Variant Perceptions

Buffett on the imperfect turnaround

Can you think of an example of a retailer that was successfully turned around?

Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins.

It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

Warren Buffett, student visit 2005

Another addition to the turnaround toolbox so that I don’t forget the obvious and known even in tempting circumstances.

And these are tempting circumstances. There are two retailers that I like their owner operators and I like their prices. Is there a need to mention their names?

Running the risk of being repetitive, my opinion is that in comeback stories the balance sheet is better used to estimate the runway of a business rather than its value. Both of these retailers have decent runways but the problem is that neither is turning.

These were some thoughts from an old previous post on players facing external threats.

The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also many of them may not have clients, hidden capabilities, or platforms to leverage.

A good financial position, like Dell’s or Yahoo’s,  can give them time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.

So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful.

I’m still curious about Dell and Yahoo. I’m still curious about these two retailers. Actually, at the moment there are dozens of interesting situations. However, my preferred style is to jump on businesses that are turning or have already turned at the risk of missing some… and there are some good ones out there.

Now, if they decide to liquidate abruptly or in willful steps … well, that’s not a turnaround.

Position: none.


A friend suggests me to read Mauboussin’s More Than You Know, Chapter 21 and I do. Retail and technology are not the best sectors to look for comebacks.

Exhibit 21.2 shows what happens to companies that realize a downturn. The sample includes almost 1,200 companies from the technology and retail sectors.

The data for the two industries are strikingly similar, and not particularly encouraging: Only about 30 percent of the sample companies were able to engineer a sustained recovery. (Credit Suisse defined a sustained recovery as three years of above-average returns following two years of below-cost-of- capital results.) Roughly one-quarter of the companies produced a nonsustained recovery. The balance—just under half the population—either saw no turnaround or disappeared. Companies can disappear gracefully (get acquired) or disgracefully (go bankrupt).

This analysis also shows how long companies experienced downturns. For both retailers and technology companies, roughly 27 percent of downturns lasted only two years, and for both sectors over 60 percent of downturns lasted for less than five years. In other words, the destiny of most firms that live through a downturn is determined rather quickly.

These mean-reversion and turnaround data underscore how strong and consistent competitive forces are. Most stocks that are cheap are cheap for a reason, and the likelihood that a business earning poor returns resumes a long-term, above-cost-of-capital profile is slim.


TARP warrants: let every eye negotiate for itself and trust no agent

A secret about the TARP warrants is starting to spread.

Most have heard of the adjustment to the strike price after dividends but there is more to the anti-dilution clauses than just the adjustment to the strike price. A few months ago I decided to cryptically suggest this insight in a visited message board, where many were buying TARP warrants, to see who else had caught it.

Actually, not many. One of the few, the author of today’s post.

Over the last few months we have discussed the anti-dilution clauses. He recently decided that it was time to confirm the major insights: discussed them with a few lawyers, that did not help much, and ran the math with one of the small banks that has TARP warrants. He finally put some of the insights, but not all, in a document. It starts with a great Mark Twain quote so how could I not like it. I am thankful that he accepted to share it in this blog.

Both Bruce Berkowitz and Francis Chou mention the secret in their most recent letters. It is mentioned so cryptically as if they did not want it to be known. In the same cryptic style, the author of this post asked to remain anonymous.

There is a lot more to the anti-dilution clauses than what is being discussed in the blogs, the press, and even this post. If you are interested, I suggest you separate several hours and READ the prospectuses fine print.  Also the numbers are from a few weeks back and not all warrants mentioned in the table are from TARP or even have the same fine print. There are no shortcuts in this investment, you have to read a lot.

For more information, I first mentioned the TARP warrants almost two years ago in the following post:

Disclosure, we both are long a few of the mentioned TARP warrants



I am frequently asked, “So what is XXXX’s edge?” I think it is possible that in some cases we eliminate 80% of the competition when we start by reading the annual report. It never ceases to amaze me, how frequently we find that an investor in a particular company did not bother to read the annual report, including professional investors.

Now get ready for some tedious reading! If you do not feel like chewing leather than you are well advised when I say you should skip the following two pages.

Recently, I realized again how few investors bother to read the primary documentation, when researching the TARP warrants of US banks. I expect analysts and investors in these warrants to be do more research than the average sophisticated investor in equities due to the offbeat nature of warrants. However, it quickly became clear to me that analysts, investors and the press clearly did not bother to read the prospectuses of the warrants. Samuel Clemens (a.k.a. Mark Twain) used to say that “A person who won’t read has no advantage over one who can’t read” and that certainly rings true here.

