Sunday, June 21, 2015

Summerset Group's Business Model - Potential Short

I have been digging around New Zealand the past week or so. I have not found any stocks I would act on right away, but I did find a few interesting business models that could make for good trades later. Summerset is one and I’ll focus on that here. Fonterra is another. I also went ahead and shorted the New Zealand Dollar (short NZD/USD), but that is for another post.

Summerset Group (SNZ.ASX)

This is a short candidate but not now. Summerset is a developer and operator of retirement villages and aged care facilities in New Zealand. Looking past the healthcare angle however, Summerset essentially borrows money from old people to speculate in properties. This I will explain in the paragraphs to follow. I will also explain why this could be a good short and when to short it.

The Business Model

Summerset’s business model produces 3 cash flows. First, you (the retirees/customers) pay around $300-500k NZD upfront, for the right to live in the villa/townhouse/apartment units. Second, you pay a weekly contribution toward village operations (for things like water, staff, activities…etc). Third, when you decide to leave (or die), you or your estate get 75-80% of your initial money back (Summerset keeps 20-25% of initial amount as “Deferred Management Fee”). It’s important that the customer don’t actually get ownership, and Summerset gets the capital gain from any price appreciation when units are resold.

Follow the cash flows above, Summerset basically borrows money from retirees, pay a negative interest rate (the weekly contributions), and pay back 75-80% of principal at the end. What do they do with that borrowing? They build/develop more properties.

The accounting reflects these economics. The large amounts that customers pay upfront are in fact booked as “Residents’ Loans”, a liability on Summerset’s balance sheet. The footnotes then attribute the asset “Investment Property” as the sum of residents’ loans and Summerset’s equity. On the income statement, main revenue sources are the weekly fees, the amortized deferred management fees, as well as any valuation gains in investment properties.

Main Sources of Profit

Of the various revenue sources, property value gains are the main source of profit. Without that Summerset would barely breakeven or be cash flow negative. A quick look at the financial statements will make this clear.

First, in the income statement if you back out the “Fair value movement of investment property”, pretax income would be close to $0. Second (as shown below), management’s non-GAAP “underlying profits” shows that profit came solely from “realized gain on resales” and “realized development margin”. This should make clear that Summerset is essentially a profit developer and heavily dependent on property value.

Summerset Group underlying profit

I also wonder what fair value really means. In Summerset’s business model, a sale of “License to Occupy” is not a true sale of property, but rather a retiree lending money to the company. Are those transaction prices really reflective of property value? The annual report does have this to say – but that doesn’t tell me much: “The fair value of the Group’s investment property is determined on a semi-annual basis, based on market values, being the estimated amount for which a property could be exchanged on the date of the valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion”. 

Let’s move on to the cash flows statement, which shows similar results. Without the borrowing from resident’s loans, cash flow from operations would actually be negative. 

summerset group cash flows

Leverage and Liquidity

I have nothing against property development or land speculation. When times are good this is a fine business model. Even the liquidity risk from resident departure /loan redemption is mitigated, as Summerset contractually do not have to repay the “resident’s loan” until they receive money from a new buyer.

But it’s also obvious that Summerset would be in trouble when there’s a big property down turn. The company is leveraged 3x in terms of asset to equities. There is very little cash on hand, and the bulk of its assets are in illiquid assets such as land, buildings, equipment…etc. An economic downturn could lead to higher retiree departure and loan redemptions (to free up cash for other uses like supporting their unemployed children). Competitors could have their own liquidity issue leading to a downward spiral of asset value impairments. If resale values are lower than residents’ loans, and new sales are low (most likely in a property downturn) then the company could have trouble redeeming residents loans. At the minimum we’ll see some ugly margins if not liquidity issues and lawsuits.

What to Do?

So yes, Summerset is basically a highly leveraged builder that borrows money from grandmothers. Its profits are completely dependent on property value gains. Meanwhile news media is full of reports about NZ being in a property bubble, with one of the most expensive housing markets in the world. The stock is trading at more than 2x P/B.

All these make SNZ a short, but not yet: 1) I actually think the property market has more room to run, as much of the price gains are due to supply constraints in Auckland. 2) This is further supported by NZ’s central bank easy monetary policy. 3) Summerset’s sales were strong in 1Q15 and its stock is showing bullish technicals.

If not now, then when? I am waiting for signs of credit deceleration from the banks before acting on this. Before retirees pay Summerset hundreds of thousands for a “License to Occupy”, they have to sell their existing homes to someone else, so Summerset needs a solid housing and credit environment.

What I can see happening is the NZ property market continue to run for a while as the central bank keep lowering rates to depreciate the NZ Dollar and keep its exports competitive (think Fonterra and its farmers). The low rates encourage building and could lead to oversupply of retirement homes. Eventually monetary policy will stabilize and loan growth at the banks will slow. Slower credit and oversupply of buildings would then have a depressive impact on property values, crushing Summerset’s margins and stock price.

