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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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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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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%.

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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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EMERGING MARKETS – EQUAL WEIGHT IS 32%

I had the pleasure of hearing Singapore based Mark Mobius, Ph. D. (Economics, MIT) Executive Chairman, Templeton Emerging Markets Group keynote speech at the Asia PE-VC Summit 2016 held 30 September 2016, run by Deal Street Asia / mint asia.

http://www.dealstreetasia.com/stories/mark-mobius-54493/

Dr. Mobius was born August 17, 1936 (six years younger than Warren Buffett, born August 30, 1930). Nobody can rock a baby blue two piece suit and white shoes better than Mobius. Style and substance are rarely brought together in such a seamless fashion. At 80 year young, he is beyond sharper than a tack and offered a great deal of insight to a crowd, on average 45 year his junior.

Templeton has $28bln invested in 70 global EM markets at present, sprouting from a kernel of $100 million circa 1987. In South East Asia, the focus has been on PIPE deals (Private Investment in Public Equity). EM is up 1848% over the 1987-2016 period.

What keeps Mark up at night, other than travails of being 80, can best be summarized as the three i’s;

1.) Interest rates – Global Central Banks are the classic non profit maximizing counterparty and Mobius thinks they are destined to “make a mess” of it. Negative interest rates are far from a rational state. In terms of rational equity valuation, almost any p/e multiple can be justified in an environment of negative rates, 100 OK, 200 sure. Mark questions the mentality of said central bankers, overly influenced by academia,  economist and other charlatans (my term). Specifically called out was Ken Rogoff’s “Curse of Cash” as poppycock.

2.) Isolationism – Both with respect to trade and investments. A damaging trend. Little comment required on this point. Mobius grew up in Boston, Mass. but long ago relinquished his US passport and holds a German passport (his father was German and his mother was Puerto Rican) and a Singapore tax domicile.

3.) Internet – On-going game changer, especially in EM. Largely a mobile phenomenon.

China, still a monster growth story. It is all about the absolute numbers. Growth is slowing, but the absolute numbers are bigger every year (10% growth in 2010 is smaller than 7% in 2015 given the absolute size of the economy).

Biggest take away:

The people you are dealing with is the most important factor in investing, over the long haul. Having  a legal agreement is of course required, and governing law important, but typically if it gets to the stage of lawyers and the courts, the result is a big zero for all involved. Word to the wise, word to the wise indeed.

My current public market favorite instrument for EM exposure is WisdomTree’s Emerging Market High Dividend ETF, DEM, yielding 4.15%, ytd 2016 performnance +20%, AUM $1.6bln. No home country bias, as a global citizen. JCG

Follow me on twitter; Caleb Gibbons @firehorsecaper

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ESG : SOCIAL INVESTING = INVESTING

Even the Asian elephant in the room is endangered.

Over 80% of the market value in the S&P is attributable to intangible factors (environmental capital, sustainability governance and stakeholder relationships). Less than 20% is accounted for by physical and financial assets.

Global sustainable investing assets grew by 61% over the 2012-2104 period and now stand at $21.4 trillion. The domicile of these assets is telling; 99% are in the United States, Canada and Europe.

Environmental and social issues affect both valuation and financial performance. If your investment decisions focus only on financial disclosures, you will not be getting a complete picture of the drivers of value.

Global ethical principles have never been more important or, it appears, more wanting than in current times (i.e. VW, Phoney Express aka Well Fargo, global Trumpism, and global lawsuits imperiling not just returns but the very viability of global commerce beyond national borders).

Community manager education world tree concept with colorful abstract leaves and earth icon illustration. EPS10 vector file organized in layers for easy editing.

The UN supported Principles for Responsible Investment (PRI) ,a not-for-profit organization, held their 10th anniversary conference in Singapore last week (Sept. 6-8th) which I attended. No conference bag full of binders and junk mail at this conference, your 1 page agenda fold up into your name tag and all meals were vegetarian, a subtle but effective message. Forbes Magazine The conference domicile was not chosen by chance. Asia has been termed the cradle of disorder for a reason, it is home to 5 of the world’s 7 billion population and on metrics of social investing if the game has even started it is is the 1st inning. When a region has practices like dynamite fishing and farmers still clear land with a match much work lies ahead.

