Hope is a dangerous thing

When the Chariman of the Federal Reserve starts to sound like a technical analyst desperately searching for evidence to support an optimistic view of the world its time to be concerned.

"Consumer spending which has proved quite resilient despite the housing downturn and increases in energy prices might continue to grow at a brisk pace, stimulating a more-rapid economic expansion than we currently anticipate,"

Yeah it might, then again it might not and what if it doesn't? Well that's probably a little too frightening to think about just now. For the time being Bernanke's testimony seems to be aimed at reassuring markets rather addressing the real concerns of an economy grinding to a halt.

Here's another:

Thus far, the weakness in housing and in some parts of manufacturing does not appear to have spilled over to any significant extent to other sectors of the economy,"

Not particularly reassuring in the same way a doctor telling a paitent with malignant cancer that the tumour in his neck has yet to spread to the brain. Benrnake continued on:

...."The implications for these developments for the housing market as a whole are less clear,"...."The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

So from the Fed's top banking offical Susan Biers the language has now been changed from "contained" to "seems likely to be contained" An amazingly hopeful sounding statement in the context of Biers earlier observation that the current problems going on in credit markets "is just the begining."

And so the scenario that all is calm continues to be expounded and the market rallies on any evidence that props up the offical position. However at some point optimistic assertions in the face of conditions that support none becomes an act of denial. Then the question becomes: How long can a state of denial be maintained?

Sub prime / US housing / US Earnings

Just when you thought it was safe to venture out into the markets again volatility rears its ugly head. For those with a memory past yesterday this will come as no surprise yet the market continues to act as though everyday is a new beginning devoid of memory. The sub prime debacle is proving to be a real nuisance, the latest casualty being homebuilder Lennar Corp who reported a 73% fall in first quarter earnings from a year earlier. So much for the sub prime problem being contained to a narrow sector. Lennar Corp's CEO commented that:

"The typically stronger spring selling season has not yet materialized. These soft market conditions have been exacerbated by the well-publicized problems in the subprime lending market,"

All important US housing data released on Monday saw new home sales fall 4% to an annual rate of 848,000 against an expected rise to 985,000. Even more alarming was the stock of unsold homes rising to 8.1 months, its highest level since January 1991.

Turning to earnings Zacks tells us that US 4Q06 earnings growth came in at an impressive 13% about 3% above expectations. Expectations for 1Q07 are currently at about 8% however if the last 2 quarters are any indication that could easily be bumped up to 11%. More interesting is Zacks revisions ratio which has fallen to 0.80 for FY07 earnings indicating analysts are cutting their earnings estimates. How many more quarters of double digit earnings does the market have left in this cycle? Consensus seems to be not many or none.

So we have sub prime problems that just won't go away, a slump in housing that continues to get worse and slowing corporate earnings. Add to that the latest figures showing consumer confidence on the wane and the case for a deteriorating economic outlook continues to get stronger. However in a market with the attention span of a hyperactive child the focus turns to dissecting Bernanke's testimony to determine the likely direction of interest rates. The market's view seems to be that the slightest hint of a rate cut will keep the good times rolling. Another view might be that the need for rate cuts is just more evidence of a stumbling economy.

PWK - Project Runway Update 2

PWK announced today it had moved a step closer to undertaking the planned construction of the undersea cable known as Project Runway aimed at increasing Australia's international cable capacity. The main points of the announcement were:

* Firstly PWK has put a price tag on the project at $200m.

* Secondly that an expression of interest (EOI)has been sent to interested domestic and international parties to solicit firm commitments. Further to this that PWK has already commenced negotiations with key parties and is now engaged in contract negotiations with those parties.

* Thirdly that an initial marine survey has been conducted ahead of schedule enabling regulatory planning to begin in collaboration with consultants and governments in several countries.

Also of note was Managing Director Bevan Slattery's remarks about current capacity constraints in the Australian market which costs Australian providers more than 1,000% more than in the US. The $200m price tag is more than PWK's current market cap and is going to entail a significant capital raising on PWK's behalf. Once again management's ability to execute is paramount and since they have consistently delivered on their promises over the last two years I'll stick with them for what should be an interesting journey. PWK shares closed up 10% at $3.25

PWK appoints ANZ as advisor to project runway

On Friday PWK announced that they had appointed ANZ Investment Bank as advisors to Project Runway. ANZ will act as a financial advisor and "provide assistance in identifying and implementing the debt and equity structure of Project Runway." Obviously PWK are committed to making the undersea cable from Guam a reality. I have no idea how much such an infrastructure project will cost but I assume it must be considerable if advisors need to be engaged to work out the funding requiremnts of the project.

