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Kyle Bass’s latest…

“The power of value investing flies in the face of anything taught in academics. Value is the way stocks are eventually priced. It requires the perspective of patience because the market will eventually gravitate toward value.”

– Joel Greenblatt

Thesis:

Mongolian Growth Group (“MGG”) is an obscure, underappreciated micro cap franchise with an attractive highly skewed risk/reward equation and substantial downside protection.

Investment Highlights:

An investment in Mongolian Growth Group around the current price possesses nearly all the qualities we look for in a great long-term investment.  These include: (1) a low valuation (2) a good, incentivized management team backed by a savvy board, (3) near to medium-term operating momentum and (4) multiple internal and external high-probability catalysts which we expect will drive substantial upside.

Other attractive attributes of MGG include:

  • A simple business model with an unlevered balance sheet and tangible assets
  • A strong competitive position in a rapidly appreciating niche market
  • Improving economics on an attractive and fast growing asset base
  • A high likelihood of experiencing meaningful improvements in profitability and cash flow
  • Leverage to strong expected growth in the Mongolian Economy
  • Relatively low correlation to the general market
  • Opportunity to deploy capital at high ROIC’s for an extended period of time

MGG owns city-center real estate assets in Ulaanbaatar, Mongolia (“UB”).  Due to the development of the country’s mining sector and certain capital market related factors, we expect per capita income in the country to substantially increase over the next 5-10 years.

This growth in the real earnings power of Mongolian citizens will be a function of a multitude of factors, but primarily driven by:

(1) The continued development, and commencement of production at two world-class “mega” mines within the next 1-2 years. Mines expected to garner over $10B in development capital over the next five years, as well as create tens of thousands of new high paying jobs (salary’s that pay ~10x the present average), not to mention generate $5-7B billion in recurring export revenue on a tiny economy whose current run rate GDP is only ~$8.6B. Additional capital devoted to further discovery, defining, developing, and bringing into production, dozens of other mines within the near to medium-term should augment per capita incomes further.

(2) Various capital market developments, such as the creation of liquid, fully functioning mortgage, bond, and stock markets should be an additional positive aiding the growth in average incomes, by helping further facilitate foreign direct investment and in turn to grow the economy. There is also the upcoming IPO of TT, where the equity of one of the world’s largest, low-cost coal mines will be distributed amongst the citizenry -allowing Mongolians to participate directly in the success and growth of the asset or if they choose and/or sell it back to the government for cash.

Basically, as mines turn on and progress on the capital market front continues, we expect a dynamic, (positive) feedback loop to develop and reverberate throughout the Mongolian economy as a whole, triggering the development of all kinds of different businesses that will benefit from a higher level of economic activity. As the Mongolian “snowball” starts to roll down hill, it should give way to a virtuous cycle that drives down interest rates/funding costs, which frees up capital to fund more businesses, which in turn provides government with higher tax revenues to invest in critical infrastructure/related projects, which will drive down manufacturing and transport costs, increasing productivity and so on, all of which will cause GDP to grow rapidly and per capita incomes to grow even faster.

With that in mind and considering the direct correlation between per capita income growth and Mongolian real estate values, we expect MFG’s diversified portfolio of high quality retail, office, and redevelopment property in downtown UB to compound at 30-50% per year going forward undergirded by a combination of rapidly rising rental yields and compressing cap rates. By purchasing the stock today at ~1.25x our estimate of “true” book value, MGG offers investors a direct way to get outsized leverage to Mongolian per capita income growth, a highly attractive theme and durable, multi-year tailwind.

Viewed from a different angle Mongolian real estate, as the largest direct beneficiary of growth in GDP and average incomes, typically appreciates at ~3x the growth rate of the underlying economy. With Mongolian GDP set to more than double over the next 5 years irrespective of either macro or micro factors – so pretty much regardless of the health of global financial markets or political developments at home – an investment in Mongolian real estate offers low-risk growth in a no growth world, basically a stable shelter from any oncoming economic storm. Evidence of this can be gleamed from the fact that even in a contracting economy that lacked the tremendous embedded growth tailwinds of the next 5 years, Mongolian real estate was flat (read held up like a champ) amidst the great recession.

Given that, we view MGG conceptually as a LEAP or long-term call option on near certain growth within the Mongolian economy with a high probability of expiring deep in the money  – a rare vantage point offering investors a chance to dance in the rain in a risk-fraught global economic environment.

Why the Opportunity Exists

We believe there are three key reasons why MGG is mispriced.

1.  Macro Concerns Regarding Economic Sensitivity

Given various recent data points from the first couple of quarters this year, fear surrounding Mongolia’s vulnerability to commodity prices and a Chinese hard landing seem overblown, especially given the imminent ramp of Oyi Tolgoi, the primary driver of Mongolia’s near to medium-term economic growth. To be clear, OT is a game changer, 100% financed and given its abundant level of gold byproduct, actually has negative cash costs on its copper production.

Notably, OT, as well as most of the other larger tier 1 projects set to come online within the near to medium-term, are all low cost producers with dominant competitive positions driven by a structural cost advantage relative to traditional sources of Chinese supply. This reality should all but ensure that they continue to take a larger and larger share of Chinese demand over time. Given its coming off such a low base, we don’t think its a stretch to say that the Mongolia’s prospects and embedded economic growth will be by and large relatively immune to 1) the state of global capital markets 2) near to medium-term cyclical swings in commodity pricing and/or 3) a Chinese hard landing. These are important points.

2. Understated Book Value

With a stated BV of ~$1.63/share the company doesn’t appear statistically cheap upon first glance, certainly not cheap enough to look particularly interesting in the world we live in and/or without digging a bit deeper. Yet for various reasons we believe that true economic BV by YE ’12 is easily north of ~3/share and set to appreciate rapidly. In other words, what appears to be trading at something closer to 2x BV is in reality trading at a depressed multiple approximating 1.25x.

A small premium to BV (all things considered) is simply way too cheap in our opinion, making MGG one of the more remarkably mis-priced investments we’ve come across in some time. Especially though given the company has been compounding BV at a run rate approaching 50% and the fact that a basket of less attractive emerging market RE focused comps trade anywhere between 4-5x.

So IFRS numbers vastly understate reality here. Confidence in this assessment is derived through IFRS numbers being naturally backward looking and calculated based on yields and subjective cap rates. Notably, MGG’s assets have extremely depressed yields (they were booked at below market rates) and because the most valuable piece of the property portfolio is the land making up MGG’s redevelopment parcels – and hence naturally doesn’t generate current income. That said, over half of their property contracts are set to rollover at rates on average 50% higher over the next 12 months which obviously distorts the calculation even further but again, because more than half of value here lies with a redevelopment portfolio that doesn’t generate income such a method makes very little sense.

We’ve also had talks with a multiple independent sources that have spent significant amounts of time with boots on the ground and who have each crosschecked MGG’s listings with present valuations of comparable assets and built estimates through a property-by-property build-out from the bottom up.

3. CNSX Listing

MGG currently trades on the Canadian National Stock Exchange, basically the worst exchange in Canada, which makes MGG’s equity by and large un-investable for most institutions due to mandate restrictions and liquidity related issues. This is about to change with an imminent up-list to the TSX-V. The dynamics here are actually very similar to the underlying dynamics of the real estate portfolio. Because the stock is un-investable at this point for the vast majority of institutional investors, the idea is to purchase these assets before that changes. So by “front-running” this liquidity unlocking event (the day it becomes investable) current shareholders should be able to sit back and enjoy themselves as the price is subject to a sharp, upward revaluation due to a massive pool of newly investable capital getting put to work in what is a small, very illiquid float with finite supply of sellers.

In addition, all Canadian equity markets have recently been crushed due to justifiable fear surrounding a slow down in Asia. This liquidity vacuum has pummeled non-resource based Canadian domiciled investments right alongside their resource based peers (particularly the more one goes down the exchange quality spectrum).

Long story short, we are comfortable that the business is both significantly mis-priced and (like the country it operates within) misunderstood.

Mongolia: A Unique Set Up

The Situation

Rich in untapped mineral wealth and on the cusp of an epic boom, Mongolia is only ~2-3 years into what we believe will be a 10-20 year secular bull market sustained by positive structural change and a diversified set of stable, competitively advantaged mineral based “exponential growth engines.”

Critically, these growth engines are poised to benefit from a multitude of durable multi year tailwinds and an uncommon stability derived through a combination of diversity (gold, oil, copper, uranium, coal, natural gas, rare earth’s, etc.), natural counter-cyclicality (base commodities vs. precious metals), long lives and the spoils of a structural cost advantage, a function of its geographic proximity to China. Together they provide the Mongolian economy with the capability to drive sustained periods of exponential growth in GDP and per capita incomes.

Why Mongolia?

  • Tiny population rich in mineral wealth
  • Construction of world class mines (on the cusp of commercial production)
  • Proximity to China results in a structural cost advantage
  • Experiencing a high teens annual GDP growth rate
  • Anticipate near-term growth to accelerate
  • Hard Working and ambitious pro western culture

Other interesting data points on the question of “why Mongolia” include Mongolia’s Doing Business Ranking: http://www.doingbusiness.org/rankings. Mongolia is #29 in the world in “protecting investors” (ahead of, for example, Australia or France) and #33 in the world in “enforcing contracts” (between Denmark and Japan).

Bottom line, we think the combination of low population density, trillions in “in ground” resource wealth, proximity to China/the Asia Pacific, and the fact that tens of billions are being spent on capital projects in planning, development, and production phases over the next five years – all in a tiny economy with run rate GDP a mere fraction of that size – has created a situation where all the stars are aligning to generate a potentially staggering level of wealth. As mines turn on and the capital that follows tries to squeeze itself into Mongolia’s tiny economy, a doubling if not tripling of GDP over the next 3-5 years is all but certain.

Mongolian Growth Group: Well Positioned on the Eve of the a Historic Boom

Enter Mongolian Growth Group (MNGGF.PK), a Mongolia based diversified investment company run by fellow VIC’ster, adventure capitalist, founder of Praetorian Capital, and CEO, Harris Kupperman. As we mentioned, MGG’s focus is on real estate and financial services or put a bit differently, the two sectors most leveraged to the growth of the economy and GDP.

We think an investment in MGG is a strategy tailor made to optimize the above dynamic, and at approximately 1.25x “true” BV (where that BV is poised to compound at approximately 3x a rapidly growing GDP) investors are getting a highly asymmetric investment opportunity with fairly predictable upside of 5-10x in 5 years and minimal probability of permanent loss. We think paying a small premium to “depressed” TBV or the market clearing (private market) value of its assets today, without any monetization of the redevelopment portfolio – immediately prior to multiple high probability “hard” catalysts offers not only an 1) attractive entry point but 2) a hard floor intrinsic value wise and 3) significant near-term appreciation potential uncorrelated to the movements of the market as a whole.

Clearly we like that risk/reward.

Opportunity Overview

Keenly aware of the short window available to them given 1) poorly functioning capital markets temporarily holding back institutional capital flows and 2) the historic tendency for downtown real estate located in the capital city of countries undergoing historic booms to accrue value to its owners in parabolic fashion, Harris (and co-pilot Jordan Calonego) wisely set about gobbling up as much prime real estate in downtown Ulaanbaatar’s (UB) as possible in anticipation of it closing.

Realizing that 1) an expanding and rapidly growing real estate market causes step change rises in property prices and rents, which acts as a multiplier on valuations – typically to the tune of 3x the growth experienced within the general economy and 2) real estate in a rapidly expanding economy offers arguably the best leveraged risk/reward set up to take advantage of that growth, the two set out building an enviable market position in the heart of downtown and succeeded.

Luckily, MGG managed to get in early enough to compile what is an utterly amazing property and land package that includes an extensive list of city-center real estate located directly on, or immediately adjacent to, Peace Avenue, Mongolia’s main (and only) street. MGG’s property and land package consists of a diversified collection of prime class A/B office property, residential apartments, and retail space. Notably, prime locations are now long gone or very expensive so the timing on this was a thing of beauty.

So why now?

  • Recent government election and foreign direct investment related political reforms aimed at welcoming the worlds capital with open arms have removed a material overhang/associated political uncertainty for at least the next 4 years
  • Billions in new government related infrastructure spending coming down the pipe
  • The receipt of full financing for a game changing, world class mineral asset Oyi Tolgoi (OT) currently on the cusp of commercial production – essentially investors are investing in Mongolia at a major inflection point that will drive rapid growth in GDP and exponential increase in per capita incomes
  • Recent announcement of QE to infinity – western central bank money printing and presence of negative real rates across the global financial markets should support hard asset prices and hence ongoing development of Mongolia’s vast natural resource base.

Ultimately we think a better, more unique set of circumstances to get exposure to Mongolian economy than on the eve of the turn is unlikely, given the above factors, rapidly improving fundamentals and the presence of external near-term catalysts set to kick start the second wave of what may very well turn out to be one of the greatest economic growth miracles in history.

