Freddie Mac - we'll only buy almost anything

By now I'm sure you've read a hundred articles about the the Shanghai panic that led to a world-wide sell off of equities so I'm not going to add to the pile. My friend over at Shenandoah Capital has a good article that summarises what led to the carnage of the last 24 hours. More specifically I think what happened in Shanghai and the reverberations it caused are a sideshow to the main event yet to unfold.

MarketWatch.com carried an interesting article today on Freddie Mac getting tough on subprime mortagage standards. Freddie Mac shouldn't be confused with a bank or other financial institution that lend to potential homeowners. They actually buy mortgages and then sell bonds and other securites backed by those mortgages. You may know this process as securitization. They make money off the differential between the bond rate and the purchased loan, e.g. they buy a loan with a 5.25% interest rate put it in a mortgage backed security with a coupon of 5% effectively pocketing the 0.25% differential. OK, so what does Freddie Mac mean when they say they are getting tough on subprime mortgage standards?

Firstly what is a subprime mortgage? Basically its a high risk loan. Subprime mortgages are aimed at those who don't qualify for loans at mainstream financial institutions, although increasingly subprime lenders are just affiliates of mainstream lenders operating under different names. Generally they operate the same as prime mortgages but only with a higher interest rate to compensate for the higher risk.

Now that's great for those who have a hard time demonstrating to a bank they have the requisite amount of assets such as those whose livelihood is cash based or who run their own business. However think of the logic behind it for a minute. Someone who couldn't qualify for a loan at a mainstream institution because they are deemed too high a risk qualify at the institution's affiliate at an even higer rate and therefore even higher risk.

In the article Freddie Mac said they will:

"limit the use of loans that don't require income verification or other documentation."

So basically you can get a loan without having to verify your income level or assets, what the f...? Freddie Mac has been purchasing and selling loans that don't require proof that the borrower can pay them back and remember they are not going to stop doing this they are just going to limit them to those customers that are fully underwritten at the full borrowing rate not a discounted 'teaser' rate. That doesn't guarantee that the customer won't default it just excludes the riskiest customers. Further on in the article..

"In addition, the company won't purchase "no income, no asset" documentation loans and will limit so-called "stated income, stated assets"

What this all means is that Freddie Mac has gone from buying anything to almost anything. Senator Christopher Dodd of the Senate Banking Committee labelled Freddie Mac's move as:

"a responsible standard that ensures that these borrowers will have the ability to repay their loans, thereby protecting their home equity," "This is the right thing to do both for the borrowers and for Freddie Mac."

I think the senator is overstating it a little, I'm not so convinced.

Sure Freddie Mac is making an effort but look at what we're talking about here. Lenders have become that greedy they will lend to people who they don't even know can pay back the loan. So what, that's the environment of easy credit we live in these days you might say. Well I'd say something is wrong. Below is one of my favourite charts of late posted here without permisson from the Contrary Investor Read the whole article in the link above and tell me if you think everything looks rosy on the US home ownership front.

All Ords 7000 here we come!

Anyone for a little irrational exuberance?
As the All Ords breached the 6000 mark for the first time last Friday euphoric cries of All Ords 7000 by the end of year have rung out. That would imply another 16.7% rise in the benchmark index in about 10 months. This in a year when corporate profits are forecast to slow bad debts are on the rise and housing is still sluggish. Sounds likes a recipe for a nasty correction. Yes most economists are now tipping no interest rate rises for the rest of the year although the RBA retains a tightening bias.

The received wisdom has it that no rate rises or the chance of rate cuts is good news for stocks. I always thought this was a counter intuitve argument since central banks usually lower interest rates in order to stimulate growth. If economic growth is contracting and by implication corporate profit growth slowing which way do you think stock prices should be heading? Of course we are not into an interest rate cut environment yet, we have a strong labour market and putting aside drought affected industries economic growth is robust...at least for the time being.

Can the All Ords hit 7000 by Dec 07? Who knows? I'm certainly not foolish enough to say it can't. However I would find hard to be fully invested at such levels.