Chris Sanderson, Co-Founder of The Future Laboratory focussed largely on the sustainability of the capital markets. He characterized global citizens as being tired of austerity, wary of politicians and perhaps even more wary of brands. Backlash culture; http://shop.thefuturelaboratory.com/products/backlash-brands-report.

Elliott Harris, Head of the United Nations Environmental Program (UNEP) gave a rousing speech on environmental and social sustainability. The end game is that all investments will be social. Elliott introduced the concept of thick profit versus thin profit, a concept akin to quality, hard to define, but you know it when you see it.

Georg Kell of Arabesque Partners Arabesque spoke of  Generation S, a cross-section of all age groups working towards making the world a better place, one worthy of handing down to future generations. While ESG (environmental, social & governance) alpha may prove illusory, ESG smart beta appears to have legs.

Millennials were of course discussed with the most shocking realization being that the oldest ones (born 1990) are in their mid 30’s now! Generation D (Digital), whose only need or want in life is wifi and lithium, was out in full force, albeit well behaved and overall attentive. The 600 conference attendees were largely baby boomers, representing approx. 50% of global financial assets under management (AUM), signatories to the PRI whose mission states, “We believe that an economically efficient, sustainable global financial system is a necessity for long term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.” Clear, concise, devoid of the typically mumbo jumbo one gets when issues like climate change and the environment are normally tabled.

The session run by GS alum David Blood, Managing Partner at Generation Asset Management Generation Investment Management was excellent. Al Gore is the Chairman of Generation Investment Management. If Obama delays the election to allow Clinton to get her legs perhaps they could run as a Third Party choice? Could not lose with the ticket “Blood & Gore”. Both men can readily point out Aleppo on a map too. In any event, David’s sage words rang true to all in attendance. Finance and capitalism is not working for everybody was a key statement. The transition to a low carbon economy will clearly not be an easy one. A full 1/3 of aggregate world equity and fixed income market value lies in the cross hairs. We can do this the hard way or the easy way, but de-carbonization is a trend now moving under its own power. Mr. Blood noted that while the majority of global asset managers in attendance (120 signatories, 50% of global AUM) were managing to sustainability factors, those not present (i.e. non PRI Signatories) are largely American. The reasoning to date for USA firms reluctance is that becoming signatory could put them in breach of their fiduciary duty. We must collectively get the remaining 50% on board as priority #1.

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Investing for the long term. Short termism. A great panel on investing for the long term had some serious panel power. The headliner was Hiro Mizuno, CIO of Government Pension Investment Fund, Japan (GPIF), the world’s largest funded pension plan. GPIF manage their liabilities to a 100 year time frame. Their most recent result showed a loss of ¥5.3tln (US$5.2bln) for the current fiscal year through March 2016. The fund’s quarterly loss through June 30, 2016 was > ¥5tln (-3.88%). They run ¥130 trillion (US$1.27 trillion) leading Mizuno-san to characterize the latest qtly loss as peanuts. The joke was not well received, perhaps because it was so unexpected, leading Hiro to quip that perhaps there were Japanese pensioners in the audience. The fund increased their allocation to equities in recent years. Global equity investment totals US$600bln, 80% of which is allocated in a passive fashion and 20% ($120bln) of which is actively managed. All investment are mandated to external manager, counter to the global trend in the pension arena of in-sourcing. Fellow panelist Paul Smith, President & CEO at the CFA Institute noted that one advantage of being old is that “you see everything twice” with such decisions as out-sourcing vs. in-sourcing set to very long term market cycles.

Several panels touch on infrastructure finance with GPIF mentioning their joint investment effort with Canada’s CPP on ESG brownfield infra projects. Mizuno-san noted the challenges of crafting/originating greenfield projects as funding challenges often drive the cheap option and the cheap option is usually dirty (materials, supply chain, etc.). GPIF will not finance dirty deals, full stop.

