Saturday, November 22, 2014

How Stock Options Inflate Payout Ratios

Imagine a firm with a price to book ratio of 1, worth $100 million, with $100 million in revenues, 10% profit margin ($10 million per year) and a 50% payout ratio.  Each year, owners receive $5 in dividends, and the firm reinvests $5 million, so that the following year, the firm is worth $105 million, etc.

Now, imagine that the firm replaces $1 million of cash wages with $1 million worth of stock options.  Let's say that, on average, when those options are exercised, employees receive $5 million worth of stock, but only pay $4 million for it.  And, let's assume the firm has a policy of purchasing the shares on the open market when those options are exercised.  So, in a typical year, the firm will repurchase $5 million dollars worth of shares in order to distribute stock to employees through the stock option program.

Note, the firm still has $100 million in revenues, $10 million in profit ($11 million in profit from operating cash flows minus $1 million in GAAP expense from the stock options), and $5 million in dividends.  And they still reinvest $5 million into the business ($11 million in profit from operating cash flows, minus $5 million dividends, minus $5 million in buybacks, plus $4 million from employee option exercises).

But, now, they have a 100% payout ratio instead of a 50% payout ratio - just by replacing 1% of market cap. with stock options in lieu of cash wages.  But true profit and profit retention remain unchanged.

PS.  I use the antidilution stock buyback here for consistency in the example, but the options cause the gross payout ratio to be inflated regardless of the buyback policy.  When the option is exercised, the firm receives cash equal to the strike price of the optioned shares.  This is a capital inflow from the employee.  The exercise of the options mean that, ipso facto, the firm had higher capital inflows than would be inferred from gross capital distributions.
Firm with all cash wages
Firm with Stock Options
Cash Profit
Options Expense
Net Profit
Less: Dividends
Less Buybacks
Operating Retained Cash
Add Stock Sales
Add back Option Accrual
Total Retained Cash
Total Gross Distributions
Total Net Distributions

Thursday, November 20, 2014

Not a good sign

While the employment market has been strong, credit has been showing weakness after initially showing strength when QE3 first started tapering.  Part of the problem, in my opinion, is that the Fed didn't commit to a full recovery in household real estate equity, relative to mortgage debt.  That, in addition to pro-cyclical regulatory sentiment, has put a stranglehold on real estate credit markets.  The recent decline in cash buyers may be related to the end of QE monetary accommodation.

So, my question is, is momentum in labor and production strong enough to keep markets growing while real estate markets continue to present a liquidity problem.

The first graph here shows Commercial and Industrial Loans and Closed End Residential Real Estate Loans since before the recession.  We can see here how both seemed to accelerate at the beginning of the QE3 taper.

But, the second graph is a close up view of recent weekly changes.  Closed End Residential Real Estate has not only flattened.  It is clearly declining and is now back to levels not seen since March.  And C&I Loans look like they may be leveling off also.

The FHFA has announced plans to lighten up on some regulations of securitized mortgages.  But the loans shown in the graph are loans owned by the banks.  The path we are seeing here is not a positive scenario.  And, 5 year inflation expectations from TIPS is still down around 1.4%.

On the bright side, inflation seems to have firmed up in the last couple of months.  I have been watching CPI less Food, Energy, and Shelter.  It has rebounded after going into negative territory in July and August.

Wednesday, November 19, 2014

Higher Education Subsidies are extremely regressive

From Twitter:

Bryan Caplan, who is working on a new book about education that should be very interesting, has also commented on this issue a lot.  I would take it even further that Garett.

1) As he mentions, students who don't attend college see lower wages because they lack the credentials that are more widely distributed.

2) For students who are incentivized to go to college, but don't graduate, the subsidy will be associated with immediate missed wages and work experience, and more debt from the portion of their education expenses that was not subsidized.

3) The only students truly subsidized are the students who do graduate.  And, they will tend to have higher lifetime earnings than the students who are net losers from the subsidies.

See Caplan's post, linked above, regarding graduation rates.

Further, there is no market failure here.  There are huge private resources devoted to distributing scholarships by need and merit.  The students that Caplan would encourage to attend college have many private options.  The effect of public funds on opportunities for students is likely harmful for many reasons.

1) It leads to increased tuitions over time.

2) It introduces student selection criteria into the marketplace of grants, loans, and subsidies that are likely to be less reliable than the existing private selection processes.

3) The additional students selected into college attendance because of public subsidies will end up taking some of the private funding sources that could have been used by students who would have graduated.  According to Caplan's data in the link, among all but the highest quartile of high school graduates, as measured by math scores, about 40% of high school graduates attend but do not graduate from college.