As far as MGG specifically, well, basically we have premier real estate assets with massive gearing on the eve of this historic multi-year growth phase in general economic activity, which again provides an ideal set up where investors have a predictable outcome, a hugely asymmetric risk/reward equation, and the chance to front run a tsunami of incoming liquidity. I’m sure all of us can appreciate that getting leverage to an specific outcome at the right time, in the right market, through the right vehicle can be incredibly rewarding. That’s exactly what we have here.

That said, let’s talk about Mongolia. Sparsely populated with only 3m people, Mongolia is a former soviet satellite that is 1) geographically well positioned to benefit from free trade and 2) endowed with bountiful natural resources to the tune of trillions. In fact, Mongolia has enough below ground mineral wealth to make every Mongolian man, women, and child a theoretical millionaire, a data point that in and of itself helps paint a pretty clear picture that Mongolia isn’t your average commodity driven emerging market or secular growth story – but something unique with extraordinary potential over the fullness of time.

To highlight this point, we are talking about a people that could go from half nomad to the wealthiest in the world on a per capita basis within the span of a roughly a decade. I mean holy sh%t!! Perhaps there is a historical precedent, but I’ve certainly never come across a country that has the potential in ~10 years time to go from one of the poorest to the richest simply by unlocking the embedded value beneath their feet through changing a few laws and signing a few JV’s. Clearly that’s an oversimplification but with avg GDP per capita of only ~$3,000 and a present run rate of ~$8.6B in GDP in a country sitting on a trillion + in embedded asset value and the potential to generate GDP of 40B+ over the next 5 years, clearly the runway is massive and the countries present run-rate represents a mere fraction of its ultimate potential.

So we think the seeds are currently being sown for an epic wave of wealth creation unlike any other nation on earth that I’m aware of – a story that’s still in the very early innings and likely to accelerate substantially in the years ahead that should (in all probability) continue pretty much irrespective of global economic conditions or turmoil within the western world. I’m not talking about GDP + type of growth, which while respectable enough in the current environment isn’t it. I’m talking about, is an economy that’s capable of creating EXPONENTIAL increases in the average real earnings power (standard of living) of its people on a sustained, multi-year basis.

For those taking score, exponential is super compounding and if most estimates are to be believed Mongolia is poised to compound GDP by a factor of four over the next 5-10 years – and if things go smoothly near-term, nominal GDP could actually double in just over two.

A Quick Word on OT & TT

With two of the largest development projects in the world in Oyi Tolgoi (OT) and Tavan Tolgoi (TT) commencing production over the next couple of years (TT won’t really get started until next year) its easy to imagine how things could get downright silly on the growth front given the amount of latent, embedded growth in export capacity held within these two assets. It’s nuts, but these two projects alone looking out over the next five years have combined (committed) levels of Cap-ex approximating ~$12B, so close to 2x run rate GDP.

To give a better idea of the scope of these near, medium and long-term growth drivers, these two mines presently sit on ~81 B pounds of copper, ~46M ounces of gold, and ~6B tons of coal (big boys clearly). Initial production capacity is looking at annual production rates of ~1.2B pounds of copper worth an estimated $4.6B, 650,000 ounces of gold worth an estimated $1.1B, and ~3m tons of coal worth an estimated $100m or taken together, ~ $5.7B – and remember this $ amount consists of ongoing (recurring) export capacity and hence stands to be a gift that will keep on giving for an estimated 60-70 years.

Of course none of that discusses any of what I’m sure is a very real, near certain pathway to expand the resource and in turn, to grow OT or TT’s ultimate steady state production levels materially above initial estimates.

So things could get a bit nutty in the blue sky scenario and again, were talking about only two mines, so none of the above includes any additional growth potential that will be driven by the 25 or so additional projects in the pipe, each of which is expected to represent ~5% GDP on average. Nor does it speak to the ripple effects and positive feedback loops that all of this investment will spur throughout the various other facets of the economy.

Real Estate Portfolio (Portfolio Composition, Valuation, & Strategy):

Property Strategy

  • Buy top quality properties along Peace Avenue
  • Focus on leasable retail and office property
  • Focus on redevelopment opportunities with sizable value uplift through redevelopment

Property Portfolio

  • 28 Residential Units
  • 6,081 meters of Retail Space
  • 5,361 meters of Office Space
  • 13,800 meters of Redevelopment Opportunities

Portfolio Composition and Valuation

Note: I apologize for the tiny font, it was the only way I could make it format properly…

Brief Primer on Downtown Ulaanbaatar:

MGG currently owns 28 residential units, 6081 meters of retail space, 5,312 meters of office space and the crown jewel, 13,800 meters of redevelopment property all strategically positioned within a prime 3 kilometer stretch in downtown. That said, one of the most important aspects of this thesis is to understand the geography of Ulaanbaatar and the nature of downtown.

UB is landlocked and runs east west as its constrained to the north and south given its wedged directly between two mountains – so its much more comparable to a place like Hong Kong than it is to your average city. Also, and this is equally as critical, there is only 1 main street in downtown UB, the aforementioned Peace Avenue. So when thinking about MGG’s property and land package its important to grasp that there is really only 1 area with a distinct financial and residential presence downtown where everyone wants to be located and its extremely small – which is a function of the fact that UB was originally constructed for only 300k people by the soviets. This is an obvious problem for a city housing 40% of the population of Mongolia or about 1.2m people.

Considering this reality then, its probably no surprise to anyone that downtown UB is currently facing a drastic supply shortage of Class A&B office, residential and retailing frontage and this shortage is getting more acute day be day as more and more of the worlds corporations and various expats are arriving in UB to set up operations. The shortage of residential apartments is particularly large, which are highly desirable to wealthy locals not only for status reasons but because of basic logistics given that traffic getting in and out of downtown is notoriously bad. Commutes on average take about and hour and a half to two hours back and forth.

So, the most important piece of the structural shortage puzzle is it’s a certainty that their is only one way to go downtown to help alleviate these bottlenecks – and that’s up – meaning the construction of office, retail and residential towers. Understanding this inevitable reality is a big part of connecting the dots in our mind as well as the sheer genius of how Kuppy went about acquiring MGG’s existing property (the specifics will become readily apparent shortly), not to mention where a big part of MGG’s ultimate upside will come – and to be clear by upside I mean big time, many many multiples of the current stock price type of upside.

Also, with 40% of Mongolian citizens living in a city built for a population a mere fraction of that, its not surprising that the infrastructure of the city is in dire shape and in critical need of repair and expansion. Why this is relevant to property prices is because any land outside of the city is essentially worthless because it has no infrastructure (so their is no water, sewers, electricity, etc.). This in turn drives up the price of the land within city limits because it’s the only land attached to infrastructure. This dynamic naturally provides a huge tailwind to property investments within the city center.

A Roadmap for the Future: Thinking about Valuation & the Kazakhstan Boom (2002-2008)

In order to better frame the opportunity and the second order effects of what we believe is in store for the Mongolian economy in the years ahead, we wanted to note investors have multiple historical comps where the transition to an open economy results in a large multi-year period marked by vast wealth creation – so there are various road maps but for our purposes here, Kazakhstan seems the most relevant.

While by no means a perfect comparison, in fact we would argue on a variety of levels that the unique nature of the Mongolian situation makes it substantially more attractive, the Kazakhstan example is a useful case study in a multitude of meaningful ways and it makes sense on a high level to use it as a blueprint for thinking about how an investment in MGG will unfold over the next 5 years or so.

As far as the specifics that make Mongolia materially more attractive, the quick and dirty outline includes 1) Almaty isn’t land locked and therefore suffers from no shortage of land with ~200 sq. kilometers (big difference) 2) UB has only one premier shopping street (Peace Avenue) where Almaty has 5, all substantially developed (another huge difference) and 3) while technically a democracy, its been ruled by the same leader for ~20 years and our read is that its generally understood that its a pretty good idea to keep ones business small enough to keep it out of sight from the authority’s. In other words, capital apparently flows out of Kazakhstan like bees to honey when it can (big big difference). After all, in Mongolia and UB, free enterprise is a big part of their national character and property rights are well respected, a point of pride amongst the vast majority of the population, so its very likely that the wealth of the country will stay within its borders and reinvested back in the economy. At the margin all of the above should intuitively make any investor more bullish on Mongolia relative to Almaty.

That being said, there are many critical similarities that make the comparison apt and at the end of the day, a solid roadmap to use for thinking about how all this plays out. Both countries are resource based economies, both came across massive resource discovery’s and grew rapidly due to large step change increases in production derived from those discoveries, both are former soviet satellites, both share similar cultures, architecture, initial infrastructure etc. – and so the primary difference (outside of those already noted), is that Kazakhstan is 10 years farther along in its boom than Mongolia so we think comparing the two helps MGG investors see around the corner of the oncoming mining boom.

As a side note, studying comparable situations of formerly centrally planned economies that have set about making the transition to a free, market based system is instructive. Historically, these booms tend to last approximately 15-20 years before prices normalize within the ballpark of developed nations and the evolution of these situations is broadly predictable as far as the general effects on the economy. These are key insights. What we have here then is textbook Soviet market reform, and the effects on the underlying economy in terms of these reforms are indeed predictable, and because Mongolia’s in the very early innings of this long-term transition, studying Kazakhstan (which is about halfway through) gives us a reasonable template to build of off.

Kazakhstan’s statistics over its 2002-2008 boom can be seen in the chart below (per MGG’s presentation)

Not bad by any means, but its much more interesting to compare present Prices in Ulaanbaatar today to get an idea where they may end up tomorrow. Odds are Mongolians have seen anything yet…

What the above comparison makes clear is that on an apples to apples basis prices per meter in Almaty are about 3-5x those in UB, which for reasons already noted we think is the absolute low end of where they will end up at in UB 5-10 years from today.

That said, if one is willing to factor in cap rate compression over time, a fair assumption we think, then MGG’s existing property will be worth something approximating 5-10x its present value within 5-10 years. Not bad for a small premium to BV today no?

Special Situations

Now for some insight into Kuppy’s value creation strategy, and again, this is just one of many special situations within the larger property portfolio that illustrate the value of a mind set focused on the right things. Of course this is just 1 example but its illustrative we think of the type of value that is accruing to MGG shareholders above and beyond the pricing and rent tailwinds but I digress, back to the point. Another colleague put it like this…

“MGG recently purchased a ground floor retail space that’s tenant was an ethnic restaurant on a side street of Peace Avenue. MGG purchased this property for $1.6m at a mid-teens cap rate from a forced seller. MGG is now beginning construction on an extension to the property that will increase the property’s rentable area by 60% at a cost of about $300k, effectively creating a low 20’s cap rate at today’s yields. In a few years we expect 10 caps or less to be the norm in central UB, and rents to be 2-3x higher than today’s on this property – effectively 5-7x upside on the purchase, not counting the interim yield.”

In a nutshell MGG’s investors are getting paid 20% a year with downside protection and a high probability of making 5x our money in 3-5 years, and all for owning prime downtown real estate in the capital city of one of the most promising economies on the planet looking out the next 10 years. Hard not to like that type of asymmetry all things considered. In fact, Steve over at the excellent Capitalist Exploits had an apt analogy, describing buying into select, high quality Mongolian real estate as akin to buying high dividend paying equities that are set to double every couple of years for a number of years going forward. I think that sums it up rather nicely.

And again, this is only one deal out of many similarly attractive “special situations” within the present property portfolio, and not an instance of “one off” cherry picking. Anyone interested in learning more about other deals should check out the company’s letter to shareholders for a few additional examples.

Resource Conversion – Monetizing the Redevelopment Portfolio

The biggest opportunity for shareholders at this point lies in the redevelopment portfolio. To understand why we think this, lets take a step back a bit and remember the underlying reality in downtown UB and how alleviating the bottleneck as far as supply/demand is concerned is a function of building out office, retail and residential apartment towers. This is the future, that I am all but certain. Remember UB is landlocked (sandwiched) in a valley between two mountains, so think of it like Hong Kong. There is nowhere to build but up. Having a downtown that is nestle between mountains makes is easy to identify the “money zone” and helps mitigate the risk that the city could “grow away from you” as an owner.

Also, the savvy I referred to earlier requires a bit of explanation in that as a former Soviet satellite, most property ownership was a function of the government privatizing its (real estate) assets, and it did it in a way so that all of its citizens participated in said land monetization and hence ended up resulting in lots of tiny land parcels (one for each man, women and child presumably). Well, to put it mildly having ~3m people each own some tiny parcel of land doesn’t do much for property values or for businesses looking to redevelop downtown by adding a new high quality office tower. Therein lies the problem and as always, the opportunity – and that’s exactly the opportunity has MGG capitalized on by exploiting its first mover advantage and quickly aggregating multiple small, adjacent land parcels along Peace Avenue into a handful of large blocks. All in, MGG owns ~7-8% of downtown’s “sweet spot,” which is amazing when you think about it. Anyhow, given the unique history here, we shouldn’t be the least bit surprised that the value uplift through the creation of large land packages in landlocked, deeply spaced constrained downtown UB along its main street is quite substantial.