For the benefit of those that have not heard about TARP warrants;

  • TARP- Troubled Asset Relief Program
  • Warrant- The right to purchase an equity security for a certain period at a certain price.

TARP is one of the programs that the US government created to bail out the banks. For example it allowed the US Treasury to purchase newly issued preferred equity from various banks e.g. Bank of America. The US Treasury received warrants, called TARP warrants in this case, with these shares. In time the US Treasury either sold the warrants back to the respective companies or it sold it off into the market where lesser mortals like us can now buy them.

The warrants have some important features.

  1. They are long term; 10 year warrants expiring around 2018-2021
  2. They have various anti-dilution adjustments
  3. The exercise price when compared to current tangible book value is low.

Continuing with the BAC A warrants as an example,

You can learn this by simply reading the relevant prospectus.

Technically, in the case of BAC and others, it is not the prospectus that holds the important information, it is the supplement to the prospectus. When you read the anti-dilution adjustments you note that the exercise price is adjusted downwards in some cases (e.g. when a cash dividend is declared) AND the number of warrant shares (shares/warrant) is adjusted upwards.

You can learn this by simply reading the relevant prospectus.

Last year you could purchase the BAC warrants for as little as $2.00-$3.00 with an exercise price of $13.30. Today, BAC’s book value is $21 and tangible book value is $12. We are NOT advocating that paying $2.00- $3.00 for the right to buy BAC until 2018 for around current book value is a good deal, but it is worth investigating. Particularly if there is potential for the exercise price to be reduced AND the number of warrant shares to be increased every time a dividend is declared.

You can learn this by simply reading the relevant prospectus and looking up the price.

There seems to be a general misconception in the market that the anti-dilution adjustments only apply to AIG TARP warrants, mainly because Bruce Berkowitz spoon fed the market with a statement in the press about AIG. However, these adjustments are not exclusive to AIG TARP warrants; in fact the exact opposite is true.

You can learn this by simply reading the relevant prospectuses.

In the case of BAC it also pays to read the “prospectus” for the warrent, Warren Buffett negotiated for Berkshire Hathaway in Aug 2011. Warrent, Warren. Get it? Eh, ok, I will move on.

The warrent comes with a strike price of $7.14 and 700m warrent shares (6% of BAC outstanding shares) and has the same anti-dilution adjustments as the TARP warrants. It is quite plausible for the warrent shares to increase from 700m to 1Bn AND the exercise price of $7.14 to be reduced to $5.00 over the 9 years to 2021. What can we say? The Master strikes, yet again!

You can learn this by simply reading the relevant prospectus.

Those of you that stuck with me through the section on warrants either enjoyed it or must feel like the man that tried to commit suicide by drowning himself in a puddle of water, one inch deep. The good news is, it is almost over.

When you research the various warrants you should realize that all these warrants are not created equal and we have found the most significant differences are evident when

  1. you compare the relevant company’s current tangible book value with the warrant’s exercise price and
  2. the normalized dividend per share.

In the case of b) I mentioned that the warrant shares adjust upwards AND the exercise price downwards when a dividend is paid. Technically the relevant amount is the difference between the dividend per share paid and a threshold dividend per share. This threshold was set by the last dividend per share payment at the time the warrant was issued. Most of these warrants were issued in the depth of the financial crisis, which means that in most cases the “last” dividend that was paid was at a time of peak profitability and before very substantial share dilution. Therefore, it is prudent to adjust for this and when we do so we come up with the following comparison.

We reiterate, neither are we making a case for or against buying the warrants nor are we saying this is anything more than a simplistic analysis. As always you have to do our own homework! 

We are simply saying that the relationship between the exercise price and the current book value and the relationship between the historical dividend per share and the threshold for the dividend to give you the “kicker” are very different from company to company. Therefore the investor that has that knowledge most certainly has a huge competitive advantage and in the case of the TARP warrants we believe it is a minority that understands the differences. All it takes is for the investor to read the relevant prospectuses.

Munger on the perfect turnaround

GEICO is a very interesting model. It’s another one of the hundred or so models you ought to have in your head.

I’ve had many friends in the sick business fix-up game over a long lifetime. And they practically all use the following formula—I call it the cancer surgery formula:

  • They look at this mess.
  • And they figure out if there’s anything sound left that can live on its own if they cut away everything else.
  • And if they find anything sound, they just cut away everything else.
  • Of course, if that doesn’t work, they liquidate the business.
  • But it frequently does work.

And GEICO had a perfectly magnificent business submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.

All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there.

And when you think about it, that’s a very simple model. And it’s repeated over and over again.

And, in GEICO’s case, think about all the money we passively made…. It was a wonderful business combined with a bunch of foolishness that could easily be cut out.

