Sizing up the Tankers - Supply and Demand in the Medium Term

“Reminiscences of a Stock Blogger” is one these blogs I regularly mine for ideas. The writer “Lsigurd” has an amazing track record of picking cyclicals upturns. Because he traffics in some of the crappiest companies out there, he not only covers the fundamentals, but also tends to be very opportunistic and flexible. This is what I imagine Michael Burry in his days would do. Anyways, after reading LSigurd’s idea on tankers here, I did some research into the sector and ended up buying Teekay Tankers (TNK), Frontline Ltd (FRO), and Capital Product Partners (CPLP).

Of the three, TNK is my biggest position. And I added more after the strong earnings today. Unlike some of its peers where earnings are mostly eaten up by depreciation charges, TNK actually has a solid earning, not just cash flows. Taking into account new ships and higher rates, Teekay can get ~$1 of EPS in 2015 and cash flows (before capex) of ~$1.5/ share. Those cash flows give TNK the option to pay a higher dividend and be valued on that basis. The stock is trading at $6.1/share. Put a modest 8-10x multiple on cash flows and I see 100%+ upside.

The Industry

Beyond TNK and consider the tankers industry as a whole, these are just about the most leveraged companies you can find. You got a cyclical industry, high fixed cost/operating leverage, and on top of that high financial leverage. Clearly, I want to make sure the industry is on the upswing. For that I tried to separate out short term vs. longer term factors, and then define my investment time frame – Is this a trade or an investment? Can I take a 2-3 year view? Or is this quarter to quarter?

The media tend to focus on the shorter term positives: lower bunker costs, China accelerate their ramping up of strategic crude oil reserves, and the “contango trade” – the use of tankers as storage, which limits the supply of ships and increase prices. These are all great bonuses but not necessarily sustainable beyond a couple quarters.

Intermediate/Longer Term dynamics – How Far to Look Out?

What’s more interesting to me are the intermediate/longer term supply and demand dynamics. On the supply side, these companies just went through years of depressed economics and capacity rationalization. For the next year or 2, fleet growth now look well under control at low single digits or even negative. I would not project earnings out more than 2 years, and even that might be a stretch. The industry is not known for supply constraints and firms can convert their other ships to tankers.

On the demand side, increases look to be structural:

1. Vast demand. China consumes roughly 11.1mm barrels per day (mmbd) of crude oil, and but produces only about 4.6mmbd. The rest have to be plugged by imports. Put this in context, the U.S. consumes ~19mmbd, with 1/4 the population. China’s crude oil demands have a long way to go.

2. Longer trade routes. Crude oil from Middle East and Africa are increasingly going to east Asia instead of say United State. The longer routes mean higher utilizations for tanker fleets. This is not just because U.S. is increasingly energy self-sufficient. Refineries capacities too have increased dramatically in East Asia the past few years. In China you actually have over-capacity of refineries. Those trade routes should be there to stay.

For me, what limits the time frame on the demand side is the threat of competition from other types of infrastructure. For example, a China-Myanmar oil pipeline just opened recently. Under this scheme (see maps below), tankers would arrive at Maday Island in the Bay of Bengal; oil would then travel via a pipeline through Myanmar into China. This would cut short tanker routes from the middle east, which currently travels through the Straits of Malacca and then northward along the coast of China. Another potential source of competition is China getting more oil from Russia through pipelines. I’m sure there are many other examples, but the point is for tanker demand I wouldn’t look out more than a couple years, as these things change.

Current Middle East to East Asia route

An example of a threat for tankers - The new Myanmar-China pipeline could cut that trip shorter

. 
Source

So yeah, from a fundamental perspective, I can only look at the tankers one year at a time. It’s simply not possible to get hold a long term, 5-10 year view on these things. This is why I hesitate to put more than an 8-10x multiple on cash flows. Also, given my lack of experience in this area - there will be days when stocks are down 5%, 7% without any news, and I will have to respect the market and cut my losses when necessary, and add on the upswing – a bit of a momo play. Definitely a trade, not an investment. Tankers are currently 6.5-7% of my portfolio.