This course will alter PWK's balance sheet and growth profile significantly. I may have jumped ship if it were not for the quality of management and their publicly stated commitment to not proceed with the project unless they have binding revenue generating contracts that make the project financially viable. These developments will be interesting to watch in the coming months.

QAN - never look a gift horse in the mouth

It seems some don't know a good thing when they get offered it. This article suggests some vested interests think the Qantas bid of $5.60 ($5.45 in cash plus the fully franked $0.15 dividend) is too low and undervalues the business. In a note last week JP Morgan now values QAN at $5.68 and adds that there is 'enormous upside risk' to earnings because of current trading conditions. Interesting.

Let's have a look at QAN's fundamentals. Average ROE of 13.1% over the past 5 years. The business is highly leveraged with $6.5bn in Equity and $5.5bn in Debt. Even with a forecast 35% increase in NPAT for FY07 ROFE is an uninspiring 10.9%. A higly capital intensive business with the inherent business risks of running an airline fair value lies around $2.60. Management has confirmed analyst estimates of a record profit for FY08 of around $860m. Even assuming this I can get no more than $3.77 per share.

If anyone knows where I can get a copy of JP Morgan's valuation for QAN please let me know, I could do with a good laugh.

BEN shareholder's bonanza is BOQ's bonfire

Bank of Queensland offered 0.748 shares of its own stock for each Bendigo Bank share plus $5.50 in cash. Based on closing prices for both stocks on the 16th March 2007 the offer amounts to $17.92 per BEN share, a 36% premium to BEN's 16th March closing price. Sound like a juicy deal for BEN shareholders? You bet and it gets even juicier if you bother to look at the numbers.

Notice how the offer is based on share prices without any reference to value. What we need to look at is what BEN and BOQ are actually worth. Firstly BEN, over the last 5 years the bank has averaged a modest 17.5% return on equity, compound average eps growth of 15.7% and paid out just over 70% of earnings as dividends. With $6.19 equity per share and assuming similar returns going forward I value the company at around $9.16 per share.

Turning to BOQ, a 5 year average return on equity of 19.3%, compound average eps growth of 13.8% and an average dividend payout ratio of 74%. With equity per share of $6.48 and assuming similar returns going forward I value BOQ at $11.36 per share. Thus using the offer parameters of 0.748 BOQ shares for every BEN share plus $5.50 in cash values BEN at $14.00 per share a 53% premium to BEN's current value. A generous offer indeed. What does BOQ get in return? All the usual talk about synergy and size are bandied about with the only hard numbers offered up being $70m in cost savings.

There is some doubt about whether the deal will go through. Hopefully for BOQ shareholders it won't whilst with BEN shares closing at $17.10 today, an 87% premium to their current value, BEN shareholders must be thinking Christmas has come early this year.

Sub prime meltdown overdone? Not by a longshot

It seems the meltdown in the subprime mortgage market has taken a back seat, at least for the time being as US investors focus on the health of the economy and more specifically the all important housing data due out this week. However the sub prime story is far from over. To reiterate the comments of the Federal Reserve's top banking official Susan Bies

"this is not the end, this is the beginning"

There seems to be some sentiment around at the moment that the stock market's reaction to sub prime revelations was overdone, that exposure to low quality mortgages is contained to a narrow sector of the market. You see this time around it was different. Banks no longer hold the the mortgages they initiate, they've got more sophisticated and sold them off as mortgage backed securities which in turn have been gobbled up by derivative vehicles such as CDO's (see previous article for an explanation of CDO's). The risk has been spread over a greater number of investors so the damage will be lessened.

This new found sophistication and the abundance of cheap money combined with good old fashoined greed ensured a steady of flow of low quality mortgages even in the face of rising interest rates. Of course this new sophisticated approach of spreading risk is all smoke and mirrors. The music has started to slow and a few have been caught holding the bag. The latest to be handed a bag of goodies is H&R Block who have written down the value of their discontinued mortgage business to the tune of almost $30m with more writedowns looking likely before they can offload the business.

When the music stops completely there will be plenty of bags to go around. Imagine as a US investor waking up one moring to find that your 401k has been belted because it has exposure to sub prime mortgages via some derivative product you didn't even know about? Stay tuned as the subprime mess continues to unravel.

PBP - where's the beef?

Probiotec today announced it had acquired 3 pharmaceutical products including all associated intellectual property from Johnson and Johnson. The acquisition price was $4.25m plus stock at cost to be funded by PBP's existing debt facility. The company claims the acquisition will be eps neutral for FY07 and eps positive for FY08. Other than that there is very little to go on. No information on the revenue that these pharmaceuticals currently bring in, their current share of the market and whether that has been declining or increasing. Thus it is impossible given the information regarding the transaction to assess the value of the acquisition.

