Sunday, September 18, 2016

Fan blades - analysts adding value

I wrote a long post about fan blades the other day. In it I pointed out that fan blades on the front of turbofan jet engines (the ones on commercial jets) are really difficult to make. They spin fast (providing most the thrust for the plane). And they have to deal with bird strikes (which are surprisingly common). And finally they are not allowed to penetrate the engine casing if one were to fly off.

Fan blades have taken a surprising amount of material science to develop. They really are "cutting edge" stuff.

I talked a bit about Alcoa supplying the fan blades on the Pratt & Whitney geared turbofan (GTF) engine. Indeed I showed an Alcoa video of the project.





Well it turns out that these fan blades are the main reason for the GTF engine being slow to deliver.

The FT is running a story about how Pratt & Whitney are cutting engine production targets. It is not good news and they are blaming Alcoa.
Mr Hayes said front fan blades were among about five engine parts “that are causing us pain” by slowing deliveries. The company is continuing to build the engines, since fan blades go on at the end of assembly... 
The fan blade, developed with Alcoa, is made of aluminium-lithium alloy and tipped with titanium on the leading edge. Efforts to speed up blade manufacturing have taken longer than expected, leaving Pratt with fewer units than it expected by now, according to people familiar with the process. 
This year, we talked about delivering about 200 engines,” Mr Hayes told investors. “As I stand here today, I think that number is probably plus or minus 100 — more like 150 engines for the full year...
I encourage reading the article.

That said an analyst on the United Technologies conference call couldn't resist the chance to get in their question about 3D printing. 3D printing has uses - one is to make really complicated parts. But it is not much use in making really strong parts (like fan blades)* because there is in weaknesses where the product is added rather than made (say in a cast/forge process) as a whole piece from inception. 

Enjoy the question and the none-to-subtle put down:
Nigel Coe - Morgan Stanley - Analyst 
Obviously, GE is making a big play in additive manufacturing. Why couldn't you print out these fan blades -- what -- easy, right? It's simple. What is your play is additive? Is that a potential for Pratt? 
Greg Hayes - United Technologies Corp. - Chairman, CEO 
It's a potential for Pratt. It's probably a bigger potential maybe even with -- at the Aerospace Systems business. If you think about where additive really gives you the advantage, think about a fuel pump today, which is essentially a piece of aluminum or nickel that you hog out, you put all of these passages and cavities in, very, very difficult to machine. Where we see the opportunity there is through additive to be able to build these up 1/10,000 of a layer at a time, and build these cavities right in.



John

*I simplify a little here. Additive manufacturing (aka 3D printing) is of great use in making the moulds for casting. You can cheaply and easily print very complicated designs which you then use for making moulds. 3D printing has its place but nobody has yet come up with a way of actually printing the super-strong cast elements.


Saturday, September 17, 2016

Saturday night pop anachronisms

Saturday night here in Australia - and music is on.

Can't help but notice the anachronism in some of the lyrics.

The Beatles Mr Postman is faintly ridiculous:
There must be some word today
From my girlfriend so far away
Please Mister postman look and see
If there's a letter, a letter for me
I been standing here waiting Mister postman
So patiently
For just a card or just a letter
Saying she's returning home to me
Still the BBC version is - well - fabulous...





But for sheer anachronistic silliness nobody can beat The Smith's classic double anachronism:
And now I know how Joan of Arc felt
Now I know how Joan of Arc felt
As the flames rose to her Roman nose
And her Walkman started to melt

Daddy what is a Walkman?







John




Wednesday, September 14, 2016

The end of Target's school charity program: demographic change or just bad management?

Addendum: I wrote this unaware of the fact that Target sold its credit card business a few years ago. That was insane too I think. But I gave up looking at Target about the same time I gave up looking at most retail. When I decided that I was perennially hopeless at analysing retail. The credit card story is however utterly real. Selling cards was just another piece of idiocy. The core work in this post was done in 2001... 15 years ago.


Target and Wal Mart once had very similar businesses - both discounters targeting similar demographics - both rolling across America.

When Wal Mart was in one town Target would just open in the next town. They were similar businesses but they did not compete.

Eventually America was saturated - you could not open a Wal Mart or a Target (or a K-Mart for that matter) without competing with an existing big-box discounter.

And then - and only then - did it become clear to anyone that cared to look that Wal Mart had lower operating costs and that to try and compete with them was a losers game.

--

K-Mart tried to compete with Wal Mart. It went to Chapter 11 (and will probably file bankruptcy again someday).

Target decided the way to co-exist with Wal Mart was to differentiate. So they did. They made the aisles wider and installed better lighting. That cost money but the stores were more pleasant.

Where Target held similar stock to Wal Mart they priced matched. But Target tried not to hold similar stock - it went up market.

The "target market" was middle-income but strained - classically a middle-income family with children, a wife who works less than she did and expenses that had gone up somewhat. They offered stuff for those people at a quality point above Wal Mart but still with a "discounter" ethos.

The average household income of a family that shopped at Target but not at Wal Mart was about 1.7 times the average household income of a family that shopped at Wal Mart but not at Target.

Target became "Targ├ęt" - a sort of aspirational up-market discounter.

--

I remember going to Target as a young professional about the time we had our first child. Children's stuff was displayed prominently and it was at a quality point that I was happy to buy. Target's shopping experience matched my demographic whereas I found (and still find) Wal Mart perplexing - extremely cheap but not particularly relevant to me.

