Tuesday, December 23, 2014

A Rant about (TREE)

I'll keep this short because the story is simple. There is a great write up on Seeking Alpha by New Capital: The Beauty of Shorting I will just highlight a few observations here.

  • This website asks you a bunch of questions then sell your contact information to strangers.
  • The company has been in business for 18 years and still can't make any money.
  • Management makes absurd claims that their brand is more recognizable than Citibank.

I tried for this research and now I'm flooded with calls from strangers. I've given away my phone number, and there's still no rate quotes - just brokers calling me. Who in the world wants this??

And yes they had the galls to ask for your social security number - again before showing any rate quotes. Who in their right mind does this??

TREE trades at 42x PE, 3x sales. Revenue is growing at a modest ~10% pace, but that is fueled by marketing and advertising spends. There are no operating leverage in this business, so no amount of sales will translate to EBITDA or earnings growth. The company has proven this in its history.

I've looked at other "lead-gen" companies. Most of them trade at sky-high prices but few are as bad as TREE. TrueCar is as least innovative and disruptive, if somewhat easy to copy. Zillow/Trulia both have name recognition and together could be considered a monopoly. is easy to use and actually have contents. TREE is none of these.

The only sensible thing to do is short the fuck out of this. Unfortunately it's a bull market out there so you have to pick your spots. Check out the LendingTree website, do your research, and short on signs of weakness.


Here's TREE asking for your social security number:

LendingTree wants your social security number

Here they try to sell me a real estate agent – despite having indicated that I’m not interested in one earlier:

LendingTree wants to sell you real estate agents

And of course, LendingTree is more famous than Citibank:

LendingTree more famous than Citibank

Monday, December 15, 2014

Musing on Ocwen’s Liquidity Situation


Last Friday (12/12/2014) Ocwen (OCN) announced the purchase of $253mm Ginnie Mae early buyout (EBO) loans. On the surface this looks like good news as it appears that OCN is back on their feet doing business again.

Reading between the lines, I see this as a confession that they lack liquidity.

1) The company was obligated to buy those loans. Barclays’ MBS analysts noted that Ginnie Mae requires servicers to maintain delinquency levels below a 5% threshold, and delinquencies on OCN serviced pools have ran above that threshold for months.

2) In November the scuttlebutt was that Ocwen tried to sell those Ginnie Mae loans but were unsuccessful.

3) Last Friday OCN finally bought what they had to buy all along. But they turned around and sold it to an “unaffiliated third party”. Since Ocwen was already the servicer on these loans, this is not adding to their mortgage servicing rights portfolio.

So here’s the more complete narrative. OCN faced obligations to put up cash for loans. They were delinquent in doing so and tried unsuccessfully to offload that obligation. When they finally bought the loans, they had to bring in a 3rd party to finance it.

Is OCN having cash issues?

Latest Liquidity Situation Uncertain From Filings

At 9/30/2014, Ocwen had almost $300mm of cash on balance sheet but planned to use that for upcoming debt obligations and share repurchases.

Ocwen has to “advance” payments on behalf of delinquent borrowers and raise the money for that through securitization of advance receivables. The advance securitization notes each have their own “amortization date”, which is when OCN has to start paying down those notes and new advances are no longer financed. October 2014 was when the majority of these notes were supposed to start amortizing. In the latest 10Q, Ocwen said they subsequently paid off some of these notes, pushed back the amortization dates of some notes, and issued new notes. The disclosures are vague in terms of dollar sources and uses, so I’m unable judge their current liquidity situation regarding the advance receivables notes. Given the show of weakness on these Ginnie Mae EBO loans, I have to wonder.


The conventional view is that Ocwen services such a large portion of the subprime market that they’re “too big to fail”. But “too big to fail” does not mean shareholders won’t be wiped out, so investors can’t ignore the tail risk. Still, Ginnie Mae loans are a small subset of OCN’s overall servicing portfolio, so how might this sink Ocwen?

Liquidity issues, like runs on banks, are a bit of circular logic. Confidence (or lack thereof) feeds on itself. It doesn't help that Ocwen may have a large legal settlement coming anytime and capital requirements for servicers are still being discussed. Should Ocwen somehow lose Ginnie Mae’s business or show further signs of liquidity/capital strains, rating agencies may feel intense pressure to downgrade them further (rating agency analysts are people and they have to protect their career risk!) Further rating downgrades could effectively make banks pull their credit facilities - lower advanced rates, higher interest cost, covenant triggers...etc. At that point the issue is no longer confined to advance receivable facilities, but spills over to MSR financing, warehouse lending, corporate debt issues, capital requirements. In short - everything. In fact banks are probably already worried about OCN. No credit access = even less liquidity -> securities price spiral downward -> less confidence -> even less cash access.

Ocwen can try to ease its cash outflows by stop advancing earlier, and quicken the pace of modifications/principal reductions. Keep in mind though, investors have already threated to sue Ocwen due to opaque servicing practices. Any further changes in operations could lead to revolt in the MBS investor base.

In theory, servicing advances and EBO loans are high quality assets with virtually no credit risk, so there should be plenty of hedge funds, insurers…etc willing to provide funding and take these assets off Ocwen’s hands. On the other hand, the corporate high yield market is currently in shambles and liquidity is also scarce there. If I were a hedge fund and OCN desperately seeks my help, I wouldn’t do so without extracting my pound of flesh (perhaps some sort of convertible preferred?)

