Monthly Archives: June 2011

the LA Dodgers’ bankruptcy: strange stuff

June 30, 2011 By in baseball, hedge funds, Industry Analysis Tags: , , , , , , , , Leave a comment

the occupational disease

The occupational disease of securities analysts is that they analyze everything.  For instance, I have a friend that I worked with over twenty years ago.  One day, she came to me at work and said she’d been counting the steps on the flights of stairs in the subway station near our office and found that each flight was 13 steps.  Wasn’t that a strange number, she said, and what did I make of it.

The notable thing about this exchange is that we both thought of it as perfectly normal.  I was flattered that she had asked me.

the Dodgers

It’s in this same vein of below-the-surface interest that I’m viewing the recent entry of the Los Angeles Dodgers into Chapter 11 bankruptcy.  I don’t see any way for me to make money–other than perhaps bar bets–from finding out what’s going on.   But I can’t help myself.

how a Chapter 11 filing usually works

The company in question has a lot of long-term debt outstanding, which is not being fully serviced.  Trade creditors are not being paid, either.  Trade creditors threaten to start bankruptcy proceedings in court as a way to force long-term creditors to pay them off.  At some point, the long-term creditors get fed up at being nickeled and dimed to death and allow the bankruptcy to occur.

Management stays in place.  Long-term debt holders trade some portion (maybe all) of their debt for 100% of the equity in the firm that emerges from the proceeding.  Equity holders are wiped out; they receive nothing.  Trade creditors may or may not get paid, depending on the circumstances.

the Dodgers’ court case

I’ve glanced through the court papers. They don’t say a lot.

–They indicate that five interlinked companies are filing for bankruptcy together.  The names suggest that the overall ownership structure is complex and involves both corporations and partnerships.

–They also indicate that the Dodgers have a working capital problem and aren’t able to meet the June 30th payroll, either through the club’s cash flow or through borrowing.

–Secured creditors are not listed in the filing, only unsecured ones, like former ballplayers who agreed to deferred compensation (Manny Ramirez, at $20 million, is owed the most).

–The only thing the McCourt camp says about the overall debt situation is that it believes the filers have more than enough assets to satisfy secured creditors; total assets are $500 million-$1 billion; total liabilities are under $500 million.

What else do we know?

1.  According to the Los Angeles Times, Fox Sports has offered the Dodgers $1.6 billion for the right to broadcast Dodgers games for thirteen years after the current contract (also with Fox) expires in 2013.  A reasonable first approximation (read: good guess) is that the present value of the proposed contract is $800 million.  That’s just about the entire asset value of the baseball franchise.

Fox reportedly was willing to advance about half that amount (the numbers being reported vary) to McCourt/Dodgers.  Major League Baseball, whose approval was needed, rejected the deal as not being in the best interests of baseball.  Reportedly, this was because about half the advance would have been paid directly to Mr. McCourt to settle personal debts, leaving the Dodgers in a deeper hole than before.

2.  The Dodgers were unable to get a working capital loan from a bank.  The club was quickly able to line up $150 million in financing from a JP Morgan hedge fund once it was in Chapter 11, however.

The issue here is that in Chapter 11 unsecured creditors go the bottom of the list of entities to be repaid–and therefore may not get back a penny of what they’ve lent.  This suggests to me that the Dodgers had no unencumbered assets to use as collateral for a loan and that potential lenders who saw the club’s financials suspected that a Chapter 11 filing was imminent.

One possible explanation is being offered by Dodger Divorce, a blog written by Josh Fisher, an ESPN correspondent.  In his June 21st post, titled Mechanics, Mr. Fisher says basically that the revenue from parking at the stadium and from non-premium ticket sales go to other parts of the McCourt empire and not to the Dodgers.  Fisher estimates this cash flow to be about $80 million a year.

One other thing:  the interest rate the Dodgers negotiated for the financing is staggeringly high.    The simplified version:  $15 million in interest yearly, plus the Dodgers must pay back $150 million, even though they’ll only get about $143 million.

