iBankCoin
Tokyo based, expat Cape Bretoner. Learning to live in a de-leveraging world. Better suited to the crusades. CFA & FRM charter holder. Disclaimer: @Firehorsecaper reminds investors to always due their own due diligence on any investment, and to consult their own financial adviser or representative when warranted. Any material provided is intended as general information only, and should not be considered or relied upon as a formal investment recommendation.
Joined Jun 23, 2015
73 Blog Posts

PUTIN’S LONG ARM – CORE VENEZUELA ENERGY ASSETS UNDER RUSSIAN CONTROL

While much of the US populace navel gaze over “he said, he said”, rear view mirror stuff with the 2016 US Presidential appointments/elections, real world carnage is taking place, in real time. Venezuela’s communist government slinky has run out of gravity and steps, falling at the feet of mother Russia. Venezuela has defaulted on $60bln of debt, officially termed “selective default” at present by the rating agencies. Russia is not sure what all the noise is about as their bi-lateral payments have been made on a full and timely basis? Ditto for China.

Caracas is 3,317 miles from Washington, versus the 4,861 miles from Moscow to Washington, DC (and much closer to key US energy assets in the Gulf of Mexico). Beijing is 11,158 miles fromWashington, for reference. Russia/China having strategic energy assets so close to the US should be a point of concern both for the current administration and for the bigger US GOM refiners. Billions of US dollars are flowing into Venezuela from Russia and China, along with a brain trust of skilled workers numbering in the thousands to ensure both execution and return bogeys are met. Russian war ships are on the way to Venezuela as we speak, a strong sign of Russia’s support for the struggling communist nation and the “financial aid” Russia has extended. Putin must have a good giggle daily at having a South American domiciled Ukraine-like foothold without an argument, let alone a public conflict with the US (for now). Back in August, Trump stated publicly that he could not rule out a military option with respect to dealing with the struggling South American nation.

Venezuela has a population of 31.6 million, about 15% less than Canada’s. Venezuela boast the largest conventional oil reserves and the second largest natural gas reserves in the Western Hemisphere. Venezuela’s non-conventional deposits are approximately equivalent to the world’s reserves of conventional oil. The majority of Venezuela’s domestic energy needs are met with hydroelectric power.

Bahrain has requested assistance from neighboring Saudi Arabia and UAE. Saudi Arabia has taken a page out of Brazil’s playbook with “Car Wash 2.0” anti-corruption crackdown. Zimbabwe overnight has seen a coup. Fun times to have the VIX in the low teems (12.6, up 9%). Sovereign EM is not the only story here as EM corporates are the ones with the more heady issuance of late, US$8bln a week at the  most recently clip. IG EM US$ bonds returns have been stellar thus far in calendar 2017 with 5 nations clocking > 10% returns year to date; Uruguay, Panama, Peru, Mexico and Kazakhstan. So much room to fall from here. Not a sky is falling comment, buy many assets are priced for perfection when we have blemished prospects for continued/further levity.

Back to Venezuela, recovery rates are very hard to handicap in EM credit, especially when the key assets that would result is some recovery have been sold to Russia and China respectively. VENZ, sovereign rating “D” standing for default,  (bond ticker, Benz with a V) 7% 1 December 2018 sold off 40% to trade $32/$35, (seems high given scant recovery prospects). Plenty of info in the popular press on the “deals” that have been struck between Petroleos de Venezuela (PDVSA) and Russia’s Rosneft in the run up to Maduro’s most recent restructuring  announcement.

The pace of EM bond issuance will be greatly curtailed, if not ceased near term. The US$ EM bond craze we have seen evident since the GFC has seen US$3 trillion of new debt issued. Little wonder high yield ETF’s have taken a knee in recent sessions, the dry heaves are coming. Calpers most recent tactical asset allocation back into bonds from DM equity will not be soon enough or far enough down the ratings spectrum to provide an air bag for the coming head on collision.

Venezuela, for their part, have been very critical of the rating agencies, “”In the last 36 months, Venezuela has canceled, for the concept of Reimbursed Capital and Paid Interest, the amount of $ 73, 359 billion, an immediate consequence of each payment and each compliance has been the increase of country risk by rating agencies risk, which have been deeply inefficient to prevent scandalous financial setbacks in financial power centers in the United States, Europe, and Asia, but which are used as an instrument of devious action against our country: the more we have paid, even though we have always been timely in honoring our payments, risk rating agencies, following the pattern of financial blockade undertaken by the Trump Administration, makes it expensive with reports devoid of any form of rigor and veracity, the cost of our debt and intervene to hinder Venezuela in its condition of good payer and solvent country, access to external financing, common and frequent for almost all countries of the world”

Only 2 non muslims nations are included in Trump’s most recent travel ban. North Korea and Venezuela. Good luck getting plug nickel out of Venezuela near term if you are a US$ bond holder. Dalio’s call on gold, increasing his weighting significantly, seems precinct. A number of geopolitical fuses have been lit, we just don’t know which one goes boom first.

Credit wider, bond steady / curve to stabilize, equity vol to spike, global equities softer, gold firmer.

Follow me on twitter @firehorsecaper

Don’t forget, cash is an option from an asset allocation perspective.

JCG

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MUNI DEBT: SALT IN THE WOUND FOR HIGH TAX STATES

tRump’s GOP tax plan is not sitting well with the high tax, blue leaning states of California (11.4% rate for State and Local Taxes, aka SALT), Connecticut (11.4% SALT), New York (12.6%) and New Jersey (12.3%). These four states account for 22% of the US population and 23% of US GDP. I frankly expected a higher percentage GDP wise, with so much of the vast contiguous states dedicated to energy production (1000 gallons a second in demand) and animal husbandry (9 ounces a day per capita).

With the proposed changes to the US tax code, removing the deduction of SALT payments from ones Federal tax bill going forward, the effective tax rate for the wealthy will be increasing significantly on passage of the bill in close to its current form. This will greatly enhance the attractiveness of municipal debt and has resulted in a stonking rally in muni bonds this week. Early innings with respect to the rally, unless the federal deduction for SALT survives in the final drafting. Rolling back SALT deductions offsets approx. 1/3 of the $1.3tln “hole in the bucket” left by the proposed GOP corporate and individual tax cuts (largely paid for by the 3% resultant GDP growth). The rally moves in muni credit will likely be muted on the heels of the ongoing Puerto Rico default/debacle, hence there is time to put in the work and do the analysis required to come up with a rational investment decision.

https://ibankcoin.com/firehorsecaper/2016/04/10/puerto-rico-the-spoils-of-war/#sthash.uTYSeX6D.dpbs

The initial read of Trump’s tax reform plans appeared to be hemlock for muni debt, driven largely by lower absolute tax rates, with the highest 39.6% (solo income >$418.4k, joint filer >$470.7k) bracket moving to 33%. With key tweaks to the tax reform plan on the deductions side, as many as 25.5% of taxpayers could see their taxes increase from current levels under the currently tabled tax reform plan. It appears the 39.6% bracket will likely be kept for those earning above 7 figures.

As an aside, NJ, post election, is expected to re-institute the millionaire tax for resident making > $1mm (2% effective surcharge on income > 1mm). In addition to the egregious existing taxes NJ levies, for no good reason other than winning geographic roulette in being commutable to NYC, one should expect a portion of NJ’s millionaires (7% of the population on net worth metric, much lower % on income) to pull up stake, taking a page out of Tepper (formerly #1 NJ taxpayer, now in Florida) playbook. With nine states credit watch negative, including NJ, a betting man would place odds on more downgrades than upgrades going forward.

