Bronte Capital

Sky People Fruit Juice and the trials of a short seller

2012-01-23T09:55:00.002+11:00

Just a link for today - to Roddy Boyd talking about Kevin Barnes and Sky People Fruit Juice.

Roddy is someone I always read.

If Sky People issue a rebuttal I will - in the interest of fairness - link that as well.

John

Diversions: Wild is the wind

2012-01-17T18:06:00.000+11:00

Just had a fabulously productive day at work (meaning I got a long way towards some money-making ideas).

And for that I am happy enough for now.

So I am indulging in diversions:

Tesco - request for comments

2012-01-13T11:04:00.001+11:00

The number of problem long investments in my portfolio doubled overnight - from one to two. (We have some small problem longs and some large longs with more minor problems - and some problem shorts but only two largish positions that are doing poorly.)

The treacherous two are the (much discussed) Bank of America long and the (less discussed) Tesco. Bank of America is a bank - therefore highly levered - and therefore total disasters can't ever be discounted. But Tesco is a grocer with a seemingly impregnable position in the UK and some positions elsewhere that may or may not be fine. It is hard to see how you compete with Tesco in its core business - and hence it is pretty hard to see how they get into real trouble. They have debt (driven by the demands of investors during the last cycle to "sweat the balance sheet" but the debt should not be problematic and the repayments are fairly rapid.)

I thought Tesco was my "safe" long. The relatively safety made the position bigger!

Oops.

On Tesco, I was sceptical of their expansion into the United States. Grocers (indeed retailers in general) have a poor record of crossing borders - there are plenty of cultural differences.

More to the point it is fairly easy to open up in competition in the US - there are vacant big-boxes everywhere and soon to be more - but it is very hard to open up in competition in the built-up cities of the UK. The UK is thus naturally a good business (hard to compete with) and the US less so. [Contra: I guess that is why they open in the US - because they can get sites...]

But when I revealed the position one of my regular correspondents (and obviously smarter than me) admonished me. He thought the American positions would be fine but the UK was going to be problematic - he thought margin declines could be nasty. And that is how it looks right now - the US has very good sales growth - the UK rapidly falling sales growth (a very bad second derivative) and declining margins to boot.

Margins may be the end of this story - but maybe there is something else. After all the competing retailers did well over Christmas - the problems look Tesco specific.

So here is a request for comments. When I was last in the UK (both recent trips) I did not step out of the international city of London. Oxford Street is visibly doing quite well. But the UK is not. My friends with businesses over the UK describe the city as a cocoon in which you can comfortably shop and see no problems with the world. Go to business parks in Edinburgh once built for grand financial institutions and it looks different.

So here is a request - and it is a request for my (relatively few) UK readers outside London. What is going on at Tesco and Sainsbury in places like Leeds or any other major regional city in the UK? Is there a reason why the problems appear Tesco specific? Is Tesco deliberately going down market (they appear to be in recent promotional videos).

My hopeful request to readers is for someone to conduct an "apple freshness test" in a regional city. For this test you buy an apple from each of the local grocers on the same day and leave them on the shelf to see the order in which they rot to the point you would not eat them. Twelve days is generally pretty good - it means the supply chain is fast and efficient. Eight days less so. The grocer that loses the apple freshness test eventually loses the reputation for fresh food and will (inevitably) lose margins and profits. This is something that happens imperceptibly - but women (and they are mostly women in this case) are very good subjective judges of where to shop.

The "apple freshness test" is the core here. The company says that at the "heart" of what they need to do is fresh foods. Fresh foods is only partly about what happens in the store. To be fresh they need to deal with the chain.

Hoping for help from my readers.

John

It is a small (meaning worthless) consolation that the two stocks on which I am suffering are the ones Warren Buffett has been buying. I am losing money in good company - but they are losses just the same. (Unlike him though I have some winning short-sales...)

The forthcoming irrelevance of the Australian consumer electronics retailers

2011-12-30T16:34:00.001+11:00

This is a post aimed squarely at my hedge fund manager readers who regularly ask me what to short in Australia. The most obvious target (in my view) is retailers - and as a taster I start with the big-box consumer electronics retailers.

Australia still has two electronics chains doing big-box consumer electronics. These are JB HiFi which is well run, has a modern format, a short history and not much balance sheet and Harvey Norman which is a little more old fashioned (like Circuit City in the 1990s it still sells fridges on prime real estate) but has a better balance sheet (reflecting its once glorious history). Harvey Norman also has a franchise model - it does not own all of its stores.

In the US the debate is whether the country can support one or zero highly profitable big box chains. Best Buy - the bears argue - is the showroom for Amazon. In Australia as I said we still have two chains - its as if Circuit City were still around. Moreover because Harvey Norman has a balance sheet it can survive quite a long time and Gerry Harvey is prone to say it is the competitor that will go out of business. But Harvey Norman really is losing share to JB Hi Fi and ultimately both will lose share to the internet.

Gerry Harvey sounds somewhat desperate these days - firstly arguing that internet shopping is a con (nobody makes any money in it) and then arguing that there should be additional taxes on it. Then he sets up an internet company in Ireland. It looks really bad except that because of the above-mentioned balance sheet he can stay around for a while and he might even be able to liquidate and be left with something valuable at the end. (I still believe liquidating a large retailer is scary-hard.)

The JB HiFi model

JB HiFi spends a lot of money to look cheap. Have a look at their website - it is almost a parody of old-style discounting pamphlets. The stores have false plywood floors to make them look like a discounting house. They have young staff wearing casual clothes and signs that are carefully printed on a computer so that they look hand-drawn. The shop is deliberately cluttered giving it a feeling of being (very) crowded. They don't do products that are not hip. There are no fridges, blenders, toasters but lots of pads, laptops, large screen TVs and computer games. The Apple products are given prime place not because selling them is profitable but because it makes the store look cool.

And for a long time JB HiFi really were cheap. The website flashes the slogan "cheapest prices - always". This was a company with the virtuous cycle of looking cheap and being cheap, selling fast, having high turnover and low inventory costs (important in electronics where obsolescence is quick) and just looking like a happening place. It was also a hot stock.

But it does not ring true any more. They are not the "cheapest prices always" - far from it. They match prices on large items where people price check and they will match prices if you really push them (trade practices law in Australia makes it hard to advertise the cheapest price if you don't have it) but I am noticing that on "convenience items" such as cables and SD cards they are pricing aggressively high. They spend money to look cheap but they aren't any more. It is the advertising tag-line of a decaying business.

They missed earnings expectations a while ago - the stock is having a rough time. But it is still fairly richly valued (do comparisons of price to sales if you want). The immediate question is how far further will it go and will Gerry Harvey keep throwing his good balance sheet at staying in the game and give them pricing pressure. Gerry Harvey it seems wants to be the survivor.

My Christmas Observation

I purchased a camcorder at Christmas and forgot to buy an SD card. These produce a lot of data so a big (ie 32gb) card was required.

Here is the only such card at the JB Hi Fi in the major shopping mall in Bondi Junction.

You see that price right: $299. It is the 45 mb/s version.

Here is the same product via an Amazon partner store at $128.

Gerry Harvey doesn't do better. Here is a 32 gb card at the Harvey Norman in the same shopping centre.

The product is a Sandisk "ultra" at $190. Amazon will sell you an identical product for $39.

I am trying to work out the dynamics of this with regard to the stock. My best model is the decline of Radio Shack which did this before them. Radio Shack had a business model built on squeezing very fat margins out of customers that needed something now. They had 2400 stores over America so they were close enough to anyone who needed them pronto.

And proximity was useful. Remember the days you absolutely needed that Firewire cable and were prepared to drive to the local Radio Shack (or Dick Smith in Australia) and pay $10-20 for something that would cost 50c to purchase in China? As the Onion observed we do not need so many cables any more and Radio Shack has become irrelevant. These days it survives by selling mobile phone contracts.

Well as my little SD card survey demonstrates the big-box electronics stores here have become Radioshack - albeit with a bigger footprint and the pretence of "lowest prices". But Radioshack didn't blow up - it just sort of drifted away. The stock was $70 in 2000 - the peak year in which everyone was connecting their computers to the net and needed all those cables. It is $9 now.

That I think is the future here too. The two stores won't deal either one a death-blow. Gerry Harvey will continue to lose share to JB Hi Fi (who look cheaper and cooler) but he and his company are rich and they can bleed for a very long time. JB Hi Fi will continue to charge "convenience prices" to the customers hiding behind their faux-cheap facade.

And we will wake up in a decade and realize these companies are just not important - or for that matter even relevant.

John

Disclosure: no position in the funds. For various tax reasons we have elected to have no Australian positions.

Sears Holdings liquidation sale

2011-12-28T11:42:00.002+11:00

We have been short Sears Holdings, publicly, albeit in small quantity. Being summer in Australia I did not even look at the market for the last couple of days - but got into work for some congratulatory emails as Sears stock is off very hard on an announcement of truly awful sales, the closure of 100 to 120 stores and $1.6 to $2.4 billion of non-cash charges. (More about the charges later on.)

I look pretty smart putting a Sears short on in November - and kudos is gratefully accepted but undeserved. I was short Sears at my old firm when the Eddie Lambert controlled K-Mart took them out for considerably more than they were worth. It was not the only time that happened to me - but multiple stabs don't dull the pain. I would gladly swap kudos for a refund of my then clients' money.*

The premise for owning Sears was property liquidation. The company owned many of its sites - sometimes on book at low historic values reflecting the company's long and once glorious history. Eddie Lambert and his merry-men were going to extract that value through selective store closures and super-profitable liquidation. Sears was an awful retailer (there was little doubt about that) but it was - they thought - a good property play.

My view: owning Sears as a property play is a demonstration of the arrogance and breathtaking naivete of much that passes on Wall Street. Sears Holdings has over 300 thousand employees. I don't know how you successfully liquidate a business integrated with that many lives. I don't know of anyone who has ever successfully liquidated a business with that many employees.** I am not sure it can be done and it certainly can't be done by someone with my skill-set (highly analytical, ability to spy value or value traps but no people management skill and not much tact).

The idea that Sears was going to be managed/liquidated by a bunch of hedge fund guys (people like me) well - that was comical.

Just to stress the point for my fund manager friends who read accounts and have my skills (but like me are often disconnected from the businesses they invest in) I will state the obvious. The employees are living breathing people and as you pull the business apart the way you treat those people and how they think about you (and behave towards you) are critical to any value you extract in liquidation. Someone has to look these people in the eye and tell them they don't have a job. And someone has to pick-and-choose which people to fire and which to retain. And they have to do this without destroying much of the value extracted along the way. They have to liquidate the firm in such a way that the value accrues to the liquidators and not to the people who are being screwed.

I don't care what you think of the morality of that. The reality of that is that it was always going to be hard - possibly very hard.***

We are about to find out how hard. Sears is going to close 100 to 120 stores (it is vague about the number) and fire many employees. But they have not worked out which employees or even which stores. Not to sound ghoulish - but my guess is that this is going to be considerably harder than the "Sears spokesman" makes it sound. And if they can't do 120 stores without trouble then the original Sears liquidation premise was insane. This is a case of Wall Street fantasy meeting reality: eventually reality wins.

The charges and reality

The large (non-cash!) charges deserve mention. This is from the Sears release:

[We Sears] expect that we will record in the fourth quarter a non-cash charge related to a valuation allowance on certain deferred tax assets of $1.6 to $1.8 billion

You know what that means. It means that you should not expect to earn that profit in the future. It is the admission from the Eddie Lambert controlled Sears that the fantasy is over.

The reality is unchanged: when you think of the 1950s you think of Sears. Sears was (in Main Street reality) irrelevant a decade ago. The Wall Street fantasy took a little longer to end.

John

*(A note about Schadenfreude.) The take-over of the old Sears by the Eddie Lambert controlled K-Mart was the second worst day of my career. The worst day was when Fred Goodwin's Royal Bank of Scotland purchased Charter One Financial. When I started the blog one of the main goals was to spell out just how atrocious Sir Fred Goodwin (the then CEO of Royal Bank of Scotland) was. The fourth post on this blog was the beginning of my "Sir Fred Goodwin death watch". I enjoyed watching him and his bank come apart. But I should not have enjoyed it. Schadenfreude is not an attractive personality characteristic and the collapse of RBS has caused real pain to a lot of innocent parties. And a Schadenfreudegasm - well that just strikes me as unreasonably indulgent. After all my clients lost money - and I should and would but cannot swap any pleasure I had for a refund of their losses.