And people were coming in who were temperamentally and intellectually designed so they were going to cut it out.

That is a model you want to look for.

Charting Banking XXIV: pre-tax pre-provision earnings

If tangible common equity multiples have their issues, what is a good valuation alternative?

If you trust the bank to survive its credit headwinds while at the same time its total revenues are growing, or at least stabilizing, I think it is fair to use some sort of multiple of normalized earnings. And if that is the case, pre-tax pre-provision earnings are a good start.

  • Why pre-tax? Two reasons. First, with all the recent losses many banks are not going to be paying taxes for a couple of years. And second, it makes easier the comparisons among banks and across time when taxes paid are fluctuating.
  • Why pre-provision? Provisions are the main way credit issues get reflected in the income statement, building up reserves for consequent charge-offs. Therefore, if we want to isolate the earnings power from the credit issues this is the main line to subtract. The other way credit issues impact earnings is loses related to sales of real estate owned REO.

And the idea is that after getting a standardized PTPP, you can use your personal estimate on steady state provisions and taxes to get to an estimate normalized earnings. We will get to that later.

There is one little problem though: that is all the consensus on PTPP there is. Each analyst and company do their own adjustments:

  • One-offs like goodwill write-downs and gains or loses on securities sold
  • CVAs and other mark to market distortions
  • REO gains and loses
  • Depreciation and amortization
  • Credit related operating expenses like mortgage servicing

And there is no consensus even on how to name pre-tax pre-provision earnings:

  • pre-tax pre-credit earnings
  • pre-tax pre-provision income
  • pre-provision operating income
  • core earnings

And of course each one of those come with its own abbreviation.

That makes life hard because you are not sure what each company or analyst is including and how to compare across companies and analysts. My opinion is that there is no way around it: you have to get your own estimates … and I will share one fast, but not very precise, recipe:

  1. Get cash from operations from the cash flow statement, and reverse the following adjustments
  2. Subtract back all working capital adjustments that are usually the lines that start with “increase” or “decrease”
  3. Subtract back stock compensation
  4. Subtract back tax provisions from the cash flow statement
  5. Subtract the equipment purchases (capex) from cash from investing
  6. Add back taxes (taxes provisions) from the income statement

Or the same, start from net income in the cash flow statement and add depreciation, amortization, provisions, one-time loses/gains, taxes, and subtract equipment purchases. Each company has different line disclosures in the cash flow statement so you still have to season to taste. But at least is much more standardized than using analysts and company estimates.

At the end, you get something very similar to what Buffett refers as owner’s earnings only that it does not include taxes. Among its benefits, it excludes non-cash charges and is somewhat conservative because it does not adjust for high administrative expenses related to foreclosures and REO administration (ie: Bank of America has 30,000 FTEs entirely dedicated to solving mortgage issues).

These are the numbers I am using as estimates for the Big 4 and the big challenger. Use them only as a reference. As I said, there is no way around it: you have to get your own estimates.

Do not try to be overprecise, I usually round up numbers trying to sin on the conservative side. Better to be roughly right than precisely wrong.

One way to double check the estimates is to compare profitability ratios  (do it with tangible figures if you prefer) across companies and across time to have a better idea of the earnings power of the bank. These are some high level numbers across companies,

Now how to get from PTPP to a normalized valuation? Well, the long way is to do a discounted cash flow with normalized provision, taxes and growth. I will recognize that I prefer simplicity, with some common sense, and generally use a 10x multiple of PTPP:

  • Very simple to calculate.
  • 10x pre-tax is close to 15x after tax.
  • 15x historic earnings multiples imply growing at the same rate as rest of the economy and returning just cost of capital.
  • Big banks cannot grow a bigger share of the economy forever so a conservative multiple looks good.
  • Substantial non-earning assets.
  • Some of them still have high cost financing (prefs, trups, tarp), despite high liquidity, that will be reduced over time.
  • The banks that I am interested in, the ones under some distressed valuations, will not pay taxes for years.
  • Non crisis provisions of around 0.3% of revenues are less than what many banks pay in mortgage mess related expenses.

There is at least one big exception to these oversimplified assumptions, banks heavy in credit cards or similar lines based on a model of high normalized provisions in line with high net interest margins. A clear example of this is Capital One. My recommendation, go to previous 10Ks and double check the normalized provisions.

Having estimated a normalized value, it is good practice to go through the credit/legal issues and estimate how many years would take to solve  them, apply your preferred margin of safety discount based on the company’s specific risks and growth prospects, and voilà.

That was today’s look inside the sausage factory.

Long BAC, C

PS: criticism of these numbers based on real figures is very much welcomed!