For muni bond investors in the 4 high tax states profiled, there are a bevy of state specific funds that cater you your investment needs, if purchasing bespoke muni bonds is beyond your ken. The advent of on-line trading platforms is improving the state of play, but the bid/offer spreads on muni bonds is high, both outright and compared to taxable peers.

https://www.marketaxess.com/trading/municipal-bonds.php

Two funds with comparable scale and liquidity are BlackRock Muni Holdings New Jersey Quality Fund, Inc. ,MUJ  and Nuveen New Jersey Quality Municipal Income Fund, NXJ. The big daddy is a Vanguard offering, 4x bigger at $2bln +; Vanguard NJ Long-Term Tax-Exempt Inv., VNJTX, yielding 3.46% (Federal and NJ tax exempt) which may seem paltry, until you calculate the taxable equivalent basis (TEB). Speaking to investment income, a NJ taxpayer in the top tax bracket in all categories pays 39.6% in Federal tax, 8.97% in direct NJ State Tax and Obamacare 3.8% tax on investment income (muni bonds are exempt). Adding up this stack gets you to 52.4% in taxes, coincidentally the same as the Province of Ontario in Canada (ditto on distress, save the pension funding shortfall issue).  Vanguard, and other veritable institutional investors have online calculators for TEB for those not mathematically inclined.

In my rudimentary NJ example, the VNJTX yield is 3.46% and the denominator is 0.476, resulting in a taxable equiv. yield of 7.27%. A quick perusal of global fixed income markets will find many gobsmacked to realize how high a 7% taxable yield is in the current environment.

US state pensions remain woefully underfunded in aggregate (70% funding rate, > $1 tln unfunded) and the public pension gravy train keeps on chugging, at least for now. Even for a $18 trillion dollar US economy, so many debt tallies in the trillion plus club should give the non-billionaire adults in the room cause for pause, if not reflection. Student loan debt; $1.3 tln, auto loans $1.2 tln and credit card debt (“revolving”, at least in theory) $1.1 tln. Those reticent to buy NJ domiciled muni debt and or NJ dedicated funds can of course give NJ a wide berth from an investment perspective. The rub is that your tax exempt muni yield will be only federal tax exempt, not state tax exempt. Following on my previous NJ example, your TEB (aka, your taxable basis “bogey”) becomes 6.11% instead of 7.27%.

The same analysis should be done for potential muni investors in “the big 4”, NNCC, as you are spoiled for choice in terms of muni debt and/or state specific funds (mutual, closed-end and ETF forms) to choose from.

When things get really interesting, “cross over” buyers, those that can not use the US tax exemption, find it compelling to buy US muni credit versus other investment options available in their home market. I’m a holder of BlackRock Taxable Municipal Bond Trust, BBN in my IRA (the underlying bonds are taxable hence distributions, currently yield 6.75% is taxable in non tax sheltered accounts). Pension obligation bonds, issued by states attempting to improve their pension funding % (in lieu of also paring benefits, which other countries do on a near 50/50 basis, until fully “funded” from an actuarial perspective) are also taxable.

With equities “off the leash”and vol compressed due to medicated markets, munis have a valid place in the asset allocation for US taxable investors (likely a multiple of gold and/or crypto). The US municipal bond tax exemption is one of the few near-free lunches on offer in global investable fixed income markets.

Keen to address any questions, as I know this space well. Follow me on twitter @firehorsecaper. Good to be back.

Caleb Gibbons, CFA

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BARINGS BANK REDUX: SANTANDER BUYS BANCO POPULAR FOR €1.

Barings Bank was sold for £1 to ING back in 1995, but the comp is close one has to admit.

Spanish regulators red carded Banco Popular, selling them to Banco Santander for €1 (US$1.13). The mechanics of a resolution mechanism provide us with a potential road map for the future. It appears subordinated bond investors were not charging enough for the tail risk being assumed.

Santander press release:

“07/06/2017

Banco Santander today announces that it has acquired Banco Popular. The acquisition takes place following an auction conducted by the Single Resolution Board and FROB in which Santander was selected as the successful bidder, paying a notional consideration of €1. As part of the transaction Santander will complete a rights issue for a total amount of €7 billion. This will cover the capital and provisions required to strengthen Popular’s balance sheet. Existing shareholders will be given preferential subscription rights. The rights issue is underwritten.”

The focus of the popular press (pun intended) has focused on the equity component of the capital structure, but the real story has been on the debt components, both senior and subordinated.

Along with the common equity, as one would expect with an outright sale at €1, addition tier 1 (AT1) bonds have been totally cancelled (traded high $50’s $ price to effectively zero). Tier 2 Popular subordinated bonds have been voided through conversion to equity @ €1 (in totality, along with existing common shareholders). Senior debt has been protected in this scenario, with the 2’s of 2020 trading up $12 to $102, at the time of publication.

Look for other challenged issuers’ AT1 bonds to “adjust” to this news (read: not higher in price) over time, although initial reactions appear to be muted.

Follow me on Twitter @firehorsecaper JCG

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ILLINOIS GO’s (Baa3/BBB-): JULY FIREWORKS AHEAD; JUNK SALE LIKELY

Illinois is in a serious bind. The road to perdition has been well lit, and signposted. 8 downgrades in 8 years for the General Obligation (GO) liabilities of the state, with another drop down to junk likely as soon as July 1st, the beginning of their 2018 “fiscal” year. Moody’s and S&P last moved June 1st taking the GO ratings to 1 notch above junk with the ominous warning that they will not be timid if further downgrades are in order. Illinois remains with a negative outlook and on negative watch with both major rating agencies. The unfunded pension liability of Illinois’ five state plans now exceeds US$130bln. IL State now has the lowest funded pension percentage (ranging from 37.5% to 44.2%) of all 50 states. All 5 plans have been achieving investment results well shy of their actuarial assumptions, the most prominent, State Employees’ Retirement System of Illinois (SERS) by -1.75%, returning 5.5% versus a 7.25% bogey (reduced modestly in 2013).

Each Illinois taxpayer is on the hook for almost $50,000 in unfunded liabilities (pensions and post retirement health benefits). Illinois is the 5th most populated state in the union at 12,800,000, for reference. Same ranking for income (for now). Illinois has proposed a 20% privilege tax on investment management services (read; hedge funds) which was tabled in February 2017, approved by the House Revenue and Finance Committee in March and if enacted becomes effective July 1, 2017. The taxation of carried interest is highly topical at both the Federal and State level presently with both NY and NJ considering similar legislation (CT and FL are gladly accepting hedge fund refugees at the time of publication).

In addition to the pension woes, Illinois has not passed a balanced budget for 3 years in a row, as required under their constitution. This has resulted in the untenable situation whereby the state has accumulated $14.5bln in “accounts payable”, on which they will owe $800mm in interest and fees as of June 30, 2017. The cascade effect (i.e. it rolls down hill) has been very damaging. Chicago Public Schools (CPS) are owed nearly 1/2 billion from the state ($467mm to be exact) and must resort to “Grant Anticipation Notes” to bridge the funding gap created. CPS are hoping to keep the cost below 8% which is the usury cap in effect for some school budgets. Chicago accounts for a full 20% of K-12 (Kindergarten through grade 12) enrollment but a more modest 15% of the IL state budget. Laughably, the Chicago teachers are not covered by the state Teachers Retirement System. Chicago Teachers Pension Fund (CTPF) is also a basket case, as you might surmise and in addition to a number of other issues led Illinois’s largest city to be downgraded to junk status in May 2015.

Bond investors have taken note. Spreads on Illinois debt to MMD (Municipal Market Data, the yield curve of the highest rated, AAA/Aaa  municipal bonds, as published by Thompson Reuters) have widened. The eventual downgrade to junk, aka non-investment grade, will make IL debt ineligible for investment for some of their major institutional investors (one of which has already called for a boycott of Illinois debt) which are restricted by mandate to purchase only investment grade muni bonds. There are of course high yield muni funds, but they tend to be smaller in terms of AUM and have had some performance hiccups (Puerto Rico) which have curtailed investor inflows. Suffice it to say there will be more sellers than buyers on a downgrade to junk status for Illinois.

