I’ve been on forced hiatus due to issues relating to a trip to Cuba, a woman named Carla and a small golden statue of significant religious value. I won’t bore you with the details.

Now that I’ve been released …err… returned to work, I’m on my way to the preeminent fixed income structured finance (FISF) conference; the American Securitization Forum (ASF). For those outside of the business, the FISF brought you such fine investment products as Collateralized Debt Obligations (CDOs), Subprime mortgage backed securities, Liar Loan mortgage securities, Commercial Mortgage Backed Securities (CMBS) and synthetic version of the same.

After the colossal market meltdown which lead to the bursting of the credit bubble and implosion of several small countries, the ASF held its 2010 conference in Washington DC as a sign of contrition and to let congress know we’ve learned our lesson and don’t need pesky laws regarding risk retention. In 2011, ASF ventured to Orlando because the business is family friendly and gave Rep. Garrett the forum to espouse his hatred for all things government especially the President, Fannie Mae, and Freddie Mac though he seemed to forget about FHA/VA loans. The time for slinking around is over and the ASF is back in its favorite city, Las Vegas!!

In a bit of delicious irony, the ASF chose to hold the convention in the opulent Aria Hotel. The Aria is located in the new City Center in Las Vegas. The construction of City Center was financed by a loan originated by a large investment bank with extremely loose underwriting standards (pro-forma underwritten and had interest only payments due). This large investment shop placed the loan into its own CMBS and made themselves a good deal of money.

The City Center loan failed as the construction project ran out of money. The equity owner was highly levered and had no interest in putting his own money into the work. The project stalled for months until a new partner came with a cash infusion for a significant ownership of the project. The ASF, having not learned its lesson, holds its conference in the very hotel which represented a shining example of how messed up the originate to securitize model had become.

BTW, the private residential mortgage backed securities continues to be stalled with two small deals in 2010 and the first deal of 2012 announced just before the convention.

Naked Bond Bear

1)      After reaching an all time high of $56.64, BJRI has retreated 20.0% to $45.32…I’m not sure the slide is done. However, it must be noted if you had been long the stock at the start of last year, you would still be up 27.2%.

2)      Revenues grew 17.6% as the company opened 4 new restaurants. This follows 17.2% growth in the 2^nd quarter when the company opened 3 new restaurants. As a growth story, investors are looking at same-store sales which doesn’t include restaurants that have been open less than a year. However, it’s still instructive to see what the top line is doing.  

3)      Operating margins declined 20bps to 5.6% after expanding 40bps to 6.9% in the 2^nd quarter. In addition, if you adjust for “loss on disposal of assets”, the margin would have declined an additional 50bps.

4)      EPS increased 10% in the most recently reported quarter. On an “adjusted” basis, EPS growth was even better at 20%. However, that’s a bit slower than the 26.1% growth in the second quarter of the year.

5)      The company does not have any debt on its balance sheet which is a positive. The cash balance was down 27.5% from the prior quarter. Given the growth plans of the company and the elevated stock price, raising additional funds should not be a problem (for the company). However, an equity offering would dilute current holders.

6)      The company operates large “Brewhouse” style restaurants with a few legacy pizza and grill restaurants. Management calls their format “casual plus” dining. There is no denying that the craft-brew format is the flavor of the month. What happens when consumers get a hankering for something different? If the economy starts to improve, consumers may want to satisfy their desires to dine at more upscale eateries.

7)      At the 2011 Shareholder meeting, management stated that they have potential for 300+ restaurants “domestically”. I am not sure the format works in too many international locales, but we can leave that one on the proverbial table.

Valuation

8)      16 analysts cover the stock, 6 have “buy” or “strong buy” – all of the others have ratings of “hold”. Median earnings for ’12 is 1.35, an increase of 22.7% over the expected full year ’11 earnings. This means the company is trading at 34x next year’s earnings (and we are still waiting on this year’s final tally!).

