Sunday, January 13, 2008

Sears Holding

I wrote this article for Seeking Alpha. Sears Holding is a very interesting story, how many retailers do you know where analysts are positive on the stock but expect the company to cease operations in 10 years. It is really all about Lampert. Funny thing is that Lampert is actually trying to save the thing and he just might, I was really impressed with the stores and Sears does have a lot of cash and debt resources. So, my short postion, very conservative (vertical call spreads) is really a short term bet that the market will lose faith in this story for the time being, not a bet against Lampert. Don't bet against billionaires in the long run, bad idea.

Finance 101: “A company is worth the discounted present value of its future cash flows.” Well, not exactly. Morningstar analyst Kimberly Picciola’s November 2007 brief on Sears uses four components to arrive at a $240.00 fair value estimate. The Morningstar model reflects a lot of discussion that I have seen on Sears Holding and it is a good illustration of how Sears Holding is viewed. Each component is assigned a percentage contribution to the value of Sears Holding.

Retail profits (24% of fair value)

This is the easy stuff, just estimate sales, margins and profits as with any other retailer. Looking at last quarter, Sears Holding’s sales slowed with the housing market and it acknowledged big inventory issues. K-mart and Sears have relentless competition; Best Buy and Costco on electronics, Home Depot on tools, Wal-Mart and Target on general merchandise. In the current economic environment, it is hard to see Sears or K-Mart excelling. Also, Sears Holding is criticized for under-investing in its stores but management disagrees profusely and I personally think my local Sears is a great place to shop. I see great appliances, yard equipment, and tools. I also see a first class kid’s department (I have two small kids), a robust men’s department, and a store that is clean, organized, and well staffed (albeit pretty empty last visit).

In any case, don’t over-think this part of the equation. The numbers are reported quarterly and, according to Morningstar (see below), all retailing will cease in 10 years anyway.

Real Estate (45% of fair value)
Morningstar’s analysis includes an eye-opener:

“After 10 years, we expect the retail business will cease and value will be unlocked by selling the real estate assets and the brands. This accounts for roughly 45% and 8% of our fair value, respectively.”

I had to chuckle when I read about “unlocking” real estate value. That is so 2005. Unfortunately, real estate valuation in 2008 is summed up daily in the press by one word, “declining.”

Brand value (8% of fair value)
Sears has exclusive brands like Kenmore, Craftsman and Land’s End. Brands have value and can be sold. Maybe Wal-Mart buys Kenmore. Maybe J.C. Penny wants Land’s End. Maybe Lowe’s wants Craftsman. No argument from me.

Eddie Lampert (23% of fair value)
I hope Lampert is in good health. His brain is apparently worth exactly 1% less than the entire value of the Sears and K-Mart’s combined. You must believe in him (Cramer does) to go long on Sears Holding. Here is how Morningtar looks at it:

“Finally, given Lampert's successful investing record, we believe he will be able to allocate the company's excess cash to generate an average annual return of 20% over the next 10 years. This accounts for 23% of our fair value estimate. We think there is room for Sears Holdings to add leverage to the balance sheet, particularly if its debt is upgraded to investment grade.”

I read the letters from Lampert to shareholders posted on the Sears Holding website. He wrote quarterly until March of 2006 and once in November of 2007. I wanted to see how he thinks and I respect Lampert for what he wrote. He is obviously passionate and cares deeply about what others think and say. Like everyone else, however, he sets a very high standard for himself. Here is my take-away and some excerpts:

Lampert as Jack Welch.

“I view Sears Holdings as a $55 billion revenue, 350,000 person start-up…my goal is to see Sears Holdings become a great company whose greatness is sustainable for generations to come…When Jack Welch took over, he completely reinvented part of Sears Holdings’ efforts to adapt, I am focusing on providing direction, raising issues, asking questions, and suggesting ideas – on challenging and collaborating – and I rely on the experience and ability of our talented management team to make those ideas come alive.”
2. Lampert as Warren Buffet:
“Warren Buffett makes clear that his goal is to increase the per-share value of Berkshire Hathaway. Similarly, our goal is to increase the per-share value of Sears Holdings..”
3. Lampert as the underdog;
“We welcome the challenge of being the underdog, and we will let our performance speak for us.”
Obviously, Lampert believes in himself and he has re-purchased $3 billion of Sears Holding stock to prove it. Morningstar also mentions that Lampert has begun investing excess capital in derivatives such as “total return swaps” and acknowledges the increased risk. If you invest in Sears Holding you get Craftsman tools on Aisle 1 and “total return swaps” on Aisle 2. You don’t get that with Wal-Mart! Of course, you also get Lampert’s brain and you will need it. Besides competitive issues in the best of times, Lampert must now navigate a housing slump, credit crunch and slowing economy. The challenges seem overwhelming and I have a small short position in Sears Holding. Nevertheless, I have a secret theory that might justify investing long in Sears Holding. Don’t tell anyone, but I really think Eddie Lampert might be Superman. What do you think?