Municipal investors are a conservative bunch. Not a lot of crypo-currency investors in this lot. They are typically older investors in the highest Federal tax brackets (39.6% & 35%), let’s call them the 3%. An increasing portion of muni bond portfolios are Separately Managed Accounts (SMA’s), but the majority are still via mutual funds and closed end funds. ETF’s have made some inroads, but modest in market share terms. 10 year Illinois debt is yielding approximately 4.3% (Federal tax exempt, State tax exempt for IL taxpayers and not subject to 3.8% Obamacare investment tax). Converting this to a TEB (Taxable Equivalent Basis) a non-IL resident in the top tax bracket would need to invest in a corporate bond yielding 7.6% to match. Note: HYG the $20bln high yield ETF yields 5.13% in comparison, hence you might need to buy an out of favor sector like bricks and mortar retail, otherwise non-rated is likely where you will find >7% in the US domestic bond market.

The same negatives that sent Puerto Rico (importantly not a State, technically a Protectorate https://ibankcoin.com/firehorsecaper/2016/04/10/puerto-rico-the-spoils-of-war/) on tilt recently are evident in Illinois as well, namely rampant crime and failing schools. Many schools are years behind in even tabulating scoring tests, which would be required to confirm their bottom quartile performance. To rival the record for shootings in Chi-town you have to go very far afield to places like Kabul.

Kentucky born Lincoln might hide the other half of his face if he were privy to the folly that has befallen “Land of Lincoln”.

Tread lightly, tread carefully. This is July business, post downgrade to junk for the GO credit. Remember, the highest yielding bond is often not the best “value”. Cross-over buyers that can not readily utilize the US Federal tax exemption (i.e.; foreigners, hedge funds) might look to the Build Illinois Sales Tax Revenue Bond which offers enhanced security (and ratings) from the dedicated sales tax pledge (This was also the thought with PR’s COFINA bonds which interest was recently suspended on by the courts, but you get the idea). The PO’s (Pension Obligation) bonds of Illinois are also taxable and will likely swoon a bit on a GO downgrade to junk status. Those looking to structured deals can vet Illinois tobacco settlement bond “Railsplitter” which was structurally superior on issue in 2012 as it could withstand smoking cessation rates of 4% wrt debt service (over $55bln of tobacco bonds have been issued across all 50 states).

Follow me on Twitter @firehorsecaper JCG

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AMERIZUELA: $FNMAS FANNIE MAE – ONLY ONE OUTCOME, RULE OF LAW MATTERS

While a number of “Mom and Pop” investors were also caught in the downdraft of Fannie Mae and Freddie Mac’s Conservatorship in September 2008 (10 year anniversary next year!), the largest current law suits appear to be from the hedge fund community at large. Fannie and Freddie had $36bln in preferred shares o/s when they were placed into Conservatorship, with community/regional banks the largest aggregate holder.

Bruce Berkowitz’s Fairholme Capital appears to be the most “all-in” with respect to position sizing with 35% of the fund’s capital deployed long Fannie and Freddie subordinated preferred shares. AUM for Fairholme is currently approximately $3bln (they were managing $19bln at their pinnacle), making this a 10 digit wager.

In Fairholme’s words:

“Fannie Mae and Freddie Mac. We believe that these two companies may be the most important financial institutions in the United States – perhaps the world – and directly support housing affordability and accessibility, including the uniquely American 30-year fixed-rate mortgage. They are a major reason why our country did not descend into a second Great Depression. Millions of American families depend on Fannie Mae and Freddie Mac to lower the costs and improve access to homeownership. In times of stress, these two have helped to ensure the continued functioning of the U.S. housing market. They have no substitutes. Fairholme’s investment in Fannie and Freddie demonstrates a commitment to ignore the crowd and invest in valuable, systemically important institutions – even those that are politically unpopular.”

Richard Perry’s Perry Capital (in wind down), is also long the prefs, exclusively.

Bill Ackman’s Pershing Square is much less committed, in terms of size of position at least (but still a sizeable swing at 9%), and has chosen to purchase the common shares of both Fannie and Freddie (although he has been rumoured to be selling common in favor of the prefs). Both GSE’s applied to be de-listed in 2010 from the NYSE and now trade over-the-counter on OTCQB, the “venture” stage marketplace for early stage companies that report to a US regulator.

The original government bailout of Fannie and Freddie was $187.5bln and they have now remitted in excess of $265bln back to the Treasury ($78bln more than the amount of the bailout). Fannie Mae accounted for $116.1bln of the $187.5bln and have repaid $159.9bln total to date (owned + $43.8bln surplus via net worth sweep).

The mechanics of the tithe were changed in August 2012 when the 3rd Amendment to the GSE Conservatorship  was passed (both GSE’s were paying a 10% dividend to the US Treasury on the Senior Preferred shares up until that point). The 3rd Amendment, as it became known, called for a “Net Worth Sweep” which is to be kept, in effect, for perpetuity. The golden geese have remained tagged since and the $ have been rolling in. Earnings for both GSE’s have been bolstered by an increase in guarantee fees as the fees on new mortgages exceeds the fees on those in the existing portfolio. Both have seen growth in their total guarantee portfolio, along with underlying mortgage origination and finally both have experienced lessening credit losses as their aggregate portfolio level credit metrics improve. An amazing turnaround story, were it not for the gold eggs being sent to corporate (aka Treasury) while they are still warm from being laid.

Fannie Mae had a profit of $12.31bln in 2016 as a point of reference. One potential fly in the ointment, in terms of reported earnings going forward, relates to deferred tax assets (DTAs). This is a bigger issue for Fannie than Freddie because of the relative size of their DTAs and the potential impact of Trump tax reform (corporate rate from 35% to 15% proposed, but many handicapping a final rate of 20%). Fannie Mae’s DTAs stand at $35.1bln and Freddie Mac at $18.7bln. Steve Eisman, who disclosed owning Fannie Mae prefs in smalls,  implied on TV this week that the DTAs could prove to be a catalyst for action, implying the US Treasury would be called upon to make the GSEs whole on the potential DTA value impairment due to the proposed Federal corporate tax cut. I may have misinterpreted Mr. Eisman’s call on this, but one thing is 100% for sure, the status quo is not sustainable. The US Treasury can ill afford to assume an additional 5-6tln of debt by nationalising the GSEs when the non revenue neutral programs on the table already get the USA to the mid 20’s (trillion) in Federal debt.

The lawsuits have not been going swimmingly for the hedge fund dominated plaintiffs to date. Shares of both GSEs have dropped >25% in the last 2 months months after an appeals court upheld a ruling against shareholders challenging the legality of the government’s Conservatorship. Shareholders continue to argue that the government’s net worth sweep of all GSE profits in perpetuity is unconstitutional.  An overturn of the perpetual full profit sweep is  the only viable alternative leading to a non zero-valuation for both the common shares and junior preferred shares of Fannie Mae and Freddie Mac. This is a binary, legal based outcome, hence not for the faint of heart. Ackman’s take, “We believe that Fannie and Freddie offer a compelling risk-reward as there are various scenarios which will generate a many-fold multiple from current levels. While a total loss is possible, we believe the probability of a total loss is relatively modest, and has become lower in the new political environment.”

Catalysts for a positive outcome:

1.) The U.S. Supreme Court overrule previous court decisions and overturn the net worth sweep.

2.) Trump and Treasury Secretary Steven Mnuchin recapitalize Fannie and Freddie, returning control to shareholders.

The 2nd scenario is the one that has boosted the stock since Trump’s win in November. FNMA and FMCC spiked as much as 250% (from $1.65 to $4.40) before settling in at the current $2.65 level (+50% from November).