McDonald's Articles that Don't Stink

The worst thing about investing in McDonald's is getting bombarded by hundreds of sophomoric articles. Cliches abound: "I'm not lovin' it", "simply the menu", "trend toward organic food"...etc. Half of these are written by either a) Captain Obvious, b) yuppies who babble on about organic, rather wait 40 minutes in line at Shake Shack, and hate fast food in general. The latter were never potential customers and never will be. The fact that they somehow have to weigh in is especially annoying for me - a customer of McDonald's for the past 18 years, and a fast food addict in general.

A wise man once said: "Opinions are like assholes. Everybody's got one and everyone thinks everyone else's stinks". That said, here are three that DON'T stink.

Fixing McDonald’s Isn’t Rocket Science

and this

How to Revive McDonald’s

and yes, those Mighty Wings were great!
Fallen Arches: Can McDonald's get its mojo back?

Mercury General (MCY) Has More Room to Fall

Mercury General Corporation (MCY) is an auto insurer that traditionally focused on California. It took a beating the past couple days after the latest earning release, dropping from $60 to $53 per share. I think it has more room to fall.

Anyone who followed this company even peripherally can te­ll it was (and still is) way overvalued. The only thing propping up the stock price is the high dividend payout, and that is hardly sustainable. The last 2 days of price action shows that dividend investors may finally be coming to their senses. If MCY finally get valued on earnings like its peers, we could see a ~40% drop.

Mercury General is obviously a less attractive business compared to peers Progressive (PGR) and Allstate (ALL). I will provide a list of reasons here.

• Unattractive business model. Mercury General relies on independent agents, which I consider less attractive compared to the direct channel or using captive agents. Independent agents can sell other brands, which means MCY will pretty much have compete on price, provide much better service or advertise to build brand equity. This puts MCY in a tough spot versus the big boys. Clearly, it's no easy task for them to compete on an ultra-low cost structure against GEICO and Progressive. On the other hand, if they go for better service and brand name, that will exert pressure on margins due to higher expenses. This brings me to the next point. Judging by MCY’s combined ratios, this is simply not working.
• Above average combined ratio of high 90 to 100% (PGR and ALL both in the low 90%’s). Mercury General is the high cost producer in the group, with expense ratio approaching 28% of premium earned, compared to Progressive at ~20%. Lower expenses allow insurers to give a better price to consumers as well as bear higher losses. On the loss side, MCY has a history of adverse reserve developments - obviously there are worse insurers out there but this is no PGR.
• Geographic concentration in California. The company is trying to expand to other states but that does not seem to be working too well, particularly in NY/New Jersey. In the near term they plan to ramp up advertising, which gets us to the next point..
• Lack of advertising fire power to compete effectively against the insurance giants. This is important as auto insurers are pretty much in a constant advertising war. How is Mercury General going to compete with the Geico gecko and Flo?? 
• Investment portfolio has high exposure to energy sector which is clearly not well in this environment.
• Insiders have been selling more than buying 
• Founder/Chairman George Joseph is highly respected in the industry but he is 92.
• Stock trades at 19x forward P/E and 1.6x P/B. 
• Dividend is not sustainable. They have about $135mm of annual dividend obligation, I calculated 2014 normalized net income (adjusted for non-recurring items) of $125mm 

So yeah, I have been eyeing this one as a short for a while. The only reason I did not short this sooner was the high dividend yield, and the lack of a catalyst to shut off that dividend (debt to capital is only 12% so they can keep borrowing to fund dividends, even in the absence of any cash flows from opco). The catalyst to start a short position would have to come from signs of business deterioration. Only then the dividend investors might wake up and see this is a bad deal.

The latest earning provided that. 4Q14 combined ratio was over 100%, even adjusting for prior year developments, catastrophes, and non-recurring expenses. In the conference call, management basically acknowledged that dividend payout is unsustainable if current performance continues. Analysts questioned how Mercury can compete on the advertising front. With some of the weaknesses I listed above being exposed, the stock price dropped 5%. I started a short position then. Today it dropped another 6% and I added more to my short. Hopefully, this is the start of a change in how the market values MCY.

MCY still trades at 19x P/E even after the latest drop. Progressive and AllState trade at 14.5x and 12.2x 2015 earnings, respectively. MCY deserves a discount, not a premium to these better run, better positioned competitors. Taking consensus 2015E earning of $2.7/share at 12x multiple would value MCY at $32.5 a share, a 39% drop from its current level of $53.