So, given that and keeping in mind that high rents in downtown UB result in property values that are several times there replacement costs, owners of existing land and property have an attractive opportunity to convert land and existing structures towards their “highest and best use.” As an example, assuming current building costs of 1,200 to 1,500 meters property owners are looking at paybacks on investment of between 2 to 5 years. So ROIC are very attractive. Thanks to MGG’s ownership of multiple large land parcels in prime locations, which again is exceedingly rare given the time, money, and negotiations it took to roll-up multiple parcels into large development ready blocks, to say these assets are valuable or that MGG is in a position to create tremendous value for its shareholders over time is an understatement.

Lets take a look and see just how tremendous by reviewing just 1 of these land packages, which possesses a total size of ~2200 meters. 2200 meters translates into (roughly) 1500 meters of sellable land space per floor if we assume the remainder is used as space for general utility (think recreational area for businesses and residents). If we then assume the tower in question being built has 20 floors (entirely reasonable if not conservative) and use current costs and values for class a residential located in the heart of downtown according to local broker BDSec’s latest report, this development would create an incremental $75m (or ~2.20/share) in value! That’s 2.20/share in value vs. a current stock price of $3.90 and that’s just 1 of MGG’s 6 land parcels. Disclaimer: I had to lay down the first time I realized this.

So the math looks like this: $4000 in sales per square foot * 30, 000 square feet of residential sellable space (1500 square meters per floor * 20 floors) equals $120m less cost of $45m ($1500 meters in cost per square foot * 30,000 square feet) which equals ~$75m in total profit ($120m – $45m = $75m).

Granted, the example above assumes MGG were to do the redeveloping themselves, which isn’t going to happen given the companies preferred strategy of entering into a JV with experienced developers and contributing the land and retaining some % of the building while taking the property management rights, so that $75m in profit wouldn’t accrue solely to MGG but that’s not the point. The point is to illustrate the incredible value creation that MGG can deliver to shareholders over time by entering into select deals on land packages with the right partners – of course its also to illustrate that MGG is dramatically undervalued at today’s quote or said differently, relative to its existing asset base assuming no additional accretion of value through rising rents and property values.

Also, with each monetization MGG would retain a high margin recurring revenue stream approximating ~100k a year. Not game changing by any means but its an asset worth at least a million bucks (i.e. 10x) so a nice little kicker for playing.

We think finding the right JV partners should be a relatively simple and painless process given the extremely high quality of the asset. As far as financing, we’re looking at 50% down payments on construction that is pre-funded – with the JV partner obviously fronting that bill.

In sum, MGG has the ability to unlock value worth several times its present price within the existing asset base and again, this is assuming no additional price increases on property values/rents.

One last recap of the redevelopment strategy before we move on, per the company presentation…

  • Partner with experienced developers
  • Contribute Land and local experience to a prospective JV
  • Manage the property afterwards which leads to high margin, recurring revenues
  • Avoid outsized financial commitments
  • Avoid completion risk
  • Avoid budgeting risk
  • Retain high returns on capital with reduced risk

Management Quality:

As I mentioned last time with my write-up on SND and reference to its CEO Nolan Watson, we think Harris also possesses that “…passion, the magic if you will, that is the hallmark of all truly great business leaders and entrepeneurs – “what he does mixes with who he is, which is cooked and propelled by what he believes.” I put it like that not to be promotional but in order to accurately portray that I think we are dealing with something special in terms of managerial quality, particularly in terms of incentive alignment, strategic vision, capital allocation, and sheer dedication to exploiting a very unique opportunity.

Not only has he put the vast majority of his net worth on the line, but unlike the vast majority of the executives I know (or people in general for that matter) Harris was willing to pack up his life and move halfway across the world from the sunny beaches of Miami to a developing, non English speaking country where he knew practically no one, with long -40 degree winters and most of the day to day luxuries all of us have come to rely on, all pursuit of fulfilling his dream. Maybe it just part of my personality, but frankly that’s the type of thing that fires me up. Attempting such a feat takes courage, conviction, and a bold, pioneering spirit – exactly the type of combination necessary to succeed in a frontier environment, and exactly what I would want in the CEO attempting to lay down his mark by building a great, truly enduring business in an emerging market on the far side of the world.

Nonetheless, readers should judge for themselves so in that vein I’ve linked the following profiles and interviews – each of which should help paint the picture as far as sizing up the caliber of the individual leading MGG’s charge.

Lets start with one on compensation and incentive alignment….

“Chris: Mongolia Growth Group is a bit different from most other public companies in terms of compensation. Can you explain?

Harris: the Company started with me asking friends to invest alongside me in Mongolia. I wanted a diversified company that would have adequate exposure to the Mongolian economy. I simply didn’t have the resources to do that myself.  I felt funny asking my friends to invest in my company and then tell them that I was going to take a salary and dilute them through stock options or any other scheme like that. Instead, I have decided to take no salary, stock options, performance allocation, bonus or anything else. I’m here in Mongolia because I’ve invested my own money in the company. My Co-Pilot in this venture, Jordan Calonego feels the same way.  Besides, we’ve been investors for over a decade now and have been disgusted to learn that the CEO always seems to do better than the shareholders. Now that our roles are reversed and we are management, it would be wrong of us to do what we have always criticized. Investors need to think of this company as a business created by a bunch of very successful hedge fund guys who want to invest their own money in Mongolia. Minority shareholders can come along for the ride if they want without any of the onerous fees normally associated with hedge funds. It is the only company that I know of like this. I hope we can use this as a template for the next time that I complain that some Management team is overpaid, but that’s a different story!”

Shareholder Letters – http://mongoliagrowthgroup.com/?cat=12

Interviews:

http://capitalistexploits.at/2011/06/a-mongolian-capitalist-part-i/

http://capitalistexploits.at/2011/06/a-mongolian-capitalist-part-ii/

http://www.distressed-debt-investing.com/2010/11/hedge-fund-manager-interview-series.html

http://www.distressed-debt-investing.com/2010/11/hedge-fund-manager-interview-series_21.html

http://seekingalpha.com/article/488591-conversation-about-mongolia-with-hedge-fund-manager-harris-kupperman

http://thedailygold.com/interview-with-harris-kupperman-ceo-of-mongolia-growth-group/

Thoughts on Mongolian Economic Sensitivity: The Rock of the Asian Pacific

For the non-believers out there, evidence of Mongolia’s decoupling from the rest of the world can already be gleamed from its 30% nominal (17% real) growth rate over the first half of this year, and this growth rate (I would add) looking out 6 months to two years will accelerate. That, and with 90% of Mongolia export capacity being Chinese driven one would think that any serious slowdown in its neighbors economic activity would result in a similarly lock-step downward adjustment to Mongolia’s economy, yet this hasn’t happened and given the dynamics at play we don’t expect it will. That’s not to say that its entirely immune, not at all, just that even if near-term weakness eventually shows itself, such weakness will ultimately be overwhelmed (and then some) in the near-term by much stronger countervailing forces.

We should also point out that such growth is unheard off pretty much anywhere else in the world today, which is telling in and of itself but especially remarkable in light of the slow down in emerging markets and China in particular, not to mention the significant recessionary fears in developed markets the world over…and again, this is PRIOR to the substantial acceleration in economic growth that will take place as OT starts to produce over the next 12 months, the $10B IPO of TT takes place, or the government starts putting to work billions towards infrastructure improvements. Candidly, if such durability doesn’t intrigue you it should, as within it are the clues to what lies ahead in my estimation, namely a Mongolia that dances happily through the rain and comes out the other side significantly stronger.

Nonetheless it appears a decoupling has already started and is likely to continue given the commencement of steady state production at OT. Basically, once OT ramps the divergence highlighted in the chart should blow out, as it will single handedly grow the real economy in the high teens and average incomes by even more – not to mention diversify the economy from one that’s primarily coal based, to a dramatically more stable one driven by a diversified, countercyclical mix of coal, copper, and gold pretty much overnight.

Given this reality, it seems pretty certain that the Mongolian economy will be shielded from 1) a reasonable level of economic turmoil within the developed world and 2) a Chinese hard landing. At the very least the implication seems to be that economic conditions (i.e. stability and growth) should hold up substantially better than other more developed economies, both east and west.

The somewhat paradoxical conclusion above is a function of a couple of things…

Mongolia’s proximity and hence sizable cost advantage (transportation costs, labor, etc.) to traditional sources of Chinese supply removes a considerable amount of uncertainty in terms of the big picture. Unlike most resource driven economies, commodity pricing plays second fiddle to the ultimate outcome given Mongolian low cost production is able to feed more and more of China’s existing demand at the expense of higher cost competitors – and we would note that even under a draconian 20-30% drop, its hard to see how that would come close to being of sufficient magnitude to materially effect the baseline demand number that China would require even if it started shrinking. Therefore, as crazy as it sounds, the health of the Chinese economy would seem unlikely to effect Mongolian economic growth prospects materially at this early stage in it’s development.

Put a little differently, the level of demand destruction required for Mongolian production to feel a GDP growth negating hit would need to be staggering – we think one that would imply a depression like scenario globally, so the simple answer is that Chinese coal demand may drop, but not to a level that would destroy demand for its lowest cost producer. Same with copper, gold etc. So we expect Mongolia to hold up as China rationally shifts their needs towards the lowest cost producer and because at the end of the day, Mongolia’s production capacity isn’t big enough (even at maturity, say 10 years down the line) to take the entire share of the commodity needs of the worlds 3rd biggest economy.

After one takes into account the gold byproduct, Oyi Tolgoi actually has NEGATIVE cash costs for its copper production. Hard to believe, but this tier 1 mega mine/multi billion dollar copper producer with a mine life of ~60-70 years literally can’t become uneconomic under most reasonable future scenarios given practically every other copper mine in the world would need to go bankrupt before OT would face material stress. I say that because as a low cost producer of gold and copper with massive scale, high grades, natural counter-cyclicality (gold should do well when copper does poorly and regardless of whether we have inflation or deflation), and a structural cost advantage large enough to drive a truck through makes it extremely unlikely. So a scorched earth scenario where this happens is REALLY difficult to envision barring some type of Yellowstone type event (such as a Chinese or Russian invasion).

Basically given the Mongolian economy’s low base and OT’s contribution, not to mention its scale as the third largest copper mine in the world, or its negative costs on copper production (due to its unusually high level of gold byproduct) etc. it remains difficult to come up with a scenario in our mind where OT’s impact as a growth driver could be negated. We just can’t figure out how to remove any legs from the foundational stool under any scenario worth worrying about given OT’s economics are bulletproof relative to competition. The mine should generate cash regardless of where we are in either commodity’s cycle, so the odds that it would ever get idled over the life of the mine is pretty much nil.

My understanding of the last few years is that much of the of torrid growth has been driven primarily through exporting coal from smaller mines, pretty much by selling it at half market to the Chinese for what is presumably their local power needs. That would seem to imply that all of the rapid growth from foreign investment from these tiny mines over the last few years is very stable and in all probability sustainable indefinitely – after all, presumably these pretty much non-discretionary foreign inflows are a function of necessity, i.e. of ensuring the lowest cost sources of coal possible can be used to keep the lights on in local Chinese cities located close to the Mongolian border (so again, sustainable because its clearly the lowest cost source of power they could possibly utilize). Either way in the long-run, unless China stops powering their cities, homes, etc. the demand for this low cost coal should be more than sufficient to support Mongolia’s present run rate GDP – sure, volatility in volumes and pricing will always be there but production increases from existing mines and/or additional coal derived from new mines should easily overwhelm that cyclicality as export capacity grows.

As an aside, planned infrastructure investments/logistical improvements should buoy run rate coal exports and hence GDP since most of today’s low cost coal is transported by truck ~250 miles to the Chinese border (so not exactly the most efficient method to put it lightly), so its worth highlighting that when the rail currently in planning is built the economics of this portion of the economy (i.e. its core driver at present) will get materially better, further augmenting Mongolia’s already steep cost advantage. Hard to tell if the entirety of the additional margin will accrue to Mongolian producers, but regardless I view any progress on this front is icing on the cake and figured I should mention it, as the positive effects on general economic activity aren’t trivial.

Summing it all up then, all signs point to the Mongolian commodity juggernaut possessing “inevitable” status in Buffett parlance given a high probability of near certain growth looking out 2-3 years from the economy’s present $8.6B base.

Catalysts:

Mining

As Mongolian mines turn on, GDP and per capita incomes will grow and hence the value of MGG’s RE assets will appreciate even faster. As far as specifics, the big near-term catalysts are the commencement of production at OT as well as the upcoming IPO of TT – both of which should result in substantial growth and large windfalls in terms of wealth to Mongolia’s citizenry, catalyzing a substantial re-rate in the value of MGG’s properties. That’s just what happens in an ~8B dollar economy where one mine is set to bring in ~$5B in recurring export revenue within 6 months to a year and another that’s expected to raise ~10B in an IPO – an amount that in and off itself is larger than the entire GDP of the country presently.