Updates, follow-ups and other stuff 2

Probiotec - not giving much away:
I fired off some questions to management about PBP's 1H07 result. More specifically I was interested in why the company changed their accounting policy for depreciation, how much product development research they intend to capitalize over the coming 6 months and if they intend to continue to pay down debt over the coming six months. Management's comments - depreciation policy was changed as "management believes past depreciation levels were distorting profits negatively" I bet they do. Capex and optimum gearing levels "cannot be discolsed at this time." The company is sticking to their guns about meeting prospectus forecasts and if they don't they can always adjust the amount of capitalized expenses to make it so. I continue to cautiously hold.

PWK - not burning shareholder value:
On February 13th PWK gave the market an update on the progress of the plan (now called 'project runway')to construct a submarine cable linking Sydney to Guam. There was not much in the report to excite the market. What I was impressed with was management's comments that "Pipe Networks will not proceed with the project unless the firm commitments ensure the financial viability of the project. This is in line with our standard investment philosophy and no investment will be made without the support of sufficient final revenue generating contracts." It gives me comfort as a shareholder to know that management is not sucked in to the mentality of seeking growth at any cost.

Reporting season US 4Q06, AUS 1H07
The latest on 4Q06 earnings in the US from Zacks tells us that more than 75% of S&P500 companies have now reported earnings. Surprises outweigh disappointments 3:1 with the median growth in earnings for the quarter standing at a healthy 13%. The point to note is the forecast deterioration in earnings for 1Q07 to a median of 8%.

If anyone can tell me where I can find data like this for the ASX I would love to know. All 1H07 results for June year end companies on the ASX are due by the end of this month. I can't give any definitive commentary on earnings growth rates however below is a table of major companies that have reported to date.

CSL - priced for perfection... and then some

CSL reported a record 1H07 NPAT of $257m, 46% up on the pcp. Eps up 46% dps up 75%. The business continues to perform well and the market thinks so too sending the share price 10% higher to $77.42 at the close today. Whilst a 46% increase in eps and NPAT seems like an excellent result what you don't see in the P&L is the $53.2m (primarily exchange rate differences) witten off directly against equity recorded as a change in reserves in the balance sheet. Once you factor that in the underlying profit is more like $204.1m an increase of 15.7% - nothing to be sneezed at but far more modest than the headline result.

So what if exchange rate difference are written off against equity? Well if you are really interested in calculating the equity value of CSL rather than focussing on earnings then writing off $53m of equity does matter. No doubt CSL runs a well managed profitable business but is the current share price justified? I struggle to come up with a value of more than $35 a share and that's assuming the company can continue to deliver the high returns on equity of recent years into the future. Rather than adding more of this perfect business to your portfolio it could be a perfect time to take some profits.

A Wonderful Company At A Fair Price

A Wonderful Company at a Fair Price: Brian McNiven

This book should up there on the essential reading list for serious stock market investors along with Benjamin Graham's "The Intelligent Investor " and "The Essays of Warren Buffett." McNiven is a disciple of Warren Buffet and quotes him often but also has plenty of his own insightful comments that investors would do well to take note of. McNiven skillfully leads readers through the process of uncovering the real value of a business by clearing away the obfuscation of creative accounting practices, poor management and popular delusions such as PE ratios and DCF valuations. McNiven insists that investors value a business as if they were buying it and look at the underlying growth in equity value rather than earnings. As McNiven clearly demonstrates a company may grow earnings year after year yet the value of the business may still decline if the Return on Equity is poor.

McNiven is particularly critical of modern day managers who often act in direct opposition to the interests of shareholders. He devotes substantial time to identifying both good and bad management practices and urges shareholders to exercise their right to question management decisions. One theme he continually drives home is that of capital allocation. Basically if equity growth can be achieved by reinvesting profits back into the business then managenment should refrain from paying unnecessary divindends. Whilst this seems like common sense McNiven points out that many companies often don't adhere to this simple principle of efficient capital allocation and squander shareholder wealth through token dividend payments.

