Charting Banking VI: industry profits

In trying to understand the state of the sector,  the sharp recovery of the financial industry profits has been the most surprising event. Here is graph from a Moody’s recent presentation based on national accounts data:

The main reason for this recovery despite the heavy losses of several banks between 2007 and 2009 was the big bailout that we discussed in the first installment of the series.  This low interest rate environment combined with less competition has been a boom for the survivors. And even those on the edge are recapitalizing and may have a second chance.

The big implication is that since the USA still has an economy heavily dependent on the financial industry, as can be seen from this chart from a recent column by Paul Krugman , its ability to profit its way to health is good news.

Charting Banking V: commercial real estate

Most people have seen a similar version of this chart with a mountain of commercial real estate problems for banks:

But the fact is that for closed banks the percentage of CRE loans non accruing is much lower than C&D

So it looks like CRE issues have been much exaggerated compared to C&D’s. Part of its better performance up to now is because

• Tighter Underwriting: no zero percent down loans or covenant lite
• Better Collateral: most of it was leverage of already performing properties
• Localized: the effects of the bubble was concentrated in specific sectors like retail
• More Capital: small banks absorbed relatively a larger percentage of these loans while having better capital ratios

But there are also some particular characteristics of CRE loans that make them a better risk

• statistics include owner occupied CRE loans that are much lower risk
• has longer durations, spreading problem loans over several years
• refinancing has a much higher probability of succeeding given that the collateral generates cash
• several of the most problematic CRE loans at the top of the bubble were securitized  and sold like MPG’s Orange County acquisition

Some people call this “extend and pretend” and would agree when the cash flow is not present or the collateral is weak. But refinancing was and is an essential part of banking and this was not a CRE construction bubble like the end of the 80s. And for investors this “extend and pretend” has the advantage that progress is more gradual and the underwriting can be evaluated without sudden NPA collapses like could happen with C&D loans.

Concluding, for investors a large percentage of CRE loans is a risk but this risk is much easier to bound than C&D’s. Look for:

• High percentage of owner occupied
• Stabilizing CRE non performing assets, provisions and charge off trends. At this stage of the cycle should indicate good underwriting
• Small concentration of loans in sectors with excesses like for example retail and hotels

Charting Banking IV: construction and development

With all the talk over the last year and a half about commercial real estate (CRE) being the next shoe to drop while not dropping, this post is about reminding us of what was really the issue. This can give perspective of the relative order of magnitude of future problems and their consequences.

The real bank killer has been construction and development loans (C&D) with the next possible culprit not even close. This is a chart detailing the type of collateral for real estate loans of closed banks.

SFR: Single Family Residential

Source: http://marketwi.se/2010/04/are-banks-failing-because-of-cre/

Careful with those construction and development loans:

1. they are large
2. with short term maturities
3. no cash flow to soften the blows
4. collateral price has collapsed
5. and no demand in the near term for all that construction

So the problem with C&D loans is part the probability of default but even more consequential its severity. Other types of loan problems can be mitigated by refinancing but it is much more difficult with C&D in the middle of a recession.

For most of the banks that I have stumbled upon with recent non performing assets surprises their issue was still related to C&D (ie: CBNK a couple of days ago). And most of their C&D loans were residential since the size of the commercial C&D market is dwarfed by the residential market.

Concluding, as an investor you have to be really sure of a bank underwriting standards (LTV in particular) when they have 20%+ of their portfolio in C&D loans even with good capital ratios. And reading 10Ks will probably not be sufficient so I personally much rather avoid those banks.

Dean Foods: got milk? got brand?

Mrs PlanMaestro knows her consumer goods and it was the first person I talked with after the recent appearance of Dean Foods in the 52 week lows lists. While I have not made a decision on this opportunity, I thought that the intricacies of the milk industry were fascinating and managed to convince her to write about them. We have the pleasure to publish her first contribution to this blog … and if you like it please say so to have more

The recent share drop has put Dean Foods (DF) on the spot so I would like to comment on the US dairy industry and provide some perspective on the attractiveness of DF’s business.

In short, the US milk industry is going nowhere. USA per capita milk consumption is among the highest in the world reaching around 70 liters per person. In recent years per capita consumption has remained stagnant in the face of more innovative categories (e.g. functional drinks) which have been gaining share of throat.

While there has been some growth coming from yogurt or soy drinks, none of the dairy industry innovations have been successful increasing the range of consumption occasions or cannibalizing other categories. Unless a radical innovation widens the range of consumption occasions and consumer profile (most probably coming from the large beverages companies, rather than the traditional dairy companies), we can only expect milk industry volume to grow at the same pace as the population growth.

What is really striking in this industry is that private label (PL) penetration has reached 70%. This is a very high number compared to any other beverage category. For obvious reasons, penetration is higher in categories with a larger share of volume sold through supermarkets (which is the case for milk). However, the gap in milk is quite astonishing. PL penetration in water is around 30%, in juices around 20%, and in carbonated drinks under 10%.

Even compared to other groceries, milk remains the category with the largest PL penetration (Cereal ~30%, Mayonnaise ~20), even though volume sold in supermarkets is quite similar for all them (above 80% of volume).

While private label penetration is usually driven by heavy discounts, until very recently milk PL prices were almost in parity to branded products. Most of the PL products are now associated with high quality and as supermarkets extend their reach nationally, they are making such brands available cross nation. On the other side, branded milk has remained mostly regional and unable to differentiate significantly from the PL offer (no single brand holds more that 2% of the industry market share). DF, after a series of acquisitions, has managed to consolidate around 18% of the industry’s market share (47% branded and 53% private label production).

It is uncertain to me how the milk industry in the US commoditized much faster than other categories. My guess it was the compounding result of several factors:

1. Available raw material and simple process: The US produces around 15% of global milk. It produces more milk than it consumes and has a competitive raw milk market with one of the lowest worldwide producer price. Access to milk and the relatively low investment requirements to pasteurize milk fostered the development of dairy companies.
2. Fragmented and weak regional brands: The US milk market is a 100% fresh (pasteurized) market, making it difficult for the development of national brands as investments in refrigerated distribution assets for a national brand would be quite high.
3. Walmart effect: The increased relevance of the supermarkets and their cross dock platforms providing a tempting and efficient refrigerated distribution network for local producers to sell milk nationally.
4. Isolated in the low value category: cheese, yogurt and other high margin branded dairy products got captured by few national brands with accumulated marketing expenditures and national coverage (Kraft, Danone, General Mills) reducing the milk producers negotiating power vs. supermarkets.

To sum up, this is a mature industry with an unclear growth perspective with a very high level of commoditization (estimated category operating margin of 5%). For Dean Foods to compete successfully in it, requires being able to differentiate its product offer versus Private Label while being able to widen its operating margin. A deeper look into Dean’s strategy will be developed in a following post.