Fwiw, these developments are practical certainties in our opinion (OT especially), and as we’ve already mentioned, should come to fruition in the near-term irrespective of cyclical swings in commodity demand/pricing, turmoil within the capital markets, or political grand standing by a small minority of Mongolian politicians dead set on killing the golden goose.

Remember, OT is fully funded and TT is arguably one of the best low cost coal assets in the world in terms of size/scale and proximity to the hungriest coal consuming economy on the planet. Remember, Mongolia’s is starting from a very low basek and its status as a low cost producer with a structural cost advantage relative to other high cost producers such as Australia, Indonesia, etc. practically ensures Mongolian production continues to displace foreign resource demand unabated.

Capital Markets

Mongolia’s capital markets do not function and any improvement on this front will be a major positive for economic growth and per capita incomes given it would unleash an additional source of upside leverage to GDP entirely independent of the mining boom, and would unlock an enormous amount of latent consumer spending power providing an economic growth/average income/real estate pricing tailwind for literally decades.

There is still much to be done but the good news is the wheels are turning. While progress is naturally slow, the positive changes on the horizon are multi-fold, including 1) the continued arrival of foreign banks 2) the passage of legislation related to various capital market related issues next month (such as the creation of laws to regulate credit and create securities markets), 3) the London Stock exchanges successful modernization of the Mongolian Stock Exchange (MSE) and 4) the successful IPO of TT (hopefully on the MSE) etc., all of which will help (at the margin) facilitate the structural changes necessary to create the foundation needed to allow fully functioning capital markets to take hold. So all of the pieces of the puzzle are in motion and coming together but this will take time.

Also, as of today most Mongolian banks generate NIM’s of 8-9%, and are still woefully undercapitalized, which naturally makes credit very expensive and access to long-term debt financing of any kind extremely rare. Something like 80% of loans are turned down, a statistic that in my mind pretty much says it all. I mean it’s an obvious problem when even the best businesses and entrepreneurs (entirely) worthy of capital can’t get. But again, luckily things are changing and when they do, a virtuous feedback loop will start to gain traction and in the process naturally drive down NIM’s, the cost of financing, etc. which will naturally broaden access to capital and help make long-term financing available, etc. and in turn facilitate the creation of a mortgage market and a liquid, fully functioning modern stock and bond market. So all of this is critical to keep in mind in context of the longer-term story here, as today’s headwinds will eventually become very powerful tailwinds.

Lastly, as long-term investors with an eye towards the inevitable, we want to get in before this happens and in truth, hope the window stays open a bit longer given the extreme inefficiencies it creates for a company like MGG run by a pair of opportunistic investors with the willingness, ability, and capital to exploit it on shareholders behalf. Obviously any time interest rates are excessively punitive and loans are short-term in nature, this dynamic will lead to a fairly large amount of financial turmoil and a pretty much continuous flow of forced selling like the situation described in the special situation segment earlier. So to tweak St. Augustine’s famous line on chastity, Lord please give Mongolia functioning capital markets, just not yet.

Exchange Up list(s)

We expect MGG to up list to the TSX-V within the next few months, the Mongolian Stock Exchange in the near-term and eventually the TSX longer term. The up-list to the TSX-V is by far the most consequential in terms of a hard, near-term catalyst and we expect it will drive a material revaluation in the company’s shares. Keep in mind that MGG is currently listed on the Canadian National Stock Exchange (huh?) or the “CNSX” – a tiny exchange for emerging companies. Basically the worst exchange in Canada. This is critical as this listing has heretofore prevented large amounts of capital (read a long list of institutions) from investing in MGG despite their willingness given internal mandate/liquidity restrictions, a barrier that critically will no longer apply once the TSX-V makes those issues mute.

Given all of the pent up demand and assuming an up-list along with a modest increase in MGG’s IFRS book value as those numbers are changed to reflect the substantial increase in Mongolian property prices and rents over the latest twelve months (which again is still substantially below “true” book value), perhaps something approximating $2.25. If we then assume a multiple on those revamped IFRS numbers at or below the lowest end of the comp range, so say 3-4x, both reasonable assumptions given the substantial uplift in Mongolian RE and the relative superiority vs. comps – MGG’s equity would end up somewhere between $6.75 and $9 in the relatively near-term, so upside approximating 2-3x the present quote at some point within the next year. Not bad.

As far as the MSE up listing, it may take a bit longer than the TSX-V up list, but eventually we think this will be a substantial catalyst as MGG is the best positioned and really the only company that will be listed that provides institutions with a conservative vehicle to play the multi year growth wave in Premier downtown UB RE. Fwiw, can’t imagine Asian sovereign wealth funds not wanting exposure once it’s available.

Point being, we see these events, particularly the imminent TSX-V up-list as having a high probability of driving a material re-rate, and in the process pushing MGG’s valuation more in line with intrinsic value and/or that of its global peers.

Risks:

Resource Nationalism/Government Related Issues

Figured we’ll start off with the elephant in the room by noting that additional government regulation/bureaucracy could affect the cost and pace of development in Mongolia going forward. For reasons outlined below it’s a negligible risk in the thesis killing sense. Also, we should probably mention that if the current political grandstanding and melodramatic/western press seeking antics of a small minority of politicians continues, its reasonable to assume some impossible to quantify amount of damage (in terms of lost FDI) will walk away. While powerless to affect change in any real sense, the mere perception of political risk could become self-fulfilling to an extent, but again it would be an immaterial amount and is nothing to lose sleep over in context of the long-term thesis but definitely something to monitor.

That said, lets remember the ambitious, pro western nature of its people and the fact that both major political parties are pro-business and better yet, that the more classically liberal of the two was just elected in the countries quadrennial elections. This is evidenced in the new governments DP plan (and others) that highlights their policies, as well as in their actions, most recently by voting down calls to renegotiate terms of the OT contract twice within the last couple of months. I emphasize it given all of the recent events/press of late that paints a very different picture, so I wanted to reiterate that right out of the gate to highlight that while its true Mongolia has its fair share of myopic, pandering politicians intent on enacting self defeating policies, so do we all, and the “kooks” in the headlines are a small minority with zero power to do anything of material consequence – just like the kooks in our own, or any representative democratic government for that matter.

So while no discussion of this topic would be complete without the above, neither would a discussion that didn’t provide a good idea of the character of the Mongolian people as a whole, particularly in terms of standing up for property rights and the democratic form of government. I mean this is a country that went on a hunger strike (for God sakes) in order to achieve democracy, so the belief in the rightness of a democratic system of government isn’t just a phase, its actually deeply ingrained in who they are as a people. At the risk of sounding hyperbolic, I actually think its fair to say that democracy is in their blood. Evidence of this can be gleamed from a variety of angles, most notably by Mongolia’s multi-decade history of stable democratic governance, a period marked by peaceful, seamless transitions of power. This type of thing is practically unheard of in the prototypical frontier market and really speaks for itself.

Also numerous sources who’ve spent a material amount of time on the ground have told us that the average Mongolian will tell you that property rights are considered sacred and that the government will simply never just take an asset from anyone. The only exception to this rule is when the Chinese are involved as Mongolians harbor a severe mistrust of their larger, more powerful neighbors, and reflexively fear Chinese control of Mongolian assets – but even here, the two countries are for the most part able to work around these differences and somehow manage to make it work. As further evidence of the larger point consider that Mongolia is #29 in the world in “protecting investors” (ahead of both Australia & France) and #33 in the world in terms of “enforcing contracts” (between Denmark and Japan). Interestingly then, as nuts as it seems, capital appears to be relatively safer in Mongolia than in a wide variety of developed western nations – and yet people that wouldn’t think twice about investing in Japan, Australia or France wouldn’t invest in Mongolia with a ten-foot pole. As fact and data driven investors, all in all this makes no sense to us given the empirical and anecdotal evidence points to a large disconnect between perception and reality in terms of the perceived vs. actual risks of investing in Mongolia in terms of the stability of government, property rights and respect for the rule of law. These are critical points for potential investors to internalize.

I should probably also note that as unusual as it may be in terms of the average frontier market, I don’t think it’s at all abnormal for country that underwent decades of oppression and the “cog in a wheel” reality of Soviet rule to have deep-seated preferences for democratic forms of government and a profound respect for property rights amongst the majority of its people (Poland comes to mind). In fact I think its intuitive if anything. So again, my read is that respect for both democracy and the rule of law is deeply ingrained, and both are enduring characteristics that are highly unlikely to change anytime soon.

Again, these are key points and while I fully realize this isn’t orthodox opinion, all things considered I just don’t see Mongolia as particularly risky on an absolute basis or relative to other western developed nations. That’s not to say that Mongolia doesn’t have its owns very real risks and issues, just that the range of outcomes here is relatively predictable and many of the typical pitfalls associated with investing in frontier markets don’t really apply in the traditional sense. As I hope is clear by now, the more you peel back the Mongolian onion the more all of this becomes obvious.

With that foundation established lets get to the point as far as why we don’t feel that governmental/political risk is all that material to the endgame here – at least not significant enough to be amongst the thesis killing variety.

The backbone of this conclusion is derived from…

The fact that Mongolia is a democracy where all existing legislation requires a quorum (or 2/3rds majority) of votes to overturn. In a very real way then handicapping this risk is a basic math problem and an easy one to solve at that.

For example, as far as we can tell the golden goose killing, resource nationalists in the Mongolian parliament (i.e. the ones whose antics get plastered all over the western press) only number in the mid twenties at best – in a government that keep in mind requires a bare minimum of 39 votes in order to affect real change of any consequence. So again, investors need to understand that that this is a small minority in a democratically elected government that frankly doesn’t appear close to having the requisite political muscle to jeopardize the country’s progress (at least for the next 4 years). So the headline risk, while not particularly helpful and a tad unnerving is at the end of the day just that (so pretty much nothing but noise). At minimum I think one can confidently say that because of this structural reality, the political risk is reasonably contained for the near to medium-term future.

Even if we assume by some extraordinary measure the “kooks” in the government managed to garner the requisite 39 votes to do something staggeringly retarded (which again is unlikely for reasons already stated), I would argue we still have an ace up our sleeve in the form of veto by the PM. What the media fails to mention 9x out of 10 is that the PM is on record stating he would veto any such legislation immediately. I mean the guys not dumb given the stakes.

If we want to go one step farther and assume he’s lying (just for the fun of it I suppose), remember that the law is still clearly on Rio’s side and the company is on record stating it wouldn’t stand for it and would fight it if necessary in court. So Rio has made clear that any change in current terms won’t fly and hence under that scenario the case would end up in arbitration within the international court system and hence, any ruling would almost certainly come down in Rio’s favor given what are very clear, mutually beneficial terms that were obviously understood to be legally binding at the time of signing by both parties involved. I’m no lawyer, but this just seems self-evident. So worst, worst, worst-case production gets temporarily delayed 6-12 months as the issue gets settled in court and the economy takes a near-term hit in the meantime.

Lastly, the embedded growth derived from OT & TT “turning on” is a lock regardless of what the future brings on all of the above fronts. I bring it up again because remember that as they “turn on,” these mega mines will in and of themselves fuel substantial gains in GDP and average incomes relative to present run rates – and hence in the value of MGG’s RE portfolio irrespective of the macro. No matter what happens, Oyi Tolgoi ramps up and that is really all that matters in terms of this thesis working. Strictly speaking, the idiocy of politicians is not an impediment to investment success.

Think about it like this, even if we assume the worst-case scenario where the government goes nuts (highly unlikely imo) and rips up OT’s existing agreement and somehow gets away with reinstituting a new contract where Rio is essentially nothing more than a contract miner earning a 10% IRR after it recoups its initial investment (with the rest of the economics going to the government) – and that nonsense stands in court – even then, Mongolian GDP will still roughly double when all is said and done. Meaning OT & TT still get built and hence run rate GDP of $8B becomes “steady state” GDP approximating ~$16B+.

The takeaway is that GDP should approximately double in ~3 years regardless and that this doubling is highly predictable. Put another way, if OT & TT turn on GDP will double and given that our downtown UB RE should appreciate at a rate of 3x that, the value of MGG’s portfolio could easily triple in value even under the most draconian – not to mention improbable – scenarios we can imagine. Again, the above assumes the government does something stupid and most of today’s projects in the works ultimately get nixed as FDI throttles back due to fear surrounding political risk.

Other critical points to internalize is that most of the politicians in power today are amongst the countries wealthiest citizens and therefore they have the most to lose by spooking the international investment community with the specter of sovereign risk. I say that with confidence because in Mongolia the political and business elite are one and the same, and because most of them actually own either 1) large interests in the mines that FDI has been – and will be – developed or 2) if not the mines, certainly any multitude of supply chain related businesses that stand to benefit royally as the country continues to develop/modernize over time. So rest assured the politicians are cognizant of what’s at stake here and any acts of staggering idiocy along these fronts would hit them directly where it hurts (i.e. in their pocketbook).