9)      The PEG Ratio (or P/E divided by Growth Rate to the uninitiated) is a healthy 1.86x. While I wouldn’t expect to see this at a neutral 1 – that is, P/E equal to growth – I’d look for something that is closer to 1.5x than 2.0x.

10)   Enterprise value allows investors to compare companies with differing levels of debt. Looking at BJ’s Enterprise Value to EBITDA multiple of 17.2x suggests the company is in a league of its own. The peers look anemic in comparison: PF Chang’s (NASDAQ: PFCB) trades at 4.8x, Darden Restaurants (NYSE: DRI) trades at 8.1x and Buffalo Wild Wings, Inc. (NASDAQ: BWLD) trades at 10.6x.

11)   On a revenue basis, BJ’s again looks overpriced at 2.2x vs peers that trade in a range of 0.5x – 1.7x with an average of 0.9x. The bullish argument is that on an enterprise basis, BJ’s is more in line. The average peer trades at 1.41x with DIN trading at 2.3x.

12)   Finally, BJ’s has 111 restaurants open with a market cap is $1.3 billion. This means the market values the restaurants at $11.4 million each. As noted earlier, management looks to have 300+ restaurants. If you apply today’s market cap on that number, the value drops to $4.2 million per restaurant. BWLD – the peer with the highest multiples – has 315 company owned stores and a market cap of $1.2 billion, implying a valuation of $3.9 million per restaurant. BJ’s market cap would need to drop by over 7% to reach that level…and open almost 200 new stores!  BWLD has a five year unit growth CAGR of 14% – at that level, BJ’s will reach 300 stores by…wait for it…the middle of 2019.  

I was hoping to write a bullish article for the New Year as we look to move beyond all volatile markets of 2011. My work on BJ’s has me more excited about PFCB, however, I need to do more work before letting my inner bull out. Happy New Year!

“Solution: allow only residents to buy government bonds

As I have previously proposed, one way to solve this eurozone-specific problem is to prohibit member nations from selling government bonds to investors from other countries. Allowing only residents to hold a nation’s government debt will prevent the investment of Spanish savings, for example, in German government debt. Most of the Spanish savings that have been used to buy other countries’ government debt will therefore return to Spain.

During a balance sheet recession, Spanish government bond yields will then fall just like those of the US, the UK, and Japan, providing support for the necessary fiscal stimulus.

Fiscal stimulus at a time when the private sector is not saving is reckless and irresponsible; fiscal consolidation is necessary at such times. But when private savings are increasing sharply and economic conditions are severe, allowing private savings to flow overseas prevents the government from implementing needed fiscal stimulus. This state of affairs in the eurozone is a tragedy that must be addressed.”

We apologize for the confusion.  If you have any questions, feel free to shoot me an email.

Thanks!

Thanks for your patience!

Created with fan fare and removed with disdain, the Office of Thrift Supervision ceased to exist after 22 years of existence. President George Bush Sr. signed the law which created the OTS  in the wake of the Savings and Loan disaster of the 80s and the failure of their previous regulator, the Federal Home Loan Bank Board (FHLB).  In typical congressional action, the OTS staff have been absorbed into the FDIC, OCC, Federal Reserve Board and FHFA.  Like OTS, FHLB didn’t actually go away until it was merged with the Office of Federal Housing Enterprise Oversight (OFHEO) to create Federal Housing Finance Agency (FHFA). The OTS represents how legislative good intentions and economic incentives led a regulator to become a slave to the industry.

Letters removed after 22 years

The Savings and Loan business model was to  fund on the short end of the curve (through CDs) and buy assets on the long end. As long as the curve doesn’t invert, they made great money. As long as members kept buying CDs and their long dated commercial loans kept paying, money grew on trees. Even the politicians were involved to make sure the business continued without government interference. Let’s not forget the Keating 5 (which included Deer-in-the-Headlights Senator John McCain). As students of financial history know, the curve inverted, commercial loans stopped paying and short end funding costs soared.