What If Liquidity Deteriorates

3 Scenarios: 

· Most likely. OCN gets its liquidity at higher funding cost or equity dilution. Ocwen and PennyMac (PFSI) appears to have some sort of alliance going on.

· Possible. Without funding, OCN couldn’t originate loans or acquire MSR. It goes into runoff mode.

· Low probability. Liquidity and confidence evaporates suddenly. Government or a consortium of investors take over OCN on emergency basis and stock goes to 0.

OCN is near the cusp of a tipping point in confidence. It’s possible that capital market goes into raging bull mode, liquidity splashes everywhere, in which case all these issues go away and stock goes back to the 50’s. For now I’m still on the sidelines, viewing Ocwen with a negative bias. If a trend emerges, I’m ready to act either way.

Friday, December 5, 2014

Risk Control and my Mortgage and Housing Portfolio

I mentioned my mortgage/housing portfolio a few months ago and here’s what it looks like now:
  • Title insurance: FNF/FAF/STC
  • Asset pools: AGNC/MTGE/ HLSS
  • Origination and servicing: PFSI/WAC. A short put position in OCN that is fully hedged 
  • Builders: UCP
  • A tiny position in Freddie Preferred.

Combined, these are more than 20% of my portfolio. My housing exposure is actually more if I count Wells Fargo, Citibank…etc.

Since that last post, I have traded in and out of STC with incredible luck, and it looks like my patience in title insurers are now paying off. I’m not so lucky in OCN however. This one killed my returns this year. Analysts are bound to make wrong fundamental calls at some point, but you have to control your losses with sound portfolio management and this is where I failed. 

Getting Scalped by Gamma

Among the many lessons I learned (and paid for), a more interesting one is the negative convexity of shorting options. I got into OCN with short put positions thinking I can subsequently adjusted my net exposure up and down by going long/short stocks. That turns out to be naïve. A simplified example using fake numbers go like this.

Time 1
Stock trade at $34.
My long position: sold 100 shares of puts strike $35, this is now in the money so I’m net long.
My short position: short 100 shares of stocks.
Net exposure:  zero; I’m hedged right?  right?

Time 2
Stock spikes to $37.
My long position: now 0. That 100 shares of $35 puts is now out-of-the-money
My short position:  still short 100 shares of stocks.
Net exposure:  
all the sudden I’m net short, when stock is making a run upward! I close my short stocks to bring net exposure down to 0.

Time 3 
Stock goes back down to $33.
My long position: Those sold puts struck at $35 went In-The-Money again.
My short exposure:  0. I closed my shorts in time 2
Net exposure: long 100 shares, but stock is plummeting.

So basically, that short put positions goes in and out of the money at the worst times. What I thought was a fully hedged position could turn into a net short exposure when stock is making a run upward; and vice versa, it turns to net long when stock is tanking.

People talk about “gamma scalping” by going long call option and shorting stock. With my set up I was short gamma and got scalped instead. 

Controlling Risk with Technical Analysis

FNF, and to some extent FAF, are core positions I plan to hold through the cycles. The rest however are not what most people would consider “quality” companies and my positions in them fluctuate greatly. When the fundamentals are shaky and information dissemination is sparse, I learned to use technicals to control my risk. That means buying things near some technical support level (ideally around 52 week or all-time lows), and cut my losses when they drop below that support level. Since that doesn’t always work (some of these stocks are known for taking a big gap downward), I further control risk by diversify my sector bets into multiple names, and look for cheap valuation (low P/Es or P/B multiples) 

Blending of Risk across Sub-sectors

Some of these sub-sectors offset each other with respect to specific risk factors. 

For example, my positions in title insurers could be hurt if mortgage transactions get lower. A partial hedge to that is a position in AGNC. This agency mortgage REIT benefits in that scenario because lower MBS issuance would drive its asset valuation higher. On the other hand, the mREITs have duration risks and could be hurt when rates go higher. The mortgage servicers provide some offset here with their MSR holdings. And so on. 

This is not an exact science because it’s hard to quantify the effect of various risk factors. Nevertheless, it’s good to think through what you’re trying to bet on and the risk you’re exposed to. For now, this portfolio is a bet on household formation, higher mortgage volumes, regulatory environment stabilizing, and various company specific factors such as operating efficiency, low valuation…etc.

Finally, I just started positions in PFSI and WAC this week. Those are for a separate post.

Wednesday, November 26, 2014

Tenet Healthcare Equity Thesis in Three Words

“Screw the bondholders”, Larry Robbins says.

Ok maybe not in those words.  But at a recent conference, Larry Robbins of Glenview Capital suggested that as Tenet Healthcare (THC), the hospital operator, digest its recent Vanguard acquisition, THC should take advantage of the credit markets to maintain 5x leverage. THC’s debt currently stands at 6x EBITDA (> 70% debt/enterprise value!), but instead of deleveraging, Robbins suggested the company can buy back stock.

Robbins is a power player in healthcare space and supposedly has so much influence on THC management that he actually drove Vanguard deal.

To be fair, THC has other things going for it. Synergies from Vanguard acquisition is one. ObamaCare is another. The company has a sensible strategy of teaming up with reputable non-profit players like the Yale New Haven system. Hospitals industry is ripe for consolidation and THC could be buyers (with more debt?). The conference notes link above noted more. There are concerns about the hospital industry as a whole, and I mentioned some in my HCA write up here, but nothing that can’t be overcome.

