Sunday, October 31, 2010

The Curious Case of JOE

In following up the recent tempest about asset valuations at JOE, several curious things stand out. For an institutional stock with very concentrated holdings, it seems to have almost no significant Wall Street research coverage. The best known firm I can find is Keefe, Bruyette & Woods, long known for expertise in financial services but not necesarily for real estate. Their analyst is quoted as saying that the points raised by Greenlight Capital are "overdone." Nothing analytical that I can access to back that point up. The S&P report on the company is totally uninformative. If anyone has some current institutional research that they'd like to pass on, I would gladly peruse it.

S&P also lists no peer companies for JOE. The company's proxy report lists many peer companies for executive compensation purposes, and the list includes REITs. home builders, and developers. Plum Creek Timber is one of the largest private landowners in the US, and came out of a similar corporate history to JOE. Yet it is a REIT, and as such paid out $205 million out of some $312 million in CFO for the most recent nine months of the current fiscal year. JOE can't provide such income comfort to its investors, and its story appears entirely on the come.

Neophytes to the stock, like myself, go to the corporate web page and are greeted by references to the Deepwater Horizon incident, the prevalence of tar balls on beach properties, and the suggestion that the company is pursuing litigation to make things right. Huh? Cash out the door, years in litigation, standing in a long queue for a settlement. This is something for an investor to get excited about? The photos of some luxe developments are in stark contrast to those in the Greenlight Capital presentation. How can these contradictions be resolved? A company conference call is scheduled for November 2nd. Hopefully there will be some good Q&A on the call, and we'll all know more.

Thursday, October 21, 2010

Musing About Margins

When the global meltdown began a couple of years ago now, analysts all over the world agreed that the financial sector, particularly in the United States, had simply become too big. Whether measured by percent of GDP or percent of the S&P's capitalization, the lubricant of our economic system had become bigger than its wheels. We then tried to make this into slogans, "Too big to fail," or "To big to save." Reading the news in the current earnings season, the financial sector continues to live large.

Cleveland-based Eaton Corporation (NYSE: ETN) reported outstanding results for a global leader in power management systems, hydraulics, automotive and aerospace. My former colleague, Norm Klopp of Midwestern Investment Management, always liked this stock. Core revenues were up 18% for this global leader, and operating EPS rose 32 percent year-over-year. Segment operating margins increased to 13%. Good company, with good management and a business model leveraged to strong volume increases, and it's as good as it gets.

Now move over to medical devices, a sector with which I'm familiar first hand. This sector offered great demographics, unmet clinical needs, technological innovation, and proprietary technologies. Multiples were in the ozone years back. St. Jude Medical (NYSE: STJ) reported an 11% revenue increase for their fiscal third quarter, and operating EPS up 5% year-over-year. Operating margins increased to 26%. That is a pretty nice margin for a manufacturing business, and it reflects characteristics of the device business. St. Jude is selling at 13x this year's projected operating EPS, reflecting uncertainty about reimbursement and healthcare reform. Remember, STJ's operating margins are twice those of the more industrial Eaton.

So, what made me wring my hands this morning? BlackRock (NYSE: BLK) reported a 74% increase in third quarter earnings, besting all analyst estimates, driven by its acquisition of Barclay's Global Investors, the leader in indexed fund products. Current operating margins were 33.8%, projected by the CEO to move to 40 percent, which will be driven by asset inflows into indexed equity and fixed income funds. I don't mean to single out BlackRock, because the large banks would also be poster children, but it was the absolute value of the operating margin that drew my attention.

In the funds business, there's no metal bending, no R&D, no product development risk, no product liability, no price controls, no FDA regulation, and no accountability for poor performance, since indexed products mimic the market risk. Goldman Sachs is reported to be ready to redeem Berkshire Hathaway's $5 billion convertible because, among other things, it has $1 trillion in excess liquidity with the Federal Reserve Bank. Something is wrong with this picture, and it could be that some numbers, particularly for banks as opposed to asset managers, are illusory.

We've written before about this issue. Simon Johnson takes a stab at guesstimating the unrecorded bank portfolio write downs as being $50-$100 billion, with a ten percent probability of losses being multiples of his estimated range. Really, really big in other words. Even if we careen to this scenario, there will be no reform and no accountability. Former CEO Angelo Mozilo of Countrywide Financial, one of the great enablers of Fannie who poured jet fuel over the early flames of the mortgage crisis, walks away with no life style changes, while the housing sector is beginning yet another episode of cardiac arrest. I took a Rolaids with my coffee.

