Housing: Where QE Works

Posted on May 14, 2013 by

There were many great comments on my most recent post “It’s Time to Fight the Fed”. Several opined that some Macro data, specifically housing, has actually improved substantially.

I purchased my home smack in middle of the great recession. I had no idea if in the short-term the home’s value would fall another $100k or rebound $100k.  Honestly, I didn’t care. The invention of a 30-year fixed mortgage makes it so that (unless you’re a “flipper”) the actual value of your home should be relatively meaningless. Relative to monthly cash flows that is.

Before I bought my home, I built a spreadsheet with monthly expenses. In one column I calculated the costs if I purchased the home – mortgage payment, taxes, utilities, insurance etc. In the another column I calculated the costs if I continued to rent – rent, utilities etc. Those were the factors that truly mattered.

Of course, if the value of the home doubled, I would be thrilled; and I’m sure I would have been upset if the value of the home continued to decline. However, what mattered most – by a long shot - were the monthly cash flow figures.

The only real factor that would change if the house priced change, was if it rose in price enough for me to take more money out of the house. Similar to how I’ve tweeted multiple times that many corporate boards are insane if they don’t borrow at these interest rates, I think people have to treat their personal finances in a similar way. At these rates, I would want to borrow as much as possible and lock up long term liabilities. When rates rise, these liabilities will “shrink” like all fixed price liabilities. For more on this, read @DavidSchawel’s post: Should You Pay Down Your Mortgage?.

Back to the monthly cash flow spreadsheet. The main variable changing that calculation is the interest rate on the mortgage. I originally got a 5% 30-year fixed rate. Holding all else equal, at a 3.25% rate, (that a close friend of mine just got,) my home’s – reverse calculated – value would be almost 25% higher! Again, this is based on a monthly cash flow analysis – monthly interest on a 30-year $500k mortgage at 5% is about $2685 a month. If your rate was 3.25% – for that same monthly payment you would be able to borrow $617k!

Is it any wonder Bernanke & Co have succeeded in turning around the housing market?

- MicroFundy

Posted in Uncategorized | Tagged | 1 Comment

It’s Time to Fight the Fed

Posted on May 3, 2013 by
The charts you’ll see throughout this post were tweeted by several people who I follow on twitter, including @tradefast, @ritholtz, @RonnieSpence, @EquityNYC, @ukarlewitz, @DavidSchawel, & @JacobWolinsky.
As always, thanks for being a part of my stream and sharing your thoughts, work, & insights! #FF

I think we are getting real close to a major inflection point. It seems like every macro-economic data point I come across is saying one thing – the same thing. There is an extremely high correlation between all the varying data points and indicators. Data like the 10yr treasury yields, PMI manufacturing, durable goods orders, copper prices, international (ex Japan) stock markets, inflation expectation, margin levels etc – are all saying that the (global &) US economy is slowing, and that the risks of deflation/contraction/recession are growing.

The only thing diverging from this pattern in all of the charts below is the US equity markets.

S&P vs Macro

S&P vs inflation expectations

S&P vs NYSE margin

S&P vs 10yr yields

S&P vs Copper

S&P vs durable goods

S&P vs manufacturing PMI

S&P vs 10yr breakevens

YTD look around the world

It is highly unlikely that all of the different macro indicators are wrong – there are too many of them & most are driven by different drivers & variables. It’s only sensible that it is the US equity markets that is diverging from everything else.

So what’s driving equities higher? Back in September, after QE3 was announced, I wrote What QE3 means for your portfolio, and predicted the following:

The “hunt for yield” caused by #ZIRPforever should bring continued demand to high yielding junk bonds, REITs, & high yielding blue chips (Staples & Utilities), while the sub-par growth in the economy should cause cyclical names to underperform.

As you can see from the next set of charts (it might have taken a few months, but) this was precisely what has occurred.

S&P vs hyper relative to counter

Defensive segments leading the chargeCycl vs Non-Cycl

Cycl vs defensives

In market weighted indexes, these defensive blue chip high dividend paying stocks have a disproportionate effect (as they are typically larger in size), which has led the broader markets higher.