--

I got interested in this because I was interested in Target's credit card.

The card was amazingly profitable - but to explain why I need to explain what makes a profitable credit card.

The average American has several credit cards in his or her wallet. There is one that is used every day at the "front of wallet". There is one at the back of the wallet used in an emergency.

The one at the front of wallet gets all the spend, a fair bit of rolling balance and is an essential part of the customer's life. It is usually very profitable.

The one at the back of the wallet doesn't get used much and is likely to be used if and only if the customer is financially stressed.

The one at the back of the wallet gets none of the daily revenue - but takes just as much credit risk. Statistically that card is likely a loser.

So credit card issuers want to get to the front of the wallet.

You also want the customer to roll a balance (ideally $2000-$5000) and to pay interest on that balance. Higher balances are often (not always) associated with genuinely financially stressed people and so may be less profitable (due to higher defaults).

Finally you want the people to feel really bad if they default. So you want people with a middle class aspiration and a deep fear of bankruptcy. In an ideal world it will be someone like a junior accountant with a young family. The junior accountant would be petrified of a record of bankruptcy - but they may meet the financially-stressed-with-young-kids demographic that Target was aiming for.

Credit cards have lots of tricks to move themselves to the "front of wallet" position. By far the most important trick is airline miles. Many an upper-income person shops preferentially on the card that gives them the best airline miles deal.

But for my financially stressed family airline miles are of only marginal benefits. Holidays are camping trips in the car (and Target will sell the family camping gear).

Whatever: Target needs another pitch to get to the front of the wallet.

And that pitch was a charity program. Target would give an education institution institution of your choice a donation equal to 1% of your spend. That institution was usually your children's school. [The old terms of the card can be found here.]

Combining credit cards with giving to your kid's school reduces the guilt of shopping on credit (or even rolling big balances). It moves the card to the front of wallet.

--

All very well - so Target now has accurately got to the desired position - the front-of-wallet position on a really nice demographic group.

But the card was profitable beyond even that. This card had more rolling money and lower default than any equivalent card I had ever seen. Obviously you want people to roll $4000 but the people who can't pay off their credit card are risky credits - so rolling balances and higher default rates are correlated.

But Target managed to achieve much better default rates than expected given their high rolling balances.

I puzzled over this for a while. I even asked some customers.

Strangely some customers believed something patently not true. At least some of them believed that if they defaulted on the card their children's school would find out.

The penny dropped. This was an absurdly profitable business. It gave money to charity (which is good) but it was brilliantly manipulative at the same time.

My respect for Target management (then very high) grew higher still.

This analysis was done in 2001 and my child was under 2 years old.

--

The occasion I had to think about Target's credit card was when Bill Ackman was trying to get Target to sell or spin out their credit card business. This was in 2009 and Mr Ackman was Target's biggest shareholder.

Target would not do it. They would not sell their credit card business.

Bill Ackman cried.

Actual tears.

And Target didn't explain why they wouldn't do what Bill said.

And I thought to myself of course they won't explain that. The whole program is too manipulative. But to sell it is to lose lots of value. This was a hugely good credit card business but it had to be associated with Target's demographic.

To explain the trick however would take some of the magic away.

So I kept my theory to myself.

--

And now I discover - much to my surprise - that Target has terminated their education charity program. Sure they gave a billion dollars.

And sure there are better charitable targets than the schools of middle-income kids.

But it struck me that Target is ruining or has ruined a very good thing.

The shift in Target's charity goals is to wellness related stuff (fairly loosely defined). Maybe that change is demographic.

But I suspect that it is just bad management. Maybe Target management imbibed some of that Ackman led Wall Street advice after all.

Thoughts anyone?






John

Monday, September 12, 2016

Albany International: a work program for a fund manager

This is going to be a stock note with a difference - because it is not a stock note. But it is about a stock/business - Albany International is a company that makes machine cloth based in upstate New York. The interesting part of Albany though is that it has a high-growth but unprofitable aerospace business.

The note however was an early work program to decide whether we wanted either

(a) no position,
(b) a small position,
(c) a large position.

The original note was a little rough - as it was an internal work program. And it involved a New York based investor who helped me with the leg-work in upstate New York. (As I do not have their permission I have not revealed either their names or the results of their work).

So I have tidied this note up a little and removed names since the original. But the note is accurate as to what we did and how we approached it.

If you wonder what a good fund manager really does this is a decent illustration. (I wish our work were always of this standard. It is a hard standard to maintain but I will try.)

For the record we settled on a small position. We were not entirely thrilled with the outcome of our research - but I am not going to tell you how we got to that conclusion. Rather I will leave the leg-work for you.

The work program was stated in a letter to my staff member (Luke) and my generalist New York friend.

Below is an edited version of that letter.

---

Fan Blades, machine clothing and Albany International

This is a project that I want to do as a joint project with James (name changed). So let’s start with an introduction –

James is a friend of mine from New York. He used to be senior at XXX (which is a way-more-than-average sophisticated fund manager). He probably has some pretty good New York connections and staff to help us do the checking there.

Luke is fairly new to funds management but has a PhD in physics – and has lots of experience as a high-end physicist/engineer – mostly in thin films. Luke is more than capable of checking any of the science that I am asserting. And I would like to be checked.

The target company is Albany International -

https://www.google.com/finance?cid=521

The market cap is just under $1.3 billion and they are based in upstate New York.

