Variant Perceptions

Category: cyclical

Charting Banking XXII: three years after Lehman

Three years after Lehman concerns about the banks’ state of affairs have resurfaced once again. The strange thing is that the performance has been very predictable: a steady improvement in all fronts. Once again we are going to take advantage of the pret-a-porter graphs from (I am very lazy). But this time it includes a couple of new charts to address the capital ratios improvement.

Let’s start with our usual guests the Texas ratio and 30-89 days delinquencies.



It does not look like the crisis is deepening, doesn’t it? 30-89 delinquencies in particular are at levels not seen since Lehman collapsed. When people talk about the credit issues of the banking system it really surprises me. The fundamentals are definitely improving.

One of the most common accusations is that banks are “extending and pretending”. Well, loan  extensions are a normal part of a bank operation. Good clients with good credit normally get extensions. Despite all the talk of recent years, there is a good difference between liquidity issues and solvency issues.

But I understand people’s concern with restructured loans, if credit standards and interests payments are reduced for lenders  it might indicate credit deterioration. It is still part of good banking, especially when rates are zero so there is room for helping lenders while maintaining spreads, but it is an issue that should be addressed.

The problem is that the bankregdata ratio that I have been publishing includes restructured loans. It was the conservative way. Though, considering the improved conditions I think it is time to show the progress without restructured loans. And it has been dramatic.



I do not even know where the “extend and pretend” argument comes from. I understand that Japanese banks were very slow in recognizing their commercial lending problems in the 90s, because of cozy keiretzu connections, and all the resulting problems.

However, Japanese banks had non-performing assets reaching 8%. US banks are nowhere near those levels and most have been building reserves, modifying and extending good loans, charging-off the bad ones, foreclosing the zombie ones and disposing REO.


And not including reestructured loans:



It has not been a pretty process but all the headlines about robo-signing and wrong foreclosures are not the result of banks being slow. Even more, for most of them there is not even the incentive to delay when their capital ratios give them space for maneuver to accelerate issues and leave the crisis behind.



And I have not yet counted the very large reserves built over the last 3 years, maybe I should.



Most banks are most probably over-reserved.  It also hints that most current provisions, that are depressing banks’ earnings, are fake expenses.

Not that there is anything wrong with that, better be safe than sorry. An overcapitalized and over-reserved banking system is better for all of us. It reduces systemic risk and provides a buffer in case of external shocks … like Europe.

And from an investor point of view, these reserves can provide a nice margin of safety. Most of the credit problems have been recognized and more than 50% of them are already in the past. So if an investor underestimated some hidden issues … there are lots of reserves – and cash from operations – to take care of them.

We have to be careful though, each bank is its own animal. Maybe on the aggregate the system is being managed conservatively; but each bank as an investment has to be addressed individually.


MPG Office Trust: recap

More than a year ago, I wrote a thesis for the MPG preferred equity and left some open questions on the value of the common equity. A sharp price recovery discontinued that series; nobody likes much to write about stocks sold or priced too high.

Some recent events, specifically the resignation of the CEO Nelson Rising, prompted a selloff so it is a good time to continue the series and answer those open questions:

  • “Not much in recourse obligations left, the OC strategy should restart cash flow generation, and there is cash, unencumbered land, a 20% participation in a profitable JV and large NOLs to carry them through the turnaround. The preferreds must be an easy kill, is there more value left for the common?”
  • Do we think that the common is not only undervalued, but has more upside than the opportunity cost: the potential 3x of the preferreds and its higher preference in the capital structure?

As we discussed at that time, Maguire is a highly indebted REIT that is barely cash flow breakeven. Since that write-up,  the company has practically eliminated all recourse debt and corporate guarantees so MPG may loose some valuable properties in the process but each mortgage is independent so a cash flow positive core will always survive.

The continuing debt restructuring is not the only recent news. The company also has a new name, MPG Office Trust, consequence of the firing and disentanglement of most business relations with Mr. Maguire, and a new CEO David Weinstein consequence of the divergent capital structure views of Mr. Rising and the board.

Over the last year my main worry with MPG has been a potential dilutive capital injection. I am not opposed to it at a property level, with a couple of asset sells if necessary, but I do oppose a capital raise at the corporate level because at the current valuation defeats the purpose of the well conceived debt structure.

Well, this worry has been mitigated with the leaks following the CEO resignation. I think it is pretty clear that the board had the same worries and is defending shareholders.