A deeper discussion ensued on better was to measure and compensate performance with a general aversion shown to managing to qtly earnings guidance. The average hold period for SPY, the > $100bln S&P 500 SPDR, the largest ETF tracking the benchmark for US stocks is 5 days. In the last 15 years 52% of the Fortune 500 companies as no longer in existence. In 1955 the average Fortune 500 company life expectancy was 55 years, in 2015 it is 15 years. Traditional valuation metrics clearly must evolve to address the realities.

ESG toolkit for Fund Managers: http://toolkit.cdcgroup.com/

Q&A with Author of the PRI’s Practical Guide to ESG Integration for Equity Investing

The ESG investment construct must be turned on its head, to my mind. Social investing = investing and “dirty” or non-socially minded investment should be the type requiring explicit sponsor/board/member approval. JCG

Follow me on twitter @firehorsecaper

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Shenzhen “beach” September 2016

Mark Carney, Chair, Financial Stability Board (FSB). Awesome 30 minutes of your life, watch it. Carnage, indeed.

 

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INCOME FUND – PIMCO FUNDS GLOBAL INVESTOR SERIES; $PIMCMEI.ID

All investors have been extremely challenged to select plausible investments for the fixed income portion of their investment portfolio in the current environment. With so much of the world sovereign bond markets trading at negative yields, it is certainly a perilous time to be a fixed income investor. Alternative fixed income and unconstrained funds are all the rage.

This brief article introduces PIMCO’s venerable offering which is a global multi-sector fixed income fund. PIMCMEI is an open ended fund, incorporated in Ireland. The fund seeks and delivers high current income, 4.06% monthly at present. The fund duration is a modest 3.1 years.

PIMCMEI is up 4.81% year to date in 2016, compared to 7.43% for the S&P. This return  comes with a lot less drama of course, as anyone long equities through February 2016 can attest.

The MER for the retail fund is high at 1.45%. PIMIX is the institutional version with a more modest MER of 0.45% but for $1,000,000 plus invested. The standard deviation of PIMIX is 2.81% and the Sharpe Ratio is a remarkable 2.01. The Sharpe ratio calc first subtracts the risk-free rate from portfolio return then divides the result by the standard deviation of the portfolio return. As a point of reference the S&P 3 year std. dev. is 11.23% and the 3 year Sharpe ratio is 1.02.

Pimco’s Daniel Ivascyn, CIO is the PM for the fund (est. 12/2012), assisted by Alfred Murata. Ivascyn, not yet 50, took over from aged Bill Gross as the “Bond King” at Pimco. The retail targeted PIMCMEI manages > $15bln and PIMIX has > $60bln in AUM.

I’m also long some of Gunlach’s Doubleline funds, but nowhere  near the scale.

Wealth managers like the consistent Pimco Income Fund returns and offer up to 4x leverage on investment in the fund at Libor +50/+75 depending on the size of the relationship one has.

Clearly this fund gets many things right. The brain trust at Pimco is substantial and all PM’s benefit from the rigorous Secular forum, run annually, which looks out 3-5 years. The sister Cyclical forum takes a 12-18 month view and between them have allowed Pimco to get to the carrot first,  in size.

For non-US investors, the PIMCMEI fund attracts no withholding tax and is not subject to US estate taxes given the Ireland domicile.

The fund fact sheet can give you a good window on where Pimco currently sees value. Weighting in high yield are low in comp to emerging markets. The highest weighting is in US mortgage backed securities at present.

Don’t write off fixed income just yet, you just have to dig.  JCG

Disclosure: Long PIMCMEI levered 1:1. Leverage to be reduced as 3 month Libor setting reaches 1% (mid 2017?).

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NINTENDO $NTDOY- MOBILE, THE SECOND COMING

Pokemon Go, get used to hearing a lot more about it.

Thus far the limited release, including the all critical USA market, has been record setting.

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From a trading perspective, the pin action has been awe inspiring, but without the wide trading ranges one would expect of daily double digit gains in the stock price of Nintendo. Buys have been exceeding sells by a factor of 7:1 on some platforms over the last week. Lower left to upper right as Gartman would phrase it. Nintendo officially has game, mobile game.