I was hoping James could do any New York style leg-work (scuttlebutt in upstate New York and finding out what we can about the Rochester plant described below) and Luke can check we are not bullshitting ourselves on the science.

The end margin of the aerospace business (described below) is also completely unknown. (I will guess – but it is a guess…)

Background 

Albany is a high-tech weaving company whose main business (where it is the world leader) is machine cloth. Machine cloth is the fabric that goes around paper plants and the paper is rolled between rollers and machine cloth.

Machine cloth naturally a pretty good business because better machine cloth makes better paper, plants get optimized making switching hard. Moreover machine cloth is a consumable and is not hugely vulnerable to the paper capital equipment cycle. There are a fair few competitors – most notably the paper making OEMs – but machine cloth seems to have sustainably high margins.

However the paper industry is in decline – especially the higher grades of paper which is where Albany has some position. So machine cloth is a good business in decline.

The company explicitly says that their job is run this business at as slow a decline as possible.

Albany International had lots of other businesses in the past – but they sold them all to focus on machine cloth and aerospace. They have purchased some aerospace businesses.

The original aerospace business comes from weaving carbon fibers. In the carbon fiber business there are a few dominant fiber providers (Toray in Japan, Hexcel in Stamford for aerospace carbon fiber) and there are a few resin companies (eg Hercules).

The carbon fiber fabrics are mostly made by formerly high-tech fabric makers. Indeed almost all carbon fiber weaving companies started at the technical end of fabric manufacture.

This is also the origin of Albany's aerospace business. The position Albany have in aerospace looks potentially good – but there is almost no revenue now (about $100m at a loss).

They are guiding towards $450 million in revenue in a few years.

If this revenue is at fat margin (likely but unknown) and the machine cloth business does not go away (also likely but unknown) then this should be a good stock.

Machine Cloth

First – I have verified externally absolutely nothing in this machine clothing business. (All my work has been on verification of the aerospace business). If anyone knows any way of verifying this stuff – for example has contacts in the paper industry – I would love verification. ("Trust but verify” is a good slogan.)

Here is Albany's web page detailing the business…

http://www.albint.com/business/mc/en-us/pmc/Pages/default.aspx

Company presentations give EBITDA margins in the high 20 percent range.

The presentations however focus on EBITDA. Alas anyone who knows about technical looms will know that it is a relentlessly capital intensive business (witness all the wining that Warren Buffett did in early Berkshire letters about the mess that the textile company was).

So lets pull the EBIT numbers rather than EBITDA –




But $140m in income on $655m of sales is not unattractive… its still greater than a 20% margin business. Alas this is before a disconcerting large amount of "corporate expenses and other". If all the corporate expenses are loaded on the machine cloth business (likely unfair) the margin winds up (pre-tax) at something like 10 percent. This is consistent with the GAAP accounts.

That said - I know little about the machine clothing business and verification would be nice.

The Aerospace business

The appeal of the stock however is the aerospace business and not the declining machine cloth business. The short-explanation can be found here…
LAMINATED COMPOSITES, USED IN EVERYTHING FROM THE skins of fighter planes to golf-club shafts, have one big flaw: They tend to come apart when the resin holding their layers together cracks under stress. Borrowing from the ancient art of braiding, Albany International Corp. in Albany, N.Y., has come up with a way to make laminated composites stronger. It's common to braid layers of a composite separately, but Albany International goes further by braiding each layer to adjoining ones. Anchored together, they can't slide past one another like cards in a deck--the leading cause of cracking in laminate resins. 
The company's Multilayer Interlock Braid technology is starting to find applications, according to the inventor, David S. Brookstein, who remains a consultant to Albany International after becoming dean of the School of Textiles & Materials Technology at Philadelphia College of Textiles & Science. The U.S. Army has used some of the prototype material to build inflatable arches for a portable hangar. And Brookstein says the company hopes to work with a large medical-device company to adapt the process to make a hip implant whose stiffness could be customized.
The only problem with this explanation is that it is from a 1995 story on Bloomberg. We are 21 years later…

Its kind of bold to assert this is a technology whose time has come…

The company has been making fairly bold claims though… this is also from a slide in (what was) the last presentation…





Note an “objective” of $450 million in revenue by 2020. (Is an “objective” lesser than an “expectation”?) And is the “assuming no new business” an indication that the revenue might be higher?

That said they have existing contracts including most importantly making fan blades for the LEAP engine.

LEAP is the successor engine to GE/SAFRAN’s engine for the narrow-body market (ie 737 and A320s). Note that GE current engines have a 65 percent share in that market but a lower share in the forward order book – so it is not as good as it looks. (The old one was the biggest selling and most profitable jet engine of all time…)

Here is the projection of LEAP revenue.



And there are a bunch of other programs that they think get them to 450 million run-rate by 2020.

They show pictures of their production facilities on the presentation – but most of these – as we shall see below – are JVs with SAFRAN. Here is the picture…




If these are real they must be JVs because there is (listed here) 1.2 million square feet of plant (and more under production) and there are only 1250 employees. This is a thousand square foot of plant per employee – which is – as you might observe – spaced out. So what these plants are and how much of them is owned by Albany International needs to be determined.

The margin question

I have no idea of the margin for all this aerospace product. That will be the determining question - because if this is fat margin business you want to own the stock. All I have done is some verification of revenue stream – particularly re fan-blades.

