by Amit Kumar
The BPOP CFO raised red flags when he mentioned that he was flabbergasted as to why his accountants were asking for higher levels of reserves when BPOP knew its borrowers well. There seemed to be many reasons mentioned during the conference that justified the demand of the accountants to raise the reserve levels:
Table 8.2
BPOP snapshot of financials and key metrics
Source: BPOP SEC filings.
Puerto Rico had an overhang of large inventory of unsold housing, even though prices had not collapsed like the mainland U.S. market. Everyone was losing money in Puerto Rico, with the exception of probably one small investment bank.
At the time, 20,000 construction units remained unsold—a relatively high number—pushing the nonperforming loan level of the construction portfolio to a staggering 45 percent. The loan-to-value ratio on mortgages had risen to 100 percent from 80 percent at the time of origination. In addition to these core problems, BPOP stock had an overhang of $900 million in TARP equity and 29 million TARP warrants. While BPOP had reduced its reliance on wholesale funding in the last two years through a stronger deposit base and stood to benefit from a consolidation of banks in Puerto Rico, the stock seemed to be a value trap.
With NPA/equity at 94.6 percent, there was a very high likelihood that equity could be wiped out in the event of a worsening economy in Puerto Rico. Because banks are highly regulated entities and required to maintain threshold capital levels (Tier 1 capital, etc.), it was highly likely that BPOP would need to raise additional equity to strengthen its balance sheet.
FIGURE 8.3 BPOP capital ratios. Source: BPOP SEC filings.
How Did It Play Out?
BPOP shares traded below $3 per share for the rest of 2010 and briefly traded up to $3.5 per share in the first quarter of 2011. They reported a quarterly profit on July 20, 2011; however, the stock was down for the year at $2.56 per share. A week later, BPOP stock fell below $2 per share as S&P downgraded the U.S. ratings on August 5, 2011. The stock continued to slide, hitting a low of $1.12 per share on December 19, 2011.
Takeaway
Banks have significant financial leverage, which accentuates the impact of poor-quality assets. They are highly regulated entities and required to maintain threshold capital levels (Tier 1 capital, etc.). High NPA ratios can often force banks to raise equity to strengthen their balance sheet.
CASE STUDY:
AMAZON.COM (AMZN)
David Einhorn was critical of Amazon’s profitability at the Ira Sohn Conference on May 16, 2012. He said that Amazon had not grown its profits in tandem with sales and Amazon’s future is a riddle.4 Unlike most of Einhorn’s shorts, Amazon stock rose 25 percent over the next year after his announcement. Amazon may have seemed to trade at a high valuation; however, it was hard to question the pace and drivers of their sales growth—the factors that could sustain Amazon’s stock price momentum.
I had looked at Amazon as a potential short in 2010 and decided to pass because I could not find any clear issues with their business model. While Amazon did not have a retail footprint, their growth trajectory seemed strikingly similar to Walmart’s during their growth years. If Amazon could continue growth at a pace similar to Walmart’s, a short case for Amazon did not stand a chance.
Amazon’s net sales in 2009 stood at ~$25 billion, with a net income of ~$900 million. Walmart’s net sales in 1990 were ~$25 billion, with a net income of ~$1 billion. Walmart multiplied its sales by 16 times over the next twenty years at 15 percent compound annual growth rate (CAGR) to $400 billion and grew its net income 14 times to ~$14 billion. During this period, Walmart increased the number of superstores from less than 100 to 2,747, and the groceries category as a percent of Walmart’s sales increased from 18 percent to 51 percent. With $400 billion in sales, Walmart traded at 13–14 times its earnings.
While Amazon’s sales had grown at ~24.4 percent CAGR since 2000, the law of large numbers could slow down the rate of growth, as their sales had grown from a much smaller base of $2.8 billion in 2000 to $24.5 billion in 2009. If Amazon’s growth slowed down to 15 percent, it would take them twenty years to reach the size of Walmart. At 15 percent CAGR growth, Amazon’s sales would reach $100 billion in ten years and net income would reach $4 billion. If Amazon continued to fetch a growth multiple of 20 times the price-to-earnings ratio, their market cap would be $80 billion. Amazon’s market cap in 2011 was $80 billion.
FIGURE 8.4 Amazon sales growth from ~$2 billion to over $75 billion 1998–2013. Source: Amazon SEC filings.
FIGURE 8.5 Walmart sales growth from ~$2 billion to over $75 billion 1980–1995. Source: Walmart SEC filings.
It was easy to make an argument that Amazon was not a cheap stock. However, Amazon silenced its critics as it leapfrogged expectations by growing sales at 36.5 percent CAGR from $24.5 billion in 2009 to $61 billion in 2012, mainly through international growth. While Amazon generated little profits in 2012, as Einhorn pointed out, Amazon did not seem to face growth issues in the near future from competition or other factors.