The global roll out of Pokemon Go is underway. I’m reporting from Japan, home of Nintendo (ticker 7974 on the Tokyo Stock Exchange), where fans can’t wait to get access to the app and begin their frolicking. The Japan roll out appears to have been set coincident with the end of the rainy season in Japan. As an outdoor “augmented reality” experience, Pokemon Go is best launched without torrential rainfall, hence I expect a release date the last week of July. The rain spigot ceases like clockwork around the 20th of July in Japan. Expect take up rates on app downloads, usage, paid users, $1 pokeball sales and overall hype to pierce the giddy precedent set by the US market.

The opportunities for Nintendo to exploit their extensive catalogue of intellectual property is immense. Pokemon, developed in 1995 by Satoshi Tajiri was already raking in $2bln in revenue per annum for Nintendo. Generations of gamers know the sketch, keeping advertising cost down and hence margins high. Others have pointed to the immense retail deals that could result with global franchises keen to build a stable of pokemonsters to drive traffic and resulting $. Poketourism can’t be far behind, I kid you not.

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The many, including me, not yet long should study further for rational entry points. Shorting this rocket is not something characterized as an investment activity and should not be considered.

Nintendo has over $7bln on cash on their balance sheet and no debt. The previous high in the ADR’s was $78.50 in 2007 and there are 15% less shares outstanding now (held as Treasury stock by Nintendo, now the largest sole shareholder of Nintendo stock via timely buybacks at much lower levels).

The current $33.38 price for the ADR’s has come too fast, but it is difficult to fade this move for the multitude of reasons noted. Nintendo has a market cap of $32bln at present.

Pokemon Go was developed by Niantic Inc., a Google spin off which Nintendo holds a 32% stake in (yet another reason to own Alphabet too). One can bet there are many more augmented reality games in the wings. No gaming company has been more successful than Nintendo, who have brought 22 of the top 25 console games to market over the history of the gaming space.

The previous stock price pinnacle of JPY 75,000 (we closed at JPY 27,780 Friday last) was achieved when Nintendo’s Wii console took the market by storm, selling >100mm units. There are 2.5bln smartphones in use globally at present, and growing. Candy Crush has the record to date for smart phone penetration at 20% and it would appear Pokemon Go could easily exceed that metric. Those early to the story in January 2016 saw 3-4x upside for Nintendo shares. The recent spike of near 2x since the limited Pokemon Go launch clearly increases the risk for new holders, but it would appear a mobile gaming juggernaut has emerged in Nintendo.

For those that feel restricted trading only North American hours, the more liquid parent listing denominated in JPY, 7974.to is another option for those enabled to trade on foreign exchanges. Any medium to long term hold would be best currency hedged, as even though the JPY has rallied 15%+ at points in 2016 seems destined to depreciate versus the USD.

Play safe and trade safer. JCG

PS: Follow me  on twitter, Caleb Gibbons @firehorsecaper

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$ICPT : INTERCEPT PHARMACEUTICALS, INC., – BIDDING PADDLES READY

Intercept Pharmaceuticals, Inc., waiting until almost midnight, the Friday before the Memorial Day long weekend, 5/27/16, announced the FDA approved Ocaliva (Obeticholic Acid) for the treatment of the liver disease PBC (primary biliary cholangitis), formerly known as primary biliary cirrhosis. Approval was largely expected (the FDA Advisory Committee had previously voted 17-0 in favour), but the good news appears to be that the conditions attached to the approval are modest. Safety concerns had some worried that sales could be hampered by restrictions on use in patients with moderate or severe hepactic impairment, but the prescription label has no such restrictions from my reading of it (link for your perusal): ocaliva_pi

PBC is a rare, autoimmune cholestatic liver disease that puts patients at risk for life-threatening complications. PBC is primarily a disease of women, afflicting approximately one in 1,000 women over the age of 40.

Sales of OCA will begin In 7-10 days and expectations are that peak sales could reach $2.6 billion per annum. $ICPT closed Friday at $141.77 with a market cap of $3.5bln. With a typical valuation of 7x sales, clearly there is scope for a rally from here. ICPT’s float is small at 17.44mm shares and 3.4mm shares (19.5%) are held short. 78.5% of the shares are held by institutions. Fidelity Investments is the largest holder with almost 15%. The lifetime high for the stock was $462.26, which will not likely be eclipsed until OCA for NASH (fatty liver) is approved in early 2019, which obviously depends of the results of the 2,000+ patient Phase III global trial.

