Home Capital Group - 2013 Second Quarter Update

Home Capital Group recently reported yet another strong quarter.  In the second quarter, adjusted EPS increased 15.6% from a year ago, and first half results were higher by 16.9%.  At 23.6%, return on equity remained high.  These stellar numbers weren't the result of deteriorating credit quality, however: non-performing loans were just 0.31%.  In addition, Tier 1 and total capital ratios remained very high.  As a result, Home Capital Group was able to increase its quarterly dividend from $0.26 to 0.28, an 8% improvement.

The company predicted good times to come, as well.  In Q2 and in July, demand increased for all of HCG’s products.  Fortunately, none of the prominent disasters – acts of god and of man – will materially affect the firm.  The company's loans in Quebec are only advanced in the major centers, so the train that exploded didn't damage any of its customers' property; there was little lasting damage from floods in Toronto; and few, if any, houses in Alberta were abandoned, despite heavy damage to household items (in total, about 20 people asked for a one month deferment on mortgage payments).  Home Capital Group won’t even have to set aside any additional reserves due to the calamities.

On its conference call, management addressed the short position that was initiated on HCG’s stock in May, largely as macroeconomic bet against Canadian housing.  Over many years, shorts sellers have held an average of 800 000 shares (out of 45 million), but the total recently jumped sharply to 5.5 million.  The CEO expressed hope that it was the firm's solid fundamentals that has pushed up the stock in recent weeks, but suggested that the wild rise in volume over the past few days may have been short-sellers covering their positions before month end (management cautioned that they merely have anecdotal evidence that the increase in volume is the result of a short squeeze; their theory is not based on the more solid stuff of regulatory filings).  In any case, the stock is now at an all-time high.

CEO Gerald Soloway is one of Canada's finest executives, but he is now well into his seventies, leaving investors to wonder how long he'll lead Home Capital Group.  In response to that very question from a private investor - it's not surprising that this all-important question was posed not by a near-sighted analyst, but by a far-seeing shareholder of the business - Soloway said that he'll “probably be around a few more years.”  In fact, he noted that his mother is still in good health at 98, leaving greedy stockholders to hope for more than just a few more years from the genetically fortunate chief executive.  If not, he also shed light on what will happen when he's gone: President Martin Reid will become CEO.  Indeed, he is already deeply familiar with all aspects of the company, in case he's required to step in on short notice. 

Overall, the company logged another fine quarter, and is very likely to do well in the near - and in the more distant - future.

 

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Uralkali and the Potash Industry

The Canadian government scotched BHP Billiton's proposed takeover of Potash Corp in 2010, largely due to the mining giant's plans to withdraw from Canpotex, the marketing arm through which Canada's producers sell and distribute their products.  The Saskatchewan government feared that a weakened Canpotex would mean a weakened price for potash, reducing royalties and income taxes for the province.  Today, the potash world saw that those fears were indeed valid.

Potash producers in Russia and Belarus have sold over 40% of the world's capacity via BPC, an institution similar to Canpotex, until Uralkali, a large Russian producer, abruptly announced that it will withdraw from the marketing body.  Instead, the company plans to market its own products, with an emphasis on maximizing volume, rather than withholding supply for a better price.  The company itself acknowledges that this move could reduce potash prices by 25%, to around $300 a tonne, at least in the short-term.  The share prices of all publically traded potash producers instantly fell by 15-25%. 

In the long-term, the supply-demand equation is likely to remain favorable to producers: in fact, $300 a tonne pricing will render any greenfield capacity uneconomic, and will reduce the number of proposed brownfield expansions that go forward, as well.  Interestingly, Uralkali itself has confirmed that it will put one of its own expansions on hold because of the move.  At the same time, lower prices will increase volumes, eventually raising the price of potash.  In addition, an industry where only three sellers - Canpotex, a smaller BPC and a stand-alone Uralkali - account for 70% of capacity remains a heavily consolidated industry (there's additional, though less visible, consolidation, as well, since Potash Corp holds significant sway with the company’s that it holds minority interests in, all of which operate outside of the main two marketing bodies).  

Still, the industry's future doesn't appear as bright today as it did yesterday.  If the marketing arrangement is permanently weakened, the average price of potash is likely to be lower than it otherwise would've been, and will crash harder in down markets than it has in the past, a dismal fact of life for producers of most other commodities.  Not only will producers be less profitable, it will force them to hold more cash - or take on less debt - than they would have under the status quo, which will increase a range of opportunity costs.