Valuation is ok -  ~8.5x EBITDA and 18x 2015 P/E (consensus is expecting some explosive EPS growth). P/E is less relevant here because THC is so highly leveraged (both financial and operating) that any little revenue growth juices earnings disproportionately. By 2016 P/E could easily be under < 15x.

So still, the equity story goes back to leverage. When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent. Tenet Healthcare’s 8% senior notes due 8/20 (rated B3/CCC+ by Moody’s/S&P respectively), are yielding a mere 4.4%. What can they do? The Fed started a QE orgy, the ECB is holding the bondholders down, and the BOJ is manning the door. It’s clear that “high yield” bond managers have nowhere else to go.  

Larry Robbins is enjoying this party and he’s inviting all equity investors to join in.

I’m in.­

4/22/2016.  Minor edit as I look back to this very old post. I sold this stock long time ago but this post could be clearer. Added "When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent.

HCA’s Organic Growth Prospects

I established a combined 2.5% position in HCA Holdings (HCA) and Tenet Healthcare (THC) last week. I have been eyeing the hospital sector for a while mostly as a hedge against higher medical utilization rates for my managed care positions (now ~7.5% of my portfolio). So when they cratered recently I bought HCA at ~$66 and THC at ~$47.5.

I will focus more on HCA here because that’s the one I might add more to, while THC is more of a trade. Compared to Tenet Healthcare, HCA has better quality hospitals, higher margins, lower leverage and cheaper valuation multiples (at least for 2015E).

Valuations multiples are high by historical standards but still reasonable in absolute terms. HCA trades at 7.5x forward EBITDA and 13x 2015E earnings. The big discrepancy between EV/EBITDA vs P/E numbers hints at the high level of operating and financial leverage. This has several implications. First, it means margins and profitability could be distorted and you have to look further out for “normalized” results. Second, it also means top line growth should be the focus of my analysis.

I will start by putting the company in its industry context, then focus on organic growth.

HCA and Industry Context

HCA is the largest-profit hospital operator in the U.S., with 165 hospitals and 113 freestanding surgery centers. Traditionally physicians are not employees and they bill their services separately, while hospitals make money off bed utilization, medical resources and services, facility charges and other ancillary services. Think of physicians as athletes and hospitals like HCA as stadium operators. HCA has a high quality portfolio - ~70% of the hospitals are in The Joint Commissions list of “Top Performer on Key Quality Measures”, which recognizes top ~37% of U.S. hospitals. Roughly ~45%-50% of revenues came from Florida and Texas facilities. Private equity firms Bain and KKR still have stakes in the company.

The core hospital industry is nothing to get excited about. Volume growth, as represented by same facility admissions growth, fluctuated around -2% to 3% the past decade. As recently as 2013, same store admissions were flat to negative. This is due to a structural trend shifting away from inpatient hospital usage, toward outpatient services and other formats, such as ambulatory surgery centers (“ASC”), specialty hospitals, urgent care centers, diagnostic/imaging centers…etc. Together, these substitutes extend the competitive landscape beyond other hospitals.

This has been going on for years. Hospitals wised up and decided on an “if you can’t beat them, buy them” strategy. Hospitals have been buying ASC, physician groups…etc. Since acquisitions serve to both defend and expand market share, hospitals with strong financial flexibility have clear advantages.

Analyzing Organic Growth

After 2Q14 it became clear that the Affordable Care Act (ACA) is a home run for the hospitals. Same store revenue growth spiked. With Medicaid expansion and insurance exchanges, hospitals got more insured patients, which not only added volume but also lowered bad debt expenses. HCA guided to a strong 2014E revenue and EBITDA growth of 7.5% and 11%.

The question is how much of that growth is organic and sustainable? There will be a day when all the uninsured already have insurance, and ACA as a source of growth goes away. Also, growth by building and buying hospitals cost money. We need to break down revenue growth between ACA, new hospital contributions, true organic/”same store” volume growth, as well as price increases.

This is harder than it sounds and I had to piece together various data points, and made some reasonable assumptions*. I attributed 2014E revenue growth into the various sources (see table below). Volume gains can be broken down as follows:  ~1 % from Obamacare, 1 – 1.5% gain from new facilities, and ~1% organic. Price gains are in terms of net revenue per adjusted admission, which would account for lower bad debt expenses.

HCA:  Breaking down 2014E Revenue Growth

This 1% core volume growth is an improvement compared to near 0% in 2013. So it appears that HCA has found a way to mitigate the shift out of hospital into outpatient and free standing facilities. The real organic growth number could be slightly lower as there could be some other sources of growth that’s not sustainable. I can imagine a few below:  

·         Whenever the rules change there will be some distortions of the system. While I have no reason to believe HCA management is anything less than ethical, doctors on the ground could be doing some unnecessary test, exams, or surgeries.
·         Some volumes could be from under-education. As high deductible plans and bronze plans are still relatively new, some people go to hospitals and don’t realize they have to pay. Sooner or later they will learn.
·         As this NY Times article highlighted, buying out physicians groups allow facilities to charge higher price for the exact same service. While legal, this is contentious and could come under challenges.

As outside investors, there is no way we could know or quantify how much these contributed to growth. But it's something to keep in the back of our minds.