But Mr. Rising believed the company also needed to sell equity to stabilize its balance sheet, people familiar with the situation said. Other REITs were doing this. But MPG shares were at such a low level, board members felt that it would be too dilutive, these people said. Mr. Rising also had discussions with possible suitors interested in buying the company. But the board felt the price would be too low because of the company’s high debt load, these people said. – Wall Street Journal

Some of you will challenge this view that the market may be missing something. After all, MPG is not your usual small cap. It is widely known in the competitive REIT sector so it should not lack suitors if it had substantial value left.

The thing is, there is a long line of suitors. For a start,

  • Winthrop Realty Trust was a large holder of preferreds and showed interest on a more active role before selling.
  • Brookfield Properties has been mentioned as interested in several articles, including the WSJ article on the resignation of the CEO. One of their analysts has been a staple in recent MPG’s conference calls.
  • Appaloosa has a very large position, close to 10%, in the common and most probably in the preferreds too.
  • Third Point had a large 10% position that was sold. Daniel Loeb in one of his tirades complained about the company rejection of a $20 buyout offer in June 2008.
  • Baliasny Asset Management, besides being implicated in the recent insider trading scandal, bought a 5% position between Q4 2009 and Q1 2010
  • Robert Maguire, founder and former CEO, increased his position to close to 10% (prices between $1.4 and $2.5) while firing a 13D between February and March this year.

Quite substantial blue blood interest, specially for a company valued at only $100 million. The question is what are they seeing here. If you go the traditional way of valuing a REIT by using a multiple of NOI (net operating income) you would be disappointed. There is not much NOI.

At the same time, that method misses that MPG was known for their subpar NOI generation compared to its NAV (net asset value). The reason is that downtown leases were not paying enough while absorbing for decades the CRE bubble from the 1980s. Though, on the positive side,  there is no new supply expected for years and, in the meantime, the office vacancy is below 20% in downtown LA so it will be absorbed rapidly after the downturn ends.

No new supply and continued downtown growth. I wonder what will happen next.

Past history is the way I have seen people arguing on behalf of MPG. They extrapolate its share price before the Orange County acquisition and conclude that it is worth more than $40 per share. But that is not right either: the OC debacle cost MPG significantly since they had to refinance and extract equity from the core Los Angeles CBD to buy those properties … properties that are being hand over.

There is value, substantial value, but it is going to take a long analysis. Please bare with me and let’s hope that this time the price does not jump before we finish the series.

Long MPG

This article was published in CGI Value two weeks ago

Two slides from Brookfield’s investors day

Nothing to add

Remembering a predator

“We’re in the business of buying assets of great quality at less than replacement cost” – Bruce Flatt

That is not a quote from Flatt’s Whitman business school presentation but from the recent interview “The Perfect Predator”. Predator is a good metaphor to what is needed when investing in commodities and hard assets: waiting while on the hunt for that few transactions that make outsized returns.

I wish I had not learned it the hard way. The 1982 Latin American debt crisis was devastating for Chile with an official unemployment rate higher that 30%. And that 30% included the benefits of the government employment programs: the kind that dig a hole only to fill it later.

The largest Chilean business groups were hopelessly levered having used their control of the largest banks for interrelated loans.  With some few notable exceptions. The most important one: Anacleto Angelini.

He was not a political man. It was whispered that his modus operandi was to contribute just enough to all political parties to avoid making enemies.

When banks were nationalized and distressed assets had to be sold not all predators were like him. Others used their political connections to grab some of those distressed assets on preferential conditions. A useful remainder that the word predator is not normally used as a compliment.

Mr. Angelini preferred to let cash do the talking and cash was responsible for his biggest coup: the acquisition in 1985 of Copec and its flagship Celulosa Arauco.

I had the fortune of meeting the man a couple of times when he was not the man but just a family friend. Still, he made an impression on that child. He drove himself the same old car and lived in the same old house. He avoided media and newspapers, that got tired of speaking of him only by hearsay and printing the same old picture… there was no other one.

But most important, he imprinted one motto in my mind even before the acquisition:

lowest cost wins – Anacleto Angelini

Celulosa Arauco’s long fiber pulp total costs are less than $300 per ton and the current market price is almost $1,000 per ton. It takes 20 years to grow radiata pine in Chile, it is not even commercially exploitable in the northern hemisphere (50 to a 100 years). Eucalyptus is ready in 12 years at a fraction of the time of the Canadian and European hardwoods.