McNiven is also the creator of Stockval - a valuation tool that utilizes McNiven's valuation method and is the valuation tool of choice of listed investment company Clime Asset Management(ASX code CAM). At $1,595 for individual investors Stockval is not exactly cheap however it contains the data of over 400 ASX listed companies meticuously input from annual reports. Subscribers can fiddle with the valuation inputs and even input the data for companies not already in the database. Whilst McNiven gives the basis for his valuation methodology in the book he is careful not to give too much of Stockval's intellectual property away.

I've tried to replicate McNiven's valuation method but seem to be missing some essential ingredient in the magic formula. Thus I'm toying with the idea of purchasing the keys to the Stockval Program not only for the valuation tool but for the wealth of data that comes with it. The Stockval website is full of useful information and the articles written by Roger Montgomery - Managing Director of CAM are worth reading as are his NTA reports released monthly to the market.

Probiotec 1H07 result - its all in the accounting

Probiotec released 1H07 results today - its first results presentation as a listed company. As shown in the table above 1H07 results were well up on every line on 1H06 but as I did for PWK's result comparing PBP's 1H07 result against 2H06 is more instructive. The results are less spectacular compared to 2H06. Total revenue up 8% just ahead costs up 7.7% leading to an increase in EBITDA of 10% on 2H06. However EBIT and NPAT were both down -9.5% and -14.3% respectively on 2H06 and this is where it gets interesting.

As is usually the case the most interesting numbers are in the notes to the accounts. You'll notice the very low depreciation charge in 2H06 that gives a higher EBIT and NPAT than 1H07. That's because during 2H06 PBP decided to change their accounting policy with regard plant & equipment changing the depreciation period from 5-20 years to 8-20 years. What does this mean? Quite simply depreciation charges will be lower helping the P&L look more healthy. So what you say, depreciation is a non-cash charge and what is really important is the replacement cost of plant and equipment. Exactly, and as it is usually wise to assume that replacement cost will be more than the historical cost on which depreciation charges are based do you think it would be a more accurate reflection of replacement cost to reduce depreciation charges? Absolutely not.

Also of note is the 14% increase in intangbles amounting to $0.8m of product development costs that have been capitalized and treated as internally generated goodwill. Now I'm not against capitalizing expenses, it can be completely justified and PBP has demonstrated it can generate profits from product development in the past but it is something that should be noted and kept a close eye on.

Operating Cashflow was reasonable at $2.2m and Debt to Equity reduced to 64% from 87% pre-listing. It will be interesting to see if the company continues to pay down debt with operating cashflow, the answer to that will depend on capex going forward. I will be firing off a list of questions for management tomorrow to get answers to these and other questions. Looking ahead the company reiterated both in the 1H07 report and the investor presentation that 1H07 results were in line with expectations and that they are confident of meeting prospectus forecasts via strong sales growth from a range of new products and a fulll contract manufacturing order book coupled with cost containment. The table below gives the implied results of 2H07 needed to achieve prospectus. It calls for a 27% increase in revenue an improvement in margins and no less than a doubling in NPAT from 1H07. Quite a tall order.


In conclusion management is making all the right noises its the numbers that aren't. Pending the responses I get from management I will have to consider whether or not to liquidate my paltry holdings or wait to assess the full year result.

The Dumbest Guys In The Room

Enron: The Smartest Guys in the Room

This almost 2hr Documentary delves into the biggest collapse in corporate History. A detailed description is unnecessary as most people are familiar with the story. To sum up what went wrong at Enron in a nutshell I would say Greed - massive amounts of it. Not only inside Enron itself but half the investment banking community that supported Enron's back door deals. The 3 masterminds at the centre of the Enron scam, Ken Lay, Jeff Skilling and Andy Fastow, created an alternative reality where corporate laws such as conflict of interest didn't exist. Blinded by their own success at deception they deceived themselves into believing their constructed reality was real - for anyone who participated in the dotcom boom you'll know what I mean.

