by Amit Kumar
Takeaway
Airlines have high operating leverage, which accentuates the impact of economic downturns. High fuel costs and legacy union issues have marred airlines from time to time and even led to bankruptcies.
CASE STUDY:
CIENA CORPORATION (CIEN)
Ciena’s revenues grew ~15 percent and stock rose 56 percent in 2013 as Ciena benefited from an increase in AT&T’s capital expenditures on 40G and 100G network infrastructures. However, Ciena faced some key risks that posed a considerable downside to the stock. AT&T accounted for ~$133 million of incremental revenue (more than 50 percent of its revenue growth in 2013) while accounting for ~17.9 percent of its $2.1 billion revenues in 2013 and 13.5 percent of its $1.8 billion revenues in 2012. Ciena’s business model had customer concentration risk.
While Ciena could benefit from upgrades by smaller U.S. carriers as well as international carriers, some of these upgrades were not on the horizon for at least a year. Besides, such upgrades did not have the potential to contribute as much as AT&T or Verizon—two of Ciena’s largest clients. Ciena had a good presence in North America but low exposure in China, where it had incurred losses in the past.
Communications network solution vendors compete aggressively, mostly on price. Ciena faced not only well-capitalized competitors (ALU, Huawei, etc.) but also smaller competitors such as Infinera, which were able to make inroads into large carriers such as AT&T (Infinera had become a preferred AT&T vendor). Ciena had barely eked out any EPS in two of the past seven years, despite the fact that that its revenue has nearly quadrupled—a hint of poor margins in this business.
Management incentives were tied to sales targets rather than profitability, which could very well cause the streak of operating losses to continue even when revenues are growing. Ciena’s CEO has been running the company since the technology bust, when the stock was trading at $400 per share in May 2001. (The stock had corrected from its peak of $1,000 per share in 2000.) If you looked at the peak sales in the last ten-year cycle, Ciena’s sales were always very lumpy. I believed that management would not be able to provide a positive margin outlook at an upcoming analyst meeting on April 3, 2014.
Ciena also had a highly leveraged balance sheet with a history of losses and poor operating cash flow for the last five years. Its convertibles from Nortel acquisition and other convertibles could potentially dilute the stockholders by at least 10 percent. With a debt/EBITDA of 9–10 and poor EBITDA growth, Ciena seemed precariously leveraged with an outstanding convertible obligation of ~$1.2 billion. The company’s credit agreements limited its ability to pay cash dividends and repurchase stock, as well as to repay debt in certain cases.
Ciena should have traded at or below an EV/sales of 1, given its high operating and financial leverage, lumpy historical sales, growth, customer concentration, and dilution risk from convertibles. I published a short thesis on March 20, 2014.
How Did Ciena Play Out?
Street analysts were torn into two camps after management provided a dismal operating profit outlook in the analyst meeting on April 3, 2014. The stock fell more than 20 percent over the next few weeks.
Industries with Inherent Dependence on Leverage
Most asset-intensive businesses (banks, miners, utilities, telecom carriers, real estate investment trusts, etc.) are naturally more leveraged than asset-light businesses (e.g., software and services companies). Investment in such businesses requires special attention to the terms of their credit agreements and off-balance sheet commitments, as well as their financial ability to service their debt.
Capital-intensive industries such as shipping, airlines, banks, and miners cannot operate without leverage or external borrowing. This inherent dependence on leverage leads to risk in the business model of weaker players or chronic structural issues for the entire industry during downturn cycles.
Leveraged industries tend to suffer more than other industries during macroeconomic slowdowns. Leveraged industries are also more prone to suffer from capacity or supply glut in their industry or in a competing industry. For example, the shipping industry saw a glut in supply of very large crude carriers and bulk carriers from 2009 to 2010 while global demand for oil dropped. Two of the largest shipping companies filed for bankruptcy in 2011, marking the longest slump in the history of the shipping industry as many other shipping companies filed for bankruptcy protection through 2012.
Similarly, the coal industry suffered from a glut in the U.S. supply of natural gas in 2012. Figure 2.2 shows the impact of the decline of natural gas prices on coal demand after the discovery of vast new supplies of natural gas in U.S. shale deposits. As utilities began to switch to more natural gas for electricity generation, coal prices tanked and coal stocks suffered.
FIGURE 2.2 Impact of decline in natural gas price on coal stocks. Source: EIA, WLT SEC Filings, Bloomberg.
Players with poor operating economics in troubled and leveraged industries tend to have high short interest. It can be extremely painful to short such high beta stocks (stocks can move up violently on a small piece of good news), and regulators may impose short-selling restrictions on them from time to time.
Recap
• Companies borrow to finance assets, working capital, and expansion.
• Creditors are ahead of shareholders to get repaid during distress or downturn. Shareholders can get wiped out in the event of a bankruptcy.
• Financial leverage increases with borrowings, while operating leverage increases with fixed costs. Leverage accelerates profits as well as losses.
• Leverage can be hidden in commitments and contingent liabilities.
• It is important to identify any negative catalysts while researching shorts, such as losing market share, structural issues, high debt levels, issues with share structure, and poorly aligned management incentives.
