Friday, August 29, 2008

From the comments - believing in Magic

Bondinvestor (whoever they may be) left a reasoned piece in the comments. It disagreed with my position on Magic outlined in this post.

I like people that disagree with me and I would love BondInvestor to get in contact...
bondinvestor said...

MTG, PMI, RDN and even ORI and GNW are all buys.

the best way to think about MI conceptually is as a bridge loan. if home prices collapse or the borrower loses a job in the first 3 yrs, the loan goes bad. otherwise, it's a solid investment.

the critical question to getting these stocks right is the level of cumulative defaults on 06/07 flow business. 05 is bad, but not catastrophic. the bulk business has already been written off. therefore, the only lingering uncertainty is what the level of defaults on 06/07 will be.

here is how to answer the question. MGIC's total claims paying resources (investments + collateralized reinsurance recoverable + the present value of installment premiums) is roughly $13B. that is 24% of the total risk in force. the subprime debacle (for which you were right to short the stock) will end up costing them about 8% of risk in force on a cash basis. that leaves 16% of risk in force (roughly $9B) available to satisfy claims on 06/07 business.

that leaves roughly 2/3rds of the claims paying ability ($9B) available to satisfy losses on flow business. the problems are concentrated in 06/07. the total risk in force on 06/07 is roughly $20B (may be high). so in order for MGIC to go bust, roughly 4/10 06/07 vintage loans must go belly up.

so how likely is that? well, if you obtain copies of MI annual statements, you can recreate loss triangles by accident year. they will show you that, over time, the cumulative default rate on a flow book is around 2%. it also demonstrates that by year 3, somewhere between 30 and 50% of lifetime defaults have been recognized.

you can use the loss triangles and historical seasoning curves to develop a rough model of what lifetime defaults will be on the 06/07 books, given the experience to date. they suggest cum defaults in the range of 10-15%. now, 06/07 only accounts for 40% of the flow book, so the total contribution to loss frequencies will probably by somewhere in the 4-6% range.

this analysis suggests that, far from being insolvent, there is actually tremendous value here that has been unrecognized by the market. the stocks are 10-20 baggers over a 5 year time frame.

that being said, i think all parts of the capital structure of these companies are interesting. for those who are intrigued by the analysis, but scared to own the equities, i'd point to RDN and PMI holding company debt. you are getting 13-25% YTM (face value 55-80% of par) for a senior interest in the holding company that owns the regulated MI subsidiary.

My objections to this are that I am not sure that the bulk book is fully written off, nor am I sure that the book in 2007 will look anything like any previous year - as the last refinance of my rolling loans was onto Magic's book.

My further objection is that statutory capital deficiency happens way earlier than this - and stat capital deficiency will close the business as per TGIC.

But I remain to be convinced otherwise - and I have had a go at reconstructing Magic's loss triangles (with help from a reader) and we got not very far (probably because we gave up early).

If Bond Investor would like to share with me I would much appreciate it.

Thanks.

John

Thursday, August 28, 2008

Ripping off two charts – Moodys mid year residential mortgage backed security performance update

Moodys has published a short report entitled U.S. RMBS Mid-Year Performance Update: H1 2008. This post will shamelessly rip off a two charts from it. The entire report is absolutely consistent with the data summary that I have been giving on this blog. Its really annoying to do all this work eyeballing hundreds of MBS pools and then find a really neat 8 page paper that does it all for you…

I would quote the report more broadly except that I do believe that they have some copyright issues. You might find someone to kindly send you it. Or you can buy it on the web here at an outrageous price. [If the price were one tenth the price listed here I would recommend it…]

But given that I do not own the research I will limit myself to a review.

The review goes through different types of collateral and different loss curves. I will not go through all of them for copyright reasons.

The first picture I will extract is cumulative losses on Subprime RMBS by year of origination. This is one of those “no hope” charts because losses are trending upwards fast with no obvious signs of stopping.



The picture makes it look like 2005 looked nasty and stabilised (something I have been saying for a while) but that the 2006 and 2007 pools have no hope. The 2007 pool is worse than the 2006 pool. [This should sound familiar to regular readers of this blog.]