Friday, January 11, 2008

Bank of America \ Countrywide Deal

Well....I submited this yesterday and it showed up on Seeking Alpha this morning, so two things happened here. 1) I was right, CFC shareholders were not rescued. 2) I was wrong, BAC did do the deal and actually paid real money (if the deal closes) which is why I sold my BAC position today.

Don't invest in what you don't understand and I do not understand this deal.

Here is the article:

B of A Deal May Be No “Rescue” for CFC longs!

I am trying to understand this beyond just what it is doing to the CFC stock price. All I have is questions and not many answers and if you can’t answer my questions, stay away from this deal, at least on the CFC long side.

Why would BAC step in to a firestorm and buy in to Countrywide’s problems?
I agree that BAC may be “strong” enough to get a deal done, but why not preserve that strength, let CFC fail and pick over the remains?
What does BAC gain in a CFC deal that it can’t gain in other ways?
Why double down on the mortgage market now at the cusp of a recession, when foreclosures are way up, the yield curve is inverted, and home sales are in the tank?
Where is the value in CFC? The people? The retail stores? The thrift? The loan portfolio (cough, cough)? The servicing business? What exactly would BAC buy?

I am absolutely certain that hundreds of analysts have BAC financials on one side of their desk and CFC on the other side and are furiously trying to piece the numbers together to see if this deal “works.” This is no normal merger rumor though as one side has all the chips. Don’t assume that whatever deal might get done will “rescue” CFC shareholders because BAC is no White Knight and they will do what is their interests.

I have been long BAC for a couple of weeks because I figured that BAC would benefit in the long run if CFC, WAMU and a couple of other players actually failed (and there is that nice dividend). BAC already has a significant chunk of the mortgage market, they are a strong commercial bank, they made a mint in China recently, and most of their competitors are having liquidity issues. BAC does not need CFC. I don’t know, maybe BAC does not buy CFC. Maybe they just take it?

Wednesday, January 9, 2008

Buying GLD

I am buying GLD: Here is my Seeking Alpha Article that explains why.

Don’t buy gold on fundamentals. Buy gold on emotion! (GLD)

What is working so far in 2008? Gold. What is not working? Google. Yea, energy works, but most managers have “been there and done that.” Sorry, no more brownie points for being long energy. To look like a genius today you need to be long gold, gold miners, gold etfs or something in that space. Maybe you want to be different and sound smart? Then go long silver (as I write silver is up today 1% more than gold so you look like a genius today) after all it has “global growth” industrial uses and investment value (double genius bonus points). So, CNBC junkie that I am, let me give you an advance copy of Erin Burnett’s next 47 interviews: “So genius hedge fund guy, what do you think about gold?” Genius hedge fund guy: “We like gold.”

And then we have “retail investor guy.” Textbook financial planning preaches “keep 5%-10% of your portfolio in precious metals as a hedge against inflation.” Does the average investor have any gold? No, they have a 401(k) or retirement account, a mutual fund and maybe a CD. Maybe they have a “money person,” but do the masses get the gold thing? Yesterday I talked to a friend, smart businessman, I mentioned gold and his eyes glossed over and I heard this: “yea, that used to be like a thousand bucks, what’s it at now, like $350?” The average investor thinks in terms of two choices, being in or out of the market, because he\she is simply too busy working to pay attention. When will the average investor pay attention to gold? At $1,000! When gold hits $1,000 it will print on the front page everywhere and on every website in headlines that go something like “INFLATION FEARS DRIVE GOLD TO $1,000.” At $1,000 it is game on. At $1,000 CNN gets involved (as opposed to CNBC which only you and I watch).

Ok, you want fundamentals. Here is the standard blah, blah, blah. India jewelry demand! Gold ETF may become world’s largest holder. Central banks are buying gold (or selling or manipulating it depending on who you believe). Boring!!

Gold is going to $1,000 because we want it to not because of any fundamentals. It makes for great drama and great headlines: Gold at $1,000! Economy In Recession! Inflation Fears Rampant! We want it, we need it, it fits the mood.

Have you ever held a 1oz. American Eagle in your hand? It is a truly powerful feeling and you can’t help but think to yourself, “this is so cool.” Don’t buy gold on fundamentals. Buy gold on emotion! Emotion drives the fundamentals, which is the difference between gold and any other long-term investment.

Buying Grey Wolf

Seeking Alpha published this article earlier this week and it explains why I am buying GW and selling $5.00 GW puts.

Natural Gas Drilling To Accelerate: Buy Grey Wolf!

Understanding the big picture for natural gas drillers requires a look at both the natural gas supply\demand picture and the outlook for rig day-rates (the price drillers are paid).

Natural gas fundamentals bode well for prices. Figures below come from the Energy Information Administration (EIA). Consumption from 2001-2006 held steady in a 6% range with variation mostly due to weather, however, use for electricity generation soared 50% in the last decade. Half of new electricity plants in the next 3 years will be gas fired and natural gas will be used heavily to increase ethanol production.

While demand is steady to increasing, the production picture is eroding. The average well today is 35% less productive than 10 years ago. The EIA reports 301,811 wells in 1996 and 448,641 in 2006 with total production slightly down.