Tuesday, October 19, 2010

Доверяй, но проверяй (Trust, But Verify)

Fairholme portfolio manager Bruce Berkowitz, whose fund owns 29% of JOE, is quoted in the Wall Street Journal today, in response to valuation questions raised by David Einhorn's Greenlight Capital: "There are auditors, a CFO and that stuff gets looked at on a quarterly basis." For Mr. Einhorn to be correct, that would mean "the auditors are sleeping," Berkowitz added.

No kidding! Where have we heard this before? Early in my career as an analyst, after I got burned by a few charismatics CEO's, I adopted the tenets of the Russian proverb loved by the late President Ronald Reagan. Start with the financial statements and notes, sure, but always look for independent validation. One only has to go back to the Anton Valukas Examiner's report on the collapse of Lehman Brothers to find failures by auditors, boards, CEO's, CFO's and legal teams. The savvy value investors I dealt with as a CFO really did their homework, which is why they were often early in a story, and often right. They also looked for a margin of safety.

Mr. Berkowitz also suggests that the management of JOE should hold an "analysts day" and take investors through the properties! I can just see the internal legal team choking on their bagels as they read this suggestion. Isn't it a bit late for what would now be seen as a PR stunt?

Fairholme has had a huge influx of cash since its early success and subsequent awards by the financial press, including Morningstar. It's not possible to tell from the website, filings, or reports how big a research staff Fairholme has. One wonders how such a large stake in JOE could be accumulated without these significant asset quality issues having been independently vetted by Fairholme. It wouldn't give me comfort to then see increasingly large stakes taken in AIG by Fairholme, since AIG was always an incredibly complex company with a dismissive attitude towards analysts, and a poor history of governance and transparency.

JOE has been very silent itself on the issues raised by Greenlight Capital. Now, JOE is in a reactive position, which is risky and undesirable. However, it has no choice but to try and help the market decipher where reality lies between the positions of its large stakeholders, for the benefit of all its constituencies.

Sunday, October 17, 2010

Termites and Foreclosures

We wrote in a 2008 post:
"The banking industry has never been set up to effectively and humanely handle large volumes of foreclosures, because it is something that they're not good at and something that was never anticipated on a large scale. The participants in the foreclosure business are yet another unregulated, unseemly lot. Unleashing this process on a large scale is like introducing termites into a house."

Now, yet again, Congress and the pundits are focusing on symptoms like documentation and robosigners. The media discussion, which will feature lots of political posturing and horse trading in front of the upcoming elections, will deflect attention from the fact that tranches of MBS's need to be written down which will again raise questions about portfolios where the paper is held.

Even potentially positive events for consumers, like sales of foreclosed homes have been revealed to be poisonous. Auctioneers have transferred homes to reasonably informed buyers with attached first and second mortgages! No one is responsible for even providing this kind of information to bidders. There's no accountability anywhere in this dismal financial chain and we wonder why consumers are not leading the recovery.

Thursday, October 14, 2010

A Cup or A Thimble of Joe?

David Einhorn of Greenlight Capital gave a terrific presentation at the Value Investing Congress, titled "Field of Schemes." His target is what's left of the old St. Joe Minerals Company, which shrunk down to a land trust holding timber and mineral assets, now called St. Joe, a public company.

Bruce Berkowitz, manager of the Fairholme Fund, is a lionized investor whose motto is "Ignore The Crowd." Fairholme owns 29% of JOE, according to the last company proxy. Other large owners include T. Rowe Price at 15% and Janus at 12%. Fidelity is shown as owning 6% of the outstanding equity.

As a preface, Einhorn mentions that representatives of the company refused to speak to him as he was doing his research. This violates one of my first principles, paraphrased as "speak to everyone with a legitimate interest in the company, and give them their due." Short sellers often do the best research on Wall Street, with a few exceptions. The other place where good research is done are the distressed debt desks of places like the old Lehman Brothers, and Larry McDonald's book is definitely worth reading for how good research is married to trading.

A CFO can always learn from speaking with the quality, institutional short sellers. There's an old Arab proverb that applies:"Keep your friends close, and your enemies closer." JOE's blowing off David Einhorn was bad judgment, bad business, and bad for the existing shareholders. I also suspect that Einhorn himself tried to speak to Bruce Berkowitz--it would be the first stop given Fairholme's stake--but the NYT reports that Einhorn's calls went unanswered.