The other way to play this is to a pair trade: short MCY and long PGR or ALL (or both). I am also long PGR - although not intended as a pair trade.

** Updated 2/12/2015

KBW find it hard to justify MCY's stock price. So, people whose job is arguably to justify high valuations are struggling to justify those valuations. If you still own MCY you need to take a serious look.

Adding to American Capital Agency (AGNC)

Summary

• At 84% of book value, AGNC is trading near its historically low.
• Upside is collect 14% dividend and perhaps more with a pull to par. 
• Downside is controlled. There are many risks, but they are mostly uncorrelated. The biggest threat in the near term is book value decline due to rising rates and mortgage spreads. 
• Comparing the current environment to 2Q13 (the worst quarter in AGNC history), book value hits should be limited. 
• I added to my positions this past week.

Situation

American Capital Agency Corp (AGNC) is a mortgage REIT. It earns a spread by buying mortgage backed securities (MBS) with low cost funding, and then magnifying that spread with leverage. In the past few years this allowed AGNC to pay a consistently high dividend yield.

AGNC’s stock price has declined steadily the past 2 months, with price to book now at 84%, among the lowest in its history. My base case outlook is a 12% dividend in the next year, while a P/B recovery (less likely) would add 16% for a total return of 28%. But what is the downside, and the likelihood of that downside?

Many Risks, But Uncorrelated

AGNC is cheap for a reason. Many reasons actually. Among its many risks, the main three are: 1) book value hit due to rising rates and mortgage spreads, 2) flatter yield curve leading to spread compression and threaten the mREIT business model, 3) dividend sustainability with dollar rolls. The last point about dollar rolls is really a unique subset of spread compression. It is relatively obscure and deserves a separate discussion, but for now I want to focus on the first two risks.

The worst case would be a bear flattener, which is a combination of 1) and 2) - rising rates and compression spreads. Rising rates would hurt asset prices and decrease book value in the near term, while compressed spreads hurt P/B multiples by lowering future income. Theoretically, these can happen at the same time. For mortgage REITs though, these are conflicting risks that are unlikely to happen at the same point in time:

o Unlike other financial institutions that constantly have money coming and risk investing with lower spreads, a mortgage REIT’s exposure to spread compression mostly comes from mortgages prepayments, where investors have to re-investment into a lower spread environment. However, if rate/ mortgage basis are shocking upward, prepayments would likely to be muted.

o For AGNC, the most relevant rates are repo funding cost and MBS yields, where repo funding costs are unlikely to spike upward short of a banking crisis. High prepayments (both voluntary and involuntary) are unlikely in that scenario, given the current state of housing markets.

Since these risks are unlikely to happen at the same time, I will focus on the risk of rising rates and spreads hurting book value. This is the more immediate risk, and is also the one that hurt AGNC more historically.

Quantifying the Downside

Historically, AGNC’s worst performance came during 2Q13, when the stock dropped 31% in the quarter. About 2/3 of that price drop was simply due to market multiples. Price to book ratio flipped from a premium of 110% to a discount of <90%, which magnified a 12% decline in book value.




The ~12% in book value (both on a total and per share basis) was due to a confluence of multiple factors:

o A violent 63bps up move in 10yr UST, while mortgage yields were up more than rates.

o A collapse in specified pool pay-ups. AGNC owned prepayment protected MBS such as low loan balance and HARP loans. Normally, these trades a premium (“pay-ups”) to more generic MBS, but as rates go up and people are less worried about prepays, those premiums shrank dramatically.

Here’s an old 2Q13 presentation slide explaining the collapse in pay-ups. Note that the 30year, 4% coupon pay-up dropped from 3.28 in 1Q13, to 0.91 in 2Q13. A decline of 237bps!




As of now, many these factors are simply not present. Comparing the present situation to end of 1Q13 (the start of 2Q13 meltdown), AGNC already trades at ~15% discount to book value as opposed to a 10% premium. Yes, it’s very possible that rates may shock upward, but probably not as violently as in 2Q13 when talks of Fed “tapering” dominated news headlines. Finally, as the below table from Markit shows, specified pool pay-ups are nowhere near where they were in 1Q13, which could be greater than 3 points. As of January 2015, the higher pay ups are for 30 year low loan balance (LLB) pools with >4% coupon, and those are under 3% of AGNC’s portfolio.

