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 Caf├ęPharma. 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.

Tuesday, September 23, 2014

Random thoughts on CarMax, Oracle, and Housing Vacancies

·         CarMax (KMX)
o   Funny that every analyst wanted to ask about subprime on the earning call. I get that KMX is arguably a finance company. But guys, falling subprime mix is a GOOD thing!! So what if revenue slows a little bit, to the extent that customer base is more sustainable, that’s good news.
o   KMX does look expensive even with today’s drop off. From lenders perspective though, it is good to hear that subprime players are tightening standards.

·         Oracle (ORCL)
o   This Barron’s article said that Oracle is threatened by Hadoop. Ironic considering that Oracle oversees Java – the language that Hadoop is written in. I have also heard that Oracle is hurt by freely available database options. Well, ORCL also owns MySQL, one of the most popular free databases. If Hadoop and free databases are really the downfall of ORCL, this needs to be a business school study on making your stuff open-source and freely available.
o   Hadoop does not replace a database. The Hadoop wiki says as much. Hadoop is great for unstructured data (for example if you’re mining terabytes of tweets) while traditional relational databases are good for structured data (in the row/column format). Hadoop is just a way to split up your job to various computing and data resources, each of those could be different form of data storage, including a database. In fact, Hadoop and database can be complementary - there’s just so much information in databases that someone mining data will have to link up Hadoop with relational databases.

·         Follow up on last week’s post about housing stock – how to find true vacancy numbers?
o   I can’t stress enough that the reported “homeowner vacancy” and “rental vacancy” numbers are just fake. There are substantial “other vacancies” that are not included in those numbers – easily 30% or even 50% of total vacancies depending on location. Here’s a helpful report that US Census put out on “Other” vacancies last year.
o   How to find the true vacancy number then!?  Those numbers are available in the American Community Survey. Unfortunately the US Census does not make this easy. To be useful you’re really looking for local statistics. FactFinders allows you to get this by entering the MSA’s one by one. But if you want to figure out say vacancies for say, all the exposures of some home builder, then this will take a LONG time.
o   Ideally you want historical time series for each local level so you get a sense of “normal”. You can try to download the ACS summary files, but those only go back to 2005 on the Census website. 
o   One way to do this is with Public Use Microdata Samples (PUMS). The U. of Minnesota has a great site that let you select the variables and the vintage years you want. Load that into a database (it's easily in gigs of data) then process it however you want. The results will not match the ACS summary data exactly because these are samples of the original survey. But at least you get a sense of the vacancy mixes going further back than 2005.

Tuesday, September 16, 2014

A Mental Model on Housing Stock and Flow

I often hear people say something like this: “household formation should be 1.5mm per year and new construction are running 1mm per year, therefore we’re facing a housing shortfall”. 

The obvious flaw with this statement is that it ignores existing inventories and focuses completely on trends and “flow”. Put another way, it assumes inventory is already in balance. The logical questions are then:  how about the existing inventory?  How do you know we didn’t overbuilt so much during the last cycle that there are still still excess home supply? 

Intuitively, I’d lay out household formation and housing starts (“flow”) against total number of households and housing units (“stock”) like this:

tracking households and housing units

Assessing whether we’re overbuilding is then a 3 step process: 1) estimate the number of households, 2) estimate number of housing units that can be occupied, 3) compare the two numbers; if there’s a housing unit shortfall then that’s the number of units we need to build. 

In the example above, I started with 2013 number of households. An estimate 750k of household formation for 2014E gets me to 2014E households of ~115mm.

Next step is take the housing unit numbers and figure out how many of those are actually available to live in? This is where subjective judgment comes in. The economy is not perfectly efficient, so at any given time, there’s a healthy amount of vacant units in transition (it takes some time going from a rental listing to actually renting out the unit, a unit could be sold but the buyer has not moved in yet…etc.) These are units that are not available, so I’ll take those out. I also remove a normalized amount of second homes and “held for market – other” units from the stock. For 2013, I estimated ~12.2% of housing units are “normalized vacants”, and removed a corresponding 16mm unit from stock. This resulted in an estimated 116.6mm housing units that are actually available to be occupied.

Finally, compare 2014E households of 115.4mm vs 116.6 of available units at year end 2013 and it’s clear that we still have excess inventory. I expect this excess inventory to decrease only slightly at the end of 2014 because household formation barely exceeds net unit adds. 

Alternatively, I have also seen analyst keeping track of the stock of vacancies, and map out the difference between demand (household formations), and supply (housing starts, demolitions…etc.) as a burn rate against excess vacancy. This is slightly more elegant but should get you similar results. Either way, the point is you have to take into account existing stock (whether in terms of available units as I did above, or as inventory of excess vacancies), rather than just compare housing starts against household formation.

* As a note, the headline reported homeowner and rental vacancies can be misleading as they both understate total vacancy. The way these numbers are reported: if census can’t categorize if a vacant unit is for rent or own, that unit will be left out of the data. i.e these numbers exclude units that are held off market or seasonal vacant. For this reason I focus on total vacancy for a big picture (construction activities). Then only drill down to homeowner vs rental vacancy when I evaluate rent vs own type of decisions.

Tuesday, September 9, 2014

Staying Patient on Title Insurers

2014 has been a tough year for title insurance stocks (as it has been for many mortgage stocks in general) as the group lagged the broader market. However, I believe that title insurers remain the best way to get exposure to housing recovery.

A 30 second thesis on the industry

·         Good industry structure and pricing power. The top 4 players have over 80% of market share. Customers are essentially captive because banks require title insurance for mortgage transactions.
·         Volumes are near historical troughs. Even without any boosts from household formation or homeownership rates, insurance premiums can go up from housing churn and more relaxed lending standards.
·         Expense restructuring. Title insurers had to control expenses through the latest cycles, as well as meet demands from activist investors. Operations are more efficient post-crisis and margins are poised to increase with any volume uptick due to high fixed cost.