This time though I am just accepting the Schadenfreude. My client are making money and I have no reason to feel guilty about that. Moreover I don't have to fire those employees. Unlike Royal Bank of Scotland (which Sir Fred destroyed) Sears employees were doomed anyway.

**. It is worth mentioning the GM example. GM was salvaged through bankruptcy with a couple of hundred thousand employees. But those employees were particularly trapped, the shareholders were wiped out and the Government contributed considerable money. That is what a "successful" transition for a business with that many employees looks like.

***. (Politics, employees and realism). I am a bleeding heart left-winger and naturally feel a little paternalistic to the employees being fired. However you don't need to be a bleeding heart lefty to agree with my analysis. A realist will tell that when you have 300 thousand employees your relation to them is going to be critical in running your business. Employees are "stakeholders" even if your only (moral) criteria is "shareholder value". Realism over politics is a better basis for investment.

Future Joseph Jett traders get a Christmas card from Mario Draghi

2011-12-23T13:56:00.000+11:00

Well the Euro fix is in. Whether it works - that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.

The Government debt has - at least for the moment - a very low (mostly zero) risk weighting for capital adequacy purposes so the return on regulatory equity is more than adequate.

Now of all the things you want to be - top of the list these days has got to be a trader at a dumb bank paid a percentage of income earned at bonus time. Massive return on equity. Unlimited funds to employ. Christmas. Indeed a lifetime of silly-seasons all at once courtesy Super Mario.

Of course your bank is not just going to sign over the 20 million check. You are going to have to bamboozle them for that. After all, the European Government Bond carry trade patently risks capital and the risk management department should charge you mega-bucks for that capital. Indeed the risk management department probably should do more than that and stop you.

At Goldman Sachs (where they are quite tight) the risk management department would stop it dead. Contra: at MF Global certain senior Goldies employees demonstrated how Goldies traders without Goldies risk management behave.

But even at MF Global the risk management department knew what was going on.

So dear traders seeking large bonuses: how do you complicate it beyond the feeble minds of your local back-office? You can do complex things with government bonds - strips, interest rate swaps and all sorts of high-fallutin maths that comes from them.

You might not believe me: remember Joseph Jett who misstated profits and risks at Kidder Peabody (then part of General Electric, now buried in UBS). He reported enormous profits and took home an $8.2 million bonus. Jett operated entirely in Government bonds and their derivatives.

So what are you waiting for? The complexity of the stuff you can trade - all dependent on the above ECB provided carry - is enormous. And surely you are smart enough to run rings around the kids in the risk management department.

Wall Street has proven that complexity and cheap money are the road to riches. Now, dear European traders, is your time.

Hop to it boys. You got a Christmas card to collect.

John

Peculiar goings on at Blogger

2011-12-14T22:13:00.000+11:00

This post is a short apology. Somehow yesterday a post I part-wrote in September - left in draft and never finished - got circulated to my email list by blogger/feedburner. It had spelling mistakes in it (it was a draft) but nobody picked up that the email was dated several months ago. People did email me about the spelling mistakes.

It mentioned solar panel prices. They are much lower now.

Sorry for the inconvenience and the incorrectly dated and priced objects.

John

PS. About half the posts I write wind up never being sent - all sorts of reasons. I guess I got to be careful with the old ones.

Solar panel prices continue to fall

2011-12-06T14:41:00.000+11:00

Guidance from Trina and other solar manufacturers was for a wholesale price to be above $1 per watt.

So I got this email from my local supplier today suggesting retail prices far below that:

Dear Client:
Just a quick note that Powerark Solar is promoting a Christmas sale on BLD solar panels, the brochure and specs are attached.
BLD panel pricelist:
190w: 95cents for 1 pallet (58pcs), 93cents for 2 pallets (116pcs)
250w (60cells): 99cent for 1 pallet (40pcs).
We are also supplying Alex Solar panel, and various brands of inverter including Ever-Solar, SMA, Afore (double MPP Trackers), JFY and APS Micro-Inverter, please feel free to contact us if interested.

Best Regards,

Will Li

Powerark Solar Pty Ltd
Add: 26 James Street, Lidcombe, NSW 2141
Tel: 1300 887 ***; (02) 9460 ***
Fax :(02) 9437 ***
Website: www.powerarksolar.com.au
Mob: 0422266***
Email: wil@pow***.com

The extent of Chinese solar subsidies and their implications

2011-12-02T13:18:00.000+11:00

Chinese solar makers are facing a countervailing tariff case essentially arguing that the Chinese Government (through state controlled banks) are subsidizing them. The CEO of Trina Solar (Jifan Gao) was party to a statement (also made by three other solar CEOs) that:

China’s solar industry had to pay higher interest rates for bank loans than U.S. and European competitors, and paid market rates for loans. With the appreciation of the yuan, “the loan rate we are paying is probably equivalent to over 10 percent,”

Ok - lets see what the interest rate the market (as opposed to the Chinese banks are charging the solar makers):

(Unfortunately you need to click this image to see the axis)...

Suntech is at 78 percent. LDK is 53 percent. Trina is "only" at 22 percent - but the Trina debt piece is a convertible and was recently trading way above par as this bond price chart shows:

(Click the image to see the axis.)

Which shows the price of the Trina piece coming down from well over 100 as the "convertible" bit lost its value.

Trina has recently expanded its loans by several hundred million dollars at low rates. But Jifan Gao says those rates are not subsidized. He is wrong and the solar makers should and will lose their case. There is a robust market telling us what the "free market rate" is and it does not look like the subsidized rate the Chinese banks are providing.

The Solyandra case

The Chinese solar makers will - with righteous indignation - point at the subsidized loan that the US Government gave Solyandra - a loan that has now gone solidly into default. They have a point - but not a good one in a court. Their problem is that the WTO agreements have a specific exemption for government loans to develop new industries and new products. The most famous recipient of these loans is (of course) Airbus who gets subsidized loans to develop every new plane. Boeing can't win that trade case because the subsidy - like the Solyandra subsidy - is international trade law compliant. (If you want a decent history of that subsidy read John Newhouse's excellent book on Boeing versus Airbus.)

The reality for solar makers

The reality for the solar makers is bleak - maybe not for the solar business - but certainly for the shareholders and debt holders in the companies. The American solar makers will win the trade case. There will be a countervailing tariff. Europe will almost certainly follow. The products will have no markets at tariff included prices and the subsidized loans that the Chinese banks gave the solar companies will not be repaid.

The banks will wind up owning the companies anyway, selling products facing crippling countervailing tariffs. When the most potent argument that the Chinese solar CEOs can come up with is that their interest rates are high (almost 10 percent) but are really 30-60 percent below market their position is clearly weak.

There is an alternative. The alternative is for the Chinese to simply agree to provide no more subsidized loans and to roll all funding as it matures into long-dated non-subsidized loans. Then the whole countervailing tariff argument just evaporates.

Of course the solar companies - every single one of them - goes bust. And quite rapidly.

But it doesn't matter - after bankruptcy the Chinese government - through their banks - owns them. They become state owned enterprises and the Chinese Government can amalgamate them as they see fit. Indeed as SOEs they can seemingly subsidize them as they see fit too - because those subsidies are much harder to argue against in a trade case.

The losers are of course shareholders and western debt holders of the Chinese solar stocks. But I see no reason why should the Chinese government should give subsidies and enter into a crippling trade dispute to protect them.

It is time for Jifan Gao and the other CEOs to have their subsidies - and their businesses - removed from them just as the CEO of Solyandra had his business removed from him. The Chinese banks will learn - as people have been learning since the advent of capitalism - that when you lend a business too much you either own it or are going to spend a lot of time collecting.

John

PS. I do not wish to enter into the morality of the trade dispute. For instance I don't wish to argue that the loans to Solyandra were moral and the loans to the Chinese companies were immoral. I just want to argue what is - and why it is from an investment perspective. The loans to Solyandra were legal. The loans to the Chinese makers are not legal. Morality does not enter into it.

Moreover a countervailing tariff will hurt some people in the US (eg residential solar installers). That is a fact - but it won't enter into the legality of the dispute.

J

The Sino Forest Independent Committee Report - Part 3.

2011-11-29T22:26:00.000+11:00

Sino Forest had a simple enough business model. It held forest and then sold the standing trees to Authorized Intermediaries. AIs (and parties related to them) often sold them the cutting rights.

Sino Forest did not own trucks, chainsaws or employ huge numbers of people because the AIs did all that. All the things needed to run a 17 million tonne per year forestry operation were done by the AIs.

So the AIs you would expect are fairly substantial organizations - bigger than Sino Forest anyway - because the AIs do all the work.

This makes the Sino Forest meeting with the AIs the critical part of the Sino Forest investigation. This was the backbone of Sino Forest. If the AIs were phony then Sino Forest is unambiguously fraudulent.

You can find the full summary of the meetings with AIs here. I am just going to quote the first page. This is not a selective quote (check the original if you want).

Terms Not Herein Defined Shall Have The Meaning As Ascribed In The Second Interim Report Of The Independent Committee Of The Board Of Directors Of Sino-Forest Corporation.
Supplier #1 (OSC Supplier #1)
Location 1
Hunan City #3
(Source: Provided by SinoForest)
 Site did not have signs or any other indication that Supplier #1 occupied
the location.
 According to an individual from the neighbouring office, Supplier #1’s
office is located on 2/F of the building. They were unsure whether or not
people worked in the office there.
 Encountered individuals who introduced themselves as Supplier #1 staff,
including one who introduced herself as the Financial Controller.
 Neighbouring occupants stated the office was no longer used and Supplier
#1’s office had moved to a new site located on 6/F of the (redacted)
building in Hunan Location 5.
 Went to new address and confirmed that Supplier #1 shared the 6/F with
Hunan City #3's Government Land Acquisition and Demolition
Remediation Department.
Location 2
Hunan City #3
(Source: SAIC filings)
 This was a factory site previously occupied by Supplier #1.
 The factory is now operated by Other Co #11, a company owned by Other
Co #12.
 According to a factory worker and neighbouring occupants, Supplier #1
moved out in 2009.
 Neighbouring occupants referred to Supplier #1 as "Sino-Forest's Supplier
#1" (嘉漢的供應商#1).
Location 3
Hunan City #3
(Source: Mailing address
provided by Sino-Forest)
 Individuals identifying themselves as Supplier #1 personnel stated that
Location 3 should, in fact, be the same as Location 1 as there was only one
insurance office building on the road. The address should be (redacted)
instead of (redacted).
Location 4
Hunan City #3
(Source: Mailing address
provided by Sino-Forest)
 This location is the same as Supplier #10 Location 1 and is now a bank
with the office above occupied by the bank itself.
 The security guard for the bank had not heard of Supplier #1.

It goes on:

Supplier #10 (OSC Supplier #10)
Location 1
Hunan City #3
(Source: Provided by SinoForest)
 This location is the same as Supplier #1 Location 4 and is now a bank with
the office above occupied by the bank itself.
 The security guard for the bank had not heard of Supplier #10.
Location 2
Hunan City #3
 We could not locate Supplier #10 from the address provided.
 Neighbouring occupants had not heard of Supplier #10.

Monty Python could have written this.

Remarkable company Sino Forest: beautiful plumage.

John

Sometimes I am glad I host this blog at Google (Muddy Waters edition)

2011-11-23T08:02:00.004+11:00

Muddy Waters Research (of Sino Forest fame) published a negative piece on Focus Media (the American listed stock of a real Chinese outdoor advertising company).

A day later Muddy Waters website is down - albeit with a short message:

MW regrets that our site has been hacked. We will bring it up as soon as possible.

FMCN is still a Strong Sell.

Happy Thanksgiving,

MW

Google does not have a flawless record at keeping Chinese criminals (ahem the Chinese Government) from hacking them - but I suspect they could beat any attempt by an outdoor advertising company.

John

To be successful

2011-11-21T18:58:00.000+11:00

I am reading Jason Manolopoulos's Greece's Odious Debt - an accessible successor to Mark Mazower - and one that reminds you that attitudes to things like tax collectors depend on history. (In Greece for instance Manolopolulos argues that under Ottoman rule not paying taxes - essentially poll taxes on Christians was highly honorable. This still influences Greek tradition.)