3.  Bankruptcy–in which equity holders virtually always lose everything–was Mr. McCourt’s best option.  That says something, doesn’t it?

One thing Chapter 11 accomplishes is to freeze litigation between McCourt and his wife over who owns the club.  And it may make that whole question moot, since Chapter 11 may well disenfranchise both.

At the same time, the bankruptcy allows McCourt to reopen the possibility of sale of Dodgers’ broadcasting rights.  It’s hard to imagine that the court would allow any money to be diverted for anyone’s personal use, though.  But who knows.

Stay tuned.  The court proceedings should be very entertaining.

one odd figure catches my eye

The obvious point of comparison is with another woefully managed franchise, the Mets.  In contrast to the Dodgers, the Mets have agreed to turn over the running of the franchise to professional baseball people and are negotiating to sell part of the team to replace what they lost by using Bernie Madoff to manage their money.

If I recall correctly, the Mets baseball team receives $60 million a year for broadcasting rights from SNY, the cable venture that the Wilpons own a share in.  But Fox is apparently offering the Dodgers more than double that for broadcasting rights to Dodgers games.  Hmm.

 

 

systematically important banks: BIS says “No, no!” to co-cos

June 29, 2011 By in Banks, hybrid bonds/contingent convertibles, Industry Analysis, Securities regulation Tags: , , , , , , Leave a comment

the BIS and “too big to fail”

The Bank for International Settlements, the unofficial rule setter for the world’s commercial banks, is in the process of making new guidelines to govern the behavior of systematically important (read: really big, or “too big to fail”) banks.

extra capital needed…

A couple of days ago it aired new regulations that would force the biggest banks to hold more capital to back a given loan than a smaller bank would need.  The bigger the bank, the more capital necessary.  And if a jumbo bank tried to become jumbo-er by adding net new loans, it would need even a higher level capital to back those.

The thrust of the rules is to create economic incentives for banks not to get bigger, or even to break themselves up into pieces, so that the potential failure of  one massive bank would no longer threaten to bring down a country’s entire financial system.

…through co-cos?  No, thank you.

During the discussion, the question arose as to whether the BIS would allow this “extra” capital to be supplied, not just by equity, but by  convertible securities (co-cos) as well.  The BIS said no.

why not

It didn’t supply reasons, but I think it’s easy to see why (before I go any further, I should warn you that I’m not a fan of gimmicky securities like co-cos, as you can see from this older post.  I may have gotten a little carried away when I was writing it, but I still believe what I wrote then.):

—bondholders and stockholders have different points of view about the issuers of the securities they own.  The former care mostly about collecting their coupon payments and getting their principal returned at the end of the bond’s life.  Shareholders want healthy growth of the enterprise, so that they get a higher stock price and greater dividend payments.  Shareholders tend to make waves; except in extreme situations, bondholders don’t.

If the idea of the extra capital is to have more people with a strong interest in preventing aggressive expansion of the loan book, you probably want to increase the number of professional equity investors with an interest in the bank, not replace them with bond fund managers.

—no one knows how contingent convertibles will work in a crisis.  In particular, if the conversion provisions of a co-co are triggered and the security becomes an equity, bond managers who own it (and whose contracts with customers doubtless bar them from holding stocks) will be forced to sell.  Having lots of stock in a troubled company being dumped on the market and forcing the price down probably won’t make the bank’s situation any better.  If it prevents the firm from raising new equity, it could make things considerably worse.

—a flaw in the terms of existing co-cos has been detected. Commercial banks and their investment bankers want the co-co conversion trigger to be based, as is the Lloyds TSB issue I wrote about in my original post, on the level of equity shown in the bank’s accounting statements.  We’re currently seeing in the EU financial crisis an example of the extreme unwillingness of governments and politically connected banks to write down the value of impaired assets (in this case, Greek government bonds).  But it’s the process of loan writedown that forces the co-co conversion into new equity.

