My ACE long WTM short call posted on this blog from 10/29 is up 3.5% from that date, but a lot more from mid-october when I first made the call (actually up 31%).
I also pushed long MA short GPN up 15% since my post on October 30th.
SLM is up since my work on the 15th, but of course the market is up big.
IAP on the other hand I believe is down.
Enough pats on the back (actually I doubt anyone is reading anyways). My work on AOC is progressing. Defensive name, good management, will outperform in a down market for sure, but is certainly not a beta name. Kinda boring but boring is nice. They do have integration of Benfield.
Wednesday, November 26, 2008
Saturday, November 15, 2008
SLM
I am returning to SLM. I think there is clearly upside for the stock. I get $14 in a runoff scenario, with $12 from the loan portfolio, with fairly elevated private credit losses (2% per annum on the whole portfolio, not just in school). I also get $14/share or 1.7X BVPS of $8.37. Current quarter run rate eps of $0.36 still translates to a 17% ROE, which correlates to a 1.7X P/B. One would assume that a run-off scenario would be a bottom for the stock, however it is currently at $7.45/share below book.
In this situation, I think more time needs to be spent on the things than could go wrong. Why such a large discount to "intrinsic" value.
Clearly, the #1 concern is rolling the ABCP facility. Unfortunately for SLM, collateral in the ABCP is marked to market, focing SLM to inject additional equity (extra collateral) in the facility. As of Q3 SLM had $29.1B of assets at book value backstopping $24.7B in liabilities. The facility is supposedly non recourse, but with such a large variance between assets and liabilities, if the facility was terminated, SLM's equity would basically be wiped out. Another interesting point on this facility is that SLM reduced the borrowing terms. However, my sense is that this was forced on SLM. The new limits are $21.9B for FFEL with a maximum borrow of $20.8B, and for private $3.6B with a maximum borrow of $3.2B. On the NNI call, NNI disclosed that their FFEL loans are currently mark to market at $0.83/$1 in their warehouse line, with significant deterioration in October. If SLM's FFEL were marked at NNI's level, that would be an additional $2.8B of collateral, that SLM would need to post. Moreover, the private loan marks would have deteriorated even further.
Signs of the impact of this ABCP vortex are evident with unencumbered FFEL loans declining from $14B to $9B sequentially, and unrestricted cash falling $3B sequentially to $4.7B ($1.4b of that cash is collateral for derivatives gains). Net liquidity declined $12B in one quarter. The saving grace here, is the new directive from the DOE that sets up a means to offload Stafford loans back to May 2003. This would provide a funding source for $16B, and would help SLM reduce its ABCP draw by double digit billions. The DOE will provide a liquidity backstop in the form of a forward purchase agreement to the ABCP investor. According to NNI, the set price should be close to or at par. I think this facility will give significant benefit to SLM. However, until that facility is renewed, there will be doubt, as banks, should they decide to play hardball, can get a great deal on these loans (can sell them to the FED at $0.90 for example).
#2 is the lack of funding for private loans. SLM has ramped up deposit gathering, and was able to do a term loan earlier in the year, and though this is something, it is certainly not ideal in terms of matched funding. As SLM cannot pass along its cost of funds to consumers, it has opted to improve returns by seeking lower credit costs with a much higher level of co-signers, as well as higher credit scores. Still at this point, the economics, or the form of private student loan market is in doubt. There is talk of increasing Stafford loan limits in a 2nd stimulus package, which would relieve pressure, but also reduce the size of the private loan market.
#3 is private loan credit. Though the company notes that charge-offs have been inline, the company did increase provisions in Q3 with expectations of further deterioration from the economic situation. Delinquencies for traditional private loans rose to 6.3%,and total delinquencies were at 9.4%. However forbearances were down, so the total bucket was only up slightly. A significant deterioration would impact earnings and could impact capital levels.
#4 is the FFEL program beyond 2009-2010. What is the plan beyond 2010? Will SLM retain servicing when it puts the loans to the DOE? Will there continue to be a shift to the Direct loan program? Will further chances to the SAP be made in the future?
#5 is the APG purchased paper program. SLM took a large impairment this past quarter, but additional impairments are possible - leading to further capital strains.