Outlook for Next Few Years and Upside

HCA’s top line is in decent shape. An 1% organic volume growth is not much. However, with a moderate 1-2% price increase and new facilities contributing 1-1.5%, HCA can expect 3-5% revenue CAGR in the next few years. EBITDA and earnings should grow faster than that due to operating and financial leverage. This is without further growth from Obamacare so 2015E consensus expectations of 5% revenue and EBITDA growth appear very reasonable.

Ultimately, the success of this company will depend on returns on incremental invested capital. HCA certainly has opportunities here. According to the American Hospital Associations, some 20-30% of hospitals operated at negative margins as of 2012. HCA is a proven consolidator with a track record of improving hospital efficiency. It also has strong capital resources in terms of free cash flows and debt capacity. HCA also just authorized $1bn of stock repurchase program. 

As with all things healthcare, the key risk is reimbursement changes.

* We have some useful data points. HCA said 4% out of the expected 11% EBITDA growth came from ACA. This is consistent what other hospitals have said (roughly 1/3 of their gains came from ACA). We also have % growth vs same store growth %, which allows us to back into contribution from new facilities. The remaining is same store organic growth. Finally, we also know what proportion of revenue comes from price versus volume, since HCA give us equivalent admissions and revenue per equivalent admission.

* Back of the envelope way:  Total volume growth is 3.3%. Assume ~1/3 new admissions are from ACA (just pro-rate as EBITDA growth contribution) that means ~1% came from ACA.  SS admission of 2% minus 1% from ACA leaves ~ only 1% organic/“same store” volume growth.

Tuesday, November 11, 2014

Genworth Valuation and Restructuring Considerations

Background & Summary
Genworth (GNW) took a dive last week due to long term care (LTC) concerns. The valuation looks absurdly low from a book value perspective. Is it a bargain? Here’s my take on it.
  • Sum of the parts analysis shows that GNW is trading within a range of fair value depending on where LTC comes out.
  • To realize the value here, GNW should restructure and cleanly separate the various mortgage insurance (MI) subsidiaries from the life insurance businesses (life insurance, annuities, and LTC).
  • However, GNW’s unique corporate and capital structure means that any restructuring would require paying down debt – the difficulties of doing so reduces upside from restructuring.

What Is It Worth

Here I did a sum of the part approach. I will intentionally leave LTC blank for now and come back later.  I get to about $9.5 per share excluding LTC. If we say US MI is probably worth more than I assigned here this thing could be worth $10-11+ excluding LTC.

·         Canada (MIC.TO) and Australia MI (GMA.AX) are valued using their respective stock prices and exchange rates.

·         Segments that do not earn its cost of capital (judged by ROE against tangible book) would certainly not deserve book value, so I used a normalized earning x multiple approach. This is unfortunately most of the businesses (US MI, Life insurance, fixed annuities, international protection)
·         “Normalized earnings” are basically taking average earnings for last 3-7 quarters and annualized. 
·         I’m probably underestimating US MI here. Earnings here should be growing due to legacy vintage losses running off. On the other hand, US MI will have to raise about $500-700mm of capital due to new regulations. Management plans to use reinsurance to meet that requirement and that would decrease earnings. The $1.2bn I assigned here is equivalent to 75% of tangible book value (ex AOCI and DAC)
·         Life insurance and fixed annuities earnings could be at risk. Genworth just got downgraded so that could hurt sales.
·         Use book value for runoff segment.
·         Corporate is basically net debt.  Netting $2.2bn of cash/investment against $500mm deferred tax liabilities and ~4.2bn of debt leaves ~- 2450mm of book value at corporate.
·         Why only ~$4.2mm of total debt vs $6.7bn total?  In segments that are valued using earnings, we implicitly netted out the debt already so we have to be careful not to double count. Interest expenses are already accounted for in Australia, Canada MI, Life Insurance (not including LTC), so those related debt are excluded here. 
·         I noticed that international protection segment has interest expenses allocated to it but I’m not sure which piece of debt that should be attributed to. So maybe I’m overestimating the debt in corporate segment, if that’s the case value would be even higher

An Ideal Restructuring

Let’s say LTC is not totally negative (a big assumption). At $8.5 / share GNW would seem undervalued. But how do we unlock this value? I attempted a stub trade: buy GNW, short Australia and Canada MI. Unfortunately my broker is telling me Australia MI is not available to short. (I’m just an individual investor and I bet a big time hedgie can get those share to short but even then international shorting surely have its own complications).

For shareholders to realize value, GNW should cleanly separate out the MI segments from Life insurance businesses. These businesses have little synergies between them (aside from financial ones which I will discuss next section). At this point, a highly specialized headache such as LTC would be better served by dedicated management and analyst attention.

On the other hand I’m not sure it’s possible to separate out life insurance between life, LTC, and annuities, as LTC is a capital hog. Those 3 will have to remain together in the near future.

Problem with Restructuring

A barrier to restructuring is the ~$4.2bn of debt at Genworth Holdings, Inc.  As seen in the corporate structure below, Genworth Holdings Inc is just a holding company and services its debt by 1) hoarding cash on hand, 2) subsidiaries to dividend upward. With life insurance subsidiaries not planning for dividends in the near future, Genworth will be even more dependent the various MI subs.