The import picture is also bleak. Imports supply about 18% of domestic need, with 80% of imports coming from Canada. Canada, however, faces similar production issues as the U.S and their domestic use will spike as the Alberta tar sands project will use massive quantities of natural gas. Imports of liquefied natural gas (LNG) could help but are constrained by a lack of infrastructure. LNG terminals require huge investment and are vehemently opposed everywhere (think mushroom cloud). Only about 2.6% of current supply comes from LNG and although a couple of new terminals will come on line in 2008, NIMBY politics promises that further increases in supply will be slow in coming.

Certainly the need for increased drilling is clear. In fact, drilling activity has more than doubled since 1999. 2006 saw a peak and drillers made record profits as the industry witnessed virtual 100% utilization. During this time, drilling capacity came on-line quickly as drillers were able to pull rigs from storage. As the cycle has continued, efficient new rigs have been entering the market and some of this older supply has been scrapped or exported.

Drilling equities have pulled back significantly as 2007 saw drilling activity abate and pressure on day-rates relative to 2006. Drillers, however, have remained solidly profitable, utilization remains historically high, and over-building of capacity does not seem likely as most new rigs are “built for purpose” and contracted in advance for up to 3 years. In fact, the Baker Hughes shows continued quarter-over-quarter increases in utilization, it is only the pace of increase that has slowed.

Grey Wolf (GW) is my favorite driller. The company has about a $1 billion market cap, it’s rig fleet is fairly modern, and they offer premium services such as turn-key drilling and top-drives (motors that make rigs more efficient) which add significantly to base day rates. Their most recent 10-Q gives a promising picture. Grey Wolf has over $250 million in cash, a quick ratio of 3.5, a share repurchase plan with $50 million recently added, and new rigs are conservatively added under term contracts that insure a full return of capital. The company has $275 million in long-term convertible notes hanging over the stock, however, the interest rates are low and the company can redeem $150 million of these notes in May of 2008. The notes convert in the $6.50 range.

The company gave the following bullish forecast; “Announcements of new rig orders in the U.S. market over the past several months have been for built-for-purpose rigs. We believe the vast majority of the new rigs will be delivered by the end of 2007. We also believe that the new rigs that have come into the market have generally displaced low-end equipment. The ability to provide equipment that addresses the challenges of deep, directional or multi-well site drilling is critical to meeting our customers’ needs in the most active domestic land drilling markets. Our fleet is well suited to these drilling opportunities given the recent acquisition of new rigs and substantial rig upgrades completed over the past three years.”

In 2007, Grey Wolf’s stock price suffered form unfavorable comparisons with 2006 performance. but 2008 may be more forgiving. The company is strong financially, has a forward PE of 8 compared to the S&P at 14, and estimates may prove to be low. Aggressive investors may wish to sell $5 puts on GW, which have favorable premiums.

Sunday, January 6, 2008

2008 Investment Considerations & My Personal Biases

This blog is about investment themes that work. In case anyone ever reads this blog, here are my three core investing considerations:

1. CONSIDERATION #1 The American consumer will be consuming less.

The American consumer has over-spent and much of the economic successes of the post 9-11 economy have been fueled by debt; both government and consumer debt has risen dramatically during this "best of times" era. This is unsustainable. Many Americans soon will be forced again to view hard work, productivity, and savings as the path wealth-not the ability to take on debt. A lot of the conspicuous consumption I have seen in the past few years is debt fueled. Moreover, as people have been able to fund consumption with debt, many have worked less and invested very little in productive assets.

Here is a metaphor that about sums it up:

Two guys driving through the desert in spanking new Escalades 100 miles from the nearest gas station. One guy is 25, the other is 5o. The 25 year-old has $5 in gas in the tank and is 3 payments behind. The 50 year-old has a full tank and paid cash for his car. Who looks better? The 25 year-old of course! He's young, he's hip, he looks rich, he's cruising! know how this ends right...of course you do.

2. CONSIDERATION #2: Investing requires independent research grounded in common sense. Wall Street analysts can't be trusted.

Remember when it was OK to invest in billion dollar companies with fifty bucks in sales? Remember those sock puppets? Remember those analysts laughing privately at their own recommendations?

Now we have the "subprime" fiasco. How were billions (if not trillions) lent to people with no ability to pay? Simple, Wall Street needed the paper to build profitable products (CDO's, SIV's) for which there were plenty of ignorant buyers willng to pay fat commissions (hedge funds, pension funds, foreign central banks, petro-dollar funds, carry-traders). This was nothing more than a ponzi scheme.

Seriously, can we trust these guys to tell us where to invest?

3. CONSIDERATION #3: Fundamentals matter.

The value of a company is the discounted present value of its future cash flows. It always has been and it always will be. It is that simple.

Stable profits are good. Debt is bad. The ability to take on debt is good. Cash is king. Proven and capable management is good. Understandability is good. Dividends are good. The past matters, but the future matters more. The macro environment matters. Diversification matters (but how you do it has changed a lot). Fear and greed can crush you.