Also critical is that as Harris has mentioned, the Mongolian people have already “stubbed their toes badly” in this respect with the 2006 excess profits tax, an 85% tax that was partially repealed (almost instantaneously) in 2006 and fully repealed by 2009. From everything we’ve read and/or heard from those in a position to know, the folly of this act was apparent to everyone, everywhere, and pretty much immediately. I mean with the switch of a button, Mongolian FDI and most of the countries mining related jobs/projects ground to a halt and the country was for all intents and purposes plunged into a severe bout of economic distress in the blink of an eye – and again, it took almost 3 years for the damage of that one act to be undone. Maybe it’s just me, but people don’t forget things like that very easily. So its no small point that the memory of what awaits such short sighted decision making is still fresh and/or that the political class stands to lose considerably from a financial standpoint should the minority of the countries politicians somehow succeed in tarnishing the countries reputation as an ideal/safe destination for investment capital. Again, I just don’t see it happening.

Last but not least, consider that the government absolutely needs foreign investors (read the associated tax revenues that these investments will generate) in order for to be able to come up with the billions in requisite funding needed to 1) repair the countries crumbling infrastructure and 2) support economic development in the countries others sectors. For anyone familiar with the situation this is a very big deal as without continued FDI, the Mongolian government would be likely be sh%t out of luck as far as alleviating so many of the infrastructure related issues currently plaguing the country. The cold hard reality is that politicians need this to happen to deliver on their existing promises to their constituents – let alone to deliver on promises relating to a brighter future. In other words, they need it to keep their jobs. That’s the beauty, as unlike most frontier markets and their dictatorial strong men that run the country uncontested (usually with an iron fist) – Mongolian politicians live in fear of losing their jobs just like the politicians in our own or any truly democratic society for that matter, after all, they have two decades of experience watching peers get kicked to the curb which tends to make an impression. Also, none of the political parties or individual politicians have enough power to not fear the reaper, as witnessed by the recent jailing of one of, if not the most, powerful politicians in the country. Because of this, again just like our own politicians, they tend to do what they need to do to ensure they keep their jobs, and not to be a cynic but if there is one thing politicians as a group can be counted on to do, it’s cover their ass and act on an opportunity that ensures their job/advances their own interests. We’re covered on both fronts.

Add it all up and our conclusion is that the majority of Mongolians and the politicians in power are both incentivized and eminently aware that capitalizing on the countries resource wealth is the ONLY way forward. Meaning, they understand that jeopardizing the investments that they depend on by enacting myopic legislation is akin to playing Russian roulette and for what, an extra 15% or whatever of OT’s equity? To say that would be self-defeating, and all around shockingly dumb isn’t the half of it. It’s not like it takes a genius to realize that chasing away the precious capital and investment at this stage in the game would level any hope the government has of achieving its plans, as without the profits from its natural resources, those plans are dead in the water. Everyone loses. Big time. So not only would all Mongolians suffer, the current politicians (read the business elite) would bear the brunt of it, as it’s likely they would not only be out of a job, but vastly poorer.

Now all of the above doesn’t stop western journalists from pasting every scary word they hear from opposition minded Mongolian parliament members every chance they get (and the political circus like press conferences they seem to hold on a bi-weekly basis). We reiterate this point not to beat a dead horse, but to crystalize how this type of thing out of context tends to unnecessarily exacerbate fear/dampen sentiment, and hence leads to overblown concerns regarding political risk when a close examination of the facts and underlying situational dynamics at play strongly suggests it’s just noise. All of this is not to say that that government related risks aren’t real to certain degrees, just that whatever happens we don’t think it will kill the golden goose and that the headlines plastered in the western press typically don’t come close to telling the whole story. Again, perception isn’t necessarily reality, especially in this case, where the members of the MP party are a small minority that happens to be unusually hysterical in their quest to strap what amounts to a stick of nuclear dynamite in the engine of Mongolian progress and economic growth. They will fail miserably, just as they have at every point so far.

We want to close by quickly mentioning that we think this article posted below on the second order effects of rising taxes at OT and other emerging Mongolian copper producers (published a couple weeks back) obviously overstates the risks of the new proposal set to come before Parliament, lacking the balance and context in terms of the larger picture which we’ve tried to synopsize in brief.

http://dealbook.nytimes.com/2012/10/15/tax-proposal-in-mongolia-threatens-rio-tinto-project/

For clarity’s sake, the new proposal set to go before parliament detailed in the article above isn’t OT specific – again, those OT specific proposals have already been voted down twice in the last couple of months – but an entirely new law aimed at the copper industry itself. The proposal, if passed, would add an additional ~300m USD in tax liability (by revoking income tax allowances), not to mention introduce a sliding mine royalty that scales up to 20% depending on the copper price at the time in question, which is considerably higher than the fixed 5% rate guaranteed under OT’s existing agreement.

Bottom line is that (as always) anything can happen, but as we hoped we’ve made clear, 1) passage of this bill wouldn’t kill the thesis and 2) a large amount of caution against reading too much into recent press is more than warranted.

At the end of the day we continue to think all signs point towards a bright road ahead for Mongolia. We’re of the opinion that Mongolia’s history says a lot about its future much like the operational track record of a 20 year old corporation does about its own. Sure the world could be upside down tomorrow we just don’t think its likely for much the same reason. The momentum of the last twenty years of history are on its side. That, and they appear to have take the cheap tuition to of the last decade to heart, and possess all the key ingredients necessary for sustained, long-term success (an exceedingly rare combination we might add) – such as an educated, hard working, entrepreneurial culture, a young population – 60% of the population is under 26, can you say baby boom? Wonder what that will do for property prices given a relatively fixed supply due to structural reasons but I digress. They also have a multi-decade history of stable democracy marked by peaceful transitions, a fully functioning legal system with a long history of respecting property rights and the rule of law, relatively low levels of corruption etc. etc. and so ultimately, we think Mongolia has a very high probability of harnessing its vast potential and becoming the wealth creating juggernaut of a country it was destined to be. We’ve positioned ourselves accordingly and look forward to a long, hugely profitable ride as this transition takes place in the months and years ahead.

Development/Production Delays at OT/TT

Closely related to the above, there is a chance that the final piece of the OT production puzzle, namely the ability of Rio Tinto to hook the mine up to nearby Chinese power lines gets scuffled somehow. Given what’s at stake, various tea leaves, etc. we doubt a mutually acceptable agreement won’t be reached near-term but even in the worst case scenario, all this would do is delay the commencement of commercial production by ~6 months or so as Rio would need to build the power capacity themselves. Like with the specter of an arbitration hearing, this would amount to a slight kick in the balls (i.e. a near-term pullback in the economy) but nothing game changing as it would push production back 6 months to a year max.

Commodity Risk

As with any country where the economy is commodity driven, Mongolia is to a certain degree affected by commodity prices and a sustained collapse in pricing obviously wouldn’t be a great thing. Given the countries structural cost advantage though, prices don’t need to improve or even stay at current levels for the thesis to work.

Also, the macro shock risk is real and while I think MGG weathers the storm much better than most, a systematic financial crisis wouldn’t be a good thing as far as FDI/capital flows are concerned. Capital flight would temporarily delay the day Mongolia realizes its full potential.

Geopolitical Tensions with China and/or Russia (Sovereign Risks)

To paraphrase Harris, there’s always a chance China and/or Russia decide to “bring the tanks in,” and while a highly remote possibility it should be noted as a risk.

Corporate Governance

With 1) a sole mandate to create shareholder value 2) a 33% ownership stake 3) full transparency, accountability to investors and an impressive BOD 4) independent verification that all MGG’s property titles are clean 5) Price Waterhouse Coopers doing the books and 6) Cushman Wakefield taking care of the property appraisals etc. etc., we think we are in good hands. As such a small company, it’s telling in my mind they didn’t skimp on fees (and they usually do, though in the good way) and hired world class auditors and appraisers because it was the right thing to do all things considered.

Let me preempt the equity raise question by noting that the up-raises were accretive to per share value as they were done at a premium to NAV and that capital was deployed at very high rates of return. The second they do a raise that’s dilutive rest assured I’ll be the first one in their ear. Don’t see it happening though given Harris and COO Jordan Calonego are both excellent capital allocators, so rest assured they have a firm understanding of what is and what is not, dilutive – and given inside ownership of 33% and the fact that they have put up millions in capital of their own money. I’m pretty sure they aren’t interested in diluting themselves to go empire building given they don’t even pay themselves a salary (there’s no upside, only downside to doing so). So between that and various other data points, MGG might be one of, if not the most shareholder-friendly I’ve ever invested in and it shows (in so many different ways). For example, as noted above, they hired world class auditors and appraisers in order to give maximum comfort to their shareholders yet they’ve raised ~$51m in capital so far, and every time they did a non-brokered deal because they didn’t want to pay the fees. Notice the pattern of spending money like they would if it was their own (which a large part of it is).

Couple more points. The raises were also done because they were approached by the right type of long-term shareholder that wanted to get in, and MGG wanted to have them, and because increasing the liquidity of the stock adds value. Additionally, in order to up-list the company had to meet minimum # of shareholder requirements. The raises helped out on all those fronts.

All that said, I tend to like the idea of additional capital raises going forward as long as they are done above “true” book value because I believe they would be significantly accretive to an already largely fixed cost base and because the window to deploy capital at these super attractive rates is closing. Operating leverage to having a larger property portfolio spread out over a fixed cost base is significant. Equally as importantly, in real estate having a bigger property portfolio is better, not only because of the substantial fixed cost leverage involved, but because having a broader portfolio gives them more negotiating leverage with tenants, and allows them to more easily gain large prospective clients like a YUM brands, where by having a wider selection of property locations to showcase they are able to meet a wider, more varied set of needs.

In terms of the initial policy on no options, and the seeming flip-flopping in that regard, rest assured it isn’t what it seems. First, its not like they are issuing additional stock to themselves (these guys don’t even pay themselves a salary) and second, the options they’ve issued so far were done solely to attract/retain local talent. Really high quality (smart), enterprising locals are naturally hard to find and so when you hire them you want them to stay and giving them an ownership stake in the company is the best way to do that. Historically, some of their best people were getting poached by large multinationals and so MGG decided it was the right way to go in order to make churn less of an issue. They can be cheap skates with quarterly turnover and have their best in brightest stolen from them or they can issue some options judiciously and try and strike the right balance. I think they are doing the right thing.

Last but not least, just take a quick look at MGG’s board, which consists of Ross Beauty’s right hand man in terms of corporate governance or notable short-seller Bill Fleckenstein (who’s also one of the largest shareholders of the company) to name a few. This is an impressive BOD for such a small, off the radar company. I think that’s telling.

Dutch Disease

In terms of the risks of Mongolia catching a case of “dutch disease,” check out the BDSec overview on the new coalition government’s latest DP plan for some good color. The DP plan is basically the government’s framework for policy decisions going forward and I think its pretty clear that they are going about things in an intelligent way designed to minimize these risks. I believe they are using Chile as a template for how to do things right.

Also important in terms of thinking about Mongolia’s ability to successfully navigate the resource curse, the mongols are/will be getting granted stock in these IPO’s like with TT. So if the mines flourish, so will the average mongolian in terms of wealth. They will certainly be much richer than they are now. That should keep a lid on a lot of the envy. Instead of a “he’s getting rich” and “I’m still poor” it’s more “where did all this free money come and its nice that we are all getting wealthier – I want more of this” if you follow me. Embracing free market capitalist principles will make everyone far far richer in the end…and again, I think they realize that and not just on some superficial level. That said, MGG’s portfolio is actually set up in a way to benefit from “dutch disease” in the near to medium term so keep that in mind as well.

Helpful Documents:

Thesis PDF (just in case the formatting doesn’t come through)

MGG Corporate & Property Presentations

BDSec Report: The Heavy Hand of Government Lightens Up

http://www.scribd.com/doc/110231053/MGG-the-Heavy-Hand-of-Government-Lightens-Up

BDSec Report: New Securities/Market Law Draft A Potential Game Changer for Mongolian Capital Markets

http://www.scribd.com/doc/110231132/MGG-New-Securities-Market-Law-Draft-A-Potential-Game-Changer-for-Mongolian-Capital-Markets

BDSec Report: Mongolian Portfolio Strategy

http://www.scribd.com/doc/110231162/MGG-Mongolia-Portfolio-Strategy

Mongolia Overview:

http://www.scribd.com/doc/110231012/Mongolia-Report

Capitalist Exploits (Mongolia related posts & Kupperman interview)

http://www.capitalistexploits.at/tag/mongolia/

Adventures in Capitalism Mongolia Related Blog Posts:

http://adventuresincapitalism.com/search.aspx?q=Mongolia

Business Week Article

http://www.businessweek.com/magazine/foreign-money-invades-mongolia-0721201

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Simply awesome!

Q3 2006

Q1 2008

Another must read

Ned Goodman’s latest…

The investment analysis below is our sixteenth in our ongoing series of guest posts, and is brought to you by friend of the blog Torin Eastburn, portfolio manager of Monte Sol Capital and second order thinker extraordinaire (see below). Torin founded Monte Sol in January 2012. Prior to founding Monte Sol, he was employed as an equity analyst at CJS Securities, a sell-side brokerage firm that provides small-cap research to institutional investors. He is a CFA charterholder and a 2006 graduate of St. John’s College in Santa Fe, New Mexico.