The second chart I think makes the story a little clearer:

The 2005 pool had a delinquency hiccup – but is now back in the fold. I think we can safely estimate losses on 2005 subprime pools now and they are not that bad. The 2006 pools looked like they were stabilizing – and I blogged to that effect. The data in the last month however has given me some pause – hence my depressing thoughts post. Any light at the end of the tunnel in the 2007 pool looks like an oncoming train.

The same trends exist for Alt-A generally – but I am not going to extract all the data from the Moody’s report as I respect their copyright. I should say with Alt A the 2007 pools are not modestly worse then 2006 pools they are immodestly worse.

This is consistent with my rolling loans thesis. The loans could never be repaid but they could be refinanced. They kept getting refinanced to later pools and the last pool contained the detritus.

The 2006 Alt A delinquencies also looked to be stabilising but with a hiccup in the last month. The hiccup in the last month was worse than the subprime pools. 2005 is right back in the fold as with subprime.

Moodys then break the Alt-A into conventional adjustable rate mortgages (ARMs) and Option Arms. It seems there is almost no last-month kick up in delinquency for conventional arms but a big kick-up for option ARMS. This suggests the problem is Option ARM resets and confirms the analysis of many of the people who have commented on my blog. [Dear readers – a lot of you are very smart - indeed the great joy of this blog is what it delivers to my inbox.]

They then do cumulative losses on jumbos. Similar trends – but there is a kick down in last month delinquency. Does anyone know why jumbo credit looks to have got better very quickly. I have no idea.

They then do subprime Closed End Seconds and HELOCs (something I have studied at great detail). There is MUCH more stabilisation in CES – even the 2007 pools appear to be stabilising, however HELOCs, which are generally more prime than CES are not showing the same stabilisation.

Also with PRIME CES the 2005 pools look awful, with subprime CES the 2005 pools look good. In general 2005 mortgages are only bad if they are prime. [That should confuse most of you - but I think its because in bad poosl the really bad loans rolled out into 2006 and 2007 pools but prime people did not roll their loans.]

I would go further than the Moodys report and note that more generally the better the credit the worse the trend, or the worse the credit the better the trend. But nonetheless the Moody’s report is accurate, neat, short and should be got by anyone with decent access. The expensive source I link to is probably too expensive – but that is your choice.

If you are really maniac you can take this data and recalibrate Bill Ackman's open-source model of the bond insurers. I have done that - but my estimates are probably not much better than anyone else who does it with some integrity.

J

Wednesday, August 27, 2008

Reducing post frequency

I started doing this blog with the idea of two posts per week, but it somehow morphed into one per day. I had a lot to say and somehow had found an outlet.

I was however chewing considerable human capital - having developed ideas over a long period of time. [I do not generate ideas as fast as I have put out posts.]

So it is time to face reality and drop the post frequency to one per week - somewhere near the level that I consider sustainable.

If given a choice between quantity and quality I will chose quality. I hope my readers are not too disappointed.

J

Tuesday, August 26, 2008

Counting and double counting – a comment on losses and accounting standards esp FAS 159

Warning: Wonky accounting alert. Don’t bother reading this if you are not interested in wonky accounting issues

Last post I asked if anyone had a decent list of the losses so far realised. The problem was double counting – which is pervasive if you do this sort of thing. Aaron of the HF implode meter (who is usually acute about these things) made a comment which misses the point entirely – but it required a little thinking – and I admit I missed it at first. Here is his comment –

Then again, some gains aren't really gains, like the gains counted on the financial co's own collapsing bonds. Sure, they could buy those back, if of course they weren't already in hock for cash...

I will get back to Aaron’s comment later…

The gains from debt forgiveness in tax

In the US if you have a debt forgiven that is income for ordinary tax purposes. It sounds quirky – but its not.

If a bank lends company A $100 and they haven’t paid it back then the bank has clearly lost $100. Company A has lost $100 too – but that loss ultimately did not come out of Company A’s pocket – it came out of the bank’s pocket.

Unless you are very careful though the tax law is going to allow both company A and the bank to claim $100 in tax losses. That is a good way for the tax system to collapse because Company A could lend to Company B who could lend to Company C and so on and a single $100 loss could theoretically produce thousands of dollars in tax losses. Those losses could wipe out the tax base of any respectable country.

Fortunately (or unfortunately depending on your point of view) the people who draft tax law in most countries are not that stupid. [I started my career doing this stuff at the Australian Treasury – so it was once an area of expertise for me. We had terrible trouble in those days with cascading tax losses in trusts…]

What most countries do is that they have provisions against “loss cascading” or the like. They fix this up ultimately by taxing gains from debt forgiveness.