PS 2: I adjusted USB PTPP to reflect its 2011 growth after comments at the Corner

Munger on patience

How many different things has Wesco done since Blue Chip Stamps? We’ve only bought two or three companies and made a few big stock purchases. We’ve probably made a significant decision every two years.

But nobody manages money this way. For one thing, clients won’t want to pay you.

But this is not fun, watching and waiting, for people who have an action bias. Too much action bias is dangerous, especially if you’re already rich.

It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.

There are a lot of things we pass on. We have three baskets: in, out and too tough. A lot of stuff goes into the ‘too tough’ basket. We can’t do that if it’s a problem at a Berkshire subsidiary company, but if we don’t own it, we just pass. I don’t know how people cope trying to figure everything out.

We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.

But our theory is that getting a real chance to invest at rates way better than average is not all that easy. I’m not saying it’s not moderately easy to beat the indices by half a percentage point every year, but the moment you seek higher returns, is a very rarified achievement.

The only way we know how to do this is to make relatively few investments of size.

It’s not so bad to have one’s money scattered over three wonderful investments.

Suppose you were a real estate investor with a 1/3 interest in the best apartment complex in town, the best mall, and the best office building. Would you feel like a poor, undiversified investor? No! But as soon as you get into stocks, people feel this way. Partly, people need to justify their fees.

Over many decades, our usual practice is that if something we like goes down, we buy more and more. Sometimes something happens, you realize you’re wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices.

The Carousel

Honoring the fallen … and a reminder of what is a brand. This device is not a spaceship, it’s a time machine.

PS: just click through to get to YouTube and play the video

Bank of America’s big improvement

Brian Moynihan is not  the most charismatic of communicators but his prepared statement was excellent. You do not need the Irish gift of gab when you show results.

Some people have said that the Bank of America’s results were made of paper-mache. As any participant of a Mexican piñata can testify, paper-mache can be very robust. With its current capital situation, the piñata would need some serious beating to go down.

This time I am betting on the piñata. Yes, I am finally buying big banks and, as hinted more than a year ago, I did so by buying TARP warrants . It was about time to end this procrastination.

PD: good discussion of the results at the Corner of Berkshire and Fairfax.

The last 2 years, we’ve been executing on a huge transformation here at Bank of America. After 6 large acquisitions in 6 years during the mid-2000s, then the economic crisis and its aftermath, we set on a course to simplify the company, to streamline the company, to reduce the size of the company, to lower our risk and build a fortress balance sheet. During that, we set goals to have 9% Basel I Tier 1 common and 6% tangible common at year-end 2011.

We set goals to reduce our non-core assets. We set goals to bring our credit risk down and to address the mortgage risk related to the Countrywide acquisition. At the same time, we also set goals to continue to invest in areas where our company can grow and has this competitive advantage. Areas like our Wealth Management area, areas like our Preferred Small Business areas, where we’ve added Preferred Bankers and Small Business Bankers, areas like our Commercial Corporate and Investment Banking areas, especially in large corporate investment banking outside the United States.

Along the way, we had to address issues that came up in mortgage, the slowly recovering economy, which isn’t moving — which is moving forward but not as fast as we all like. The European crisis, a muted interest rate outlook and the revenue loss to the new regulations that have been passed. These then result in our focus on cost, and we announced early last fall our New BAC program and the goals that we had for it.

So as we think about 2011, we saw the following. First, on capital and liquidity. This quarter, our Tier 1 common equity ratio ended at 9.86%. Our tangible common equity ratio ended at 6.64%. In the case of each of these ratios, they are dramatic improvement from the beginning of the year. And we made these improvements while absorbing significant mortgage-related costs during the year. We have ratios that are in line with our peers, and we expect further improvement due to continued work on our balance sheet we’ll make during 2012.  In addition, our liquidity is and remains at record levels even after the downgrades we experienced in the fall.

Moving from capital and liquidity to our core businesses. On Slide 3, you can see, we continue to do what we’re here for. We simply serve our clients and customers and we do it very well. Our core business activity continues to move forward. During 2011, we continue to grow our deposits and our investment assets for our corporate and personal customers. We originated 20% more in small business loans this year, in 2011, than we did in 2010. This met our internal goals we had for that unit, but importantly, also met our $1 billion incremental goal we committed to the White House and the Small Business Administration a few months back. For our commercial clients and our corporate clients, we did what we’re here to do. We provided more loans, more capital and more market access here in the U.S. and around the world. For example, in the fourth quarter, you can see strong growth in our loan balances in our corporate area. And for our investor clients, we achieved the #1 Institutional Investor Overall Research ranking. Evidenced in the quality of ideas to match our capital to help them make their investments.