Chapter Two however starts with one of the best quotes I have ever seen:

To be successful, keep looking tanned, live in an elegant building (even if you're in the cellar), be seen in smart restaurants (even if you nurse one drink) and if you borrow, borrow big.

-Aristotle Onassis

Seldom have I seen a business/political philosophy so diametrically opposed to mine stated so clearly. And exemplars abound - think Angelo Mozilo in American finance or Andrew Peacock in Australian politics.

Just a fabulous quote and a world view that seems to work for the people who hold it if not for the rest of us...

J

Oversimplification and financial crime (Felix Salmon edition)

2011-11-19T12:09:00.001+11:00

I sometimes joke that straight accounts like virginity refer to one state only - whereas financial crime - as does sin - refers to a multitude.

This blog aims to provide - in part - a morphology of sin - and alas like the loss-of-virginity and relationships that ensue - it is complicated.

Not everybody always sees it that way. Felix Salmon posted about "The Return of Obvious Graft" which is about three financial crimes and how simply he sees them. I quote:

It’s almost comforting to find a spate of financial scandals which involve simple, easy-to-understand illegal and unethical behavior, after all these years rummaging around in synthetic mezzanine collateralized debt obligations and the like. Three have particular salience right now:

(i) The Congressional insider-trading scandal. Spencer Bachus is the poster boy here: one minute he was getting highly confidential briefings from Hank Paulson and Ben Bernanke on the parlous state of the economy; the next he was loading up on contract options on Proshares Ultra-Short QQQ, a synthetic ETF designed to maximize profits when the stock market falls, and which is emphatically for day traders only.

(ii) Olympus, which now seems to have channeled more than $2.5 billion to yakuza crime syndicates, including the country’s largest, the Yamaguchi Gumi.

(iii) MF Global, which increasingly looks as though it stole money in customer accounts.

I am surprised that Felix - who is a bit of an aficionado of this sort of stuff - should boldly state that these three involve "involve simple, easy-to-understand illegal and unethical behavior". Felix is - I think - wrong about all three. In the second case I think Felix's error is important because it has investment implications.

Congressional trading scandals

The congressional trading scandal is simple enough - I can't think of any way in which is ethical for someone like Spencer Bachus - who is elected to represent a broad electorate - to use information that he gains as a representative to trade against the same people. Conflict of interest springs to mind. The problem is - as the article Felix links indicates - that the behavior probably isn't illegal. It should be. I don't disagree with Felix's sentiment here - just the fact of illegality is not clear.

Olympus

The Olympus scandal is alas much harder. I spent about eighteen (almost continuous) hours recently looking at Olympus. I wish the story was as simple as Felix indicates because you would buy the stock with your ears pinned back. If the story was that $2.5 billion were simply stolen then you would have a business that could generate $2.5 billion (which makes it a very valuable business) and the looting would likely stop now. If the story was as simple as Felix says you would buy the stock as the business will continue to be highly profitable and the stock has cratered.

But Felix's story isn't even the official story now. The official story is that Olympus made some very large (albeit genuine) trading losses over a decade ago. It hid them. And hid them. And hid them. And its books did not balance so the hiding involved many senior staff. Then after many years (and towards the end of the careers of the malefactors) they sought to bring the books back into balance. So they jigged up some large fake acquisitions and paid a couple of billion for them. The money however was not looted - it was recirculated to fill the hole in the balance sheet from the trading losses.

If that story were true you would still probably buy the stock because that is still a story about a very profitable underlying business that will probably retain its profitability and a stock that has cratered.

Alas I am not sure even that story is true. At the core of Olympus is an amazingly profitable medical devices business. It makes gastrointestinal endoscopes - devices you stick you know where - and look for colorectal cancer. These devices are also used in operations. Stated revenue for this segment was 355 billion yen and operating profit was 69 billion yen. Put this in dollars because I don't think in yen - that is $4.6 billion in revenue and $890 million in operating profit. That is a lot of profit and a lot of revenue from peering where the sun don't shine.

My fear was that was too much profit. I could not convince myself that this business should be as profitable as all that. An alternative hypothesis occurred to me - which was that Olympus was sharply overstating the profit of its core medical devices business. Over time their accounts would then shift from reality - possibly by cumulatively more than a billion dollars. So some day they would chose to fill the hole (just as they supposedly filled the hole on the hidden trading losses). And then they did the fake acquisitions.

If my alternative hypothesis is correct then the case for buying Olympus stock evaporates. What you have is a cratered stock and a business that had been fraudulently overstating profits for years. And it has a lot of debt.

The underlying low-level-of-profitability hypothesis is more consistent with the debt load.

Olympus just isn't as simple as Felix makes out - and the differences have investment implications. If only it were simply looted.

MF Global

What happened at MFGlobal is not clear. There is no question that client cash is missing - but there is some doubt as to whether it was "stolen" or whether something else happened to it.

A US based broker-dealer (though not broker-dealers in other jurisdictions) is obliged to keep client assets (usually securities) separate from firm assets. Usually this means that client assets which are not required to be pledged to support client balances are kept in a client segregated account. Client assets are allowed to be pledged but only to a low multiple (usually 1.4 times) the client balance and then only to support client obligations. In other words client assets can be pledged if the clients are leveraged.

Client cash is also meant to be segregated under similar terms. The problem is that client cash is not kept as cash - that is it is not bits of paper sitting in vaults. Client cash is kept as people usually keep cash - in bank deposits when it is small in volume and maybe in short dated government securities when it is large in volume. Brokers have always been allowed to buy government securities as a use of client cash.

If they held Euro cash then they would presumably be allowed to buy Euro government securities (and in Europe now that means German Bunds).

Robert Lenzer in Forbes suggested (and possibly with good evidence) that the cash was held as Italian, Greek and Spanish government bonds - possibly longer dated. These are Euro government bonds held against Euro cash - which would be OK if it were US Government bonds against US cash. But in Europe its a problem: European governments can't print the Euro so they are not riskless and the assets were long dated. In which case MF Global may have legally speculated with client money. This is not the simple, easy-to-understand illegal and unethical behavior of Felix's blog post - rather a glaring policy loophole. Moreover Lenzer suggests that MF Global actively lobbied to keep the loophole open.

Still I am not even sure of the Lenzer story. There is a story doing the rounds in Asia (meaning I have heard it from multiple sources) that Deutsch Bank and/or Goldman Sachs got the client assets - the client assets were posted as collateral maybe for client positions and maybe for MF Global's own positions. And the bulge-bracket guys snitched it.

Now if it were clearly marked as client collateral and DB or GS snitched it then the big-boys would be involved in theft. But if were not clearly marked as or somehow DB and GS were not informed that it was client collateral then DB and GS would be entitled to grab it. And if they grabbed client collateral then alas it is not there for the clients.

So it is a real question as to what collateral was posted to whom and who snatched it. That will be litigated for a long time - and a malicious - or for that matter a not-guilty party at MF Global is likely to tell the jury that they posted the collateral to Goldman Sachs and clearly told Goldies it was client collateral and that Goldman Sachs pinched it anyway. It may be a simple crime - but a simple defense - and one that many people would find intuitively appealing - is that Goldman Sachs et al, not MF Global, stole the money.

Summary

All I am saying is that Felix has picked yet another three which do not meet Felix's criteria of "simple, easy-to-understand illegal and unethical behavior". Financial crime - like any morphology of sin - is complicated. Almost always.

John

The Sino Forest Independent Committee Report - part 2

2011-11-18T06:57:00.000+11:00

Sino Forest's Independent Committee of Directors has - as explained before - concluded there was no substantial fraud at Sino Forest.

Here without adornment is another paragraph (paragraph 54) from the process memorandum sent by the Independent Committee's legal and accounting advisers to their law firm:

The extent of historical electronic data (e.g. emails) at the Guangzhou office where two of the senior members of Management are located (CHEN Hua and Albert ZHAO) was almost non-existent. There was no backup of the email server (according to Management, the email and file servers were not being backed up at this location). The earliest email retrieved from Ms. Chen and Mr. Zhao’s computers and servers was dated June 10, 2011. It is to be noted that the IC Advisors attended at the aforementioned office on June 13, 2011 for data preservation but access to the company servers and IT staff was denied by Ms. Chen. Subsequently, on June 15, 2011, the IC Advisors were provided access to commence data preservation.

The Sino Forest Independent Committee Report part 1.

2011-11-16T18:00:00.000+11:00

Sino Forest - a Chinese forestry company listed in Canada - is the subject of the most spectacular fraud allegation of this cycle of Chinese frauds. The allegation was made by Muddy Waters LLC (MW).

The allegation had three prongs:

(a). The forests largely did not exist
(b). Where they existed the valuations were determined largely by phony transactions with undisclosed related parties (the so-called Authorized Intermediaries or AIs) and
(c). There was no evidence that that many tonnes of wood was harvested in the relevant areas in China - there was for instance nowhere near the necessary number of log trucks.

After the allegations several of the non-executive directors formed an "Independent Committee" (IC) to investigate the claims.

The IC has reported and declared the MW allegations to be false. In particular they declared they have seen documents proving the accounts are (mostly) accurate and they are confident in the authenticity of those documents.

The press originally reported on the IC report as definitive. They have become a little more nuanced since.

Anyway I plan on extracting parts of the supporting documents for the IC report - the most interesting document released so far being the "process memorandum" which outlined the IC's processes.

This part - Paragraph 83 - is concerned with checking the authenticity of the documents purporting to evidence ownership of forests (either land or more often cutting rights or plantation rights certificates).

It is on the basis of the evidence presented here that the IC is confident that the MW allegations are false. I am (proudly) short Sino Forest so I am biased. I am just going to repeat Para 83 verbatim. You can decide.

---

83. There are a number of factors which have affected the forestry bureau visits and confirmation process:

(i) Management did not provide a comprehensive list of plantation assets which reconciled to its financial statements until June 23, 2011;

(ii) Shortly after the MW allegations, Management, on its own initiative,caused all forestry bureau confirmations to be relocated from their various locations throughout the SF organization to Guangzhou. This resulted in delay in these documents being made available to the IC Advisors.Management explained the forestry bureaus wanted the confirmations returned as they may have exceeded their individual authorities in confirming certain rights. However, the confirmations were not returned to the forestry bureaus and were sighted by the IC Advisors in the offices of Chinese counsel to SF;

(iii) Forestry bureau officials are not required to meet with any party regarding the confirmations or the process they had undertaken in issuing those confirmations.

(iv) Prior to August 29, 2011, the process determined by the IC did not allow the IC Advisors to ask any forestry bureau any questions relating to the existing confirmations;

(v) The IC Advisors have not had visibility into the process regarding the setting up of meetings relating to existing or new confirmations. Judson Martin, in his capacity as CEO, has agreed to provide a letter of representation to the IC with respect to the process undertaken while he has held this position;

(vi) The IC Advisors were directed by Management to visit Yunnan FB #1. This forestry bureau further directed the IC Advisors to go to one of its subordinate county-level forestry bureaus (Yunnan FB #2);

(vii) In all four instances where new confirmations were obtained, the forestry bureau or other parties who issued the confirmation did not sign the new form of confirmation as sought by the IC Advisors but instead prepared their own versions whereby ownership is not confirmed and only a contractual arrangement between SF and its Supplier is recognized;

(viii) The time made available for the meetings with forestry bureau officials has been limited and the IC Advisors have not been permitted to ask certain questions;

(ix) Due to the limited number of senior SF employees/Management participating in meetings at the forestry bureaus with the IC Advisors, the processes at the various forestry bureaus were conducted consecutively rather than concurrently;

(x) The process for SF employees to arrange meetings with forestry bureau officials has taken some time;

(xi) Certain forestry bureaus have deferred or not permitted the IC Advisors’ requests to access the plantation rights registries. Others have advised they have not yet established a searchable registry of plantation rights. The forestry bureaus also indicated they do not issue new PRCs for the transfer of standing timber alone. As such, the IC Advisors have been unable to confirm the existence of the PRCs during the IC Advisors’ visits;

(xii) In some instances, forestry bureaus would not issue the new confirmations using their letterhead, which is inconsistent with prior practices.

