Subprime Crisis Act II: The Greek Tragedy

Goldman's testimony was just a distraction. The real act was the country that gives us those letters to describe derivatives and volatilities.

Following last Thursday's report that Europe’s statistical office (Eurostat) had revised up the Greek 2009 budget deficit and Moody’s subsequent downgrade of Greece’s credit rating by one notch, another major rating agency S&P lowered Greece’s credit rating to BB+ from BBB+ and warned that bondholders could recover as little as 30 percent of their initial investment if the country restructures its debt.

That means Greece's credit standing is now "junk," or the sovereign equivalent of a subprime borrower.

The downgrad marked the first time a euro member has lost investment grade rating since the currency’s 1999 debut. S&P also reduced Portugal by two notches to A- from A+.

According to Bloomberg news, Greek 2-year note yields soared 505 basis points to almost 19% and Portugal’s jumped to 5.7% as credit-default swaps on Europe debt surged to a record. The yield on Greek 10-year bond climbed 45 basis points to 10%. That makes the Greek bond yield curve even more inverted, signalling a short-term tragedy and a long-term pain.

The fear in the market is that the sovereign credit crisis may spread to other euro members, notably the other PIIGS countries.

What's the way out?

According to Stratfor,

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece’s part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.

Yet another way out perhaps is to let Greece out of the euro pact quickly, so that it can persue its own independent monetary policy (i.e. print money).

Whatever it is, the European banks or other investors holding these sovereign debts are facing the pressure of a massive writedown, thereby weakening the already weakened European banking sector. This threatens the nascent global recovery currently underway, but shouldn't derail it.

See a more detailed analysis on why PIIGS crisis matters.

Is Goldman a buy?

Goldman Sachs is facing a political firestorm. Some heads may have to go, but it has a deep bench.

The forward P/E and the trailing P/E all look attractive at 6-7 range, now that the price is at $152/shr.

Is it a buy? Popular bank analysis Dick Bove thinks so.

We note in the Abacus deal, John Paulson came out ahead with $1B, and the losers were a German bank, IKB, which lost $150M, and Royal Bank of Scotland (RBS), which lost $840M.

The congressional hearing on Tuesday may yet create more discount on the shares.

What drive the V-recovery?

More and more investors and business leaders now believe we are onto a normal V-shape recovery. The supporting evidence from GDP growth and leading economic indicators to corporate and consumer spending are just too strong to ignore. Yet this vision of a normal recovery clashes with other pieces of hard evidence of sluggish job creation, persistent high unemployment, sluggish construction spending and slow lending to consumers and small businesses.

So where does the apparent V-recovery come from? Is it for real and sustainable?

Many economists and analysts have tried to gain insights for these question by examining aggregate reports and statistics such as GDP, Employment Situation, Housing Starts, Existing and New Home Sales etc. While these analyses are useful, many important forces can get lost in the statistics and aggregation. Skeptics and conspiracy theorists will continue to find holes in any of these numbers and trends. Discussions can easily become sports fans' wars of taking sides, or economists' religious fights, both are largely a matter of which college they've gone to.

I'd like to do this differently. Much like what Warren Buffett has been doing by looking into Berkshire Hathaway's component businesses that are vital to the economy: Railroad, Banks, Home Construction and Mortgage, etc.

Today, let us examine one of Mr. Buffett's long-time holdings, American Express, in hope to gain more insights into the question imposed above. American Express (AXP) is nearly perfect for this purpose, as it is a global business focusing on credit-based transactions and credit lending. We all know that the great recession we are now recovering from was in large part caused by a credit crisis. Whether or not we're indeed experiencing a V-recovery must be reflected in its various business segments.

Last Thursday, AmEx reported first quarter net income of $885M, double the $437M it earned a year ago during the depth of the recession. Consolidated revenue increased 11% from $5.9B to $6.6B. Both exceeded analysts' expectations. Provisions for losses totaled $943M, down nearly 50% compared to $1.8 billion in the year-ago period. The decline reflected continued improvement in credit quality on the overall portfolio.

It is a very strong rebound. Almost V-shaped, as we will see below in more details.

AmEx has two broad segments: payment business (called "Billed Business" by the company) and lending business ("Cardmember Loans"). So it is very transaction- or spending-based, with about a quarter of sales coming from its leading business. Both businesses are international. They are very sensitive to the speed of economic activities and credit quality.

Chart 1 below from AmEx shows customer spending in dollar amount and in year-over-year (YoY) growth rates in both "as reported" and "FX adjusted" bases, month by month. Click to enlarge.

 
For the first quarter of 2010, customers increased spending by 16% from a year earlier. And the YoY growth rate has reached 20% for March. During the first quarter of 2009, the business had a most steep deline YoY in February when the growth rate was negative 20%. The recovery in growth rate is remarkably V-shaped.