When it is finally clear that Company A in my above example will not have to pay back the said $100 it gets assessed on a “gain from debt forgiveness”. The idea is that if you borrow $100 and don’t have to pay it back that is a gain of $100. It offsets the loss of $100 above.

Gains from debt forgiveness in GAAP

The accounting rules do the same thing. When Conseco (a company I knew extremely well) completed its bankruptcy it compromised a few billion in debt (mostly preferred shares). The $2 billion or so it did not have to repay was a gain for accounting purposes – and the “New Conseco” published accounts reflecting that gain.

There were similar adjustments for the removal of Conseco Finance from the balance sheet.

Done properly these gains will remove double counting of losses from the accounting system. If you add up the losses made by Conseco and the losses made by the preferred stockholders without assessing the gain from debt forgiveness you get double counting.

Accountants rightly get concerned about double counting. But the accounting answers questions in a way that might be misleading to investors.

Typical question:

How much did company X lose doing that stupid lending:

Two possible answers:

(a). $2 billion dollars

(b). $500 million dollars [but we have ignored the $1.5 billion more borne by debt holders but ultimately forgiven].

The accounting answer is technically correct but doesn’t really get to the guts of why the lending was so stupid.

Now accountants are often pedants and investors should be practical people. And I have never seen a place of more vociferous disagreement than the disagreement over FAS 159.

FAS 159 says (roughly and in this context) that if a company is using mark-to-market accounting on its assets and its liabilities it should also use mark-to-market accounting on liabilities whose market value is affected by their own credit worthiness.

To take a real example, Ambac is a bond insurer which is showing in its accounts about 7 billion in derivative losses. During the last quarter they booked about a billion in gains because the market assessment of their credit worthiness went down and so the market value of Ambac’s derivative liabilities went down. Had the accounts been measured a month later Ambac would have booked over a billion in losses on the same transactions. The result was that during the last quarter Ambac’s profit was approximately equal to its market cap. It will reverse that profit this quarter.

That profit of course was meaningless for an investor assessing Ambac stock. [I own Ambac stock - purchased at $1.30.] I don’t think the FAS159 movements make any difference in assessing Ambac. I ignore them. I think Ambac’s results were not great but they showed stabilisation which was enough given the stock price.

David Einhorn – a man considerably smarter than me - put it this way in a speech (“FAS 159: Profiting From Your Own Demise”)

If your own credit spread widening counts as revenue...

... and you pay compensation as a percent of revenue ...

... the most profitable and lucrative day in the history of your firm will be...

THE DAY YOU GO BANKRUPT!

Ok – so let’s ignore FAS 159 assessing Ambac, investment banks and the like. And the results are much worse than the headlines. The underlying of the investment banking industry sucks.

When you shouldn’t ignore FAS159

In once sense what FAS159 does is it brings forward the gains from debt forgiveness. If the price of repurchasing Lehman’s debt falls then Lehman has made a gain which it is hard for shareholders to profit from. If Lehman goes bust and has its debts forgiven Lehman has also made a gain – but it’s the same gain recognised on a mark-to-market basis as its credit worthiness collapses. [Its also hard for the shareholders to benefit from this gain.]

This is of course a problem with mark-to-market accounting generally. Mark to market accounting brings forward profits. It also brings forward losses. It’s a darn stupid way to run an investment bank when you pay cash on profits that are not realised but just bought forward. It’s a darn stupid way to invest when the profits being bought forward are the profits from total collapse and debt forgiveness.

But if you are adding up losses then the gains from debt forgiveness are a necessary part of ensuring that you don’t double count.

Likewise – in a mark-to-market world if you are adding up losses then the gains on FAS159 are a good thing to include.

Now let me bring back Aaron’s comment:

Then again, some gains aren't really gains, like the gains counted on the financial co's own collapsing bonds. Sure, they could buy those back, if of course they weren't already in hock for cash...

Aaron bought this up in the context of double counting. But this is the one context when those gains really are gains. Aaron is thinking like an investor – and I love him for it. But just for once I wanted someone thinking like an accountant.

J

Monday, August 25, 2008

Does anyone have a good estimate of losses recognised to date?

