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BAC: CHINESE WATER TORTURE - THE NEXT DRIP

Highlighting FHA Exposure

In light of today's news about BAC hindering the HUD foreclosure investigation, we are revisiting Bank of America's exposure to potential losses from the FHA insured loan pool.

 

Bank of America currently holds $20B in 90+ days delinquent FHA-insured loans on its books, up from just $400 Million  two years ago.  When a loan defaults from a GNMA trust, BAC buys it out of the trust to minimize the servicing advances on the loan.  Since these loans are insured by the FHA, Bank of America should theoretically have no associated liability.  However, we doubt that this will be the case.

 

BAC: CHINESE WATER TORTURE - THE NEXT DRIP - fha dq

 

Return of the "Fantastical Stretch" 

Our primary concern around BAC's exposure is that they would be subject to a suit analogous to the May 4, 2011 Dept of Justice suit against Deutsche Bank.  As we wrote when the lawsuit hit the news in early May, "The US Attorney said in the press conference that it would not be a "fantastical stretch" to expect other institutions to face lawsuits, while the general counsel for HUD added that HUD would make "appropriate referrals" to the DoJ wherever they suspect underwriting fraud."

 

Recall that the DoJ sued Deutsche on behalf of the FHA under the False Claims Act, which permits triple damages.  The treble damages is a punishment clause intended to dissuade businesses from defrauding the government. As the GSEs are not technically government entities this law did not apply to them, but the FHA is a direct government agency. The FHA alleged that Deutsche had lied about its underwriting policies on 39,000 loans originated between 1999 and 2009, of which 12,500 later defaulted.  The FHA had paid out $386M in insurance on the contested loans.  If all $386M in insurance payments was a False Claim under the law, Deutsche's liability could be more than $1B.  

 

Afterparty at the FHA

As the chart below demonstrates, credit quality at the FHA deteriorated significantly in 2007-2008.  At the same time, volume increased sharply on both a market share and absolute basis. This is a classic case of adverse selection. The subprime party ended in 2006/2007 and the party then migrated to the "afterparty" at Fannie and Freddie where it carried on for about 18 months. Beginning in early 2008 and continuing still today the "after-afterparty" has been at the FHA. If anyone doubts this, have a look at the loss curves associated with late vintage FHA loan books. The bottom line is that the FHA will ultimately get around to seeking recourse on what was clearly terrible underwriting. The Deutsche case was the first shoe to drop, but there will undoubtedly be others.  

 

BAC: CHINESE WATER TORTURE - THE NEXT DRIP - FHA market share

 

BAC: CHINESE WATER TORTURE - THE NEXT DRIP - fha

 

GSE Putbacks as a Model - Liability Likely $4.5B+

To get some idea of the magnitude of potential losses from FHA loans, we can use the GSE experience as a guide.  Bank of America has disclosed that the GSE delinquent loan pool is $109B.  The table below walks through the steps to determine ultimate loss content.  Bear in mind that this methodology is predicated largely on BAC's own numbers and estimates, which likely understates the problem. The bottom line is that BAC will likely end up paying $8B+ on $109B in delinquent Fannie/Freddie loans, or a loss rate of 7.3%.  

 

Looking at only the $20B in 90+ FHA loans currently on BAC's balance sheet, and applying a 7.3% loss rate, the minimum liability would be $1.5B.  This doesn't take into consideration defaulted loans no longer on BAC's books (where the FHA has already paid the insurance claim).  

 

Keep in mind that if the Department of Justice were to pursue BAC under the False Claims Act, as they have with Deutsche, BAC would be exposed to triple damages.  On our math, that works out to at least $4.5B.  This would be in addition to the $25 billion we already think they're on the hook for (see our table below for details).