 

There are still many unanswered questions.  For one: Why?  It's possible that Uralkali is merely maneuvering against its Belarusian partner, due to reports that one or both parties have sold product outside of the arrangement.  Indeed, Uralkali appears no better off in this brave new world of its own making.  Its stock, too, fell by about 20%, and even selling at all-out capacity, the company predicts flat earnings, suspended its stock buyback, and, as mentioned, put at least one planned expansion on hold.   

Economists often use the classic "prisoner's dilemma" as a model to help explain - and predict - how players in this sort of situation will behave.  Uralkali is behaving in a way undreamed of in this formulation: it "squealed" on the others, but did so with no benefit to itself.  The prisoner’s dilemma assumes rational people making informed, disinterested decisions, however.  In this case, Uralkali may be attempting to correct a perceived lack of fairness (experiments show that people sometimes act counter to their own interests in the name of fairness) or it could simply be behaving foolishly.  Or the company may in fact be acting rationally, after all, with the explanation to be found not in an economics textbook, but at the poker table: this could be a bluff.

In any case, the industry appears less attractive than it once was – although it’s also more appealingly priced.  

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Potash Corp - 2013 Second Quarter Update

Potash Corp's second quarter was somewhat weak, and the softness is expected to continue for the remainder of 2013.  Indeed, EPS fell from $0.99 (as adjusted) to $0.72 in the quarter, and full-year guidance was lowered to $2.45-2.70 from $2.75-3.25.  However, some perspective is in order: even at the low end of that range, the company's return on equity will still be around 20% for the year, despite steadily growing assets, as its capital expansion continues, and moderate amounts of debt (an immoderate amount of debt reduces equity, and artificially boosts ROE).

At about 56 million tonnes, global shipments of potash are expected to be in line with last year.  However, because it's requiring a lower price to keep volumes steady, it cannot be denied that the market has weakened since last year.  Realized potash prices fell significantly in the quarter, from $433 to $356, an 18% drop.  Nitrogen and phosphate prices fell, as well.  Also contributing to the weak second half forecast is the lack of a potash contract with China, which will stall sales in the third quarter, though CEO Bill Doyle predicts an agreement will be forged before the fourth quarter.  In addition, currency headwinds are affecting results: a weaker rupee is part of the reason Indian demand has been soft (the major cause remains a domestic subsidy that punishes potash purchases relative to nitrogen), just as a weaker real has offset some of the strength in Brazil.  In the latter case, because Brazil is a major exporter, the economics roughly balance out, since a weaker real means higher US dollar prices for goods sold.

While the softness in the potash market has lingered longer than many investors and analysts had expected - and may persist for the short or even medium-term - the industry's long-term strength remains intact.  People must eat.  In fact, the latest estimate of how many people are going to be eating in the decades to come was recently revised upward, from 10 billion, to a staggering 11 billion, by 2050.  While eventually there will be greenfield supply to meet growing demand, little is likely to come on-stream over the next decade.

Potash Corp shares trade for under $40, but the company's stock market investments are worth $8 per share.  Even after adding back a little over $3 per share in debt (net of cash), the "all in" cost of a POT share is $34-35.  This means that Potash Corp shares are trading at just 13-14 times 2013 earnings, using the mid-point of the newly announced guidance.  Happily for shareholders, management announced a $2 billion share repurchase that will retire up to 5% of shares outstanding over the next year.  This may be increased next year, management noted, as capital expenditures fall, and the already significant dividend could be upped, too.  Investors may want to follow the company’s lead and buy some Potash Corp stock at today’s low prices.

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Leucadia National - 2012 Letter to Shareholders

The end of an era at Leucadia National was announced late last year and made official earlier this year when shareholders voted in favor of a merger with Jefferies, a leading mid-sized investment bank.  Alas, the long-time duo at Leucadia's helm recently penned their final letter to shareholders.  Warren Buffett's annual letter is the gold standard in the corporate world, but Ian Cumming and Joseph Steinberg's co-written communication is not far behind.

This year's piece strives to do two things: make the case that the new incarnation of the company will be a success, and recap what's happened over the past three and a half decades.  Cumming and Steinberg met Rich Handler, Jefferies' CEO and the incoming chief executive of Leucadia, more than 25 years ago, and have been doing business with him ever since.  Jefferies returned an exemplary 22% per year for the 23 years ending in 2012.  Importantly, not only did Jefferies survive the recent financial crisis, it flourished, using the upheaval as an opportunity to almost triple revenues between 2008 and 2011.  Put simply, Jefferies is in sure hands, and it’s likely that Leucadia is too.

