Management Turnovers at Pharmacyclics (PCYC)

So someone told me about this company with a wonder drug. She loves the product but got this weird feeling about management. Maybe it’s the way management interacted with each other on the latest earning call, or the way they answered analyst questions. She could not put a finger on what it is.

She also told me they just got a new chief commercial officer but the chief medical officer (CMO) just left. So naturally I googled the CMO’ name. Multiple names popped up. Digging deeper here’s the summary timeline I found:

·         Dr. Ahmed Hamdy - appointed CMO March 2009

·         Eric E. Hedrick - interim CMO sometime around 2011

·         Lori Anne Kunkel - appointed Dec 2011; departed July 2013

·         Jesse Seton McGreivy  - departed Aug 2014

So you have 4 CMO’s in 5 years.  When a company’s CFO or Chief Accounting officer leaves, you worry there’s something wrong with the numbers. But how about when a biotech’s CMOs keeps leaving?  Do you worry that the product is fake?  Is it even possible to fake your way through FDA approval?

More research. What is wrong with Pharmacyclics, Why would top executives keep leaving?

·         Nothing positive in CaféPharma. Let’s just say this is a highly entertaining board. You got threads  named “Pharma-stall-ics”, “Pharmasucklycs”, and “Pharmafuckyclics”.. .etc. Definitely some employee relationship issues here. There are also widespread mentions of wrongful termination suits.

·         A post on investor hub paints an unflattering picture of COO, and mentions former CMO Lori Kunkel.
·         Bloomberg  article. Lots of insinuation here when the article talked about Duggan’s association with fraudster Slatkin. The article spent almost no time on what Duggan did at Intuitive Surgical (which would have added to Duggan’s credibility).

Obviously all of the above could be written by people with agendas. The fact though, remains that you got 4 CMOs in 5 years at a biotech. I doubt CMOs leave due to “work life balance” issues because these are overachievers and probably workaholics to begin with. It’s also hard to explain this as CMOs asking for big pay raises because well, you should pay them.

I get the sense that this tight clique of Duggan, Zanganeh, and Erdtmann calls all the shots. Given the rampant turnovers and the colors above, I can only infer that at best that the top management are unpleasant dictators, at worst there’s something unethical going on.

But, they have an awesome product!

Does all this matter when you got a hot product like Imbruvica?  In general, when do management matter the most?

First, if this is a fraud then obviously all bets are off. Again, is it even possible to fake your way through FDA approval? Granted that EVP of Corporate Affairs Ramses Erdtmann is a Scientology Operating Thetan VIII, which according to Wikipedia gives him the power to "control others from a distance" and "create illusions perceivable by others", the probability of a fraud getting through FDA has to be pretty small.

Second.  If it’s not a fraud but top management are major tyrants, does that matter? I think it depends on context:

o   If the company’s valuation depends on the ability to keep innovating and create demand (think Apple and Steve Jobs), then management competence matters a lot, but management likability not as much (again Steve Jobs was known to be a bit of a dictator).

o   If this is a mature / growing company trading on say 15-20x earnings, management have to optimize revenue, control cost…etc. Clearly management matters a lot more.

o   In PCYC’s case though, the company is trading on vast market potential of a single product, Imbruvica. The patient demand already exists. The product is already there, theres no more innovation that’s needed. The science either works or it doesn’t, and there’s nothing management can do about it.

Ultimately, this comes down to how PCYC fits into your investment style. If you’re allocating to numerous small positions with catalysts for quick pops, then management matters less. If you’re trying to find that rare company that's built to last, then I'd say this is not the situation for you.


**** Updated 10/2/2014 (originally posted on Seeking Alpha Instablog)***

I normally don't like to dwell on management too much. In fact in my blog post here I concluded that management turns at PCYC can arguably be a secondary consideration depending on your investment style.

Then I learned that the drugs are made in China. Why would you do this? So you have a biopharma who keeps losing medical/science personnel; core executives couldn't answer questions about IMS data in their own presentations (and get yelled at by the Morgan Stanley analyst). And oh, by the way the drugs are made China.