In fact, according to the CFO, March 2010 has been the highest March ever for the billed business. During the conference call, when asked how can that be when more people are unemployed and companies seem to be spending less, the CFO said (my amphasis):

I think what we see here is when things improve that discretionary spending is coming back. I think it is really the impact of a more affluent customer base. I think that is one part of it. The next part has to do with corporate card. Corporate card generally is more of a V. It goes down sharper than the rest of spending and it comes back a lot steeper and I think we are seeing that make a strong contribution here. We have a very strong position in corporate card.

Thirdly we have a strong G&S ["Global Network Services"] business. As you can see from the charts spending on cards issued by our partners that run on our network is performing very well. ..

Right there are three important insights for the V-recovery. First, more affluent consumers have generally recovered, perhaps due to both of their more stable income and wealth recovery. We see more and more retailers catering to affluent customers reporting knock-out earnings and revenue growth. And, they are big spenders.

Second, corporations have come out of the recession in a much more healthy shape than consumers. It is really interesting to see the V-shape remark on corporate spending. Executives need to travel more as soon as business starts to pick up and corporate accounts are not as pinched as consumer accounts.

Third, both export and import have been surging. Trade with emerging markets has been a growth contributor, which has bounced back a lot faster than consumer-focused businesses.

We should also note that the current recovery has also been led by manufacturing and technology, most of the activities going there are tied to business-to-business and trade.

Chart 2 takes a further look at the growth rate of the billed business by its following segments: U.S. Card Services (USCS), International Card Services (ICS), Global Commercial Services (GCS) and Global Network Services (GNS). The first quarter revenue of these segments are, respectively, $3.5B, $1.1B, $1.0B and $997M. Click to enlarge.

The most V-shaped recovery is the GCS segment, "reflecting increased spending by corporate cardmembers and higher travel commissions and fees."

The GNS segment has been the most remarkable. It never stopped growing, although its growth rate was tempered by the great recession. The first quarter result reflects "higher merchant-related revenues from the rise in global card billed business, as well as an increase in revenues from Global Network Services’ bank partners."

Of course, not all of AmEx's business receovery is V-shaped. Its card member loan business has continued to decline. Chart 3 shows the growth rate comparison between this business and the billed business discussed above. Click to enlarge.

During the height of the housing boom, AmEx made a strategic mistake to expand its lending portfolio, thereby increasing its credit exposure to consumers who were already very stretched.

The credit crisis has put a huge dent in AmEx's financial performance. But over the course of 2009, the company has sought to shrink the credit exposure by lending less and by controlling credit risk. Recovery for loan growth, however, is nowhere in sight. This also reflects consumers' de-leveraging behavior coming out of the crisis. The declining loan growth is consistent with the "soft demand" claimed to experienced by U.S. commercial banks.

We are witnessing bifurcated recoveries: There is a strong V-recovery, at the same time there is also a very sluggish L-recovery, with the former more tied to corporate spending and international trade and finance, and the latter more tied to domestic and less-affluent consumers. Depending on where you look, you see a totally different recovery.

For the economy as whole, it will take the shape of where the leading/expanding sectors are point to: a "normal" V-recovery.

Watch Out for Standard Pacific’s Massive Dilution

This week’s releases on existing home sales and new home sales have ignited a sharp rally for home builders. The momentum seems un-stoppable, as more and more investors looking to participate in the government-assisted housing recovery.

According to Google Finance, year-to-date, the shares of Hovnanian (HOV) has gone up more than 80%, while Standard Pacific (SPF) has gone up more than 70%, and Lennar (LEN) more than 60%. The sharpest rally has been in the month of April, especially this week.

I have turned bearish on Hovnanian based on valuation concern. For Standard Pacific, I like its business model and its dominating exposure in California and in the South. But at $6-7/share, there is a massive potential share dilution hanging over its head.

When Standard was teetering on the edge of bankruptcy two years ago, a private equity firm MatlinPatterson from New York came in with a several hundred million dollars infusion. It saved the company. Moreover, the turn-around management team it installed has been successful in restructuring the company’s debt structure. At the same time, the team led by Ken Campbell was focused on controlling costs, selling off non-performing assets and other areas that are crucial for profitability. The company has also been early in acquiring lands in promising locations and communities. Impairment has stopped, and the company is now well-positioned.

All these did not come cheap. As of December 31, 2009, MatlinPatterson owns 450,829 shares of Series B Preferred Stock which are convertible into 147.8 million shares of common stock (as a point of reference, the current shares outstanding is 106 million). The conversion price is $3.05. As the stock heading higher, it’s only a matter of time before MatlinPatterson converts this massive amount of holding in preferred.