We will need to try and get a handle on what the margin will be. (More on this below.) However the way of thinking this is through the history of fan blades - and some discussion on how easy/difficult this project turns out to be.

Fan blades – a potted history

Modern commercial jets are “turbofans”. A turbine drives a fan at the front of the engine – and that fan creates up to 90 percent of the thrust. It also has to be able to withstand bird strike (at horrendous forces) and has to be enclosed by a case which is able to withstand an accident where a fan breaks off. (This is the so-called fan-blade-off test which is the hardest of the FAA mandated safety tests…)

The case and the fan are almost always a unit – and the tolerance between them is extremely fine. The inner surface of the case is usually some abradable material as the tolerances are so fine some abrasion is possible.

When Rolls Royce developed what was the first decent engine capable of carrying a wide-bodied plane (the RB211) they had an agenda of making an engine in which the fan could spin at a different rate to the core of the engine (which is done through multiple spindles) and having a carbon composite fan (made of a carbon fiber product called Hyfil).

They succeeded on the first task - Rolls Royce developed an engine in which parts spin at different rates.

But they failed comprehensively at a reasonable composite fan. The fan shattered when chickens were shot into it at high speed. (Obviously bird-strike is an area.)

So eventually they wound up with a titanium sandwich fan blade. You can see these blades and something of the manufacture in this video.




They key section goes from 12.20 to 17.40. (The rest of the documentary is kind of fun too…)

--

GE in JV with SAFRAN has managed to make a composite blade and they use it on their wide-bodied engines…

This is a video released by GE Aviation (apparently to the surprise of the Hexcel who told us that they had been told by GE that much of this is secret). Watch the whole thing – because you will get some idea of the tech.




Note that this is a laminate production process – the starting product is a roll of pre-impregnated carbon fiber. The supplier of that is Hexcel (based in Stamford) and the resin is supplied by Hercules. The Hexcel IR told us that the room is also refrigerated because the pre-preg goes off if warm.

Rolls Royce have always maintained that the Rolls Royce titanium blades are just as good as the GE blades. (GE of course differs and you can see their pitch here - http://www.youtube.com/watch?v=zy4A-z2WKhw.)

In fairness the claim to the most efficient long-haul engine has fluctuated between GE and Rolls with most the time Rolls having the current leader. This suggests that Rolls’ claim is okay.

One thing is indisputable. A composite fan requires gets paired with a composite fan-blade case. And that is lighter than a metal one. This is the main area in which GE engines are lighter than Rolls Royce ones. (There is an offsetting Rolls Royce advantage explained in this blog post… https://leehamnews.com/2014/07/10/is-the-a330neo-engine-rolls-royces-first-carbon-fan-model/)

For the most part - especially given the above blog post - I am mostly comfortable with Rolls Royce's claim that the titanium sandwich fan blade is competitive with carbon fiber blades.

Or I was comfortable before this: a video of a next-generation Rolls Royce engine (scheduled for a 2025 release…)





This is a film of a 747 flying with three standard engines and a "donor engine". The donor engine is very large and the fan blade is blue. It is blue because the blade is made of plastics.

When Luke and I went on a factory tour of Rolls Royce we asked them how they reconciled their previous statements that their titanium blades are as good as composite blades with the obvious research they were doing on composite blades.

Their answer: titanium blades are thinner than composite blades. This means that for similar aerodynamics they can be made less deep than composite blades – and this offsets the weight advantage of composite blades. This I have seen with my own eyes (sorry I do not have pictures) but the Rolls Royce blades are indeed less deep than the composite blades. This can sort of be seen in the above videos as well.

Then the clincher. The new technology will allow composite fan blades to be made as thin as titanium ones – and therefore (at least on engines larger than a corporate jet) the titanium ones will be obsolete.

It was this discussion that led us to Albany International.

Albany and LEAP engines

We know for sure that this is being used as the blade on the LEAP engine. Here is a video of the Rochester plant (see picture above)…



Note that it is a Safran plant but the signage shows it to be a JV with Albany. Moreover the video clearly shows carbon fiber being woven in an obviously complicated pattern. (Hexcel has confirmed to us that they provide the fibers to this plant.)

Moreover we have a press release from SAFRAN.

Moreover they have a similar JV plant in France.

And here is the French Prime Minister visiting a JV plant in France. There is a similar video a year ago with the French President.



This is obviously pretty important to Safran. Again it is quite clearly a joint venture with plenty of staff in Albany uniforms.

Questions we should think about answering

  • What are the terms of the JV and how does Albany get paid? It seems in the press release to be an equal partnership but honestly I do not know.


C-FAN (the original composite fan blade business) is a JV between SAFRAN and GE. And only GE planes fly them. Is this a JV between Albany and SAFRAN because the JV wants to sell to parties other than GE (ie Rolls, Pratt & Whitney)?


  • First question: Who provided the technology for the Rolls Royce composite blade (ie the blue one in the video above). 