In other words, in a future crisis, governments may not permit their banks to acknowledge that their capital is impaired.  So the conversion of co-cos may never be allowed to take place–meaning that the institutions will be seen to be even more leveraged than thought.

 

 

 

there are hard-core digital gamers, lots of them

June 28, 2011 By in Industry Analysis, Stock ideas, Technology, Video games Tags: , , , , , , , 2 Comments

shrink-wrapped software–yesterday’s story

In the heyday of shrink-wrapped video game software, the dominant companies, like Nintendo, Electronic Arts and Activision, had three key advantages other than engaging original content. None were well understood by Wall Street.  They were:

–these firms owned/controlled the strongest distribution networks

–like other entertainment forms, fans restocked their inventories with titles in the newest format.  So they enjoyed a big surge in sales growth every four or five years as a new generation of game devices was introduced, and

–perhaps the key competitive advantage, the industry spawned a group of intense users of their products, maybe 300,000 strong in the US and an equal number abroad.  These hard-core gamers could be counted on to buy almost any well-crafted game.

hard-core users

How important was this group?  If you figure that the wholesale price of a shrink-wrapped game would be $40, and that it would be a hit only in the US or only abroad, then you could be very confident of generating revenue from a good game of about $12 million from the hard-core group.  Until the past few years, when game development costs spiraled up over $20 million, that meant that a well-made game would be highly profitable even if no casual gamers bought it.

social gaming

Enter simple games, cheap to develop and delivered either through social networking sites or through cellphones.  My assumption, and that of Wall Street, I think, has been that these gamer players are by and large casual fans who dabble but don’t get very involved in game play.  Maybe it’s just that the games are relatively simple and don’t require the lightning reflexes most hard-core shrink-wrapped gamers display that fosters this belief.

It turns out, however, that that’s not so, at least according to a recent survey by market researcher NPD.  In fact, there is a large group of hard-core mobile and social networking gamers.  These gamers bear more than a passing resemblance to their hard-core console gaming counterparts.  For example:

–avid console gamers spend 18 hours a week (yes, that’s right) playing; their digital counterparts spend 16 hours

–hard-core console players buy 5.4 games a quarter; digital gamers buy 5.9.

One big difference between the two groups is size.   There are presently about twice as many obsessed console gamers as there are mobile/digital ones.

A second is dollar purchasing volume, although the disparity may not be quite as high as it seems at first.  At $50 each, hard-core console gamers spend just under $1100 a year on games.  Their mobile/digital counterparts lay out only a tenth of that.  But console gamers’ net outlay can be far lower than the gross, depending on how many of their games they resell, either privately or through video game stores.

investment implications

The real question on the table, if you think there’s a chance (as I do) that social gaming will develop along the very lucrative lines of console gaming, is how to make money from the idea that digital/mobile gamers aren’t as “casual” as they may seem.  Using the shrink-wrapped game industry as a model, I think one should look for companies that:

–control distribution

–can charge by the device for use, and

–are able to attract large numbers of hard-core gamers who provide a steady stream of recurring revenue–whether by buying game downloads, microtransactions or advertising.

Ideally, this would seem to mean finding social network companies that have their own game subsidiaries.  As far as I’m aware, the only publicly traded ones exist in Japan.  The worry about companies like DeNA and Gree (I own both) is whether they will be able to exporting their very successful domestic market model to the rest of the world.  All the Japanese firms are trying, and aiming either at China or the US.  But it’s too early to tell.

 

more problems from Greece

June 27, 2011 By in Banks, Current Market Thoughts, Industry Analysis, Recent Market Action, Securities regulation Tags: , , , , , , , , , , , , 3 Comments

Last week, the new Greek finance minister tried to renegotiate the bailout plan the country had agreed to with the rest of the EU, by suggesting weaker austerity.  After that overture was rebuffed, the Greek government–the one that revealed the prior administration had been falsifying the national accounts for years, triggering the current crisis–was found to be preparing legislation for a necessary parliamentary vote that incorporated the weaker austerity measures the EU had rejected.  Apparently, Greece was planning to ratify the weaker terms and then present the rest of the Eu with a fait accompli.