 

BAC: CHINESE WATER TORTURE - THE NEXT DRIP - reps and warranties

 

Chinese Water Torture

For Bank of America, housing exposures keep adding up.  We estimated in our 5/10/2011 note ("BAC: Another Big Charge is Coming in 2Q11 as Home Prices Fall Faster") that BAC is likely to see another $1B write-down related to the GSE settlement in 2Q, based on ongoing declines in home prices.  Further, the PCI book is significantly exposed to downside in home prices - we estimate potential further losses of 10-30% on the $41.7B book, or $4-12B, over the next several years. Again, all of this is in addition to the $25 billion itemized in the table above and the $4.5 billion enumerated on the FHA front. Moreover, Bank of America will have a substantial share of the eventual servicer settlement (we estimate $6.7 billion here), when it is finalized in the likely not-too-distant-future. For those keeping score, that's a sum total of $45.2 billion.

 

Given this magnitude of loss content coming down the pike, we think it goes without saying that it's justified for BAC to be trading well below tangible book value until some clarity emerges to contradict these estimates. 

 

Joshua Steiner, CFA

 

Allison Kaptur


Nickel: Deflating the Inflation Part I

 

Conclusion:  Inventories of nickel are set to increase due to more tepid demand and increasing production, which will lead to lower prices.  Deflation of the Inflation is bad for commodity producers, but positive for consumers.

 

In the 1940s, the nickel industry was a monopoly in the literal sense of the word as Canada’s Inco controlled more than 90% of the global nickel market.  Today, the production of nickel is much more diversified with the largest producer, Russia’s Norlisk Nickel, holding roughly 20% of the global market share.  Just behind Norlisk in terms of market share is Vale SA, a Brazilian company, which acquired Inco in 2006.  While still a concentrated industry in terms of production, the price of nickel is very much driven by supply and demand, especially as its correlation with the U.S. dollar weakens.  (Incidentally, the United States has no active nickel mines.)

 

Nickel is a metallic element and is the fifth most abundant element in the earth, after iron, oxygen, silicon and magnesium.  Close to two-thirds of new nickel is used to make stainless steel.  Alloys containing nickel are known for their strength, toughness, and corrosion resistance.  These attributes make nickel critical to many industries.  Construction and transportation account for 37% of nickel demand and 18% is used in machinery and electrical applications. 

 

Similar to many commodities, China is a primary driver of global nickel demand given the vast urbanization trends.  Specifically, China consumes about a one-third of the world’s nickel and is the world’s largest producer and user of stainless steel due to its rapid growth and urbanization.  Not surprisingly then, much of the recent decline in the price of nickel, and really many commodities, can be attributed to slowing growth in China.  In the chart below, we show the price decline over the past month, though it is still above its estimated marginal cost of $17,500 to $20,000 per metric tonne.

 

Nickel: Deflating the Inflation Part I - n1

 

In the short term, decline in demand for nickel from China is being attributed to stainless steel mills being shutdown, Chinese power shortages (see a note by Darius Dale on this point from June 1st, 2011, “Asia’s Power Struggles Part 1”), and monetary tightening by Chinese authorities.   In fact, Chinese steel giant Baosteel indicated that they expect Chinese steel consumption to grow 5-7% over the next five years, which is a deceleration, but consistent with the most recent 5-year plan from China.   This is also consistent with recent comments from Norlisk, whose Chief Analyst indicated:

 

“Primary nickel usage will expand more than 5 percent this year, compared with 15 percent in 2010.”

 

More broadly, we’ve charted below Chinese steel imports and nickel and alloy imports, both of which highlight a decline in demand from China in 2011 versus 2010.

 

Nickel: Deflating the Inflation Part I - nickel223

 

Nickel: Deflating the Inflation Part I - n3

 

Interestingly, nickel inventory, as measured by the London Metals Exchange, has actually been trending down since the start of the year, which is obviously a bullish factor for price.  That said, over the past three years, the trend of nickel inventory has been up and to the right, as we show in the chart below.  Looking past the short term drawdown in nickel inventory, there are two factors that should drive a growth of inventory: 1) growing use of nickel pig iron by China and 2) accelerating global nickel production.