We know a little about the Rolls fan from this press release – and it does not look like a braided/woven fan blade – which is somewhat contradictory of the argument above. In it Rolls says:
The new CTi blade is created by laying strips of carbon fibre, pre-impregnated with an epoxy resin, into a mould using a precision controlled robot. This is then cured in an autoclave by applying temperature and pressure (a bit like a very advanced pressure cooker). The moulded blade is precision machined and coated before a titanium sheath is bonded to the front edge. The finished component is inspected and measured using ultrasound and subjected to very rigorous mechanical testing

This looks a lot like the C-Fan video aboce – rather than the Albany-SAFRAN JV. Moreover the partner is GKN – the auto company that happens to make some carbon fiber components for the A350 – and that is not this sort of weaving. Those products are traditional carbon fiber laminates.
  • Second question: What are the opportunities for Albany for aerospace projects beyond the ones listed. [I gather for instance that it is not possible to retrofit carbon fans to old engines because because the rest of the engine is essentially paired with a fan technology…]
  • Third question: What are Pratt & Whitney doing re composite fan blades? I do not know but the forward order book of their geared turbofan product is pretty good. Getting the Pratt business would be nice. The GTF product probably has different forces on fan blades because the company has a gear box which slows the front fan blade down compared to the engine core.
  • And finally the critical question: what eventual margin can I expect for all this business. My guess is about 30 percent – which seems about right for a new tech in aerospace – but in all honesty that is a straight guess. That would be enough margin to get excited about this stock.


If we can clear all this how do we value it?

I have deleted this section. It was a little crude - and you dear reader can do that yourself.


---

Now all this was a "work program" and we did plenty of work. And there are several things in this I know now to be wrong. For instance the geared turbofan has a metal fan as per this Alcoa video:





I suspect other suggestions in the work program are wrong. I am happy to be corrected. Email, phone. Please be in contact.





John Hempton

Thursday, September 1, 2016

Meta-information and insider trading

This is a question that pops up from time to time. But I will do it by stylised example.
A small cap miner has announced a very significant gold find. The stock has moved from 10c per share to a dollar per share. 
The problem is that if the find really is as described it is obvious that stock is worth $5 per share. 
It doesn't trade at $5 per share because there is such a widespread history of small cap miners overstating (or even flat lying about) gold deposits. If you regularly bought the stock of small-cap miners announcing big finds you would probably go broke. 
Now imagine you are the drilling contractor who drilled the gold. So you know exactly where the drill samples were taken with certainty. 
And suppose you took those gold samples to the lab run by your brother without any third party intervention. And so between you you know with certainty that the drill samples are real and the gold in them was accurately measured. 
The results have been completely announced to the market. So the market has been fully informed. 
But you know one thing with certainty that other people don't know. You know the results have not been faked.
So you buy the stock and it is a five bagger. 
Note that every piece of information you have is public except one piece. The one piece is that the company is telling the truth.

Your information is meta-information. It is information about the quality of information.

So are you guilty of insider trading?

This is not an idle question. At the moment Herbalife (to pick a controversial example) is a cheap stock if the company is telling the truth. (And that is where my research has been focused.)

If you knew with certainty that the company was telling the truth you would buy the stock.

This situation comes up regularly with controversial stocks and is in background in almost all stocks I buy or short.

I spend a fair bit of my time trying to work out the quality of information given to me. A lot of the time spent stock-picking is spent on the search for meta-information. 

Discussion wanted both as to where legality begins and ends and (if anyone is game) on methods of assessing the quality of information.





John Hempton


PS. I am fascinated by edge-cases in insider trading. This one illustrates the difference between American and Australian law.

A gold explorer operating on their own privately owned tenement makes a big gold discovery.
 
The discovery is alas right on the boundary of their tenement and it is open and spreads (pretty obviously) into the neighbours' tenement. 
The neighbours tenement is owned by a listed company (in this case a penny stock).  
They go and buy this penny stock aggressively whilst the majority holder of the penny stock sells aggressively thinking nothing is there.

Under Australian law this was found to be insider trading. Under American law I suspect it would be fine. The person owning the private tenement is clearly not an insider in the penny stock - but they do have material non-public information.

Okay - lets extend this. Suppose the drilling contractor works all this out too. And they join in the trading but the owner of the tenement (who hired the drilling contractor) has not freed the contractor to trade the (third party) penny stock. Is the drilling contractor okay under American law?

Saturday, August 6, 2016

So which position will Mr Ackman exit: Herbalife or Valeant

Bill Ackman just exited his large position in Canadian Pacific.

This was a stunningly successful position: genuinely I wish I had done it.

It also produces a very large taxable gain.

Mr Ackman however has been producing less-than-stellar performance for his Pershing Square fund.

So at the moment he is leaving his clients with large losses plus a large tax bill. I can't imagine they would be thrilled with that.

Logically then Bill Ackman will wipe his taxable gain by reducing or exiting one of his large losing positions - either the short on Herbalife or the long on Valeant.

I really don't have any insight into which - but he is on the board of Valeant and that makes moving the Valeant position more problematic.

Thoughts anyone?




John

PS. This observation is not original. I received similar from at least three separate emails.

Monday, July 25, 2016

Herbalife and the end of the world

A necessary part of Herbalife being a pyramid scheme is that distributors are buying huge amounts of Herbalife that they cannot sell and are being encouraged to do so.

The term in the industry is "inventory loading". The FTC in their press releases mention inventory loading but do not specifically allege Herbalife is a pyramid scheme.

Inventory loading seems unlikely to me because Herbalife offers a 100 percent refund to distributors for unsold inventory including postage. (The length of time that refund is offered however is increased by the FTC settlement.)

I have looked hard for excess inventory (for example contacting sellers on EBAY or the like) and cannot find it. Truly I never found anyone who had $6000 worth of Herbalife sitting unsold, uneaten in their cellar.