In the long run, many believe that the “Bernanke Put” allows you to be invested at all times. Their thinking is that if the economy improves, although you might lose QE, but it’ll only be because of an improving economy, so you’ll be in a real bull market. In this scenario, cyclical companies should lead the way.

If the economy doesn’t improve, Bernanke’s Put is in place and QEforever will drive the hunt for yield causing higher equity markets. In this scenario leadership would come from these defensive/high yielding names.

So theoretically the Bernanke Put makes sense. The markets should/will always go up, if it’s led by cyclicals, that means the markets believe we’re getting somewhere and QE will end sooner rather than later, but at least growth is gaining some traction. If it’s led by defensives, that’s telling us that deflation/recession/contraction etc is all back on the table, but the markets are still going up because of Bernanke’s ZIRP.

So at least we understand why the divergence is taking place. The economic data is bad – we all know that. Look at copper, bonds, inflation breakevens, everything. Nobody will/can argue otherwise. Even the US equity markets are not saying otherwise. Look at cyclicals etc. It’s only the Bernanke Put – QE – causing the hunt (and now almost the fight) for yield – that is pushing up the indexes (hence led my defensive high yielding names), and not because of growth.

The Bernanke Put in all its glory:

S&P vs Fed bal sheet

Another reason why defensive names have done so well, is that investors that are aware of the above and are afraid to invest in the market because of the above economic data etc are “tiptoeing” into the markets and “playing it safe”. By buying these defensive healthcare/staple/utilities names, they figure even in a correction, they wont get hurt as bad as if investing in higher beta/more aggressive names. (more on this in a bit)

This is all fine, up until a certain extent, and here is where I believe we are approaching an inflection point. There has to be a price point where investors will realize that the risks of buying a typical 12x p/e stock – a stock where you’ll normally be thrilled to earn 10% a year (when you include their dividend) – are greater than the reward. Some of these stocks are trading at a high teens multiple, others over 20x. There are some that just rallied 20%… in 3 months! The risk vs reward, yield or not, just isn’t there. I think we are close to that level where investors will “fight the Fed”. Not because they want to, but because the alternatives are worse.

The same goes with high yield bonds, and most other investments (REITS, MLPs etc) buoyed by the hunt for yield. This is especially the case when the economic data is coming in so much worse than expected.

There are two extreme scenarios that can “correct” the above divergence, although I believe it will be a combination of the two.

1 – We could see a correction of 15-20% that would put the US equity markets back in line with most of the charts above. It would then be priced closer to fair value based on most of the recent economic data.

2 – The economic data can pop back up. Whether it was because of the payroll tax increase, sequestration, or some other seasonal event(s)… maybe this is/was just a blip on the radar these last few months, and the economic data will “catch up” to the US equity markets.

If these scenarios were mutually exclusive, I would bet the farm on #1. A realistic base case assumption though, is a combination of the two. I am anticipating a good 10% correction combined with a small pickup in some of the macro data.

Either way, something’s gotta give. The level of divergence here is bordering historical, and the relative and absolute over-valuation of some of these high-yield names are frightening.

One last point… Although during a correction defensive names typically correct less and are known as the place to hide… I think this time it will be different. Because of the historical nature of their increase, and the way they were leading the market on the way up – which is also non-typical – I believe they will lead to the downside and decline more. They have become a bubble of sorts, as they are probably the most over-owned & chased sub-asset class around.

In conclusion: stay safe, raise some cash, buy protection, & don’t chase!

To the investors chasing these yields, it might not be as bad as picking up a nickel in front of a steamroller, but it’s pretty darn close. Think of the risk vs. reward here – long term.

And to those “smart” investors (who must have only skimmed through the first set of charts of this post…) “tiptoeing” into these names because you’re trying to be prudent and take less risk. You might only be tiptoeing, and doing so ever so carefully & quietly, but you might have just tiptoed yourself onto a train that is about to derail.

UPDATE: 5/3/2013 11:42AM.

Today’s NFP data came in stronger than expected, with really good revisions higher for the last two months. As I type this, copper is trading up around 6%, and the broad equity markets are up around 1.25%. The key however is that today’s run-up is being led by cyclicals.