In this post I talked about the Bloomberg list of losses recognised to date. I even gave a spreadsheet here.

The problem with the Bloomberg list is that it doesn't include lots of entities that have booked losses. It excludes for instance insurance companies (AIG does not appear and they are almost exhibit A in big companies gone mad). It also excludes GSEs, mortgage insurers, bond insurers, hedge funds that have lost money and the like. It does not include Residential Finanial Corp (GMAC), or any of the imploded subprime issuers.

Even then recognised losses come in above 500 billion.

Does anyone have a complete list?

Even better - does anyone have a complete list with spreadsheets speculating on obvious problems of double-counting. For instance if someone is mark-to-market on a bond insured by MBIA then they are probably showing a loss. MBIA is showing losses. There is of necessity some double-counting here. [Such an adjustment will be rough...]

Hoping for help.

---

The reason is that I want to work out how far down this credit crisis really is. The Bloomberg list is misleading for that task.


Thanks.


John Hempton

Sunday, August 24, 2008

This week's bank collapse

FDIC Friday - and another bank was taken over by the FDIC. The number so far is relatively small - because the bad mortgages are not in the banks. (The bad mortgages were sold to the securitisation market as this blog has made clear several times.)

Anyway this bank collapsed due to commercial real estate. That matters as the CR loans are in regional banks.

Calculated risk has a nice post observing that this collapse - whilst small - is probably going to be representative of this cycle. I have short positions in a few CRE exposed banks.


J

Saturday, August 23, 2008

Berkshire risk aversion - a follow up

Thanks for all the people who followed up on this. I think we can safely conclude that the factual background in the original post was correct. Mostly GEICO sells household insurance as an AGENT for Travelers. It may or may not take on umbrella policies through other Berkshire subsidiaries.

I really appreciate the confirm from my readers. Disagreements about facts should be easily sorted [provided of course I remain adequately circumspect about what constitutes knowledge]. I expect disagreements about interpretation to be much more difficult.


This is a follow up from my Berkshire risk aversion post.

I have received an email from a finance guy who has a homeowners insurance policy attached to his GEICO auto policy. In some states (notably Florida but also possibly other states) this policy may actually be written by Berkshire - but mostly it is a policy whereby GEICO acts as an agent.

Can people with umbrella and homeowners insurance policies from GEICO tell me who the underwriters are for the homeowners component - and what State they are in. Also useful would be the number of years that they were policy holders.

Thanks.


J

Some depressing thoughts

The position of this blog has been stated several times. Subprime credit is a pig-in-the-python. It got bad very quickly – and it will get better very quickly. The losses on some pools (particularly loans originated in early 2007) will look implausibly large – but 2005 pools will be much tamer.

Prime credit by contrast is deteriorating at an increasing rate and there is no obvious end in sight. It is not able to be modelled. It is very scary.

The thinking behind that is detailed here and here.

Wish it were so simple. The prime credit is looking every bit as bad as all that. But the trend in subprime credit is also less clear than a month ago. In some pools (not all) the trends are less good. Short dated delinquency is rising in some places. Losses look a little larger than they might have looked a month ago. The improvement trend was three months old. And one month does not a cycle make – but my level of comfort is falling.

Friday, August 22, 2008

Risk aversion – Berkshire style

Chatting with a well known blogger yesterday who made the (common) assertion that all insurance companies eventually go to zero. The world – it is argued – is full of surprises – and if you take even a small chance of blowing up then eventually your number will be up and you will blow up.

Then our protagonist argues all insurance companies take a small chance of blowing up – and eventually there number is up.

This I think is too simplistic. I think some types of insurance have realistic (albeit small chances) of blowing up. Others (rarer) do not.

Take for example household versus auto insurance.

Household insurance is subject to super-catastrophes. Big earthquakes are theoretically possible anywhere (although vanishingly unlikely in some locations). Hurricanes happen as well and the 250 year storm seems to happen fairly regularly.

But auto insurance is not generally subject to super-catastrophes – cars drive away from hurricanes and bounce around in earthquakes. The only catastrophes that regularly affect cars are hailstorms – and the biggest hailstorm claim in insurance history happened in my home town (check this out about 3 inch hailstones).

Has anyone noticed that Berkshire does auto insurance (GEICO) but does next to no household insurance (it writes a few policies in Florida which it tries regularly to cancel – but regulatory rules force it to renew).