In our Mortgage business, we continue to reshape our operations to focus solely on origination of mortgages for our customers and to do it well. And importantly, we continue to help those who have difficulty making their payments in mortgages. We’ve now crossed over 1 million modified loans in our servicing portfolios.

The third area we focus on, after capital liquidity and the core businesses, was costs. It’s clear that we’re going to grind forward with the recovery in this country. Our clients continue to push forward and we’re seeing the activity continue to move forward, but a full recovery to what we would call normal, may take some time. So with that in mind, we begin to focus on bringing our cost down across the company.

Our cost structure for Bank of America has 2 broad elements today. First, the cost we incur to deal with the mortgage issues. And second, the remaining cost to run the rest of the company for the benefit of our customers. Overall, cost were down from 2010 to 2011, and we expect substantial cost savings in 2012. This quarter, you can see that starting to take hold. We made significant progress towards our overall FTE reduction goals. Our period-end FTE is down about 7,000 people in the fourth quarter compared to the third quarter. This is over and above the 2,500 people we added in this quarter for our Legacy Asset Services. There’s 2 things about this. One, this shows that our New BAC implementation has begun in earnest. And second, the good news is, that we expect that LAS is at and near its peak staffing.

The fourth area we’ve been concentrating on in 2011 was trading. Trading was strong in the first part of the year, but with the issues in Europe, the depth of U.S. downgrades, the downgrades of our company and changes in client risk appetite, results were weak in the second half, especially in the third quarter. However, during the fourth quarter, we partially recovered as Bruce will talk about later. Yet, we still reduced risk during the quarter to ensure we were well positioned to handle what might have come up. We still have work to do in trading, but the team got active this quarter, as the quarter unfolded, and we saw a stronger results.

From a credit risk perspective, you can see that our charge-offs and cover ratios continued to improve. We ended the year with strong ratios. And we’ll also end the year with $15.9 billion in rep and warranty liability reserves. We built significant litigation and other reserves in this area also.

So the 4 areas of 2011 was all about raising capital and liquidity, driving the core businesses, managing the cost and risk management.

Long BAC warrants

Eastman Kodak, legends of the past

Today is a day of sorrow. Eastman Kodak, the icon of American invention, filed for bankruptcy protection. And not only that, it has been an incredible waste of shareholders’ cash and resource over the last decade.

One of the first posts on this blog, and one that I am proud of, was a review of the dangers of Eastman Kodak as an investment. You will be able to read it in its entirety after the jump but first some comments.

To start, I am not going to say that I predicted Kodak’s demise because, as you will read, I did not. Instead it was

  • an example of the dangers of investing in companies under revenue stress based only on its assets
  • a call to avoid investing in turnarounds before they show signs of revenue stabilization.

What happened to those assets that supposedly provided a Margin of Safety? What those assets did provide was time, time to realize that things were not going well and get out! It was one reason I sold Premier Exhibitions: despite the very real possibility that they are going to sell the Titanic assets for a premium: cash and revenues started to decline.

Finally, there are several interesting situations today that fit the mold, priced well below book value but with revenues under stress, like Research in Motion and Sears Holdings. Both have much better chances than Kodak of surviving. Research in Motion revenues are even growing though at a much slower rate. But still be careful, turnarounds are not asset plays. There is no hurry, wait for revenues to stabilize first.


After a while Buffett asked everyone to pick their favourite stock. What about Kodak? Asked Bill Ruane. He looked back at Gates to see what he would say.

“Kodak is toast” said Gates. Nobody else in the Buffett Group knew that the Internet and digital technology would make film cameras toast. In 1991, even Kodak didn’t know that it was toast.

“Bill probably thinks all the television networks are going to be killed” said Larry Tisch, whose company, Loews Corp., owned a stake in the CBS network.

“No, it’s not that simple” said Gates. “The way networks create and expose shows is different than camera film, and nothing is going to come in and fundamentally change that. You’ll see some falloff as people move toward variety, but the networks own the content and they can repurpose it. The networks face an interesting challenge as we move the transport of TV onto the internet. But it’s not like photograph, where you get rid of film so knowing how to make film becomes irrelevant” – The Snowball

Maybe I gave some of you the wrong impression in my previous post. Turnarounds are not the Holy Grail so let’s start by reviewing a dog. Well OK, maybe not a dog dog but a company that I decided not to invest in given the few signs that the turnaround was turning. And that company is Eastman Kodak.

Is Kodak worth analyzing? Well it is a company that symbolizes the best of American innovation and mass marketing in the twentieth century. Kodak is even today one of the most recognized brands in the world with a book of patents that used to be the envy of every business. A great blog Distressed Debt Investing has his sight on this situation as a debt opportunity and irony of ironies, Bill Gates has invested aggressively in it.