So as I tweeted this morning “bad news = good news for defensives, while good news = good news for cyclicals.” “This Bernanke Put however – at least on the bad news = good news front – is getting ridiculous. Either way defensives should underperform.”

In other words, even if the above 2nd scenario – better econ data – is the one that will close the divergence, (again, i think this is less likely,) defensives will still underperform.

- MicroFundy

Posted in Uncategorized | Tagged , , , , | 21 Comments

Netflix and their House of Cards

Posted on April 29, 2013 by

(The title isn’t original… I know. Sue me.)

I wrote two prior posts on Netflix ($NFLX) both in August of last year. First about their Off Balance Sheet Liabilities “Enron, Lehman Brothers, and… Netflix?“, followed by their competitive challenges “Netflix, meet Porter“.

Full Disclosure: Similar to $AMZN “The Amazon Dilemma“… although I continue to write negatively about it, I have never shorted $NFLX (personally, as well as for clients). With certain investments, you have to respect John Maynard Keynes’ famous saying “The market can stay irrational longer than you can stay solvent.” The hype, stupidity, extremely high short interest, focus on top line vs bottom line, lack of respect for standard valuation metrics etc. make them extremely difficult shorts.

Back to my first post, Zero Hedge wrote a similar – Off Balance Sheet – post after this quarter’s earning last week. He made the same mistake as I originally did – failing to add a corresponding asset line on the balance sheet when bringing in the off balance sheet liabilities. In other words, while you would add the $3.3B of liabilities to current and long term liabilities, you would also have to add another $3.3B to their Content Library assets.

I totally agree with him though – as I wrote in my original post – that those asset lines, even the way they currently are, makes a little difference to the financial health & liquidity of the company. So adding billions more to it doesn’t mean much. The only “real” assets the company acquires from all these content liabilities are subscribers. At least the company hopes so.

I was inspired to write this follow-up post mainly because of a twitter conversation I had with @KidDynomiteBlog. (You should be able to see the thread here.) I wanted to clarify the “issue” I had/have with the approach $NFLX is taking here by keeping these liabilities off balance sheet.

First, I agree with KidDyno 100% – this has no effect on their income statement or their statement of cash flows. Even the current off balance sheet liabilities when paid show up on those statements, and are the main reason why the company isn’t really profitable. The balance sheet isn’t there to show investors income or cash flows, the balance sheet is important for many reasons, but mostly to see the financial health & liquidity of the company.

Many investors buy a stock like $NFLX and – assuming they are somewhat educated – would like to understand the risks involved. What happens if $NFLX loses subscribers? What type of liabilities – especially fixed – to they have?

In my most recent post – Leverage: Financial vs. Operating – I wrote about Financial Leverage – actual debt – vs. Operating Leverage – leverage attained by having lots of fixed (vs variable) costs. Of course the upside was displayed with $SIRI, and we all know plenty of over-leveraged companies that suffered downside – to the extent of bankruptcy – because of leverage.

$NFLX is leveraged. Big Time.

Looking at their typical “financial leverage” via debt to equity or debt to assets,  you can surmise that the company isn’t badly leveraged at all. They have just $700M of long term debt vs. >$12 billion equity value and a stated $4.36B of assets! That seems pretty solid.

However, similar to many retail companies which have long term leases on their stores, and since the company needs those stores to operate and generate revenues, the money that is owed for the leases, is money that will have to be paid, and consequently, when looking at the company’s financial health & liquidity – must be factored in.

Same with Netflix and their content cost. Without content, Netflix will lose their subscribers, they have no business without it. It must be paid, and therefore has to be treated as an obligation/liability.

On their balance sheet, they show that other than the $700M of LT debt,  they have another $2.44 Billion in content liabilities, which have to be paid to content providers in order for them to continue to have the rights to stream their content. The balance sheet is also where you realize that $2.97 billion of their $4.36 billion of assets, aren’t your standard assets.

When I look at the Asset side of a balance sheet, I’ll always separate things like Cash/Accounts Receivables/PP&E vs (almost any) intangible assets, especially goodwill. Since most intangible assets are hard to sell and convert into cash or into something tangible, when looking at the financial health of the company, you have to discount those assets considerably. (I almost always give zero value to intangible assets.)