Nobody is better suited to craft and execute GSE reform than Mnuchin, aka “The Loan Ranger”. Post Goldman, he purchased failed Pasadena, CA IndyMac,  doubled its capital base (via additional acquisitions) renamed it One West and sold it to CIT for a tidy profit.

https://cei.org/blog/mnuchin-must-bring-transparency-fannie-mae-and-freddie-mac

Mnuchin has publicly stated:

“[We have got to] get Fannie and Freddie out of government ownership. It makes no sense that these are owned by the government and have been controlled by the government for as long as they have. In many cases this displaces private lending in the mortgage markets and we need these entities that will be safe. So let me just be clear we’ll make sure that when they’re restructured they’re absolutely safe and they don’t get taken over again but [we have got to] get them out of government control.” (Footnote: Nov. 30, 2016)

“[…] it’s right up there in the top 10 list of things that we’re going to get done and we’ll get it done reasonably fast.” (Footnote: Nov. 30, 2016).

Mnunchin’s right hand man is Craig Phillips, a near 40 year Wall Street veteran (most recently at venerable Blackrock) but he ran the Mortgage Securities unit at Morgan Stanley in the lead up to the GFC (May 2006, about a year before the wick was lit on the MBS woes to follow).

With Housing Finance Reform a top 10 priority, in terms of timing this likely makes it 2018 business (prior to 2018 midterms). The Trump tantrum we saw in the markets yesterday provide a potential entry point for punters willing to take Mnuchin et al at their word. FNMAS, the most liquid Fannie subordinated pref traded off by 5.6% to $6.75 yesterday (17-May-2017). The 52-week range has been a wide $3-$11, reinforcing the speculative nature of the proposed foray. The low was close to 9/11/2016, the 8 year anniversary of the prefs going ex dividend on 9/11/2008. The Trump Bump sent the Fannie prefs prices skyward, from lower left to upper right as Gartman would put it, approaching $11, appropriately, on Valentine’s Day 2017. FNMAS now at $6.75 have since given back 38% from the February 2017 $11 high.

This is the appropriate time to ask, “What is the upside on an investment in Fannie Mae subordinated prefs (FNMAS)?”, given that the downside has been shown to be zero. Fannie Mae did not file for Ch. 11. It was placed into Conservatorship, along with Freddie Mac. The capital structure remains legally intact, under which the subordinated prefs rank behind the US Treasury senior prefs, but importantly ahead of the common (which is to be diluted by 80% …. the US Treasury mandated “deal” when placed into Conservatorship). Also worthy of note, at the time the GSEs were placed into Conservatorship all senior and subordinated debt of the GSEs was paid/matured at 100 cents on the $. Before the US Treasury prefs can be extinguished (legally) it highly likely the dividends on the subordinated prefs would have to be reinstated. There are 16 discrete series of Fannie Mae subordinated prefs, FNMAS just happens to be the most liquid. None of the prefs are cumulative (i.e. no legacy dividends are owned once they start to pay again). The coupon on FNMAS is Max (3 mth Libor +4.25%, 7.75%) with a par value of $25.00. Cessation of the net worth sweep would see FNMAS trade back to par ($25) in short order for a 3.7x return on invested capital. It will likely take Fannie Mae time to build a capital buffer once/IF the net worth sweep is nullified. The US Treasury, despite the windfall seen via the net worth sweep will likely mandate the timetable for their senior prefs to be repaid. FNMAS, on a dividend reinstatement would pay 7.75% until Libor gets to 3.495% (good things are happening if/when we get 3mth Libor back to a 3 handle, I assure you), at which point L+4.25% would become the MAX, hence the applicable coupon. Given how high the rate is versus current market rates, it stands to reason that steadfast FNMAS investors could well see the market price trade well above par. I like the potential payout on a positive outcome for FNMAS  (3.7-4.5X invested $) much better than FNMA common. FNMA common traded off 3.3% yesterday to $2.65 and with some analysts guessing on an equity value of $15 post net worth sweep that would get risk-seeking investors a 5.66x return on their money. The pick-up versus the subordinated prefs does not seem worth the substantial additional unknowns and the known capital structure inferiority in terms of priority of payments.

Mnuchin is scheduled to speak today on GSE Reform in front of the Senate Banking Committee. Nobody is holding out for 100% clarity, but in a land increasingly filled with mere whispers, a clear voice can go a long way in setting the future course for perhaps the #3 priority for the Trump administration (just behind healthcare and tax reform).

Follow me on twitter @firehorsecaper

JCG

Disclosure: Long FNMAS, 2% allocation @ $6.75.

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HOME CAPITAL GROUP: $HCG – REALITY CHECK FOR LONGS

Equity investors in HCG have been heartened by the 70% rally seen thus far the week of May 8, 2017. To put this dead cat bounce in context, the stock, after rallying 70% this week, remains down 72% year to date. Home Capital Group trades on the TSX in Canadian dollars, last traded C$8.76 (US$6.40 with USD/CAD at 1.37) and started 2017 at just under C$32 (high print was a 55 handle in 08/2014 when USD/CAD was at 1.08!). There is an otc listing in US$, HMCBF as well but I’d use it for tracking only, given the lack of liquidity evident.

I would argue there is too much Home Capital equity glee evident.

The costly (>20% all-in with full fee stack) HOOP (Healthcare Ontario Pension Plan) liquidity facility for C$2bln was the bullfighters spear in this drain spiral. In addition to onerous monetary terms, the degree of overcollateralization HCG had to agree to (2x, i.e. a 50% haircut on Home Capital’s uninsured mortgage collateral) means that access to funding will have a terminus when HCG has no additional collateral deemed finaceable. Short of the HOOP facility terms being re-cast (near zero chance), it appears the days of HCG holding mortgages on their own balance sheet are long past. The company has admitted such in their latest press releases, and have entered into an arrangement with their competitor MCAP (as reported in the press, not by HCG) to on-sell mortgage commitments and renewals, initially for C$1.5bln with the potential to expand the program. Quebec pension plan (you can’t make this stuff up) CDPQ part owner of MCAP has responded that MCAP is the not the end buyer rather is a facilitator for the sale of the mortgages (MCAP will manage and service the loans for the buyer). MCAP have > C$61bln in AUM with a speciality in Canadian mortgage assets.

HCG currently has C$18bln in mortgages on balance sheet, currently largely funded by C$12.7bln in GIC deposits (including brokered GICs) which are eligible for Canada Deposit Insurance Corp (CDIC) coverage. Home Trust’s May 24th deposit notes traded in a range of $89.75-$94.875 on May 5, 2017, as reported in the popular press. Taking a mid off this wide trading range get us to a price of $92.3125. Assuming the CDIC insured 100% of the GICs in question, this would represent a liability of C$976.3mm of the aggregate insured deposit note program (C$12.7 * (100-92.3125)). This implies the Canadian government (via CDIC) is a bigger stakeholder than HCG equity holders, given the mkt cap of C$562.4. Based on the rally in HCG equity since May 5, 2017, secondary GIC levels have likely improved, but this example is more to show that this is a more of a razor’s edge scenario than most “hold my beer” financial journalists are acknowledging. HCG has a market cap of C$562mm and a mortgage portfolio of C$18bln, meaning just over $3 in price for the book wipes the equity out (C$18bln * 0.03 = C$540mm). Fraud naturally tends to widen bid/offer spreads as potential buyer naturally require a safely buffer for the unknown.

HISA funding has largely rolled off, and will not likely be a source of funding going forward. HCG also have the noted HOOP C$2bln liquidity back-stop (more than 70% drawn 2 weeks from establishment) which effectively served to replace the hole in their bucket from HISA redemptions. Home Capital’s  bigger problem may be they are NOT too big to fail. In my view, there would be little public support within Canada for a bail-out of HCG, either directly or through backing white knights (domestic or foreign). Why did the Canadian cross the road? To get to the middle. Not going to happen, especially in light of the blanket Moody’s downgrade just announced for all the Canadian banks, although still very highly rated versus global peers (RY to A1 from Aa3). Moody’s pointed to the banks collective exposure to over-indebted consumers and high home prices, and all remain on negative outlook. Distressed situations call for IRR’s in the low 20’s (HOOP’s facility is estimated at 22.5%, GS and FIG participated in the syndicated deal, and rarely accept less).