Therefore I believe AGNC’s downside is limited - any book value deterioration from rate increases should be less than the 12% drop as seen in 2Q13, and thus well within the current 84% P/B buffer. I do not think P/B will drop much further because that would have to come from spread compression, which as I explained previously, is incompatible with a “rate up” scenario.

Finally, if all else fails management always have the option to do buybacks, as they have done before.

Week Ending 1/16/2015: Wrapping up on Ocwen, Moving on to Other Names (SERV)

I closed out of a short position on OCN first thing this morning. It was a small but material position that protected my portfolio from the tough markets the past 2 weeks. I closed out of the short because OCN is basically trading around liquidation value, as if the company is in bankruptcy already. So why not turn around and go long? 1) the valuation range I came up with is wide, and 2) I think more bad news are likely on the way. Even if Ocwen muddles through, there’s not much upside in terms of business growth. More on each of these as follows:

1. Liquidation value. I did a liquidation scenario assuming OCN hits bankruptcy, and came up with a $4.5 – $13 per share. This is the floor value assuming no further legal issues. The valuation is very sensitive to how you value the MSRs, as well as how much you haircut the advances (Some people would say advances should be valued at par, but I disagree. This is a 0% interest receivable that requires financing cost –i.e. negative carry. There’s an operating cost to collect those advances, and it takes time to get them all back. So I think a smallish haircut is certainly warranted in a bankruptcy scenario. Note that a 5% haircut =~$1.3 per share)

2. More bad news likely and no growth outlook. (Warning, I’ll get a little philosophical here). In my mind there’s 2 basic ways to profit off discrepancies between fundamental vs market prices. First is the traditional value investing concept: there’s an intrinsic value that’s not reflected in market value. If the intrinsic value is much higher, buy the stock and ignore market fluctuations. If the stock drops 30% on no fundamental changes, I’ll buy more. Call this “reversion to the mean”, classic value investing, or the Warrant Buffett/Seth Klarman way.

The second way is George Soros’ “reflexivity” feedback loop. In this model, market prices actually change the “fundamentals”. How does that happen? Soros has his examples but one way is this: when stock prices go down and negative media attention, regulators are emboldened to, even pressured to take legal actions. Rating agencies / bankers / analysts all toughen up on the company. Customers may stop doing business with you. Working capital terms deteriorate. Basically everyone’s trying to cover their own ass. This leads to more lawsuits, less future business, working capital deterioration, liquidity/capital stress -> even lower market prices, and the cycle repeats. Call this “trending market”, or “Reflexive feedback loop”

Successful investing requires one to recognize which of the 2 situations we’re in. When I first wrote about Ocwen almost a year ago here, I was working under a Buffett/Klarman framework, insisted on a long term, “normalized” view and ignored the price actions. Somewhere down the line, I (slowly and belatedly) realized that Ocwen became a Soros “reflexive spiral” situation, where declining prices actually does influence the fundamentals. Recognizing that has been very helpful the past 2 months. More concretely, Ocwen is not likely to get through its regulatory troubles before July this year, thus giving more time for bad news to pop up. Even if it survives through this whole thing, fundamental upside is shot because 1) who dares to give new businesses to Ocwen? 2) what consumer wants Ocwen as a lender? (I say “fundamental upside” because speculation can certainly get this stock much higher)

Taking a Break from Mortgage Servicing

I plan to take a mental break from mortgage servicing the next 2 months. At this point, my only position in that subsector is PennyMac (PFSI), which 1) unlike its peers, PFSI already has an origination segment that more than offsets servicing runoffs. 2) can benefit from FHA lowering its premium, 3) has good upside participation if the regulatory overhang in the sector improves, 4) downside protection in the sense that PFSI has potential to take over MSRs if Ocwen gets fired (note that HLSS already does business with PennyMac). 5) Ocwen will likely vacate the Ginnie Mae space and PFSI is a strong player there.