I don't have the guts to outright short this company given strong reviews about Imbruvica, but at some point the red flags pile up and I stop looking further.

Random thoughts on CarMax, Oracle, and Housing Vacancies

·         CarMax (KMX)

o   Funny that every analyst wanted to ask about subprime on the earning call. I get that KMX is arguably a finance company. But guys, falling subprime mix is a GOOD thing!! So what if revenue slows a little bit, to the extent that customer base is more sustainable, that’s good news.

o   KMX does look expensive even with today’s drop off. From lenders perspective though, it is good to hear that subprime players are tightening standards.

·         Oracle (ORCL)

o   This Barron’s articlesaid that Oracle is threatened by Hadoop. Ironic considering that Oracle oversees Java – the language that Hadoop is written in. I have also heard that Oracle is hurt by freely available database options. Well, ORCL also owns MySQL, one of the most popular free databases. If Hadoop and free databases are really the downfall of ORCL, this needs to be a business school study on making your stuff open-source and freely available.

o   Hadoop does not replace a database. The Hadoop wiki says as much. Hadoop is great for unstructured data (for example if you’re mining terabytes of tweets) while traditional relational databases are good for structured data (in the row/column format). Hadoop is just a way to split up your job to various computing and data resources, each of those could be different form of data storage, including a database. In fact, Hadoop and database can be complementary - there’s just so much information in databases that someone mining data will have to link up Hadoop with relational databases.

·         Follow up on last week’s postabout housing stock – how to find true vacancy numbers?

o   I can’t stress enough that the reported “homeowner vacancy” and “rental vacancy” numbers are just fake. There are substantial “other vacancies” that are not included in those numbers – easily 30% or even 50% of total vacancies depending on location. Here’s a helpful reportthat US Census put out on “Other” vacancies last year.

o   How to find the true vacancy number then!?  Those numbers are available in the American Community Survey. Unfortunately the US Census does not make this easy. To be useful you’re really looking for local statistics. FactFinders allows you to get this by entering the MSA’s one by one. But if you want to figure out say vacancies for say, all the exposures of some home builder, then this will take a LONG time.

o   Ideally you want historical time series for each local level so you get a sense of “normal”. You can try to download the ACS summary files, but those only go back to 2005 on the Census website. 

o   One way to do this is with Public Use Microdata Samples (PUMS). The U. of Minnesota has a great site that let you select the variables and the vintage years you want. Load that into a database (it's easily in gigs of data) then process it however you want. The results will not match the ACS summary data exactly because these are samples of the original survey. But at least you get a sense of the vacancy mixes going further back than 2005.

A Mental Model on Housing Stock and Flow

I often hear people say something like this: “household formation should be 1.5mm per year and new construction are running 1mm per year, therefore we’re facing a housing shortfall”. 

The obvious flaw with this statement is that it ignores existing inventories and focuses completely on trends and “flow”. Put another way, it assumes inventory is already in balance. The logical questions are then:  how about the existing inventory?  How do you know we didn’t overbuilt so much during the last cycle that there are still still excess home supply? 

Intuitively, I’d lay out household formation and housing starts (“flow”) against total number of households and housing units (“stock”) like this:

Assessing whether we’re overbuilding is then a 3 step process: 1) estimate the number of households, 2) estimate number of housing units that can be occupied, 3) compare the two numbers; if there’s a housing unit shortfall then that’s the number of units we need to build. 

In the example above, I started with 2013 number of households. An estimate 750k of household formation for 2014E gets me to 2014E households of ~115mm.

Next step is take the housing unit numbers and figure out how many of those are actually available to live in? This is where subjective judgment comes in. The economy is not perfectly efficient, so at any given time, there’s a healthy amount of vacant units in transition (it takes some time going from a rental listing to actually renting out the unit, a unit could be sold but the buyer has not moved in yet…etc.) These are units that are not available, so I’ll take those out. I also remove a normalized amount of second homes and “held for market – other” units from the stock. For 2013, I estimated ~12.2% of housing units are “normalized vacants”, and removed a corresponding 16mm unit from stock. This resulted in an estimated 116.6mm housing units that are actually available to be occupied.