Rather than merely discussing the year that was, though, the CEO and President recap their 35-year run, which investors would be wise to read.  Starting at a small firm, ironically named Carl Marks, they navigated booms and busts, invested in a wide range of businesses, suffered some failures and hard luck, enjoyed some great good fortune and came through it all far ahead of where they were at the beginning.

Leucadia's future will almost certainly not be as dazzling as its past.  There's an unfortunate Catch-22 in investing: every year of above average gains makes it more difficult to outperform the market in the future, because increased size shrinks the number of potential investments.  In 1979, Leucadia's book value was $22 million; by the end of 2012, it had grown to $6.8 billion (and now stands at $9.8 billion).  Cumming and Steinberg note that good investments have become harder to find these past few years, but blame increased competition from hedge funds and private equity, rather than the constraints of being an elephant.

Still, there's a good chance that Leucadia 2.0 will be able to outperform the market for years to come, though by a narrower margin.  Handler and number-two Brian Friedman will likely continue their very fine work at Jefferies, and Leucadia's handful of long-serving senior executives, minus only the retired Ian Cumming, remain on board.  It's worth noting that Leucadia has successfully navigated the pitfalls of global investing, rather than focusing only on the US.  This brings many risks, but also greatly increases the pool of possible investments, which should somewhat counteract the "Elephants-can't-dance" problem.  Now may not be a bad time to buy, either, since Leucadia's share price is trading at less than book value.

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Costco - Culture and Competitive Advantage

An enduring competitive advantage is a must in any would-be investment.  Generally, there are just a few kinds of "moats" including a low-cost position, high switching costs, high barriers to entry and network effects.  In rare cases, a corporate culture can be included on this list.  Part of the reason investors ought to be wary of investing in a company based on its culture is because it's inherently difficult to measure, particularly for outsiders.  Nearly all companies insist in public that they have a one-of-a-kind culture, and the loyal, motivated staff that goes with it, but usually it's not true.  In addition, while a winning culture only exists if it has spread throughout an entire organization, it takes just one imperious, foolish or unethical CEO to destroy it, so even if it exists today, it may be gone tomorrow.

A recent BusinessWeek article makes a compelling case that Costco belongs to the very short list of companies with a culture so favorable to employees that it gives the company a competitive advantage, and is so ingrained that it's almost certain to endure over many decades.  In general, and unlike many of its competitors, Costco sees workers as an asset to invest in, rather than a cost that must be reduced.  (Costco's unique culture also includes a genuinely customer-friendly approach, and a commitment to keeping costs low that’s double-stitched into the company's DNA, but this particular article focuses on employee relations.)

In the US, Costco pays workers an average of nearly $21 per hour, almost three times the minimum wage and about twice what most notable competitors pay.  In addition, the company's health care package is far more attractive than what rivals typically offer.  In fact, many competitors are cutting workers' hours to below 30 per week, the threshold at which Obamacare would force them to offer coverage.  The company insists that its generosity isn't charity, but is motivated by bottom-line results.  Not only does a generous approach lower turnover and training costs, the company notes, it increases loyalty and productivity.  There's much truth to this claim.  Turnover is a mere 5% for workers who've been with Costco over a year, and a vanishingly small 1% for executives.  These saving indeed hit the bottom line: net income was $1.7 billion in the year ended 2012, up 33% from 2008, despite a stagnant economy.  

However, it's clear that there's a moral element to Costco's approach.    The CFO acknowledges that the company could make more money if wages were lower by a few dollars an hour, but says simply "We're not going to do it."  In short, the company simply believes that it's the right way to behave.  Jim Sinegal, Costco's long-time CEO and head culture-maker, recently retired.  This represented a rare occasion where, if handled poorly, the company's principles could have been undermined.  It didn't happen.  The new CEO believes the same things as his predecessor.  It doesn't hurt that the board includes Berkshire Hathaway's Charlie Munger, who, along with Warren Buffett, has been instrumental in building one of the business world's most unique and impressive corporate cultures.

While its culture is likely to give Costco an ongoing edge over its brick-and-mortar rivals, a long-term competitive threat exists online.  Amazon and similar firms have largely cut out workers, since they've cut out the physical retail channel altogether, and sales over the internet are growing significantly faster than in-store buys.  However, the faster growth is happening from a very small base, and Costco's large scale will allow it to offer low-priced wares online just as it does in the physical world.  In summary, Costco has a wide, shark-infested "moat" that's likely to ensure stellar long-term performance.  Currently, the stock is trading at a designer price, not at a discount, but Costco possesses all of the other elements of a superb investment.  