The first thing I noted was the trouble beginning when JOE chose a CEO, Peter Runnell, who came from Disney. A decisive step was taken to turn JOE into a real estate developer, a competence for which the company had no history, no depth of management, and no relevant experience on the board of directors. Runnell left in 2008.

Much of the work shown in Einhorn's presentation represents good, solid, fundamental grunt work, with his staff poring over local government filings and regulatory filings which filled in the mosaic where the company's disclosures were inadequate or uninformative. I've spent lots of time in court houses and government offices as an analyst, and there are rich veins of information, but it is tedious and time consuming to go through it. Kudos to Greenlight Capital for doing the work.

Einhorn notes that over the past ten years, JOE has earned some $710 million in pre-tax profits from the sale of low basis cost properties from its beginning portfolio. In other words, its quality of earnings was not good, because of one-time items like gains and because it was not sustainable. Half of the quality portfolio has been sold, according to the presentation.

The company's pitch shifted once much of the quality real estate was sold, and Fairholme reports were about JOE owning land for the Panama City Airport, the construction of which would open Bay County to a huge influx of tourism into an area where JOE was developing resorts, conference centers, homes and golf courses. Einhorn goes into the realities of the fact that JOE's current land holdings are outside of the airport, and the company can't benefit directly from development because it had to give some of the land away to governmental bodies in order to develop it. Only one gate out of seven in the airport can accommodate the jumbo jets flown by Southwest and other major carriers. Current prospects for the airport are uncertain.

Other issues surround the lack of transparency in JOE's disclosures about the amount of capital investment it has made in its properties, the capitalization of expenses, and the fact that properties are reported as developed if one home has been built though the majority of the site is fallow. Einhorn estimates, with reasonable logic, that developed lots in the RiverTown development project are carried on the books at $74.5 million versus his estimated market value of $6 million. He goes through several other projects. The bottom line is that the company has taken relatively little in the way of impairment charges to-date, and based on the fact that the Florida market has been hurt significantly worse than most other US markets, current market values suggest that significant additional write-downs need to be taken. Einhorn's provocative floor for the share price is $7-10 versus a quote of $20.20 at this writing.

He derives the $7-10 number from market value estimates of the remaining rural land in the portfolio, leaving aside some unknown value for 41,000 additional acres of entitled acres that could be developed in the future.

It will be interesting to see where this discussion goes and how the board and the auditors deal with the questions raised. Stay tuned.

Wednesday, October 13, 2010

Tea Leaves

The Ceridian-UCLA Pulse of Commerce Index uses real time purchase volumes for diesel fuel as a proxy for over-the-road trucking volumes, which in turn relate to the volume of goods-in-process and final goods moving to distributors and retailers. According to the latest publication, the consecutive monthly declines for August and September have not been seen since 2009 and suggest that the economic momentum for inventory rebuilding has come to an end. The performance of this index is said to lead turns in the Federal Reserve's Index of Industrial Production. While we haven't worked with this Index directly, we have tried to use diesel fuel volumes as an indicator before, but never had the data that Ceridian can generate by providing financial services to volume purchasers. It's not a good sign.

At the same time, a friend who is in the market for rail cars indicates that cars are, and have been, coming out of mothballs, which is a positive for the rail car mode. Rail cars are associated more with movements of fuels, grains, fertilizers, chemicals and agricultural commodities. What he's seeing correlates well with the movement in grain prices, and it seems to be also related to growing export demand, despite the grousing about currencies. The problem with this indicator is that is seemingly more contemporaneous than leading. We'll have to wait and see, but the great results reported by Cargill yesterday reflect strength in the types of commodities that ship by rail, and to a lesser extent trucks.

Finally, the European Central Bank has published a paper by de Bondt, Maddaloni et al. that surveys the relationship between low rates in the run up to the financial system collapse, and it suggests that central banks may again be keeping rates too low for too long. The Fed is due to make more august pronouncements this week, and it may have painted itself into a corner. Backing away from the low rate commitment is off the table, especially given the pending mid-term elections. However, it is a very reasonable question to ask, namely the diminishing power of monetary policy to effect a meaningful boost of adrenalin to the economy going forward.

Thursday, October 7, 2010

Duelling Pundits

It's one thing to have sports commentators or journalists talking over each other on the air. That's like bear baiting at the Globe Theater: an uncivilized sideshow. I can't remember anything like the daily spectacle of Federal Reserve Bank Presidents talking over each other in speeches and press releases. This practice should be reined in because it's unseemly and disconcerting. The Fed is in danger of being trivialized.