If you write household insurance there is the mega-storm that could bankrupt you. Buffett has said that storms substantially bigger than Katrina are possible. Buffett won’t do it even though GEICO could probably – if it chose to be – become the most profitable household insurer in the US.

Also take life insurance

Any student of human history knows that plagues – real devastating plagues which wipe out very large numbers of young healthy people happen irregularly but often enough to be a real risk.

The insurance industry have gotten quite complacent about them – because the only new plague of our lifetime did not affect life insurance companies. HIV is – within the West anyway – primarily a disease of gay men, IV drug users and haemophiliacs. None of these people were regular buyers of life insurance. Had HIV been a disease of middle age men who visit prostitutes because they don’t get it at home it would have selectively targeted the core market for life insurance companies – and every life insurance company in the Western World would have gone bust. In Thailand HIV morphed into such a disease – but surprisingly or not life companies have not been heavily impacted in the West.

Note that if you think plagues are inevitably going to happen then most life insurance companies have a finite life.

Notice that Berkshire does not insure mortality at a primary level and does almost no mortality reinsurance. Swiss Re is the dominant player in that business. Buffett has the capital and the expertise and he does not play.

By contrast annuities are not subject to plagues or shock risk – they can cost you money as life extends due to medicine – but that looks like a continuous process – not a shock process like plagues. Berkshire will write you an annuity online (see http://www.brkdirect.com/)

Again a small risk of blow-up and Buffett will not play.

The Gen Re debacle

The terrorist attacks of 2001 were a true shock to Buffett. General Re was taking a chance of complete wipe-out and had the attack been nuclear there is a fair chance that Gen Re would have folded. Buffett wrote about that in a special letter to shareholders – see this quarterly report which differs from other Berkshire quarterlies as it contains a shareholder letter...

Buffett criticises Gen Re for writing risks that could have been lethal. His company broke the first Buffett rule of risk aversion. [Despite the joke that the rule is don’t lose money – the rule really is don’t blow up. Buffett is quite prepared to lose 5 billion on a single policy.]

Note that almost none of this involves mathematical models. It involves stress tests. And the stress is not a selected 99% probability stress test – it’s a complete implausible debacle stress test.

And when most people do stress tests the process is “well what happens if property prices drop 30%?” and someone says “what if they drop 40%?” and the response is – they can’t go that far.

The Buffett question for a risk manager is “what if they drop 70%?” You might say it can’t happen. One word: Japan.

I know how you live by the Buffett stress test with a diversified portfolio – when I open a fund it will live by that test. (No intolerable concentrations of long only banks or life insurance companies.) But I have no idea how you run a life company by the Buffett stress test. I don’t think you can. That doesn’t mean the businesses shouldn’t exist – but they probably never be considered completely safe. And a portfolio investor should never be totally weighted there even if that is their field of expertise.

John

Thursday, August 21, 2008

Market puzzles - Fannie Mae and Freddie Mac

Crank your mind back to 2006. You are a run-of-the-mill hyper bear (as I appeared at the time). Someone told you that in 2008 there would be a crisis at Fannie Mae and Freddie Mac. The Secretary Treasury would ask for and get an essentially unlimited pool of government money to ensure that the senior debt of those institutions did not fail. [He said nothing about the preference shares or common.]

What would you have thought would happen?

To me it seemed obvious. The senior debt would now be as safe as Treasuries and the spread on the senior debt would come in to maybe 30bps from crisis levels.

But the whole scenario would be very bad for the US dollar because the implied debt of the Federal Government just rose an awful lot.

So what did happen?

Well the spread on Fannie and Freddie securities widened not narrowed, and the US dollar got strong.

The widening of the spreads on Fannie is either irrational or a rational bet that the US Government cannot be trusted to honour its promises. But if it is the latter why is the USD strong?

What is happening now is every bit as weird as what happened in the bubble.

Wednesday, August 20, 2008

I blame the one child policy: explaining the brokers part II

This is going to look very tangential – but I know someone who is a demographer. And just as I think everything in the world comes down to banks (because that is what I understand) he think that everything in the world comes down to demographics.

He has a better chance of being right than me.

And the biggest thing going on demographically in the world is the one-child policy.