There is a lot of concern, across the political spectrum, for the high level of publicly subsidized student loans.  High default rates are definitive evidence of the lack of reliability in student selection among these subsidies and loans.  This is a case where the effect of public spending on national welfare could very likely be negative.  The spending hurts us, not least of which those of us who can least afford it.  We should stop it.

Tuesday, November 18, 2014

From the "We are the 100%" file: Sticky Wages and Sticky Fed Funds Rate

Scott Sumner has a great post at econlog.  The words were flowing from my penny pencil today, so I thought I'd copy & paste a comment I left there.  But, I encourage you to read Scott's post.


Great post.
I think this is related to another illusion - that rising wages are inflationary. If Fed policy is sticky, then it will be pro-cyclical, and Fed policy will lead to inflation when a strong economy leads to rising real wages and interest rates.
The illusion is bolstered by the cognitive illusion of narrative thinking, where we imagine that employers and employees are in a negotiating battle and that rising wages are a result of employees having a stronger hand in negotiations.
But, rising wages aren't associated with falling profits.
But, this also is related to an illusion. Since profits are not sticky, they are the first measure to fall when a correction comes. When they begin to fall, it will naturally happen at the cyclical high point of wage growth and profit. So, if one is inclined toward believing the negotiating narrative, the empirical evidence will seem clear as a bell. Don't you see? Whenever real wages are growing at their highest, profits fall.
The narrative says that when a worker has readily available other options, he can go to his supervisor and demand a raise. This is why rising wages are associated with low unemployment.
But, the negotiation is a red herring. The real effect in that picture is that the worker has other opportunities, and that they are willing and able to move out of their current job into a job that captures more of their productive potential. It's the movement that creates the rising wage, not the negotiation. And, this is obvious in the JOLTS data.
This and a thousand other effects where frictions that keep labor from flowing freely to its best use are what keep real wage growth down when unemployment is high. Everybody is better off without the frictions. So, we see high real interest rates, high profits, and growing real wages together. The correlation of these sources of income is so overwhelming through business cycles, it's incredible that it is so universally misunderstood.
This is why it is so infuriating to me to see the "1% vs. 99%" rhetoric and the "corporations love to see high unemployment" rhetoric. Humanity has a special ability to use divisiveness in the service of ignorance. This is a case where the unifying truth is right in front of our noses, and so many people just aren't going to accept it.

Mass Transit

Tyler Cowen linked to a story about some new bullet trains in Japan that will travel almost as fast as airplanes.

A commenter at Tyler's post pointed out that the Japanese rail system is run by private firms.  Here is a Wikipedia page about them.

Seoul also has a very nice subway system which is operated privately.

By far the largest mass transit system in the United States is also largely run by private, competitive firms - Southwest, United, Delta, etc.

It's a sad commentary on the present condition of our electorate and our governance that mass transit is generally explicitly assumed to be public, even though we all utilize private mass transit frequently.  How strange is it that in the United States - the supposed beacon of laissez-faire sensibilities, the international leader of disruptive and innovative technological industries - we can't even seem to imagine the private funding and operation of industries and institutions where such has been the case for decades in many parts of the developed world?

Monday, November 17, 2014

Fun stuff from other blogs

1)  The first recorded evidence of "trickle down" economics. (HT: Tyler)

2)  A great post on the ethics of trading for third parties. (HT: Tyler)  It's hard to excerpt.  He walks through a series of days where a client asks you to buy oranges at the market price.

3)  Timothy Taylor has some interesting figures on incomes.

Here is a table he posts.  As he points out, much of the difference between the lowest quintile and the second quintile is that the second quintile gets more government transfers.  (In fact, the middle quintile gets the most transfers.)This points to one of the difficulties of using these numbers to arrive at summaries of income distribution.  Many of the lowest quintile households are retired, students, or are households with very volatile incomes.  The second quintile might, in some ways, be more indicative of marginally working class households.

Here is a graph I did that shows the make-up of different income levels by age.  While the bottom quintile certainly contains some of the most vulnerable families, statistically it seems that some work would need to be done to separate the single young male living with his parents because he is an unemployed construction worker from the 85 year old widow in the nursing home and the grad student who will start making $150,000 when they are in their 30s.

Here is a graph from Taylor.  There are a number of narratives we could build here.

1) The incomes of the 1% have outpaced everyone else.

2) The incomes of the top 1% and the bottom 20% are highly correlated.