From an investment point of view what is amazing is that amongst all these so-called smart guys none of them knew how to run a profitable business. Thus they ran an unprofitable and illegal one that was presented as both legal and profitable through market manipuation and some very creative accounting. The passive acceptance by the investment banking community of Enron's supposed 'amazing results' was astounding. The way Enron generated their profits was referred to as a Black box as none of the Wall street analysts could understand it and thus took the company's word as gospel. The same reasoning is employed by those who believe in magic. Incidentally the only analyst who had the audacity to doubt Enron's presented results was fired by Merril Lynch. Benjamin Graham's famous words "Wall Street people learn nothing and forget everything" has never rung truer.

In the context of the Australian market mention of the word 'Black Box' brings to mind Macquarie Bank. Analysts have never really understood how Macquarie get their results and have come to accept that Macquarie can decide what their results will be each period. That's not to say that Macquarie Bank is another Enron. Far from it, Macquarie has been one of the most successful stocks on the ASX over the last 15 years. The lesson here is that if you don't really understand how a business makes its money then you would be well advised to steer clear.

My Portfolio: 3 month return

Above is the performance of My Portfolio over the past 3 months. The portfolio has increased 11.3% in value since inception and represents a 10.5% total return after transaction costs. PWK has continued to perform well, the company's 1H07 result was well received by the market tacking on $0.25c or 8% since reporting. PBP hasn't moved much it's 1H07 result expected sometime in the next 2-3 weeks (I asked the company for a date but they couldn't give me one) to provide some type of catalyst for the share price.


Above is the relative performance of My Portfolio against the XAO over the past 3 months. This graph is useful for reminding myself that I am not doing anything particulary brilliant as the broader market has risen 8.3% over the same period. As you would expect my Portfolio of only 2 stocks is much more volatile. You might even say that with such a concentrated portfolio I should be significantly outperforming the benchmark in a rising market. I would say myself that price performance over a 3 month period means very little from an investment point of view.

Updates, follow-ups and other stuff

Like a balance sheet that presents a snapshot in time of a company's financial position so too the posts on this blog represent a snapshot of my analysis and thoughts at a certain point in time. Thus I will endeavour to update and follow-up on previous posts as some of the issues and my views change.

CYN 2Q07 Cashflow improves but too early to get excited: Subsequent to my rantings about CYN's failure to address profitability the company released 2Q07 cashflow numbers. Cash in the period increased to $6.3m up from $3.7m in 1Q07 due almost entirely to a $3.3m injection from the capital raising announced last November. Also of note was the improvement in Operating cashflow from $-1.7m in 1Q07 to $-0.8m in 2Q07. At this cash burn rate the company could fund operations for the next 2 years. However looking at the table below there is no clear trend in the direction of cashflows and therefore too early to start calling an improvement in profitability.

Since the company is cashed up with $6.3m and have plans to expand operations into India it would come as no surprise to see them up their capex spend and push Operating cashflows back to the levels of 1Q07. It would be nice to hear the company comment on cost control in the upcoming half yearly report but I won't be holding my breath given the company's track record to date.

PWK 1H07 negative cashflow due to timing issues:
As reported last week PWK's 1H07 results showed them tracking along very well however there was some concern about their negative cashflow from operations number of $-0.7m. I spoke with the company yesterday and it appears a large receipt for approximately $3m was received in the first week of January excluding it from the numbers to Dec 31st 06. I don't believe the company is experiencing problems in collecting from customers however it will be something to monitor when the full year results are released in August.

S&P 4Q06 earnings update and FY07 outlook:
Here is the latest article from Zacks on the S&P500 4Q06 earnings season. With over 60% of companies having now reported the median earnings growth is tracking at 13.2% (Remember this is the median ie. the middle score not an average). What is more interesting is Zacks revisions ratio which represents the number of upward earnings revisions divided by the number of downward earnings revisons. A number less than one indicating more downward revisions and a number greater than 1 indicating more upward revisions. The ratio currently stands at 0.82 which means analysts are becoming more
bearish on the earnings outlook going forward. This is reflected in average earnings for FY07 which are expected to slow significantly to 8.3% for FY07 down from 14.6% for FY06 making the case for limited upside in the S&P 500 this year. The caveat as always being that Wall Street analysts quite often get it wrong.