Asian style industrialisation and current account deficits

Pretty well every Asian tiger economy has gone into large current account deficit whilst it industrialises. Savings rates may have been 20-25 percent of GDP but the investment rates were higher. The high levels of current account deficits have left those countries vulnerable to current account crises – and they got their crisis in 1997.

China is different. The investment rate is higher in China then elsewhere. Chinese statistics are abnormally patchy – but Chinese investment may have got has high as 40 percent of GDP. (You can see this in the performance of various capital equipment exporters in the West.)

And yet China never managed to get a current account deficit. That is really strange.

We have investment of 40% of GDP and a large current account surplus. This means that the average Chinese person is saving maybe 46 percent of their income. Now once when I had a very high income I saved that much. But we have poor people saving half their income.

I ran this idea past a Chinese friend of mine (now resolutely middle class). He remembers his family saving money furiously whilst he was hungry for lack of food.

Question: what is it that makes them save so much?

Answer: fear.

In most poor jurisdictions there is a simple method of saving for old age. Have six kids. They will have a few each and if you survive there will be lots of grandkids trained to respect their elders who will look after you.

This does not work in China. Indeed if everyone has only one child there will potentially be four grandparents per grandchild. You can’t expect to get supported.

In most developed countries people trust the system to look after them. Mutual funds are well developed, there is often a social security savings net, and a lot of people (perhaps falsely) expect to sell their house and live in clover.

But in China you can’t trust that either. So you save. And save. And save…

Chinese families save because they have a gun at their head. They save an amount that is almost incomprehensible by Western standards.

I point this all out because there is a lot about excessive spending in the west (and the spending has been excessive). But for all this excessive spending there has to be an area with excessive savings. Japan has it. Petrodollars have it – but the big incremental excess savings of the last five years has been China.

And for that I blame the one child policy.

I am going to give Mr Bernanke a plug here. Before the crisis started Ben used to talk about excess savings in the world. He figured the bad lending in the US happened not because people were venal or stupid in the US – but that there was just an endless supply of investable funds because the world had excess savings.

I think he was right. Go look at a Japanese bank now and you still see excess savings. We discovered that we can’t lend them endlessly in America without substantial credit losses. But that doesn’t mean the excess savings aren’t there.

It is a strange reversal to blame bad lending on the people in China who wanted to take no risk with their savings – but it is the reversal that interfluidity made in one of the best blog posts of recent times. It’s a reversal I believe in too.

My thesis - which will be expanded in future posts is that the brokers have become the intermediaries between this endless demand for products to save in (China, Petrodollars etc) and the endless willingness of the profligate in the West to spend. What they do is - through their trading, their securitisation and through other things they turn the complex financial instruments of the West (mostly but not entirely debt) into vanilla instruments that the Chinese and petrodollars want to buy.

How they did that intermediation will be the subject of the next couple of posts – but it begins to explain why they got so big. This is the biggest demographic feature of the world and the brokers made themselves front-and-centre. (They may not have even understood what they were doing - but that is also subject of another post.)

Indeed how they did it altogether and its implications are for later in this series.



John Hempton

Tuesday, August 19, 2008

Rick's rats on its clients

I gather the kiss-of-death for any brothel owner is to blow confidentiality. You do that once - and nobody much has any incentive to keep you in business.

The kiss of death for a "adult entertainment venue" is much the same. So it is with great interest I read this extract from the 3Q earnings release for Ricks - a listed consolidator of strip joints:

Eric Langan, President and CEO, said: "Both our internal growth and expansion by acquisition programs continue on course and we are looking forward to a strong performance at Rick's Cabaret Minneapolis in our fourth quarter, which should benefit from the Republican National Convention in early September." He noted that the company's cash position increased to approximately $13 million at the end of the quarter due to strong cash flow and a recent capital raise.

Are RICK's executives ratting on the Grand Old Party? Is this sensible?

In the mode of Fox News: "We report - you decide".

I might turn up at the next conference call to ask the poisonous question: how much did turnover in Minneapolis go up around the convention? But only after the obligatory congratulations for a great quarter guys...

John

Rick’s Cabaret – a Gentlemen’s Establishment with a private jet


This blog does not usually comment on small caps – but following Jeff Matthews I couldn’t resist. Ricks Cabaret is a listed consolidator of strip joints. Yeah – you read that right. The business consists of renting crappily constructed barns on the edge of towns (Houston, Vegas etc) and getting gals to jiggle their silicon around. They do own a fine-dining strip joint in NYC.