#6 slower prepayment speeds could impact cash flow needed for debt paydown if capital markets remain closed.
#7 Residual interests have been marked down largely due to higher discount rates. SLM has $2.3B in residual interests on balance sheet. This is another source of potential capital strain.
#8 Rating agencies and capital requirments for private loans, and for FFEL. There may be pressure for SLM to hold more capital vs. managed assets. Will SLM participate in TARP, will the government pull a AIG in a worst case?
#9 Future of the wholesale funded model? can SLM compete as a standalone, what form will the ABS market return in and when.
All these concerns are weighing on the stock. However, they fall into two buckets. Can the company survive without additional capital? what is the future earnings power of SLM? If the answer to question #1 is yes? then the stock should trade in the mid-teens. If we get reasonable clarity on #2, then we could have a recovery to the 20s. As the source of earnings growth in the past few years has come from private loans, a resolution there is key. Continued cost cutting provides opportunities, and SLM has opportunities in servicing, including the 2010 contract for servicing the direct loan portfolio for the DOE.
I need to see if this liquidity extension back to 2003 is working, but the big question is this ABCP facility. I think it will get renewed in a slimmed down fashion. I also think that pricing for FFEL loans will improve slowly further reducing strain going forward. That makes me a buy on the stock at this price. With that being said, it seems that NNI is in a more enviable position. Yes they have a warehouse line that is causing them similar angst, but they are in discussion with BAC to amend it. And yes Moody’s downgraded Nelnet’s senior unsecured debt to Ba1 from Baa2,with review for possible further downgrade. Nelnet has $275 million of unsecured debt
maturing 2010. The ratings downgrade resulted in a 30 bp step-up in cost of Nelnet’s
$750 million unsecured credit line. However, they have limited private loans ($1B of a $26B portfolio) so the tail of credit risk is not there, and have a larger fee component from non- FFEL related programs. That stock is also trading below book value per share, and may well be better value than SLM.
This new funding facility, where the government is providing a liquidity backstop but not directly purchasing the loans, may well be a model for the future. It could result in lower funding costs but also in retained servicing since the loans are not sold to the government at any point. Looks like the structure is for cash for 97% and the lenders financing the other 3%. Much better than the curent situation, but still worst than the past. If lenders cannot sell the lower tranches and have to retain them going forward, then capital needs will have to go up.
In this situation, I think more time needs to be spent on the things than could go wrong. Why such a large discount to "intrinsic" value.
Clearly, the #1 concern is rolling the ABCP facility. Unfortunately for SLM, collateral in the ABCP is marked to market, focing SLM to inject additional equity (extra collateral) in the facility. As of Q3 SLM had $29.1B of assets at book value backstopping $24.7B in liabilities. The facility is supposedly non recourse, but with such a large variance between assets and liabilities, if the facility was terminated, SLM's equity would basically be wiped out. Another interesting point on this facility is that SLM reduced the borrowing terms. However, my sense is that this was forced on SLM. The new limits are $21.9B for FFEL with a maximum borrow of $20.8B, and for private $3.6B with a maximum borrow of $3.2B. On the NNI call, NNI disclosed that their FFEL loans are currently mark to market at $0.83/$1 in their warehouse line, with significant deterioration in October. If SLM's FFEL were marked at NNI's level, that would be an additional $2.8B of collateral, that SLM would need to post. Moreover, the private loan marks would have deteriorated even further.
Signs of the impact of this ABCP vortex are evident with unencumbered FFEL loans declining from $14B to $9B sequentially, and unrestricted cash falling $3B sequentially to $4.7B ($1.4b of that cash is collateral for derivatives gains). Net liquidity declined $12B in one quarter. The saving grace here, is the new directive from the DOE that sets up a means to offload Stafford loans back to May 2003. This would provide a funding source for $16B, and would help SLM reduce its ABCP draw by double digit billions. The DOE will provide a liquidity backstop in the form of a forward purchase agreement to the ABCP investor. According to NNI, the set price should be close to or at par. I think this facility will give significant benefit to SLM. However, until that facility is renewed, there will be doubt, as banks, should they decide to play hardball, can get a great deal on these loans (can sell them to the FED at $0.90 for example).
