Friday, November 15, 2013

Stocks DD Opines on FNMA: Why investor's focus on Government's/Congress's GSE Exit/Reorg proposal is a Red Herring and Mr. Ackman's bet.


Read, understand and consent to the blog's DISCLAIMER here before proceeding to read the article

Additional Disclaimer: Please note this post is speculative and inevitably would be riddled with inaccuracies and errors in judgement. This is HIGHLY RISKY investment(esp common equity) esp with the legal uncertainty revolving around the conservator-ship. If legal judgments don't go in favor of private shareholders, then stock holders get ZERO. 

First things First: If you are a shareholder of GSE, please sign shareholder petition here. This is created by non-profit organization by Ralph Nader who is fighting for shareholder rights
Background: Fannie and Freddie don't directly make loans. Rather, they buy mortgages from lenders, package them as bonds, guarantee them against default and sell them to investors. In doing so, they help make loans available and exert influence over the housing market. Together, Fannie and Freddie own or guarantee about half of U.S. mortgages — nearly 31 million home loans worth $5 trillion. And along with other federal agencies, they back about 90 percent of new mortgages. This link provides a fantastic historical perspective, multi-decade profitability of GSE,  financial condition of GSE, significantly improved underwriting quality since 2009(half of the current portfolio) that will bode well for future profitability compared to historical profitability, and talks about return to stockholder control. This is a MUST-READ document and is fairly recent(Aug 2013). An interesting quote from the above article: For stockholders, the economics of the GSEs’ mortgage business could be attractive, but the psychology of the decline in stock prices and the federal government’s claim on all profits could potentially offset this plus
Why investors focus is wrong
Everyday the headline and sound bytes news on GSE is about the Reorganization and the potential lesser government role in GSE. For investors, this is a 'red herring' news to focus on. Investors are wrongly focused on the uncertainty of Government or Congress action on the various Re-org Proposal. Instead the clear signs of lack of distress and profitability in GSE, investors should be focused on the Court decision on Aug 2012 agreement and the current significant undervaluation of GSE. This will largely determine whether the upside to common equity is limited or is very significant.

Mr. Ackman owns 10% in equity of Fannie Mae and Freddie Mac and has expressed his intent to be part of the Recapitalization proposal discussion with the US Treasury( 1 of senior preferred holders as well as $187b loan issuer which is now nearly paid out) amongst other stakeholders. Ackman was buying all the way until Nov 14th and started buying the shares Oct. 7 and accelerated purchases after Oct. 21. Ackman paid a total of $401 million for his combined holdings. The backbone of the thesis on investing in commons could likely be the following. BTW here is Ackman's recent interview

Thesis on Investing in Common Equity

1.  Constitutional challenge(5th amendment-property rights) of Aug 2012 "Net Sweep agreement"(profits are being swept and given to US Treasury) and the breach of fiduciary duty to shareholders (read Legal perspectives below). See the website Restorefannie. The court hearing date is Dec 6th. Mr. Ackman is likely convinced that Conservatorship fiduciary duty towards shareholders has to be honored, esp considering GSE was on road to profitability and was not in distress even back in Aug 2012 when the net sweep agreement was signed. In any case, the 2 parties may be focused on negotiating the path forward since $187b is nearly repaid and the path forward would likely be restoring conservatorship's fiduciary duty to shareholders since GSE clearly are not showing signs of deep distress(although they are far from capital adequacy). So while the actual exit option may take a long time and congressional consensus, the court judgment will clearly RE-Rate the Common equity because such a judgement on breach of fiduciary duty would emphatically restore the rights back to its common shareholders. BTW here is Ralph Nader (congressman) interview is on the side of shareholders.

Quote from below article
"The Third Amendment to the Stock Purchase Agreement represents just this kind of one-sided transaction. Yet the government seeks to avoid this obvious implication by three specious arguments. First, it claims that there really was a mutually beneficial bargain here. After all, the Third Amendment was needed “because of a concern that the Enterprises, although solvent with Treasury’s assistance, would fail to generate enough revenue to fund the 10 percent dividend obligation.” Fat chance. Indeed, the one way to magnify the miniscule risk of default is to strip Fannie and Freddie of liquidity by the unilateral “dividend” payment made to the government. As a conservator, FHFA is supposed to defend shareholders, not fork over their money to Treasury."