It’s fair to say any corporate break up would require paying down debt due to 1) rating concerns, 2) current reliance on mortgage subsidiaries for holdco debt service. 

However, companies don’t just get to pay down debt whenever they want. The bonds I looked at are all non-callable and make-whole premiums at T+30 would be very expensive. Tender-offers would also be tough as most bonds are still trading above par.

The valuation above already needs to be way above stock price for an activist to take on the black hole that is LTC, having the additional cost of retiring debt just makes it that much tougher.


That’s not to say a restructuring can’t be done. GNW can selectively retire some but not all of the bonds and optimize between debt service coverage, ratings, and costs.

Genworth has plenty of assets that can be converted into cash. Australia and Canada MI are already publicly traded so Genworth can sell more stakes. US MI should have plenty of bidders. Upstarts like ESNT and NMIH are better buyers than RDN/MTG due to their lack of legacy issues and thus capital needs. Also, I’m sure some banker is pitching AIG to combine United Guaranty with Genworth’s US MI and be spun off into its own company. Because GNW holds some cash cushion for debt service, deleveraging would itself free up some of that cash on hand.

Maybe if 4Q reserve reviews leaves capital in a good position and thus more visibility on the LTC end, management can start deleveraging and set the stage for restructuring. I'm not counting on it.

Simplified Corporate Structure


Capital Structure

Wednesday, November 5, 2014

Santander Consumer USA (SC) – Update on Normalized Losses and Volume

A few months ago I wrote about Santander Consumer USA ("SC", "SCUSA") in an article. My long thesis was twofold. First, losses will get worse but still be manageable, so eventually reserve releases will serve as a positive catalyst. Second, volume growth will lead to steady earnings. After the 3Q14 results yesterday, my views have shifted. I now see little upside from both credit and volume, while management credibility is getting questioned. Accordingly I exited my already small positions.

Normalized Losses

In my old write up, I estimated normalized net charge-offs to be around 7.5% or 8%. Now it looks like charge offs for 2014E will be at higher end of that, meaning normalized levels could be higher depend on competition. The core auto installment loan business is actually still running within my expectations. What I completely missed was the deterioration in SC’s unsecured loans business.

SC missed its 3Q14 earnings due to a larger than expected credit provision, and that was mostly driven by unsecured consumer loans. Of the $770mm in total provision, consumer loan provisions contributed $167mm, a big jump from $70mm and $62mm in 2Q and 1Q, respectively. This is despite net charge-offs for that business being ~$80mm for the quarter. So management is either being super conservative or they see consumer loans getting destroyed in the future, perhaps both. The earning call offered little visibility, but management did explain that they see the consumer business making money from both fees and interest, so they’re ok with high charge-offs levels.

Regarding the auto loans portfolio, I now see average net charge-offs for 2014E to come in at low 7%s – a fairly comfortable level. We’re looking at 2 year average life so the worse 2013 vintage should be worked off sometime 2015 and there’s actually some credit upside there.

However the lack of visibility in unsecured loans is a big issue and I can no longer count on credit stabilization as a positive catalyst.


The company is running below target penetration of Chrysler’s originations. Management says this is due to lack of subvention support from Chrysler so they won’t be held accountable for that: 
“And I think at this moment, the amount of subvention that we have access to is not very similar to some of the other OEM captives and therefore these penetration rates for the contract would not be something we would held to. ... the actually penetration rates for the contract are tied to us being treated like other captives and I think today it's clear that we are not.”

That may be true, but it also means we can no longer assume that volumes will grow due to the Chrysler relationship, removing some of the upside. I also see SC’s value proposition to Chrysler diminishing. During the summer SC changed their strategy to selling most of the prime Chrysler loans, so at the end SC is no longer providing the financing but is more as a servicer.

Management credibility

Management continues to lose credibility in my eyes. For example, back in June SCUSA put out a press release saying that reserves are expected to come down slightly and expenses to increase due to higher compliance cost. Now the opposite has happened - reserves are actually increasing and expenses decreasing. Another example - in the 3Q14 call Dundon said that unsecured loans were not a big part of variability, when the 10Q clearly showed that it was in fact the key driver this quarter (it was even cited as a factor in the earning slides). Reading through the transcript, it appears that sell-side is also increasingly skeptical of anything management says.

The stock still looks cheap and I may get back in at some point. But I need to see of the drivers above improving first.

Thursday, October 30, 2014

A TrueCar Short Case - Victim of Its Own Success


(I started looking into shorting this when stock was trading at $20 but did not pull the trigger. Now it is around $17 going toward $16, have I missed the boat?  I’m hoping for TRUE to go up so I can short it... )

At $20/share, TRUE’s stock trades at 8x sales, ~150x forward P/E. LTM EBITDA and cash flows are both negative. As a result people have started looking into shorting the stock. A couple of short articles here:

Here I will layout my own short case from a different angle. My thesis different from others in that I think TRUE is an innovative company with a real value add, but ultimately will be undone by its lack of competitive moat.

What TrueCar Does and How it Makes Money

TrueCar (TRUE) does online lead generation for car dealers (mostly new cars). Its main property is website where car shoppers can see a range of prices that other people paid for the same car in their area. Where TrueCar differs from other website is the idea of binding price. Users can click a button on the website to get a price offer that dealers have to honor. In terms of revenue model, TrueCar is free to customers and dealers pay $299 for each successful transaction. The company also gets traffic from affiliates such as USAA, and TrueCar splits the fees there.