What is certain is that PBP's gearing level has risen to around 70%. My preferred measure of a company's performance is Return on Equity however it is more instructive to look at Return on funds employed (ROFE) for businesses that carry high debt levels. The extra debt brings PBP's ROFE down to an uninspiring 9.0%

As an investor you would like to think that management would only purchase market leading products with firmly established market share or up and coming products that are gaining market share. However if that is the case it begs the question as to why Johnson & Johnson is offloading them. Lack of information means you have to take management at their word. PBP haven't disclosed any more or less than most companies do regarding acquisitions however the lack of information doesn't inspire much confidence. PBP shares closed up 5.9% at $1.07.

And now for the main event

Now that the sideshow of plummeting Chinese markets is all but forgotten its time to turn to the main event. Sub prime mortgage lenders are coming under increased pressure as creditors make calls and defaults increase. Here is a roundup of the latest:

New Century Financial Corp (NEW), whose shares have been suspended from trading, made an error of $500m in reporting their debt obligations. Whoops we actually owe $500m more than we thought - the level of incompetence is staggering. Add to that NEW has received notices of default and reservation of rights from Barclays, Guaranty Bank, Morgan Stanley, State Street Global Markets and UBS Real Estate Securities. Won't be long until New Century is filing for Chapter 11.

Accredited Home Lenders (LEND) plunged 65.6% after it said it's seeking more capital and exploring strategic options after paying about $190 million in margin calls since Jan. 1. Chapter 11 sounds like the most probable strategic option for LEND.

Countrywide Financial Corp. America's largest US mortgage lender, told its brokers on Friday to stop offering borrowers the option of a "no-money-down home loan". Wise decision to tighten lending controls however I fear the damage has already been done. Banks will no doubt see more missed payments and foreclosures in the coming months as consumers with weak credit histories begin to face higher monthly mortgage payments. As the Fed's top banking official Susan Bies said last friday

"This is not the end, this is the beginning".

Outside the strictly subprime arena General Electric Co's WMC Mortgage arm is sacking more than 450 staff members and also stopped lending home loans to borrowers who can't or don't make a deposit. WMC contributed 28% of GE Money's $US163.39 billion in revenue last year. Expect the 2007 year P&L to take a hit.

Bies also said that problems in the mortgage market are well-contained in a very narrow segment (the subprime sector.) An opinion echoed by the Treasury secretary Henry Paulson.

"If, as I think the case, the housing correction has bottomed, it shouldn't be a surprise to anyone if there is some fallout in the subprime mortgage market. I believe there are going to be dislocations. It is painful to some mortgage holders. It is going to be painful to some lenders, but it is largely contained."

What do these distinguished officals mean by contained and exactly how contained is it? In financial markets major events rarely happen in a vacuum - in fact such events are usually highly contagious. A report from the US Mortgage Bankers Association showed foreclosures are rising on loans to borrowers with the best credit ratings, as well as subprime borrowers. Overdue payments on all types of loans rose to 4.95% in 4Q06 from 4.67% in 3Q06 the highest since the second quarter of 2003.

This article contains implications for the Mortgage backed securites (MBS) market. The riskiest portion of MBS's is obviously the sub-prime portion. Enter collateralized debt obligations (CDO's) which have been the major buyer of the riskier end of MBS offerings and in doing so helped underpin the residential mortage boom of the last 3 years. It is estimated that 40% of the collateral of CDO's is residential MBS's of which 75% is sub-prime and home equity loans. The CDO market is estimated at $500 billion.

What does this all mean? If CDO's decide that the writing is on the wall for the residential mortgage market and exit for greener pastures liquidity in the MBS market will dry up making it difficult for mortgage originators to onsell their loans. Availability of home loans for subprime borrowers will dry up (already underway) leading to higher interest rates for borrowers with good credit.

People who had committed to buy homes from failed lenders such as New Century will now find it extremely diffficult, if not impossible to refinance. Those looking to refinance after the honeymoon rate on subprime mortgages is over will need to stump up cash they haven't got because the new lender will demand a deposit or need to find more equity in the home they are tyring to refinance - a tough call in an environment of falling house prices.

The Contrary Investor has been harping on for some time now about the extent to which US household consumption has been financed by dipping into rising home equity values. You don't have to be a genius to see what happens to this trend when house prices start to fall. Have we seen evidence of this already? US retail sales for February were up a lacklustre 0.1%, excluding gasoline and car sales they were down 0.3% - the lowest level since April 2004. A robust emplyment market seems to be about the only thing stopping the US falling head first into a recession.