Finally, compare 2014E households of 115.4mm vs 116.6 of available units at year end 2013 and it’s clear that we still have excess inventory. I expect this excess inventory to decrease only slightly at the end of 2014 because household formation barely exceeds net unit adds. 

Alternatively, I have also seen analyst keeping track of the stock of vacancies, and map out the difference between demand (household formations), and supply (housing starts, demolitions…etc.) as a burn rate against excess vacancy. This is slightly more elegant but should get you similar results. Either way, the point is you have to take into account existing stock (whether in terms of available units as I did above, or as inventory of excess vacancies), rather than just compare housing starts against household formation.

* As a note, the headline reported homeowner and rental vacancies can be misleading as they both understate total vacancy. The way these numbers are reported: if census can’t categorize if a vacant unit is for rent or own, that unit will be left out of the data. i.e these numbers exclude units that are held off market or seasonal vacant. For this reason I focus on total vacancy for a big picture (construction activities). Then only drill down to homeowner vs rental vacancy when I evaluate rent vs own type of decisions.

Staying Patient on Title Insurers

2014 has been a tough year for title insurance stocks (as it has been for many mortgage stocks in general) as the group lagged the broader market. However, I believe that title insurers remain the best way to get exposure to housing recovery.

A 30 second thesis on the industry

·         Good industry structure and pricing power. The top 4 players have over 80% of market share. Customers are essentially captive because banks require title insurance for mortgage transactions.

·         Volumes are near historical troughs. Even without any boosts from household formation or homeownership rates, insurance premiums can go up from housing churn and more relaxed lending standards.

·         Expense restructuring. Title insurers had to control expenses through the latest cycles, as well as meet demands from activist investors. Operations are more efficient post-crisis and margins are poised to increase with any volume uptick due to high fixed cost.

Industry Characteristics

·         Product.  Title insurance is generally required by lenders whenever one purchases or refinances a property. Premiums are some percentage of loan amount or property value, with purchases generating higher premiums than refinances. The mortgage industry does not expect much growth in refinance volumes going forward, meaning purchase mortgage volumes will be the biggest driver in the coming years.

·         Players. Top players are Fidelity National Financial (FNF), First American Financial (FAF), Stewart Information Services (STC), and Old Republic (ORI). These 4 traditionally have 80-90% of the market.

·         Pricing. Pricing is regulated by the states and there is very little price competition. As opposed to true pricing power where firms can get away with price hikes, I would say the industry enjoys stable pricing that is very much fixed across the market. The firms also has upside from home price appreciation (remember premiums are a percentage of loan/property amount).

·         Value add. Title insurers are closer to labor intensive service companies than true “insurance” risk pools. “Insurance” in the typical sense of the word is about protecting against future losses yet to incur. However, title insurer actually guard against historical events that ALREADY occurred. As such title insurers can actually minimize losses by just doing a better job upfront (more thorough title search for example).

o   This puts sell side coverage in a weird position. Does the housing analyst cover this?  Or does the insurance analyst cover this? How about the business services analyst?

·         Cost structure. Personnel cost (semi-fixed) are the largest component of expenses, rather than the more unpredictable losses. The combination of fixed cost and relative low margins means earnings can have maximum leverage to volumes gains.

Upside 1:  Macro Narrative

Both total home sales and purchase mortgage volumes are near historical troughs. The current housing environment is marked by 1) low household formation and 2) a shift away from home ownership toward rentals. The mainstream narrative says young people are staying home due to student debt; and when they do move out (thus forming households), they rent instead of own. While that argument has merit, my personal view is household formation will eventually have to pick up, while home ownership rates will have to plateau as rental vacancies decline to more normal levels.