Despite having compiled an index of the price of hookers in various Eastern European locations I don’t usually hang around these businesses. I had never heard of Rick’s before Jeff’s post.

The stated premise for Rick’s Cabaret is that being a listed company gives Ricks (RICK:NASDAQ) access to capital and hence provides an exit for the thousands of strip club operators throughout the land. This of course ignores the other exits that Jeff Matthews points out (busted for prostitution, non payment of taxes etc).

But let’s take them at their word and look at the accounts as given. Here is the balance sheet:

CURRENT ASSETS:


Cash and cash equivalents

13,191,087

Accounts receivable


Trade

1,339,413

Other, net

722,868

Marketable securities

2,225

Inventories

1,706,544

Prepaid expenses and other current assets

975,067

Total current assets

17,937,204



PROPERTY AND EQUIPMENT:


Buildings, land and leasehold improvements

44,031,599

Furniture and equipment

11,463,950


55,495,549



Accumulated depreciation

-7,288,117



Total property and equipment, net

48,207,432





OTHER ASSETS:


Goodwill and indefinite lived intangibles

60,272,095

Definite lived intangibles, net

1,322,111

Other

761,753

Total other assets

62,355,959

Total assets

128,500,595





LIABILITIES AND STOCKHOLDERS' EQUITY




CURRENT LIABILITIES:


Accounts payable – trade

912,190

Accrued liabilities

4,390,849

Current portion of long-term debt

1,561,244

Total current liabilities

6,864,283



Deferred tax liability

16,278,165

Other long-term liabilities

508,579

Long-term debt, less current portion

28,877,816

Long-term debt-related parties

1,260,000

Total liabilities

53,788,843



COMMITMENTS AND CONTINGENCIES




MINORITY INTERESTS

3,359,595



TEMPORARY EQUITY – Common stock, subject to put rights (461,740 and 215,000 shares, respectively)

10,935,020



PERMANENT STOCKHOLDERS' EQUITY:


Preferred stock, $.10 par, 1,000,000 shares authorized; none issued and outstanding

--

Common stock, $.01 par, 15,000,000 shares authorized; 9,272,237 and 6,903,354 shares issued, respectively

92,722

Additional paid-in capital

52,807,479

Accumulated other comprehensive income (loss)

-11,123

Retained earnings

8,821,839

Less 908,530 shares of common stock held in treasury, at cost

-1,293,780

Total permanent stockholders’ equity

60,417,137



Total liabilities and stockholders’ equity

128,500,595



Now I am a dopey sort of guy – more used to bank balance sheets than strip joints. But there are a few things that are odd about this one.

The first is that there is over 60 million in goodwill on the balance sheet. That is 60 million paid to owners in excess of the value of couches and other fittings. That is a lot of goodwill for strip joints and leads you to the conclusion that if you want to be a multi-millionaire forget hedge funds – start a strip joint and sell it to RICK.

Indeed despite selling considerable common stock in unregistered sales to institutional investors the company manages to have almost no net tangible net worth. [The cash flow statement shows 27 million raised from sale of equity in the quarter – but I can find only one SEC 8K for about half that amount.]

The second thing that jumped out at me was the large deferred tax liability. The deferred tax liability of 16.2 million.

My first reaction was whoa – a deferred tax liability happens usually because profit for GAAP purposes is substantially higher than profit for tax purposes. This could be accelerated depreciation or some other tax incentive (though why the IRS/congress might give tax incentives for strip joints is beyond me) or it might just be that the company is declaring income for accounting purposes but not for tax purposes. There is of course a problem with faking your income up – which is that you tend to have to pay tax on the phoney income – unless you tell something different to the IRS.

In the quarter the prima facie tax was over a million but the payments were just over half a million. There is no large current tax liability to note – so there is prima-facie suggestion of overstating GAAP vis taxable income. Indeed the cash flow statement benefits from 632 thousand being added to the deferred taxes during the quarter… This does not surprise me – but it is not the main reason that that there is a large deferred tax liability. This company peculiarly tax effects the goodwill purchased – a treatment I have not seen elsewhere – but then I am used to looking at financials. [Anyone known why you would do this?] To quote:

Included in the Company’s deferred tax liabilities at June 30, 2008 is approximately $14,400,000 representing the tax effect of indefinite lived intangible assets from club acquisitions which are not deductible for tax purposes. These deferred tax liabilities will remain in the Company’s balance sheet until the related clubs are sold or impaired.