That is what I call an unfair advantage, an unfair advantage he was ready to buy at the right price.

The acquisition transformed his financing arm Antarchile into a multibillion commodity conglomerate and, over time, Mr. Angelini became the richest man in Chile and South America. A nice ending for an Italian immigrant that drove trucks in Abisinia and spent time in a British concentration camp during the Second World War.

Anacleto Angelini died in 2007. He was fair and honest. He was not a visionary. He was a predator. One of the best.


Bruce Flatt on investing in hard assets

Link to video

It is one year since we mentioned Maguire Properties Group as a potential opportunity only to be followed some months later with a specific recommendation to buy the preferreds. It has bothered me that the series was interrupted by a sharp price increase before I could disclose the common equity thesis. Now it is time to make amendments, so next week we will continue that series and hopefully end it this time.

The company has gone through some big changes in this period. It has a new name, MPG Office Trust, and a new CEO. Also the common stock is not as cheap as it was in December last year but is cheap enough to make it worthwhile to dust off those notes that I thought were not going to see daylight again. And if the price gets away once again so be it.

As an introduction, I thought that this  overview by Brookfield’s CEO Bruce Flatt was one of the best presentations I have seen on the issue of investing in hard assets.

What is Brookfield’s way? The best explanation I have read comes from the interview “The Perfect Predator”

Flatt laid out his new game plan: the giant squid of a holding corporation would focus on operating in just three sectors—real estate, power generation and infrastructure, areas that could deliver consistent revenue, locked in by long-term contracts, and where assets tended to rise in value, making them relatively cheap to finance. With this simplified focus, Flatt invited pension funds to put money into Brookfield-run investment funds, with the resulting management fees serving as a cushion for the company’s own investment returns.

When we review MPG next week please keep this presentation in mind. Do not miss his discussion on 245 Park Avenue (yes, the one in the picture):

  • Great location: downtown Manhattan
  • Acquisition price: bought in 1995 for $500 million ($250 per sqf)
  • Market perception: Due to the internet most people will work at home
  • Variant perception: People want to work close to other people
  • Current valuation: $2 billion ($1000 per sqf)
  • Profit: 4x enterprise value, 10x equity due to leverage, plus rent income

The Q&A follow-up session is also very good – $1,000 per sqf replacement cost estimate for downtown Manhattan- and of course take note of the 8 principles that guide Brookfield’s operations. Mmm, maybe I can be of help with that:

  • Buy great assets: look for good locations with good fundamentals even if that means paying a premium
  • Buy on the assumption of owning forever: allows to avoid fads, think long term and compound tax free
  • Prudently finance your assets:  Long term and investment grade financing to avoid situations when you can not get financing. Live to see another day (I would add non-recourse)
  • Never become too positive or too negative: Toughest rule to follow. Assets revert to the mean and seldom the mean changes. Technology in the few cases that it has an impact it takes time.
  • Invest against the common trend: prepare for the great opportunity. Look for the 1% of business activity that generates outsized return. In normal times, be prudent.
  • Build with quality people: turbulent times test the cohesiveness of a team.
  • Execution, execution, execution
  • Never deviate from the first 7 principles: the consequences of short term solutions can be sometimes, not always, business threatening

    P&C insurance historic profitability

    One industry that has been mentioned in passing in this blog, and which I am following for signs of better pricing and a cyclical bottom, is property and casualty insurance. We mentioned in a previous post how several players are priced well below book value consequence of a soft market with ROEs below cost of capital. This situation should be unsustainable and the big question is when is going to reverse.

    This nice chart from a recent W.R. Berkley Corporation presentation illustrates not only the under performance of the industry in terms of ROE but also its dependency on investment profits to achieve those returns. With interest rates at the end of a secular 30 year decline – they can not go below zero, can they – the question is when and how much pricing and underwriting profits should recover.

    These are some estimates of which lines will be most impacted and the price elasticity to compensate for the investment income shock. Oh, and thanks Mr. Berkley for that nice  checklist too.

    Sinochem likes Potash Corp

    The announcement is not very much of a surprise

    Sinochem, the Chinese-state owned chemical group, said on Friday it would “pay close attention” to BHP Billiton’s $39bn hostile bid for PotashCorp, and added that it was “interested in overseas potash investment opportunities

    Given the confrontational history of BHP with Chinese government companies, this is only just one more chapter in the battle for control of key natural resources supporting the fast growth of the emerging economy.  More interesting is the description of the distribution monopoly used to control prices and provide a stable supply of fertilizers in China.