Home Capital is a regulated mortgage lender, and is the largest non-bank mortgage lender in Canada. This distinction is as critical as it was during the global financial crisis. Non-banks lack critical access to wholesale funding and access to the central bank funding window (The Fed in the US and the Bank of Canada in Canada).

Liquidity: Bear Stearns was sold to JP Morgan in March 2008 via arranged marriage for $2 a share ($236mm). The deal was announced over the weekend to quell global market nerves ahead of the Asia open. Bear closed at $30 a share (0.38x of $80 book value) on the Friday before the deal was announced at $2 (note: later revised to $10 as further due diligence could be conducted, the NYC headquarters of 85 year old Bear Stearns alone was worth $1bln). The Fed provided a $30bln back-stop to JP Morgan to better digest the thorny prey. Bear Stearns traded as high as $172 a share in 2007 and as an aside bought back $1.6bln in stock in 2007 alone.

Leverage: Fannie Mae was levered at 20:1 coming into the GFC. An increase in their loan loss experience from 4 basis points to 52 prompted both Fannie and Freddie to be placed into conservatorship where they remain. Leverage accentuates the negative by more than most can envision.

It remains to be seen if the poison laiden HOOP spear is lethal for HCG, but I’m confident that the stock is worth less than it is trading for now, and near fully certain it is not a 2.5 bagger from here (CIBC Asset Mgmt have tripled down on their initial long position and own 15% of the common). The only institutional investor that owns more of HFC stock is Turtle Creek Asset Mgmt  which holds a concentrated bet (25 positions in total) for 19% of the embattled lender. Turtle Creek’s flagship funds is at approximately C$2bln (closed to new investors) and it should be noted their track record to date has been stellar, boasting a 23.7% CAGR (1998-2016). I’ll be sure to check if they are open to new investors in 2018.

This blog post in being penned in Tokyo which is 13 hours ahead of North America, but a big day lies ahead for all involved in the HCG story. Delayed quarterly earning for Q1 are due and more importantly management is expected to shed more sunlight on recently announced transactions, including the price terms and cpty on the C$1bln mortgage sale. The other disclosure investors are keen to hear is on HCG’s announcement that they will be “tightening our lending criteria and replacing some of our broker incentive programs and expect that will result in a decline in our originations and renewals.” There have been daily tweaks to the rule book this week, but local mortgage brokers report Home Trust is still in business. New business is being written, with a few caveats; Best pricing has been eliminated (called Ace pricing), the max mortgage amount is C$600,000 which it was noted is not that useful in Toronto, their lowest rate is 4.69% with a 1% fee and their non conforming rate is 6.5% (noted as off market). Other B lenders have raised rates as well resulting in a widening gap between the A and B rates. Smaller competitor Equitable (who scored a liquidity facility on much better terms than HCG) is going flat out and not taking refinancings right now due to volumes. As of Wednesday May 10th Home Trust was also just doing purchases (no refinances). Broker finder fees were reduced this week as well (as HCG noted they intended to do).

The press is Canada, to my mind, has been too sanguine about the risk to the HCG story playing out well for retail HCG equity investors. Most analysts have given the situation a wide berth of late. TD presented an analysis this week showing their thoughts on HCG equity valuation for different valuation levels for the C$18bln mortgage portfolio; at $91.00 (a $9 discount) they saw equity as worth $0. At $95.00 (a $5 discount) they saw C$9.70 (close to where we are now at C$8.76) and a sale at par, $100 resulting in an equity valuation of $21.68. Put another way, to make 2.5x your money you need all the stars to come into alignment and see Home Capital get 100 cents on the dollar for their mortgage book. Hope is not an investment strategy.

Those long intent on riding this out should get up the curve on CCAA (Companies’ Creditors Arrangement Act), Canada’s equivalent of Ch. 11.

Follow me on twitter @firehorsecaper. JCG

Disclosure; Currently flat, as borrow for a short position has been unavailable from my current broker (IB).

 

 

 

 

 

 

 

 

 

 

 

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RARE EARTH METALS REDUX: UCORE RARE METALS INC.; $UCU.V, $UURAF

Background:

Rare Earth Elements (REE) are expected to be a $9bln market by 2019, hence a tiny but critical market. Industry shipments totaled 133,000 tonnes in 2010 and have grown at a 9% CAGR over the last several years, with shipments expected to total 192,000 tonnes by 2019.

75% of global REE are currently sourced from China, where the bulk of global supply is processed, due largely to lower labor costs. 22% of REE emanate from Japan, and a scant 3% rest of world (ROW). 97% of current mine supply is from China.

Many, including the author, think the US should urgently take steps to secure a consistent supply of REE, strategic metals both for clean energy initiatives (rechargeable batteries for electric vehicles and the generators for wind turbines making up a goodly portion of the demand) and for national security & defense applications (jet fighter engines, missile guidance systems, anti-missile defense, satellite and communication systems).

The US currently imports 100% of their REM (Rare Earth Metals) and REO (Rare Earth Oxides) from China. World REE reserves are estimated at 110mm tonnes with China accounting for 50% and the US at 13%. Obama brought a 2012 WTO case against China, accusing them of hoarding key rare earth metals. Little progress has been made, although the WTO did rule against China in the case and export restrictions were lifted in 2015. The odds for Trump sweet talking better relations seem long. The typical business greeting in China is now the handshake, but most have little exposure to Trump’s Krav Maga version of the customary greeting.

Name of element Atomic number and symbol – REE: lanthanum 57 La (produced as an individual metal, est. to be 24% of REE value shipped 2013), dysprosium 66 Dy (used for control rods in nuclear reactors), cerium 58 Ce (produced as an individual metal, est. to be 40% of value shipped 2013),  holmium 67 Ho, praseodymium 59 Pr, erbium 68 Er, neodymium 60 Nd (produced as an individual metal, a key, rare 28ppm element used in producing lightweight permanent magnets in combination with iron and boron, NdFcB) , thulium 69 Tm, promethium 61 Pm, ytterbium 70 Yb, samarium 62 Sm, lutetium 71 Lu, europium 63 Eu, scandium 21 Sc, gadolinium 64 Gd, yttrium 39 Y (produced as an individual metal, used in alloys to strengthen aluminum), terbium 65 Tb (fuel cells). There are 17 REEs in total (15 lanthanides, yttrium & scandium) with most produced as oxides (produced as metals where noted).

Crystal abundance for REEs ranges from 0.5 to 60 ppm (part per million). It is often not economically feasible to mine solely for REE given the scant concentrations found in most deposits (Cordier 2011). Further, their often conjoined occurrence and similar properties makes the extraction of a sole REE both difficult and cost-intensive (London 2010). Copper is typically 50ppm, as a point of reference, hence while rare in relative terms, a concerted effort by the USA (#MAGA) to be self sufficient in elements like neodymium (29ppm as noted) is within the realm of possibility. Where should we start? The state with the lowest population density, Alaska (Sarah Palin land) seems like a good place to start.

Ucore:

Ucore Rare Earth Metals is a Canadian (Bedford, N.S.) development stage, micro-cap company with some big aspirations in the REM space. Ucore’s primary listing in on the TSX Venture exchange under the ticker UCU.V sporting a market cap of C$89mm (US$66mm). Very low liquidity, but the name also trades over the counter (OTCQX), under the ticker UURAF in US$.

