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an opinion on fairness opinions

2 Nov

Several months ago, I reviewed the NYSE Euronext’s proposed merger with Deutsche Borse.  At nearly 900 pages, it was a huge document with loads of information: the agreement and exchange offer, regulatory issues, standalone financials, pro-formas, management discussion, risk factors, background of the merger (a personal favorite), projections of synergies, opinions about the merger from investment banks, etc..  Each time I’ve reviewed merger documents trying to find holes and glean new insights, I continue to be amazed that banks are still paid so much for so-called ‘fairness opinions’.  [This post is a bit longer than usual, but contains several citations with our emphasis that don’t require word-for-word reading.]

Let’s face it, executives are going to push a deal through whether or not it’s good.  With Excel spreadsheets it’s too easy to ‘click and drag’ indefinite predictions of a rosy future.  Valuation models are ‘garbage in, garbage out’, and many large mergers turn out to be just that, garbage, at least for shareholders (executives tend to fare better, owing to change-in-control provisions).  So, predicted ‘synergies’, mostly cost-savings, can really be about anything executives say they are.  Who am I to question their predictions?  And fairness opinions are there to serve the C.Y.A. function for boards of directors.

A fairness opinion is essentially a stamp of approval from an investment bank about a transaction.  In official terms, “A fairness opinion addresses, from a financial point of view, the fairness of the consideration in a transaction.  Fairness opinions are routinely used by directors of companies in connection with a change in control transaction, such as a merger or sale or purchase of assets, to satisfy their fiduciary duties to act with due care and in an informed manner.”

To us, “to satisfy their fiduciary duties” essentially means to pass the buck when a merger doesn’t work as projected.  According to professor Robert Holthausen (@Wharton), more than half of mergers fail and “one recent study found that 83% of all merger fail to create value and half actually destroy value.”  Yet, 80% of board members involved in acquisitions thought theirs had created value for the company.  So, I know out of the gate that regardless of what the opinion says it has about a coin’s flip chance of being accurate.  Yet, bankers are paid millions to prepare these 3-4 page documents with a clear financial incentive to help engender that outcome.

The below excerpt increases the length of the post, but it need not be read in its entirety.  I’ve bolded the main points.

The full text of Perella Weinberg’s written opinion, dated February 15, 2011, which sets forth, among other things, the assumptions made, procedures followed, matters considered and qualifications and limitations on the review undertaken by Perella Weinberg, is attached as Annex B to this document. Holders of NYSE Euronext shares are urged to read Perella Weinberg’s opinion carefully and in its entirety. The opinion does not address NYSE Euronext’s underlying business decision to enter into the combination or the relative merits of the combination as compared with any other strategic alternative that may have been available to NYSE Euronext. The opinion does not constitute a recommendation to any holder of NYSE Euronext shares or Deutsche Börse shares as to how such holders should vote or otherwise act with respect to the combination or any other matter and does not in any manner address the prices at which NYSE Euronext shares, Holdco shares or Deutsche Börse shares will trade at any time. In addition, Perella Weinberg expressed no opinion as to the fairness of the combination to, or any consideration to, the holders of any other class of securities, creditors or other constituencies of NYSE Euronext. [Isn’t this a fairness opinion?]  Perella Weinberg provided its opinion for the information and assistance of the NYSE Euronext board of directors in connection with, and for the purposes of its evaluation of, the combination. This summary is qualified in its entirety by reference to the full text of the opinion. Perella Weinberg’s business address is 767 Fifth Avenue, New York, NY 10153, United States of America. Perella Weinberg has given its consent to the use of its opinion letter dated February 15, 2011 to the Board of Directors of NYSE Euronext, in the form and content as included in this document, as this document stands, at the time of publication.  In giving such consent, Perella Weinberg does not admit that it comes within the category of persons whose consent is required under Section 7 of the US Securities Act of 1933, as amended, or the rules and regulations of the US Securities and Exchange Commission thereunder, nor does Perella Weinberg thereby admit that it is an expert with respect to any part of the Registration Statement on Form F-4 of Alpha Beta Netherlands Holding N.V. filed with the Securities and Exchange Commission, which includes the proxy statement/prospectus, within the meaning of the term “expert” as used in the Securities Act of 1933, as amended, or the rules and regulations of the Securities and Exchange Commission thereunder.

So, hopefully it’s apparent that the opinion really isn’t anything but an expensive formality.