BHP kicks off reporting season with a bumper profit:
Almost guarnateed you'll see a headline like this or something that carries the words "record profit" in one of the major papers tomorrow. BHP reported NPAT of US$6.2 billon up 41% on the previous period on the back of improved prices and volumes. I'm not going to go into too much detail but suffice to say the market was very happy with the result and the announced US$10 billion in buybacks. Buying back stock or returning profits to shareholders in the form of dividends is a prudent measure when a company finds itself in a position where it cannot achieve a reasonable return on investment in new projects. However since we are supposedly still in a resources boom you'd have to ask whether BHP couldn't find some more profitable ways to spend their money. Yes they have a significant portfolio of new projects in the pipeline some of which are suffering huge cost blowouts. Could it be that the buybacks are a cautious signal from BHP that they believe prices have peaked whilst costs remain at levels unattractive to new investment?

It's that time of year again.

It’s that time of the year again – reporting season. Whilst it doesn’t really kick into gear until next week 1H07 results have already started to trickle in and will continue for the next 3 weeks or so. Half year results give us an indication of how company profits are travelling and also serve as a gauge of the health of the broader economy. Company profits have been tipped to be lower than in the previous few years, some pundits putting growth in the high single digits however if US 4Q06 earnings for the S&P 500 are anything to go by I think we’ll still see double digit earnings growth this half in Australia. With about half of the reports already in, the S&P500 4Q06 median earnings growth according to this article is currently tracking at 12.5% with nearly 4 times more positive earnings surprises than negative.

Whilst company profits have been generally robust I’ve noticed a few large companies have been announcing hefty job cuts, namely Ford, Pfizer, Motorola, AstraZeneca and the latest casuality Chrysler rumoured to be announcing that 10,000 jobs will go. Cutting jobs is something you don’t normally do when business is good and whilst it’s a little sporadic to start calling it a trend I believe it’s another nail in the coffin of the Goldilocks economy argument. It will be interesting to see whether any ASX100 companies start talking about job cuts. It’s hard to imagine given the tight labour market and shortage of skills in some industries but it’s something that may be worth taking note of this reporting season.

PWK 1H07 results

Pipe Networks (PWK) reported 1H07 results yesterday Feb 2nd summarised in the table above. Whilst growth on every line from Sales to NPAT has been impressive from a year ago I believe it is more instructive to compare 1H07 results to 2H06 as the network from which PWK derives the vast majority of its revenue stood at just 174 kms at the end of 1H06 compared to 724 kms at the end of the current period. Most of the construction taking place in 2H06 at the end of which the network reached 560 kms.On that basis revenue growth has still been impressive up 27% from 6 months ago. The company cited some key contracts that came online during the period as driving the growth. EBITDA was up 20% from 2H06 reflecting costs growing slightly ahead of revenue for the period. NPAT was up 10% on 2H06 due to higher depreciation charges and net interest expense reflecting an increase in capital spending and borrowings.

Compared to my own forecasts, Revenue was lower than expected whilst EBITDA and NPAT were higher reflecting my belief that margins would deteriorate slightly due to capex spend. However it was pleasing to note not only that the company beat my forecast EBITDA and NPAT numbers but that they managed to maintain margins. An area of concern was the negative cashflow from operations of $(0.7m) for the period. However, examining the balance sheet receivables grew 64% to $6.3m from 6 months earlier whilst payables actually declined 20% to $3.1m.

Looking ahead the company anticipates continued revenue growth for the rest of calendar 2007 as the full effect of the $8.5m capex spend is realised. The company will commence construction of a $2m data facility this month with the full effects to be felt in FY08. Management "believes that the company is well on track to meet full year forecast profit of between $4.7m to $5.0m." Accordingly I have made little change to my full year earnings forecast for FY07.