Ucore has trademarked an innovative separation technology, “SuperLig” which can extract valuable RREs from oil sands and other tailings such as coal ash. Test results thus far for this innovative and potentially disruptive technology look promising. Ucore has been able to extract specific rare earth elements via it’s Molecular Recognition Technology (MRT)  nanotechnology to >99% recovery rates and purity.

Ucore is not just a mining technology company via SuperLig MRT, they also own over 11,000 acres of land in mine friendly Alaska – Bokan-Dotson Ridge, in Southeastern Alaska.

http://ucore.com/ucore-acquires-new-strategic-rare-earth-properties-in-alaska

Readers can dig into the assay result provided via the link. Ucore advertise they have the highest grade heavy REE (HREE) deposit in the US (N1-43-101 compliant). REEs with atomic numbers =<62, the ceric group, are termed light REEs. 63 and above are more rare (hence expensive) and termed heavy REEs. The 4 elements highlighted above have an anomalous skew in Bokan results thus far. The Alaskan government is certainly excited at the prospects for Ucore (Jewel CD sales have hit full saturation at 30mm). Through AIDEA (Alaska Industrial Development and Exploration Authority) they have made a US$145mm financing commitment to the Bokan-Dotson Ridge REM/REO project, subject to a laundry list of conditions of course. A pledge of this magnitude from the Alaska government could cover 2/3rds of the capex for the project and importantly, avoid dilution for common shareholders.

The only ETF specifically targeting the space is VanEck Vectors Rare Earth / Strategic Metals ticker $REMX which has AUM of $53mm and approx. 50,000 shares trade per day, on average.

Global names:

China Northern Rare Earth (ticker 600111.SS). Market cap, 44.6bln CNY (US$6.5bln). A shares, hence most can not access, even if you wanted to.

China Minmetals Rare Earth (00083.SS). Mkt cap 12.3bln CNY (US$1.8bln). A shares, hence most can not access.

Rare Earth Mineral Plc (REM.L) Mkt cap 43.2mm GBP (US$53.6mm). Highly liquid, London stock exchange listing, GBP denominated.

Very small allocation justified, if all all, given the perilous track record rare earth miners have left behind for forensics. Molycorp Inc., ticker MCP filed for Ch. 11 in June 2015, having reached a market cap of $6bln at its peak ($77 share May 2011). Skull and cross bones warnings.

Follow me on Twitter @firehorsecaper JCG

Note: Monitoring  UCU.V liquidity and vetting a long position in smalls. Currently flat.

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TESLA – $TSLA SHORTS: ASSAULT AND BATTERY

[Merrill Lynch: Thematic Investing – Global Future Mobility 17-Feb-2017:

Sustainable mobility: $7tn transport market facing disruption With over 1.2bn cars on the roads today, transport is a behemoth sector generating c.US$7tn in vehicle sales, supplies, and services. We believe that the sector is highly inefficient with 95% of cars parked at any one point, cars costing up to US$8.5k/year to own and operate, vehicles accounting for 1.2mn deaths p.a. and generating 23% of C02 emissions. Demographics (population to reach 9.7bn by 2050E) and urbanisation (70% living in cities by 2050E) will further strain existing infrastructure. The rising financial, social and environmental costs of transportation are unsustainable and demand a fundamental rethink of mobility. We see change catalysed by disruptive technologies and business models, rapidly evolving consumer preferences, and regulatory pressures. 4 game-changers: electric, autonomous, connected, and shared. In a world of exponential change as per Moore’s law, transport is a problem being solved at a tech pace. We believe that the convergent and mutually reinforcing trends of electrification, autonomous driving, the Internet of Cars (IoC) and the sharing economy will drive a fundamental shift from today’s car-centric travel to a platform-centric model whereby transport becomes a utility. Future Mobility – including an integrated, on demand electric fleet of autonomous taxis – can generate US$3.8tn of total positive impact in the next 10Y and lead to a “world of zeros”, including a 59% decline in vehicle demand, 87% fewer accidents, 54% fewer parking spots, and 85% lower emissions.]

Tesla Motors: One would think that Tesla could crack $300 a share on such ebullient projections (Tesla/Uber M&A perhaps). A lot of market cap has been added in a very short period of time, that is for certain. The last $100 move has been a blur with the stock up a full 24% year-to-date in 2017.  To grow in to the resultant current market cap Tesla has to be selling 1.7mm vehicles, at a profit, within 5 years (versus the 2.2mm currently produced and sold by mainline competitors such as BMW and Mercedes Benz).

As with all things “on the come”, much depends on the trajectory of China where 350,000 NEV’s (New Energy Vehicles) were delivered in 2016, 1.45% of the 24.3mm total vehicles delivered (up 15% yoy and accounting for 1 in 4 cars sold globally). EV’s account for 0.9% of sales in the USA and 1.3% in Europe in comparison. Chinese car producers accounted for 43% of global EV production (dominated by leading models from BAIC, Geely and BYD) and 46% of all plug-in sales globally. Tesla’s market share is 2% of NEVs in China (Japan is lower at est. 1.5%).  source: EV Volumes

Taking 59% of passenger vehicle demand out (ML 10yr #) should reduce emissions by at least that amount as some of the remaining internal combustion engine powered passenger vehicles are replaced with electric ones, but 85% seems like a high estimate to me. In China 31% of air pollution is attributed to vehicles, but heavy trucks as a sub category account for a full 90% of current total vehicle emissions. Despite Elon’s claims, electric transport trucks are not ready for prime time yet on the scale required to markedly change the emission numbers, the batteries required would be just too heavy (even before factoring the weight of the cargo) to stay within max payload limits (80,000 lbs.).

Estimated life to date Tesla sales in China are pegged at approx. 9,000 units (3000 were sold in 2015 versus an initial target of 10,000) and Japan at a very weak 2,000 (Japan’s EV subsidy is ¥950,000, or US$8,400), roughly equivalent to the US EV credit of US$7,500. As of mid 2016, Japan has more EV charging stations than gas stations. Tesla opened their 14th Supercharging station near Fukuoka in Kyushu earlier this month.

The fact that any credence is given to announcements like “opening” the Tesla market in India is laughable. Tata sells complete cars for less than the 55kWh battery cost projection on the new Model 3 Tesla. Ditto for Dubai on a relevance metric, Dubai will likely never hit 1mm in total car sales and 70% of current car sales are Japanese models.

I have previously written on the fact that EV subsidies are being curtailed in key global markets. The story does not end with EV subsidies either as Tesla has provided very generous residual buyback programs in key global markets like Hong Kong, which has very generous government incentives at the front end (fully detailed in the  legacy post below) putting a Tesla Model S pricing nearly on top of a gas powered Honda Civic and well below a Mercedes entry model. The 75% of purchase price buyback program after 24 months (low km) has been curtailed, but I fully expect lucky HK Tesla owners that have the “golden ticket” to exercise their put to Elon Musk. Factoring buybacks there is the potential to post net negative sales into China for Tesla in late 2017 to early 2018. Losing money on both the way out and on the way back into inventory as an exhibition (aka used) model will test the resolve of the hardiest Tesla bulls.

https://ibankcoin.com/firehorsecaper/2016/03/05/tesla-ev-subsidy-taper-tantrum-alert/

In the case of China, Federal NEV subsidies are expected to roll off by 20% in 2017 and regional subsidies by a more substantial 50-60%.

There has been a great deal of speculation about Elon Musk’s relationship with President Trump. Most recently, it seems like Elon is being relegated to dealing with VP Pense. Trump is very concerned with his image, it appears from afar, and it likely makes him uncomfortable that Tesla stock trajectory has left Elon with a paper fortune approaching treble his. Despite the fact that both Trump and Ryan have expressed a dislike for the current EV credit, Tesla stock has autonomously avoided the potholes and turned skyward like a SpaceEx rocket, seemingly never to re-enter Earth’s atmosphere. The EV credit may not be fully extinguished in the next budget, but it will likely be reduced from $7,500 which along with cheap $3/gallon gas might dissuade some of those Model 3 deposits from actually closing.