Until now.

There are it seems a small class of customers who have signed as distributors and buy tens of thousands of dollars worth of Herbalife product precisely so they can store it in their cellars. They also shatter my preconception that personal use is limited to $200 or so worth per month.

They are millennial members of the Church of the Latter Day Saints who carry vast food stores in their cellars awaiting the end of the world. Herbalife shakes with a variety of flavours and long shelf lives are part of that store.

No I am not kidding. Sure it is an edge case - but the FTC settlement limits distributors to "reasonable personal use" volumes and members of the LDS millennial community are prone to buy quantities of Herbalife for personal storage far in excess of FTC/Company agreed volumes.

These people are real. And the Government is enforcing a deal which financially disadvantages them for their religious beliefs.

Truly.




John

Tuesday, July 19, 2016

Herbalife in the Sydney Morning Herald

There is an article on the FTC settlement in the Sydney Morning Herald. Good read.

Its made better by this cartoon image of me:








John

Sunday, July 17, 2016

The Herbalife Rorschach Test

On Friday Herbalife agreed a settlement with the Federal Trade Commission (the FTC). The stock popped on enormous volume - but it is fair to say that almost all longs are disappointed with the size of the movement.

Whilst the settlement is agreed there are very substantial differences between what effect the FTC says the settlement will have and what effect the company says it will have.

The company states this:
The terms of the settlement do not change Herbalife's business model as a direct selling company and set new standards for the industry. With the settlement agreement announced today, the FTC's investigation of Herbalife is complete
The FTC state something almost the opposite - stating in their title of their release that "Herbalife Will Restructure Its Multi-level Marketing Operations". They also put out a particularly aggressive press release that stated "it’s no longer business as usual at Herbalife".

The bull case is thus the government risks has gone away and there will be no substantial change in business model. And the bear case is that the conditions placed are so large they will cause the business to collapse in the US and that those changes will be exported globally.

The disagreement regarding this settlement is enormous. The stock traded - and I can scarcely believe this number - 35.3 million shares. Almost 40 percent of all shares changed hands. Obviously some people think this settlement is really good news, some think it is really bad news. And clearly some people are just flat day-traders.

The disagreement is almost total to the facts too. There is a form of settlement in the United States which does not accept nor deny liability but accepts a fine. This settlement does not follow that form. The company disagrees with all facts in the FTC complaint except that the court has jurisdiction.

The only thing that they agree on is that the FTC did not declare Herbalife to be a pyramid scheme. But even that is a limited agreement. The FTC has stated that it did not declare that Herbalife was not a pyramid scheme - they just don't want to use pyramid language.

That said the FTC's rhetoric is unimportant. And for that matter so is Herbalife's rhetoric. They can say whatever they like about the settlement and that does not make it true. What matters is what Herbalife has agreed to do and what effect it will have on the business.

So bluntly what have they agreed:

a) That Herbalife will pay $200 million in restitution - but the details about how that restitution will be paid are left open. [I have a pet suspicion that they will find it hard to find well documented losers who lost anything like $200 million - but again that is irrelevant - Herbalife has agreed to pay it and it is cash out the door.]

b). They have agreed a change in business practices. The exact form requires a fairly detailed understanding of Herbalife's compensation scheme - but this is the list as described on the FTC's website:



  1. The company will now differentiate between participants who join simply to buy products at a discount and those who join the business opportunity. “Discount buyers” will not be eligible to sell product or earn rewards.
  2. Multi-level compensation that business opportunity participants earn will be driven by retail sales. At least two-thirds of rewards paid by Herbalife to distributors must be based on retail sales of Herbalife products that are tracked and verified. No more than one-third of rewards can be based on other distributors’ limited personal consumption.
  3. Companywide, in order to pay compensation to distributors at current levels, at least 80 percent of Herbalife’s product sales must be comprised of sales to legitimate end-users. Otherwise, rewards to distributors must be reduced.
  4. Herbalife is prohibited from allowing participants to incur the expenses associated with leasing or purchasing premises for “Nutrition Clubs” or other business locations before completing their first year as a distributor and completing a business training program.


Discount customers

The big condition is the first one requiring a distinction between "discount buyers" and "distributors".

This goes to the crux of one of the biggest Herbalife arguments. By far the bulk of Herbalife distributors do not sell sufficient product to qualify as a sales leader and thus are entitled to almost no checks based on downstream consumption. At the last 10-K Herbalife had approximately 4 million distributors globally. There were "only" 364 thousand "sales leaders". Only a "sales leader" is entitled to checks from the company based on indirect sales down many levels. (There are trivial circumstances non sales leaders will receive checks. These are described below.)

Globally there are about 4 million distributors and less than 400 thousand sales leaders thus there are 3.6 million distributors who are not sales leaders.

We do not know how many of these are in America - but as the sales leaders are about 20 percent in the United States I would guess that 20 percent of the distributors who are not sales leaders are also in the United States. That is about 720 thousand people or almost a quarter of a percent of all people in the United States.

The default for these people will be that they are recategorised as "discount customers" and this will change their relationship with the company. The importance of these changes is open to dispute (and discussed below).

The first way that it will change their relationship is that they cannot harbour any illusions of receiving a check from the company based on downstream sales. If they are customers rather than "distributors" there is no "business opportunity".

I would argue most of them were under no such illusions anyway - but this removes the possibility altogether.