(xiii) Certain forestry bureaus have given few details as to what due diligence processes they have undertaken before issuing both the existing confirmations and the new confirmations.

(xiv) At a meeting at Hunan FB #1 on September 2, 2011 to validate the authenticity of the existing confirmations, Management represented a forestry bureau official to be the Forestry Bureau First Vice Chief when in fact this individual was no longer in the position of Vice Chief, and had been paid by SF for several months prior to the visit to act as a consultant for SF. The IC Advisors understand this meeting was recorded by SF employees, but have not been provided with a copy of the tape.

(xv) The new confirmation obtained at the Hunan FB #2 was not issued by the forestry bureau; rather, it was issued by a “social institution legal person” sponsored by the Hunan FB #2. The relative degree of comfort of this confirmation as compared with the new confirmations from forestry bureaus is not clear.

(xvi) During the Hunan FB #2 visit held on October 18, 2011 the IC Advisers were informed by the former Chief of the bureau, FB Official #1, that Vice Chief FB Official #2 was assigned by the forestry bureau to work with SF since approximately 2008 to assist SF in conducting its business. The IC Advisers were informed that FB Official #2 continued to receive a basic salary from the forestry bureau while working with SF. They were also advised that this practice occurs with other companies.

(xvii) The new confirmation obtained at the Yunnan FB #7 was not issued by the forestry bureau; rather, it was issued by a division of the bureau, namely, the Yunnan Forestry Entity #1. The relative degree of comfort of this confirmation as compared with the new confirmations from forestry bureaus is not clear.

(xviii) The IC instructed the IC Advisors not to make direct contact with forestry bureau officials. The IC explained that Management cited strong concerns that such contact would negatively impact the Company’s relationship with the forestry bureaus.

Buy Ben Bernanke a marijuana pipe and an Hawaiian shirt

2011-11-11T11:42:00.003+11:00

Edward Harrison annoyed me this morning. He writes the useful but sometimes disagreeable Credit Writedowns blog and he has a post up on why the Fed should never buy Italian Government bonds. His conclusion - which sounds reasonable but is dead wrong is repeated below.

First of all, a central bank’s buying dodgy assets is always a solution to a liquidity crisis that is fraught with peril. if those assets go bad and losses are crystallized, it could render the central bank technically insolvent and undermine confidence in the central bank. Fear of this technically insolvent outcome was a major reason the Europeans did not allow the ECB to participate in the ‘voluntary’ haircuts that it has attempted to coerce onto the private sector in the latest Greek bailout.

Clearly, the ECB could just print money and use the seigniorage from that printing to earn its way back into solvency without having been declared insolvent. But you can see the problem. To maintain the ECB’s credibility it would need to be recapitalised.

But if the Federal Reserve were to load up on Italian bonds, then the seigniorage route is out. The Fed would be exposed to default on foreign currency assets. If Italy defaults, then the Fed is on the hook. Officially, the Fed is under Congressional jurisdiction. The US Congress has oversight of the Federal Reserve and Congress should never allow the Fed to make unsecured loans to foreign governments without prior and specific Congressional approval.

The Fed should never buy foreign currency assets. And if it does, Congress should intervene.

America's monetary problem however is that they are in a liquidity trap.

Six or seven years of 6 percent inflation, 2 percent interest rates and to stick the losses to the Chinese who (in their mercantilist fashion) own the debt would be a wonderful way out of America's malaise. And you would think you could induce 5 percent inflation by printing money. You would think the option is open. Indeed you would swear given how much money the Fed has printed that it would have happened.

But it has not happened.

Sure the Fed has printed money. And when it finished that it printed some more. Soon we will get to QE4 and yet another round of "quantitative easing" and we will still not manage to induce 5-7 percent inflation, 2 percent interest rates and to stick the losses to the Chinese.

If you had - without any understanding of monetary theory - been told that the Fed could increase money stock from say $800 billion to $3 trillion and not result in an inflationary torrent you would not have believed it. It would have sounded like nonsense.

But you better believe it because it happened. And that requires an explanation.

The explanation is simple enough. The Federal Reserve has too much credibility. Each time it increases the money supply it buys some asset (say a government bond or even a foreign security) and issues cash. And people hold the cash because it is a reasonable store of value. And it is a reasonable store of value because they trust - at the end of this cycle - that the Federal Reserve will eventually take its vault full of assets, sell the assets for hard cash (which it will destroy) and will thus suck the excess liquidity out of the system.

If people really believed the cash was trash they would all try to get rid of it (ie buy something) but collectively they could not get rid of it (every time they buy something it would have a new owner) and the result would be inflation. Inflation would then reduce the real value of the money stock to a level where people were comfortable holding it.

To get inflation you need to damage the Federal Reserve's credibility. You need the Federal Reserve to make a credible promise to be reckless.

And Ben Bernanke - despite the helicopter speech in which he outlined this view of the world very clearly - is not your man. Maybe it is the facial hair - but he looks - well just too responsible.

When he got on 60 Minutes he proved the point. He was asked point-blank whether the Federal Reserve could print all that money and control inflation and he said it could. He was right of course - but it was the wrong message. He had his one-mass-market-opportunity to be credibly reckless and his media-conservatism meant that he squibbed it. He should have just said that he did not know but that it was a risk that was necessary to take...

When he appeared all media-conservative I knew he blew it. I was thinking then of asking for his resignation because he was just not up to the job that he himself outlined in the famous helicopter speech.

But the European crisis gives the Fed Chair the opportunity to get it right this time being being credibly reckless. Indeed what I want is for him to be incredibly reckless. He should not only announce that the Fed is buying Italian debt. He should do it whilst wearing an Hawaiian shirt and carrying a marijuana pipe. (I would even buy him the pipe...)

Ok, the marijuana pipe is not happening - but I dream of a day when a central bank knows that the best way out of a debt-deflation is inflation induced by deliberately and credibly reckless policy rather than an endless austerity-recession and deflation.

In this case - where the debt is held disproportionately by the Chinese the Fed has an opportunity to stick the losses to someone else. Come on Ben - what do you say about that?

And when we are done we can sit down, you can have a joint and I will have a beer.

John

Post script: Edward Harrison reminds me (fairly) that he is not generally opposed to inflationary solutions and he (fairly) thought that this post implied he was. I am diametrically opposed to his view about the necessity to maintain Federal Reserve credibility. Indeed few things have annoyed me quite as much as the referred to post. However we are closer much of the time.

Post post script: Ed Harrison thought that the issue was democracy - congressional oversight of buying of foreign bonds. That I think is peculiar - central banks have been buying foreign bonds since - well - forever. It is how they hold foreign reserves. But he does think it unreasonable and subject to oversight for a central bank to buy stressed foreign bonds. Respectfully I disagree - but that is another story.

Trina Solar updates guidance (part 2)

2011-11-07T14:58:00.009+11:00

After the results note: We now - post the result - know the difference. They took a charge - only thinly disclosed - on receivables Someone did not pay them!

Note: the post script is an important part of this story. My original blog post was too hasty in making an assumption about third-party module sales.

The Trina Solar press release updating guidance has me utterly perplexed (and I follow this stock closely).

Here is the key text:

The Company estimates its solar module shipments in the third quarter of 2011 to be in the range of 372 MW to 375 MW, compared to the Company's previous guidance of 480 MW to 520 MW for the reasons discussed below. Additionally, for the third quarter of 2011, the Company estimates:

* Gross margin relating to its in-house wafer production and module production to be in the range of 18% to 19%, in line with the Company's previous guidance of high teens in percentage terms; and

* Overall gross margin to be in the range of 10% to 11%, which includes a non-cash inventory write down of approximately $19 million, compared to the Company's previous guidance of mid to high teens in percentage terms.

This had me reaching for my calculator. Shipments of 372-375 MW - lets call it 374 MW as a reasonable average. Gross margin of 18% to 19% from wafer production - so lets call it 18.5 percent and in-line with their guidance. Gross margin of 10% to 11% - lets call it 10.5% - after an inventory write down of approximately $19 million (which compares to the old high-teens margin).

So by simple subtraction we estimate that 8 percentage points of margin represents $19 million. This suggests that the total revenue is = $19 million /.08 = $237.5 million.

But that is the revenue from 374 MW - so revenue per watt = $237.5 million/ 374 million watts = $0.635 per watt.

The lowest solar panel price mentioned in any analyst report I have seen is $1.08 per watt.

Under 64 cents per watt is either a catastrophe inconsistent with any observable solar panel price or there is a significant charge the company is not disclosing.

Which is it?

John

Post script. Some people have observed the typical 3 percent difference between IN HOUSE wafer production and END GROSS MARGIN - the difference being third party panels they buy in and then distribute.

They then calculate 5.5 percent margin difference - implying ASP in the 90s. Plausible - but still a disaster.

I had discounted this. Reason: I did not think there would be many third-party product sales when they are storing their own stuff in warehouse and can't sell it and are cutting production. That was a guess only. Their own production cut is so severe that third-party sales through their channel just look unlikely.

But maybe there really are large third party sales remaining. There might be a few reasons - but I am open to suggestion. Here goes for some thoughts:

(a). They are contractually obliged to sell for third parties and they have contractual expenses larger than they are telling us, or

(b). They still sell for third parties because the third parties can deliver cheaper than their marginal manufacturing cost, or

(c). The third party stuff is higher quality, or

(d). The collapse in volume was so total that there were third party sales in the beginning of the quarter but not in the end - so third party sales were a realistic part of the story but will not be next quarter, or

(e). Something I can't think of.

I was thinking - falsely perhaps - with the disastrous delivery numbers - that the third party distribution would be cut to zero. I should have put that assumption in my note.

J

Trina updates guidance (part 1)

2011-11-04T21:42:00.000+11:00

Trina issued updated guidance yesterday. This unsurprisingly included an earnings downgrade and a decline in margins. Somewhat more surprisingly it included a massive shipment volume downgrade.

To quote:

The Company estimates its solar module shipments in the third quarter of 2011 to be in the range of 372 MW to 375 MW, compared to the Company's previous guidance of 480 MW to 520 MW for the reasons discussed below.

And the reasons discussed below are:

A deflationary pricing environment impacted by challenging financing conditions for some of our customer's European projects resulted in the shortfall of our targeted shipment volumes.

This guidance was for the period ended 30 September 2011.

The decline was - unsurprisingly blamed on challenging financing conditions in Europe.

The reason why a huge shipment volume downgrade was surprising was because the last guidance was given in a conference call on 23 August 2011, in other words when the quarter was more than half done.

And in that conference call they actually saw a pickup in demand in Southern Europe. To quote:

Mark Kingsley (COO): I have been waiting for Italy since I got here. So, we are actually seeing some good activity finally. And we have some pickup in activity. We see it. Obviously, our historic Italian account is at the utilities. We also see Spanish accounts that a lot of them actually served projects there. So, after much waiting and unclarity, we are seeing some pickup in demand. There is – we still have a mix of utility projects in commercial rooftop there. And so what we are seeing moved quicker was the stuff that was utility that was finishing off and now it’s blending into commercial rooftop.

Now Mark Kingsley's comment was not forward looking. They were "actually seeing some good activity" in Italy and "some pickup in demand" in Spain. These were historical comments not protected by the various safe-harbors in the securities law. So they must be true or Mark Kingsley is going to be subject to securities fraud claims. And Mr Kingsley is not a Chinese executive - he has to live with his historical comments so I figure he must be telling the truth.

Whatever: volume came in more than 20 percent lower than an estimate made in the last half of the quarter.

Presuming as I do that Mark Kingsley was telling the unvarnished truth as it was on 23 August then demand in Europe must have fallen close to zero for the remainder of the quarter.

That is even worse than I thought.

John

Andy Borowitz and the buy case for Bank of America

2011-11-03T09:12:00.001+11:00

Andy Borowitz (a daily email you must have) lays out the buy case for Bank of America succinctly:

A Letter from Bank of America

An Apology to Our Customers

NEW YORK (The Borowitz Report) – The following letter was sent today by Bank of America to all of its debit card customers:

Dear Valued Customer:

As most of you probably know by now, last month we instituted a $5 monthly fee for all of our debit card users. To say that what followed this decision was a shitstorm would be a massive understatement.

Considering that just three years earlier taxpayers had bailed us out with billions of their hard-earned dollars, it’s understandable that Bank of America was compared to a person who, as he is pulled from a burning building, turns and kicks the fireman in the nuts.