#2 is the lack of funding for private loans. SLM has ramped up deposit gathering, and was able to do a term loan earlier in the year, and though this is something, it is certainly not ideal in terms of matched funding. As SLM cannot pass along its cost of funds to consumers, it has opted to improve returns by seeking lower credit costs with a much higher level of co-signers, as well as higher credit scores. Still at this point, the economics, or the form of private student loan market is in doubt. There is talk of increasing Stafford loan limits in a 2nd stimulus package, which would relieve pressure, but also reduce the size of the private loan market.
#3 is private loan credit. Though the company notes that charge-offs have been inline, the company did increase provisions in Q3 with expectations of further deterioration from the economic situation. Delinquencies for traditional private loans rose to 6.3%,and total delinquencies were at 9.4%. However forbearances were down, so the total bucket was only up slightly. A significant deterioration would impact earnings and could impact capital levels.
#4 is the FFEL program beyond 2009-2010. What is the plan beyond 2010? Will SLM retain servicing when it puts the loans to the DOE? Will there continue to be a shift to the Direct loan program? Will further chances to the SAP be made in the future?
#5 is the APG purchased paper program. SLM took a large impairment this past quarter, but additional impairments are possible - leading to further capital strains.
#6 slower prepayment speeds could impact cash flow needed for debt paydown if capital markets remain closed.
#7 Residual interests have been marked down largely due to higher discount rates. SLM has $2.3B in residual interests on balance sheet. This is another source of potential capital strain.
#8 Rating agencies and capital requirments for private loans, and for FFEL. There may be pressure for SLM to hold more capital vs. managed assets. Will SLM participate in TARP, will the government pull a AIG in a worst case?
#9 Future of the wholesale funded model? can SLM compete as a standalone, what form will the ABS market return in and when.
All these concerns are weighing on the stock. However, they fall into two buckets. Can the company survive without additional capital? what is the future earnings power of SLM? If the answer to question #1 is yes? then the stock should trade in the mid-teens. If we get reasonable clarity on #2, then we could have a recovery to the 20s. As the source of earnings growth in the past few years has come from private loans, a resolution there is key. Continued cost cutting provides opportunities, and SLM has opportunities in servicing, including the 2010 contract for servicing the direct loan portfolio for the DOE.
I need to see if this liquidity extension back to 2003 is working, but the big question is this ABCP facility. I think it will get renewed in a slimmed down fashion. I also think that pricing for FFEL loans will improve slowly further reducing strain going forward. That makes me a buy on the stock at this price. With that being said, it seems that NNI is in a more enviable position. Yes they have a warehouse line that is causing them similar angst, but they are in discussion with BAC to amend it. And yes Moody’s downgraded Nelnet’s senior unsecured debt to Ba1 from Baa2,with review for possible further downgrade. Nelnet has $275 million of unsecured debt
maturing 2010. The ratings downgrade resulted in a 30 bp step-up in cost of Nelnet’s
$750 million unsecured credit line. However, they have limited private loans ($1B of a $26B portfolio) so the tail of credit risk is not there, and have a larger fee component from non- FFEL related programs. That stock is also trading below book value per share, and may well be better value than SLM.
This new funding facility, where the government is providing a liquidity backstop but not directly purchasing the loans, may well be a model for the future. It could result in lower funding costs but also in retained servicing since the loans are not sold to the government at any point. Looks like the structure is for cash for 97% and the lenders financing the other 3%. Much better than the curent situation, but still worst than the past. If lenders cannot sell the lower tranches and have to retain them going forward, then capital needs will have to go up.
Wednesday, November 12, 2008
Compare and contrast
I have always been leery of life insurers, and have always preferred P&C companies. A traditional P&C company does not have liquidity issues. Of course if there is a massive CAT, then the company has to pay claims, but if there is a ratings downgrade, customers may opt to not renew their policy but they cannot claim collateral, or demand payment etc... I like that. I went to a Fitch seminar a long time ago, and one sentence stuck in my mind: P&C companies fail because of problems on the liability side (under-reserving, adverse development) and a life company fails because of problems on the asset side (poor investment choices). This is because life companies liabilities are much longer in duration, leading to much higher asset to equity ratios. Realized impairments are therefore magnified on the equity line.