Legal Perspectives 
2. GSE's value could be far significant than its liabilities (see below). GSE's have a  multi-decade history of profitability leaving aside 2008,2009 and 2010. All the upside after the preferreds are made whole will have to inure to Common equity. So the upside to preferred  is just 3 times where as upside to commons would be many times over and interestingly an investor in both preferred and commons are basing it on the same premise that net sweep is seizure of property rights.
      Enter Activist Investor Ackman
      Generally speaking, Mr. Ackman is in for the long term. Ackman is a real estate expert and has great credibility when it comes non-operational restructuring (non-business related as in Balance sheet restructuring, forecasting legal outcomes) as was witnessed in General Growth. The equity investment in General Growth Ackman made has grown >20 times in a few years. Here is another article that gives some historical perspective along with various exit options. "By law, conservatorship will end with their return to stockholder control if the  GSEs become safe and solvent or with receivership if they are unable to pay their debts". Right now Fannie mae only has net worth of $10b with a balancesheet of ~2.75T, but if and when the sweep is terminated those $9b/quarter earnings(see earnings presentation below) would start to add to the capital base and it is easy to see capital adequacy($150b?) within 2-3 years for the current balance sheet(without any new injection of external capital) provided sweep is terminated & housing rebound continues(Fed has announced to keep short term rates low until at least mid-2015. GSE finance portion of their investment portfolio with short term borrowing). 

      3. Alignment of incentives between Govt(Taxpayer) and Private shareholders as Govt owns rights to 80% warrants based on Sept 2008 agreement. So one can rest assured the Govt would want to maximize their profit and protect their interest in common esp after the $187b is paid out and the govt sees reduced risk in GSE from a capital adequacy standpoint. Note however though, it would take 2-3 years for the GSE's to be considered well adequate. So Ackman could be sitting with the US govt on the same side, helping to figure out how best to maximize the value or their pay out to common in whatever exit option the govt or congress decides.In this sense , the GSE Exit option and political consensus needed and the net sweep agreement with  constitutional challenge is somewhat of a Red Herring that the Market is currently focusing because both the GOVT(thru its 80% warrants) and Private Shareholders are on the SAME side (and it is clear due to the housing rebound there is NO immediate capital needs for GSE)..Both own stakes in GSE.  Also note that the government could be sympathetic to stockholders for another reason: A number of employees of GSE have historically owned stock of GSE's.

      4. MOAT of GSE A.K.A The Monopoly it is
      This is ONLY enterprise(monopoly) that has the below advantage: Ability to consistently make highly attractive  NIM (net interest income) by matching LONG Term mortgage rates with LONG Term Agency backed MBS or Agency Bonds. This competitive advantage for Funding exists because of the implicit government backing the agency enjoys for its MBS and Bonds.

      5. Their earnings will likely be more insulated with what happens in the economy compared to 2008,2009. This is because of underwriting quality since 2008 which is now materially superior and it is 50% of their portfolio and their loan loss provisioning (and credit losses) will likely be in control even if housing prices go south (higher LTV Ratio,higher borrow quality and such).

      6. Without GSE (a.k.a implicit guarantee for agency MBS to investors), the affordability of 30 year mortgages(pivotal support for home ownership in the US) will no longer exist. So shut down of GSE  is unlikely. 

      The Berkowitz Proposal
      Here is The Berkowitz Recapitalization Proposal  Berkowitz recapitalization proposal IMHO is giving away the value and upside to preferreds. Why would the shareholders would want to do that when they can maximize their value by doing a market auction. Lets remember by Law preferred are entitled to ONLY 100% of principal in their recovery and any residual value has to inure to common shareholders



      Speculating on the Value of GSE's Common Equity

      Back of the Envelope Calculations (This is a highly oversimplifying calculation. I am ignoring debt because as of most recent quarter GSE had a positive net worth): So the question is what could be the residual equity value to private shareholders after paying off preferreds and the govt: 