3) All the gains since 2009 have gone to the top 1%.

Different parts of the elephant....

I do wonder, though, if that correlation between the top and bottom is a product of the unsystematic nature of the residents of the bottom quintile at any given time.  Maybe the correlation is a product of the temporary movements into and out of the quintile from households with volatile incomes.

Friday, November 14, 2014

Interesting Article on Non-Emotional Investing

CFA Institute Magazine printed an interview with C. Thomas Howard, director of Athena Investment Services.  He has an extreme style of investment, meant to eliminate all emotional biases.  Some of his ideas are definitely outside the mainstream.  He makes a good argument that the Prudent Man Rule, and even modern portfolio theory itself, are, in some ways, the institutionalization of emotion-driven investing, so that even our ethical and academic frameworks are damaging to optimal investing.

I think he makes some great points, and has some challenging ideas about how to invest wisely.

In the end, the problem comes down to the fact that optimal investing is hopelessly bound up with uncertainty on many levels.  We can never cleanly separate temporary and permanent changes, losses from mistaken tactics and losses from volatility, etc.  So, while the best long term investment needs to be unconcerned with volatility, there will always be the possibility, at the nadir of volatility that is likely to be mean-reverting, that it is actually only the beginning of the consequences of a very poor or very unlucky position.  That includes tactics as broad as having a diversified exposure to the global productive economy.  And, that problem is multiplied many times over when your portfolio is under the management of a 3rd party.

Even when a portfolio does well, it can be for reasons that are unclear.  For instance, the Athena Pure portfolio has gained an average annual return of 25% over 12 years. Howard attributes this to his non-emotional, behavioral finance approach.  But, it just so happens that part of his theory regarding this approach is that he prefers firms with high levels of debt and large dividends.  How much of his gains have come from behavioral finance insights, and how much has come from the happenstance that this profile might do very well in a context of falling interest rates?  (I haven't researched the fund's holdings.)

Here is the link (pdf).  An interesting article, with food for thought, and several good ideas, in any case.

Thursday, November 13, 2014

September JOLTS come in strong

September JOLTS confirm recent strength in employment.  Hires and quits jumped and job openings remained strong.  Taken together, openings and quits suggest a labor market similar to mid-2005, when the unemployment rate was at about 5%.  Recent strength in both of these measures suggests to me that the approx. 0.8% of the unemployed who are very long term unemployed (VLTUE) are not aggressively involved in the labor market.  The strong trends in quits and openings makes me more confident that the slow decline in VLTUE will continue and also that recent trends in regular unemployment declines will continue.  We might see the current pace of a monthly drop of 0.1% or more continue for a few more months before the trend flattens out.
After the June employment report, I argued that quits and openings pointed to an unemployment rate just about where we were at the time (6.1%), once adjustments were made for demographic comparisons and the remaining inflation in the unemployment rate stemming from VLTUE.  Since then, the unemployment rate has dropped 0.3% and momentum in hires, quits, and openings confirm the strength of that drop.

Wednesday, November 12, 2014

Monetary Offset applies to Asset Values, too

The conflation of asset prices with inflation has led to very damaging confusion.  Much of the discussion of this point seems to build on the idea that either open market operations (OMO) from the Fed bid up treasury bond prices or that the cash infusion is somehow funneled persistently into asset markets, as opposed to consumption.

While there are some (arguable, in scale, persistence, and effect) ways in which OMO might create short term jumps in some asset prices, is there any theory that lays out how dovish monetary policy could create persistent inflation of asset prices relative to consumption prices?

Here is a graph of household real estate values and mortgage levels, as a proportion of GDP.  Note that, while there was some rise in mortgage levels, relative to incomes, total real estate values were expanding much more quickly in the 2000s.

The next graph shows the leverage of household real estate (mortgages / market values).  Leverage had increased in the late 1980's and early 1990's.  But, this was coincident with declining relative home values.  (I have speculated that these patterns are consistent with the idea that real estate serves as a means of consumption smoothing in economies with high levels of human capital, and that we should have expected the baby boomer demographic to lead to higher mortgage levels in the 1990's, and then higher real estate prices in the 2000's that were mostly in the form of equity gains.)

So, there was no net leveraging during the entire period of the subprime loan buildup.  Leverage didn't create the housing boom.  The sudden rise of leverage was the result of the collapse of asset values.

The next graph shows the YOY change in nominal levels of real estate values, mortgages, and net equity.  Again, we can see here that, for most of the housing boom, real estate market values were rising much faster than mortgage levels were.  So much faster that for much of the bubble, households were gaining about $2 in equity for every dollar of mortgage funding.