Here are some more “outs” from Deutsche Bank’s opinion (emphasis ours).

DBSI prepared these analyses for purposes of providing its opinion to the Deutsche Börse management and supervisory boards as to the fairness to holders of Deutsche Börse shares from a financial point of view of the Deutsche Börse exchange ratio. These analyses do not purport to be appraisals nor do they necessarily reflect the prices at which businesses or securities actually may be sold. Analyses based upon forecasts of future results, including the broker projections and estimates of the synergies, are not necessarily indicative of actual future results, which may be significantly more or less favorable than suggested by these analyses. Because these analyses are inherently subject to uncertainty, being based upon numerous factors or events beyond the control of the parties or their respective advisors, none of Deutsche Börse, NYSE Euronext, DBSI or any other person assumes responsibility if future results are materially different from those forecast.

Each opinion issued contains similar language.

Don’t forget the indemnification language.  “Deutsche Borse also agreed…to indemnify Deutsche Bank and its affiliates against certain liabilities, in connection with this engagement.”  This language applies more or less equally to each company issuing its opinions and advice.  Bankers are relying on management’s internal projects and representations, and this becomes another out through which they can’t be held liable for future results.

I could go on and on with examples, but won’t belabor the point beyond those illustrated above.

In the NYSE case, Pirella Weinberg was paid $5 million upon the public announcement of the agreement of the combination and is to be paid $22.5 million upon the completion. Deutsche Bank will be paid €14 million ($20.5 million) contingent upon completion of the combination — or a max of €2.4 million ($3.5 million) if not completed, and JP Morgan will be paid $10 million, “a substantial portion of which will become payable only if the proposed exchange offer and merger are consummated.”  Is it really worth more than $50 million for some financial analysis and a rubber stamp?

In summary:

  • The incentive structure is misaligned:
  • Indemnification from the company makes banks’ liability negligible, absent some demonstrable lack of due diligence or fraud
  • Banks are paid mostly through contingent fees (if the deal is consummated)
  • There are numerous “outs”:
    • Like auditors, the representation letter signed by management gives opinion-writers an “out”, i.e., “We relied on management’s representations and do not independently verify…”
    • Buckets of “we do not do X, Y, Z” and “…the opinion is not…” statements
    •  “The future is inherently unpredictable”

All of that said, there is a lot of work involved and some fairly sophisticated modeling is required to back up the opinion.  Yet they simply should not cost $10-20 million on both sides of the transaction.  My company, Sagacious, Inc., offers fairness opinions and is working on for those who desire a fairness opinion but prefer it delivered on a non-contingent, fixed fee basis.  We offer experienced analysis and will work one-on-one with boards of directors and managements to offer an informed, measured opinion.  We’ll determine whether the deal is fair from a financial point of view for a lower, fixed price sans conflicts of interest.  Meanwhile, the shareholders will continue to pay (way too much) for such opinions.

Disclosure: No positions in any of the companies mentioned.


Credit Problems in Perspective

4 Apr

With all of today’s seemingly dire newspaper headlines, sometimes it is difficult to keep things in perspective. Consider, for instance, the current “credit crunch,” including mortgage-related write-downs and credit losses and their effect on financial institutions globally. Through April 1, over 45 of the world’s biggest banks and securities brokerage firms have announced a total of over $230 billion in asset write-downs and credit losses, according to Bloomberg.

This is certainly a very large number, but let’s view it in context. It is just 0.4% of the $57.7 trillion U.S. household net worth and less than 2% of our annual gross domestic product. In addition, only $26 billion of this is actual realized losses. In other words, over $200 billion has been due to valuation changes in the securities, whose underlying assumptions may or may not accurately reflect the eventual economic reality that will transpire. If losses actually turn out to be less than is implied by these valuations, we could see “write-ups” and/or higher returns on equity in future periods (owing to the smaller capital base caused by asset-writedowns) . But, of course, losses could also be larger than expected…

Where Is the Bottom?

7 Nov

“Many will be restored that now are fallen and many shall fall that are now in honor.”