      OldCo's value(runoff of existing assets) + NewCo value (Securitization platform+IP+Human Cap +Goodwill+Relationships) =  
      Prefered's Dividends  (7%) + Preferred's Principal ($136b-FNMA + $86b-FMCC = $222b) + Common equity ($20b*-FNMA + $10b*-FMCC)  + 80% warrants given to US Treasury
      Note*-based on stock price of ~$3.3

      Obviously Mr. Ackman is betting the left side of the above equation is much bigger than > $242b (not counting preferred dividends) ? Note, both FNMA and FMCC reported ~$9b in quarterly earnings each. Remember also, as housing market improved, extraordinarily, both Fannie and Freddie have paid out $187b in the last 4 years what they had borrowed from Treasury during the crisis. So if housing rebound continues and less so short term interest rates remain low(as GSE finances a part of investment portfolio with short term funds), and FNMA and FMCC can earn net profits of $72b/year(annualizing Q3's ~18b net profit), and the number $252b just translates 3.5 times its net profit (removing one-time incoming from release of tax deferred asset/valuation allowance-then you get $45b for FNMA alone. So the $72b in income for GSE seems reasonable). Assuming average 7% interest on ALL preferred, that translates to $15b/year on the $222b preferred..So that would still be 4.42 times net profit. 

      At 10 times EBITDA, enterprise value would be at 10*$90b=$900b or  $678b left over for common equity . Factoring in US Govt 80% warrants, private shareholders equity would be valued at 0.20*$678b = $134b (approx 4.5 times present price) . This is where Mr. Ackman's legal, real estate, restructuring and value maximizing expertise fits in nicely in terms of preserving value for existing equity holders (as he did in General growth)


      Near term catalysts 
      • Dec 17th - Defendants file briefs on the suit (Aug-2012 agreement challenge)
      • Legal proceedings of the various investor suits. Look at the court calendar here
      • Word spreads on 5th amendment case - Lobbying by investors and other stakeholders -> restorefannie
      • Ackman's investor letter (his thesis on FNMA could be disclosed)
      Longer term catalysts
      • Potential NYSE Listing (2014,2015?)
      • Capital adequacy and returning control to stock holders (2015? 2016?)
      • Ability to raise non-dilutive capital from a position of strength(2015?) 
      Miscellaneous Thoughts/Quotes
      Is it possible that the OldCo itself can make whole the preferreds (dividends & principal) and NewCo's value will entirely inure to existing Common equity? Or could some of the preferreds stay in OldCo and some just transferred to NewCo's capital structure?
      The other question is to ask is "Will the NewCo's value be substantial without any implicit guarantee from Govt" ? Will they be able finance their investment portfolios without implicit govt guarantee on their bonds.

      Also, right now no dividend payments are being made to preferred and in Dec when the complete $187b is paid out to US Treasury, there is still no plans of what is going to be done to GSE profits which is substantial(Fannie mae in recent quarter earned $8.6b). See below lawsuit. The existing Net Sweep Agreement entitles the US Treasury to receive all profits (including settlement or restitution payments) from Fannie Mae and Freddie Mac. A few preferred shareholders are currently suing the US challenging the Sweep Agreement and demanding the resumption of dividend payments.  Here is a quote from seekingalpha article  "Conservatorship alone doesn't absolve the FHFA from its fiduciary duty to shareholders of those companies. The notion of a breach of fiduciary duty on the site of the conservator could further increase chances that the Net Sweep won't stand its ground in court."


      Here is somewhat different exit option -> Link

      Under Fairholme’s proposal, the preferred shares would be exchanged at their full par value of $34.6 billion for shares in a new mortgage insurer that would separate new underwriting from the legacy investments held by Fannie Mae and Freddie Mac. Ackman’s common shares would give him ownership of the pair’s legacy book of business, including mortgages that soured during the housing crisis.While that legacy business would shrink over time, Ackman, in an interview with CNBC last year, said Fannie Mae should stop selling foreclosed assets and become a residential real estate investment trust.  “They should just keep the foreclosed assets, fix them up and rent them, and become a big residential REIT that owns homes,” Ackman said in the interview. “That would immediately stabilize the housing market.