As a long-time shareholder in Radiant, I’ve shared Torin’s belief that there are currently some very compelling investment opportunities in the 3PL industry for quite some time now, and hence wanted to share his wonderful piece with my readers on Radiant and the 3PL space in general. For patient investors willing to look out 3-5 years and perhaps bear some volatility along the way, I think an investment at or around today’s price is likely to do very, very well – and while Radiant is admittedly an economically sensitive business in an increasingly uncertain world, I would remind potential investors that this is a non asset based forwarding network that should grow at order-of-magnitude faster than GDP, has fixed SG&A, network effects, operating leverage, minimal capex, high/improving ROIC in a stable to growing world, no-brainer buyback potential at low to mid single digit normalized EBIT, and near certain multiple expansion once it gets to critical scale and comparisons to the bigger boys becomes more appropriate.

Of course if we get a global recession over the next year or so Radiant may come under pressure, but I remain convinced that such an outcome is nothing to fear and perhaps may ultimately represent what I consider an almost “best case” outcome, as I imagine the thinner margins of the small players would almost certainly get hammered under such scenario, offering up a buffet of incredibly compelling acquisition opportunities at rock bottom prices, and in the process setting the stage for Radiant to emerge at the other end of the cycle materially stronger then it was on its way in. In Bohn I trust.

Anyhow, before I turn it over to Torin, I wanted to quickly plug his brand new (and quite fantastic) blog – make sure to check it out.

Enjoy!

Overview

Third-party logistics, or “3PL”, involves arranging the transport and/or storage of someone else’s goods. Third-party logistics companies serve as middle men between companies that want to have goods moved (the customers) and companies that do the moving (the shippers). If you, the reader, want to ship a parcel somewhere, all you have to do is take it to UPS, FedEx, or DHL. But what if you want to ship a truckload of goods from Seattle to Bozeman? Who do you call? There are more than one million trucking companies in the United States. And what if your shipment’s destination is not Bozeman, but Bangladesh?

Or let’s say you run a small or mid-sized business. Your company is great at designing products, or selling products, yet you seem to spend a lot of your time, money, and energy just figuring out how to move your inventory from the port to the warehouse to the retail location. Isn’t there someone who can take care of all of that so that you can focus solely on your products and your customers?

Enter the 3PLs. These are companies that don’t typically own transportation assets like trucks and containers. Instead, they have relationships with thousands of shippers—trucking companies, railroads, and air and ocean cargo companies. The most common type of 3PL is a freight broker. A freight broker evaluates its customer’s shipping needs and then polls its own network of shippers with whom it has relationships, in order to figure out how to get the cargo to its destination cheaply and on-time. In some cases this might involve just one shipper, and in some cases it might involve multiple shippers and multiple transport modes (ocean then rail then truck, for instance).

Different brokers are good at different things. Some brokers focus on trucking while others focus on air freight. Some focus on domestic freight while others focus on cross-border freight. Some focus on slow-moving freight while others focus on time-definite freight. Some focus on the food industry while others focus on autos. And so on. In some cases freight brokers contract with shipping companies on a freelance basis, and in some cases the two parties have an ongoing, or even exclusive, arrangement. The same is true for the customer-broker relationship. Sometimes the two parties only transact a few times a year, and sometimes they do business together every day. It all depends.

Freight brokers serve a number of purposes. The most fundamental purpose is the aggregation and matching of supply and demand. The brokers obviate the need for each customer to call each shipper, something which would be terribly inefficient. Brokers also increase customers’ purchasing power by pooling orders, and decrease costly “deadhead” miles by finding secondary shipping customer who have cargo to ship ‘back’ on the return journey. As compensation for their services, brokers take a cut of the shipping fee, typically 20% or so.

In addition to brokers, there are many other types of 3PLs. Freight forwarders, for instance, assemble cargo from multiple shipping customers into one load in order to take advantage of bulk shipping rates. Customs brokers take care of the customs process for cross-border freight. “Reverse” logistics 3PLs handle product recalls, refurbishment, or recycling for their customers. At its most complex, third-party logistics can involve the outsourcing of virtually the entire supply chain, up to and including warehousing, distribution, and even light assembly.

Armstrong & Associates, an independent research firm dedicated to the 3PL industry, estimates that the U.S. 3PL market is about $140 billion in size on a gross revenue basis. “Gross” revenue refers the total cost of shipment, including what is paid to the shipper, as opposed to “net” revenue, which refers only to the broker’s ~20% share. So while gross revenue is ~$140 billion for the 3PL industry, the actual share of revenue kept by the 3PLs is probably closer to $30 billion.

A&A breaks down the 3PL industry into four subsectors: domestic transportation management (about $40 billion in size on a gross revenue basis), international transportation management (also $40 billion), value-added warehousing ($35 billion), and dedicated contract carriage (~$10 billion), which is essentially another form of domestic transportation.

Despite being quite large, the 3PL industry has grown at an 11% CAGR for the last fifteen years, even with the interruption of the global financial crisis. Industry growth has been driven mainly by two things: the increasing globalization of trade, and greater adoption of supply chain outsourcing by large corporations. In 2001 only 46% of Fortune 500 companies used 3PLs, but by 2008 that usage rate had increased to 77%, and my guess is the rate is probably closer to 85% today. The chart below, which is in billions of U.S. dollars, provides a good visual representation of the industry’s growth.

The 3PL industry is extremely fragmented. Domestic U.S. trucking is a $650 billion business, yet C.H. Robinson (CHRW), the largest truck broker in the U.S., generates just $9 billion of gross transportation revenue. That means it only brokers 2.5% or so of U.S. truck freight. Landstar (LSTR) is probably the second-largest truck broker in the U.S., and its $2.7 billion of truck brokerage revenue accounts for less than 1% of total U.S. truck freight.

Why is the industry so fragmented? There are many reasons, but the big ones seem to be the fragmentation of the trucking industry itself (there are more than 1.2 million trucking companies in the U.S., and 90% of them operate less than seven trucks) and the cost of growth to brokers. The first reason is fairly self-explanatory: since the trucking industry is fragmented, the truck brokerage industry (the largest 3PL niche), which has grown up alongside it, is too.

The second reason, the cost of growth, bears a little more explanation. Most small brokers cannot grow quickly because they cannot fund the associated increase in working capital. Freight brokers extend credit to their customers as an inducement to do business. A consequence of this practice is that when a broker books a load of cargo, it must pay the shipping company before it receives actual payment from the customer. As a result most freight brokers have accounts receivable balances (which is the money owed to the broker by its customers) that are 50% to 100% larger than their accounts payable balances (the money the broker owes to shipping companies).

Why is this such a big deal? Well, the receivables/payables difference is usually equal to about 5% of gross sales. Take a small broker with $50M of gross revenue and $1M of EBITDA (2% margin). If this broker’s sales grow by 30%, to $65M, the increase in working capital is going to be about $750k (the $15M increase in sales multiplied by the 5% accounts receivable/payable difference). Because this fictitious broker’s $1M of EBITDA equals about $500k of after-tax income, growing 30% in a year actually requires more incremental working capital than the business itself produces in profits.

This is a difficult problem for small brokers to overcome, and makes it hard for small brokers to grow large. The only obvious solutions are to A) increase sales or profit margins and thereby profits, or B) establish a relationship with a large and willing lender. Unfortunately for the small brokers, both of those are hard to do without having size and scale in the first place.

Because growing as a freight broker is so hard when you’re small, the industry has tens of thousands of tiny brokers that each focus on one or a few shipping lanes and/or shipping modes, but relatively few large brokers with global, diversified service offerings.

Yesterday, Today, Tomorrow

The U.S. 3PL industry was more or less born out of the Motor Carrier Act of 1980. This act deregulated trucking, morphing it from a concentrated and somewhat cozy industry into an extremely fragmented and price-competitive one. The result was an explosion in the number of trucking carriers: there were less than 20,000 in 1980, but there are 1.2 million today. This explosion necessitated a middle man to help the customer navigate the multitude of new trucking options. 3PLs were born, many in the form of truck brokers.

Then came China. Economic initiatives implemented there in 1990 quickly turned the country into the global epicenter of low-cost manufacturing. This made almost all finished goods and components cheaper, but it also added great complexity to global supply chains. Sourcing goods and components, shipping them, storing them, and keeping track of them became something companies no longer wanted (or could) do on their own, so they started hiring 3PLs. In 2001 only 46% of Fortune 500 companies used 3PLs, but today about 85% do.

Finally came computers and the internet. Software has enabled great advances in the efficiency of logistics and distribution. More importantly though, as the internet has turned retailing into an art of scale and distribution rather than of selling, use of 3PLs by retailers and tech/consumer goods companies has grown dramatically. Once upon a time, moving agricultural products from farms to factories and grocery stores was the U.S. 3PL industry’s biggest business. Today, moving consumer goods is far larger.

Trucking deregulation, Chinese manufacturing, and internet retailing took the 3PL industry from virtually nothing in 1980 to $140 billion today. But those trends are losing steam. While online retailing continues to grow faster than traditional retailing, the growth rate is slowing. And on absolute basis, U.S. online retail sales are growing by $20-25 billion each year, but not much more or less. So while Internet retailing will continue to drive 3PL usage at the margin, the growth won’t be industry-changing like it once was.

Globalization also seems to have played out as a driver of 3PL growth, as virtually all large companies have become sophisticated outsourcers by now. Nearly all Fortune 100 companies use 3PLs, and more than 80% of the largest 300 Fortune companies do. Since these 300 largest companies account for 90% of total Fortune 500 revenue, the remaining opportunity for offshoring-driven 3PL use is probably quite small.

If the 3PL’s industry two biggest growth drivers of the last fifteen years are losing power, it seems reasonable to question whether the industry is starting to mature. The table below, which shows “then & now” growth rates for some of the largest 3PLs, appears to confirm this suspicion, although with the caveat that recent growth rates include the global financial crisis.

So what opportunities remain?

Today, many investors and 3PLs are focused on U.S. truck brokerage as the next driver of industry growth. The domestic trucking industry generates about $350 billion of revenue annually, but 3PL gross revenue from domestic transportation management (“DTM”) is only $50 billion. That means just 15% of trucking revenue, at most, goes through a broker. Here is what Bradley Jacobs, the CEO of XPO Logistics (and formerly the founder and CEO of United Rentals and United Waste Systems), has to say about the truck brokerage opportunity:

For me, [truck brokerage penetration] was a very important point, because my bet is that the $50 billion penetration – which is 15% of the total trucking transportation spend in the United States – is going to increase significantly. It’s a very similar bet to the one I made at United Rentals, where I saw a lot of construction equipment that was under-utilized. It was being used only a week or two, or maybe a month total out of a year. Yet people were buying the equipment. I was certain that over time, people would rent that equipment instead of buying it.  And the penetration of equipment rental has indeed grown from 15% in 1997 to around 45% today.

I think it’s a very similar situation with the way transportation is purchased in the United States. That 15% is going to increase. If you look at the growth rates of brokerage versus trucking as a whole, trucking has mainly been going up and down with GDP. The outsourcing to brokers, on the other hand, has been growing at two or three times GDP.

I think the reason the pie is growing is because it makes good economic sense to use a broker. The Fortune 500 have discovered that about brokerage. 85% of the Fortune 500 uses a broker. But below the Fortune 500, transportation is very inefficiently purchased, by and large. The average small-to-medium sized shipper doesn’t have a freight department, and frankly, for the amount of freight that they move, they really shouldn’t have people dedicated to checking out the market all day long. That should be outsourced to brokers like C.H. Robinson, Echo, or hopefully XPO Logistics.

Mr. Jacobs makes a compelling case, and it seems quite likely that brokerage will indeed continue to grow faster than GDP. But DTM is already the single most-used service among existing North American 3PL customers, with 75% reporting using it. This means the opportunity is probably not massive like it was 10 years ago, which will be a limiting factor of growth. Arguing more favorably for truck brokerage though, DTM’s high penetration rate among existing 3PL customers suggests that DTM will often be the first service adopted by future 3PL customers. It is also worth pointing out that North America’s 75% DTM usage rate is the lowest of all the major regions—European, Asian, and Latin American DTM usage rates are 94%, 89%, and 80% respectively. So I am of two minds about the U.S. truck brokerage opportunity. The opportunity is clearly there, but its size is up for debate given the already-high penetration of DTM among large U.S. companies.

The Few and the Many

I don’t want to bet against Mr. Jacobs’ track record, but I do wonder if consolidation is not the bigger opportunity. The early phase of consolidation has already enabled aggressive mid-tier 3PLs to grow at astonishing rates. ECHO’s 5-year revenue CAGR is 79%. Coyote, a similar-sized but private 3PL company, has grown 73% annually for the last five years. XPO, RLGT, and AUTO all have grown at about 30%. The growth rates of the big 3PLs pale in comparison.