President Bush Sr said “never again will America allow any insured institution operate without enough money” when signed the law which created the OTS. (I guess Jr missed that speech.) Since the GOP doesn’t believe in requiring taxpayers to be taxed for anything (except military based activities), the OTS was funded by a tax on the very institutions they regulated based on the size of company’s assets. Hence, OTS could hire more examiners, have nicer office furniture, and increased regulatory prestige if they could grow their portfolio of regulatees. Initially, the first real leader of the OTS, T. Timothy Ryan (now running the Wall Street lobbying group SIFMA), shut down thrifts and OTS suffered as they lost “clients”.

In the mid 1990s, OTS management, especially OTS Director James Gilleran, made a concerted effort to market themselves as the easier softer regulator. He even brought a chainsaw to a Thrift industry event. Just imagine what their marketing must have been like:

“Capital requirements got you down? We will beat any other regulator’s requirements by 50 bps!”

“No interest rate or credit risk model capabilities? No problem! At the OTS you can use ours!

“Our regulators await your call! Free up capital for those BBB CDOs you want to buy NOW!”

Countrywide and others headed their call. In 2005, Countrywide switched their charter and became a Thrift. At the same time both EMC (a Bear Stearns mortgage originating sub) and Lehman Brothers’s mortgage unit also became Thrifts. OTS staff nearly doubled by the time the economic crisis hit. When Countrywide spun off IndyMac, guess which regulator they chose? OTS of course! Ka-Ching!

As early as 2003, mid level OTS examiners starting finding major issues with thrifts like IndyMac, Countrywide, EMC, AIG and WashingtonMutual and raised them to senior management. These earnest folk actually wanted to reign in these thrifts to protect them.  These examiners were no match for the Thrift lobbyists and incompetence of senior management.  Even the FDIC couldn’t get past OTS management to protect “their” thrifts.

At the end of the day, OTS was doomed from the start due to its mission and economic incentives. It’s a model for how not to set up a financial regulator. OTS’s failures are well known and thousands of pages of text have been written about it. Regulators are supposed to be the last line of defense when financial institution management goes off the deep end and OTS just furthered their insanity. OTS had lost its way.

In the same vein, assuming the Consumer Finance Protection Board ever gets off the ground (and in a twist of irony are moving into OTS’s old offices) they too will be captured by the industry (and the lobbyists) they are supposed to regulate if incentives are misaligned and independence isn’t protected. (Which may not be a bad thing if you a member of the Banking Lobby).

Further Reading on this topic:

Requiem For A Regulator

Senate Financial Crisis Report (161-242)

**update**

Scribd sucks (as I’ve said since it started), so I’m just uploading the pdf directly here. Sorry for the confusion

.Luxury-extends-its-reach-across-China-201005

Overall Dealer UST positions decreased vs. the previous week by 2.31bn to -29.049bn. Maturities less than 3 years decreased by 9.398bn to 12.983bn; maturities 6-11 years increased by 1.579bn to -18.167bn, while maturities greater than 11 years increased by 1.574bn to 4.287bn. TIPS: Total TIPS positions decreased by 541mn to -619mn. Dealer Corporate positions totals decreased by 1.972bn to 100.467bn. Maturities less than 1 year decreased by 1.737bn to 22.486bn while maturities greater than 1y decreased by 235mn to 77.981bn. Dealer MBS positions decreased by 3.741bn to 82.528bn.

Full NY Fed PD Report

NY Fed Primary Dealers Report and Chartbook [GDocs]

NY Fed Primary Dealers Historical Statistics [GDocs]

Dealer Financing Highlights:

Total Dealer Treasuries in decreased 50.538bn to 1.972tr; treasuries out decreased 54.324bn to 1.740tr. Agencies in increased 1.586bn to 162.527bn; agencies out increased 12.104bn to 207.412bn MBS in decreased 15.945bn to 461.972bn; MBS out increased 25.942bn to 812.245bn Corporates in increased 790mn to 128.279bn; corporates out increased 751mn to 175.686bn

Repurchase agreements in decreased 14.889bn to 2.610tr; Reverse Repo out decreased 54.064bn to 2.042tr.