Is Kodak toast? The short answer is I don’t know. But it is also the wrong question, we should ask on the probability of Kodak going toast. And the best way to estimate that probability is to hear the story: what management is trying to achieve:

Is your case based on Kodak’s entry into the inkjet-printer business? The new printer business is part of the thesis, which is that Kodak has introduced a technology that has the potential to disrupt the entire industry because it will be able to charge a lot less for ink cartridges — about half the current price.

What’s the rest of the thesis?
 It’s simple. Throughout this entire transition, during which sales from film have dropped by almost two-thirds, Kodak has continued to generate about $1 billion in free cash flow before restructuring charges. That’s because as film sales have dropped, its graphic-communications and digital businesses have improved. Investors today are valuing $1 billion of free cash flow at $14 billion to $15 billion in the marketplace. But Kodak’s market value is just $6 billion. Why is it so low? Because for each of the past four or five years, Kodak had cash restructuring costs — for environmental-cleanup liabilities, for the costs of closing plants, for severance when there were layoffs — that have totalled roughly $600 million to $700 million per year at the peak. There will be $500 million to $600 million in additional restructuring charges this year related to closing film plants and the sale of Kodak’s health-care business. Next year, there will be no restructuring charges. Unless the business gets a lot worse in the next year or so, Kodak will do $1 billion to $1.2 billion of free cash flow in 2008. And if that happens, the stock should be up 50% to 100% in that period of time. – Bill Miller 2007

So this is a story of new divisions (graphic communications and digital) taking the torch from the traditional film division that is being milked down. These are the divisions

  • Film Product Group is the remaining traditional film business, that will continue to decline. The decline rate will depend on the speed of the transition to digital in both the consumer and film markets.
  • Consumer Digital Imaging Group includes digital still and video cameras, digital devices such as picture frames, snapshot printers and related media, kiosks and related media, consumer inkjet printing, Kodak Gallery, and imaging sensors. CDG also includes the licensing activities related to intellectual property in digital imaging. Expenditure will likely be down until the recession ends and if past performance indicates future performance it is unlikely to carry the whole group
  • Graphic Communications Group serves a variety of business customers in the creative, in-plant, data center, commercial printing, packaging, newspaper and digital service bureau segments. Products and related services include workflow software and digital controllers; digital printing including equipment, consumables and service; prepress consumables; prepress equipment; and document scanners.

Here is a hint, the type of turnaround is critical. A turnaround based on closing or selling cash consuming divisions and cost cutting is usually much simpler than one that is based on new products, debt restructuring or business model innovation. Therefore, this is a difficult turnaround that merits a guilty veredict until proven innocent. What surprises me is that Bill Miller said so himself

There aren’t many companies that have been terribly successful making big technological transitions. How many typewriter businesses moved into computers? – Bill Miller about Kodak 2005

Besides having a credible story, the execution needs to measure up to the story because turnarounds usually do not have lucky breaks. You want to see the wheel turn. So what can we say about the Kodak execution


It seems that all divisions are struggling in the recession. A good point though is that the Film Products Group is not carrying the whole weight. Can the non-film divisions carry Kodak out of this difficult situation?


Well, maybe management was a little overoptimistic on these new businesses. Or maybe the new printers need more time to penetrate against strong competitors like HP and Lexmark. Also digital cameras are commodities with low margins and profitability. So it looks like this is a company carried by three motors, only one is working (traditional film) but it is stuttering and about to shutdown.

Also it seems that those restructuring costs are never ending.


So if we review a checklist summarizing the thesis of investing in Kodak the situation is bleak and deteriorating

  • New inkjet-printer business? Not ready for rock and roll
  • $1 billion in FCF before restructuring charges? Disappeared
  • Graphic-communications improving? Doing just OK
  • Digital businesses improving? Bleeding
  • No more cash restructuring charges? Continuing and no sign of abating

This is a difficult turnaround, innovation does not work very well under stress, but I would not dismiss it with a hand wave. IBM’s turnaround, one of the most remarkable success stories in the 90s, was the result of the surge of the business service division.

Instead I am waiting, and this is a key difference with the traditional value investor mentality. A traditional value investor when faced with an asset play with a sufficient margin of safety he would make a decision right there: Is it cheap enough? I argue instead for the value of

  • Waiting for confirmation instead of just buying
  • Adjusting the commitment as the probability and value is discovered instead of just holding

Is it possible to find a margin of safety in turnarounds like Eastman Kodak? Just look at the deterioration of Kodak’s assets the last quarters, and take into account that it had more $4 billion in cash less than two years ago.

