Friday, October 23, 2009

Where We Are in the Crisis… Plus, One Sell for Today

Agora Financial
Agora Financial's Capital & Crisis

Capital & Crisis Hotline -- Where We Are in the Crisis… Plus, One Sell for Today
October 23, 2009

Recommendation: Sell Leucadia National (LUK:nyse)

"American real estate is not worth zero."
-- Sean Dobson of Amherst Securities, at the Value Investing Congress

Dear Capital & Crisis Reader,

I was in New York earlier in the week for the Value Investing Congress. Among the more valuable presentations were those of Sean Dobson at Amherst Securities and Whitney Tilson and Glenn Tongue of T2 Partners.

They were valuable because they helped frame where we are in the mortgage crisis, which has been the main shark in the water over the past couple of years. You should know where that shark is and whether or not it is hungry.

This chart shows you it isn't over yet. It shows you that we are past the viscous subprime crisis, when that shark chewed through the balance sheets of a number of banks and financial institutions, in some cases devouring them whole. However, it is not yet safe to get back in the water:

Mortgage Loan Resets

There are these other slices of mortgages that are not quite as risky as subprime that reset in the next couple of years. Years 2010 and 2011 face big resets in so-called Alt-A and Option ARM loans. What this means is more write-downs and more losses for banks and others who hold these mortgages.

Making all this worse is the fact that the housing has not yet recovered. The T2 duo made the case that the current "stabilization" of the housing market is a head fake. Mostly, it's due to huge government support of the housing market. But there is still a large inventory of homes out there. And with these resets coming due, we've still got a large amount of foreclosures on the horizon..

All the while, the unemployment numbers are still poor. The T2 duo calls the unemployment situation the "most severe since the Great Depression." The U.S. economy has shed over 8 million jobs in this recession and unemployment -- officially -- is nearly 10%.

Plus, it's not like the average U.S. consumer is in a good position to sail through this crisis. If we applied our CODE metrics to U.S. consumers, they would fail the "E" -- for excellent financial condition -- miserably. Household liabilities are still high, as this next chart shows:

U.S. consumers need to save and rebuild their financial strength. This is why the savings rate is on the rise. This is why, for the first time since the 1950s, household credit debt declined.

As investors, it seems clear that any idea that depends on discretionary consumer spending -- say, buying trendy new sweaters or watches or expensive shoes -- faces some big head winds. Better to the stick with the necessities, I say.

Also, it looks like the bounce in the stock prices of overleveraged banks and financial institutions is premature. Most bank stocks should be sold, not bought. The bounce in home building stocks looks ridiculous in light of what they have to look forward to. The T2 duo actually recommended shorting the home building stocks through the iShares Dow Jones U.S. Home Construction ETF (ITB). By shorting it, you make money when the stock prices of the home builders go down.

They made a compelling case, of which I will highlight a few things. Exhibit A would be the fact that the average new home has been on the market for 12.9 months. Exhibit B is that we have about 2-3 years of existing home sales just to absorb the vacancies that exist. According to T2, about 6% of all homes built this decade are vacant.

Exhibit C is that the home builders themselves have too much debt and too much inventory relative to their thin equity cushions. The home builders are in the position of trying to hold up a bowling ball with a sheet of paper -- in the rain.

Lastly, the home builder stocks are almost universally expensive on a price-to-book basis, as this chart shows:

Stocks with lots of debt, too much inventory and an awful market don't deserve premiums over book value. Discounts are more like it.

So there you go. I like the idea of shorting the home builders. At the very least, I wouldn't buy one. I'd also stay away from banks and financial institutions that hold mortgage assets. American real estate is not worth zero, as Dobson said, but it can be worth a lot less than today's price.

I recommend we stick to our knitting here. We will stay with companies that own needed assets and build needed things. As I like to say, we will stick with what keeps civilization a going concern. We will also avoid any stock that is dependent on regular access to the credit markets. As we saw in 2008, a mortgage crisis can shut down the credit markets. We don't want to be held hostage by lenders in that situation, so we will stick with excellent financial conditions.

Some updates for you this week, including a sale…

*** Leucadia National

I'm recommending we part with longtime holding Leucadia National (LUK:nyse). This our holding company in the hands of those two uber-investors, Ian Cumming and Joe Steinberg.

I've been revisiting our holdings in a little more depth as we roll into earnings season. I'm always looking to trim what I view as the weaker holdings. I like to keep a tight list of best ideas, and this means constant evaluations of what's in the portfolio.

The main idea behind owning Leucadia is that we get the investing acumen of Cumming and Steinberg, who have a great track record dating to 1978. The stock is probably fairly valued somewhere around $25 per share, in my view. That's taking their public holdings -- such as Jefferies Group and Fortescue Metals -- at market value.

But part of what makes me want to sell is the fact that Cumming and Steinberg themselves are sellers of their stock. Cumming recently sold $22 million and Steinberg sold $25 million. Another director, who owns less than 1% of the company, is also selling shares. And Cumming, at least, is not done selling. He's announced he'll sell another million shares soon.

Insider selling is not a reason by itself to sell the stock. Both Cumming and Steinberg still own 21% of the company after the selling. The company is worth $6 billion today, so that puts the selling in perspective. It's not a lot.