In $NFLX’s case, you have most of their assets in the form of their “content library”. Other than for accounting purposes – where every liability will always have to be matched with a corresponding assets – why is this content an asset? Do they own it? For the most part – No. Can they resell their streaming rights and convert it into cash? It definitely isn’t like cash, receivables, inventory, or a piece of property, so what makes it an asset?

Say $NFLX signs a deal with $CBS for $500M per year for 5 years. The first year’s $500M goes as “content liabilities” and “current content library” (under assets), and the other $2B goes as “Non-current content liabilities” and “Non-current content library” (under assets). So for accounting, similar to buying a company for more than their book value, you have to add a line to balance the purchase, which creates “goodwill”, here too (to an extent) you add these assets.

Are these really assets? They’re definitely not cash. Can/will they convert into cash? Through subscribers, yes. But not definitely. And here’s the key – the amount of subscribes in relation to the amount of library assets that they have – although probably correlated somewhat (where the more/better content they have the more subscribers they’ll retain/acquire) – it is not that important.

In other words, if they owe $2.5B for this library, does that $2.5B of supposed assets mean they’ll be getting that in subscriber money over the next X number of years? Would it make a difference if the library was valued at $1B or $4B? Should they do impairment charges to change the “fair value” of what the library is worth?

My point here is that it’s an intangible assets, and should by no means be valued at face, or anywhere close to it. Due to the content contracts and money owned they have the business, but it isn’t inventories, especially not from a financial health & liquidity prospective.

So returning to their off balance sheet liabilities. By now adding an additional $3.23 billion of liabilities (and assets) to the balance sheet, the real leverage goes through the roof! Real assets vs real liabilities.

From the assets side, it’s mostly irrelevant if these off balance sheet assets are brought back on the balance sheet – it doesn’t matter – because they aren’t really real – I would have discounted them like all intangibles assets either way! It is the subscribers that produce revenues. They are the real assets – did the subscriber numbers change when you added more of those assets (& liabilities) onto the balance sheet? No! These are contracts that the company already had.

The liabilities side though makes a huge difference. Adding them back in adds real liabilities and real leverage to the balance sheet.

I created a simple spreadsheet with a few important columns. Please look at the huge difference. First between the company’s stated balance sheet to the “real” balance sheet. Then look at the company’s TANGIBLE balance sheet. The company has a little over $1B of cash and a total of $1.4B of tangible assets vs. $6.78B of liabilities. Real liabilities.

This doesn’t even include the following paragraph from the 10-Q presented without comment (emphases is mine however ;-) )

The Company has entered into certain license agreements that include an unspecified or a maximum number of titles that the Company may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether the Company will receive access to these titles or what the ultimate price per title will be. Accordingly, such amounts are not reflected in the commitments described below. However such amounts are expected to be significant and the expected timing of payments could range from less than one year to more than five years.

Back to @KidDynomiteBlog, yes this is why the company isn’t earning money – content costs are through the roof. However from a prospective of leverage / balance sheet / health of company / liquidity etc… How risky is $NFLX? If you look at Column B – what the company wants you to look at – not so bad. Column E however, is just brutal.

I believe this is the reason that over the last few years $NFLX has probably been the single highest beta stock in the S&P500. The company is the epitome of leverage. It isn’t your typical financial leverage, and it isn’t even your typical operating leverage. But if subscribers grow as bulls think, and somehow their content costs stay stable or even decline – cash flow will flow straight to the bottom line, and you’ll have a cash cow. If however (which were the worries last year,) competition causes subscriber growth to stall, then the company is toast. Liabilities are just way too high to compensate.

- MicroFundy

Posted in Uncategorized | Tagged , , | 9 Comments

Leverage: Financial vs. Operating

Posted on April 10, 2013 by

Leverage - of any type - magnifies returns. This is true for both the downside (see $SVU & $CZR in 2012) as well as on the upside (see $S – Sprint doubled! Meh).

The above examples, as well as most talked about levered companies, are levered financially. Meaning their equity is a small portion of their entire enterprise value. So even a relatively small change in the value of the entire company, will cause a large change in the equity.