ASSETS Q4 2008 Q1 2009 Q2 2009
Consumer Digital Imaging Group 1647 1498 1194
Film Products Group 2563 2408 2301
Graphic Communications Group 2190 2115 1826
All Other 8 1 5
Consolidated Total 6408 6022 5326
Cash and Marketeable Securities 2155 1319 1141
Deferred Income Tax Assets 620 587 639
Other Corporate Assets / Reserves -4 1
Consolidated Total Assets 9179 7929 7106

It is critically important to avoid investing in turnarounds as if they were asset plays. The key success factors, the dynamics and the character traits needed for both situations are very different. With few chances of liquidation, hope trumping reality and red numbers for years, buying based on asset value is asking for pain. I will argue in future cases that it is possible to have some margin of safety but not in the traditional Graham way.

Dimon on housing

I could not have said it better, with such a command of the facts, while impromptu in a conference call Q&A. Demographics help the United States, it is not turning Japanese.

And he does not fall in the temptation of making a prediction. Impressive.

Yes, so let me answer the first in part. I think what you need to see is employment. That’s what you need to see because employment, in our opinion, will drive household formation.

But if you look at the other factors, okay, we’ve been destroying more homes than we build in the last several years. We’ve added 10 million Americans. We’re going to add 3 million Americans every year for the next 10 years, that’s 30 million Americans who need 13 million in drawings or something like that.

Household formation has been half what it normally is, and most economists tell you that’s going to come back with job creation. And the so-called shadow inventory is coming down, not going up.

So for all the chatter about it, it is very high. Rental in half the markets in America is not cheaper to rent than to buy — it’s cheaper to buy than to rent. Housing is an all-time affordability and my guess is, is that mortgage underwriting will loosen, not tighten.

So if we put all of those things together, you’re going to have a turn at one point. Look, I don’t know if it’s 3 months, 6 months, 9 months. But it’s getting closer.

PS: Having read it twice, this was a feisty conference call. You just have to feel sorry for the analysts. Let me add a couple of extras, here is a good one after a nonsense question,

As I said, we’re not macroeconomists, okay? If you want to know about that you should seek that out yourself.

On media looking for an angle,

By the way, I just got a note that one of the newspapers out there thinks that we haven’t done a full disclosure on Europe. The reason we didn’t add our European business, it’s pretty much like it was last quarter, not much has changed, so if anyone’s interested.

On Basel confusion,

Let me answer your confusion here a second, okay? We’re running Basel I, Basel II, Basel 2.5 and Basel III. Remember, the European banks early on in effect of Basel 2.5. So they just have to go from 2.5 to 3, where the American banks had to go from 1 to 3.

And so when they say it has to get to 9%, it’s not Tier 1 Common, it’s Tier 1 Core, which is slightly different, by June of 2012, that’s an accelerated, getting there already. And they’ve already got, I’d say most of Basel III in there, maybe a little longer than that. But I think most of Basel III is already incorporated in Basel 2.5.

On headcount growth,

No, we’re not pulling back.

In the overhead number, I think we already mentioned the $50 billion is, I believe, going to be pretty consistent so far for next year. And the headcount, let me split it 3 things.

We are always gaining efficiencies which you don’t see. In tech, ops, overhead, a whole bunch of stuff.

And we’ve added and we break it out, and you’ve got to do it by business, with branches. So we’ve added 3,000 salespeople in branches in Consumer, some of that is in the new branches, some of that is in existing branches. We’re adding private bankers, we’re adding branches overseas. We opened 20 branches overseas, mostly for TS&S. So all those things add people.

And for the biggest add, which we’ll not be adding any more, was to handle default. So there’s — I’ve got the total number, we’ve added 15,000 people the last 2 years, maybe more, just to handle default mortgage, in mortgage. That number has probably peaked and I think you’ll see it coming down in the next couple of years.

And add this recent “issue” of releasing reserves,

we have a $9 billion reserves we don’t need, okay? So until we get through all of this, I’m sure we’ll just add them up. But basically, the numbers have gone too good over time to leave up that amount of reserves under current accounting. There’s going to be a change in accounting. But that’s not — we’ll worry about that when we get there.

Analysts must like to be handed their heads off. They were jumping over themselves to get into that queue. But that was not all, there is some clear thinking in this conference call of a man that wants to do the best for shareholders.

Dividends is a small decision from capital standpoint, so that raise a little bit here, that’s not going to be material. We still — we started the dividend again, we’d like to increase a little bit every year. It’s a board decision.

And the stock is very cheap and particularly below tangible book value, I’d like to buy a lot back which, of course, we can’t do. By the time we’re allowed to buy a lot of stock back, I’m sure it’s going to be much higher priced and then we may change our decision about that.