• Economic downturns or industry-specific issues have an accentuated impact on companies with high operating and financial leverage.
• The financial crisis forced many banks and airlines out of business.
• Leveraged industries are also more prone to suffer from capacity or supply gluts in their industry or in a competing industry.
• Coal stocks suffered as a result of the discovery of natural gas supplies.
*See the Glossary for a definition of short squeeze.
3
Structural Issues in Industries
To improve is to change; to be perfect is to change often.
—WINSTON S. CHURCHILL
GREAT COMPANIES RESPOND TO CHANGE; however, changes in the marketplace can sometimes completely alter traditional business models and threaten the viability of once-successful businesses. The rise of the Internet and e-commerce broke the business models for many traditional industries, including newspaper and book publishing, brick-and-mortar retailers, and music and video distributors. Their model needed to change often and keep changing forever. Stocks of declining businesses can appear cheap based on historical performance; however, they can prove to be value traps if the decline continues for an extended period of time. They have no moat around their business.
In other cases, companies can suffer from poor growth prospects, loss in demand for their products, bad investments, and other issues specific to their own business situations. When a fast-growing company shows signs of slowdown, its valuation multiples shrink as the market begins to question the growth story and temper its growth expectations. Technology, consumer, and pharmaceutical sectors tend to contribute the lion’s share of growth stories and broken growth stories.
Value traps and broken growth stories can appear cheap for many reasons: cash on their balance sheet, recent peaks in their revenues and profitability, the support of a key customer, trough valuation multiples, and continued expectations for management to deliver good results. The investment case for such companies hinges on the question, “Has the business model changed for the worse and has it changed permanently?” Excess leverage, possibl
e write-downs on inventories or investments, and regulatory requirements can further accentuate issues with the business model. Cheap stocks can get cheaper—dirt cheap—and eventually become worthless.
Takeaway
Companies may suffer significant blows to their business model that may be irreparable. Their growth story may be broken as a result of disruptive products, competition, etc., or the value of their business may be on a structural decline.
Value Traps
Value traps are like fallen-angel stocks, whose glory days may not come back because of structural changes in the business or industry. Let me begin with my experience with value traps in two completely different industries: AIG (a multiline insurer) and Carpetright (the largest carpet retail chain in the United Kingdom).
CASE STUDY:
AMERICAN INSURANCE GROUP (AIG)
In 2007, I joined Swiss Reinsurance in their structured credit group. Our group worked with large investment banks to sell credit default swaps (CDS) on structured credit products and competed with both monoline insurers (e.g., MBIA, Ambac, FSA) and multiline insurers (e.g., AIG). In the summer of 2007, we saw the beginning of a credit crunch and suffered severe losses as the price of credit protection skyrocketed. On November 19, 2007, Swiss Re announced $1.2 billion mark-to-market losses on its $5.3 billion credit investments. Approximately $1 billion of the losses came from a 100 percent write-down of the asset-backed security (ABS)-collateralized debt obligations (CDO) portfolio. These investments were worth zero.
During the six months of this credit crunch, I gained immense insights into the financial sector. I could see that other monoline and multiline insurers would be forced to take similar mark-to-market losses on their subprime-related ABS-CDO investments. As per their August 2007 investor presentation, AIG had $64 billion of notional investments in CDOs with subprime exposure, including $19.4 billion of BBB-rated mezzanine collateral. They also had net exposure to $280+ billion corporate CDS, which was beginning to show signs of distress as well.
Most of these AIG investments were marked to model. In other words, they relied on their own optimistic housing market assumptions to estimate the price of their investments—unlike Swiss Re, which had marked down the prices based on low market prices for similar securities. If AIG were as aggressive in marking its investments as Swiss Re, their losses would be anywhere between $20 billion and $40 billion (15–30 percent of AIG’s market cap of $147 billion on December 31, 2007).
However, accounting treatment for these derivative transactions allowed AIG to not report them on its balance sheet. They were disclosed under special notes in AIG’s filings. An excerpt from the annual report said, “Notional amount is not a quantification of market risk or credit risk and the hedge is highly effective, while it uses the periodic dollar offset not recorded on the consolidated balance sheet.”1 AIG was trading at a historically low price-to-book (P/B) multiple of ~1.4 and appeared to be a value stock.
AIG seemed cheap based on its brand strength in traditional multiline insurance. However, AIG’s business model had changed with its foray into these off-balance sheet transactions in securitized products. Insurers like AIG earned a premium of 0.1–0.3 percent for insuring bonds, or 10–30 basis points per $100 of risky credit. In a stress scenario, AIG’s leverage from exposure to these products could significantly hurt their shareholders. AIG seemed like a value trap.
Monoline insurers, such as MBIA and Ambac, were in a similar position with even greater leverage of 50 to 100 from exposure to these products. They got the name monolines because they operated in one line of business, insuring municipal bonds. Monolines started in the 1970s by insuring municipal bonds which had rarely defaulted in the last 30 years. These insurers had steered away from their core business to insuring risky ABS-CDOs, which were much more likely to default. Securitized products, such as ABS-CDOs, had lower-quality underlying assets such as subprime, alternative A-paper (Alt-A), which did not have a long history of performance. These loans were much more likely to turn sour than municipal bonds and traditional insurance products.