Now it appears the Greek government may not have the votes to pass any austerity plan.

It’s hard to know which side to have sympathy for–Greece, which merrily used its EU membership to run up bills it knew it never could pay, or the rest of the EU, which fudged its membership criteria to get  Greece in and which seems to have known what Greece was up to, but just underestimated the extent of the fraud.

I think the EU has two objectives:

–it wants to avoid having its banks forced to write down the Greek government bonds they’re stuffed to the gills with; and

–it wants to avoid setting a precedent that Ireland and Portugal, if not Italy and Spain, could reasonably expect to follow.

Greece, on the other hand, seems to fully appreciate the maxim that if you owe $20,000 to the bank you’re in trouble; if you owe $200 million, the bank is in trouble.

Today’s development is that large French banks have “voluntarily” proposed to roll over much of their Greek debt for thirty years, while reducing interest and reinvesting a large part of the coupon payments into new Greek sovereign debt.

A wildcard in these proceedings is credit default swaps–how large, who owns them and what are the precise terms.  History tells us that Continental European banks tend to be the ultimate “dumb money,”  which would lead to the surmise that there are a lot of CDSs and European banks are on the losing side in case of default.

The burning question, then, would be about the terms.  Let’s say the EU as a whole reaches an internal agreement about Greek debt that it believes solves the problem without requiring the banks to write down any of their Greek bondholdings.  What happens if the rating agencies declare that despite this legal paper shuffling, the solution is in fact a default.  Does this trigger the credit default swaps?  My experience says “Yes” is probably the correct answer, but I don’t know.

It seems to me we’re entering the final innings of the game.  The outcome is still in doubt, and no one is leaving the ballpark.

From an equity investing point of view, I think the negative effects of an ugly outcome to the Greek situation will be felt mainly in European financial companies and in firms doing most of their business in Europe.  A good portion of the ugliness has to already be discounted in global stock prices.  Still, this is an issue to watch carefully to make sure the ripples don’t spread far wider than one might expect.

two famous investment professionals, two embarrassing moments: Paulson and O’Neill

June 26, 2011 By in Current Market Thoughts, emerging markets, Getting financial advice, Recent Market Action, Stock ideas Tags: , , , , , , , , , , , , , 2 Comments

Every well-known person in the investment world, from Warren Buffett to Donald Trump (including DT may be like calling Paris Hilton a hotelier), is some combination of talent, drive, self-promotion, and right-place, right-time.   Normally, a highly crafted public persona is all the public is permitted to see.  Occasionally, though, an event occurs that gives us a chance to see behind the veil.  Two such moments have caught my eye recently.

Jim O’Neill and the A-list

1.  Jim O’Neill invented the term BRICs while he was the chief economist at Goldman.  He’s now the head of the firm’s wealth management division, and one of the celebrity columnists the Financial Times’ has grouped together under the rubric “A-List.”

In an A-List contribution this week, Mr. O’Neil wrote that a contact of his in Japan had just tipped him off to the existence of Renesas, a semiconductor company whose loss of production capacity in the March earthquake/tsunamis is a key factor in subsequent supply chain disruptions throughout the world.  Had he known about Renesas, he would have taken a less optimistic view of near-term global economic growth.

It’s hard to know what to say.

First of all, Mr. O’Neill apparently doesn’t read the newspaper–at least, neither the Wall Street Journal nor the Financial Times.  In both, Renesas was quickly identified as being a key element in many supply chains and as having lost a very large amount of production capacity due to the March 11th disaster.

Also, in the early 1980s the Japanese technology industry took a disastrous wrong turn by deciding to concentrate its efforts on commodity semiconductors like memory, rather than to branch out to areas like logic, which have higher design content.  This saddled Japan with a bunch of MUs rather than INTCs or TXNs.  It also left the country vulnerable to price competition from emerging economies–first Korea and later China, when it designated semiconductors as a critical focus for industrial development about a decade ago.  You’d think even a macroeconomist might know about that.