While some of the above is hypothetical I find it difficult to buy into the containment argument just yet. Economic figures due out over the next few months will be very interesting. The volatility seen in financial markets in the last two weeks is set to continue - enjoy the ride.

My Portfolio: 4 month return

After 4 months my Portfolio is up 9.1% vs the All Ords of 6.9%. From a month ago my Portfolio is down 2.8% twice as much as the fall in the All Ords of 1.4% - decreasing outperformance of the benchmark index. Despite all the drama surrounding global markets in recent weeks my portfolio has been surprising less volatile than the All Ords as can be seen in the graph below.

Delusion is a powerful thing

The All Ords rebounded almost 2% today clawing back most of yesterday's losses. Today's rally had conviction, strong volumes as buyers were back with a vengeance. The sentiment seems to be that the recent sell-off triggered by the Shanghai markets last week was just a short correction and the time is ripe to jump back in and pick up some bargains.

However there seems to be a disconnect in thinking with the US. US investors have strong memories of a recession just a few years ago which Australia bypassed riding the back of the resources boom and a generally strong economy. Also today the $USD fell below 116 to the yen. Anecdotal data suggests money is flowing out of Mutual Funds at a rapid rate. Sentiment in the US seems to be that they are getting prepared for a bear market. The US economy is looking shaky, durable goods orders well down, new home sales and new house prices down in January. Inflation risk to the upside and credit market troubles gaining momentum.

Australia's economy is looking weaker now than it has in the past few years. Official GDP growth numbers due out soon will show a sluggish expansion of around 2%. The commodities boom has run, any increases in prices if at all will be moderate going forward. Inflation is still slightly ahead of where the RBA would like it and the risk to interest rates is leaning toward a hike.

Australian investors haven't seen a bear market for 6 years. The stockmarket tends to have a short memory of such things. The economy is not in such good shape to ignore the US lead. A 5-6% correction in stock prices does not mean value has been restored. Equity market valuations have gotten so far away from reality in recent years as to be bordering on the ridiculous in some sectors. I'll be holding on to my yen for a little longer. The best bargains are yet to surface.

You Can't Have Your Cake & Eat It Too

This article puts in persepctive the fantasy of the goldilocks economy or 'soft landing' scernario. The soft landing argument goes something like this, raise interest rates to slow the economy and keep inflation in check but not too far to push the economy into receession. Key to this scenario playing out is that housing doesn't fall off a cliff- and so far it hasn't however signs are looming that it might just be a matter of time. As the article suggests delinquencies and foreclosures are on the rise, banks are applying stricter lending policies whilst upping their provisions for doubtful debts.

Durable Goods orders fell almost 8% in January, maybe its a little early to tell if this is a knock on effect from the housing sector but it certainly can't be ignored. 4Q06 GDP growth was revised down to 2.2% whilst inflation in January has not subsided and actually core inflation showed its highest rate of growth in seven months outside of the Fed's preferred range of 1 - 2%.

As the article suggests if the Fed tries to reign in growth in the money supply to tame inflation short term interest rates will rise putting further pressure on housing. If they do nothing the Fed looks like they are dropping the ball on inflation. The Goldilocks economy could easily transform into the 3 bears economy. The 3 bears being a collapse in housing, slowing growth and rising inflation. Just the right envirnoment for the equities bear to come out of hibernation.

I still can't hear you, show me the money!

That's right I'm still picking on CYN. Not because they are doing anything terribly wrong - I could have picked any one from dozens of small companies. More to the point I wanted to contrast them with another small company ANH.

Firstly CYN's 1H07 results. Management seems to have run out of pep in their commentary and for good reason. Revenue up just 8% on pcp, loss after tax reduced by just 6% from -$3.5m to -$3.3m. Looking at the numbers a slight improvement on the previous year but no indication that they can run a business profitably and no indication from management that they will be able to any time in the near future. It's business as usual over at Cygenics.

ANH is an online media company that derives revenue from selling advertising space on a network of search engines, portals and popular websites. Briefly ANH's 1H07 results Revenue up 105% Net Loss up 59% from -$0.67m to -$1.05m. To be fair the increased loss included $0.52m in share-based payment expenses. Revenue growth is good but they are yet to turn profitable. ANH also stated 5 objectives they wish to achieve for the rest of the FY07, one of them being..

"Achieve month on month profitability"

Also CEO Dean Jones commented in an interview on boardroom radio late last year that the biggest challenge going forward was to manage the strong revenue growth by controlling costs. Whether they can achieve month on month profitability remains to be seen but at least management are communicating to the market that operating a profitable enterprise is at the forefront of their minds - as it should be.