All of this was before the new guarantees on variable annuities, which have added a further layer of complexity to analysing these companies. Life companies also stretch for spread with GIC products, fixed annuity products and funding agreements. These products can not only lead to asset-liability mismatches but also push the insurer to stretch for yield. Hence more private placement debt, whole loan mortgages, CMBS, high yield, alternatives etc...
Bearing all that in mind, let's take a look at HIG. HIG stock has cratered. Why? first because the company has suffered massive realized and unrealized losses from its investment portfolio. The company has $15B of CMBS exposure and an overweight on the corporate side to financials. It also owned equities in financials (RBS and Barclays to name a couple) that are not coming back fast. WE are talking about $5.1b of realized capital losses in the first 9 months. With all this the company was buying back stock through the first half of the year, but then the second shoe dropped. As equity markets fell, guarantees on variable annuities went in the money, and not only does HIG suffer from lower fee income, but WORST, statutory capital requirements increase dramatically as this obligation needs to be covered. The company estimated that it would need an additional $2.5B of capital if equity markets were to hit 800 (30% down from Q3). This number would rise exponentially beyond that. So no surprise that it raised capital from Allianz. No surprise that the stock is trading at 0.25x BVPS, as no-one including management knows how much capital they need. Additional impairments are possible in the investment portfolio, rating agencies are getting nervous (downgrades would impair the institutional business first), and equity markets could drive capital needs even higher.
By the way, company always said the the risk in the variable annuities was hedged - apparently not enough! so what do you have now, a stock with a beta of 3. LNC and other annuity writers are also at risk. THAT is why, I never liked these guys. AND HIG and others will need to take large DAC write downs (basically the profitability of the business is less than they thought). Disturbing to me, is the explicit assumption of 8-9% market return built into these VA products by life companies. We have the S&P flat past 10 years.
Now let's turn to ACE. I just read the Q, and I like it. The one risk is 8.7B of corporate fixed income securities. There could be losses there in a big downturn, but manageable. ACE actually reinsures some variable annuity contracts but only GMDB and GMIB contracts. Risks are manageable (Max loss on GMIB at present is $539M, but nothing before 2013), and the company has stopped writing the business to keep within preset limits. As I said above, it is the liability side that gets P&C companies in trouble. ACE is releasing reserves, and has been more conservative than others. To be honest I have not done a reserve study recently, given the recent hard marke, but ACE is the only Bermuda to offer global loss triangles. ACE has asbestos exposure (was a big deal in 2002) but that is dormant right now. ACE is also very well positioned to take advantage of turmoil at AIG, XL and others. Result a stock trading above BVPS, and outperforming on big down days. This is my favorite stock in the balance sheet risk category (MA is my pick for income statement risk, and AOC is my most defensive name). Another good one would be CB.
All of this was before the new guarantees on variable annuities, which have added a further layer of complexity to analysing these companies. Life companies also stretch for spread with GIC products, fixed annuity products and funding agreements. These products can not only lead to asset-liability mismatches but also push the insurer to stretch for yield. Hence more private placement debt, whole loan mortgages, CMBS, high yield, alternatives etc...
Bearing all that in mind, let's take a look at HIG. HIG stock has cratered. Why? first because the company has suffered massive realized and unrealized losses from its investment portfolio. The company has $15B of CMBS exposure and an overweight on the corporate side to financials. It also owned equities in financials (RBS and Barclays to name a couple) that are not coming back fast. WE are talking about $5.1b of realized capital losses in the first 9 months. With all this the company was buying back stock through the first half of the year, but then the second shoe dropped. As equity markets fell, guarantees on variable annuities went in the money, and not only does HIG suffer from lower fee income, but WORST, statutory capital requirements increase dramatically as this obligation needs to be covered. The company estimated that it would need an additional $2.5B of capital if equity markets were to hit 800 (30% down from Q3). This number would rise exponentially beyond that. So no surprise that it raised capital from Allianz. No surprise that the stock is trading at 0.25x BVPS, as no-one including management knows how much capital they need. Additional impairments are possible in the investment portfolio, rating agencies are getting nervous (downgrades would impair the institutional business first), and equity markets could drive capital needs even higher.