That’s why we are writing to you today with a simple message: “Our bad.” And to tell you that we are refunding the $5 to you, effective immediately. All you have to do is pay a simple, one-time $10 refund fee.

You can receive your refund online, or pick it up at your nearest Bank of America branch, where a teller will hand the money directly to you for a simple, one-time $15 handling fee.

If you do visit your branch, feel free to use any of our services, including our state of the art ballpoint pens and deposit slips. (Prices on request.)

Again, accept our apologies for instituting the debit card fee. We have learned our lesson, and we make this solemn promise: next time we squeeze money from you, we’ll do it in a way you won’t notice.

Sincerely,

Bank of America

Weekend edition: Firing Rosa Parks for not giving up her seat on the bus

2011-10-30T15:40:00.001+11:00

The woman holding up the so-called "Abacus sign" at the Occupy Wall Street demo has been identified. Her name is Caitlin Curran and here (again) is the famous picture of her holding her sign.

As readers will know I thought this sign was misleading in that it was inaccurate about the nature of the Abacus transaction. Still - as written - and as one of my readers has observed - the statement is pure motherhood. If you think it is not wrong to create a mortgage-backed security filled with loans you know are going to fail so that you can sell it to a client who isn't aware that you sabotaged it by intentionally picking the misleadingly rated loans most likely to be defaulted upon then let me know. (I will find you a job in investment banking!)

The picture has had career adverse impacts on Caitlin. She was a journalist at The Takeaway and the picture got her fired. There is currently a tendency of non-right-wing news outlets to enforce a rigorous non-advocacy position on their staff - and they will fire them for any political donation or any political involvement. Caitlin wrote about this in Gawker.

The right-wing news outlets don't enforce that - just look at the roster of Fox News.

This is ridiculous. The managing director Mark Effron is enforcing a standard that is philosophically indefensible but he is too brain-dead to see it.

So let me put it simply for Mark Effron's benefit. Had Rosa Parks been an employee of yours - and had she chosen to not stand up on the bus because a white person wanted that seat would you have fired her? (Rosa Park's action was clearly political protest...)

If you would have then you are evil and you should resign for the benefit of society. Go on Mark - do it now.

If you would not have fired Rosa Parks you are admitting that your standards are nuanced and your action in firing Caitlin is somewhat more sophisticated than Caitlin suggests in her article.

So spell it out. Spell out why Caitlin's offense is a firing offense and Rosa Park's offense is not?

If you don't have the intellectual nous to do that at least give Caitlin her job back.

John

Shorting - early can be wrong: First Solar edition

2011-10-27T11:39:00.000+11:00

At Bronte we mostly short frauds. Our typical positions are tiny (less than 1 percent of funds under management). The reason is that if a company has fake 20 million in earnings and a market cap of $200 million there is nothing stopping it having fake $200 million in earnings and a market cap of $1.5 billion. A real company increasing its earnings from $20 million to $200 million is hard - business is tough. A fake company is just a stroke of a pen. You are thus more likely to have a really bad experience shorting frauds than real companies. The only solution we know is to short many frauds and keep the positions tiny and the aggregate position small.

Sometimes though we short real companies. The beauty of a real company in decline is that the earnings are not going to rise sharply and hence the stock is unlikely to go up five fold rapidly. You can safely take a much bigger position. A four percent short position in a real company has about as much capital risk as an 80bps position in a fraud. (It however has a lower expected return.)

At one stage our biggest short (indeed the second biggest we have ever had) was First Solar. It is a much better company than we usually short - and it was the non-fraudulent nature of the accounts that allowed us to take such a large position. There was no way that the stock was doubling because there was no way the earnings were rising sharply.

Alas earnings took some time to fall sharply. And we carried the short for about a year and about broke even. It was not a fun experience because we used capacity (capacity that would have much better been allocated to Chinese frauds!) and because it added to our misery during our worst couple of months ever (in the middle of 2010) as the stock raced up into the 160s. We were not short First Solar for the recent collapse in stock price.

Our analysis was not bad - not entirely accurate - and the inaccuracies are painful when you look at them from 18 months distant - but all-in we were mostly right.

Except we made no money. With a long early is just early. With a short early is plain wrong.

But just to wallow in the misery here are the two key posts reprinted. They were long the first time. They feel interminable now. (Originals can be found here and here.)

John

Post 1: Why I am short First Solar

(The following is an extract from Bronte Capital’s client letter. I thought it deserved wider circulation. It also provides grist to Felix Salmon who described shorting – and in the context by implication me – as socially useless. I think that was harsh – but not necessarily in this case. I will write an article in the future on socially useful short selling.)
------------

Case study: our short on First Solar

Investing in technology stocks has lots of traps for neophytes – and by-and-large we are neophytes so we do not do very much of it. We however spend a lot of time thinking about it primarily because we are scared of what technology can do to other businesses. (The demise of many low-tech newspapers provides a good demonstration of why – as investors – we should think about technology.)
Technology offers value creation like few other industries. In Australia Cochlear has created enormous value and improved the world. It can literally plug a bionic ear into someone's brain-stem and get them to hear. And the stock has paid about 20X – which is better than anything in our portfolio. Many of the biggest fortunes were made in technology. But technology – and specifically technological obsolescence has thrown many a fine company to the wolves. Palm for instance is likely to go bankrupt even though the concepts it pioneered are in everyone's pocket.
We do however have a framework to hang around our (limited) technology investments. A technology, to be a really great investment, must do two things. It must change part of the world in a useful way – a big part of the world is better of course – but you can be surprisingly profitable in small niches. And it must keep the competition out.
In technology the competition is remorseless. In most businesses the competition might be able to do something as well as you – and it will remove your excess profit. People will build hotels for instance until everyone's returns are inadequate but not until everyone's returns are sharply negative. Even in a glutted market a hotel tends to have a reason to exist – it still provides useful service. And someday the glut will go away so the hotel will retain some value.[1] In most businesses the game is incremental improvement. If you get slightly better you can make some money for a while. If the competition gets slightly better you will make sub-normal returns until you catch up.
In technology the threat is always that someone will do something massively better than you and it will remove your very reason for existence. Andy Grove – one of the most successful technologists of all time (Intel Corporation) – titled his book “Only the paranoid survive”. He meant it.
If your technology is obsolete the end game is failure – often bankruptcy. Palm will fail because Palm no longer has a reason to exist. If we wait 20 years Palm will be even more obsolete – but the hotel glut will probably have abated. Nothing left in Palm is likely to have any substantial value. Businesses that produced plenty now, produce nothing then.
Surprisingly, changing the world looks like the easy bit. Plenty of companies do it. The problems are in keeping the competition out. Only a few do that (Microsoft, Google are ones that seem to). Hard drive makers changed the world (they allowed all that data storage which made things like digital photography and internet multi-media possible). But they never made large profits – and they trade at small fractions of sales.
The limited technology investments we have are not driven by any real understanding of the technology. Sure we try – but if you ask us how to improve the laser etching on a solar panel then we will not be able to help. The driver of our investment theses in almost all cases is watching the competition.
A simple example is Garmin. We have a small short position in what is a very fine company. Garmin – once a small avionics company - led the mass-marketing of satellite navigation and allowed John – without stress – to find his son's Saturday sports game. Sat-nav it seems has saved many marriages and meant that school sports teams do not run short players because dad got lost.
Garmin has over a billion dollars cash on the balance sheet – and that cash represents past profits. It has changed the world – and thus far it has been well remunerated.
The only problem is that they can't keep the competition out. Nokia has purchased a mapping company. Iphone now has a Tom-Tom app, downloadable for $80 in Australia. Soon sat-nav will be an expected application in every decent mobile phone. Google has mapping technology too and will embed it into their android phone. Eventually the maps will be given away because people might book hotels using their sat-nav device whilst they are travelling. [It is darn useful to know where a decent hotel with a spare room is when you are on the road.]
Garmin has a great product. They have improved my world. The only problem is that they can't sell their product at any price that competes with “free”. Garmin's business is going the same direction as Palm. Bankruptcy however is only a remote possibility – they have a billion dollars on the balance sheet and unless they do something really stupid on the way down they will remain a profitable avionics business.
Is it fair that Palm is facing bankruptcy? Or that Garmin is being displaced? We don't think so – but then capitalism is not necessarily moral or fair – but it does produce goods and services quite well. We don't invest on the basis of fair – we invest to make you good returns.

The solar industry – and the possible failure of the good

First Solar is a company that improved the world. It drove the cost of production of solar cells to quite low levels and made utility-scale solar farms viable with only modest subsidies. There are some places where solar is now viable without subsidies.[2]

Our biggest short position though is First Solar – a company we have little but admiration for. There is a distinct possibility that First Solar's business will fail in the same way as Palm or Garmin. It won't be fair – but fairness has nothing to do with it. Like Garmin it probably won't go bust because it has a billion dollars in liquid assets on the balance sheet – assets which represent past profits.

Moreover we suspect that First Solar's profits are about the same as the rest of the industry put together. The stock still trades with a high teens trailing price-earnings ratio – a fading growth stock. It hardly looks like a failure. It is a strange conclusion to come to. So we should explain how we got there. To do that we need to explain how a solar cell works.

How a solar cell works

To make a solar cell you need three things.
1). A substance which is excited (i.e. spits off electrons) when a photon hits it.
2). A layer which separates the electrons. This layer is usually a “semiconductor” which means that electrons go through one way and cannot go back.
3). Something at the back which conducts the electrons away.

Thin film versus wafer

Traditional solar cells were made with a semiconductor ingot cut to a thin sheet. On one side it was “doped” with a substance that kicks out electrons. The other side was laced with wires to conduct the electrons away. This was expensive.
There were generally two types of ingot – monocrystalline – where the wafer structure was perfect or near perfect and polycrystalline which had visible crystals in the wafer. Monocrystalline wafers are primarily used for computer chips (where atomic level imperfections are problematic) and are expensive.
Polycrystalline silicon is cheaper. For most large-scale uses polycrystalline wafers were sufficient. These have about a 17 percent conversion rate – which means that 17 percent of the photon energy that strikes them is turned into electricity.
The ingot itself was a substantial part of the cost of a photovoltaic cell. Polycrystalline ingot used to sell for $450 per kg.
First Solar (and others) developed a process for making solar cells with considerably less semiconductor material. They have a Cadmium Telluride process which vapor-deposits semiconductor at atomic level thickness and comes up with a cell that is now exceeding an 11 percent conversion ratio.
This company is a technological wonder. Glass goes in on one end of the manufacturing process and comes out as solar cells at the other with next to no human intervention. Labour is used only when it comes to putting frames around the glass and for similar tasks.
This was revolutionary – it made cheap solar panels and hence made possible commercial scale plants like this 1.4 megawatt roof installation in Germany. This is enough to supply a few hundred households – not earth shattering – but a complete revolution in the solar industry.

We can think of few companies which have pushed a technology so far and with such high environmental benefits. Companies like this will allow us to maintain a modern lifestyle whilst addressing greenhouse issues.
Still for all the benefits of First Solar’s cells, they are inferior in many important ways to a polycrystalline cell. Their efficiency is lower – which means you do not get as much solar energy off the constrained roof space. Secondly, whilst they save a lot on the semiconductor part of the manufacturing process they have to use more glass, more wires etc to generate the same amount of solar electricity. Each cell generates less electricity too so inverters, connectors, installation all cost more with thin film. Thin film also degrades over time. First Solar warrants their performance over their lifetime – but with the warranty being for lower levels of performance in the second decade of operation (google the Staebler-Wronski effect for a non-trivial explanation). Thin film does however have some advantages in low light - keeping a slightly greater proportion of their peak capacity.
Indeed the main advantage of thin film is cost – and that cost advantage has been driven by the cost of the semiconductor component. After all ingot did cost $450 per kg.
That cost advantage made First Solar absurdly profitable – and they used that profit to grow into a behemoth. Revenue has grown from $48 million to over $2 billion. Gross profit (before selling and administrative costs) has grown to over $1 billion. We do not want to tell you how far the stock ran for fear of invoking insane jealousy. This stock would have made Berkshire Hathaway shareholders jealous.
But remember – all of that was predicated on a cost advantage (almost all other things being inferior). And that cost advantage is predicated on expensive semiconductor material.