I might also get into NationStar (NSM) at some point (I got stopped out of my position on Walter Investment (WAC), put that money into NSM and then got stopped out of that one too). At some point, someone is going to justify a high price for NSM, probably with a flawed valuation method (using EBITDA multiples for servicing and P/E multiples for originations). If the market falls for that I want to be along for the ride..

Onto Other Things (ServiceMaster)

One of the ideas I’m looking at is ServiceMaster (SERV). The company’s largest segment is Terminix (pest & termite business), which is a direct competitor to Orkin, owned by Rollins (ROL). Rollins trades at 30x forward PE and 18x LTM EBITDA. ServiceMaster is much cheaper at 20x forward P/E and 12.3x EBITDA.

ServiceMaster can achieve a higher valuation (10-30% upside) with the following transaction. They can sell their home warranty business, and use the proceeds to pay down debt. This would deleverage the company, and leave the Terminix segment to be compared directly to Rollins, which of course trades much higher.

I know people will say Rollins is overvalued, but I actually think it’s reasonable because: 1) it historically has traded at a rich multiple, 2) 10-15 years of consecutive revenue / earnings growth, 3) large untapped growth potential through further consolidation, 4) stable industry demand. As for the how much American Home Shields (the home warranty business) will fetch, I think 10-15x P/E is reasonable. (First American Financial is a title insurer that owns a home warranty business, and they trade at 15x P/E)

Of course, I can’t tell management what to because I don’t have control. But the biggest owner of SERV is private equity firm Clayton, Dubilier & Rice (“CDR”), and they definitely have control. I think the CDR guys has to be thinking about the transaction I highlighted here. I’m looking for an entry point here.

HLSS and evolution of tail risks

HLSS stock got killed this week. To me, this is an example of when the market re-prices former “tail risks” as not so “tails”. The market starts out seeing certain risks as a <1% probability event, then re-evaluates that to be a 5% probability event, and then a 20% probability event. How did this happen?? I’m writing this to clarify and record my thoughts. Also, this could be of help to someone looking at HLSS.

Although it’s clear that HLSS’ problems are tied to Ocwen (OCN), how OCN’s issues transmit to HLSS can get pretty esoteric and not well understood –even now. This is not a simple matter of Ocwen no longer adding any more MSRs and thus curtailing HLSS’s growth potential. (In fact, anyone investing in HLSS should have valued it based on a runoff scenario in the first place).

I’ll go over a few risks here. A year from now we may look back and say these concerns are absurd. But what I want to emphasize here is how they changed over time.

Evolution of Risks

1. Risk of forced servicing transfers away from Ocwen. Ocwen’s weak servicer ratings triggered Event of Default (EOD) in certain nonagency MBS, which makes them eligible for servicing transfers. Ying Shen at Deutsche Bank gave an example recently:

“For investors of MSAC 2005-HE3, the Master Servicer, Wells Fargo, sent an EOD notice to all bondholders seeking to vote by the January 5, 2015, deadline as to whether Ocwen shall be terminated as a servicer.”

Just a few months ago, the default reaction is “Impossible! MBS investors won’t terminate Ocwen given lack of alternatives!” But now, firing Ocwen is no longer some unimaginable tail risk, but rather an actual item on the table, being voted on. The probabilities are still low, but not that low. If Ocwen’s troubles keep dragging on (perhaps due to even more lawsuits which Dr. Shen contemplated), then MBS investors will really have to start thinking about plan B. If and when that plan B develops, Ocwen will be in real trouble. How that plays out for HLSS will be left to the lawyers. Keep in mind HLSS never actually owned the legal title to Ocwen serviced MSRs, but is technically more like a secured lender.

2. Cash flows to equity from advance securitizations get shut off (very esoteric). Dr. Shen also commented on HLSS’s servicing advance (SA) deals:

 “We expect extension of distress timelines due to the delay in the foreclosure process…likely result in a slowdown of advance recoveries…Significant reduction of recovery speeds beyond certain thresholds will likely trigger an early amortization event, which will likely result immediately in paydown of the SA notes”.

For equity holders, the implication is cash flows getting funneled to pay down debt instead of going to equity. This would hurt dividend coverage (which are still strong but have deteriorated) and reduce present value of cash flows by pushing them back. I bet not many people thought of this one back in January 2014!