Another likely scenario is an approach from a larger player seeking a blockbuster drug to add to their stable. With OCA approved for PBC there is now a risk buffer to await the 2018 outcome of the phase 3 “Regenerate” trial for OCA in the treatment of NASH. Nonalcoholic steatohepatitis (NASH) is a significant metabolic form of chronic liver disease in adults and children effects a much larger percentage of the population that PBC. The OCA dosage for the treatment of PBC are 5-10mg whereas for NASH the trial is being conducted at dosages of 10 and 25mg. There are currently no drugs approved for the treatment of NASH and OCA for PBC is the first liver drug approval granted in the last 20 years. PBC & NASH are distinct, progressive liver diseases. Both diseases may lead to fibrosis and cirrhosis of the liver. From a valuation perspective most would argue 20% to the PBC application of OCA and 80% to the much larger NASH opportunity.

XBI the SPDR S&P Biotech ETF is -26% ytd in 2016. ICPT is the 4th biggest holding in the ETF at 2.6%.

What lies ahead:

Next week analysts will be tweaking their ICPT numbers based on the terms of the OCA for PBC approval. Most recently MS moved to underweight with a price target of $80. Stingy indeed when ICPT have > $22 a share in cash on their balance sheet! Merrill Lynch have an underperform on the stock and a $144 target. ML used to be the biggest bull on ICPT, with a target > $800 per share when Rachel McMinn Ph. D covered them, before joining Intercept Pharma as Chief Business & Strategy Officer in April 2014.

The street conjecture will also begin as to the timing of a bid and take-out premium likely on a bid for ICPT, now that a level of uncertainly has been removed. JCG

Disclosure: Long ICPT, 3% weighting, trailing stops, not inclined to sell < $200.

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iCAR – NAV SET FOR $AAPL DEAD END

I for one think that Apple entering the automobile business is a very bad decision. Road & Track’s rendering looks like a Citroen and we know the lumps the French have taken on that misventure over the years. It has been reported this week that Apple has spent $4.7bln on automotive technology R&D over the 2011-2015 period, nearly 25x what incumbents (i.e. actual car companies) have spent on R&D, in aggregate, over the same period ($192mm). Apple’s “Project Titan” (the name of Nissan’s capable truck offering) is said to target having 1,800 employee by 2019. A car could come out at the other end by 2021. We will be on iPhone double digits by then (skip 13?), and shareholders will likely be highly fatigued by this farcical endeavor.

As per trusty Exodus, AAPL’s P/E stands at 11.2x. The average diversified electronics P/E is 20x, tech 22.2x, and overall market 20.6x. Ford, king of trucks with their best selling F-150 and global offerings like the Focus could not even make a go of it in Japan. Ford’s P/E is 6.23x, autos aggregate 10.2x, consumer goods 22.1x. The only car company to not totally step in it this year between emission scandals, recalls (airbags, etc.) and the like is Fiat Chrysler (FCAU, P/E 13.1x) who successfully spun out Ferrari (RACE, P/E 23.26x), tagging it with a portion of the parent debt as well. This was textbook creation of shareholder value, boosting the P/E of a niche, premium priced brand to elevate the P/E to one in line with a consumer goods P/E with a 22 handle.

Morgan Stanley gushed about Apple’s prospects in the car business this week in a research report, estimating an eventual 16% market share. What a lark; GM’s share is 17.7%, Ford 14.5%, Toyota 14%, Fiat Chrysler 13.2%, Honda 9.2% and Nissan 8.5%. Apple would need a best selling truck for the US market to get a sniff at a 5% share overall. They would need an EconoBox for Japan (who have the Nissan Leaf). They would need a budget, tank like SUV for the Chinese market where commuters increasingly fear death in any mechanized chariot weighing less than 5,000+ lbs (Great Wall SUV below). They would need affordable bling for the India market, one of the fastest growing automobile markets in the world (charging stations an issue). Finally, might as well throw in an estate version for Continental Europe.