Dealer Fails Highlights:

Treasuries: Fails to receive increased 5.378bn to 30.426bn; fails to deliver increased 5.704bn to 25.436bn. Agencies: Fails to receive decreased 477mn to 27.719bn; fails to deliver decreased 1.027bn to 25.101bn. MBS: Fails to receive increased 389.019bn to 575.638bn; fails to deliver increased 408.120bn to 634.468bn. Corporates: Fails to receive increased 2.16bn to 10.408bn; fails to deliver decreased 57mn to 11.405bn.

More on fails in the Agency MBS market and the proposed TMPG fails charge. Nothing (yet) on dealing with the pretty massive amounts of fails in the non Agency MBS market.

Updated August issuance calendar which will (??) change after August 2nd.

US Bond Auction Calendar, Statistics and Charts [GDocs]

And one more chart you don’t want to miss, from our colleague Dutch Book

With all that being said, here goes:

I don’t think YOKU is a fraud, although there may be some relatively minimal finagling of some numbers esp in the PP&E. they’re going to be youtube size soon, they lease alot of their equipment/bandwidth but claim to operate a proprietary content delivery network with like >6000 servers all over China, but carry “servers & network equipment” on their balance sheet at like $24 mil? Youtube probably has 100-500x that (they dont disclose much).  I fully expect their capex costs to increase (although bandwidth cost tends to scale, server & network equipment costs may get a bit heavy if they continue to grow so much/fast).

I spent some time watching videos (in Mandarin, so no clue what they were saying) to observe ads; brand/company, frequency, type of ad, duration, etc.  I saw ALOT of ads for YOKU-produced/developed content, perhaps disproportionately so, indicating that perhaps they are not selling alot of their inventory (if you wanna give them the benefit of the doubt, possibly this could be result of any ad-targeting algos that go on the fritz with IP’s outside China).

As far as I know, YouTube loses money, and Google is the best internet company on the planet at monetizing content (debatable, but at the least they’re top 3).  Besides Hulu (supposedly), I can’t name a single online video company that actually makes money off the top of my head.  Add to this fact that  Chinese consumers have FAR less discretionary income (and will for at least a decade, if not two or three), and FAR more % of their population is rural/remote.  Internet adoption rates will surely increase, but I think YOKU’s price (and GS $55 estimate) imply they’ll be extremely fast and widespread, faster than even my most aggressive bordering on retarded expectations.  I fail to see how this company is going to turn a profit by possibly late 2012/early 2013 (GS estimates 2013 p/e at >40x).

Another major area of concern: content acquisition costs are going up almost exponentially around the globe, and China is not immune to this phenomenon.  As YOKU goes more mainstream it will invariably (at some point) face more pressure from intellectual property owners to police its site (it current has 300 contract workers filtering inappropriate/illegal content).  I talked to a friend in China about this, and she said her and her friends like Tudou & competitors better because you can get more movies/tv shows you actually want to watch (largely illegally hosted).  Because the online video watching market in China is so young (relative to the US), and technologies like bit torrent are more widespread, viewers are not going to pay for content they can get (relatively easily) for free elsewhere.

Its not like here in the U.S. where most middle class households can afford the $10/month for HBO/NFLX/etc & do so because they’re too technologically inept to figure out bit torrent/websites that illegally host content.  The more popular YOKU gets, the more pressure they’ll face to remove illegal content & buy it, less they drive mass viewer attrition to competing sites/technologies.  YOKU can’t just keep issuing stock to pay for all of this; at a certain point they’re going to need to generate some cash flow to afford all of this

My issue with YOKU vs The Street (eg Goldman) is they are assuming insane revenue growth and margin expansion, despite deep-pocketed competitors (e.g. BIDU’s QIYI video) coming after them.  GS’ whole thesis is that online video (advertising) in China is going to be a “winner take all” market, which I’m not so sure it will be, or if it is, I don’t think YOKU will get the market share analysts expect.  Implied growth rates and market share gains right now are absolutely ridiculous despite all of these concerns.