But keep in mind, household formation and home ownership rates are not the only driver of mortgage volume!  In fact, mortgage volume should be more related to total existing home sales (which is a multiple of new home sales).  This means that housing churn and mortgage access can actually be more important than household formation and home ownership rates.

o   Churn measures housing turnover (shown in chart 1 as total home sales as % of year end number of households). Since the late 1960’s this number has trended up with economic growth, dropped during the great recession and now trending up again. Intuitively, as the economy gets better, people will buy and sell houses and move around more, even if the total number of households remains constant.

o   Average mortgage sizes (shown in chart 2 as purchase mortgage volume divided by total home sales) are still at depressed levels even though home prices have recovered. This means either a) lower percentage of buyers taking out mortgages, or b) people take out smaller mortgages (lower LTV loans). Lenders are already in the process of expanding access, so that will help mortgage volume and by extension title insurance volumes.

Title insurers will likely see their premium revenues increase if either, or both, churn and mortgage sizes increase. This is better than say, homebuilders that are depend on new constructions, which goes back to household formation and home ownership rates.

Chart 1:  home sales activity can increase without the benefit of household formation

Chart 2:  mortgage size has room to grow when lending standards normalize

Upside 2: Expenses and operating leverage

The expense picture will be different from each firm and I encourage investors to dig deeper on their own. Just reading through the transcripts though, expense control is clearly a focus for the industry. This is particularly true after the great recession then the refinance boom-bust in 2012- 2013. First American, for example, has condensed its 103 claim centers, 30 accounting centers and 30 data centers in 2006 to 4, 2, and 2 respectively today (source: conference transcript). These are structural costs that are not expected to come back when purchase volumes come back. As a result, FAF now sees a 10% pre-tax margin as the new floor, as opposed to the ceiling it was during pre-crisis days.

Expense initiatives are hardly limited to FAF. FNF and STC have both attracted activist investors in the past couple years and management teams are on tight leashes regarding expenses.

It’s not just the level of expenses improving either. Expense will be easier to manage going forward because purchase volumes are more predictable than refinances. Refinance volumes are very sensitive to rates so companies had to quickly ramp up and ramp down their staff. The transmission goes something like this:  rate volatility -> refinance volume boom/bust -> difficulty in staffing  -> inefficiencies  -> earning volatility. Going forward though, a primarily purchase driven market should be more predictable and thus costs will be easier to manage.

A better blend of risk vs housing related subsectors

Why title insurers versus other housing/macro plays? The table and discussion below will outline how I mentally think of the various housing sub-sectors.

·         Competitive risk. Housing subsectors like home builders, loan origination, mREITs are typically fragmented and competitive. Title insurers and non-bank servicers are the only subsectors with highly concentrated players.

·         Regulatory risk. Non-bank servicers are currently fighting through a host of regulatory issues. Title insurers could have some risk here also, as the uninitiated tend to think of it as a sham product. However as one does more research they realize the protection is necessary.

·         Consumer credit risk. Credit losses are currently minimal but are bound to increase as lenders fight for market share by expanding credit boxes. If you don’t like the idea of normalizing losses (or already have enough in your portfolio) you can screen out origination, mortgage insurers, as well as some of the nonagency mREITS.

At this stage of the cycle, competitive and regulatory risks are my primary concerns. By process of elimination this leaves title insurance as the least risky way to get housing exposure.

Recap

I will leave off at this point. You have an industry with concentrated market power, volumes at a trough but normalizing, and expense running at efficient levels. Note that I have not discussed valuation. However, if you have a positive view on housing in the long term, this should be the best sub-sector to look into, given the better risk blends compared to other housing plays.

MGIC Investment Corporation (MTG) - Normalized ROE does not look attractive

This could turn out to be a multi-part project. I just started looking at this company last week so my insights would be limited. However, I’m writing anyways as it helps me gather my thoughts and move forward.

An Inherently Unattractive Industry

MGIC Investment Corp (MTG) is a Private Mortgage Insurer (PMI). This is one crappy industry. Results are incredibility cyclical and sensitive to some assumptions. On the competitive front, we have already seeing new players trying to compete on not just price, but underwriting terms (NMIH Holdings is an example). Now it looks like the 7 players will not be putting a united front with respect to proposed capital requirements.