3. Ocwen and HLSS re-negotiate their contracts to the disadvantage of HLSS. This was my main concern back around August. I think the risk actually decreased with the exile of Bill Erbey, because OCN affiliates are now more likely to deal in a true arms-length manner.

My Own Experience in This Name

My investments in HLSS mirrored how these risks evolved. I first bought HLSS in late 2012. It was a major position after a lot research. But honestly, I never even thought of three risks discussed above! Even if I did, I would have considered them extremely low probability to the point of paranoia. It wasn’t until August 2014 that I started worrying about #3 (threat of recontracting) and reduced my positions. October 2014 is when the market really started talking about #1 and #2, and I further cut my position to a minimal amount. By mid-December I exited the remaining stake and actually thought about going short, but the high dividends held me back. Overall HLSS was a slight loss for me.

In each of these gap downs, I was tempted to say “these are super low probabilities, the market is over-reacting, and I should be a contrarian and double down” but decided not to. The reasons are twofold: 1) given my belated recognition of these risks, I wonder if there's even more risks that I have not thought of?  I’m just not close enough to the non-agency MBS market to sense its latest developments. 2) what’s the upside? Why wouldn’t people just move to AGNC which yields a solid 12% without these issues? I think the latter argument will be repeated throughout 2015.

Bright Horizons: Overvalued Stocks Can Be A Good Thing

Bright Horizons Family Solutions, Inc (BFAM) runs day care center sponsored by employers. The company has a long history and Bain was the sponsor of the recent IPO. Famous Bain alum Mitt Romney even mentioned it in his presidential campaign.

On the surface, valuation has always looked stretched and it just continues to get worse over the past 2 years. At $45.4 per share, BFAM trades at 26x 2015E earnings and 16.5x LTM EBITDA.

When Rich Valuations Can Help the Long Thesis

I decided not to short this for a variety of reasons. The more counterintuitive one (at last to me) is that in BFAM’s case, over-priced stock can actually be a good thing. BFAM is a serial acquirer and they’ve been able to acquire at 5-9x EBITDA (recent acquisitions include kidsunlimited, Childrens Choice…etc). If you can raise money at >16x EBITDA and acquire at 8x EBITDA, you can do this all day and add to shareholder value in the process.

Everyone knows that companies should do buybacks if stock is undervalued. The flip side of that is if your stock is over-valued, you should issue shares and buy something of value with it.

This seems borderline ridiculous. After all, if over-priced stocks could be part of a long-thesis, then when is anything ever too expensive? Clearly there has to be caveats with the “use over-valued stock as cheap currency for accretive acquisitions” argument. There are a couple requirements I can think of, both of which BFAM was able to meet.

1. Large potential for growth through acquisition, and acquisitions make sense because you can’t simply take business from competitors
2. Price arbitrage between acquirer and target. 

I think the criteria above should filter out most high P/E stocks. Typical high priced internet companies cannot buy each another cheaply. For disruptive companies, acquisition might not even make sense if you can simply take business away from competitors. For example, TrueCar (a car lead-generation company) can take business from competitor AutoBytel. It would not make sense for TrueCar to buy AutoBytel.

Bright Horizons, on the other hand, meets these criteria. Its market is vast and highly fragmented, with over 100,000 licensed U.S. day care centers (BFAM currently has <900 centers). The day care center business is location dependent, so you have to either build or acquire, instead of simply taking business away from competitors. Finally, the ability to raise money at 16x EBITDA then acquire at 5-9x certainly qualifies as price arbitrage.

Other Reasons AGAINST Shorting BFAM

These are more mundane and should be part of any standard long-thesis for this name. I will just list them out below.

• This name deserves premium multiple 
• EPS growth in the high teens or even 20%+
• Stability of cash flows and track record = lower required returns from investors
• The company is a bit of a glamour stock and commands glamour valuation. Normal, day to day people actually have heard of Bright Horizons, and would like to brag that they own their kids’ day care center.
• EBITDA is understated because they're adding new facilities and those have not fully ramped up yet. As children age each year, Bright Horizons’ pricing naturally falls due to lower operating cost. This allowing them to raise prices without customers noticing.