Tesla Energy: Even though the battery storage system revenue thus far in 2017 is estimated at a trickle like $15mm, Gigafactory 1 in California has launched and Musk is already projecting heady battery cost reduction of as much as 35% to under $125/kWh. With material costs estimated at $80/kWh this cost reduction is impressive. This result could allow the promised $35,000 Model 3 to be closer to a break even proposition for Tesla Inc. As for the sale of batteries to residential, business and utilities, all indications are that the business case is plausible, if not sound, and it is not unfathomable that revenues for 2018 approach $1bln, with the heavy lifting to come from the commercial and utility customers. Tesla’s PowerPack is scaleable to 1GW and will be an economically viable means to store relatively cheap mid-day produced power to be used when peak pricing is in effect later in the day (typically 5-9pm).

SolarCity clouds the analyst’s lens as to magnitude of the negative cash flow generation, but clearly not the sign (unprofitable; check, negative cash flow; check). The now combined Tesla entity carries a substantial $6bln in debt. Tesla has a market cap of $43.9bln, now greater than Nissan and honing in on fellow American Ford. Tesla has issued secondary equity on several occasions, the last being for $1.7bln in proceeds ($1.4bln + Greenshoe exercise) at $215 in May 2016. The stock rallied over 6.5% the week following the announcement, with the proceeds earmarked for Model 3 production with deliveries by the end of 2017 and bringing forward Tesla’s 500,000 vehicle unit build plan 2 years from 2020 to 2018 (as in next year, 2018). Patient investors should ready themselves for another secondary in 2017 (more debt on the heels of the SolarCity combination is not likely in my view), as fundraising has been an annual affair since 2012 and profitability can still not be seen with a Hubble telescope. Tesla’s market cap is so enormous at this juncture $3bln + might be in order to keep the transaction costs down. Tesla has 161mm shares outstanding and a float of 129mm shares. 26.6% of the float is held short, part of the reason for the recent pin action. Elon Musk owns over 20% of Tesla stock personally (all other insiders own 1.3% in aggregate, this is the Elon Musk show, have no doubt). The largest institutional investor is FMR LLC, better known as Fidelity Investments who own 13% of Tesla’s equity.

The Gini Coefficient at Tesla is off the charts, making it ripe for the UAW to eventually turn California plants. What potential gains Tesla might realize on battery cost via a well executed Tesla Energy launch can more than be given back through higher labor cost. Starting wages are $17/hr. in the Tesla plants (Toyota Motors Manufacturing average is US$39.50) on 12 hour shifts. Elon has been quoted as saying “changing the world is not a 9-5 job”. There is a reason that North American auto jobs have migrated from Canada to non-union southern USA and on to Mexico. If Tesla wants to retain its silicon valley nucleus it will have to eventually pay left coast wages, unionized or not.

Tesla’s book value per share is $17.03, hence it is trading nearly 16X book and 5x sales. Tesla does not own much in the way of proprietary technology. The Gigafactory is plug and play Panasonic technology. Elon once characterized patents as “a lottery ticket to a lawsuit”. The Japanese, by way of contrast, own 1/3 of the world’s o/s patents and it is the Japanese firms that dominate is areas such as ADAS (Advanced Driver Assistance Programs), electrification and emission control systems. Musk arguably has a narrow moat, with venerable global competitors breathing down Tesla’s neck across the broadening business lines of Tesla Inc. Rather than focussing on the pedestrian, largely outsourced means of propulsion (i.e. the battery) shareholders may have been better served in the long run (in the short run they have done just fine!) by focussing on the semiconductors and other high end technology components that are crammed into high-end, modern, connected EV’s (5x the amount of a “low end” vehicle, contributing over a 1/3 of the vehicles all-in cost).

Tesla Inc. has proven to be a difficult short, even for tenacious hedge funds, let alone lowly individual investors like moi. My TSLA T-acccount is close to flat on my 3rd short attempt (short @ $260 into “revenues”) with the 1st try profitable, 2nd a loser (1/3 of 1st trade profit) and the 3rd, so far, offside. Q4 2016 numbers are out after the close this Wednesday the 22nd with analysts expecting and adjusted loss of $0.51/share which would be a marked improvement on the loss of $0.87/share booked in Q3 2016. SolarCity is enough of a wild card to lead one to suspend opinion, but it is certainly not outside of the realm of possibility that the Q3 loss is further eclipsed.

Hopefully 3rd times a charm, but I have no plans to overstay with my short position and a stop loss at $300 is in place. JCG

Follow me on Twitter @firehorsecaper

Tesla short is the fellow on the right, to be clear.

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SUPERNOVA INVESTING : URANIUM

Symbol U, atomic #92, Uranium is Earth’s heaviest natural occurring element in the periodic table.

periodic_table

Earth is dominated by the following 4 elements; Oxygen #8, Magnesium #12, Silicon #14 and Iron #26. For reference Silver is #47 and Gold #79.

Uranium has garnered a lot of attention this far in 2017. Little wonder, as the uranium plays are up nearly 60% since the deemed pro-nuclear Trump was elected in November 16′. Using the largest uranium ETF, ticker URA – Globe X Uranium ETF as a proxy for the space, https://www.globalxfunds.com/content/files/Global-X-Uranium-ETF-1.pdf ,one can clearly see the pain inflicted over the last 5+ years;

2017 +27%, 2016 -1%, 2015 -37%, 2014 -23%, 2013 -21%, 2012 -19%, 2011 -60.%. From inception (11/4/2010), URA is down 79.5% cumulative.

U3O8 uranium currently trades as $25.31.lb. down 81.4% from the 2007 high of $136/lb.

uxc_graph_u3o8

The merit of nuclear power on metrics of both energy security and a low-carbon future are beyond refute. Real facts;

fuelcomparison

1 kg. of uranium, post enrichment and used for power generation in light water reactors produces 45,000 kWh of electricity. From an output perspective 1 kg. of uranium is equivalent to almost 10,000 kg. of mineral oil and 14,000 kg. of coal.

The comparisons on emissions are as striking as on energy output;

Greenhouse-Gas

Approximately 10% of current world energy supply comes from nuclear power. There are 447 operable nuclear reactors in the world at present, requiring 140 million lbs. of uranium per annum. Utility stocks are estimated at 478 million lbs., 3.4 year of demand. The largest 3 markets for nuclear power are France (58 reactors, 75% of overall power coming from nuclear), Japan (42 operable reactors, 40% of power pre-Fukushima disaster, only 3 have been brought online since all closed in 2011) and USA (99 reactors, 20% of overall power). A total of 60 reactors are under construction at present in China, India, South Korea, UAE and Russia . Twenty two of the nuclear plants under construction are in pollution ridden China, where 40% of growing electricity demand is still coal-powered, and the liveability of 25 of its largest cities hinge on nuclear power’s hockey stick growth projection. China is expected to have 40 nuclear reactors online by 2020 and to add 10 per annum thereafter. CNECC (China Nuclear Engineering and Construction Corporation) is the exclusive nuclear plant builder in China.

The USA only produces 4.3mm lbs. of uranium at present (2% of global output) versus an annual need of 56mm lbs., hence 93% of the uranium the US needs annually to operate existing nuclear plants is imported from places like Kazakhstan (39% of world uranium supply). Canada accounts for 22% of world supply and Australia 9%.

The World Nuclear Association (WNA) appear to have the best stats on the space. The top producer is Kazakhstan’s KazAtomProm at a 22% share. They recently announced a 10% production cut for 2017 (3% of world supply).