Source:  www.businessweek.com/articles/2013-06-06/costco-ceo-craig-jelinek-leads-the-cheapest-happiest-company-in-the-world

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A Summary of James Surowiecki's "Boom or Bubble"

Warren Buffett has noted that two highly important data points have a gravity-like effect on the stock market: the price/yield of bonds, and the ratio of corporate profits to GDP.  He remains bullish on stocks, explaining that they are attractive compared to bonds.  In the past, Buffett would likely be cautious about the second number, though, given that corporate profits now stand at over 10% of GDP, far higher than the 6% it has averaged in the past.  Yet he remains upbeat on the value of stocks, and James Surowiecki explains why.

In "Boom or Bubble," Surowiecki explains that three secular shifts have boosted corporate profits, and why those inflated earnings are here to stay.  First, the average corporation paid a tax rate of nearly 50% in 1951, over 30% in 1965, but now pay only 20% or so.  As corporate tax rates have fallen almost everywhere in the past few decades, any movement from here will almost certainly continue in a downward direction.

Second, the denominator - US GDP - is no longer as relevant as it was in the past.  Due to globalization, a third of corporate profits now come from abroad, compared no almost nothing a few decades ago.  Moreover, the mature US economy will grow at a significantly slower pace than the economies of the developing world, so the non-US portion of profits is sure to grow over time.

Third, the decline of unions combined with a sluggish job market has led to a much diminished labor force.  For years wages have risen slowly, if at all, and every dollar not spent on salaries and benefits boosts a firm’s bottom line.  Even as the labor market strengthens, Surowiecki suggests, increased sales will likely counteract any pressure from squeezed margins.

Anticipating the predictable response - that people always claim that "This time is different" as bubbles inflate - Surowiecki argues convincingly that this time is indeed different.  Wary investors should step off the sideline and into the game, because US stock markets are likely to keep setting records for years to come.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Home Capital Group - 2013 First Quarter Update

Amid a weakening housing market, Home Capital Group recently reported adjusted EPS that grew 19.1% in the first quarter of 2013.  Over the same time frame, Canadian home sales fell 15% year over year, though prices have increased modestly.  Despite the doom-and-gloom predictions in the media, HCG sees a fairly balanced relationship between supply and demand, however.  Sales trends have improved in the early second quarter, and new listings have increased as well, while prices have remained fairly flat.  Overall, management sees no bubble in Canada's housing market.  

The company's return on equity remained high at 24%, though that figure has been falling somewhat in recent quarters.  Still, it stands at about twice the level of the average North American business, and the company is able to redeploy the vast majority of its earnings at that level.  In addition, non-performing loans remained low, despite the usual upward blip in the first quarter, due to customers that tend to be recovering from Christmas expenses and seasonal layoffs.  Since customers’ average Beacon score is improving, this trend is likely to continue.  CEO Gerald Soloway reaffirmed full-year 2013 guidance, and pledged that if he ever doubted Home Capital Group's ability to deliver on it, he would say so.

Mr. Market, however, isn't impressed.  In fact, HCG's stock has swooned by more than 15% from its recent peak, with much of that fall occurring over only a few recent trading days.  Several prominent investors are short the stock - a remarkable 23% Home's shares outstanding were held by short sellers as of May 14 - mostly as a macroeconomic bet that Canada's housing market is overvalued.  While it’s likely that home prices are overvalued by 10%-15%, it’s unlikely that Canada will see a US-style crash.  After all, 70% of Canada's aggregate home value is equity, a significant proportion of home owners have fixed rate mortgages, the jobs market has grown slowly but steadily since 2009, and regulators have taken responsible measures to prevent excess.  

Even if Canada's housing market falls harder than expected, it's unlikely that Home Capital Group would suffer adverse consequences.  The company has a long history of careful lending, and has avoided risky areas of Canada's mortgage market, such as condominiums and high-priced neighborhoods.  As a further safety net, HCG insists on meaningful down payments, and its borrowers tend to have significant equity in their homes.

Assuming growth at the low end of its guidance – the company has given a range of 13%-18% for the year - Home Capital Group is currently trading at just 7 times 2013 earnings.  There's no guarantee that the stock can't fall further, but investors should keep in mind both of Ben Graham's two most important ideas.  First, the aforementioned Mr. Market is there to serve patient investors, not to frighten them.  Second, the lower the price of a stock, the higher the margin of safety - which offers both downside protection, and upside opportunity.

My original investment analysis of Home Capital Group is here.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.