But we can be very precise about the way in which their relationship with the company changes.

In the old days I could buy Herbalife from a distributor and pay full freight. (Some people do.) Or alternatively - for $70 a year - I could sign up as a "distributor" and buy Herbalife (delivered by UPS) for a 25 percent discount. The 25 percent discount applies at almost all levels of purchase (volume points) that are consistent with personal consumption.

There are two advantages for buying it at a 25 percent discount. The first is that I get it cheaper (which is nice if I want to consume it myself) and the second is that I might sell it to someone (at par) and pocket that 25 percent myself. If someone bought it from the company at par and named me as their distributor then I would be entitled to 25 percent of their sales (a check from the company). However at the 25 percent level my volumes must be small. Volumes consistent with a solid diet by three to four people would entitle me to more than 25 percent discount.

Whatever - the volume of checks from the company for 25 percent distributors was trivial. (Sure some was sent but the total dollar value was small. They occurred only in the case that a small distributor convinced someone to buy product from the company at par and name them on the order form as the up-line.)

For a 25 percent customer who never convinced anyone else to order directly from the company (ie most of them) paying full-freight there has been no change.

Calling this person a "discount customer" rather than a "distributor" changes nothing. A 25 percent distributor is still entitled to buy it at a 25 percent discount. And if they actually manage to sell some at par (above list price) they can probably pocket the 25 percent anyway (but they can't formally tell the company). If they managed to convince someone to buy it at full freight ordering direct from the company they have lost that - but in toto this is not very much because 25 percent distributors are buying only volumes consistent with personal use. (Bigger volumes would entitle them to more than a 25 percent discount.)

I have met many 25 percent discount customers and almost none are selling the product ever. By number these are - by far - the bulk of the 4 million Herbalife distributors globally.

The company has always asserted that are not really distributors anyway - they always were discount buyers. By contrast the shorts - led by Mr Ackman - have asserted these people are "distributors" rather than customers - and when they work out the income and failure rate of distributors they always include these people in the denominator which makes the failure rate look high and incomes distributed by the company look pathetic. (After all they are counting in the denominator a huge number of people who were not selling any - so were not entitled to a check from the company anyway).

The volumes associated with these distributors cum discount customers are typically less than 600 volume points per year - an amount entirely consistent with personal consumption of diet products.

There are a small number of distributors who do greater than 1000 volume points but less than 4000. 4000 volume points entitles you to be a "sales leader". These people are entitled to buy the product at 35 percent or 42 percent discount depending on their volume (rather than a 25 percent discount) and if they sell it to someone else they make a somewhat larger "retail profit". None of that changes.

However if this customer were to sign up another discount customer (say at 25 percent) they would be entitled to a check from the company for the difference between the customer's 25 percent and their 42 percent. The aggregate amount of such checks from the company is trivial but they do exist. These people are going to either become distributors (to qualify for this check) or remain as discount customers. To qualify as a distributor they will now need to submit a business plan. My guess is that very few of them will do so. There will be a small loss to the company from people who become distributors accidentally - joining for the discount and selling a little on the side.

The shorts have fairly continuously asserted that the "discount customers" do not exist. Here is a typical Seeking Alpha assertion of precisely that. The longs have asserted that most distributors are in fact discount customers.

Bluntly this is the crux of the argument. If the 25 percent "distributors" are in fact people who dream of receiving checks from the company then telling them they cannot will cause the scheme to collapse. If that huge swathe of people are just "discount customers" the formalising the arrangement will have almost no effect on business.

This is the first Rorschach Test: if you believed in advance that the discount customers were a myth you believe now the FTC conditions will collapse Herbalife. If you (like me) believe that the bulk of distributors were in fact discount customers then calling them such will have almost no effect.

What is great about this is that the existence or not of discount customers is easily determined. Go and visit half a dozen decent sized herbalife distributors and find their downline. (This will take you four days maximum - but you will need to use shoe-leather.) If you don't find many discount customers you can short the stock. (The shorts will be right.) If you find plenty you can go long the stock. (The longs will be right.)

And the beauty of this is that you can know. You do not need to take my word for it. Just do it yourself and make some money.

My assertion is the people I think are "discount customers" and Bill Ackman thinks are "failing distributors" are about a quarter of one percent of the US population. It should not be hard to find them if you look.

The second business change demanded by the FTC

Here again is the provision from the FTC website:
Multi-level compensation that business opportunity participants earn will be driven by retail sales. At least two-thirds of rewards paid by Herbalife to distributors must be based on retail sales of Herbalife products that are tracked and verified. No more than one-third of rewards can be based on other distributors’ limited personal consumption.

The shorts have continuously asserted that retail sales do not exist. (See the above discussion of whether discount customers do not exist.)

If you believe that retail sales do not exist then the requirement that two thirds of sales in the downline of a distributor be retail sales (rather than sales to another distributor) will be very hard to achieve.

If you believe like me that retail sales exist and are widespread the FTC requirement above becomes merely an auditing requirement.

Again you should not take my word for it. Get on the road. Go find some distributors. Talk to their customers.

But if the discount customers are in fact discount customers (see the discussion above) then this should be trivial.

But lets put some numbers around it. A distributor who is entitled to multi-level compensation is (with the trivial 42% distributor described above excepted) someone who is a "sales leader". Sales leaders are entitled to a share of sales up to three sales leaders below them.