Why would anyone buy a PMI then? The standard long thesis says 1) FHA will be giving away market share to the private sector, this coupled with an improving mortgage market will lead to high volumes. 2) Lower losses from legacy vintages running off, as well as fixed cost/operating leverage would lead to a spike in earnings.

Some parts of this hypothesis are valid but I think the sell side tends to bake in both 1) mortgage industry recovery, AND 2) losses stay low at post crisis levels, when in fact the two may not be compatible. While losses are sure to come down from present levels in the next couple years, some analysts seem to assume the pristine underwriting quality of 2009-11 vintage will continue forever. Given that 1) first time homebuyers will be needed to drive housing recover and 2) they tend to be of lower credit quality, the assumption of “2009 forever” is clearly unrealistic.

So you have multiple offsetting factors at play and investing in the sector requires one to say “ok, new businesses will have higher losses at some point, but I don’t think it will be that bad, and meanwhile this thing is dirt cheap and I like the risk and reward”.  This reminds me of my write up on Santander Consumer USA. While there’s a place in your portfolio for a speculative play like this, these could be good ideas but not the best ideas.

Normalized Losses and ROE

Unattractive industries demand great valuations. I want to get some sense of economics and value before filing this away. To do that, some conception of a “normalized return” is needed. Anyone who has followed the industry would know that current loss levels are far from “normal”, since MTG is still working off legacy businesses. So blindly applying some P/E or P/B ratio to next year’s forecast would be meaningless. 

Below are my estimates of new businesses economics when losses normalize, under the current capital regime, and then under the proposed PMIERs.  I’m thinking about this at the opco level so that’s why there’s no interest expense.

 

Two part discussion here, first on impact of capital requirement, then on normalized losses.

First, capital requirements. Management said that if PMIERs goes through, capital requirements for recent businesses probably correspond to 11.5-12x in the old risk to capital framework and that gets them to low teens ROE before reinsurance.  

From 2Q14 transcript: “…Under the proposed eligibility requirements, the mix in the first half of the year seems to require a risk to capital of about 14-to-1 at time of origination, i.e. they are all current. But as we know, even with the high-quality profile, some will go delinquent. So, if you factored that in and probably goes to 13-to-1. And then if you want to add some room away from the capital requirement just to give yourself some margin you probably talking 11.5-to-12-to-1.

And by our calculations, on a direct basis before any reinsurance and whatnot, we think that delivers a return in the lower double-digits. On the current or prior to eligibility requirements that we are issued here, we were think and closer to 18-to-1. And if you give yourself a little room and whatnot operate around 16-to-1. We think those returns are kind of back as Curt said where they probably should be for the overall risk of the business in the mid-teens.”

So let’s say losses will revert higher in new vintages going forward, I think a 10:1 risk to capital, single digit ROE after reinsurance is probably reasonable.

How about normalized losses? In the 2Q14 call, management said the 2009-2011 books are running about 15-20% loss ratio. This is how I got the 35bps loss as % of RIF assumption (50bps premium * 17.5% loss ratio / 25% RIF = 35bps). Keep in mind 2009-2011 vintages are loans with pristine underwriting standards. Going forward as the mortgage industry reach down the credit spectrum, it’s reasonable to think that losses will be higher. How much higher? To give an idea of how volatile these items are, below are historical loss ratios from 1996 to 2006 before the whole industry blew up. I used 50bps credit loss in the above table as a placeholder, but the ROE sensitivity table is all over the place.

So you got a cyclical, competitive industry getting hit with higher capital requirements. What should investors demand? The CEO gave some jumbled answers on the 2Q14 call but I think he meant to say mid-teens return overall and high teens for low FICO/High LTV businesses:

GS analyst: “Now, but if you were just, say, isolated – let's say you were the only player in the industry in a very hypothetical scenario, I mean, what required return would you want to get on those lower FICO, higher LTV buckets? I mean, would you be looking at low-teens? High-teens to account for some of the greater volatility in those buckets?