Interestingly, bank stocks (it’s the same big 4 that dominate both Australia and NZ) have shown weaknesses in the last month while Summerset and its peers have stayed strong. The two cannot diverge forever.

Thursday, June 11, 2015

Spotting Turns in Market Cycles

This is the hypothesis I’m working under. To the well-read there’s nothing new here, and lots of market players probably already look at the world this way. But it took me a while to piece it together, as schools don’t teach this and you don’t get this type of stuff from reading Warren Buffett. 

First though, I want to address a common misunderstanding of credit and growth.

An Essential Point about Debt and Growth

I was reading an old economic report from Goldman Sachs by Andrew Tilton. In that report there is a sentence that stood out with its clarity of thought.

“…the growth rate of spending is related to the second derivative of credit – accelerating credit can fuel an increase in growth, but credit cannot accelerate forever, and when it begins to decelerate there will be a negative impact on spending growth.”

Everyone knows that spending growth can be driven by changes in credit – duh!? But that’s actually not exactly right. It’s really the second derivative of credit. There’s a subtle but incredibly important difference here - one that most people have a hazy understanding of (including myself until recently). That lack of clarity shows up when people talk about the world’s high level of debt, and they say something like this: “You can’t cure debt with more debt. Forget about actually pay down debt, how about just stop borrowing for a start? Is that too much to ask?”

Let’s walk through this with a simple example. Let’s simplify and say the whole nation is just one person. Let’s say I want to buy some fancy car for $100k. I don’t have the money, so I borrow $100k and buy. GDP for that year is $100k. Next year though, if I don’t do anything – not paying down debt or increasing debt), GDP naturally goes down to $0! In order to keep GDP flat, I’d have to borrow another $100k to buy another car– doubling my debt just to have 0% GDP growth.

This is what Goldman means by spending growth being related to the acceleration (2nd derivative) of credit, and not just changes (1st derivative) in credit. That is the tyranny of debt addiction. GDP growth could go negative just from people borrowing less than before (in the above example, say I only borrow and spend $50k in year 2, then GDP is down 50%).

Per Federal Reserve data, U.S. total credit market borrowing (SAAR) was $2,472bn in 4Q14. GDP was $17,701bn for the same period. So new borrowing contributed to ~14% of the GDP. If everyone stops borrowing, GDP would take a 14% hit. We would have massive unemployment and social unrest.

That’s just not an option. So the sensible way to “deleverage” is not to decrease the level of outstanding debt in absolute terms. But rather to INCREASE debt at a slower rate, and try to increase income at a faster pace, so that both debt and GDP increase in absolute amounts, but the ratio of Debt/GDP declines. In this sense, we have no choice but to “cure debt with more debt”


So what does that have to do with investments? In my last post I mentioned Kostolany’s explanation of how liquidity drives broader markets. But he gave little guidance on when that would happen. Ray Dalio though, has a framework on the typical deleveraging processes and when central banks need to provide liquidity to the market. Combining the two frameworks should us a better sense of credit cycles and turns in the equity market.

I read Dalio’s writings on credit cycles a long time ago but did not understand it completely. Turns out understanding the above dynamics of debt and GDP growth was the missing piece – particularly the “why” behind various government’s alternatives. I went back and re-read his stuff and everything became clearer this time around.

In his paper “An In-Depth Look at Deleveragings”, Dalio mapped out the typical steps to deleveraging. In the first phase of deleveraging, debt growth either decelerates or turn outright negative, and countries attempt to cope via some form of austerity. Debt to GDP ratio will go up mostly because of declines in GDP. In the second phase, austerity and resource transfer reached its limits, and central banks are forced to pull the monetary policy lever and pump some liquidity into the system.

That’s when the stock market will take off despite the weak economy. The increased liquidity mostly goes to juice up the financial markets first, since people still lack confidence in the real economy.

So here are the big picture steps: Watch out for countries that are in the start or middle of deleveraging. Ideally you find a country that had explosive growth in Debt/GDP ratios and then a subsequent deceleration of debt which triggers a deleveraging cycle. Follow that deleveraging cycle and wait for central bank to print money – that would be time to play the stock market.

Appendix: Where is the U.S. in the Cycle?

Where is the U.S. in the long term cycle? The blue line in the chart below shows nominal Debt/GDP levels. The takeaways are 1) the U.S. went on a debt binge starting late 1970’s, so it’s possible that much of our GDP growth the past 40 years are just a debt fueled mirage. 2) The Great Financial Crisis was the first time we deleveraged to any material extent since the 1940s’. 3) Despite the deleveraging since 2008, debt/GDP is still at an extremely high level. 4) the pace of deleveraging has slowed and we actually have signs of re-leveraging.

My data does not go back to show the Great Depression. But per Dalio’s data, Debt to GDP went all the way from 155% in 1930 to 252% in 1932, then down to 168% in 1937. That’s a much greater swing of leverage levels – one that probably contributed to the rise of Hitler and World War II.

Given the still high level of debt and the deflationary forces of any potential deleveraging, as well as the already high P/E levels, I have to agree with the common notion that equity markets are in for long years of low returns ahead.