On top of that, the private equity firm also holds a warrant to purchase 272,670 shares of Senior Preferred Stock at a common stock equivalent exercise price of $4.1 per share, which is exercisable for Series B Preferred. And the shares of Series B Preferred will initially be convertible into 89.4 million shares of the common. The warrant may not be exercised in full before the stock reaches $10.5. But at this point, it is already quite far in the money.

A comparison in dollar value will help us understand just how much dilution the share holders will be subject to. For this purpose, let us fix the common stock price at $6.5/share. The current market cap is $689M.

If the preferred is converted into common right now, its value is $147.8*(6.5-3.05)M = $510M.


If the warrant is assumed to be fully exercisable and converted into common, its value is about $89.4*(6.5-4.1)M = $215M.

Add these all up, the if-converted total market cap would be $1.414B. Given the book equity of $435M, we’re looking at a potential market-to-book ratio of 3.25. That’s usually associated with high-growth stocks (Google’s is about 4.5, Cisco’s is about 3.8).

Just two months ago, when SPF was trading in $3-4 range, this was not a big concern yet. But now in the $6-7/share range, MatlinPatterson’s massive holding is becoming much more valuable than the current market cap. It’s only a matter of time before they flood the market to exit their astute investment.

For investors at large, it’s not a great idea to bid up the shares too much ahead of earnings. At this point, the company only has the potential to deliver, but has not consistently delivered the earnings that would justify the high multiple.

Other home builder stocks, especially the still-highly-levered Hovnanian (run by the same management that drove it to the ground), also appears to be running too much ahead of their earnings.


(I want to thank Seeking Alpha member Searsdog for bringing up this important issue. I’ve earlier put out a warning on my blog after Standard Pacific’s Q1 earnings release.)

Perma Bull?

Jim Paulsen's view on Normal recovery.
See my summary of his view earlier.

Wells Fargo, positioning well

WFC missed on revenue, but beat profit estimate. Unlike other large banks, Wells Fargo does not have an big investment banking or trading operation. So it didn't benefit from security underwriting or trading. The flip side of this is that its business would be the least affected among big banks if Washington pushes through its regulation to separate deposit-based banking from investment banking and trading.

It has two main sources of revenue: interest income and non-interest income. They are about equal in size, each brought in $11B last quarter. Mortgage income about flat, which means the company saw a soft loan demand. Deposit had continued to grow. Net interest margin came down a few basis points at 4.27%, largely due to this good problem: lots of deposit that earns no interest, but Wells could not find meaningful ways to park them. So they are keeping their gun powder dry. Wait for the loan demand to grow with the economy.

The biggest positioing story is of course the Wachovia integration, which appears to be on track. Company expects to achieve $5b in merger savings. The value in this merger is to convert Wachovia into an extension of Wells Fargo, using the same focused business model to realize higher efficiency and revenue generation by cross-selling more products to the same customer base. The end result will be a stronger coast-to-coast national franchise.

For a good summary, other than my take on its positioning, see this. Wells is getting everything ready to thrive in a growing economy when unemployment rate starts to decline materially.

Standard Pacific: Don't sweat the small stuff

Earnings was released early in the morning. Missed revenue projection by a mile. Surprisingly, the stock held up OK.

Despite the miss, there are things to like about the company's position: both  net new orders and backlog are up substantially year-over-year and Q-to-Q. Land acquisition is up significantly, and according the CEO, approved land deals in April was above $100M, which is about the amount approved in all of Q1 (itself a significant increase). These will translate into substantial land holding this year.

The company focuses on higher price points than entry level homes, so it's not competing directly with foreclosures. That is, it is focusing on move-up home buyers.

It is still focusing on controlling the cost structure and profitability, not so much on increasing sales and revenue. Company not looking to increase sales a whole lot year-over-year, due to high unemployment rate. Higher sale should arrive when the employment picture improves. That's when things get interesting.

During the call, CEO estimated that the company can comfortably do $2B in revenue when the housing market recovers. It did $1.1B in 09. With a disciplined margin control, if and when that happens we can expect annual net income to hit $100M. Roughly, the market cap can reach $1B. So from here to there, we're looking at a double.

CEO also mentioned that there are prospective buyers who do have jobs and qualified, but still need to feel more confident about keeping their jobs before making new home purchases. They need to see that the economy is adding jobs consistently to jump off the fence. That's my view as well.

This is the kind of micro-cap I like to play: it has a clear plan and is focused on a long term vision that it knows it'll come out ahead. At this point, Standard's stroy is all about positioning. When buyers return, which they will, the company will do very well.

Caution for investors: Watch out for the massive dilution that will for sure arrive when the private equity firm MatlinPatterson converts their Series B Preferred shares and their warrants. Until then, enjoy the bumpy ride.