Curt S. Culver: “Yes, but I, on your question, I think for the lower FICO you need a mid-teens minimum return, given the variability on that business and how quickly things can change. So, certainly it demands a higher return. The returns on the other business will be, I think low-to-mid teens so that certainly would require in my opinion, a high-teens return.

So management want double digit returns but the analysis above shows that ROE with 1) normalized credit loss, and 2) new capital regime will likely be in the high single digits. And MGIC trades at 3x book value when the only thing we can really count on is volume growth. Surely there are better ways to play a housing market improvements? 

Up to now, I have referred to new business economics at the opco level, assuming equity capital = investment assets. In reality there's a mix of vintages books, the investment portfolio is much higher and there's interest expense from the holdco debt. To value MTG you have to take those into account. I won't bore anyone with the model here but my calculation shows that MTG is about fairly valued right now ($8.4 per share).

A Cash Flow Model

REIT Analyst did an SA article on MGIC last week. Specifically, he actually tried to project out the cash flows of mortgage insurance premiums and losses, then calculate a present value. Financials analysts as a group tend to stay away from cash flow statements, so what he’s doing is very different. That and the result of over 100% upside got my attention.

I can understand why his valuation is so much higher than market and what I have above. My guesses are 1) discount rate used - the market is rightly demanding more than 10%, 2) Not all investments are excess. Put another way, they are operating assets required to back the day to day MI business, so the investment income stream needs to be discounted together with other operating cash flow streams.  3) subtle assumption difference in premium, loss curves, reinsurance...can all make a big difference. 

Nevertheless, some sort of cash flow analysis would be useful to quantify the positive effect of legacy vintage running off - a big part of the long thesis. A real deep dive here would mean building a full cash flow model myself. At this point it is not a high priority given all the negatives I discussed earlier.

For now, I say we give this guy the sensitivity table and a set of darts, and call it a day.

Fannie and Freddie: Is the Debate on Net Worth Sweep Enough to Save the Commons?

In this piece I will raise questions and provide some analyses, rather than attempt to make any conclusive statements. My questions are:  “If the Third Amendment (Net Worth Sweep) is repealed, can the Senior Preferred stocks be paid down?  Or is some more fundamental challenge to the conservatorship needed?  And how would the GSE’s build capital if the senior preferred stocks cannot be redeemed?”  I will focus more on Fannie Mae here.

A couple of articles from John Carney of WSJ caught my eyes.

8/11/2014 – Time for Fannie and Freddie Investors to Surrender

8/17/2014 – Snatching Defeat from Victory at Frannie

An interesting point in both articles is that even if the Net Worth Sweep is repealed, Fannie and Freddie would still have trouble paying the 10% preferred dividends, making the commons nearly worthless.

Not surprisingly this angered GSE supporters 

A reader commented on Carney's article: 

“You also fail to mention that if the sweep is invalidated then dividends that they "owed" were calculated incorrectly.  There are strong arguments that can be made that the Senior Preferred Stock will have to be voided in any favorable decision. 

 “With simple logic the entire premise of this article can be refuted.  Your premise is that if the 2012 third amendment sweep "agreement" is found to be unlawful and Bill Ackman wins, he will still lose because the companies will still owe 187.5 billion toward the preferred stock and would have to pay the 10 percent dividend as well the commitment fee from their earnings.

You neglect to mention that since the 2012 sweep they have paid almost 100 billion in dividends at 100 percent”

The comment is based on two related but separate premises. First, the Net Worth Sweep caused GSE’s to overpay by a large amount compared to if they just paid the 10% dividend. Second, if Ackman wins his lawsuit, that over-payment would be applied toward reducing senior preferences. 

It’s the second point that is in question here. Note that Ackman also made this assumption in his May 2014 Ira Sohn presentation.

 

Looking at slide 99, Pershing Square estimated ~$6-7bn and ~4bn of combined dividend to Treasury preferred in 2014 and 2015, respectively. Consider 10% on outstanding balance would amount to $19bn, it’s clear that Ackman assumes the over-payments would be used to reduce Treasury preferred principal balance and thus dividend amount. Also note that the ability to repay treasury preferred is a material part of his thesis on how GSEs will build capital.

