil continues to flow from the broken well, this aspect of the cost equation is still unknown, as is the exact daily flow rate. Current estimates are 35,000-60,000 barrels per day. If we assume the oil flow is completely stopped by September 3oth (the current expectation is sometime in August) and a penalty of $4,300 per barrel is assessed, these fines could amount to about $30 billion. However, those fines and penalties will likely be fought over in court and therefore the amount will be unclear for a while. Still, because of this unknown liability, I likely will not be buying more BP stock until the well has been capped completely.

The question for investors, obviously, is whether or not BP can afford these projected costs. We are talking about $17 billion per year in containment, clean-up, and damages, plus fines. Let’s look at some of their first quarter 2010 financial metrics to get an idea of their financial capacity:

Operating Cash Flow: $7.7B     Capital Expenditures: $4.3B     Free Cash Flow:  $3.4B     Dividends Paid: $2.6B

The dividend has been scrapped for now, so we can expect that BP’s ongoing operations will generate about $14 billion per year in free cash flow. However, we must keep in mind that these costs are pre-tax figures. BP paid about $8 billion of income taxes in 2009 and all spill costs will be able to be used to offset operating profits and therefore save the company billions in taxes. On an after-tax basis, $17 billion in annual spill costs comes out to an adjusted figure of about $12 billion of cash outlay. As you can see, BP should be able to handle these clean-up costs without dramatic capital expenditure reductions (they have announced a 10%/$2 billion annual reduction in capex).

Additionally, BP has said they have about $10 billion in available credit facilities and also expect to divest $10 billion of assets over the next 12 months. Undoubtedly that money will be used to help pay the penalties and fines that it will ultimately be forced to pay, as well as serve as a cushion if claims come in higher than $20 billion or the well gets worse rather than better. Unlike some energy firms, BP has a very strong balance sheet, with $8 billion of cash and a debt-to-capital ratio of 20%, at the low end of their 20-30% target range. As a result, the company could take on up to $17 billion in new debt and still be within that range.

Finally, we cannot forget that BP only owns 65% of the ruptured well. They will almost certainly ask Anadarko (APC) and their other partners to foot their portion of the bill, although we can expect the court system to play a major role in that process.

All in all, the financial strength and size of BP makes it possible for the company to use normal business activities and a bit of financial management to pay for the spill. Even using an aggressive estimate $50 billion in total spill-related costs over the next few years should not force BP into dire financial straits. Not only that, but the last Exxon Valdez spill claims were settled quite recently, about 20 years after the accident occurred. Even if costs are higher than current estimates and take longer to resolve, BP should be okay given that the company brings in about $30 billion per year in operating cash flow.

I figured it would be helpful to go through these figures because some people on Wall Street have been talking about BP being forced into bankruptcy due to the Deepwater Horizon disaster. Barring some unforeseen, unexpected, or simply unheard-of developments, it certainly seems that BP’s reputation will be hurt far more from this spill than their finances will be. Obviously things can change, but these are the kinds of numbers I have been looking at in recent weeks and I think they are very interesting, even if one has no interest in bottom-fishing in BP stock. Less aggressive investors might want to look at BP bonds, which recently yielded between 8 and 10 percent in the 1 to 5 year maturity range.

Full Disclosure: Peridot Capital had a small long position in BP stock at the time of writing, but positions may change at any time

Despite Better Growth Prospects, Investors Are Shunning Biotechnology and Big Pharma Firms Alike

It was not too long ago that leading biotechnology companies fetched premium multiples to their large-cap pharmaceutical competitors. As the large well known pharma companies face many patent expirations in coming years, smaller and more growth-oriented biotech firms commanded both higher valuations and more favorable outlooks among investors. However, for some reason in recent months we have seen biotech stocks give up much of that premium. For the first time I can recall, many biotechs trade for below-market prices, in-line with slower growth pharmaceutical counterparts.

Here is a summary of some leading large cap stocks in both the biotechnology and pharmaceutical areas. You can see that the P/E ratios are very similar but the projected growth rates are meaningfully higher for the biotech sector, by a factor of nearly 5x. The only conclusion I can make from this is that biotech stocks continue to deserve higher relative valuations, but for some reason Wall Street has lost sight of this recently.

WSJ: U.S. Corporations Sitting on Stellar Balance Sheets

From the Wall Street Journal:

“The Federal Reserve reported Thursday that non-financial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest increase on records going back to 1952. Cash made up about 7% of all company assets including factories and financial investments, the highest level since 1963.”