Where is the bottom? At this point, it doesn’t seem like there is one with banks and mortgage-related companies. Several very good companies’ stocks are down more than 50% year-to-date, yield in excess of 10%, and in many cases trade below book value. I’ve seen many of them trade down 5-10-15% in one day on no specific news. Fear is pervasive. Investment capital continues to shift to commodity-related companies – energy, materials, industrials – which continue to perform well, from bank and mortgage-related stocks – on concerns about bad loans – which are performing terribly. Yet the degree of stock price selloff in many cases is disproportionate to the actual levels of economic value that may be impaired by escalating loan losses. Eventually, stock prices will reflect the companies’ true fundamentals.

While it is nearly certain that many banks and mortgage companies will experience lower levels of profitability over the next few years, that profitability is well below normal. Yet the stock market is valuing many as if declining loan losses will continue indefinitely, all dividends will be discontinued, and book value will erode far beyond its current levels. While these scenarios are inevitable with some specific names that are less prepared for a more difficult credit and economic environment, several will do very well as market sentiment shifts.

It is important to keep a clear head in this environment. Investors seek to earn a total return on their capital over time and historically dividends have been a big piece of that return. At their current quotations, some financial stocks offer (growing) yields of 10% or better. This happens to be the S&P 500’s approximate average annual return over 70+ years. At those yield levels some very good companies trade for in the market today, one need not see any price appreciation from here to earn satisfactory returns over long periods. But when most of the problems seem resolved, the market is not likely to leave yields at these levels for long.

For those looking for a diversified way to play this opportunity, take a look at the Financial Select Sector SPDR (XLF), which continues to (not surprisingly) hit 52-week lows. It yields 2.8% and trades at 1.6 times book value. For those unwilling or unable to handle the short-term volatility, buy a long-term call option on the XLF out to January 2010 at a strike price of $30 (roughly its current price). Buying the calls now cost $5.75 for a net cost basis of less than $36 if shares are worth more in a couple years. Also attractive (and probably more so) is the iShares Regional Banks ETF (IAT).

The quote at the beginning of the post sums the case up nicely, and for those willing to venture into individual names there are opportunities for significant upside potential with little risk of permanent capital loss.

Full disclosure: No positions in the securities mentioned.

"Good" Mortgage News

27 Oct

Countrywide Financial (CFC) reported a huge quarterly loss yesterday, amounting to $2.85 per share. Most of this was a noncash charge to write down asset values – both of performing loans that are simply now worth less in the marketplace today as well as securitization residuals, on which there is not likely to be a recovery of value. CFC also added meanginfully to its loan loss reserves as delinquencies rose during the quarter. With respect to residuals, there is still $900 million on the balance sheet. On the other hand, there are between $900 million and $2.7 billion of mortgage servicing rights not reflected on the balance sheet, according to management. The conservative thing to assume is that both are $900 million and thus offset each other, having no effect on book value.

After today’s write-down and the 32% stock price rally, the stock still trades below its diluted book value of over $20. Now, in the near-term, book value is tough to get the arms around. Is it too high? While you may not be able to liquidate the company for that, as long as CFC has the ability to hold the loans they can wait for more favorable pricing. In this case, the economic value of the loans on its balance sheet could be even higher. While GAAP encourages write-downs of assets deemed permanently impaired, it does now allow “write-ups.” So if asset values are significantly written down due to higher loss assumptions that do not materialize, the balance sheet values will actually understate the economic value. Despite this possibility, I assume things will get worse.

In a more normal environment, Countrywide can earn returns on equity of 15% or greater. In this case, the company should be worth in excess of $30 per share versus its current price of around $17. In my view, that is a big enough discount to offer a solid margin of safety. Management, while surprised by the depth with which the credit market disruptions affected their access to the capital markets, is now stronger. Loan underwriting standards have already improved. During their conference call Friday management offered a slide I would call their “oops” slide showing the past business they would underwrite now versus under their old underwriting guidelines. On $170 billion of business underwritten 2006 and before, only less than $60 billion would have been accepted under the new guidelines. That is an admission of how lax their standards became and explains why loans on 2005 and 2006 vintages are performing as poorly as they are currently. Loan performance from those years certainly would be a lot better now had the company (and most of its competitors) not been as aggressive in pursuing market share while ignoring prudent underwriting principles.

While the company is not out of the woods, it seems they are dealing well with the current market realities. Access to capital has improved and the company is working to virtually eliminate its reliance on the commercial paper market, formerly its largest source of short-term financing. Having migrated its primary financing to the bank, near-term growth will slow as the company either sells loans to GSEs or holds them on its balance sheet. Given its exit from certain lines of business and elimination of 10,000 to 12,000 employees, Countrywide from here will grow from a much smaller base. But the company is poised to take share in a smaller, more rational market and be a meaningfully more profitable company in future periods than it is today.