These insurers seemed cheap based on the historical performance of their traditional business, but their risk of losses from significant leverage and the risks associated with their new securitized products business made them value traps. My short thesis on AIG and monolines landed me the analyst job at our long-short equities group in December 2007.
How Did AIG Play Out?
On February 11, 2008, AIG announced a material weakness in its investment portfolio following a dispute with its auditor, PricewaterhouseCoopers (PwC). PwC disagreed with the mark-to-model methodology used to price the company’s CDS contracts, forcing AIG to mark down its CDO portfolio. (Selling CDS on the CDOs was tantamount to investing in the CDOs.) The stock fell ~12 percent on the news, but it recovered the losses after two weeks.
AIG released earnings on February 29, 2008, announcing bigger losses on the CDOs. The head of AIG’s Financial Products group was fired. The stock fell 10 percent to $46.86 on larger-than-expected losses. Two months later, AIG announced a sale of 196.7 million shares at $38 and other equity and fixed-income securities to raise $20 billion and cover the impact of these losses. The stock was down another 30 percent by the end of May. It seemed that AIG might be able to navigate through tough times after raising this capital, but things got surprisingly tougher for AIG, leading to their eventual bailout by the Federal Reserve (“the Fed”) in September 2008.
Takeaway
While AIG seemed cheap on a P/B basis, its book value was inflated because it did not account for off-balance sheet liabilities from the CDS business. Because AIG could suffer losses on this protection well in excess of its book value, it was not a value stock based on cheap P/B.
More on the Financial Crisis to Better Understand the AIG Short Case
An excerpt from the U.S. Department of Housing and Urban Development (HUD) website says, “Typically, subprime loans are for persons with blemished or limited credit histories.” Lending to these risky borrowers grew from $40 billion in 1994 to $160 billion in 1999. Subprime lending got a shot in the arm from a new HUD regulation in 2000 that boosted government-sponsored enterprise participation in the subprime market. Subprime lending grew to $330 billion in 2003 as Freddie Mac and Fannie Mae purchased more than 50 percent of all subprime loans.2
In 2003, 58 percent of subprime loans were securitized. Origination volumes of Alt-A loans (for borrowers with less than full documentation) began to rise. Subprime lending grew to $600 billion in 2006, with 75 percent of the subprime market financed by private-label residential mortgage-backed securities. Subprime loans then accounted for 20 percent of total mortgage originations, and Alt-A loans accounted for another 13 percent. Low interest rates and poor underwriting standards increased the availability of loans, leading to high home prices and fueling growth in home equity loans (i.e., a second mortgage on the home). Rising home prices and unprecedented growth in subprime, Alt-A, and home equity loans flooded the secondary mortgage market with a slew of securitized products. While higher home prices were good as a collateral value, they deterred new buyers due to lower affordability.
New products, such as adjustable-rate mortgages (ARMs), offered low teaser rates for the first few years; however, rates were designed to increase by 4–6 percent after the reset of this teaser period. Continued deterioration in underwriting standards led to a variety of poor-quality loans, such as “liar loans” and NINJAs (no income, no job, no assets). Investor demand for such loans emboldened investment banks to keep large inventories of subprime loans. The bank stock index KBW Bank Index (BKX) hit an all-time high of $121.06 on February 20, 2007.
Beginning of the Subprime Crisis
New Century, the second-largest subprime lender listed on the New York Stock Exchange, announced on February 7, 2007, that it would restate its earnings and report a loss in the fourth quarter of 2006 due to rising delinquencies on subprime loans. Two months later, they filed for bankruptc
y, marking the beginning of the subprime crisis. Soon after, HSBC announced huge losses from its subprime unit in California. The contagion began to spread to secondary mortgage products, such as structured CDOs, SIVs, and other investment conduits. Banks that created and managed SIVs to make investments in secondary mortgage products were forced to consolidate these SIVs on the balance sheet and take massive write-downs. HSBC and Citigroup were the first victims. Monoline insurers were the next victims, from financial guarantees on super-senior ABS-CDOs.
Government’s Initial Response
In late 2007, Treasury Secretary Henry Paulson indicated that the government may not allow resets on ARMs, which could potentially force en masse default on a majority of loans issued in 2004 and 2005. The Fed started cutting rates in 2007 and bailed out Bear Stearns in March 2008 to allay market fears. The Fed opened the discount window—their tool to lend directly to banks during emergency situations—for a period of six months to calm down the markets.
Lehman Bankruptcy and AIG Downgrade
Subprime delinquency rates rose dramatically by the end of 2007. Both fixed-rate and ARM subprime delinquencies rose from 10 percent in 2007 to 20 percent by the summer of 2008. ARM subprime lenders began to reset rates in 2007 and sparked an increase in foreclosures. Foreclosures on homes financed by ARM subprime loans rose from 2 percent in the beginning of 2007 to 7 percent in the summer of 2008.