Industry Characteristics

·         Product.  Title insurance is generally required by lenders whenever one purchases or refinances a property. Premiums are some percentage of loan amount or property value, with purchases generating higher premiums than refinances. The mortgage industry does not expect much growth in refinance volumes going forward, meaning purchase mortgage volumes will be the biggest driver in the coming years.

·         Players. Top players are Fidelity National Financial (FNF), First American Financial (FAF), Stewart Information Services (STC), and Old Republic (ORI). These 4 traditionally have 80-90% of the market.

·         Pricing. Pricing is regulated by the states and there is very little price competition. As opposed to true pricing power where firms can get away with price hikes, I would say the industry enjoys stable pricing that is very much fixed across the market. The firms also has upside from home price appreciation (remember premiums are a percentage of loan/property amount).

·         Value add. Title insurers are closer to labor intensive service companies than true “insurance” risk pools. “Insurance” in the typical sense of the word is about protecting against future losses yet to incur. However, title insurer actually guard against historical events that ALREADY occurred. As such title insurers can actually minimize losses by just doing a better job upfront (more thorough title search for example).
o   This puts sell side coverage in a weird position. Does the housing analyst cover this?  Or does the insurance analyst cover this? How about the business services analyst?

·         Cost structure. Personnel cost (semi-fixed) are the largest component of expenses, rather than the more unpredictable losses. The combination of fixed cost and relative low margins means earnings can have maximum leverage to volumes gains.

Upside 1:  Macro Narrative

Both total home sales and purchase mortgage volumes are near historical troughs. The current housing environment is marked by 1) low household formation and 2) a shift away from home ownership toward rentals. The mainstream narrative says young people are staying home due to student debt; and when they do move out (thus forming households), they rent instead of own. While that argument has merit, my personal view is household formation will eventually have to pick up, while home ownership rates will have to plateau as rental vacancies decline to more normal levels.

But keep in mind, household formation and home ownership rates are not the only driver of mortgage volume!  In fact, mortgage volume should be more related to total existing home sales (which is a multiple of new home sales).  This means that housing churn and mortgage access can actually be more important than household formation and home ownership rates.

o   Churn measures housing turnover (shown in chart 1 as total home sales as % of year end number of households). Since the late 1960’s this number has trended up with economic growth, dropped during the great recession and now trending up again. Intuitively, as the economy gets better, people will buy and sell houses and move around more, even if the total number of households remains constant.
o   Average mortgage sizes (shown in chart 2 as purchase mortgage volume divided by total home sales) are still at depressed levels even though home prices have recovered. This means either a) lower percentage of buyers taking out mortgages, or b) people take out smaller mortgages (lower LTV loans). Lenders are already in the process of expanding access, so that will help mortgage volume and by extension title insurance volumes.

Title insurers will likely see their premium revenues increase if either, or both, churn and mortgage sizes increase. This is better than say, homebuilders that are depend on new constructions, which goes back to household formation and home ownership rates.

Chart 1:  home sales activity can increase without the benefit of household formation
Total home sales and churn as % of households

Chart 2:  mortgage size has room to grow when lending standards normalize
mortgage volume per home sales

Upside 2: Expenses and operating leverage

The expense picture will be different from each firm and I encourage investors to dig deeper on their own. Just reading through the transcripts though, expense control is clearly a focus for the industry. This is particularly true after the great recession then the refinance boom-bust in 2012- 2013. First American, for example, has condensed its 103 claim centers, 30 accounting centers and 30 data centers in 2006 to 4, 2, and 2 respectively today (source: conference transcript). These are structural costs that are not expected to come back when purchase volumes come back. As a result, FAF now sees a 10% pre-tax margin as the new floor, as opposed to the ceiling it was during pre-crisis days.

Expense initiatives are hardly limited to FAF. FNF and STC have both attracted activist investors in the past couple years and management teams are on tight leashes regarding expenses.

It’s not just the level of expenses improving either. Expense will be easier to manage going forward because purchase volumes are more predictable than refinances. Refinance volumes are very sensitive to rates so companies had to quickly ramp up and ramp down their staff. The transmission goes something like this:  rate volatility -> refinance volume boom/bust -> difficulty in staffing  -> inefficiencies  -> earning volatility. Going forward though, a primarily purchase driven market should be more predictable and thus costs will be easier to manage.

A better blend of risk vs housing related subsectors

Why title insurers versus other housing/macro plays? The table and discussion below will outline how I mentally think of the various housing sub-sectors.

housing subsectors risk comp:  builders, parts, origination, mreits, pmi, servicing, title insurance

·         Competitive risk. Housing subsectors like home builders, loan origination, mREITs are typically fragmented and competitive. Title insurers and non-bank servicers are the only subsectors with highly concentrated players.

·         Regulatory risk. Non-bank servicers are currently fighting through a host of regulatory issues. Title insurers could have some risk here also, as the uninitiated tend to think of it as a sham product. However as one does more research they realize the protection is necessary.

·         Consumer credit risk. Credit losses are currently minimal but are bound to increase as lenders fight for market share by expanding credit boxes. If you don’t like the idea of normalizing losses (or already have enough in your portfolio) you can screen out origination, mortgage insurers, as well as some of the nonagency mREITS.

At this stage of the cycle, competitive and regulatory risks are my primary concerns. By process of elimination this leaves title insurance as the least risky way to get housing exposure.


I will leave off at this point. You have an industry with concentrated market power, volumes at a trough but normalizing, and expense running at efficient levels. Note that I have not discussed valuation. However, if you have a positive view on housing in the long term, this should be the best sub-sector to look into, given the better risk blends compared to other housing plays.