Canada’s Cameco is world #2 producer, not far behind KazAtomProm, at 18% of global production. The stock ticker is CCJ on the NYSE in US dollars and CCO on the TSX in dollarette’s (CAD). Despite all the seemingly good fundamental news on uranium, the price action has been nauseating. Cameco has some issues. Customer concentration is one, whereby almost 1/2 their long term sales contracts are with 5 key customers. Cameco received a termination notice last week from Japan’s TEPCO (Tokyo Electric Power, operator/clean upper of the crippled Fukushima plant) on a contract running through 2028 worth approx. $1bln. To give you an idea how offside TEPCO was on this long term uranium contract, 9.3mm lbs. spot is worth approx. $233,000,000 versus the $1bln contracted value, that is a $767mm potential hickey for Tepco. They have claimed “force majeure” in cancelling the Cameco contract, which might have had a shot of success if they had not accepted deliveries and paid for uranium 2014-2016. Sounds more like force manure to me, most expect Tepco will have to honor the contract via legal settlement. The news sent CCJ shares down 12.5% last week, although it remains above the 200-day moving average at $10.67.

The 2nd blemish to be addressed by potential longs is Cameco’s ongoing tax battle with the Canadian tax authorities, the venerable Canadian Revenue Agency (CRA). CRA are asking for C$2.2bln (US$1.7bln) in back taxes related to a purported tax dodge run by Cameco 2005-2015 where C$7.4bln of earnings were allegedly run through a low-tax Switzerland subsidiary. Most expect this case to be settled out of court in either 2017 or 2018, but the magnitude is unsettling to say the least. Plenty of press on the matter for those that would like to weight the merit of the case. The market cap of CCJ, as noted, the 2nd largest global uranium producer, is $4.15bln or 10% of TSLA ($40.4bln), as a point of reference.

There is a high degree of idiosyncratic risk in buying the listed equity of  individual uranium companies. The largest ETF highlighted above, URA has enough daily turnover to be considered liquid, but it small at $250mm in AUM (MER 0.70%). The weighting of the ETF in Canadian uranium names is high at 60% (23% in Cameco alone). The Kazakhstan names do not have listed equity.

For those seeking modest allocations to the uranium space, I would recommend looking at URA for the diversification, but shorting CCJ to reduce the single name exposure. With the proceeds of the CCJ short I would buy smaller US producers (some better described as micro-caps) as they will likely have few headwinds under the current administration (i.e. permitting, production, and expansion). The smaller players are largely unhedged without long term supply contract hence they provide more leverage to the underlying uranium price.

A sustained recovery in uranium equities depends on uranium prices staging a recovery from the depressed levels we have seen over the last several years. We have smoke, we need fire. JCG

Note: Long CCJ (1% weighting), but looking to diversify near term to a broader grouping of uranium names.

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NEIMAN MARCUS – CONTRARIAN LUX RETAIL CREDIT PLAY

There are few things held in more deplore than retail at the moment. The list of retail equities that have blown up year to date is long, with Ralph Loren being only the latest to banzai skydive, and miss the chute. Luxury retail has not been immune, despite overall robust consumer spending.

While ibankcoin’s readership is largely focused on equity investment/speculation, hopefully my blogs posts have opened a few eyes to the bond opportunities that occasionally arise and merit both your attention and deep due diligence.

Enter the venerable luxury department franchise, privately held, Neiman Marcus (NMG), rated B3/B-. The speculative grade (Caa2/CCC) cash pay (I’ll explain shortly) NMG 8% 10/15/2021 (cusip 570254AA0) got rocked to trade < $60.00 last week for the first time. The bonds are currently wrapped around $61.00 for a yield to maturity (a quarter shy of 5 years) of > 21%.

C24EugXVEAA1cuj

The capital structure is complex and the 8’s 21′ are as you might expect, rank near the bottom with a couple of classes of debt ranking ahead on them in terms of priority of payments. In the event of a tap out, the recovery rate would be expected to be low.

New York based independent credit research firm CreditSights moved to a buy from hold rating on the unsecured debt of NMG on 1-Feb-2017 on some “early signs of stabilization in the luxury good market, the benefit of a runway clear of maturities until 2020, and a decent prospect for neutral free cash flow generation over the next  year. While we view the prospects for recovery in the bonds as limited – given the significant contractual subordination to the ABL (Asset-based Loan) and large term loan – yield opportunities of approx. 20% offer an enticing return while the company attempts to get the story moving back in the right direction during 2017.”

The October 2020 term loan maturity is a big one at $2.9bln. There is $1.56bln of unsecured debt maturing 10/15/2021, including $960,000,000 of the cash pay 8’s 21′ and $600,000,000 of 8.75% 21′ PIK (Payment in Kind) notes.

Beyond poor operating results in terms of comps, margins and outlook, the market is reacting to the fact that NMG pulled plans for an IPO (filed August 2015, delayed and most recently pulled). The history of NMG is long, complex and storied. Founded in 1907 with a head office in Dallas, Texas, NMG has has varied ownership over the years. The first store outside of the Dallas/Fort Worth area was opened in 1957. NMG was publicly traded from June 1987 until May of 2005 when it was taken private via leveraged buy out (LBO) by Texas Pacific Group (TPG) and Warburg Pincus for $5bln. The exit was prolonged, but in October 2013 NMG was sold for $6bln to Canada Pension Plan Investment Board (CPPIB) and Ares Management, netting TPG and Warburg Pincus a $1bln gain versus purchase price. CPPIB & Ares went 50/50 on the venture contributing $1.6bln in equity ($2bln was “expected”) with the rest of the deal financed via the debt markets.

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Note: Trump’s signature. He is signing these executive orders Neiman Marcus? More recent renditions are even more similar.

 

Fast forward to today and approx. $900,000,000 of shareholders equity remains. The degree of leverage imparted in NMG on acquisition would make even Trump blush, and it has only intensified over the last 18 months. On the positive side, NMG is closely held by very savvy institutional investors that are used to taking the long view (CPPIB much longer in terms of liability matching). The next NMG IPO filing must be a successful one and beyond a century + long track record as a competent luxury retail operator, the elephant in the room is the immense debt burden approaching $5bln. NMG is well within their rights to suspend interest payments on the $600mm 8.75% 21′ PIK notes, a move that would save $52,500,000 per annum going forward. The signaling effect of such an election on the PIK notes would likely not be viewed as favorable though, and would likely take a potential IPO take-out off the table for the foreseeable future.

Owners with deep pockets is certainly a positive attribute. CPP and Ares have been equal partners to date, but there is nothing to dictate this has to be the case going forward. Ares would likely be somewhat reticent to add to a trade that has moved so far offside since late 2013. CPPIB, for their part, might look to creative ways to decrease leverage while operational efficiencies are given time to work through (cost cutting, reduced capex, further build-out of successful online offering “mytheresa”, etc.).

The current yield on the NMG 8% 10/15/2021 is 13.1%, if the bonds can be purchased for indicated $61.00 (+ accrued interest). The yield to maturity, as noted, is in excess of 20%. A plausible outcome would be for the current owners CPPIB/Ares to tender for the cash pay bonds, leaving the PIK bonds outstanding for debt servicing flexibility. Pure conjecture to estimate what percentage of the $960,000,000 of cash pay note holders might respond to a $70.00 tender offer, but given the prospects for a near term recovery from the dregs, I would expect at least a 50% take up rate would result. Deploying another $336,000,000 of equity under such a scenario would have the effect of extinguishing $480,000,000 par value of public debt, greatly improve the gearing numbers at NMG.

While not a pure “Red, White & Blue” lux retail play, given the Canadian connection, it merits further study for certain. Not for the widows and orphans due to outsized potential for losses , but in a measured dose Neiman Marcus debt may be worth a look.

Follow me on twitter; Caleb Gibbons @firehorsecaper

Disclosure; Not yet long, but vetting a 2.5-3.0% allocation to NMG 8’s 21′ in clips of 100k par value.

 

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