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      Thursday, November 7, 2013

      Stocks DD Opines: Is The Market Stupid ? Skewed Risk Perception(Valuation) & Following of Development stage companies vs Established Pharma


      Read, understand and consent to the blog's DISCLAIMER here before proceeding to read the article

      Do you understand R-I-S-K ?
      Most biotech/pharma "investors" esp retail investors either don't understand risk or don't bother to understand risk well. Majority of these biotech "investors" are traders trying to speculate on valuation changes based on clinical or regulatory or speculative M&A event of unproven companies/management. Investors chase 1 drug pony companies(esp buying at high valuations) without fully understanding various risks (clinical,regulatory,marketing,commercialization/reimbursement) if the event does not turn in their favor. The market usually disregards one of the biggest risks which is the market competition, and the longer the lead time for the drug to reach meaningful revenues, the bigger the risk for market competition (potential for new and improved competition drugs). Development stage companies also carry dilution risk all the way until company reaches profitability. At the same time, the market surprisingly continues to ignore blue chip businesses with solid earnings today and near future with relatively low risk profile trading at cheap valuations. 

      Case in point is this undiscovered pharma company: Taro Pharma which although operates in generic business, has limited competition due to the "niche-ness"(higher technical barrier to entry) of the topical/dermatology sector and has delivered strong results in the last 4 years since the new control took over. And unlike a brand innovator that comes with R&D, Regulatory, Commercialization risk and a very-high risk R&D and Marketing/Commercialization dollar spend, this company has low R&D risk, Regulatory risk and Commercial risk, and spends productive R&D dollars on low-risk clinical equivalence studies. As a generic company it spends little to nothing on marketing/commercialization. The R&D spend(<10% of sales) replenishes part of its aging generic pipeline, while at the same time it enjoys limited competition on a good part of its portfolio, thus allowing it to enjoy a sustainable EBITDA margin of >40%. 
      Below I have tried to objectively evaluate the favorable business characteristics of Niche Generic Pharma with Branded Pharma as well as Generic Pills Pharma.





      This company has a lot going for it that should make it really attractive for investors and they are listed below. Yet as indicated by Seeking Alpha and Stocktwits it is covered/followed  30 times Lower than AMRN/DNDN . (Amarin is a 1-drug pony where the regulatory risk unraveled recently when the FDA's Adcom vote came in unfavorable for its Anchor indication despite a SPA. Interestingly about ~1000 Amarin shareholders have congregated to create a petition to FDA for considering approving "Anchor" indication). Hopefully the recent debacles of AMRN and SRPT highlights the regulatory risk for these 1 drug ponies.


      Snapshot taken on 10/30/2013

      Isn't the market stupid in chasing speculative 1 drug pony with enormous risks and disregarding relatively lower risk companies with a fundamentally solid business and proven performance ? I have highlighted in BOLD the 3 tenets to my Bullish Taro thesis: Valuation(& strong business highlighted above), Management's ROI record and Minority Shareholder protections.
      1. Number 1(Yes the Market Leader) in Generic Dermatology in the USA
      2. Operates in an Oligopolistic sector with unique barriers to entry
      3. Yet Trades at Only  ~7 times ttm EBITDA*
      4. Accumulated cash of $613m (end of June 2013) and est at $700m (by end of dec 2013)
        1. An opportunity to make an acquisition in the specialty sector
        2. Accretive acquisitions would add significantly because of synergies
      5. Top Class management that knows how to allocate capital (it has returned 38% annually for close to 20 years! Can it get better than that ?) see page 32 SUN IR
      6. Almost zero leverage with a debt of $29m
      7. Backed by a business with stable cash flow of >$250m/year
      8. Longstanding Brand name in the US amongst practitioners and patient
      9. A relatively untapped sales opportunity in the rest of world markets for its portfolio of 180+ products.. which they could monetize by selling ROW rights to their products in emerging and other international high growth markets
      10. Minority Protection including "majority of minority vote" for any strategic transaction and highly watchful & active activist investors. Israel has STRONG minority shareholder protections. Read pages 93-105 to understand this
      11. Robust generic pipeline in 3-4 years as well as a significant specialty product entering phase 2b which could garner $500m sales/year.
      Note: The next 1-2 years may have some challenges due to entry of competition in some products but this company's earnings growth outlook in 4 years time is Solid. Plus, they have great leverage with est $700m cash, with just $29m debt and unlocking value in ROW markets which today is 1% of sales.



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