Dallas Federal Reserve Bank President Richard Fisher gave a good speech at the Economic Club of Minnesota. It covers quite a few points we've made before about the huge liquidity trap resulting from the unprecedented "quantitative easing." He quoted a statistic that is from the classic central banker paradigm: member banks at the Fed are holding more than $1 trillion in excess reserves with the central bank! I have an idea to mop these up. Do like the gift card issuing banks do with consumers: make the excess reserve balances decline monthly at a 2% annual rate. In other words, use 'em or lose 'em.

In Fisher's conversations with small business leaders, he says access to credit is rarely their number one concern. Interesting, and surprising too.

Aside from share buybacks and dividend increases, big company leaders have told Fisher that they don't see the case for investing in capital beyond their depreciation, and the biggest factor is uncertainty about the political situation and the subsequent roll out of regulations from health care reform and financial system reform. This makes some sense, but it also makes the global executives seem to be indecisive leaders.

The upshot of Fisher's speech is that additional expansionary policies by the Fed would be "pushing on a string," and that's something that we've said for a long time. He is one of the few Fed Presidents to really put the onus on fiscal policy going forward as a key to relieving the angst felt by big company executives.

Wednesday, October 6, 2010

Choking on Disclosure

The newsletter Compliance Week reported on a symposium of general counsels, risk and compliance officers from a variety of public companies, mainly mid to large cap companies. These officers generally felt overwhelmed with the current and evolving structure of disclosures and filing regulations. Having gone through SOX as a first generation, accelerated filer, I can speak personally about the pressures this Act put on a small, efficient finance and accounting function. The people in the CW Symposium have very large staffs and access to sizable outside resources, and they feel overwhelmed!

They also felt that their boards had been forced into a checklist mentality, which has taken them away from their most important function which is to formulate, implement and monitor the company's strategic growth initiatives.

The example of the new SEC disclosures on climate risk is cited as an egregious example of regulation without purpose or value. Responsible scientists globally have a difficult time quantifying what climate change is, let alone "climate risk." Take this down to the level of an individual corporation: the concept of a corporation being able to describe or measure the effects of its actions on its incremental climate risk is laughable. Nevertheless, trees will be felled, paper wasted, and expensive lawyers will draft opaque prose that meets the standard, but which also will be glossed over by institutional investors for whom this provides no guidance on whether or not to buy or sell shares.

Ken Jones, the Chief Compliance Officer of Huron Consulting said, "We spend three times as much money...on executive compensation reporting than we did two years ago." This is a CAGR of 73%! The Dodd-Frank bill will add considerable complexity to the already foggy bog of executive compensation reporting.

To be fair, there's another side to the executive compensation issue. The previous disclosure was woeful, and in light of egregious practices that came out during the financial meltdown, it was clear that this was, and is, a serious issue of misappropriation of shareholder funds as well as an issue of economic rent capture. Since nothing substantive was achieved to address the fundamental issues that Rakesh Khurana has so clearly identified for so long, it was inevitable that a crushing set of regulations, yet to be implemented through rules, would emerge from the vacuum.

What about smaller public companies, which is where I have served as a CFO and a board member? Kevin Fry, the general counsel of PACCAR, said "You can't be a little public company anymore." That is not good for economic vitality.

Tuesday, October 5, 2010

VW Loses Its Way

VW is shaking up its top executive management and changing its strategy to focus on the American market, and it couldn't come at a worse moment. The North American market is probably permanently downshifting to a lower level of sales, and it is narrowing the mass market segment, while also increasing segmentation in the luxury segment.

VW's always had wonderful, German characteristics: tight, precise steering; great brakes; a good front suspension; reliable gearbox and short throws, to name a few. Plus, they were economical and flat-out, fun to drive. My last VW, a German-built diesel got 50 mpg in New York City driving in the eighties and cost me nothing to maintain.

Now comes the news that they are going to "Americanize" the car. Big mistake. They were so close to having the right car in the Jetta, which had Rabbit-like performance in a big, comfortable sedan. They never got it quite right, but they were very close. They should go over the finish line with the Jetta platform. Apparently, it's back to the drawing board, and I don't think it will work. We have Saturns, Hyundais, Accords, Camrys, Nissans and Mazdas. Another me-too model won't work, and without the Teutonic flavor, VW will lose all its distinctiveness.

Some consumers regarded VW higher-end Jettas as BMW for the Ordinary Joe. Now their cup of Joe is going to become a cup of Sanka. Too bad.