Additionally, what might be the biggest systemic issue here, (I’ve written at length on this but havent published my entire study, available upon request), Goldman uses 6.5% for Equity Risk Premium across ALL of their offshore (HK and US listed) China stock coverage.  Another part of GS has Europe ERP at 6.3%, and NYU’s Damodaran has the US ERP at 5.72%.  Does it make any sense, even intuitively, that risky tech stocks that are essentially 100% Chinese businesses (where they’re listed shouldn’t affect ERP, just beta) are only 20-75bps more risky than developed country large/mega-cap stocks?

I think not.
Using their 6.5% ERP for YOKU, GS gets a WACC of 11.9%.  In my model, I used 15% WACC (ERP of somewhere around 7.5-8% if memory serves, don’t have it in front of me).  If I use their WACC the valuation jumps 80%!!!!!  Approximating, if they’d used 15% WACC instead of 11.9% in their model, their target price would drop from $55 to somewhere around $30-$35.  Earlier this year, Damodaran estimated the China ERP at 7.6% (whole market, probably still too low for a risky, money losing tech company), which in YOKU’s case would produce a WACC of 14.5%.  Had Goldman used this number, their estimated valuation would be again around the $35, not $55 range.

In terms of valuation practices, its one thing to BS your way to a high valuation using super aggressive revenue growth and margin expansion (cost reduction) assumptions, that’s just poor/incorrect form, but hardly out of the ordinary (not surprising coming from an underwriter/advisor, but that’s another topic for another time).  Its also not out of the ordinary to assume said firm will grab more market share than is reasonably probable (especially with aforementioned well-monied competitors coming at you from all sides).  But when you start screwing with the discount rate (ERP), then you are really pulling out all the stops in my book (short of using blatantly impossible assumptions, etc).

YOKU is trading at a pretty big discount to my estimate in the low 20′s, using what I think are pretty damn aggressive assumptions: a 40% 10-year revenue CAGR, 55% gross margin CAGR, etc.

I think the only possible saving grace for YOKU is if advertisers in China fall even harder than they have in the US for the “video ads are more effective” bullshit (who watches video ads?????).  This is a distinct possibility, although from conversations with some in China, there’s no love for ads, especially video ones there, either, so even if there’s an ad bubble, eventually some brand executive is going to ask why they’re spending X millions on video ads when even their own kid is telling them how annoying they are.

That’s pretty much my YOKU thesis boiled down into as short as it gets  It will likely continue trading at high/inflated levels as each quarter’s earnings continue to show ~100% revenue growth and investors anchor onto that and assume it’ll continue almost indefinitely into the future (despite the challenges I mentioned).  I think the China tech/internet trade has alot of potential to mirror our internet bubble v1.0 with a few differences (eg actual revenues and in a few cases, profits), but I think they may learn the hard way that 1. web metrics lie, and even if they told the truth, they’re still bullshit, 2. effective targeted advertising has been promised for a decade but even the leaders in the space still fail with alarming frequency and magnitude, and 3. who watches the ads on/next-to/before/after online videos?

One last potential concern: Once growth naturally starts to slow, I fear management is going to truly feel the pressure of politicians to keep the growth high (a bunch of the frauds have been driven in some part by these pressures, or so the CEO’s claim).  Whether Victor Koo will jump ship (like he did from Sohu) or stand strong in the face of inevitably mounting political pressure is a real question I think.  New management that doesn’t have the Founders’ ethic/pride behind them may give in to such political pressure which may open up the firm to very funky/fraudulent accounting/reporting down the road.  I can’t quantify this concern, but I think its one worth considering.

Getting a high valuation for delivering record growth rates is both a blessing and a curse; investors are myopic and are often just as quick to punish a stock for failure to live up to impossible expectations as they were to praise it for doing so in the past.

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This quick summary is a glimpse into our research approach, and more and more detailed analysis is available to institutional and high net worth investors.

If interested, please contact us, information (at) stonestreetadvisors (dot) com.