Here is a sign of the problems caused by the subprime boom, though.  Initially, because of low interest rates, mortgage debt service remained fairly stable, even though mortgage levels were climbing along with home values.  When short term rates started to rise in 2004, debt service ratios began to climb fairly steeply.  Previously, debt servicing ratios had not been so responsive to short term rate movements.

So, by early 2006 home prices had topped out and mortgage debt service levels had reached the highs of the previous cycle and were steeply rising.  No crisis had come yet, and leverage levels were still where they had been for 10 years.  And, already by this time, the yield curve had inverted.  The Fed Funds Rate would remain higher than the 10 year treasury rate until February 2008 - a full 20 months.

I want to keep all of this in mind as we look at the next graph.  During the housing boom, until 2006, presumably, there was a net increase in aggregate demand as a result of credit creation.  On the other hand, some of these activities reflect household savings.  The balance of these factors would play out through inflation and NGDP.

If loose monetary policy was creating home price increases, we would expect to see something like the late 1970's, where everything is moving together - inflation at 5-10%, currency growing at 10% per year, NGDP growing at 10%+ per year, and houses going up along with everything else.

A target-based monetary authority, whether targeting inflation or NGDP, would automatically offset demand coming from asset price movements.  In the 2000s, NGDP and inflation were both well within their 20 year bands of normal (relatively low) growth levels.  If homes were acting like ATM's, flooding the economy with cash, then why wasn't NGDP high?  If NGDP doesn't look high because it didn't account for the high cost of housing, how can this be the case when mortgage debt servicing was stable until after rates were hiked?  If mortgage debt service was only low because the Fed was artificially pushing down rates for years on end, then why was currency in circulation growing at less than 5% per year?  How does the Fed push down rates without pushing currency into the economy?

In fact, the very low growth in currency in circulation suggests that the Fed was, indeed, offsetting any effects.  They wouldn't have to do it explicitly.  Their inflation target would cause them to do it implicitly.

And, I wonder, maybe this was the problem.  The Fed had only been implicitly offsetting the demand effects of the housing boom.  When their offset became too strong, and home values started to collapse, the offset became explicit.  Now, the consensus was that the collapse had been a long time in coming and was probably something the economy needed to see.  In fact, those high home prices must have been a product of loose policy that was showing up in home values instead of inflation.  Now that the idea was explicit, the Fed simply continued with their explicit policy of not offsetting the demand effects of the housing market.  From February 2007 to September 2008, YOY growth in currency-in-circulation remained under 2.5% while home prices fell by nearly 10%.

But, don't blame the Fed.  How much flack would they have taken if in 2009 inflation was at 4%, homes were up another 20% instead of down, if subprime teaser loans had been reset at low rates, and if bankers were sitting on high profits?  Now, they are largely seen as heroes, and if there is one complaint against them it is that they didn't let the banks suffer enough.  In the counterfactual, where many working class households would still be in their homes, sitting on some home equity, and unemployment may never have topped 7%, would the Fed be seen as heroes?  Or would the country be divided between many on the left complaining that the Fed was feeding inequality by boosting asset prices and many on the right complaining about the coming day of reckoning and malinvestment?  We wouldn't let them explicitly offset the housing bust.

Yet, take out housing, and there is nothing in that data that comes close to implying monetary excess in the 2000s.  And the one thing about housing that is completely outside the historical norm is the devastating collapse of 2007-2012.

Will we always be fighting this deep human tendency to distrust abundance?  This is not a partisan issue, which is why it is such a problem.  It spans the political spectrum.  For some time, speculators (buyers and lenders) were cashing in on an asset boom.  Speculation isn't an admirable way to gain treasure.  We aren't going to purposefully create destruction, of course.  But, if losses have to be taken, well, we kind of had it coming, didn't we?  OWS fans and Austrian business cycle proponents may speak different languages, but they are really part of an ecumenical movement from our shared source of human intuition.  Is there a more universal human intuition than the idea that the gods are serving us our comeuppance?  How do we know it was a bubble?  Well, just look how bad the bust was.

"All asset bubbles come from carnal greed which is in speculators and bankers insatiable" is only a slight paraphrase.