The credit market turmoil is not over. The housing market is far from recovery, having not yet bottomed. There is still substantial excess housing inventory that must be lapped up. In some areas, prices went up far too much for far too long to not have a longer “payback” period where the excesses are wringed out and prices move more into alignment with income levels. There are more shoes to drop, but this news from Countrywide is reassuring to investors who have watched the stock freefall amid panic selling the last few months. Yet for a value investor, the bigger the discount to underlying business value, the greater is the implied future return on the stock.

Full disclosure: Long CFC shares and call options.

A Win-Win Deal?

23 Aug

Bank of America (BAC) scored itself a sweet deal, announcing yesterday that they’ve acquired $2 billion worth of 7.25% convertible non-voting preferred securities in Countrywide Financial (CFC). The securities are convertible at $18.00 per share, so they’re already in the money by over $4 per share. Assuming the preferreds trade at a price based only on the underlying common stock, at this point they’re sitting on a capital gain of nearly $500 million. Both sides are touting it as win-win, though it gives some insight into the terms B of A can garner given its reputation and solid finances.

So why did Countrywide accept terms that appear to offer asymmetrical economic benefits? Put simply, the credit market continues to be tight and it’s difficult to discern how widespread or deep the problem could go. Credit was abundant for a long time as risk premiums declined to historic lows. Now, to paraphrase Warren Buffett, the hangover may be proportional to the binge. Countrywide’s primary funding sources, or “oxygen” as CEO Angelo Mozilo calls them, are commercial paper, the repo market, and medium-term notes. The markets for each of these has more or less seized up. The Fed’s discount window is available to them, but only to the Banking division. But the bank doesn’t have sufficient assets to borrow in amounts that will put much of a dent in the needs of the Home Loan division, where most of the assets are held. Over time, as the banking business becomes the primary funding source for home loans, the discount window would be a much more viable source of funds. But it isn’t at this point.

To make a long story short, Countrywide needs capital to continue funding new loans. The transaction gives Countrywide some additional capital along with the implicit backing of deep-pocketed Bank of America. Countrywide has traded some of its economic value (offering a conversion price that is half what the shares are worth) in exchange for a strong endorsement and (at least implied) reliable access to capital.

How does this affect Countrywide value to common shareholders? It dilutes shareholder value, but because it saves them from selling off assets at fire-sale prices to continue to finance operations, it looks to be more wealth preserving than wealth destroying. Start by assuming B of A waits to convert. In this case Countrywide is on the hook for $145 million in preferred dividends, which is around 5% of the company’s 2006 net income. The 7.25% interest rate is reasonable, but does not enjoy the tax break that interest receives (preferred dividends are paid from net income, not pretax income). But the additional expense is not unduly burdensome.

In calculating per-share value, I assume B of A will convert the shares, which adds an additional 111 million shares to Countrywide’s 562 million outstanding. So the share count goes up by nearly 20% and B of A owns 16-17% of the company. Book value (as of June 30th) now is a little over $20 (down from over $24) after considering the dilution. The widespread credit market problems have destroyed some shareholder value here, which is why a margin of safety in initial purchase price is so important. Though this is only a start, Countrywide is now on more solid footing. The media, which has been a part of the problem these past few weeks should now (hopefully) cast the company in a more positive light going forward, which should reinforce confidence in the company by its investors, depositors, and other stakeholders.

Full disclosure: Long CFC and BAC shares.

Panic Sellers Want Cash

18 Aug

The recent market selloff, led by financials and consumer discretionary stocks, looks very much like a panic. By mid-day Thursday, the S&P 500 was down 10% – an unofficial “correction” level. The last couple weeks have been one of the best times to invest new money in a very long time.

Over the past few weeks, we’ve seen indiscriminate selling across the board. For instance, one company I watch very closely was down as much as 50% since the end of June, a result not of its own operational problems but of being lumped into a broad category along with American Home Mortgage (AHM), a just-bankrupted mortgage REIT. Yet its business model and risk profile is very different than the typical “mortgage REIT.” It has now rebounded 50% from its lows and the indiscriminate selling offered a great opportunity to add to positions. This situation is not isolated only to this one stock; I’ve seen it with many others.