As I’ve written in the past, when investing in financially levered companies, you have to keep a close eye on the debt of the company. Since it’s the larger component of the enterprise value and bond markets tend to be “smarter” than the equity markets, small moves in the company’s bonds are often followed by larger – more amplified – moves in the equity.

There is another type of leverage that is less talked about & harder to quantify, but - perhaps because of that – probably more lucrative.

Operating leverage.

Say you have two companies in similar sectors, one company invested in their infrastructure right off the bat… they purchased property, purchased material, built molds etc. while the other took an “invest as we grow” strategy. Once each company reaches their respective break-even points, the first company’s profits will explode higher vs a much slower increase for the other.

There are companies within the same industry that have significantly different amounts of operating leverage, and similar to financial leverage, this works in both directions. If the industry is growing, you would want to invest in the company with more leverage. On the other hand, on the flip side, the fixed costs of the company will be a huge liability if the industry is in a decline.

This exercise is also tremendously useful moving up a level.  If the overall economy is going through an expansion phase, you want to invest in assets of industries with higher amounts of operating leverage.

A perfect example of the power of operating leverage is Sirius Satellite Radio ($SIRI). After their merger with $XMSR in 2008 their stock took a beating. This wasn’t so surprising. The company invested billions of dollars in launching satellites, hiring and developing exclusive content etc. that during the “great recession”, with the prospects of subscriber growth dwindling, the company felt the pain of all those fixed costs.

In came John Malone (via Liberty Media ($LMCA)) with what has to be one of the best investments of all time. $SIRI had $3.25B in debt, with almost $200M of that due on 2/17/09. A few days prior to the 17th, literally on the verge of bankruptcy, Liberty loaned the company $550M in exchange for shares convertible into 40% of the common stock. Within the year, $SIRI was able to refinance and repay the loan.

As the economy & revenues started to rebound, some serious operating leverage kicked in. With so few variable costs, almost all of the company’s new revenues from new subscribers and new advertising flowed straight down to the bottom line.

The company went from an adjusted EBITDA loss of $136M in 2008, and a low of $0.05 per share – that’s five cents – on 2/11/09, to an adjusted EBITDA gain of $920M in 2012. At a current $3.13 the stock is up a staggering 62x!

Malone bought more over time and now controls over 50% of the corporation. His original 40% – which had a theoretical negative cost (because the debt was paid back with interest) is worth an astonishing $8.2 Billion!

Now that’s some nice leverage!

- MicroFundy

Posted in Uncategorized | Tagged , , , , | 5 Comments

Leave the insiders alone!

Posted on March 13, 2013 by

inside-sells

Source: Investech Research with a h/t to @ritholtz who posted it earlier today in his post: “Is Insider Selling A Concern? (No)“

As you can see from the chart and linked post above, insider sales are not really as good as an indicator as most people are led to believe. Also, (importantly,) there is absolutely nothing wrong with them.

Of course there are many exceptions (such as excessive sales, especially during a time where execs are leading investors to believe things are fine but they really are not etc.) – but for the most part, enough of the “if the company is doing well, why are the insiders selling?” comments!

For close to a dozen years I’ve been professionally advising high net-worth individuals on how to invest their money. I have never not recommended an executive to diversify and sell as much of their company stock as they can.

It is typically the case that most of these executives have almost their entire human capital and almost all of their financial capital tied to this one company. I don’t care how good the company is doing or how much other money they have, that should not be the focus.

Human capital is the future earnings from one’s employment. Of course most executives at established companies can find other work if “shit hits the fan”, but currently almost all of their future compensation is expected to come from their current employer.

Most of these executives earn a high enough salary or have already sold enough stock to live a nice life style and most have other assets as well, so they do have other financial capital. But most of the focus on insider selling is typically on the huge sales – the millions, tens of millions, or even hundreds of millions of dollars. These executives typically don’t have other money like this sitting around in other stocks, real estate, cash etc. This is their “real” money and it’s all tied to one company’s stock price.