In his 2012 letter to shareholders, Jeff Bezos, Amazon founder and CEO, noted the complaints on profitability: “Our heavy investments in Prime, AWS, Kindle, digital media, and customer experience in general strike some as too generous, shareholder indifferent, or even at odds with being a for-profit company.” He went on to argue that doling out just-in-time improvements is too risky in the modern fast-moving world and taking a long-term customer-centric view would ultimately align the interests of customers and shareholders.5
Bezos had been advocating this focus on the long term since 1997 and successfully delivered on his promise. Capital expenditures at Amazon continued at the rate of $2.5 billion to $3.5 billion per year at the expense of profitability, in line with Bezos’s mantra for success in the long term. Clearly, pointing to poor profitability and high valuations was not reason enough to short Amazon—even for smart investors—as the history of proven growth at Amazon outweighed profit concerns. A short case would need to clearly articulate why Amazon could face slower growth and identify near-term threats.
Takeaway
High valuation and poor margins are not always good enough reasons to short a fast-growing company. A CEO with a proven track record would attract loyal investors who are willing to overlook short-term issues and obfuscate short sellers.
CASE STUDY:
APOLLO GROUP (APOL)
Jim Chanos was an early short on the for-profit education sector at the Ira Sohn Conference in 2009. He argued that these companies derived 80–90 percent of their revenues from student loans backed by federal taxpayers—a business model that abused taxpayers’ dollars. A year later, Steve Eisman of Frontpoint Partners presented his short case on the same sector at the Ira Sohn Conference, arguing that for-profits claimed ~25 percent of the $89 billion of Federal Title IV loans, and these claims required greater scrutiny.
Apollo stock had fallen from the $60 per share range in 2010 to $46 per share in July 2011, after Apollo withdrew guidance citing declining enrollments and increased regulatory pressure on the for-profit industry. Apollo group shares yielded free cash yield of over 10 percent based on historical cash flow, and one of my clients asked me to take a look at it.6
While researching Apollo Group, the owner of University of Phoenix, I focused on their free cash flow, specifically to determine if the free cash flow seemed sustainable in the face of declining enrollments. This would be central to a bull thesis because it would allow Apollo to aggressively buy back its shares and boost its earnings per share.
An earnings sensitivity analysis showed that the stock was already pricing in a 15–20 percent decline in enrollments over the next two years. However, the stock was not pricing the risk to Apollo’s business model from the regulatory risks pointed out by shorts. High reliance on Title IV loans remained a major concern. According to Apollo’s filings, “University of Phoenix generated 88 percent of its cash basis revenue for eligible tuition and fees during fiscal year 2010 an
d 86 percent in 2009 from the receipt of Title IV financial aid program funds under the 90/10 rule.”
FIGURE 8.6 University of Phoenix enrollment trend, year over year percent change.
Source: Apollo SEC filings.
FIGURE 8.7 Apollo Group enrollment mix and operating cash flow.
Source: Apollo SEC filings.
Under the 90/10 rule, Apollo Group could become ineligible to participate in Title IV programs for at least two fiscal years if, for any two consecutive fiscal years, it derived more than 90 percent of its cash basis revenue from Title IV loans. Apollo stated that it was likely to exceed 90 percent in fiscal year 2012 due to the expiration of the loan limit increases relief in July 2011. If Apollo continued to exceed the 90 percent threshold in 2013, its business model faced serious questions. I agreed with the bears and recommended against buying Apollo.
Analyst Downgrades
Wall Street analysts cover a number of stocks and routinely upgrade or downgrade their stocks. These rating changes may not always be prognostic; for example, an analyst may choose to downgrade a stock after it falls 20 percent on missing earnings numbers. In such a case, the stock mostly prices the downgrade risk. However, if such downgrades result from a prognosis of fundamental issues related to accounting, competition, channel stuffing, capacity, executive turnover, etc., the stock merits a closer look at the issues. Such analyst downgrades may lead to good short ideas. I will cover some short ideas from a successful short-focused research firm in the next chapter.
Recap
• Well-publicized shorts become crowded trades. It is extremely hard to make long-term bearish bets on such stocks, even if you agree with the bear.
• Increased borrowing costs, short sale restrictions, and stock volatility are some of the key impediments to coattailing short trades.
• Long investors can underestimate and overlook risks with the investment. Close examination of these risks can generate short ideas.
• High valuation and poor margins are not always good enough reasons to short a fast-growing company.
• Analyst downgrades from prognosis of fundamental issues related to accounting, competition, channel stuffing, capacity, executive turnover, etc., may lead to good short ideas.
9
Off Wall Street
Two Decades of Successful Shorting
The main thing short ideas have in common is that their business model is not going to produce the sales and earnings that are expected by the market.
—MARK ROBERTS
An Interview with Mark Roberts
Mark Roberts left Fidelity to start Off Wall Street in 1990 to serve a small but growing hedge fund industry. Roberts found hedge funds to be the most dynamic (yet underserved) part of the investing business and saw a clear opportunity to write research for hedge funds. On May 1, 1990, he published his first piece titled “TCBY Is in Deep Yogurt,” and successfully sold it to hedge funds for $5,000 per copy. Since 1993, Off Wall Street has closed out 433 positions, with 343 winners and 90 losers—an impressive batting average of more than 80 percent.