Understanding the Bull Perspective and Reframing the Question

The over-valuation problem is exaggerated. The market is clearly looking at something else aside from > 100x P/E. Management’s stated long term goal is raising market share from 3% to 10%, and raising EBITDA margin from 2-3% to 35%. If these goals are achieved, they would more than double their revenue and generate about ~$175mm of run rate EBITDA. With < $2bn of enterprise value, all the sudden you're looking at low teens multiple –arguably cheap for a business with high return on capital (if they hit that margin goal).

These plans are not as crazy as they sound. Revenue has been growing at 50%+ pace so doubling in a few years is not unreasonable. The biggest expense is sales and marketing. The idea is to slow down marketing spend once the company reaches a critical mass of customer recognition. In fact, the company can actually grow advertising dollar amount slightly and still decrease the percentage cost due to operating leverage.

So that’s what the market is looking at. As a potential short seller here, the question should be reframed as “do we have a high degree of confidence that revenue can't double and margin can't hit 35%?”

TrueCar’s Value Add – Why Customers Use Them and How That Can Change

I don’t doubt revenue can double but I question the ability for a company to taper down marketing and advertising expense, and still maintain or grow site traffic and drive car transactions. Ultimately, this can only happen if your product is that much better than everyone else’s (and able to sustain that advantage through the period we’re evaluating).

Why do customers use TRUE and not a substitute or a competitor? And what would change that? There are two customer sets here:  potential car buyers and dealers.

·         Car buyers.
o   Target customers are those who do not like to negotiate and distrust dealers. These car buyers are “satisfiers” instead of “maximizers” – they are not looking to buy a car for the absolute lowest price possible. Rather, these customers just want a fair price and not walk away with some lingering suspicion that they’re ripped off.
o   Where does this fear of getting ripped off comes from? It comes from wide dispersion of prices among dealers.
o   Arming customers with information is also a value-add but competitors do this as well. The “marginal value add” of TRUE is upfront, committed pricing (via price certificates).

·         Dealers. 
o   TrueCar replaces less efficient advertising spends.  TRUE will never replace all of dealer marketing because dealers still want to build their own brands, so TRUE can only aim to replace less efficient advertising budgets (most obviously less efficient lead generation firms)
o   convert ad spend to variable cost (because dealers pay only for successful transactions)

The points above imply that TRUE’s edge goes away if:

For car buyers, TrueCar’s value add goes away when the day comes that price dispersion is minimal. The industry is already moving toward One Price, with KMX, Sonic, Tesla…etc. all pushing some variant of pricing commitment. AutoNation has even talked about moving to directly selling cars online. If pricing transparency and commitment becomes the industry norm then TRUE is useless.

Similar things happen if competitors implement pricing commitment. CostCo and Edmunds already try to do no-haggle pricing, it’s not too far of a step toward offering a price commitment like TRUE does.  One can argue TRUE’s advantage here is tying into dealers inventory systems, but perhaps others can get information from DealerTrak or other sources.

For dealers, TrueCar’s comparative advantage goes away if other sources of advertising becomes more efficient, either by copying TRUE’s model or if they are forced to cut prices. As the market share of these relatively inefficient forms of advertising gets taken by TRUE, it’s hard to imagine they won’t increase quality to compete better

Ultimately, TRUE will be a victim of its own success because it is innovative but easy to duplicate. In the next few years, I can see the company push the car industry further toward One Price paradigm, force competitors to offer pricing commitment or becoming more efficient.  All these things are great for consumers, but diminish the necessity of using TrueCar. Without product advantages, it’s hard to keeping advertising down and still double revenue. In some ways, not shorting TRUE requires you to think that auto sales processes are still the same in 5 years and that other player can’t improve their game despite being eaten alive by TRUE.



Bear argument
·         The Industry is already moving toward one price and TRUECAR's value-add will diminish as price divergence decreases.
·         Unlike sites such as Yelp or Facebook, TRUE does not have the benefit of user networking externality. People use TrueCar because they want a fair price, not because all their buddies are hanging out on it, nor because they want extensive dealer reviews. As soon as the proposition of “fair price” diminishes (due to everyone already offering that), TRUE becomes unnecessary.
·         What happens when new car sales go south? 
o   Used car pricing are coming down due to increasing off-lease supply. This can spill over to new vehicle market. OEMs will defend sales with incentives but eventually lower pricing should cut into dealer margin.
o   When dealer gross margins are under pressure, Truecar's $299 per sale look less attractive. Dealers will push for lower cost lead generation or take advertising in house. Dealer consolidation would give them even more bargaining power.
o   As TRUE wins over other sources of advertising, these sources will lower their prices to compete.
o   Lower industry volumes will hurt the company.
·         Operational failures
o   I read that some dealers have dispute with TrueCar about how a successful lead is defined and how dealer has to pay.
o   Bait and switch at unscrupulous dealer can become legal liabilities for TrueCar