By the way, company always said the the risk in the variable annuities was hedged - apparently not enough! so what do you have now, a stock with a beta of 3. LNC and other annuity writers are also at risk. THAT is why, I never liked these guys. AND HIG and others will need to take large DAC write downs (basically the profitability of the business is less than they thought). Disturbing to me, is the explicit assumption of 8-9% market return built into these VA products by life companies. We have the S&P flat past 10 years.
Now let's turn to ACE. I just read the Q, and I like it. The one risk is 8.7B of corporate fixed income securities. There could be losses there in a big downturn, but manageable. ACE actually reinsures some variable annuity contracts but only GMDB and GMIB contracts. Risks are manageable (Max loss on GMIB at present is $539M, but nothing before 2013), and the company has stopped writing the business to keep within preset limits. As I said above, it is the liability side that gets P&C companies in trouble. ACE is releasing reserves, and has been more conservative than others. To be honest I have not done a reserve study recently, given the recent hard marke, but ACE is the only Bermuda to offer global loss triangles. ACE has asbestos exposure (was a big deal in 2002) but that is dormant right now. ACE is also very well positioned to take advantage of turmoil at AIG, XL and others. Result a stock trading above BVPS, and outperforming on big down days. This is my favorite stock in the balance sheet risk category (MA is my pick for income statement risk, and AOC is my most defensive name). Another good one would be CB.
Thursday, November 6, 2008
More on MA
MA Q3 well ahead of expectations, though the company did guide to lower topline for next year below their 12-15% long run goal. However based on the tremendous leverage the company has (76% incremental margins) and variable operating costs (largely advertising and personnel), MA believes it can hit 20-30% EPS growth with high single digit topline (at constant currency, a strong dollar is a negative for the numbers).
Current consensus is at $10.50 which is below 20% growth. Of course consensus is coming down. My realistically pessimistic take on 2009 gives $10.08. This still has 6% topline growth and y/y operating margin expansion (1.5% increase in expenses). Management believes that the company can hold the line on expenses and given its composition I think that is very likely. Even with flat transaction and GDV growth I get EPS above $9.20. There would still be some topline due to pricing and lower rebates as volume targets are not met.
A conservative DCF well below management expectations of margin expansion and topline growth gives $268. Given the lack of visibility, I think the value of the DCF at present is lessened, however it does capture the longer term value of the company. MA is a FCF machine with a very stable franchise, a very good candidate to apply a DCF towards. Of course the DCF does not account for legal, regulatory or some technological shift that would damage the franchise but it is a very good datapoint.
MA currently at $140/share is trading at 14X my 2009E EPS estimate. Can the stock go lower, clearly it can, however I am quite certain the MA will continue to trade at a significant premium to the market. Even after this period of hyper EPS growth subsides (next 3-5 years as company expands margin), MA should still be able to post low double digit EPS growth ( the usual levers, some topline, some margin expansion, and share buybacks). Given the global franchise, the balance sheet strength, the high returns and cash flows, the future MA would still have a 18X multiple similar to over global brand stocks like KO. Currently KO is trading at 13.3X 2009 exactly the same as MA (on $10.50 consensus). MA's growth profile and margin expansion opportunities are significantly greater.
Current consensus is at $10.50 which is below 20% growth. Of course consensus is coming down. My realistically pessimistic take on 2009 gives $10.08. This still has 6% topline growth and y/y operating margin expansion (1.5% increase in expenses). Management believes that the company can hold the line on expenses and given its composition I think that is very likely. Even with flat transaction and GDV growth I get EPS above $9.20. There would still be some topline due to pricing and lower rebates as volume targets are not met.
A conservative DCF well below management expectations of margin expansion and topline growth gives $268. Given the lack of visibility, I think the value of the DCF at present is lessened, however it does capture the longer term value of the company. MA is a FCF machine with a very stable franchise, a very good candidate to apply a DCF towards. Of course the DCF does not account for legal, regulatory or some technological shift that would damage the franchise but it is a very good datapoint.