It would be irresponsible not to sell and diversify. (think Enron)

So if you’re bearish on $KORS or $CRM et al… say the company is overpriced, write about slowing growth, the GAAP vs non-GAAP numbers, or some accounting issues etc. I’m sure there are plenty of (valid) reasons to be short, but don’t blame Michael Kors or Marc Benioff for selling stock, I (and you) would have and should have done the same.

- MicroFundy

Posted in Uncategorized | Tagged , , , | 5 Comments

Enough of the Marissa Mayer love fest

Posted on March 6, 2013 by

Seriously.

I’ve never met Marissa Mayer, and based on the few times I’ve heard her present she might very well become a great CEO… but we are talking about $YHOO here. Of course some of $YHOO’s stock rise (from ~$15.50 when she was hired to a current ~$23) has to do with the hope and faith in her ability to turn around their US core business. But will they? Possibly, but not likely, at least not to the extent people are expecting or hoping for. Yes, $YHOO has hundreds of millions of users & visitors, but most of their business is still reliant on display advertising, which is a declining business, especially with the ongoing  shift to mobile.

Google ($GOOG), where Marissa achieved her major success and recognition, has always had their cash cow to fall back on, enabling them to work on many ventures over time, giving them the ability to create future money makers. $YHOO does not have that luxury.

When I wrote my bullish thesis on $YHOO (YHOO isn’t really Yahoo! & YHOO to $60.41?)  $YHOO’s core US business had a tiny implied value. Meaning, if you stripped out the company’s cash & Asian assets, an investor was getting the US core business for very close to nothing. To the extent that when $YHOO was trading under $14, there was actually a negative stub!

As I wrote back then, the value had nothing to do with the US business, it was all about unlocking the value of the Asian assets.

When Dan Loeb purchased his stake in $YHOO, did he know Marissa was going to come on board and save the company? No, this was never the thesis.

As you can see in my updated $YHOO spreadsheet  – (the first tab, cell E-28) – the implied value of the $YHOO core US business is pretty close to my fair value estimate (cell B-13) for it.

Look at all of the company’s earning growth over the last couple of years, it’s has all come from the “Earnings in Equity Interests” line of the income statement. Those are the Asian assets, not the US core business. Look at the second and third tabs of the spreadsheet, see how well Alibaba & Yahoo Japan have performed!

The US business however has gone nowhere. As a matter of fact, the company’s ex-TAC revenues and adjusted EBITDA was flat at around $4.5B & $1.7B respectively over the last three years, while their cash flow from operations & free cash flow has actually decreased in 2012 over 2011.

So if it wasn’t Marissa & the US core business, why did $YHOO stock soar almost 50% since she joined? There was a clear unlocking & appreciation of their Asian assets.

1 – The original Alibaba deal was announced (and while this was originally announced prior to Marissa joining $YHOO (on May 20th) the use of the cash was still up in the air (and actually exacerbated when Marissa joined and filed this 8-K in August causing a 10% decline in the stock). It was only later (in September) when $YHOO committed to return almost all of the Alibaba money to shareholder that the stock started its ascent.

2. Yahoo! Japan’s stock went from 22,000 to 40,000 yen per share.

3. Alibaba’s Jack Ma resigned, followed by multiple rumors/reports of Alibaba IPO plans.

All of  these events strengthened the real bull thesis - the sum of the parts valuation. This had always been the bull case, and until we see some meaningful turnaround in the US core business, with all due respect to Ms. Mayer, this isn’t “her” rally.

Said differently, I honestly believe that the stock would be at or at least close to the same level if Ross Levinsohn was still CEO.

As you can see from the spreadsheet, my current fair value for $YHOO is around $24 per share (which has gone up from my original ~$22 fair value estimate, mostly due to the increased value of Alibaba & Yahoo! Japan). I wish I didn’t, but as the stock approached $20 I liquidated my entire position because the risk-reward just wasn’t/isn’t as compelling unless you believe(d) the US  core turns around.

Actually, if/when the company sells more of their Asian holdings, more and more of the stock’s current fair value (as a percentage) will be tied to the US core business. Back when I was buying $YHOO, that percentage was close to zero, based on my current spreadsheet, it’s around 30%. The higher that percentage gets, the more I will dislike $YHOO and after the Alibaba IPO, if the stock rises much higher, I would actually consider shorting it.