The strongest balance sheet backdrop for Corporate America in nearly 50 years can only be a positive for the U.S. stock market. Extra cash for strategic mergers, share repurchases, and dividend payouts can help boost stock prices until businesses become confident enough to invest money back into their own asset bases. The latter likely won’t occur until some of the bearish headlines of recent weeks subside. Among the important ones I would highlight, in order of potential resolution, would be the financial regulation bill going through Congress, the Goldman Sachs fraud case brought by the SEC, and the Gulf of Mexico oil spill. Second quarter earnings will likely be quite strong, but the headline risk is trumping fundamentals for the time being.

BP Stock Drop Hits 50%, Market Value Loss Reaches $94B as Panic Ensues

Shares of BP are getting clobbered again today, down to about $30 per share, or 50% since the rig explosion in late April. Today’s worries are being attributed to two stories. First, talk of a dividend suspension is not exactly new and even if the company did suspend dividends, or as I have suggested, paid out a BP stock dividend rather than cash it should not have any impact on the stock price (shares are not valued off of dividend yields, only cash flows). Also today the New York Times wrote about a possible pre-packaged bankruptcy for BP:

“But all those numbers don’t account for the greatest possible threat: a jury verdict against BP. Such a verdict might push the cost of the spill into the hundreds of billions. If that happened, even BP might buckle.

This outcome might seem far-fetched right now. But on Wall Street bankers have already coined a term for it: “the Texaco scenario.” In 1987, Texaco was forced to file for Chapter 11 because it could not afford to pay a jury award worth $1 billion to Pennzoil. That award had been knocked down by a judge from a whopping $10.53 billion.”

Talk about instilling fear into the market. The New York Times forgot to mention that shareholders did not get wiped out in the Texaco bankruptcy, as they normally do in Chapter 11 proceedings. It simply was a restructuring move. BP has now lost half its value, a stunning $94 billion, since the oil rig they were leasing exploded on April 20th. The dividend yield now sits at 11%, even though it seems unlikely BP will ignore political pressures and actually continue to pay out cash to shareholders while oil is still flowing into the Gulf.

As is often the case, the stock market has now entered full blown panic mode with BP stock. It is pretty crazy to watch all of this play out. I can understand if people don’t want to touch BP stock with a ten foot pole, but I am sitting tight on a small long position in client accounts, as I don’t really see how one can argue a $94 billion market value loss is warranted here.

Full Disclosure: Peridot Capital was long BP in select client accounts at the time of writing, but positions may change at any time

Given Its Financial Strength, BP Should Pay Its Dividend in Stock Rather Than Cut It

The main reason value investors may be willing to take a stab at BP plc (BP) stock after a nearly 40% drop since the rig explosion is their financial strength. BP earns about $20 billion per year and has a net debt to capital ratio of less than 20%. Combine very profitable operations and a strong balance sheet with plenty of borrowing capacity and you can see why even an ultimate liability of $15-$25 billion over the next several years could be absorbed by the company.

Given that these situations usually turn out to be buying opportunities, I have begun to accumulate small positions in the stock for some of my clients, even though I admit the ultimate financial impact is unknowable at this point. The company’s financial strength coupled with the $70 billion market value loss so far give me enough of a cushion to take a position so long as it is part of an otherwise diversified portfolio.

With the failure of the “top kill” procedure and news that relief wells likely will not be completed until August, there are renewed worries about the sustainability of BP’s dividend, which at $3.38 per share ($10.6 billion) annually stands at about 9.25% right now. Given that BP’s operations are still throwing off tons of cash and the company has only spent about $1 billion in the first five weeks of this disaster, cutting the dividend does not seem like a necessary step to take from the cash preservation perspective. Still ,with political pressures mounting, BP may not want to pay out billions of cash to shareholders until this spill is under control.

I think that makes sense from a PR perspective,  but BP should really consider paying out their dividend in stock rather than choosing to cut it for PR purposes. Such a move would succeed in padding the company’s cash hoard (which stood at $8 billion as of March 31st) and silence any critics who would be angered if the company paid out cash to shareholders before fixing the hole and paying for the cleanup. After this spill is contained, BP’s underlying profitability will be unchanged and any dividend cut would be reversed anyway. Some banks shifted to stock dividends in late 2008 and early 2009 and it worked very well. Such a move would both silence the critics and preserve precious cash, but the shareholders would not be completely left out in the cold. It simply makes more sense to do that rather than take on more debt and pay interest on the additional borrowings or sell certain assets that are the key to BP’s future success.

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