This led me to think that the company might be doing something very strange like buying the clubs and not the corporate structures that the clubs reside in. That indeed would be sensible because it would absolve the acquirer from unpaid taxes and penalties (criminal and otherwise) that might live with the old owners. That might give a peculiar GAAP treatment of goodwill. And indeed they are – as this 8K shows . If there is any accounting expert here – can you explain this.

But this still gives us a residual of 1.8 million of deferred tax liability that comes from another purpose. This implies GAAP income of about 5 million more than cumulative taxable income over the history of the firm. I will make the point that this is roughly the half cumulative profit of RICKS. When in doubt (and where I can’t see a good explanation for deferred tax liabilities) I tend to prefer the income people report to the IRS than their stated income. (Maybe that is something I just learnt in the mortgage market!)

Now the premise for listing this thing is – I presume – access to capital. But you got to wonder the extent to which a bank or for that matter typical financial market type might lend money to a strip joint whose tax accounts don’t match their GAAP accounts. Well for the most part they don’t lend that way. Indeed almost every strip club they consolidate they do with high interest vendor finance. This is typical:

On November 30, 2007, in connection with the acquisition of Miami Gardens Square One, Inc., (see Note 9), the Company entered into two secured promissory notes in the amount of $5,000,000 each to the sellers (the "Notes"). The Notes bear interest at the rate of 14% per annum with the principal payable in one lump sum payment on November 30, 2010. Interest on the Notes is payable monthly, in arrears, with the first payment due thirty (30) days after the closing of the transaction, which occurred on November 30, 2007. The Company cannot pre-pay the Notes during the first twelve (12) months; thereafter, the Company may prepay the Notes, in whole or in part, provided that (i) any prepayment by the Company from December 1, 2008 through November 30, 2009, shall be paid at a rate of 110% of the original principal amount and (ii) any prepayment by the Company after November 30, 2009, may be prepaid without penalty at a rate of 100% of the original principal amount.

Most the long term debt is pretty short term – 30 November 2010 won’t get them to a time when bank lending standards drop enough. So they better have the cash when they get there. And that is not the only "long term debt" on the books.

Indeed access to capital looks questionable when the CEO has to personally guarantee corporate debt:

In connection with the acquisition of the real estate in Dallas related to the acquisition of Hotel Development Ltd., on April 11, 2008 (Note 9), the Company issued a $3,640,000 five-year promissory note (the "Promissory Note"). The Promissory Note bears interest at a varying rate at the greater of (i) two percent (2%) above the Prime Rate or (ii) seven and one-half percent (7.5%), and is guaranteed by the Company and Eric Langan, the Company’s Chief Executive Officer, individually.


Come to think of it – this company also purchased its private jet on hock:

In February 2008, the Company borrowed $1,561,500 from a lender. The funds were used to purchase an aircraft. The debt bears interest at 6.15% with monthly principal and interest payments of $11,323 beginning March 12, 2008. The note matures on February 12, 2028.

Hey – the interest rate on a private jet (presumably secured by the jet) is almost 8 percentage points better than the interest rate on a strip joint secured by the strip joint. Impressive.

Summary

So what have we got?

  • A company in a seedy business usually infiltrated with the sort of people who you would not want to have marry your daughter.
  • A company whose tax returns do not match their GAAP accounts
  • A company with no obvious access to capital and with a lot of debts that mature quite shortly and pay high interest rates,
  • A company who has no reason to be listed but manages to buy a private jet

People own this stock? Search me as to why…

That this is listed and retains a market cap over $100 million tells me that this market has a long way to fall. I shorted a token number last night.

A positive: the company has a code of ethics

I can’t be all negative.

Rick’s must be the only strip joint with a public stated code of ethics. You can find it here. However at Rick’s ethics tend only to apply to financial matters. The code is also only applicable to the following persons:


1. The Company's principal executive officers; 2. The Company's principal financial officers; 3. The Company's principal accounting officer or controller; and 4. Persons performing similar functions.

I will leave it to your imagination what other unethical behaviours might happen at a strip joint and who might perform them.

I wonder if you can think of any ethical violations that might involve the private jet.

I thought you could.

John

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.