Bull argument
·         TRUE is an innovative and visionary company with a history of disrupting the industry. When TRUE first came out, the transparent pricing caused dealers to undercut each other and customers got the cheapest prices possible. This led to an industry-wide boycott by the dealers and near death for TrueCar. TRUE has since changed its business model to not let each dealer see each other’s pricing (so they don’t undercut each other).
o   Incredible track record of turnaround in dealer relationships. The company has doubled dealer participation from its trough. In fact, the leader of this dealer revolt, Jim Ziegler, is holding an upcoming conference and will have the President of TRUE as a keynote speaker.
o   TRUE is a cutting edge big data company. They are transforming a mom and pop business by leveraging new technologies such as Hadoop

·         TRUE as a potential M&A target
o   Combining with lead generation competitors would decrease the need of an advertising arms race and allow margin gains.
o   Vertical integration (True+ KAR = TrueKar?) TrueTrade is trying to compete with CarMax (KMX) by enabling a network of used car dealers to offer committed pricing on trade-ins, but without the need to hold inventory. Now, one reason KMX can do this competitively is because they run their own auctions, which helps KMX dispose unwanted trade-ins economically. A merger between TRUE and Kar Auctions Services (KAR) can replicate KMX’s functions. This might be interesting for KAR because its main competitors Manheim (owned by Cox, which also runs AutoTrader and offer upfront pricing on trade-ins) and KMX are already parts of larger entities. Also, TRUE owns ALG which would be extremely valuable to KAR.
·         Increasing part of a dealers marketing budget. Dealers still spend on newspaper, radio, and TV so there could be some low hanging fruits there. If automobiles demand decreases, TRUE may actually gain market share because dealers would want to shift marketing to TRUE’s variable cost model (they only charge for successful deals)
·         Margin increase can be achieved by lowering marketing cost once a critical market share is achieved.
·         Opportunity to go beyond dealer advertising spend and grab a share of manufacturer’s advertising and incentives.

Tuesday, October 7, 2014

UCP Lot Valuation

  • I was skeptical of the long thesis on UCP because analysts tout strong inventory valuations but glosses over the fact that it takes time to realize value - i.e. they do not apply a present value.
  • It turns out that the approach of valuing lots by ascribing value as % of home prices is flawed but surprisingly robust. This is because the 2 missing factors are offsetting: 1) Applying a discount rate would decrease value, but 2) this method also understates cash flows and correcting for that increases value. 
  • Valuation is $18/share.  UCP trades around $12 per share at the time of writing.

UCP and Its California Inventory
UCP, Inc. (UCP) is a land developer turned home builder that historically focused on California. Its operating subsidiary, UCP, LLC is 57.5% owned by PICO. As of 6/30/2014, UCP owns 4,639 lots and LTM net new order was only ~300 units. UCP has enough inventories to last years, so valuing the company requires valuing the lots.

When people hear that UCP owns lots in California, they think of San Francisco, Silicon Valley economy…etc. and assume high prices. However, UCP mostly operates in inland locations like Fresno and Madera where it could take 3 hours to reach the coast. According to Zillow, median home prices for Fresno and Madera are less than $200k. Other areas where UCP has strong presence are Monterey County in CA (prices in the $400-450k neighborhood) and Thurston County in Washington (low $200k’s range). These are not exactly your premium million dollar homes in San Francisco. UCP acquired Citizens Homes earlier this year, which allows them to expand into the Southeast.

The Long Thesis

This is an asset play. Much of UCP’s land inventories were bought during 2008-2009, when lots are cheap. These are now worth much more than what market value would suggest. With enough inventories to last several years, UCP also has some nice options:  a) monetize the lots by building homes themselves, b) sell lots to other builders, or c) sell itself to another company. Being acquired is a possibility due to the small market cap and their local footprints.


The bullish write ups I have seen tend to value the inventory without a discount rate, then net out the liabilities to result in a massive net asset value. There was a PICO article published 9/8/2014 on SA included detailed valuation of lots by locations. The methodology separates inventory into developed and undeveloped lots. For developed lots - assigns a reasonable home price for the area (say $450k for Monterey Bay area), and assume lots are worth certain percentage of home value (50% here). For undeveloped lots, just assign value per lot based on location, using UCP’s historical revenue per lots sold for context.

I duplicated the exercise below and got a very similar ~$350mm of value for the lots (164mm for developed lots and 183mm for undeveloped). Netting out liabilities and minority interest this would value UCP at ~18 per share.

UCP Lot Valuation

It's tempting to stop here without applying a discount, and point out as upsides the optioned lots (which are not included here) and UCP’s potential as M&A target.

There are 2 things missing here. The first is obvious - it will take years for UCP to monetize this inventory and thus time value discounting is not only necessary but makes a big difference. Clearly, it takes time for local housing demand to emerge, and for UCP to build and sell those houses. The second missing piece is what amounts should we be discounting?  Just spreading the $350mm of total value and discount back would be a mistake, because the total cash flows UCP will get is actually more than that.

The second point requires some explanation so bear with me. What exactly do we mean when we say a lot is worth x dollars?  An excellent article here makes it clear that the value of a land lot is what another builder is willing to pay for the lot, and still be able to generate some profit. The profit part is key. For example, if other builders are willing to pay UCP $100k to buy some inventory, incur another $80k of construction cost, and sell the house for $200k, their profit is then $20k. The lot to ASP ratio would be 50%. How much cash flows will UCP get for this lot? 

·         If UCP sells the lots to another, then you should discount just the $100k proceed from the lot sale. 
·         UCP however, plans to build the homes itself. In this case UCP gets $120k of incremental cash flows ($200k selling price – $80k construction cost). The other way to think about it is they get $100k of working capital back, plus $20k profit.