Finally, even if we say that it really isn’t part of Mr. O’Neill’s job to know much himself about technology or Asian industrial development, you’d hope that someone in the wealth management division would be up to date on stuff like this.  There’s apparently no communication between Mr. O’Neill and whoever it is who’s actually steering the ship.

Strange.

the story of Sino-Forest is another bizarre one.

2. John Paulson runs the hedge fund Paulson & Co, which has $38 billion under management.  The firm made its reputation by betting heavily against the housing market from 2007 on.

If we take the assets under management and assume a 2% management fee, then the firm is generating annual revenue of about $700 million, even without considering the 20% of profits it potentially earns.  Subtract $100 million for marketing and administrative expenses–I’ve just plucked that number out of the air.  I think it’s much too high, but that doesn’t matter.  What’s left over is $600 million, which pays for the investment research prowess of the firm’s professionals.

That’s a ton of money.  It’s more than all but a handful of investment organizations globally have to fund their research organizations.  It’s more than most buy-side firms have; its more than most sell-side firms allocate to research.  It’s enough the Paulson should be better informed about the areas he chooses to invest in, and the securities he elects to hold, than anyone else on the planet.

I don’t know the Paulson managers, but it seems their expertise is in the US, the global bond market and in financial stocks.

Why, then, would they buy 14% of Sino-Forest, an obscure Chinese forest products company, using 1%+ of their clients’ capital to do so?  And why would they know so little about the company that as soon as short-seller Muddy Waters issues a negative report on the company they sell the holding, taking a $100+ million loss (over $500 million, based on the opening stock price this year).

I’ve glanced at the Sino-Forest financials.  They look ok to me.  They’re audited by a major accounting firm, which gives them an unqualified opinion (in other words, a clean bill of health). The Wall Street Journal reports that Paulson looked at the financials, too, listened to management conference calls, had follow-up phone conversations with management and had an analyst visit the company in China.

For a $600 million a year research operation, that’s not doing much.  And it’s certainly not enough when dealing with emerging markets.  After all, too, that’s probably what the average investor with Bernie Madoff did.

Paulson also seems to have ignored a number of red flags.  In particular:

–although it’s a mainland Chinese company, Sino-Forest isn’t listed on any mainland stock exchange, nor is it traded in Hong Kong.  These are the natural destinations for a Chinese firm.  Maybe Sino-Forest couldn’t meet the listing requirements, or withstand the informed scrutiny of local institutional investors. That would be my first assumption, and a major source of risk in the stock.

–the forest products industry in Asia is highly politically charged and has had, to my mind, more than its share of stock market scandals.  So it’s not the first place I’d look to invest.

–ownership of anything in China is, in my opinion, a slippery concept.  It takes a lot more than listening to management to figure out what’s going on.

–China has no structural advantages in  forest products vs., say, Indonesia, Brazil or even New Zealand.So Chinese forest products isn’t even the best of a bad lot.

–the Sino-Forest story, as I gather from press reports, is that the company uses semi-legal means to acquire access to forest lands, and sells the wood it harvests through other semi-legal channels.  Not a great concept.  When you think about it, if the company makes its money by manipulating the laws to the disadvantage of its suppliers, what makes you think the company won;t do the same thing to you?

If we figure that the Paulson research budget was spread evenly over the positions it holds based on their size, then the company spent over $20 million since acquiring the stock in 2007 on the portion of the portfolio that Sino-Forest represented.  This was the best it could come up with?

My hunch is that selling the stock when it did was the right thing for Paulson to do.  But selling also seems to imply that Paulson knew nothing in-house that would refute the Muddy Waters’ research.  In other words, Paulson didn’t know much at all about its close to billion dollar position.

On rare occasions, stuff like this happens, even to professional investors.  Once you realize you’ve made elementary mistakes, cutting your losses is the best option.  But it’s still extremely embarrassing.