First, what is the overpayment amount?

Quantifying the amount of overpayment is pretty straight forward. In Ackman’s latest filing, he calculated the amount GSE’s should have paid with the 10% dividend against the amount they actually paid under the Net Worth Sweep. The difference pointed to combined over payments of ~ $130bn consisting of ~$80bn from Fannie and ~$50bn for Freddie.

Were the Senior Preferred redeemable before the 3^rd amendment?

If Ackman wins then ~$80bn of overpayment would be returned to Fannie - no chunk change given FNMA’s $23bn market cap. So Fannie would obviously not be worthless in that scenario. But could that amount be used toward redeeming Senior Preferred principal?  

Going back to Fannie's 10K for 2011 (before the Net Worth Sweep), I find the following: 

"We are not permitted to redeem the senior preferred stock prior to the termination of Treasury’s funding commitment under the senior preferred stock purchase agreement. Moreover, we are not permitted to pay down the liquidation preference of the outstanding shares of senior preferred stock except to the extent of (1) accrued and unpaid dividends previously added to the liquidation preference and not previously paid down; and (2) quarterly commitment fees previously added to the liquidation preference and not previously paid down.”

So the Senior preferred stocks are redeemable when Treasury's funding commitment is terminated. When could that happen?  see below (emphasis mine):

“The senior preferred stock purchase agreement provides that the Treasury’s funding commitment will terminate under any of the following circumstances: (1) the completion of our liquidation and fulfillment of Treasury’s obligations under its funding commitment at that time, (2) the payment in full of, or reasonable provision for, all of our liabilities (whether or not contingent, including mortgage guaranty obligations), or (3) the funding by Treasury of the maximum amount that may be funded under the agreement.

In addition, Treasury may terminate its funding commitment and declare the senior preferred stock purchase agreement null and void if a court vacates, modifies, amends, conditions, enjoins, stays or otherwise affects the appointment of the conservator or otherwise curtails the conservator’s powers..”

So technically these preferred stocks were not redeemable even before the 3rd amendment. This would support Carney's statement that even if the 3^rd amendment were to be repealed and Fannie get back its $80bn of overpayment, it would STILL be on the hook for about $12bn of senior preferred dividends per year. This also means FNMA will not be accumulating capital if you use Ackman’s $10bn run rate net income. (That $80bn still sit on the balance sheet as capital, but just not adding to it)

On the other hand, the senior prefs can be redeemed if the funding commitment is terminated, either voluntarily (unlikely) or due to a broader challenge to the conservatorship (more likely)

The Need for Wider Focus

A commentator on Investor Hub widens the issues:

“(John Carney) is missing the point. The filing eluded that the conservatorship agreement was a guise for receivership, and the conservatorship agreement should be null and void. This would erase the 79.9%. This would erase any dividends owed. This would erase the conservatorship!”

I’m not a lawyer. But based on the non-redeemable nature of the senior prefs, it does seem that for shareholders to pay down the Sr Prefs and accumulate capital, they will have to challenge the conservatorship at a more fundamental level than just the Net Worth Sweep. This is a harder task. The Net Worth Sweep may be obviously unjust, but the initial decision to put GSE’s into conservatorship is harder to question given the circumstances back then. Looking at Ackman’s filing, the “Prayer for Relief” section looks pretty vague and I’m not sure what exactly he is asking for. The "Preliminary Statement" section is pretty focused on the Net Worth Sweep though.

Clearly Ackman assumes that these senior preferred can be paid down despite the legal language saying otherwise.  Given 1) I’m not a lawyer and  2) Ackman has armies of them, I’m probably missing something but I’m unsure what that is.  

From what I’m seeing though, the ability to redeem senior preferred is an important issue. GSE’s can’t redeem the senior preferred stocks unless the lawsuits goes further than 3^rd amendment and perhaps invalidates even the initial conservatorship.  Otherwise GSEs will likely have trouble meeting the treasury preferred dividends, as lower reserve releases and winding down fixed income arbitrage business will both reduce earnings.