But it is part of the bigger picture that's coming into focus on Leucadia. It's just another weight on the "sell" side of the scale. I've been a little nervous about the financial strength of Leucadia of late. When we bought it, Leucadia had $1.6 billion in cash with practically no debt. Today, the situation is reversed. The company has $1.7 billion in long-term debt and practically no cash.

So by my own CODE metrics, it's starting to slip. It's not cheap -- which is the "C" in the CODE -- but, rather, close to fairly valued. It no longer sports that excellent financial condition, which is the "E." And now the insiders are sellers after having not sold stock for over a year.

I also have to say that I am not enamored with its biggest holdings at the moment. I wouldn't buy Jefferies Group or AmeriCredit or Fortescue Metals (too leveraged). So far, I've trusted in the skills of Cumming and Steinberg. But again, this is just another item on the "sell" side of things.

We can always pick it up again should it become cheap or insiders starting picking up shares or they shore up that financial condition. In the meantime, I find it hard to envision big gains from the current setup and at the current price.

Leucadia has been an excellent investment for us. We more than doubled our money on the stock, scoring a 109% gain. We held onto half of the position and exit that half with a 14% gain.. All this from September 2005. We've owned the stock for just over four years. Considering that the market lost money over that time, we did very well owning LUK.

Recommendation: Sell Leucadia National (LUK:nyse).

*** Ensco Intl.

Shares of our offshore oil driller Ensco (ESV:nyse) have been on a tear of late. We got an earnings report this week and there really isn't much to worry about here right now. There is lots of room for earnings to grow in 2010, especially from Ensco's deep-water segment.

Ensco has managed itself through this crisis like a champion. Its balance sheet is as clean as can be, with more than $1 billion in cash and practically no debt. Ensco continues to generate cash and fund the build out of its deep-water fleet with that internally generated cash.

The conference call was optimistic. It seems like the bottom is in for the shallow water rigs and there is plenty of work and good rates on the deep-water stuff still.

We're up 117% on Ensco as I write, but I think we've got more gains to come. Hang onto your shares.

*** Nabors Industries

Nabors (NBR:nyse) is our land driller, and we've had a gut-wrenching ride with this stock. It got as low as $8 in the crisis. Today, it's $23 per share. I think it will head a good deal higher -- to something in the $40-50 range -- as the rig count turns sometime next year.

The main thing I've been watching with Nabors through this mess is how the financial strength holds up. You can't rightly enjoy the rebound if you're not around for it, or if you have to dilute your shareholders to get through the valley. In Nabors' case, its financial strength is excellent.

The company finished the last quarter with $1.2 billion in cash. And Gene Isenberg, the chairman and CEO, said that he expects the company to build cash in the coming quarters. Spending on new rigs is down, and Nabors should spend only $400 million in 2010. That's down from $1.1 billion in 2007. The company will probably generate $300 million in excess cash this year and more in 2010.

All of this puts it in good position to retire about $1.9 billion in debt that is due in May 2011 and leaves it with room to make deals and other investments as the opportunities come along. Nabors has a relatively high-tech and new fleet of rigs, which the tough-to-crack shale plays and other new fields will require.. So it's in good position on that front, too.

I rate Nabors a buy. When the drilling cycle turns, we'll make good money owning Nabors. I made the decision to hold it through this last down cycle, which, had I known the stock would hit $8, I wouldn't have done. But in any case, I reiterated my buy several times at those low prices, and hopefully, your average cost is looking good today.

We have lots of room for things to get better here. The rig count is still half of what it was at the last peak. All we need is some solid traction upward and the stock will fly. I tend to agree with Isenberg's comment on the conference call: "Let me close by saying that this was, in my view, a pretty poor quarter, but the important thing is we think this is the bottom."

*** PotashCorp

PotashCorp (POT:nyse) also released earnings this week. POT is our producer of potash, a key fertilizer. Normally, you might panic if a company you owned showed an 80% drop in new profit, but this was all baked in. This earnings report changes nothing.

I think POT is close to fairly valued on a conservative replacement value basis -- about $123 per share, by my estimate. That is, you are buying POT today for somewhat less than it would cost you to build your own POT in the marketplace. That's a kind of theoretical value, because the kind of potash mines that POT owns don't really exist in the market. Quality potash deposits are hard to find.

In any event, the stock is cheap compared with the earnings potential of the company. We are in the trough of the cycle. Potash pricing and volumes have been weak. But we know that they will bounce back, as potash is a key fertilizer in maintaining crop yields and quality.

There are also all kinds of good macro tail winds to owning potash, as we've discussed before. I will revisit a few new wrinkles in your next issue, which I plan to put together next week. As CEO Bill Doyle said on the conference call, "Growth never follows a straight upward line, but the need for more potash in the future is undeniable."

You'll see more on why soon. In the meantime, hang tight with POT.

*** Back Home

After traveling for about three weeks straight, I've got a lot to chew on and dig through, as you can imagine. I'll share some of what I've learned in your next issue.

While I like to travel, it's good to be home. To my kids, three weeks must seem like a long time. After I got back, my 10-year-old son Calvin said to me, "Gee, Dad, you're taller than I remember."

Have a good weekend!


Chris Mayer

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