 

Nickel: Deflating the Inflation Part I - n2

 

On the first point, Chinese production of nickel pig iron, which is a low cost substitute for refined nickel, is set to increase up to 50% this year from 160,000 tons in 2010 to 240,000 in 2011. Production of nickel pig iron will continue to accelerate into 2012.  To the second point, there are a number of projects that are coming over the next five years that will add significant production.  In fact, according to Wood MacKenzie, the largest five projects alone will produce 220,000 tons of nickel, with the bulk coming online in 2012 and 2013.

 

As commodities prices continue to trade more in line with their fundamental supply and demand drivers, nickel is a commodity that is increasingly looking like it has price downside over the intermediate term. 

 

Daryl G. Jones

Managing Director



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JCP: Not iJCP. Shorting.

Conclusion: Keith just shorted JCP in the Hedgeye virtual portfolio.  And I quote... "Very few things are easy in the life of a short seller - but re-shorting iJCP here is."  People are looking for a 'transformational change', but they'll need to wait til Spring 2012 for a clear articulation -- and it will need plenty of capital. Margins going down before they go up again.

 

 JCP: Not iJCP. Shorting. - 6 14 2011 2 07 07 PM

 

 

  

  

I’m not saying that the guy is not a retailing genius, but when you have the best content in the world, no competition, a customer that has no price boundaries, and an unlimited SG&A budget, it does make it a bit easier to be a ‘visionary’.

 

JC Penney, on the other hand, has some of the worst content (over-indexed to mid-tier private label), endless competition, a cash-poor customer, and the most limited SG&A budget in retail. I don’t care if you took the equivalent of what Sam Walton was to retail when he founded Wal-Mart in 1962…if you don’t deploy capital, you can’t grow.

 

Look at JCP over time.  Can anyone explain to me how JCP grew square footage by 12% over the past 8 years (after they sold Eckerd to CVS), but held SG&A flat at $5.7bn? This thing has been cut bone dry. Opportunities to cut more costs to improve margins are extremely slim. It needs to invest in SG&A, Capex and the right working capital (which is tough to do without the R&D/marketing [i.e. SG&A] to back it) in order to turn JCP around. All of the ‘retailing 101’ best practices have been put in place.

 

I cannot imagine that anyone coming in from a place as high-profile as Apple with such a wide-open checkbook would come into JCP and not demand the same.

 

Heck, maybe Mr. Johnson a retailing god, and he does things in a way that none of us can imagine (a la Apple). But it won’t be without taking JCP’s margins down – by a long shot – to make it happen.

 

JCP: Not iJCP. Shorting. - 6 14 2011 12 33 41 PM


JCP: JC Penney is NOT Apple

Conclusion: Apple's retail head would be positive for JCP. But these two companies could not be more different as it relates to content, consumer connectivity, and financial management. Any great retail ideas from here are likely to take down margins -- a lot -- before they go up.

 

 

I’m not saying that the guy is not a retailing genius, but when you have the best content in the world, no competition, a customer that has no price boundaries, and an unlimited SG&A budget, it does make it a bit easier to be a ‘visionary’.

 

JC Penney, on the other hand, has some of the worst content (over-indexed to mid-tier private label), endless competition, a cash-poor customer, and the most limited SG&A budget in retail. I don’t care if you took the equivalent of what Sam Walton was to retail when he founded Wal-Mart in 1962…if you don’t deploy capital, you can’t grow.

 

Look at JCP over time.  Can anyone explain to me how JCP grew square footage by 12% over the past 8 years (after they sold Eckerd to CVS), but held SG&A flat at $5.7bn? This thing has been cut bone dry. Opportunities to cut more costs to improve margins are extremely slim. It needs to invest in SG&A, Capex and the right working capital (which is tough to do without the R&D/marketing [i.e. SG&A] to back it) in order to turn JCP around. All of the ‘retailing 101’ best practices have been put in place.

 

I cannot imagine that anyone coming in from a place as high-profile as Apple with such a wide-open checkbook would come into JCP and not demand the same.

 

Heck, maybe Mr. Johnson a retailing god, and he does things in a way that none of us can imagine (a la Apple). But it won’t be without taking JCP’s margins down – by a long shot – to make it happen.