PS. Matt Taibbi at Rolling Stone introduced us to Alayne Fleischmann.
Her decision to go into finance surprised those closest to her, as she had always had more idealistic ambitions. "I helped lead a group that wrote briefs to the Human Rights Chamber for those affected by ethnic cleansing in Bosnia-Herzegovina," she says. "My whole life prior to moving into securities law was human rights work."
But she had student loans to pay off, and so when Wall Street came knocking, that was that.
Clearly, she is not one of them.  And, he notes:
Back in 2006, as a deal manager at the gigantic bank, Fleischmann first witnessed, then tried to stop, what she describes as "massive criminal securities fraud" in the bank's mortgage operations. (emphasis mine)

I don't mention this to cast doubt on Ms. Fleischmann.  I don't think anyone would be surprised to find out that there were a lot of people scrambling to cover their backsides, frequently in unscrupulous ways, and that the large banks have tentacles in the regulatory agencies.  That timing is interesting, though.  When she first witnessed securities fraud, the Fed Funds rate was solidly at 5.25% and 10 year treasuries were bobbling around 4.75%.

Saturday, November 8, 2014

Scott Sumner shares my input on Monetary Offset

Scott Sumner argues that since the monetary authority is the last mover in targeting the nominal economy, fiscal cyclical policy is mostly neutered.  If the Fed is targeting a certain nominal production level or inflation level and the government institutes fiscal policy intended to increase nominal economic activity, then the Fed will offset that policy in order to remain on target.  If the Fed wouldn't offset fiscal policy stimulus, then the question is why wasn't the Fed creating more stimulus to begin with?  The zero lower bound isn't a reason.  I have found that the Fed has been able to influence forward inflation and interest rate expectations at the zero lower bound.  Here is a recent study coming to the same conclusion.

At any rate, Scott has posted some comments I made about the issue.  Click on the link for the full story.  The short version is that we can see monetary offset in the Fed transcript from September 2008.

In fact, I suspect that, on a policy like Emergency Unemployment Insurance (which was first implemented in this cycle by President Bush in June 2008), the modelers at the Fed probably model the policy as stimulative.  So, there is a double whammy effect of monetary offset.  Someone like Janet Yellen sits down at the FOMC meeting and she looks at the models from the Fed quantitative staff, which reflect perceived additional fiscal stimulus, and thinks, "Hey, things aren't so bad.  We don't have to be as accommodative as I thought."  Then, bringing her own intuition to the meeting, she notes that the unemployment rate is probably overstated because of the recently instituted emergency unemployment insurance.  We would normally expect rising unemployment to be disinflationary, but since it is likely exaggerated by the effects from EUI, we can kind of figure that the labor market is doing better than the unemployment rate would suggest.

So, EUI might cause Fed modelers to point to a more hawkish policy and then the FOMC adds their own additional hawkish twist.

In actuality, Janet Yellen was right that EUI probably caused higher unemployment, but this probably called for more dovish policy.

Here is a fiscal policy that could be contractionary, but that leads to an exaggerated monetary offset that is also contractionary.

Friday, November 7, 2014

October Employment

I thought this was a good, strong report.  Fixed income markets disagreed with me, I guess, with rates dropping 6 to 8 bp on the news.  I presume that is because of what is considered weak wage growth.  I argue that wage growth is right where we should expect it to be, considering current inflation and unemployment levels.  A supply shock in housing is causing wage gains to go to rent.  The consensus take on this seems to mostly take low growth in nominal wages as a sign against there being inflation pressures.  I think there are some subtle but important problems with that interpretation, but I suppose in the end, it is pulling the fixed income market toward my position where it counts - in forward rates.  I expected to get a small bump in rates today, but I suppose that I was expecting that bump to come from what I consider to be errors in the consensus paradigm.  I should probably be careful about that sort of position, since, as happened here, a differing paradigm may have its own ways of arriving at a pricing conclusion.

....Anyway, on to the data.  The decline in the unemployment rate was reported as a drop from 5.9% to 5.8%, but it was actually from 5.94% to 5.76%.  In fact, the last two months combined have seen a drop of 0.39% in the unemployment rate.  So, we are really only a 0.02% drop away from the 5.5% to 5.7% range I have been forecasting for the EOY unemployment rate, with some indication that we might arrive at the lower end of that range.  (There are some discrepancies between the unemployment duration data and the other data.  I'm not sure what the source is.  The unemployment durations add up to a rate of 5.83%.  But the flows data points to the same 5.76% as the headline number.)

First, the durations data.  My estimate of very long term unemployed (VLTUE) did find its downward trend again (though much of the noise here comes from my simple model), but long term unemployment held fairly steady.  The drop in unemployment didn't come from an obvious drop either in short or long duration unemployment in particular, although nearly 0.1% of the reported drop in unemployment isn't accounted for here.