Great Wall Motors is a domestic producer in China and is China’s largest manufacturer of SUVs and pick-ups (X Series pictured below). An interesting fact in terms of quality control is that they have the front doors (deemed the highest wear and tear item) made in Thailand by in plants entirely staffed by women. The doors are then sent back to China for final vehicle assembly. Their trucks sell well in markets like Australia as well where even with onerous import duties you can be “on the road” for under US$18,000 (kangaroo catcher grill is an aftermarket item, non OEM).

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Nearly 30% of the oil demand in the US is driven by commuting (gasoline), with most drivers solo passengers. We need another $75,000 greenfield electric car like we need Trump as leader of the free world. Mass transit like China’s proposed 1,200 passenger Hoverbus makes a lot more sense. Driverless cars is another joke, a car is not a wearable and most have less than no interest. Autopilot transport truck trials in Europe are promising where road safety for other drivers is increased, along with improved fuel economy when travelling as a convoy.

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Apple sticking to their core strengths is a highly preferred strategy, along with a return of capital to shareholders, by way of a special/extraordinary dividend. Apple’s cash hoard has been covered to death in the press, with the bulk of it is held offshore, not having felt the effects of the 35% tithe of the US Internal Revenue Service, yet. Domestic US cash generation has not been able to keep up with the outflows from programs like their $50bln stock buyback plan and the dividend increases activist investors have been able to cajole management into committing to. Apple now has $50bln in debt. Apple, already the largest sole taxpayer in the US at $10bln would owe an additional $23bln+ if they brought the overseas cash home to Cupertino, CA home spaceship base.

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My April blog on the spike to come in copper due to the growth in “renewables”was echoed by BHP this week. This Apple news, should it come to fruition, adds more demand to the equation.

For those that missed it: http://ibankcoin.com/firehorsecaper/2016/04/23/lithium-vs-copper-basis-trade/

Carl Ichan recently sold his entire Apple stake after holding for a period of 3 years, an active 3 years for Carl, in terms of shareholder activism. Worries about Apple’s relationship with China was his main gripe in jettisoning the full position. Soon after, Apple cut a $1bln check to invest in Chinese cab hailing UBER rival Didi Chuxing, to help Apple better understand the critical Chinese market. Surely China education can be secured more prudently, hopefully they do not serve up a Dud-i instead. Pre-IPO Apple took a paltry $3,600,000 of VC funding. Quite in contrast to the latest $1.8billion round by Snapchat, valuing them at $20bln.

Other punters, including Warren Buffett’s Berkshire Hathaway have been the cupped hands, investing approx. $1bln on the most recent AAPL stock swoon (some sources reporting at prices in the $109 area, other surmising in the $90’s). Just yesterday block buys were evident, 12.5mm shares across 2 trades for a cool $1.25bln as AAPL stock re-took $100 to close $100.41.

Apple should return excess liquidity to shareholders, when feasible from a taxation perspective, and let them invest where they see fit. Any by the way, how about fixing iTunes too. JCG

Follow me on Twitter. Caleb Gibbons @firehorsecaper

 

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US MUNICIPAL FINANCE – HIGH SCHOOL FOOTBALL STADIUM HUBRIS

If they ring a bell at the top of the muni bond market, this muni bond issue will be the poster child. Muni investors have long been considered the “C students” of Wall Street, but even for them, this may be too much.

McKinney ISD (Independent School District), Texas just voted yes to a new $220mm tax exempt bond issue which will help finance a $72,800,000 football stadium for their high school, yes their high school. Even though MISD is projected to grow by a scant 71 students (net) per year over the next 5, it has been determined that this all makes abundant sense. Most sane voters (Grassroots McKinney) would squash such financial folly, but the proponents of the deal, labelling themselves “Vote for McKinney’s Future” included the $50.3mm of “new” stadium earmarked money ($10mm was previously spent for the land and $12.5mm of debt was raised a full 16 years ago for the stadium) into a larger debt deal with sensical use of proceeds as a means push through this farcical stadium plan. The only way this could be more emblematic of the funk taking place in US of A is if it carried the name TRUMP stadium. A 10 year stadium naming rights deal could at least have resulted in some savings versus the ridiculous budget  for this open-air teenage concussion petri dish.