Competition cometh

To make money in technology you need to do two things. Firstly you need to change the world (which First Solar clearly did) and secondly you need to keep the competition out. Alas very few businesses manage the second trick.
The competition came in a couple of forms. Firstly it came from Applied Materials. Applied Materials, or AMAT (as the company is known) is the most important company in the world you have never heard of. It is the dominant maker of capital equipment that goes into semiconductor factories and it is thus the company that – more than any other – provides the kit to keep Moore’s Law active.
AMAT has tried competing head-on with First Solar in the thin-film space. AMAT developed the vapor deposition equipment that made large-screen LCD televisions possible. This entails deposition in large sheets (5.6 square meters) which are then cut down into several large screen TVs. An imperfection in the vapor deposition shows on the TV as a bad pixel.
AMAT appropriated this technology for solar. The silicon semiconductor is not as efficient as First Solar’s Cadmium Telluride technology – and it is equally subject to the Staebler-Wronski effect, however they can do much larger panels than First Solar (with comparably lower wiring, inverter and balance of system costs). AMAT’s thin-film business could do some damage to First Solar – but it is unlikely to kill it. (Indeed AMAT appears to be de-emphasizing that business for the reason discussed below.)
Far more important have been developments in the wafer business. AMAT (often the protagonist) has developed wire saws for cutting wafers thinner and thinner. They are now 80 microns thick. These wafers are so thin that they flutter down in air and break if held on their side. AMAT will of course sell the whole kit for handling these wafers – including laser etching material and other steps in the manufacturing process. Much less semiconductor is needed in the wafer business.
But worse – the price of ingot has fallen – and spot prices are now $55 per kg – which is a lot less than $450. The cost of ingot is still falling. First Solar’s advantage is entirely dependent on the fact that they use much less semiconductor than wafers – an advantage that disappears entirely as wafer prices fall. At that point all of First Solar’s many disadvantages will shine through.
We are trying to work out the cost-structures of the polycrystalline manufacturers – but it looks to us that the extra glass and other balance of system costs that First Solar panels have are getting close now to completely removing the advantage of low semiconductor material usage.
If that happens though, First Solar is toast. It probably won’t file bankruptcy because it has so much in past profits to fall back on – but it will be every bit as obsolete as a Palm organizer is now or a Garmin car navigation system might be in five years.
We do not wish failure on First Solar – and if we are right it could not have happened to a nicer company (no irony intended). Capitalism is not fair – and technology investment is particularly unfair.
We don’t make money from fairness. We make money from getting the business analysis right and betting on (or against) the right business – and in this case we are betting against the most successful company in a massively important growth industry.
If we are right (and we think we are) then we will make money from the demise of a company that has much improved the world. We like to think our business is noble. And it is sometimes – but in this case we can see why people dislike short-sellers. Their opinion however is not our business.

[1] Unfortunately the hotel is usually mortgaged – and the value often reverts to the debt holder.
[2] One way amuses us greatly. Walmart started putting solar cells on the rooftops of many of their super-centers in the Southern United States. They did this originally because of implicit subsidies. However the test centers showed something quite interesting. Good solar panels turn quite a lot of the energy hitting the rooftop into electricity which is conducted away. That energy does not wind up as heat in the building – and the cooling load of the building went down. The rooftop solar installation may not have been justified by the electricity output alone – but combined with lower cooling bills it worked a treat. [Addendum. This footnote is anecdotal from good source rather than published... many people have asked us about it - and a few have said they have heard this sort of thing before but they would like hard data... I apologize as I am unable to provide...]

Post 2: Kickback on First Solar

One of the biggest benefits I get from writing this blog is that sometimes some very smart people disagree with me. In the investing business you will be wrong often. The earlier you realize that you are wrong the smaller (on average) your losses will be. I don’t think the blog can move markets through talking my book. (I disclosed a good argument for shorting First Solar and the stock went up!) But I do think that kick-back from smart people can help reduce my losses when I am wrong. Believe me that is often enough! If all that the blog delivers me is smart people who disagree with me then I will wind up being a well-paid blogger (and my clients will be grateful)!
I got a lot of kick-back on my First Solar piece – some of which makes me more nervous about the short – and some of the kick-back is from people who are very smart. I thought I ought to lay this kick-back out at least in part to get my own thoughts straight.
One of the solar industry trade publications asked my permission to republish the piece – which I have granted. They also warned that they might have a follow-up piece titled: “Why I am short Bronte Capital”. That ought to put us in our place! I have yet to see that piece – but honestly I look forward to it (even though reading it will be painful). It may convince me that I am wrong – in which case I will cover my short forthwith!
The basis for the kickback I have received
The core to my argument was that First Solar has disadvantages (notably lower conversion efficiency) offset by a couple of advantages – notably keeping higher generation in low light, less sensitivity to angle of light – and most importantly – lower cost.
My view was that lower cost would determine almost everything. Solar modules are fundamentally a commodity – and whilst the low-light advantages were real – they could easily be overwhelmed by cost.
I then made an assertion – which I did not back – that the cost structure of wafer-based cells will be competitive against CdTe (First Solar) cells when the polysilicon price gets low enough.
Most – but not all – of the kick-back I have received is based around this cost structure issue. This falls into two camps. Firstly they assert that I have the cost structures of the competitors wrong. Secondly they asset that First Solar will reduce costs enough to offset the advantage that wafer-module-manufacturers get from lower silicon prices.
The other kick-back I have received is on the sales-and-marketing department. First Solar has – according to customers – by far the best sales force. “They are a machine!” First Solar they think that this will allow First Solar to travel well for longer than I might anticipate. Moreover they thought First Solar’s average selling price would remain high because FSLR has presold a lot of modules to solvent utility scale operators – notably EDF in France.
In this post I examine these issues with the aim of getting my own thoughts straight (and hopefully invoking more kick-back from more people that are smarter than me).
A cost model for polysilicon producers
Polysilicon has several disadvantages vis CdTe technology. First the materials are more expensive (wafers are thicker than thin film) – but just as importantly the manufacturing process is much more complicated. At First Solar glass goes into the plant and comes out – about three hours later – as an almost complete module. Human involvement is minimal. Wafers however require more manufacturing – they are sawn – they have breakage rates – they are laced with wires to conduct the electricity away – and they are “assembled”. Manufacturing cost are higher.
That said we can construct a simple cost model for wafer manufacturing from comments made by competitors. YingLi – a Chinese module maker – made the following comment in their fourth quarter conference call:

In the fourth quarter, our non-polysilicon costs including depreciation further decreased to $0.76 per watt from $0.81 per watt in the third quarter and $0.86 per watt in the second quarter and $0.90 per watt in the first quarter of 2009. This decrease demonstrates our strong R&D capabilities, and execution capabilities to continuously improve the yield rate, field conversion efficiency rate and operational efficiency.
The blended cost of polysilicon continuously decreased by the mid-teens in the fourth quarter. I would like to emphasize again that Yingli has now provided long-term (inaudible) provisions to write-down inventory costs or polysilicon prepayments the challenging fourth quarter of 2008.

Now YingLi is a good (meaning low cost) Chinese producer. It has terrible blended costs – but that is because it purchased silicon at high prices and its blended silicon costs are too high. But these costs do not seem wrong relative to competitors. [Inventory problems are surprisingly common in the industry as people hoarded polysilicon to avoid excessively high spot prices and wound up with huge inventories as the price collapsed.] The thing that is most notable about this is how fast the non-silicon costs have been falling – the sequence by quarter is 90c, 86c, 81c, 76c. This is roughly 4c per watt per quarter. It is of course impossible to know how far this will continue to fall – diminishing returns to technology and manufacturing reports will eventually occur. But for the moment we can take 76c and falling fairly fast (roughly 4c per quarter) as the non-silicon costs for various manufacturers. [Contra: slide 8 in Suntech’s latest quarterly presentation gives a much lower non-silicon price. That slide is so “out-there” different I tend to dismiss it – though if anyone has a clear explanation I would like it.]
Solar wafers used to require 7 grams of silicon per watt. Some manufacturers run at about 6.2 grams of silicon per watt – with 180 micron silicon. Applied Materials talk about 80 micron thick silicon wafers – though silicon use for those wafers is not reduced by 80/140 because wire saw (kern) losses are similar regardless of wafer thickness. Also as wafers get thinner they have higher breakage rates (and the incentive to cut wafers thinner is lower as silicon prices fall).
Its probably fair enough to use 6.5 grams of silicon per watt as the right number for modeling a silicon wafer module producer. The 6.5 grams is falling and in five years it may be 5 grams (if AMAT manages to sell more of their kit). Ok – but at 6.5g (or 0.0065 kg) per watt then the cost structure is easy to model…

YingLi cost per watt (in cents) = 76 (less any efficiency they get from manufacturing improvements) plus silicon price (in cents per kg) * 0.0065.

Now I am going to take a wild stab at what the number will be by June 30. My guess is that spot silicon will be $40 per kg and the 76c will be reduced to say 71 cents (which is still falling but by less than the 4c per quarter which the cost has fallen). This gives a cost per watt by the middle of this year of 97 cents. Polysilicon costs go below the magic dollar per watt!
Obviously this is highly dependent on the silicon price – a $20 silicon price would make the cost 13c per watt cheaper – say 84 cents per watt. A $100 silicon price takes cost per watt to $1.41.
Cost is also dependent on YingLi (and presumably the other commodity panel makers) getting efficiencies in the production of modules although at a reasonable clip – though as noted, I model a rate below the historic rate of cost improvement.
[I should observe here that Trina Solar – another Chinese manufacturer – gives their non-silicon costs at 78c per watt – 2c more expensive than YingLi in the fourth quarter. Trina’s cost reductions are also about 4c per quarter… See page 8 of their quarterly presentation.]
This cost model is fraught. The accounting of many of the Chinese players is difficult to decipher. One person I have talked to suggests that most other players are way above 78c per watt in non-silicon costs (although competition will get them there or force them out of business replaced by people who are at that level). They thought YingLi would be at 70c by the end of 2010. Against this the same person thought my grams per watt was too high (suggesting 6 grams per watt based on 180 micron thick wafers) and they thought that YingLi would be at 5.5 grams per watt by the end of the year. This is more or less a wash – with wafer costs a little lower than my estimate but base costs winding up a bit higher. Again all of this stuff is fraught – and although these broad numbers are not controversial the end competitiveness of First Solar is surprisingly sensitive to fine differences in base cost and silicon costs of their competitors.
What is the cost structure of First Solar?
First Solar has laid out ambitious plans to increase the efficiency of their cells and to further reduce costs. I do not want to go through those in detail – but I think we can extract two key charts from the last presentation. First slide 13 – which has the cost per watt falling still – but at decreasing rates. The cost-per-watt has fallen by 1-2 cents per quarter for the last couple of quarters (versus 3-5 cents for the non-silicon costs at YingLi).

Then there is the less-specific presentation from their “roadmap” (see slide 14) which shows their 2014 target cost per watt.