Recent Buys - Putting Cash To Work

I went on a shopping spree the past 2 weeks putting cash to work as the market went from plummeting to small leaks downward. For the most part, this is more about buying quality companies that I’ve been eyeing for a while rather than seeing specific catalysts or levers to boost earnings. For some of these companies, I’m actually looking for the market to go down further so I can buy more.

Here are some bullet points for each.

·         Nielsen (NLSN)

o   Not cheap but you’re buying an established monopoly in TV and part of a duopoly in digital along with comScore. Advertisers trying to measure effectiveness across multiple platforms (TV, online, mobile…etc) require a single currency and Nielsen is it.

o   The company recently started integrating its Online Campaign Rating (OCR) system into Google’s DoubleClick. Although comScore has a lead in digital, Nielsen’s unique proposition is allowing Google to measure online video against TV viewership - an important first step toward taking advertising dollars from TV.

o   Buy the dips.

·         Wells Fargo (WFC)

o   As the king of mortgages, WFC stand to benefit from any rebound in industry volumes, which are at a trough. Citi and Bank of America recently settled, giving hope that the regulatory troubles are starting to subside, and industry is talking about a new non-agency RMBS frameworkto revive that market.

o   Aside from mortgages, WFC is also #1 in auto loans. And they’re expanding their card business by teaming up with Amex. Talk about keeping the good people together. (Btw the 2 companies share the same founders).

·         American Express (AXP).

o   The legal issue with Department of Justice is overblown. The DOJ case is really about the smaller merchants. The guys who would steer customers away from Amex is probably already doing so - I mean how would you even catch those guys?  And besides what can merchants really offer to steer AMEX customers?  A 1% discount?  That’s not going to sway customers who use AMEX as their first card out of the wallet.  Even if DOJ wins and AXP cut prices, they’ll likely get more volume. (Keep in mind AMEX is already signing up merchant acquirers to acquire small merchants)

o   Slow growth and weaker consumer spending are threats. This one could actually face existential threat down the road with payment tech evolving.  If it breaks below technical support of $84 I will cut my losses.

·         Citigroup (C)

o   This is a turnaround story, so what’s the plan?  First, Citi has to get through the CCAR process. This will not only lift some overhang but allow them to return capital and boost ROE. Second, continue to wind down its CitiHoldings legacy business as it adds to risk and detracts from ROE. Thirds, management talked about improving their efficient ratio. I certainly don’t doubt there are lots of fat to cut here! If anything litigation expenses should naturally come down.

o   Citigroup would benefit if interest rate goes up. Also, don’t forget Citi does have one of the best credit card franchises out there along with JPM. Here’s a better, more detailed write up on SA by Weighing Machine.

o   I would strongly consider cutting my losses if more setbacks arise or stock falls below the $46 support level.

·         McDonalds (MCD). 

             There are no catalysts - if anything near term headwinds. This can go lower and I will be buying. As a big consumer of fast food I just love this company. Consider what you’re getting with $93-$94/share:

o   Best real estate portfolio in the business. I like Wendy’s sandwiches better, but I end up eating at McDonald's a lot more. Why? MCD is usually at more accessible locations (and tend to be cleaner).

o   Global brand recognition built with massive advertising dollars and history. Arguably the brand recognition hurts them because people identify them with junk food. But hey not everyone’s a health nut.

o   One of the few companies in the world that can legitimately claim a “culture”, as high level executives routinely come up the ranks starting from cashier. Franchisees have restaurant experience and goes through Hamburger University training. 

o   History of using creative solutions to improve results - drive-thrus, breakfast, increase franchising…etc.  Great financial flexibility with high ROE and cash flows.

o   In terms of current initiatives, MCD have great coffee. I actually prefer their iced-coffee to Starbucks’ version. McDonalds got the formula down on the ice coffee – exactly the right amount of milk and sugar regardless of location.