The general rate of exits from 15+ week unemployment continues to grow, although this month was the latest in a string of months that has pulled back toward the moving average.

After a couple of months where continued unemployment claims pointed to lower unemployment, but total unemployment didn't follow, for three months now total unemployment followed the expected trend downward.  The 0.4% drop in unemployment in the last two months has basically been a reflection of the lower rate of job loss.  It appears to be a real, sustainable drop.  If anything, this still points to possible further drops in total unemployment.

The trends in flows continue to look stronger for workers moving into the labor force and workers moving into employment.

The moving averages for flows, with a longer time frame also show strong trends.  Net flows from unemployment into employment are at cyclical peaks.  And, net flows from not-in-labor-force into employment continue to look strong, mimicking the strong trends in the 2005-2007 time period.  Net flows from unemployment to not-in-labor-force continue to be slightly inflated, however.  I believe this UtoN movement reflects the remaining VLTUE workers who are marginally attached to the labor force.  There is some evidence that in previous cycles, these workers would have seen similar outcomes, but would have tended to report as not-in-labor-force.  The level of unemployment among "Re-entrants" tracks very closely with the level of flows between Unemployment and Not-in-Labor-Force.  Re-entrant unemployment is about 0.4% above long term lows, and it should continue to slowly move down over the next year or two.  This probably largely relates to my VLTUE measure, representing about half of them.

Looking at the last chart, most cyclical movement in unemployment comes from job losers.  The recovery among job losers has been surprisingly linear for the entire recovery.  This certainly establishes a reasonable trend, although there is no reason to expect the trend to continue indefinitely.

Before this report, I was beginning to question the sustainability of the strong trends downward in long term unemployment.  But, the continued strong trends in unemployment insurance together with the strong trends in flows this month suggest that the recent stagnation in long duration unemployment is probably the aberration.  Unemployment durations over 26 weeks were reported this month at 2.9 million.  This is where most of the remaining drops in unemployment will come from.  I think there is still reason to be confident that this will move below 2.5 million in the next 2 to 3 months as VLTUE continues to fall apace, regular flows from unemployment to employment remain strong, and some additional mean reversion from statistical variations all push the number down.

At that point, I expect the linear decline to finally kink, and to see further reductions in unemployment to come at a pace of closer to 0.5% per year.  If regulatory relaxations in mortgage credit lead to acceleration of construction employment, a faster paced decline might continue.  I am hoping for that outcome, although a lot of confusion over asset prices and inflation will lead to push back against that sort of progress.

Wednesday, November 5, 2014


HTCH posts fiscal year 2014 results this afternoon.  They recently issued guidance and refinancing news, which included bond conversions at $3 to $3.75, with the stock currently trading at $3.62.  So, while we are unlikely to be shocked by unexpected news, I am submitting this post before the report to maximize the likelihood of being roundly embarrassed by subsequent information.

Generally, recent results have been improving, though not as quickly as I might have hoped.  Last quarter they announced a potentially significant new product that utilizes their technology for optical lens stabilization in smartphone cameras.  I will leave analysis of that aside.  It serves as a sort of free option on forward valuations, and could amount to a large new revenue base.

While it is disappointing to swallow the up to 50% dilution coming from their refinancing arrangements, I think the problem is that they have the core business, which is recovering, but is scraping the limits of available working capital until positive cash flows can pull it higher.  And, they have this new, but unproven, revenue base, which is basically like a tech. startup venture.  Because of the point where they are in their core business' recovery, they can't leverage it for financing the new venture.  And, the new venture can't attract mature pricing on its own.  So, they have had to finance with bonds that have elements of early phase financing, including convertibility at relatively generous share prices.

Here is a post I did on HTCH about 5 quarters ago.  Operating results have been somewhat disappointing since then, mostly in terms of revenue.  Here is the forecast of a model based on gross margins.  At the time, this forecast was based on quarterly production of 130 million units with gross margins approaching 19% at the end of 2014.

In the September quarter, they produced 117 million units with 12-13% gross margins.  They have guided a slight increase in production for the December quarter.  In the June 2013 quarter that preceded the post with the graph, they had produced 99 million units with quarterly gross margins around 2% and TTM gross margins around 6%.

So, there has been significant improvement.  Disappointment has come mostly from revenue levels. Margins should still approach expectations at any given level of revenue, and management continues to stand by their guidance for higher market share on new dual stage suspension programs, even though the programs have taken longer to ramp than expected.