Countrywide Financial (CFC), a company I’ve mentioned here as a reasonable value at higher prices, is down 50% year-to-date on concerns the company doesn’t have access to enough liquidity to continue funding its operations. I’ve read all the recent filings and press releases, but what has been reported in the media based on those communications has amounted to “spin.” In the most recent example, the widely reported news that “Countrywide is forced to max out its credit line” was an exaggeration. True, CFC did max out one of its credit lines, but has access to quite a bit of additional short-term liquidity that will allow it to continue making loans. And now, with the Fed cutting the discount rate Friday to 5.75% and the borrowing term now 30 days renewable, CFC now has access through its bank to highly-available, reasonably-priced capital.

As of June 30, CFC was paying its depositors a weighted-average rate of about 5.15% on deposits and is now offering 12-month CDs at 5.65%. Discount window loans won’t cost them much more. Countrywide is continuing to make loans and take market share. They bought five branches from HomeBanc a few days before it entered bankruptcy and are hiring workers from American Home, previously mentioned. Year-over-year through June 30, market share rose to near 19% from under 15% last year, and funding grew despite an overall mortgage market that was down 10%. I cannot summarize the entire investment case here, but I (still) believe CFC shares are an excellent value at current prices, but are not for the faint of heart because the road will be very bumpy until the dust settles.

As Ben Graham said, “In the short term, the market is a voting machine; in the long-term, it is a weighting machine.” And in the past few weeks people have “voted” by taking their capital out of the market, and especially certain sectors. During just the past week ended Thursday, $585 million was pulled from the Select Sector SPDRs Financial fund (XTF), which was nearly 20% of its assets. Money market funds reported net inflows of $41.484 billion, the largest year-to-date. The week prior to that, money markets had net cash inflows totaling $36.229 billion, the largest inflows since 12/7/05. Investors are selling stocks (and bonds) and going to short-term funds to “wait out” the storm. As a value investor, I am happy to turn over some of my cash for the undervalued assets they’re selling.

The best time to get in is when everyone else is getting out. Analyze well, consider worst-case scenarios and downside risk, and if your reasoning and analysis are good market prices will eventually reflect economic reality, regardless of the irrationality of Mr. Market.

Full disclosure: Long CFC.

Subprime Concerns Again!

18 Jul

The concern from the subprime market continues to spill over into the stock prices of companies such as Countrywide Financial (CFC) and others. Countrywide has been the subject of frequent posts and that mainly is because (1) I own the stock so I’m watching it and (2) subprime concerns have caused its price to bob around well under intrinsic value for some time now. And now its share price is back under $35 apiece amidst renewed subprime concerns (less than 10% of its business was subprime).

The latest news regarding subprime is that two Bear Stearns hedge funds that specialized in subprime mortgage-backed bonds have ended up virtually worthless. Much of the reason the funds went down so fast was likely due to the leverage employed, as the index that tracks subprime loans originated in the 2nd half of 2006, the ABX “BBB” 07-1 index, fell to nearly its lowest level ever over the last couple days.

This is a classic illustration of the market being irrational longer than one can remain solvent. Yet these funds were probably using “risk controls” that considered the probability of such an event as so miniscule that they ignored it (based on the dubitable “proof” of historical data or simulations heavily contingent on multiple assumptions). Turns out the risks were higher than the so-called models told them. Looks like they opted to be precisely wrong rather than approximately right.

Over the past few years, anyone could sell a mortgage. Just get in touch with GMAC, provide the documentation they want, and get paid a fee based on each mortgage obtained for them as a broker. GMAC (and many others) in turn would package the loans together and sell them to investors. So the accountability was really lost at each stage while the packaging, or securitization, process mysteriously turned a group of loans into investment grade despite the dubious characteristics of its individual constituents. Downgrades in these bonds over the past few weeks have called into question the quality of the underlying loans and hit these two funds very hard.

I think underwriting standards today are likely to have improved overall (yet, even though its only anecdotal, I still see advertisements touting “no down payment” loans available). But overall, going forward, the lax lending standards have likely subsided and overall loan quality has probably improved (that is, until the next boom period for housing). For originators whose loans are sold through securitization, the bigger players are the ones that will benefit long-term as smaller competitors are shaken out. This includes Countrywide, Wells Fargo (WFC), and other large banks such as Bank of America (BAC) and Washington Mutual (WM).

Full disclosure: Long shares of all companies mentioned.

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