I wish I understood how all of these gains were likely to be achieved – but they think they can get to 52-63 cents per watt by the end of 2014. However – for the moment I assume that they can meet their cost target and get to 58c per watt (a reasonable midpoint) by the end of 2014.
That cost per watt reduction is 26c over 16 quarters – or 1.625 cents per quarter – roughly the rate at which costs have been falling historically.
Figuring that the were at 84c per watt during the fourth quarter of 2009 – and they are reducing costs by 2c per watt per quarter (that is a little faster than historic and slightly faster than their roadmap) costs will be about 80c per watt per quarter by the June quarter of this year.
A raw cost comparison – with the price of silicon being the main variable
With the trusty spreadsheet I can produce a reasonable cost-per-watt comparison…

On this cost structure the YingLi panels have higher production costs unless the silicon price is very low. That sort of makes sense. YingLi panels have higher production costs (the process for making them is more complicated) offset by lower non-silicon materials costs (they are more efficient and hence use less glass, backing wire etc). The swing factor is silicon.
This table however leaves off the single most important swing factor – which is that the YingLi panels are smaller per watt of output. (Remember my whole argument is dependent on the higher conversion efficiency of the polysilicon wafer modules.) There are wildly different versions of how much the installation cost advantage is. The advantage comes about because you need less cells, less land, less brackets and less converters to generate the same amount of energy.
This paper from the National Renewable Energy Laboratory has been my guide. This paper suggests that First Solar modules need to be priced 25-30 cents below c-Si modules to generate equivalent project returns (see page 26). Some people think this far too high. For instance Stephen Simko (an analyst from Morningstar who disagrees with me) thinks a 10 percent penalty (roughly 7c per watt) will do the trick. I for the life of me do not understand why this is a percentage (there is limited evidence that installation costs are falling at the same rate as manufacturing costs). 7 cents per watt is very different from 25-30 cents.
I would really like people to detail what the cost difference is. (If informed people send me emails I will be grateful…) I suspect it depends on all sorts of things like labor costs, brackets, land availability and things you would not expect like wind levels (wind requiring better anchoring for the panels).
For the moment I use 15c per watt (a number my research indicates is too low – but which Stephen Simko thinks is too high). At this point my cost table needs to be adjusted…

Now at this point the First Solar cells are about cost-competitive at a $40 silicon price. If silicon prices go as low as $20 per kg then the Chinese polysilicon makers (represented by YingLi) have the goods by a long margin.
I should note that this cost structure does not match the cost structure as presented by several people bullish First Solar… Here is a cost structure as presented by Stephen Simko comparing First Solar to Trina Solar (yet another Chinese wafer-module maker). In it however he keeps the silicon price constant at $45.

You can see the difference between Simko’s estimates and mine. I have Q2’10 costs for the wafer manufacturer a few pennies (say 3c) lower than Simko. Simko has the cost structure of First Solar falling about 3c per quarter (versus my 1.5 cents per quarter and adding up to a further 3c cost advantage) and he has an efficiency penalty of about 8c versus my 15c (or another 7c of cost advantage). He thus has First Solar maintaining a cost advantage of about 15-18c per watt over the next twelve months whereas the extra costs I suggest wipe most of that advantage.
At a $20 silicon price even with Simko’s cost estimates First Solar’s cost advantage disappears. This of course led Stephen Simko and me to a discussion of what drives polysilicon ingot prices. In that he changed my mind somewhat…
What drives the polysilicon price?
Polysilicon is a commodity. Sure there is better quality stuff (which makes more efficient wafers) but it is still a commodity. Usually with a commodity – when there is spare capacity in the system – the commodity is priced at the cash running costs of the highest price operational plant. When the world runs out of capacity the commodity disconnects from its “cost curve” and is priced at whatever the market can bear. At that point being a commodity maker is frightfully profitable. That profit attracts new entrants and new capacity. Eventually there is enough supply and the commodity price reconnects to the cost curve. (This pattern is familiar to anyone who has – for instance – studied metal prices generally. The pattern drives much of the Australian economy.)
As the solar industry ramped up polysilicon prices disconnected from their cost curves. Spot prices of $450 were not unknown. The NREL paper cited above mentions spot prices higher than that. The spot price however was rarely paid – because most wafer makers purchased large inventories and entered into forward contracts. Some solar-cell makers have got themselves knotted up financially because they have purchased thousands of tons of polysilicon inventory at prices that are well above current prices and which prohibit them from making profits.
The excessive profits made by the ingot makers introduced many new suppliers to the industry. One source suggested that we have gone from six suppliers (and a cozy oligopoly) to 26 suppliers (who will cut each other’s throats). This market is becoming very glutted very fast. That means that the poly price will go to marginal cash cost. So what is that cost?
Well I started with the big players – and they have cash costs in the low 20s. I thought the polysilicon price would thus go to the low 20s. That would settle the issue because – even on the Stephen Simko’s numbers – the Chinese-wafer-based modules will have lower costs than First Solar at a $20 polysilicon price.
So – without stating it so clearly – I thought that the poly price would wind up closer to $20 per kg than the $45-55 modeled by most First Solar bulls.
Stephen Simko disabused me of this notion – and this time I am fairly convinced by his explanation. During the boom the most insane polysilicon manufactures built plants and with very different cash costs to the established (and presumably knowledgeable) players. He thinks the cash cost outside the established players is considerably higher than the cash costs of the established players. He points to a presentation by REC Silicon. Slide 45 of the presentation gives what REC purports is an industry cash-cost curve and whilst the Y-axis is not labeled the bottom of the curve represents about $20 a kg – and the top of the curve represents – well – who knows what? Here is the slide:

If this curve is correct the polysilicon price is unlikely to get to $20 because the marginal players will have costs substantially higher than $20.
The issue comes down to how flat is the cost curve? It strikes me – intuitively – as being likely to be very flat as the equipment to make silicon is pretty well understood – but if anyone is genuinely expert in this then I would love them to contact me. [The cost curve REC/Simko showed me however is emphatically not flat…]
This REC graph however has given me pause – because the really brutal outcomes for First Solar were dependent on a very low silicon price. If the silicon price were really to go to $20 and my cost numbers (somewhat more brutal than Simko and other bulls) are right then First Solar will wind up with no reason to exist – and the stock will go below $10 (currently about $130). If the poly price does not go below $45 and Simko’s numbers are right then First Solar will keep a cost advantage – and that cost advantage is sustainable – at least until a better technology comes along or First Solar’s patents run out. First Solar earnings might be difficult – but the business has a reason to exist.
Funny – I have not mentioned profitability
So far – in neither of my notes – I have not made a profit estimate for First Solar or any of the competitors. I have modeled cost – but thus far have not modeled selling price. Once we have a reasonable estimate of selling price and a reasonable estimate of cost we should be able to model profits give or take some things. [The main things we would need to give-or-take are inventory losses for the silicon manufacturers – some of whom have thousands of tons of overpriced silicon inventory, and the project gains and losses for First Solar which is an investor in utility scale solar projects.]
Looking at the current price for modules is not going to help you much. Many companies have both purchased silicon at fixed rates and pre-sold panels at fixed rates. First Solar locked in lots of fixed rate contracts – some with good solvent parties (for example EDF) – some with parties that are more questionable. The current prices realized by the solar manufacturers depend more on the contracts that they entered into (both price and solvency of the counterparty) and less on spot price for panels than a first glance might look.
There are disclosures in First Solar’s 10K which illustrate the problem. These disclosures can be read as “red flags” though I prefer to keep more neutral about their content.

During the first quarter of 2009, we amended our Long-Term Supply Contracts with certain customers to further reduce the sales price per watt under these contracts in 2009 and 2010 in exchange for increases in the volume of solar modules to be delivered under the contracts. We also extended the payment terms for certain customers under these contracts from net 10 days to net 45 days to increase liquidity in our sales channel and to reflect longer module shipment times from our manufacturing plants in Malaysia. During the third quarter of 2009, we amended our Long-Term Supply Contracts with certain of our customers to implement a program which extends a price rebate to certain of these customers for solar modules purchased from us and installed in Germany. The intent of this program is to enable our customers to successfully compete in our core segments in Germany. The rebate program applies a specified rebate rate to solar modules sold for solar power projects in Germany at the beginning of each quarter for the upcoming quarter. The rebate program is subject to periodic review and we adjust the rebate rate quarterly upward or downward as appropriate. The rebate period commenced during the third quarter of 2009 and terminates at the end of the fourth quarter of 2010. Customers need to meet certain requirements in order to be eligible for and benefit from this program.

Essentially the customers or sales channel was liquidity constrained – so terms needed to be made more generous (45 days versus 10 days). Moreover we needed to offer a price rebate (presumably a rebate on our fixed price contract) to enable customers to compete. Those rebates were subject to certain tests (presumably solvency tests but we do not know the content of those tests). Some of these contract changes exchanged smaller fixed price contracts for higher volumes at lower fixed prices.
Whatever – the industry is rife with fixed price contracts. Spot prices are below the fixed price contracts. One day these fixed price contracts will roll off – and new fixed price contracts will struck at considerably lower prices. As we do not know the duration of the fixed price contracts – and even if we did that duration keeps getting extended in exchange for lower prices – we can’t really tell the path of the selling price.
But I have a method which should be familiar to any economist – and I think works for working out where the long term selling price will wind up. It is simple really. The Chinese competitors are numerous and very hard to pick apart from each other. Some are ultimately going to be pennies per watt better than others – but because they are numerous and in fierce competition they will drive the price. This should be bleatingly obvious – anyone who has competed with numerous Chinese manufacturers by now would know that the price is driven down to the price where the Chinese manufacturers make a mid single-digit ROE.
That price however is much lower than the current selling price and probably much lower than the selling price First Solar will realize in 2010.
Moreover the price should be fairly easy to determine: I will just do it for one manufacturer. At year end Trina Solar had book value of $677 million. Some of that value was inflated because they were carrying some high-cost silicon inventory. They had output ability of about 550 megawatts per year (averaging 600 in panels and 500 in wafers). To earn 15 percent pre tax on that equity they need to make roughly 100 million per annum or they need a margin of 18c per watt sold. The first-cut estimate of the long term price of these things is thus – and I am being very simplistic here – whatever the Chinese manufacturers cost plus 18c per watt.
This first cut however is a sharp over-estimate. The equity I am including is too high because of overpriced inventory. The ROE I am demanding is too high too (Chinese competitive manufacturers make far less than that!) The industry is continuing to get efficiencies – and they will be competed away – so the margin per watt will come down for that reason too. You do not need to make any unreasonable assumptions for the right margin per watt over the cost for the Chinese manufacturers to be 10c.
From here an earnings model is easy… First Solar will produce (on their guidance) about 1.7 gigawatts this year and 2 gigawatts next year. The selling price will be whatever YingLi’s cost is plus 10c… You can work out the margins using either mine or a bull’s cost estimates (I use mine). Multiply margin by wattage and you get pre-tax profit – give or take a little bit. I do this below.

Now – using numbers I think are inherently likely – I get earnings falling sharply. If we take the silicon price to $20 then First Solar has no earnings. If we think the installation penalty is 25c rather than 15c as per the NREL paper earnings go away up to a silicon price of about $40.
Now Mr Simko reckons that the cost advantage of First Solar is about 13 cents per watt better than my number. [He has an 8c installation cost rather than my 15 etc…] 13c per watt equates to $20 per kg on the silicon price (remember we are assuming 6.5 grams of silicon per watt). In other words if you use Simko’s numbers then take my silicon price estimate and add $20 (say $60 instead of $40) to read the earnings numbers. Even on Mr Simko’s numbers First Solar’s earnings fall fairly sharply when the competition amongst Chinese manufacturers drives their ROE down to normal Chinese levels. That makes me more comfortable with my short. First Solar may not be a devastating failure but earnings will fall sharply and the stock starts with a teens PE ratio…
Innovation and the long-term future of First Solar
So far my argument has been predicated on the silicon price falling. At low silicon prices First Solar becomes uncompetitive. The only real question being how low is low?
But First Solar can become more or less competitive depending on how much they can reduce costs or increase efficiency versus their Chinese wafer-based competitors. First Solar has an ambitious target of reducing costs over the next four years. I want to repeat the slide on that cost reduction strategy.