This is why the $350mm value above understates cash flows - because it implicitly assumes UCP will sell these lots to another builder, and thus fails to include the profits UCP will get upon a home sale.

I get to roughly $18/share. It turns out that applying a discount rate is offset by this extra cash flow - even with some very conservative assumptions about sales pace.

Value destroying growth is always a risk

Growth ambitions are dangerous in homebuilding. At the peak of cycles, financing becomes widely available so builders gorge themselves with expensive inventories. During a crisis when they should be buying cheap, they can’t because of financing constraints. In short, builders always risk buying at the worst times.

By virtue of having land that can last years, UCP can theoretically avoid this type of behavior. In my opinion, the best case for UCP would be to stop trying to expand, and focus on monetizing its existing lot inventory as quickly as possible. Of course, management teams never want to liquidate themselves and UCP has in fact been acquiring.This makes them more like other builders, but with subpar scale and diversification. Business expansion also makes UCP a less likely M&A target (which I wouldn’t count on as the basis for an investment anyways). These factors perhaps call for a higher discount rate than peers, but still result in a strong valuation.

Thursday, September 25, 2014

Management Turnovers at Pharmacyclics (PCYC)

So someone told me about this company with a wonder drug. She loves the product but got this weird feeling about management. Maybe it’s the way management interacted with each other on the latest earning call, or the way they answered analyst questions. She could not put a finger on what it is.

She also told me they just got a new chief commercial officer but the chief medical officer (CMO) just left. So naturally I googled the CMO’ name. Multiple names popped up. Digging deeper here’s the summary timeline I found:

·         Dr. Ahmed Hamdy - appointed CMO March 2009
·         Eric E. Hedrick - interim CMO sometime around 2011
·         Lori Anne Kunkel - appointed Dec 2011; departed July 2013
·         Jesse Seton McGreivy  - departed Aug 2014

So you have 4 CMO’s in 5 years.  When a company’s CFO or Chief Accounting officer leaves, you worry there’s something wrong with the numbers. But how about when a biotech’s CMOs keeps leaving?  Do you worry that the product is fake?  Is it even possible to fake your way through FDA approval?

More research. What is wrong with Pharmacyclics, Why would top executives keep leaving?

·         Nothing positive in CaféPharma. Let’s just say this is a highly entertaining board. You got threads  named “Pharma-stall-ics”, “Pharmasucklycs”, and “Pharmafuckyclics”.. .etc. Definitely some employee relationship issues here. There are also widespread mentions of wrongful termination suits.
·         A post on investor hub paints an unflattering picture of COO, and mentions former CMO Lori Kunkel.
·         Bloomberg  article. Lots of insinuation here when the article talked about Duggan’s association with fraudster Slatkin. The article spent almost no time on what Duggan did at Intuitive Surgical (which would have added to Duggan’s credibility).

Obviously all of the above could be written by people with agendas. The fact though, remains that you got 4 CMOs in 5 years at a biotech. I doubt CMOs leave due to “work life balance” issues because these are overachievers and probably workaholics to begin with. It’s also hard to explain this as CMOs asking for big pay raises because well, you should pay them.

I get the sense that this tight clique of Duggan, Zanganeh, and Erdtmann calls all the shots. Given the rampant turnovers and the colors above, I can only infer that at best that the top management are unpleasant dictators, at worst there’s something unethical going on.

But, they have an awesome product!

Does all this matter when you got a hot product like Imbruvica?  In general, when do management matter the most?

First, if this is a fraud then obviously all bets are off. Again, is it even possible to fake your way through FDA approval? Granted that EVP of Corporate Affairs Ramses Erdtmann is a Scientology Operating Thetan VIII, which according to Wikipedia gives him the power to "control others from a distance" and "create illusions perceivable by others", the probability of a fraud getting through FDA has to be pretty small.

Second.  If it’s not a fraud but top management are major tyrants, does that matter? I think it depends on context:

o   If the company’s valuation depends on the ability to keep innovating and create demand (think Apple and Steve Jobs), then management competence matters a lot, but management likability not as much (again Steve Jobs was known to be a bit of a dictator).
o   If this is a mature / growing company trading on say 15-20x earnings, management have to optimize revenue, control cost…etc. Clearly management matters a lot more.
o   In PCYC’s case though, the company is trading on vast market potential of a single product, Imbruvica. The patient demand already exists. The product is already there, theres no more innovation that’s needed. The science either works or it doesn’t, and there’s nothing management can do about it.

Ultimately, this comes down to how PCYC fits into your investment style. If you’re allocating to numerous small positions with catalysts for quick pops, then management matters less. If you’re trying to find that rare company that's built to last, then I'd say this is not the situation for you.

**** Updated 10/2/2014 (originally posted on Seeking Alpha Instablog)***

I normally don't like to dwell on management too much. In fact in my blog post here I concluded that management turns at PCYC can arguably be a secondary consideration depending on your investment style.

Then I learned that the drugs are made in China. Why would you do this? So you have a biopharma who keeps losing medical/science personnel; core executives couldn't answer questions about IMS data in their own presentations (and get yelled at by the Morgan Stanley analyst). And oh, by the way the drugs are made China.

I don't have the guts to outright short this company given strong reviews about Imbruvica, but at some point the red flags pile up and I stop looking further.