- MicroFundy

Posted in Uncategorized | Tagged , | Leave a comment

Vodafone’s European troubles. Is this a case where bad news = good news?

Posted on February 20, 2013 by

There was a point in time, when QE2 & QE3 were mere speculations, that bad news (a bad jobs reports, a lower GDP number etc.) was considered good news for the markets. The theory was, that if the data came out showing that the economy was deteriorating, the likelihood of additional QE was higher. The markets responded in many of these cases by rising in the face of the worse than expected data.

I think we’re approaching a similar phenomenon with Vodafone ($VOD). I’ve written about “Vodafone’s crown jewel” back in September, and since then Verizon’s ($VZ) stock is literally unchanged, while $VOD has fallen by over 12%. The implied value of their respective Verizon Wireless (VZW) stake is getting out of hand.

Here’s David Einhorn’s take via marketfolly – in his Q4 Letter from last month:

We have also increased our Vodafone (UK: VOD) holdings, as the stock fell sharply on news that just doesn’t seem that bad. After achieving an August peak of £1.92, the shares ended the year at £1.54. At this valuation, it appears that the market is placing no value on VOD’s 45% stake in Verizon Wireless. And the Verizon Wireless stake is clearly quite valuable. Look at it from Verizon’s perspective: Historically, Verizon had a very profitable landline business, and Verizon Wireless owed it billions of dollars. Verizon received Verizon Wireless’s free cash flow as it repaid the debt. For years, Verizon used its control to try to starve VOD by refusing to allow Verizon Wireless to pay dividends. Today, Verizon’s landline business generates no cash and the debt from Verizon Wireless has been repaid. Verizon’s 55% control stake in Verizon Wireless is probably worth more than all of Verizon’s market capitalization, and Verizon has become wholly dependent on dividends from Verizon Wireless to fund its parent company obligations and shareholder dividends.
Excluding any contribution from Verizon Wireless, VOD stock pays a 7% dividend and trades at less than 12x cash earnings – roughly in line with other large European telecom companies. Meanwhile, VOD has never become dependent on Verizon Wireless distributions.
Given the huge valuation disparity between what the market thinks Verizon Wireless is worth to Verizon (at least a couple hundred billion dollars) and what it ascribes to VOD (about zero), combined with Verizon’s increasing dependence on Verizon Wireless, it wouldn’t surprise us if Verizon decided to buy all of VOD to gain full ownership of Verizon Wireless.
It could decide to become a global telecom leader or it could spin out parts of VOD that it’s not interested in owning. Maybe there is an investment banker with time on their hands reading this letter.

The most recent pullback in $VOD has been again attributed to the weakness in the EU, and to reports that $VOD might put in an offer to purchase Kabel Deutschland. The issue is that $VOD’s stock has fallen by over $12 Billion in market cap since the rumor floated, and the entire market value of Kabel is around $8 Billion.

The thesis here is simple. If their European biz turns around & improves, that should boost the stock price (especially since they’ve already written down a good portion of their troubled European assets). But even if it doesn’t revert and pickup, this “bad news” still might be “good news”. Whether it’s from shareholder activism or the need for cash to sustain their dividend and share repurchases, the longer the struggles in $VOD’s European businesses, the more likely there’ll be a deal done for (a portion of) their VZW stake.

Taking it to the extreme, based on Mr. Einhorn’s numbers (I think he’s being aggressive with his assumptions), if the European businesses start to improve, the stock’s upside might actually be less than if they stays weak.

Either way, from these levels, $VOD’s stock seems like a win-win.

Trade Idea: The most recent #FF list‘s addition @OptionsHawk‘s posted in yesterday’s daily freebies - a bullish option trade called a “risk reversal” where an investor bought 10,000 July $27 calls, financed by selling the July $23 puts (for a net credit of $0.14). The trade is under water a day later, but the worst case scenario is being forced to buy the stock at a net cost of $22.86. (There was also a huge buyer of July $25 calls today.)

- MicroFundy

Posted in Uncategorized | Tagged , , | 2 Comments