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Note: artist rendering of the new 12,000 seat McKinney high school football stadium.

This is far from an isolated case. Allen ISD is only a few miles away from the planned McKinney stadium, seats a much larger 18,000 and was built for $60mm (bargain). KATY ISD (near Houston) is in the final throws of approval for their very own $62.5mm cost, 12k capacity high school football stadium. The KATY ISD was established in 1898 and includes 60 school with a total annual budget of $785mm. KATY is ranked 13th place within Texas. One would think a top 10 academic placement might be a pre-requisite for spending $50mm+ on a stadium for a non-pro sport, played by teenagers, that may well be extinct or highly amended a decade out (watch the film Concussion, circa 2015).

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The US muni market is immense at $3.6 trillion and as with the Federal debt tally, much has been issued in the last couple of decades. In 1945 there was $20bln of muni debt, in 1960 there was $66bln, in 1981 there was $361bln and now we sit at $3.6 trillion.

Texas is a AAA/Aaa rated state. KATY ISD is rated Aa1/AA stand alone, but as with many muni issuers they often procure credit enhancement to get to AAA/Aaa ratings (saves on interest cost for timid muni bond investors that love the idea of a AAA/Aaa rating). The point here is debt is not free. Even if McKinney can get their debt deal done in the mid 2’s, that is still $5.5mm of interest per annum, enough to pay 150 Texas 10 year tenure teachers ($37,000 per teacher). The right be be able to issue debt on a tax exempt basis is a powerful right, in and of itself. Most of the holders of muni debt are the wealthy, the top 10% of taxpayers, with a big concentration in the top 1% of taxpayers. A seemingly paltry 2.5% tax exempt yield is much more attractive when converted to a taxable equivalent basis (TEB) = 2.5% / (1 – marginal tax rate). The 1% are taxed Federal at 39.6% at the margin. There is a 3.8% tax on investment income to pay for Obamacare, but muni interest is exempt making 2.5% tax exempt equivalent to 4.42% on a taxable equivalent basis.

These silos of affluenza are not sustainable, full stop. The World is watching. Smaller government will be a necessity going forward. It will start with towns, which will share essential services (police, fire, education, health care …. high school football stadiums) skimming 20-25% of the bloated unpaid  bar tab for pension and OPEB (Other post employment benefits). Prudent investors should brush up on their Ch. 9 Title 11, Authorization for municipal bankruptcy knowledge. State amalgamation will follow within a decade. We can have a naming competition on the new name for Maine/New Hampshire/Vermont, followed by Washington/Oregon, North and South Dakota, etc.

Each $500bln of frivolous muni debt represent a huge  opportunity cost for the US government. With a weighted average (current) coupon assumption of 2.5% and a marginal tax rate of 39.6% (+3.8% Obamacare tax levy on investments) the Federal tax leakage is 5.4bln (12,500,000,000 of interest income taxed at 43.4%) per annum. Texas has no State tax, the opportunity cost is even higher in the high State tax states like NY and NJ.

All this is happening at a time of near unparalleled uncertainly (GFC aside, but that is a much longer blog …. AIG bailout, TOB – Tender Option Bond Programs, aka “Tons of Blood”, global arbitrage of the steepness of the US municipal interest rate curve gone awry). Puerto Rico (PR), which I have recently written on, will be restructuring their debt, as soon as legally feasible. PR defaulted last week on a large slug of GDB (Government Development Bank) debt. PR’s benchmark 8% 35′ GO’s (General Obligation bonds, top of the food chain from a “priority of payments” perspective) ,are yielding > 13% tax exempt this week (23% + on a taxable equivalent basis even as a Texas taxpayer).

The Federal stance on the PR pension plans will be precedent setting for the woefully underfunded US States. Illinois has the worst pension in the nation (funded 40 cents to the $1), aside from the non-state bastard PR (sub 10 cents funded on a blended basis). IF we see an insolvency at the state level in the next  decade it will be Illinois.

More than 45,000 students in Detroit missed school for a couple of days this week due to the “sickout” staged by teachers, embroiled in a strike. Detroit was the largest city bankruptcy in US history, July 2013 ($19bln).

Something is rotten in the state of Denmark (Shakespeare). JCG

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