His notable recommendations include the Enron sell report, which received praise at the Senate Enron hearings, particularly from Senators Joseph Lieberman and Barbara Boxer. During the Senate hearing, “The Watchdogs Didn’t Bark: Enron and the Wall Street Analysts,” Senator Lieberman praised Roberts’s variant view on Enron. He noted that Mark Roberts, unlike Wall Street analysts, had diagnosed key problems with Enron: shrinking profit margins, related party transactions, and poor cash flow and returns from recurring operations.1
I first met Mark Roberts in 2008 at his Cambridge office and was inspired to start my own research firm. I have remained in touch with him and discuss my own short ideas with him from time to time. When I reached out to him for an exclusive interview for my book, he generously agreed to share some of his past research work as well.
Off Wall Street’s short ideas have been based on a variety of reasons, such as accounting issues, business model issues, and competitive threats. I believe that the readers will greatly benefit from Roberts’s insight on researching short ideas and related short stories. I have included his past short ideas in this chapter, along with the following interview.
Q: How did you decide to start Off Wall Street?
I have an undergraduate and graduate degrees in French literature and art history. I joined my brother in a family business in the early 1970s to run the largest steel distribution company in New England. During the Carter years, we sold our steel businesses when the interest rates were very high. I separated with my brother to get involved in technology business and started the largest franchise chain of retail software stores. Retail software business was a passing phenomenon, and I sold out my interest in the business in 1984. I moved to New York, where I became interested in investing. I thought, wouldn’t it be nice if I could make money in the stock market and not have to go back to “real work”? But I was thoroughly unprepared for such a career. I began to look for a job where I could learn how to analyze stocks.
I met Mark Boyar at Boyar Asset Management, who was kind to offer me a job to write research in his publication “Asset Analysis Focus.” Mark did [me] a big favor because I was totally unqualified, except I was a good writer and had practical business experience. After a year, I moved back to Boston to write research for a brokerage house whose main client was Fidelity, and I eventually landed at Fidelity. During my one and a half years at Fidelity, I realized that hedge funds were the most interesting and dynamic side of the investing business. There was not much research for hedge funds because most research was long and nothing short, for which they had a clear mandate. I left Fidelity to write short ideas and peddle them to hedge funds.
Q: How did you come across your first short idea? How difficult was it to sell your first idea?
While I was putting together my business plan, I worked as a consultant for Seth Klarman at Baupost, where I learned a lot about value investing. At Baupost, an investor approached me because of my background in franchising. He asked me if I knew about TCBY enterprises. I started looking into the TCBY franchising chain and realized it was a can of worms. That became my first short idea and I published my first piece on May 1, 1990. At first, I used to give clever names to my research pieces and even put cartoons to make them look like The New Yorker, something like James Grant does today. My research was titled “TCBY Is in Deep Yogurt,” and I successfully sold it for $5,000 a copy to a few hedge funds.
However, I quickly realized that business model won’t work because it was too much effort to sell the research. I wanted someone to put me on retainer. Meanwhile, I was working on a second idea, Summit Technology, a photorefractive keratectomy laser company, which eventually went bankrupt after a long battle with me. While I was working on Summit, I managed to get a hedge fund to put me on retainer. My next idea was CompUSA. These ideas were well received and I picked up another retainer and I was in business.
Q: What drove Summit Technology to bankruptcy?
Summit Technology was overly promotional with an inferior laser. They tried to expand to other businesses, like laser centers, and they overreached. David Muller, who ran the business, drove Summit into bankruptcy by being aggressively promotional.
Q: How has your research style evolved over the last 23.5 years?
I actually think that nothing much has changed over these years. We are not doing anything too much differently, but probably doing it better with more experience and more staff. The only change through all the ups and downs is that we have become more risk averse. We have learned to avoid problems by avoiding certain kinds of potentially short stories. We have been burned by certain types of short ideas and we have lowered our risk profile.
Q: What are some of the reasons you would not short a stock?
Generally speaking, the dangerous short stories involve a long runway of sales growth. Investors can pay up for multiple years of sales growth in advance. Some of these
companies can keep growing for a good period of time as well. We tend to avoid companies with good growth track records and a long runway of growth.
Q: How do you determine the runway of growth for such companies?
We look at the potential market size and try to determine if the market does exist. If the company has a good growth track record and is well managed, it may also fetch high valuation; however, the high valuation does not matter.
Q: What do you see differently about short ideas and long ideas?
When we look at long ideas, we look at risk first. We try to limit downside on the long ideas and our first goal is not to lose money. Secondly, we look for stocks that are not well liked, where investor sentiment has changed due to missed earnings, where investors do not like the management or something else has changed. We are value investors on the long side.
On the short side, it is quite different. Clearly, shorting is an inherently risky business because the math works against you. As you know, you can lose multiples of your investment, but you cannot make more than 100 percent on your investment. On the short side, we are interested in limiting risk, but shorting stocks is inherently risky. We look for short ideas with high valuation where we feel we cannot get too blown away and we think that the valuation is arguably 30–40 percent too high, provided our thesis about the future of the business will play out the way we want.