So you can get a little frustration in my — in about how we’ve had to do our capital buyback. But we are getting more clarity from the Fed. The Fed has asked for these stress tests. The stress test, all the banks have put in their CCAR and we are going to tell you what that is when we get it back. 

So, but I’m not going to change the statement I made at the Goldman conference, which was, we hoped to be able to do a little more than we did in 2011.

Jamie Dimon’s conference calls and letters shoot from the hip and are always fun. I wish he had not also taken the role of spokesman for the industry so I have to be skeptical of his views regarding regulation. What can I say, he let it go and that is what is probably going to appear on the headlines.

Charting Banking XXIII: tangible common equity

More than 3 years after Lehman, I continue to get involved in board discussions over the uses of the tangible common equity (TCE) and its close relative the TCE ratio.

TCE ratio = Tangible Common Equity / Tangible Assets

I am not a fan of using TCE for valuations, very seldom you will encounter a bank going through an orderly liquidation. In good times earnings show and in distressed times, like the ones we live, is precisely when banks can not liquidate orderly. They either,

  1. Survive: and go on to live better times
  2. Dilute: increase capital to navigate bad loan issues
  3. Sell: to a bidder with the balance sheet to navigate the bad loans
  4. Collapse: so who cares about valuation after a wipeout

Surprisingly, most capital raised has been negotiated around TCE multiples, usually close to 1x TCE. To have a future it is first essential to survive the present so capital sets the rules. I will argue though that with credit issues declining fast, current and potential earnings multiples should increase in importance. The age of TCE multiples should and will recede.

The second use of TCE, and the one that I personally use, is the TCE ratio. A measure of leverage and its close cousin: excessive risk taking.

Why the TCE ratio and not all the other capital ratios that regulators use for capital adequacy, like tier 1 leverage, tier 1 capital, total risk? I am old-fashioned, and I think it is important to be skeptic of measures that open opportunities to hybrid capital, that is partly debt, or use “risk” weighted measures of assets, when there are no “safe” assets only safe underwriting. When financial booms come, hand in hand with financial deregulation argued for by the banks themselves, exoteric metrics can easily hide or tempt risk taking.

Leverage is not the only way that banks can take risks, bad loans and investments are even worse. But a risk taking bank will pull all levers and high leverage is a good warning signal. For example, let’s see the TCE ratio for American banks at the bottom of the 2009 crisis.

It does not look like all banks were pushing the envelope but what about the Big 4! Some will argue that these are precisely the banks with high pre-provision profitability to cushion the crisis, with Warren Buffett one of them, and it has some truth.

Dick Kovacevich specifically told me to ask you your views on tangible common equity.

What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they’ve got huge earning power. And Wells … you can’t take away Wells’ customer base. It grows quarter by quarter. And what you make money off is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that’s what they do. (…)

You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on. And that’s where people get all mixed up incidentally on things like the TARP. They say, ‘Well, where’d the 5 billion go or where’d the 10 billion go that was put in?’ That isn’t what you make money on. You make money on that deposit base of $800 billion that they’ve got now. And that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they’ll put out the money differently.

Even more, I would argue that this set of banks was not even very responsible for the bubble. Investment banks and other banks that had already collapsed should carry more of the blame.

But add a fizzing real estate bubble to large real estate loan and securities portfolios. Who should you trust with this mounting evidence of too much risk taking? Or as Buffett would say

banking is a very good business unless you do dumb things

So with all the complaining about the new emphasis on the TCE ratio in the dark days of 2009, I wonder … what was new? Banks lobby for deregulation and more leverage only later to complain of regulation “overreach” . The system flatlined only because they asked for the rope to hang themselves.

And let’s not forget that capital for the whole system is important. Capital works as a cushion and help banks to recognize loses faster instead of gambling on a rosier future. To be the lonely good bank, and most were prudent, when the national banking system is collapsing is no consolation. As the Bank of Ireland sadly learned.

The flip side of the TCE ratio is that its improvement also signals banks reducing risk, voluntarily or not, and the progress has been spectacular.

What about Europe? As is public knowledge, European banks have their issues. And it is not just the sovereign debt exposure. Some big banks need capital and the TCE ratio is one if several guidelines that hint on this despite all their complaining.

Does this mean that the American banks are threatened? Good banks but sadly part of a collapsing global banking system?

Not so fast. Retail banking crisis are more of a local/national affair connected to local/national deflation. International assets  are usually not big or risky enough in retail banks balance sheets. But that is an assumption that must be checked, specially with the Big 4 taking more investment banking roles, as we will do in a future Charting Banking.