Now I know you have seen this slide before… what you probably did not notice is that it is not drawn to scale. The company plans to get 18-25 percent cost-per-watt reduction via efficiency – and and only 15 or so percent cost-per-watt reduction through everything else (plant utilization, scale etc). That makes sense because First Solar plants are already highly automated. Glass goes in one end and almost-complete modules come out the other end with little human intervention. It is almost impossible to improve that manufacturing because it is already almost perfect!
So the only place they can get their cost-per-watt down is by getting more watts-per-glass-sheet – that is improving efficiency. Efficiency is the core to First Solar’s roadmap to lower costs.
I will be blunt. I do not think they can do it. Efficiency is already 11.1 percent. If they get 21 percent out of efficiency – something like a midpoint of their 18-25 – then they need to get efficiency to 13.4 percent – and they need to do it over 16 quarters. Efficiency must improve almost 15 bps per quarter. Efficiency for the last six quarters was 10.7, 10.8, 10.9, 10.9, 11.0, 11.1 percent – something less than 10bps improvement per quarter. This is something which should asymptotically approach a theoretical limit – and yet First Solar is modeling that the rate at which they improve efficiency will increase for the next four years. Maybe they can do it – but trees do not grow to the sky.
Against this – what is driving the Chinese manufacturers is manufacturing efficiency as well as conversion efficiency. The Chinese processes are difficult – involving sawing, lacing wires on wafers and assembly. There are many more and difficult steps than First Solar’s thin film process. That is bad for them now but provides opportunity. Chinese manufacturers are – if we know anything about them – relentless in taking out costs.
So my guess is cost-per-watt will fall faster in the Chinese silicon manufacturers than in First Solar precisely because there are more opportunities for manufacturing improvement.
Stephen Simko had the opposite view. He figured that thin film is a new technology whereas wafers have been around for a long time. That means that there are more opportunities for conversion efficiency improvement in thin film than wafers – and he thought that would drive costs over time. I have an answer to that – 10.7, 10.8, 10.9, 10.9, 11.0, 11.1. But really to get comfortable with that I want to talk with a particle physicist who knows a lot about semiconductors. My knowledge of (low energy) particle physics (and hence the mechanism by which a thin film semiconductor might work) is not much more than you can garner from Brian Cox’s excellent mass market book on Einstein and the Standard Model and a few other populist things (many from Mr Cox). On the interaction between atomic sized gates and the efficiency at which electrons can be forced across a thin-film semiconductor layer I am – as you might expect – totally out of my depth…
So there you have it – the whole First Solar thing modeled out. I think I am right – but sensible people take the opposite view – and one industry publication wants to write a piece about why they are short Bronte Capital. If anyone tells you this investing game is easy ignore them. This is tough – and the bets we take occasionally fill us with angst.
John

Thinking about the Abacus sign

2011-10-26T07:54:00.000+11:00

The widely distributed - nay viral - picture of a young woman carrying a sign referring to Abacus - the much litigated Goldman Sachs/Paulson/IKB deal got me thinking.

Here is the sign for the small number of you that have not seen the picture:

It says that "It's wrong to create a mortgage-backed security filled with loans that you know are going to fail so that you can sell it to a client who isn't aware that you sabotaged it by intentionally picking the misleadingly rated loans most likely to be defaulted on".

I can't help but agree except this is not what happened in the Abacus case. The Abacus security was an entirely synthetic security. It was not filled with loans that were intentionally picked, it was loaded with derivatives that someone thought were most likely to be defaulted on.

That is an important distinction. If Goldman had created a security filled with bad loans and sold them there is no way that the client would be able to work out that someone was betting against the loans.

But that is not what happened. It was filled with derivatives where it was obvious that a financially sophisticated counter-party was taking the other side. Indeed what the security was was the reverse side of a bundle of bets against mortgage securities bound up by Goldman Sachs and the simplest understanding of it revealed that fact. Sure the buyer did not know it was Paulson taking the other side of the bet. (Indeed, given Paulson's latest run the fact that was Paulson neither adds nor subtracts from the case for buying or not buying the Abacus bundle.)

I think Goldman Sachs was done here unfairly (although it is hard to imagine it happening to more deserving people). Anyone who was financially sophisticated (and IKB certainly portrayed themselves as sophisticated) should have realized there was an opposite side to that bet and that someone had deliberately taken the opposite side with respect to every derivative in the bundle.

Now contrast this with what happens when I make a short sale. I borrow a security from a broker which is identical to any other security with the same cusip number. I sell it in the market. The person on the other side purchased a security and they have no idea whether they purchased it from a long or a short.

People who buy securities from me in the regular securities market are at a disadvantage to IKB. IKB knew there was someone making the opposite bet. When we make money short selling (and we have made plenty) the people who lose have no way of knowing that Bronte/John Hempton was on the other side of the bet.

I am (in part) a short-seller. I regularly try to stuff the market with securities that are "intentionally picked" as "most likely to be defaulted on".

Where is my sign?

John

Huabao: derivative transactions and disclosure

2011-10-20T09:15:00.000+11:00

Huabao - a fragrances and flavors company and the subject of attention on this blog - has suffered a rapid stock-price decline lately.

The company put out a press release related to the unusual activity in the stock.

To quote:

UNUSUAL PRICE AND TRADING VOLUME MOVEMENTS

We have noted the recent decreases in the price of the shares and the significant trading volume involved of Huabao International Holdings Limited (the “Company”). Save as disclosed below, we are not aware of any reasons for such incidence.

We have been recently notified by Ms. CHU Lam Yiu, the controlling shareholder of the Company, of her entering into a derivative transaction on 14 October 2011 relating to a long position of a monetary value equivalent to 94,736,842 shares of the Company with a contract period starting from 14 October 2011 to 13 January 2013...

I have a simple question: what is the "derivative transaction" that Ms. CHU Lam Yiu entered into regarding over 94 million of her shares?

In my world all derivatives can be bifurcated into a series of forwards, put options and call options. (The bifurcation is alas not unique...)

Unless I am mistaken then she has either

(a) sold her shares using forwards in which case it is effectively a forward sale (she has just cashed out and used fancy language and derivatives to obscure this fact),

(b) sold the upside of her shares by selling call options or

(c) protected the downside of her shares by buying put options or

(d) some combination of the above.

All of those are bets against her shares in some form or other. Of course I can be mistaken, but it seems the CEO is betting against her own shares using derivatives.

I am also betting against her shares - so I have something in common with her.

But not much.

You see I am just a guy who reads public filings. She is the controller of the company and the world's youngest self-made female billionaire. She is a smart cookie too: took her company public via reverse takeover, sold a chunk of shares in 2008, and again in 2009 and again recently. She is, on some lists, the eighth richest woman in the world.

And she still seems to be betting against her shares. Mostly she sells at lower prices.

But whatever: I think we are entitled to know precisely the nature of the bet that the CEO has taken against her shares.

I am happy to disclose my bet: I am short. Ms. CHU Lam Yiu, it is your turn to disclose.

John

Huabao and the Queen of Cashout

2011-10-17T17:24:00.001+11:00

The Shanghai Daily (subscription required) has taken to calling Zhu Linyao as the "Queen of Cashout". She is otherwise known as the controller of Huabao - an interesting company I have previously written about.

She is the second biggest insider-seller of any Chinese stock according to this list - having cashed out about half a billion US dollars this year.

I have now emailed with many people who have an interest in Huabao. Some visited the (recently purchased) reconstituted tobacco leaf plants - and they were moderately impressed. Some visited the flavors plant (the legacy business) and they found a few blue drums and a vat full of strange liquid but nothing redolent of a business then worth over USD3 billion. They ran a mile from the stock.

The most impressive website any of the people I communicate with has found is for their Peacock brand. They sell 572 products (far less than most retail shops) including "tomato sauce" and "cheese powder". Press "new products" and you get a one word answer: "no". A similar response is given for "food flavor". Isn't this meant to be a flavors company?

This compares as I noted in my previous blog post with maybe 100 thousand pages of text on the website of the major company in this industry (Givaudan).

It is unlikely you make 60 plus percent margins reselling flavored yogurt on an obscure Chinese website. I am not joking - see this link.

The only way that the margins - almost five fold the margins of Western competitors - are possible is by selling at an inflated price to the Chinese state owned tobacco companies. And indeed that is what the bull story is as many of my readers have pointed out.

I can neither confirm nor deny the existence of those sales. My only correspondents who have visited the factories responsible for those sales found a few blue drums. But there might be a large and complex factory behind that or there may be other sites so their word should not be taken as complete.

Moreover Price Waterhouse Coopers audited the accounts and they tell me the sales are real so I presume they are. Whatever: if real it is likely that one day the State Owned Enterprises will try to renegotiate the deal which seems unreasonably favorable to Huabao...

Maybe that is why Zhu Linyao is the "Queen of Cashout".

John

Bronte Capital enters strategic partnership with Diageo - maker of Guinness beer. Oh and a comment on Trina Solar

2011-10-15T04:13:00.001+11:00

Bronte Capital have entered into a strategic partnership with Diageo - the maker of Guineess. But we haven't really. We are in a pub in London knocking back a pint of the black liquid. Guinness tastes better in the old country. [It is the old country to an Australian...]

We now have a commercial arrangement with Diageo - albeit a temporary (though tasty) one. But that has not stopped us writing a press-release trumpeting this "strategic partnership". I may send a copy to the news wires to see if they will run it.

In all seriousness they probably would. They ran this:

CHANGZHOU, China, Aug. 17, 2011 /PRNewswire via COMTEX/ --
Trina Solar Limited (TSL) ("Trina Solar" or the "Company"), a leading integrated manufacturer of solar photovoltaic (PV) products from ingots to modules, today announced that through its subsidiary, Trina Solar Australia Pty Ltd, it has signed a strategic partnership with Origin Energy Australia ("Origin"), the leading Australian integrated energy company.
Under the terms of the agreement, Trina Solar is expected to supply Origin with approximately 22 MW of PV modules over the next twelve months starting from the third quarter of 2011.

"We are delighted to initiate our relationship with Origin, Australia's leading energy retailer and the country's largest green energy retailer with significant investments in renewable energy technologies," said John Susa, Trina Solar's Country Manager of Australia and New Zealand. "We are confident that this long-term partnership with Origin will bolster our ability to expand and strengthen our market position in the residential segment."

Being a cynical sort of guy - and knowing that Origin Energy are reputable I checked this release. Here is what Origin said.

Hi John,

Origin has not put out a release as it is simply part of our ongoing supply arrangements and not material in its own right. Trina is one of a number of suppliers we use.

Cheers,

Angus

Angus Guthrie
Group Manager, Investor Relations

I blogged this response here.

I almost did not need to check. When a party announces a "strategic partnership" and the press release offers contacts from only one side of the deal then you should be skeptical. Indeed it can hardly be strategic if only one side comments.

There are other strategic partnerships announced by Trina. In all cases there is no contact given for the "strategic partner", for they once announced a strategic partnership in Italy.

I am going to be blunt. The Origin press release has as much substance as Bronte's "strategic partnership" with Guinness. I have no idea about the other strategic arrangements but Trina says some strange things about Italy. For instance in the last conference call the chief operating officer said:

I have been waiting for Italy since I got here. So, we are actually seeing some good activity finally. And we have some pickup in activity. We see it. Obviously, our historic Italian account is at the utilities. We also see Spanish accounts that a lot of them actually served projects there. So, after much waiting and unclarity, we are seeing some pickup in demand. There is – we still have a mix of utility projects in commercial rooftop there. And so what we are seeing moved quicker was the stuff that was utility that was finishing off and now it’s blending into commercial rooftop.

It is possible that Italy was taking off just as he said this - but it seemed unlikely to us. After all the banks in Southern Europe were under sharply increasing financial stress at precisely the time of this conference call and funding for long term projects (like solar) was drying up. I did not believe the statement. Maybe it was true - but there is a problem with statements about insignificant "strategic partnerships". Those statements predispose you to not believe further statements.

So here is what I believe. I believe Trina is burning cash increasingly fast. So fast that it is in deep trouble.

Trina, through operating cash burn and capital expenditure chewed through $136 million last quarter. I blogged the calculation here. Chinese banks funded this.

The average selling price during the quarter was $1.46 per watt (reference given here).

The prices per watt have fallen to $1.10 or below when priced wholesale.

So revenue per watt is running 36c lower than during the quarter.

The costs per watt have dropped too. Polysilicon has dropped from say $48 to $38 per kilogram - but exact numbers are hard to find. At 6 grams per watt the costs per watt thus dropped 6c. Efficiency gains add another 2c reduction in costs per watt.

Nonetheless margin per watt will be 28c per watt lower than last quarter.

Production is going to be (at least) 450 million watts - so aggregate margin is going to be $112 million lower than last quarter.

There won't be any tax paid - or anything like that - but the company looks like it will burn through $136 million plus $112 million in cash - more if stuff keeps accumulating in warehouses - less if the hard-selling they are doing actually works.

$248 million per quarter - or roughly a billion dollars a year is a little bit much for Trina to bear.

Unless there is something dramatically wrong with my calculation Trina is doomed. Not even a Chinese bank comes at a billion a year funding requirement just to stay in business.

Now of course all of this is my estimates. I can only go on public information and my own inquiry and my own analysis. I wish I could just use Trina's statements but - and it might just be the PR people who have done this - Trina has devalued its statements with overblown puff pieces about "strategic partnerships".

But I have trouble trusting Trina. And you should have trouble trusting me. I am effectively short the stock. Besides, I have just entered into a very enjoyable "strategic partnership" with Diageo.

And I might just have another Guinness.

John