The 3PL giants like C.H. Robinson and Expeditors International never needed acquisitions to grow, because they climbed onto the 3PL wave at its earliest point. So acquisitions never became a part of their corporate cultures. But for the mid-sized 3PLs who came later to the party or haven’t reached the same scale, consolidation has been an integral part of the business plan. ECHO has made 13 acquisitions since 2007. NFI, a private 3PL company, has made 11 since 2000. RLGT has made six in its short history. XPO has $200 million sitting in the bank, and all of it is earmarked for acquisitions.

Consolidation has clearly already started, but I think we are still in the early stages, for four big reasons.

Reason 1: Fragmentation

Even after the early phase of consolidation, the industry remains extremely fragmented. I’ve already discussed this point in some depth so I won’t belabor it here. 3PL fragmentation exists in part because 3PL’s biggest economic partner, the trucking industry, is itself extraordinarily fragmented, and in part because of the current stage of the 3PL’s industry lifecycle. The typical cycle involves a great proliferation of companies during the industry’s rapid expansion phase, and then consolidation as maturity arrives.

Reason 2: Advantages to Scale

In the 3PL industry, life gets better as you get bigger. The chart below is the most succinct way I can think of to illustrate the advantage of being big.

Clearly, bigger means more profitable. Much of 3PL corporate spending—payroll, financial & tax reporting, IT—can be scaled at minimal cost. Take software, which is rapidly becoming one of the most important competitive advantages a good 3PL can have. If two 3PL companies each spend $10 million to develop the same software suite, but the first company has 1,000 employees while the second has 2,000, then the first company is paying twice as much per employee for the same software system. So the bigger you are, the more value you get for your corporate dollar.

Another natural result of this scale effect is that as freight brokers grow, their return on investment improves. The investment to support the first hundred million dollars of revenue is much greater than the investment needed to support the second hundred million dollars of revenue, and so on. The cost to hook up the one hundredth sales associate to your network is de minimis. So mature providers earn returns on equity in the 20-40% range while the smaller, younger 3PL companies like those at the bottom left of the chart above generate ROEs closer to the 10-15% range—still good, but not elite like the mature 3PLs.

The steepness of the 3PL margin curve also means that the larger a 3PL provider gets, the easier a time it has financing its growth. At the end of Part 1 I gave an example of a small freight broker that earns a 2% EBITDA margin and does not make enough money to take advantage of the rapid growth opportunities that exist in the industry. But for big 3PLs who earn 6% to 8% EBITDA margins, financing growth is no problem. After-tax profits are not only large enough to pay for increased working capital, they leave huge amounts of cash to be distributed to shareholders every year.

Being larger also makes your earnings less cyclical, because changes in revenue (the X axis) on the right side of the 3PL margin curve entail much smaller margin shifts (the Y axis) than do changes on the left side of the curve. Add in the fact that during recessions freed up shipping capacity lowers the price of transportation and thus raises 3PL margins, and you will typically see the big 3PLs lose much less in profit than in revenue during bad times. The results below, from 2009, demonstrate this.

Being small—especially really small—is hard.

Reason 3: Father Time

The Motor Carrier Act, the 3PL industry’s version of the big bang, went into effect in 1980. If the average 3PL entrepreneur was 30 years old then, he or she is 62 now and thinking about retirement and succession. Many of the 3PL businesses that were started back then are still quite small, and without the “head guy”, they face uncertain futures. To cash out while also ensuring that the business lives on in some form, many of these entrepreneurs will have no choice but to sell to larger 3PLs, either for cash or for equity in the acquiring organization.

Reason 4: Value Creation

This might be the most compelling reason of all for consolidation. Because many of the small 3PLs are not self-sustaining without the talent and motivation of their primary owners, they are in a tough position from a negotiating perspective. They simply cannot command high prices when they sell themselves. EBITDA multiples in M&A deals for 3PLs/brokers with EBITDA in the single-digit millions have historically been for 4-6x EBITDA, with part of the consideration paid up-front and the remainder paid in the form a multi-year earn-out. In contrast, established mid-sized and large 3PLs generally trade for 10-15x EBITDA, making the opportunity for value creation through M&A enormous.

Why Mid-Sized is the Right Size

If more consolidation is coming, what is the best way for an investor to profit from it?

I don’t think the big 3PLs are the way to go. They are good companies and they have scale-related advantages over smaller competitors, especially very small ones, but they all trade at high multiples and their growth may be slowing, as previously discussed. This fact alone makes them unattractive from an investment standpoint.

More importantly, these big guys are simply too big to be the prime beneficiaries of the consolidation I’ve talked about. The greatest quantity of M&A opportunities is at the small end of the industry—companies with EBITDA below $10 million. The big 3PLs have EBITDA in the many hundreds of millions. For them, $10 million doesn’t move the needle. The due diligence isn’t worth the time. Buying companies with more than $10 million of EBITDA is an option, but the opportunity for value creation isn’t there because any acquisition of that size is probably not going to happen at an EBITDA multiple much below 10x.

So the big guys are off the table, unless you’re working with an enormous capital base and you can only buy large cap companies. What about the small guys, say those with less than $100 million of gross revenue? They’re too small to be public, so you can’t invest in them unless you’re a PE or VC firm. But even if you could, realizing high returns would be a challenge. Survival is getting tougher for tiny 3PLs, and because these guys sell for such low multiples in M&A transactions, it would be hard to make a killing even if you could successfully identify the companies that will be bought out.

That leaves the mid-sized 3PLs—those with gross revenue of roughly $100 million to $1 billion—as the companies that are best-positioned to capitalize on 3PL consolidation.

On the one hand, the market has shown a willingness to award mid-sized 3PLs the same big multiples (see ECHO and XPO) that it awards the mature 3PLs. That means creating value through the acquisition of tiny 3PLs at 4-6x EBITDA is a very real opportunity for the mid-sized 3PLs, especially since they are still small enough for $10 million EBITDA deals to be meaningful to their growth.

On the other hand, I think the big guys could end up needing to make acquisitions to keep growing. All of them still sport the double-digit EBITDA multiples befitting high-quality growth companies, but continued high growth is far from certain. If their growth remains subdued, markets are going to start questioning whether the big 3PLs are still the growth machines they once were. If that happens, I would not be surprised to see some of the bigger 3PLs that have historically shunned acquisitions finally turn to them as a way to restore lost growth. And since the tiny private 3PLs are too small to move the needle, the only sensible targets will be the mid-sized guys who have already gotten fat consolidating the tiny guys.

This makes the mid-sized 3PLs doubly attractive from an investment standpoint. Not only will mid-sized 3PLs be the ones who get most of the benefit from M&A value creation, but some of them may also end up getting bought out for very sizeable EBITDA multiples by the bigger guys.

Now to Radiant and the specific opportunity…

Summary:

• Non-asset-based 3PL provider with a focus on expedited freight
• 5 year revenue CAGR of 34%
• The 3PL industry has grown 10% annually for 15 years and is now starting to consolidate
• Vast consolidation opportunity means there is no end in sight to growth for RLGT and select peers
• Currently trades at 8x FCF and under 6x EBITDA based on NTM guidance
• Peers trade at 10-15x EBITDA
• Stellar CEO owns 30% of company, recently bought shares in open market

RLGT has been written up multiples times elsewhere, and on VIC as well. I am writing it up yet again because the stock’s recent pullback, has driven RLGT shares to a price at which I believe ANY microcap investor—growth, value, whatever—should take notice.

Some quick background:

The non-asset-based and asset-light 3PL industry consists primarily of intermediaries who organize the storage and transport of goods, both domestically and internationally. Most of them don’t own transportation assets, just relationships with shipping customers and shippers. Driven by supply chain modernization and the globalization of trade, the 3PL industry has grown 10% per year for 15 years. The industry is extremely fragmented, with the largest U.S. 3PL, C.H. Robinson, having only a 2% domestic share.

The economics of the 3PL business are great at scale. The 3PLs that have focused on the right niches of the industry have grown their revenues at double-digit rates for a long, long time, and all of the large well-run 3PLs earn ROEs of at least 20% and generate a tons of cash. The market has rewarded them each with EBITDA multiples in the 11-12x range.

But things are starting to change in the industry. In 2001 only 46% of Fortune 500 companies used 3PLs. Today, about 85% do. As a result, the adoption of 3PL services by large corporations is losing strength as a driver of growth. This is causing the top end of the industry to mature, as the big 3PLs rely most heavily on large corporations as customers.

The next step in the industry lifecycle is to consolidate. The 3PL industry is profoundly fragmented, consisting of thousands of companies, many of them little more than a few guys in an office arranging truckloads.

The industry’s fragmentation has two causes. The first is that the trucking industry, which is the backbone of the U.S. transportation system, is itself extraordinarily fragmented—there are more than 1.2 million trucking companies in the U.S., and 90% of them operate six or fewer trucks.

The second cause of the extreme fragmentation at the smaller end of the 3PL industry is working capital. In freight brokerage, the largest 3PL subsector, the dollar value of accounts receivable is typically 1.5-2.0x the value of accounts payable, so 3PLs must front money to grow. A lot of the small ones don’t have enough capital, which throttles growth and makes scale hard to achieve.

So there are a lot of very small 3PLs out there, and the small end of the industry is going to consolidate, which will be great for the consolidators. But there is one minor problem for the big guys like KNIN, CHRW, LSTR, and EXPD—they are too big. They all generate EBITDA in the hundreds of millions. Buying up 3PLs with EBITDA in the single-digit or low-double-digit millions won’t move the needle. The return on time invested is not sufficient to justify the investment.

So the mid-sized 3PLs (and smart PE and VC firms) are doing it. They are happy to oblige, because the tiny 3PL/freight brokerage businesses available for purchase are not indefinitely sustainable on a standalone basis, so their purchase prices are a pittance—typically 2-2.5x EBITDA in cash up front, and an additional 2-2.5x EBITDA in the form of a multi-year earn-out. Sometimes there is actually no price paid at all—a lot of the consolidation that goes on in the industry consists of attracting new sales agents from competitors and out of college with the allure of a larger shipping network to offer customers, as well as better IT and back office systems. Since the good 3PLs trade at 10x+ EBITDA, there is an obvious and enormous opportunity for value creation through consolidation.

Since consolidation has started, the mid-sized 3PLs doing the consolidating have grown at staggering rates. ECHO’s five-year revenue CAGR is 79%. Coyote Logistics, a private VC-funded 3PL, has posted a 73% CAGR. XPO’s number is 32%. RLGT’s is 34%. AUTO’s is 28%. The table below shows how the industry’s maturation and consolidation have shifted growth from the large 3PLs to the smaller ones.

5 Yr Rev CAGR as of 2005 5 Yr Rev CAGR as of today
SWX:KNIN 12% 1%
CHRW 15% 10%
EXPD 15% 5%
LSTR 12% 2%

ECHO 79%
Coyote 73%
AUTO 28%
RLGT 34%
XPO 32%

And because corporate costs can be scaled, EBITDA has been growing even faster. The incremental EBITDA margin on new sales is 6-8% depending on the mix of business, but the mid-sized 3PLs only earn 3-4% EBITDA margins, because they haven’t achieved full scale yet.

The 3PL business is cyclical, but with a few counter-cyclical features. During recessions excess transport capacity increases, which brings down the cost of shipping, thereby making shipping more economical than it was during the good times. In addition, companies looking to cut costs become more incentivized to outsource, which can bring additional work to 3PLs.

For the mid-sized 3PLs, economic cycles are even less of an issue because there are plenty of 3PLs out there for purchase, boom or bust. The deregulation of the U.S. trucking industry in 1980 basically gave birth to the 3PL industry, and the entrepreneurs who started 3PLs at age 30 in 1980 are now approaching 65 and looking for financial exits. In the dark days of 2009 the large 3PLs all saw healthy revenue declines, but most of the mid-sized consolidators actually grew, albeit with the help of acquisitions..

2009 Revenue Growth
SWX:KNIN -18%
CHRW -12%
EXPD -27%
LSTR -24%

ECHO 28%
Coyote 12%
AUTO 2%
RLGT 7%
XPO -9%

Why invest in RLGT specifically?

You can’t invest in Coyote because it’s private. ECHO is public but it trades at a big EBITDA multiple and its founders have a history of using very aggressive accounting. XPO too trades at an extreme price, because its CEO and largest owner, Brad Jacobs, has a long history of success rolling up fragmented industries. And AUTO is miniscule, with a $7.5M float. RLGT is all that’s left.

Luckily RLGT is not exactly a bad date to be stuck with. The company was founded in 2005 with $5M of equity capital by Bohn Crain. Today RLGT’s market cap is $60M, and its intrinsic value is easily in excess of $100M (and growing quickly). Mr. Crain was formerly a financial executive with CSX, Schneider Logistics, and a few other companies. He still owns 30% of RLGT, and has purchased shares in the open market on multiple occasions, including a purchase a few weeks ago. Substantially all of his net worth is invested in RLGT, and his salary is modest. He is an excellent manager, something you can learn by listening to RLGT’s conference calls. There are plenty of companies out there that are five times RLGT’s size but would be lucky to have Mr. Crain at the helm.