The model shown in the graph would predict a current share price of about $8.  It may be the case that the model overstates the current valuation because it is largely based on gross margins.  In the past, gross margins probably mostly captured changing revenues, but recent margin gains have come from cost cutting.  At gross margins I expect to see over the next 2-3 years, this model would predict a share price of $10-$20.  Maybe the contraction in the asset base that has coincided with the recent gross margin improvements would argue that this target range should be reduced.

On the other hand, market valuations for HTCH before the post 2007 decline in market share ranged in the 1x to 2x range for both Price-to-Sales and Price-to-Book.  These valuation ranges would also predict a share price in the $10-$20 range in the coming few years.  And, with the recent refinancing, even the stagnant market share projections with no projected OIS revenue point to annual Free Cash Flow of around 40 cents per share.  Projections more in line with guidance (my scenario 3) point to Free Cash Flow growing to more than $1 per share, even without OIS.  Keep in mind that there is a tremendous asset base here, much of which had been written off, and that depreciation levels are much higher than sustainable capital expenditures.  Plus, there are off-balance-sheet tax assets worth more than $5 per share, even with the recent dilution.

Here are projections of revenues and gross margins.  They have around a 22% market share currently.  This is down from around 60% before 2007.  The bottom scenario here projects a stable 22% market share, which would be well below guidance and would also represent a decline from recent trends.  The top scenario forecasts a 1% market share gain per quarter for the next 3 years, topping out at 34%.  This would correspond to growth of about 5 million additional units per quarter.

The final three graphs demonstrate the effect of the refinancing on the three scenarios going forward.  There were two main parts to the move:

1) A conversion of $15 million in debt exchanged for 5 million shares.
2) A planned exchange of approx. $37.5 of bonds with new bonds that include a conversion option at $3.75 per share.

Pre-conversion outcomes reflect forecasts before the refinancing.  The middle bars reflect just the first step.  The right, purple bars, reflect the balance sheet in the case where the second set of bonds are also converted to shares.

I have been slightly unfair in the graphs here, as the retired bonds were also convertible at a higher strike price, and I have not accounted for that previous potential dilution, as it would have only affected the best future outcomes.

These moves were probably necessary in order to secure working capital in the very near term in all potential scenarios regarding both suspensions and OIS.

In some ways, the dilution may not have been as bad as it seems because, by converting debt expense into profit, the refinancing brings Hutchinson into a more profitable position.  This has the effect of creating a little more of a safety net for the worst case scenarios.  But, it also has the effect of recapturing the tax assets more quickly.  We can see that at play in these last two graphs, where book value increases substantially from scenario 1 to scenario 3, but book value that includes the tax assets grows more slowly.  Since tax assets are currently larger than the enterprise value of the firm and represent an asset that provides no compounding returns to the firm during the time they are not utilized, the conversion provides a bit of a free lunch that partly mitigates against the dilutive effects on current shareholders.

While the delays on the hoped for returns on this position are aggravating, I continue to believe that the worst outcomes are diminishing in probability while the most likely outcomes provide valuations several times the current market value.

October Employment Preview

October has been another month with strong signals from unemployment insurance claims, which continue to push to new lows in both initial and continuing claims.  Here is my favorite chart on the topic, with the comparison of total unemployment and unemployment insurance.  The forecast is based on a linear decline in very long term unemployment (VLTUE), so the recent divergence of total unemployment and insured unemployment suggests that VLTUE has stagnated.  This is corroborated by my analysis of unemployment durations, which also suggests that the decline in VLTUE has stalled.  In addition (see the second graph), normal unemployment (after subtracting the VLTUE) also remains elevated compared to insured unemployment.

There is a tendency for unemployment to settle in near 2.8*insured unemployment, except for cyclical shocks when insured unemployment briefly rises.  There was one brief period in 1993-94, while emergency unemployment insurance (EUI) was in place, that total employment briefly remained elevated.  And, throughout the post-recession 80's total employment deviated from the expected level.  Both periods occurred when unemployment rates were higher than they are now.

Here is another way to look at the numbers.  Graph 3 is continued claims (which cover up to 26 weeks) as a percentage of unemployment less than 26 weeks.  Here we can also see the ratio of claims to total unemployment falling below the typical bottom range, toward the atypical range of the 1980's.

I don't have a theory regarding this deviation from typical trends, and so I don't have any firm clues about the persistence of this deviation.  The clear stagnation in residential construction is an obvious source of possible persistent unemployment, so that I wouldn't be surprised if this pattern proceeds along with developments in housing.  This speculation comes from other evidence, though, and not directly from the numbers here.