MA currently at $140/share is trading at 14X my 2009E EPS estimate. Can the stock go lower, clearly it can, however I am quite certain the MA will continue to trade at a significant premium to the market. Even after this period of hyper EPS growth subsides (next 3-5 years as company expands margin), MA should still be able to post low double digit EPS growth ( the usual levers, some topline, some margin expansion, and share buybacks). Given the global franchise, the balance sheet strength, the high returns and cash flows, the future MA would still have a 18X multiple similar to over global brand stocks like KO. Currently KO is trading at 13.3X 2009 exactly the same as MA (on $10.50 consensus). MA's growth profile and margin expansion opportunities are significantly greater.
Tuesday, November 4, 2008
MA
MA up big today. Have not read transcript but I would wager they reaffirmed longer term targets just like V, and highlighted the resiliency of the franchise in case of a downturn. Price had gotten way cheap for a unique franchise, even if numbers were not going to be so fantastic.
I will update my model on this one and put in some bearish assumptions especially on cross border and we shall see. I will note that the company got a 5% boost from pricing - who else has pricing power? Of course that is unlikely to continue but points to the robust franchise.
Debit purchases up strongly in the US compensating for weakness in credit.
This is one of my favorites, even at $160. At $120 it was as steal
.
I will update my model on this one and put in some bearish assumptions especially on cross border and we shall see. I will note that the company got a 5% boost from pricing - who else has pricing power? Of course that is unlikely to continue but points to the robust franchise.
Debit purchases up strongly in the US compensating for weakness in credit.
This is one of my favorites, even at $160. At $120 it was as steal
.
WSJ article
WSJ article today mentions potential government participation in other finance companies such as bond insurers but also specialty finance companies. Given the political importance of student lending, I would imagine that SLM is also on the list. Not knowing the form of a government infusion, it is hard to tell if this will be positive for the stock. With regards to SLM the government has other levers to pull to make their life easier.
Having the hand of government tilting the scales makes investing in financials very difficult at present as there is no clear set of criteria regarding the basis for intervention and the form that intervention will take.
Having the hand of government tilting the scales makes investing in financials very difficult at present as there is no clear set of criteria regarding the basis for intervention and the form that intervention will take.
Sunday, November 2, 2008
Voice brokers
Very interesting comment from ICE CEO (one of the industry's most dynamic and respected figures). ICE is about to roll out a clearing solution for the CDS space, which will lead to greater standardization and electronicfication of trade execution. However Sprecher believes there will be a strong role for the voice brokers:
"I also think that the voice broker business as a whole, that surrounds the CDS business, will do well. I think that is a view that may not be shared looking at the stock prices of some of the pure CDS brokerage companies. But I think that what you will see is a need for voice brokered structuring, and options, and other things, just like you have around the standardized energy business"
Now the leading voice broker (for CDS) GFIG is currently trading at 3.5X EPS (no bberg yet so this may be stale), at $3.11/share (was as low as $2.60 at one stage on friday). If Sprecher is correct, and bear in mind ICE is an exchange (though it does own Creditex), then GFIG is crazy cheap. I have favored IAP.LN because of its greater product diversity, and stronger electronic platforms. However, GFIG is also worth taking a look at. Hopefully will have a chance to do work on that name as well. I have the GFIG transcript, so will take a look.
"I also think that the voice broker business as a whole, that surrounds the CDS business, will do well. I think that is a view that may not be shared looking at the stock prices of some of the pure CDS brokerage companies. But I think that what you will see is a need for voice brokered structuring, and options, and other things, just like you have around the standardized energy business"
Now the leading voice broker (for CDS) GFIG is currently trading at 3.5X EPS (no bberg yet so this may be stale), at $3.11/share (was as low as $2.60 at one stage on friday). If Sprecher is correct, and bear in mind ICE is an exchange (though it does own Creditex), then GFIG is crazy cheap. I have favored IAP.LN because of its greater product diversity, and stronger electronic platforms. However, GFIG is also worth taking a look at. Hopefully will have a chance to do work on that name as well. I have the GFIG transcript, so will take a look.
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