 

JCP: JC Penney is NOT Apple - 6 14 2011 12 33 41 PM

 

 


R3: WSM, M, GILT, WMT, COLM

 

R3: REQUIRED RETAIL READING

June 14, 2011

 

 

 

 

RESEARCH ANECDOTES

  • The ante has just been raised for online home goods retailers with WSM announcing it will offer free international shipping. When this trend emerged early last year, industry players were forced to follow suit as free shipping became an increasingly important factor driving consumer purchasing decisions. While many retailers followed suit, we don’t expect a similar shift in the industry in response to this move given the added costs associated with international shipping. As a purely domestic concept, this initiative is likely to be margin dilutive, but will be a key first step in introducing the brand into international markets ahead of what is likely to be a more aggressive store expansion effort.
  • Among the benefits of the acquiring TBL is that it will boost VF’s international exposure to 35% of sales, a significant step towards its goal of achieving 40%. That said, we won’t give VFC a free pass  -- it still needs to grow the core suggesting 45% Int’l is the new delta.
  • With only 81 stores currently located in the U.S. and 138 worldwide, LULU accelerated its plans for store expansion to 30 in 2012 up from the 22-27 suggested at year-end. This will include 10 new markets, which the company identifies in part by tracking online shipments to gauge demand. As if the U.S. didn’t provide enough potential, LULU is also growing stores in Australia with 12 there currently. This is one of those concepts where we don’t think we’re anywhere close to questioning the unit growth potential.

OUR TAKE ON OVERNIGHT NEWS

 

Union Votes to Authorize Strike Against Macy's - The Retail, Wholesale, and Department Store Union, which represents more than 4,000 workers at four of the retailer’s New York City area stores, including the Herald Square flagship, has authorized its executive board to call a strike in the event that a new contract is not secured by midnight on Wednesday. To hedge its bets, the department store took out an ad in The New York Times on Sunday seeking temporary sales staff in the event of a possible labor dispute. “A vote by the union to authorize a strike is an expected part of the process during contract negotiations,” said Elina Kazan, vice president of media relations for Macy’s Inc. “We have been meeting daily to negotiate a new contract for approximately 3,800 employees before the current contract expires on June 15, and we will continue to be at the bargaining table with the union, discussing issues and working together towards reaching an agreement before the deadline. We have offered the union wage and benefits programs that will positively impact the lives of our associates, and will be among the best at department stores in New York City and across the country. <WWD>

Hedgeye Retail’s Take: A reported $0.35 increase off a base of $7.50 for some is not much of an improvement. Not to mention when you take into account one of the other key bargaining points – the potential implementation of a new electronic scheduling system that could ultimately reduce full-time shifts and overtime. If this passes without a hiccup, it’d be a win for Macy’s. Probably not enough to change our negative view on the name – unless the model changed meaningfully relative to consensus. We’re doubtful that’d be the case.

 

Gilt Groupe Moves Deeper into Full-price Retailing - Gilt Groupe Inc. will depart from the limited-time, deep discount e-retail model that fueled its enormous sales growth with the launch this summer of Park & Bond, a men’s apparel site that sells items at full price. The company says the success of Gilt MAN, the company’s flash-sale site for men, inspired it to move into full-price retail. “Moving into the full-price retail space is the natural next step following the runaway success of Gilt MAN,” says John Auerbach, general manager of Gilt MAN. Auerbach will also work as president of Park & Bond. Gilt Groupe, No. 49 in the Internet Retailer Top 500 Guide, had Internet Retailer-estimated sales of $425 million in 2010, up from $170 million in 2009 and $25 million in 2008. The e-retailer is currently testing another non-flash sale site, GiltTaste, which sells gourmet foods. <InternetRetailer>

Hedgeye Retail’s Take: We give GILT a lot of credit here in that it continues to grow its footprint – fully recognizing that it cannot scale existing concepts. This move, however, is clearly a push to go deeper. They can leverage existing infrastructure, which is good. Though if it takes off, it will need to scale up its pick/pack capability in ways that it is not traditionally accustomed.