The outline of unemployment last month was:

4.3% Unemployment proportional to insured unemployment
0.7% Normal unemployment above the expected level
0.9% VLTUE
5.9% Total Unemployment

Insured unemployment has declined again this month, so that normal unemployment would be expected to decline nearly 0.1% (from 4.34% to 4.26%).  I don't know what to expect of the current 0.7% deviation in normal unemployment.  And VLTUE had been declining by about 0.05% per month, but has leveled off.  As we can see in graph number 4, the question remains whether this is noise or a new trend.

JOLTS are also mysterious.  Job openings have been through the roof, but hires and quits have stagnated in recent months (JOLTS have been reported through August).  So, are the hires and separations hitting a plateau because we have full employment for 99% of the labor force while 1% of the labor force remains marginalized?  Or are hires are separations simply at a temporary low point around their upward trends?  The drop in hires and quits in August was sharp, and it didn't seem to be corroborated by other data, so I suspect that we will see a recovery, and possibly even a strong upward revision, especially considering the strong hiring reported in September flows.

I expected to look at the numbers and predict another gap down.  But, I think the recent deviations from my forecast may be changes in trends and not just noise.  There is a chance we could see another gap down to 5.6-5.7% this month.  But, I'm not as confident as I have been in previous months.  The unemployment rate may remain in the 5.8-5.9% range.

Monday, November 3, 2014

Construction vs. Industry, the plot thickens

Two charts from Calculated Risk today.

First, the ISM Manufacturing Index reaching the top end of its long term range.  "The PMI was at 59.0% in October, up from 56.6% in September. The employment index was at 55.5%, up from 54.6% in September, and the new orders index was at 65.8%, up from 60.0%."

Then, Construction Spending.  "On a year-over-year basis, private residential construction spending is now up 1%. Non-residential spending is up 6% year-over-year. Public spending is up 2% year-over-year."  And growth trends look terrible.
So, where is the most likely source of financial instability?

1) Industrial output growth at cyclical peaks in spite of extremely low corporate leverage and high risk premiums.

2) Private construction spending growth rapidly falling while institutional buyers decline, home owners continue to deleverage, and banks hold real estate assets below the levels of 7 years ago.

3) Monetary and regulatory policies aimed at thwarting financial instability.

Scattered Thoughts on Monetary Policy

Tim Duy discusses Kocherlakota's dissent in this month's FOMC statement.  Kocherlakota would have preferred a statement "committed to keeping the target range for the federal funds rate at its current level at least until the one- to two-year-ahead inflation outlook has risen back to 2 percent, as long as risks to financial stability remain well-contained."

As Duy points out, even the dovish dissent sees 2% inflation as a ceiling.  But, more disturbing to me is this frequently cited concern about financial stability.  As I have argued in several posts, in practice this concern is kind of a price ceiling on housing, because the economy isn't likely to gain much traction until home prices reach a level that raises these misplaced concerns.  In 2007, the main risk the financial industry was caught flat-footed on was catastrophically tight monetary policy.  But since the concensus is that the main risk was in real estate, then when real estate starts tickling intrinsic values again, there will be demand to fix the imagined risks with catastrophically tight monetary policy again.  Then everyone will agree that those greedy banks pushed us off the economic cliff again because they just keep making these crazy bets on real estate that we have to rescue them from.  Being concerned about financial stability in 2014 is like being concerned about inflation in September 2008.  And this is the dissenting dove....

On that topic, here is the latest weekly update on commercial bank assets.  Commercial real estate and Industrial & Commercial Loans continue to march steadily upward.  The second graph is closed end residential real estate, which has been dead since 2007.  On the closer view, we can see how it showed signs of hope for the first half of 2014, and then died out as QE3 came to a close.  At least the monthly peak this week came in as high as last month's peak.

Another thing that gets me is how people discuss ZIRP (zero interest rate policy).  Like we're here because the Fed is pegging short term rates.  Exactly how is this their policy?  What would happen if they set the target Fed Funds Rate at 2% tomorrow?  Nobody would care.  If they announced a target rate of 2% tomorrow and then started selling bonds in OMO to try to get there, the end result would peg us even more thoroughly at the ZLB.  The only way we are getting off the ZLB in the near future is if they wait for a while and then pull some repo hocus pocus to temporarily pull reserves out of the banks.  Maybe we should have the FOMC issue a pro-gravity statement, too.  I saw some children skipping at the park today, and as each one jumped into the air, I realized what a disaster it would be if they just kept going up and didn't come back down.  Why haven't they gone on the record about this?