To become a sales leader you need to have 4000 volume points annually. A meal replacement is roughly 1 volume point. So you need to be ordering roughly 4000 meal replacements per year.

The most anyone reasonably personally consumes is two meal replacements per day for them and their spouse. This is about 1400 volume points a year. Only in the extreme example of a couple who sell precisely the minimum number of volume points per year and personally consume the reasonable maximum is this provision even going to bind.

In other words the provision does nothing at all (once you have decided that retail volume truly exists). As a long I am utterly unconcerned about this provision. But the shorts (who think that retail volume does not exist) think this provision will be lethal too.

Again you can test it. Just get put on the shoes and allow yourself a few days to check it out.

The 80 percent rule company wide

Under the third condition the company is required to ensure that 80 percent of volume company wide is sold to must be legitimate sales and (as per the consent decree) specifically this means sales for reasonable personal consumption plus verified retail sales. This should not be hard even if you restricted it to retail sales.

In North America there are 76 thousand sales leaders doing 1.1 billion volume points. This is about 14,500 volume points per sales leader. The maximum amount of personal use (as estimated above) is about 1400 volume points per year.

This rule should be trivial to meet. Absolutely trivial.

Of course if the retail sales don't exist and the 25 percent distributors are really failed customers all bets are off. But again that debate is easily solved by using shoe leather.

Requiring at least a year as a distributor before opening a club

The final change demanded by the FTC will change business practices. It will require that a distributor be a distributor for at least a year and submit a business plan before they open a club.

Normally I would find it odd and patronising that the Government tells people (and in this case mostly Hispanic people) that they can't open a business. Notwithstanding that I am going to cheer the condition.

I have visited several viable clubs - and several non-viable clubs. But the viable clubs are barely viable. I blogged about that here. In that post I argued that clubs would be better if the number of clubs were restricted. I stand by that view. The FTC has done club owners and the company a favour.

===

The FTC settlement is a Rorschach Test. You will see in it what you want to see in it.

If you see a pyramid scheme in advance then the conditions that the FTC has imposed will cause that scheme to collapse.

If you see something that is not a pyramid scheme then lo - the FTC conditions will do almost nothing.

You can check this out yourself. Shoe leather. It's really an opportunity for you to make money on primary research.

I have for a long time asserted that Herbalife is not a pyramid scheme. I was worried however that some bureaucrat would (in direct contradiction of the facts on the ground) decide it was and try to shut it down. Indeed the extreme time that it took for the FTC to come to a settlement on Herbalife increased that risk dramatically. We had limited our position size (a little) to account for the insane-bureaucrat risk. That risk has gone now - and I upped the position (slightly) near the close on Friday.

But of course if this is a pyramid scheme then the conditions imposed by the FTC will cause the scheme to collapse. And so shorting it now is a low risk proposition.

Again - as stated - the FTC conditions are a Rorschach Test. You can see what you want to see.

===

One worthwhile detail is that more than a dozen top distributors signed non-disclosure agreements and okayed the settlement with the FTC. They did not think it will affect their business adversely. They did not bear the cost of litigation - so they only had an incentive to sign an agreement that did not hurt their business.

Take that detail as you wish.

===

Finally I remain resolute in my view that Herbalife is not only not a pyramid - it is a highly ethical organisation.

I think that the FTC might actually have trouble finding enough "victims" to distribute the $200 million in restitution. I intend on FOIA requests over time to monitor that.

The "restitution" makes me think of the FTC not as a competent and honest regulator but rather an extortion racket. I am a liberal and I always thought the argument that the US Government was an extortion racket was far-fetched. But I find myself agreeing with this article in The Economist.

The only saving grace is that the $200 million was "restitution" and not a "fine" and is therefore tax deductible.

I think by owning Herbalife you will make a lot of money.

But more - you will be standing up for an ethical company against lies and extortion. I am proud of the money we have made thus far, expect to make more and am proud of the position.

The FTC decision is now made and the arbitrary government decision risk is removed. If this is a pyramid scheme then the conditions imposed will cause it to collapse.

On that I think I am safe.





John

PS. There are a few other FTC provisions which should have very limited effect.

The company already gives distributors a refund for any unsold product including postage. The deal with the FTC forces Herbalife to offer that refund for a longer period.

Also the deal with the FTC prohibits auto-refilling orders at Herbalife. Herbalife has previously disclosed that about 0.5 percent were auto-shipped. This won't be a big change.

The company already requires distributors to order directly from the company if you wish the volume to count towards sales leader classification. There is already good granular data on these purchases. Refunds are readily available.

Tuesday, July 5, 2016

Want a tough job - try collecting debt door to door in the council estates of Northern England

I was reading the accounts of Provident Financial Group - a UK subprime lender. I have no position - but this appears to be an old relatively well run subprime lender with a prohibitively high price to book ratio.

Whatever - they are growing now through a credit card business where they are hawking cards on the street. And they are shrinking their foundation business which involves selling loans and collecting debt door-to-door.

That business - Provident - has a network of 5,500 agents who call each week at the homes of 900 thousand people in the UK. That is 32 homes each per working day.

And they originate credit and collect loans.

Here is an extract from the annual report:




According to this the agents are primarily paid commission on what they collect, not what they lend.

Just imagine this job. Being paid for collecting on tough debts in the rainy, dark north of England, a bit like an old rent collector, just a little more seedy.

By comparison my life (and probably yours) is sheltered and easy.




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.