    PotashCorp has strong links with China, the world’s biggest fertiliser importer. The Canadian company owns a 22 per cent stake of Sinochem’s listed subsidiary Sinofert, China’s biggest fertiliser maker and distributor and the country’s biggest importer of Potash. PotashCorp is a leading member of Canpotex, a cartel system that Chinese buyers favour because it ensures reliable annual prices….

    … China considers agricultural self-sufficiency a matter of national security, but only produces enough potash to cover about half of its fertilising needs. The country also favours the current system of annual price contracts for potash. BHP has suggested it would shake up the nearly 40-years-old potash pricing system

    … Sinochem is China’s largest fertilizer distributor, and until 1998 held a government monopoly on fertilizer imports. Sinofert on Friday handles all of Sinochem’s fertilizer business, running 2,000 distribution centers throughout China. The subsidiary was listed on the Hong Kong stock exchange in 2005, and now has a market cap of HK$30bn.

    This possible shake up is similar to the negotiations with BHP over iron ore. The Chinese are not standing still and they are moving to expand fertilizer capacity and access

    Sinochem has been hungry for agribusiness opportunities abroad, but was humbled last year by its failure to secure a deal with Nufarm after six months of talks. After the Australian firm accepted a rival Japanese bid, Sinochem vowed to “continue to strengthen our co-operation with the world’s agrochemical enterprises and unswervingly push forward the globalization of our agrochemical business.”

    China has been aggressively expanding the country’s domestic potash production, with output doubling between 2005 and 2009. China’s potash demand was 7.9m tonnes last year, down from a 2007 peak of 11.93m tonnes, said Wang Ling of China Fertilizer Market Week.

    Some of you may ask why this interest in potash. Well, fertilizers is an industry close to my heart despite some people’s opinion that it is “by and large, an unexciting business” (Heidi Moore, WSJ). One person’s fish eggs are another person’s caviar. Non renewable limited resources, high barriers to entry, controlled by a few players can be a road to riches. Also, I stumbled upon one potash opportunity while researching mining stocks and with all the M&A hoopla might be time for a deep analysis. If readers have recommendations in the phosphate or potash industries I would gladly take a look.

    Bloomberg on Potash

    Short Bloomberg video on the importance of Potash

    Fertilizer industry prospects

    As part of the rejection of BHP’s acquisition proposal, Potash Corp (POT) released an interesting report about the fertilizer industry and its prospects. On the question of why a mining company could be interested in the fertilizer industry, it is worth remembering that this business is segmented in the three primary crop nutrients (nitrogen, phosphate and potash) and potash in particular is mined. Potash Corp controls 22% of the worldwide potash production capacity.

    As side notes, Potash Corp is one of Mohnish Pabrai largest holdings and is interesting to see SQM, one of my first investments, as part of the melodrama. SQM is one of several minority participations that, according to Potash Corp, BHP’s offer is not valuing at their true worth.

    The key phrase in the presentation?

    Industry characterized by substantial barriers to entry, few producers and no known product substitutes

    No position

    UPDATE: Fortress International Group

    FIGI filled an 8K disclosing their sales progress during the first half:

    today announced that it has closed approximately  $44.0 million in new contracts for the six months ended June 30, 2010, an increase of nearly 300% compared with $15.0 million in new contracts for the comparable period in 2009.

    Seems like the industry capital expenditure is back after the severe cash crunch after Lehman and the pent-up demand is showing. We also discussed the sales uptrend while reviewing the first quarter announcement and the deep cost reductions.

    The breakdown by division is as follow:

    • Technology consulting – $12.4 million (includes the previously announced Task Order Contract of $10.0 million, which covers a five-year period)
    • Construction management – $25.1 million
    • Facility management – $6.2 million

    It is nice to see some facility management recurring revenue. Management also emphasized that they are getting repeat business from old contracts:

    In addition to new contracts, we are attracting considerable repeat business from premier customers such as Power Loft, SAIC, Home Depot, US Army Corps of Engineers, as well as our three fortune 500 IT based customers and the NIH. We also continue to add to our list of recurring service contracts for maintenance and emergency service coverage on containerized systems throughout the US where we see considerable opportunity to capture additional business.

    Long FIGI