 

Wal-Mart Loses Appeal of $187 Million Verdict in Worker Lawsuit - Wal-Mart Stores Inc. (WMT), the world’s largest retailer, lost its appeal of a $187.6 million verdict in a case accusing the company of denying Pennsylvania workers rest and meal breaks. A three-member appeals court panel ruled June 10 that there was “sufficient evidence” in the record to conclude Wal-Mart violated state wage laws for contractual rest breaks. The court ruled that the trial court must recalculate more than $45 million in attorneys’ fees in the case.  “Wal-Mart’s own internal audits revealed violations of company policies regarding missed breaks and work off-the- clock,” the panel said in a 211-page opinion.  The verdict is the largest against Wal-Mart over missed breaks, Michael Donovan, an attorney for the Pennsylvania workers said. Wal-Mart agreed to pay as much as $640 million in 2008 to settle more than 60 federal and state lawsuits over similar claims. Former Wal-Mart employees Dolores Hummel and Michele Braun sued the company in state court in Philadelphia over claims they were pressured by store managers to skip breaks and cut meals short. Lawyers for the women argued that the company made workers skip more than 33 million rest breaks from 1998 to 2001 to boost productivity and cut labor costs. <Bloomberg>

Hedgeye Retail’s Take: There are right ways and wrong ways to cut costs, we’ll let you decide which this falls into. After being docked for these practices just a few years back, one would think the retail giant would improve oversight of such practices. At the end of the day, cutting corners is costing the retailer more from both a dollar and brand perspective.

 

Columbia Sportswear Files European Antitrust Complaint W.L. Gore - Columbia Sportswear Company announced that the company and its Italian subsidiary, OutDry Technologies S.r.l., have filed a complaint with the Commission of the European Union against W. L. Gore & Associates, Inc., alleging that W. L. Gore & Associates has violated European Union competition laws by abusing its dominant position in the market for waterproof breathable membranes for footwear and gloves. Columbia and OutDry Technologies also said they welcomed the recent public news that the United States Federal Trade Commission has issued a subpoena to W. L. Gore in connection with its own investigation into whether Gore has "engaged in unfair methods of competition 'by contracts, exclusionary practices, or other conduct related to waterproof or waterproof and breathable membranes or technologies and related products.'" <SportsOneSource>

Hedgeye Retail’s Take: Now that Columbia owns one of the greatest threats to W.L. Gore’s Gore-Tex technology it’s no surprise that the defacto weather-proofing giant is trying to protect share. However, shining the light on this case could actually be a meaningful step in the right direction enabling COLM to accelerate the integration of this technology. The critical technological difference between traditional Gore-Tex is that it uses interior membranes to keep water out whereas OutDry is breathable membrane on the exterior of wearable product a key element in reducing weight among other benefits.

 

Sergio Rossi Buys Back China Shops - Sergio Rossi is expanding in China and buying back its five boutiques in the region from its local franchisee partner, Shanghai Kutu Trading Co. Ltd.“We’ve been in China for five years now, developed a sense of maturity and global vision and this step is part of leading the brand into the future,” said Christophe Mélard, president and chief executive officer of the luxury footwear firm. The stores are located in Shanghai, Beijing, Ningbo and Shenzhen. Sergio Rossi is maintaining an existing franchisee agreement with Sichuan Lessin Department Store Co. Ltd. to further develop its business in second- and third-tier cities in China. Mélard stressed that while the Italian company plans to double the number of stores in China in three years, it is not steering away from a highly selective distribution. <WWD>

Hedgeye Retail’s Take: Solid move by the PPR owned label and a common trend by brands looking to accelerate store growth in the region of late. With slightly more than 50 stores worldwide and nine in China we’re not talking a massive acceleration in store growth, but the initiative will certainly increase geographic exposure in China.  The key here is ‘control.’ When any brand worth its salt reacquires content ownership from a licensee, it not only consolidates the profit at a higher margin (and hopefully accretive to the P&L based on purchase price), but it allows growth to accelerate due to direct control by the parent.

 

 

 


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