Why buy RLGT now? In a word, DBA.

DBA, or Distribution By Air, is a an expedited freight broker based in New Jersey. RLGT bought DBA in March of last year for $12M, making DBA Radiant’s largest acquisition yet. Unfortunately, to get the deal done RLGT broke one of its own cardinal rules and agreed to a deal without an earn-out. Not long after the acquisition closed, one of DBA’s owners left and went into competition with RLGT. RLGT sued, believing this constituted a breach of the noncompetition clause (it seems likely that it did, and that RLGT will receive monetary compensation in return).

The bad results at DBA as a result of the previous owner’s actions broke a string of otherwise-consistent margin improvement and profit growth for RLGT. Radiant’s management has been adamant that DBA will be fixed, however, and has released June 2013 guidance to substantiate that claim. The guidance calls for $13.5M of EBITDA, which puts the stock at under 6x EBITDA at the current price, and under 8x cash earnings. Thanks to operational improvements at DBA, RLGT should actually post improving results over the next 12 months even as the economy falters.

A few weeks ago, when the stock was below $1.80, Mr. Crain and a board member each bought $50k worth of stock. $50K is not a huge dollar amount on its own, but I view it as meaningful given that A) Mr. Crain is already up to his neck in RLGT exposure, and B) Mr. Crain made $450k in cash compensation in 2011, meaning that after taxes and living expenses his $50k purchase probably represented a decent portion of his discretionary income for the year.

Based on a simple 12x peer EBITDA multiple, RLGT should be a $4 stock. Looking out five years, EBITDA could easily be three or four or five times what it is now, and RLGT could easily be a $10-15 stock.

How many chances do you get to pay 8x FCF for a great business growing 30% a year, in strong financial shape, with a huge growth runway ahead of it, and run by an excellent CEO who has everything on the line?

Miscellaneous:

For those who are interested (Ryan here), I figured I’d also point you towards friend of the blog Adam Wyden of ADW Capital’s older write-ups on the name for some further color. Adam’s write-ups can be found here and here.

Wonderfully wise read illustrating the timeless truth that all intelligent active management is simply a “search for mistakes” or as Seth Klarman reminds us in the defining quote of this blog “while knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities.”

Indeed!

Enjoy!

Greenlight’s latest…

While certainly not the first time Einhorn has dazzled me with his wit, couldn’t help but be particularly delighted by this clever poke in Buffett’s eye vis a vi Gold.

“The debate around currencies, cash, and cash equivalents continues. Over the last few years, we have come to doubt whether cash will serve as a good store of value. If you wrapped up all the $100 bills in circulation, it would form a cube about 74 feet per side. If you stacked the money seven feet high, you could store it in a warehouse roughly the size of a football field. The value of all that cash would be about a trillion dollars. In a hundred years, that money will have produced nothing. In a thousand years, it is likely that the cash will either be worthless or worth very little. It will not pay you interest or dividends and it won’t grow earnings, though you could burn it for heat. You’d have to pay someone to guard it. You could fondle the money. Alternatively, you could take every U.S. note in circulation, lay them end to end, and cover the entire 116 square miles of Omaha, Nebraska. Of course, if you managed to assemble all that money into your own private stash, the Federal Reserve could simply order more to be printed for the rest of us.”

Enjoy!

The investment analysis below is our fifteenth in our ongoing series of guest posts, and is brought to you by friend of the blog Lane Sigurd. Lane‘s background is in oil & gas, and he author’s one of my favorite new blogs (the outstanding) Reminiscences of a Stock Blogger. I mean with a tag line like “moneyball without the ball” you know its good.

Lane and I have gone back and forth for almost a year now swapping ideas and digging for value, and it wasn’t long before I realized that not only did I love the way the guy thinks, but that we shared a similar addiction to the pursuit of misunderstood or under-appreciated value in the small and micro cap space. So a friendship was born and this is yet another example of a guest post that’s been a long time coming.

So with that said, let me introduce you to Lane’s latest on PHH, a write-up that we’ve been planning to co-release for a couple of months now and should help outline why we feel it’s pretty hard to lose here given the rock solid downside protection and the likely spin (or divestiture) of its fleet business at some point within the near to medium term. While not official, a close reading of the tea leaves (recent changes at the executive level, undeniable strategic and financial logic, etc. etc.) suggests we’ll see one sooner rather than later, and in the process provide shareholders with a high probability catalyst that would unlock substantial embedded value by forcing the market to assign a value to the companies market leading fleet operations. I don’t know about all of my readers preferences, but while I like cheap, I like cheap a whole lot more when its coupled with a high probability hard catalyst, and that’s what I think we have here.

If we’re right about all of this then (really, even if we aren’t), the asymmetry of an investment at or around today’s price is hard to ignore, as I think a spin should cause the stock to roughly double upon consummation, and any normalization in MSR multiples and housing generally could cause it to promptly double again as (1) servicing costs normalize (2) interest rates rise, and as a result (3) TBV is written up to reflect the true value of it’s long duration, high quality servicing annuity (fwiw, I think one could argue that the servicing cash flows are worth much more than say the normalized 4x-6x historical multiple given where we are in the cycle but that’s a discussion for another day and ultimately irrelevant to the thesis at this valuation).

Again though, with interest rates at a 30 year low (and more importantly, at the zero bound) they have nowhere else to go but up, which we would remind readers that this will start to choke off (1) any material refinancing activity (which shouldn’t consist of much looking forward as is given its reasonable to assume that most everyone that hasn’t refinance by this point probably can’t/won’t and (2) the slow drip of MSR related write downs that have been a constant headwind to this business for a very long time. The takeaway then is that PHH has already come through the worst of a multi-decade storm and given the valuation, the market has yet to take notice.

Add it all up, and it seems like this indeed has all the trappings of a classic Greenblatt style home run.  Enjoy!!!

Thesis:

I swear its the name of a book, not the punchline of an infomercial

You Can Be a Stock Market Genius was written by Joel Greenblatt in 1999.  It is an oft recommended book by value investors.  The recommendations, however, generally come with the following caveat, or something similar in effect:  “Now I know the title is awful but…”

If you can get past the cheesy title and into the meat, the book provides an investor with a wealth of knowledge, focusing on areas of the stock market that are overlooked by most investors, and explaining how you can find value there.

One opportunity that is discussed at length in the book is the spin-off. A spin-off typically occurs either when the company feels that the sum of the parts is greater than the whole, or when a bad business is overwhelming the perception of a good business.  Usually a spin-off involves two or more businesses that are mostly mutually exclusive from one another.

The basic premise of the spin-off is that the underlying businesses will be realized for a higher value separately then they are being realized for together.  In his book, Greenblatt focuses on the inefficiencies with the spin-off process.  In many cases investors of the original security will be more interested in one of the resulting securities than the other.  In some cases the spin-off will result in one entity that is far smaller than the other, and institutions with size limitations on what they can hold will be forced to sell.  These reasons lead to a lot of selling pressure over a short amount of time, which can depress one of the spin-off companies and lead to a good value situation.

I want to focus here on the basic premise of a spin-off; that the businesses that underly the parent company are undervalued as a whole, and that often there is money to be made simply from the recognition of value brought about by their separation.  The intent of the spin-off is to create value, and often times it works.  There are plenty of examples of company’s whose stock popped on the announcement of a spin-off or divestiture.  With investors being more able to focus on the simpler business structures of the resulting spin-off companies, the value is more readily perceived.

The Spin-off Potential of PHH Corp

I believe that PHH Corp is an ideal candidate for a spin-off or a divestiture that would create significant value for shareholders.  Moreover, even if a spin-off never happens, the value is there to be realized and the market appears to be in the process of reevaluating its worth.

PHH is involved in two businesses that, from what I can tell, have very little efficiencies with one another apart from the fact that both involve money.

  1. Mortgage Origination and Servicing
  2. Fleet Management Services

When I became interested in PHH Corp a few months ago it was because of the Mortgage Origination and Servicing segment.  PHH is one of the few large originators out there that trades publically.  I learned about the company while reading a 13G filing from Hayman Capital, the investment management firm run by Kyle Bass.  Bass took a 7.9% stake in the company.

My initial investment analysis focused on the servicing and origination segment of the business.  I was pretty sure I could see the value that Bass saw, and I will get to that in a minute.  I bought the stock soon after and watched it do well for a couple of weeks.

Well at some point my procrastination was overridden by my curiousity and I thought I better take a look at this Fleet Management business.  To be honest, I didn’t even know what Fleet Management was.  What I was shocked to learn was not only that Fleet Management is a solid, growing business, but that an argument could be made that its value alone could be worth a large percentage of the PHH market capitalization.  I can imagine a scenario where the Fleet Management business is spun off or divested from the mortgage business, with the result being a significant realization of shareholder value.

What is Fleet Management?

The best definition I could find as to what the business of fleet management is all about came from wikipedia:

Fleet management is the management of a company’s vehicle fleet. Fleet management includes commercial motor vehicles such as cars, vans and trucks. Fleet (vehicle) management can include a range of functions, such as vehicle financing, vehicle maintenance, vehicle telematics (tracking and diagnostics), driver management, speed management, fuel management and health and safety management. Fleet Management is a function which allows companies which rely on transportation in their business to remove or minimize the risks associated with vehicle investment, improving efficiency, productivity and reducing their overall transportation and staff costs, providing 100% compliance with government legislation (duty of care) and many more. These functions can be dealt with by either an in-house fleet-management department or an outsourced fleet-management provider.

Its a fairly simple business, and one that has proven to be consistently profitable even through one of the worst recessions ever.

The hidden consistency of Fleet

I went back a few years and looked at the earnings numbers on the PHH Fleet business:

Average earnings from Fleet over the past 6 years have been $0.83 per share of PHH.   Even in the depths of the 2008-2009 recession Fleet delivered respectable earnings.

The Fleet business continued its operational performance in the first quarter of this year and looks ready to break above a $1 per share in earnings for the first time since 2007.

Think about that for a second.  Here you have a business that has shown the ability to earn money consistently, even through what was probably the worst recession of our generation.  It could quick likely earn $1 per share of earnings this year.  Earnings have grown in the high teens for the past 3 years.

What would you value such a business at?  12x earnings? 15x earnings?  Maybe more?

If you use either of those multiples on the average and peak earnings numbers, it becomes clear that the Fleet business is worth something not too far away from the current stock price.  Or in other words, when you are buying PHH you are buying the mortgage business for very little.

Moreover, as one would expect, the Fleet Management business is going to improve along with the economy.  As per last year’s 10-K:

The fleet management industry continues to be impacted by the relative strength of the U.S. economy. As the U.S. economy improves, we expect to see continued improvement in the industry. We believe that improvement in the economic conditions will be reflected in continued growth in our service unit counts.

If the US economy is indeed improving, the Fleet business could turn out to be a cash generating machine.

This all leads to the speculation of whether there could be a spin-off or sale of Fleet from the rest of the company at some point.  A sale of Fleet would provide the cash needed by the servicing business to grow and allow PHH to continue their correspondent lending business at higher levels.  A spin-off would most likely realize value for shareholders, as the value of each individual business would be more easily identified.

There was a question on the Q4 conference call that alluded to the possibility of some sort of divestiture.  Management did not deny it, saying only that it wasn`t an appropriate topic for a public forum.   On the fourth quarter conference call the CEO, Glenn Messina, was asked about the possibility of bidders to the Fleet business (as well as the mortgage servicing business).  His response was:

As it relates to anything regard to Fleet or Mortgage, this public forum is not the place to have any discussions about anything like that. I’m focused on maximizing shareholder value. We’ve laid out our four strategies and that’s what we are going to be pursuing.

That certainly is not a no.

But wait, there’s more!

So a spin-off or sale of Fleet is certainly a possibility.  But that is the not the only source of value hidden within PHH.  PHH is in the business of mortgage origination and mortgage servicing.  The company breaks origination and servicing up into two distinct segments.

Mortgage Origination

Mortgage origination basically consists of finding a person that needs a loan to buy a home, showing that person a list of mortgage options of how they could finance that loan, qualifying the borrower for loan guarantees such as those from the GSE’s, processing the loan (doing all the paperwork) and passing it through to the eventual lender institution (usually to Fannie, Freddie or a bank that will either keep it on their books or sell it to another investor).  PHH takes a cut in the process, or anorigination fee, that is typically between 1/2% and 1%.

Mortgage Servicing

Mortgage servicing happens after the loan is made. The servicer is responsible for determining how much the borrower owes and collecting that amount.  If a loan is not being paid then the servicer takes on additional responsibilities such negotiating a workout upon default, looking after the foreclosed property and such.  There are also other contingent responsibilities such as taxes and insurance, depending on the specifics of the servicing agreement.

The natural hedge of servicing and origination

PHH refers to the servicing and origination businesses as a natural hedge of each other.  Why?  Because they are inversely correlated with respect to interest rates.

Let’s say interest rates fall.  What happens?  People that have mortgages at higher rates refinance those mortgages.  That’s great for the origination business.  They are writing up refi’s and taking in the fees.

Not so great for the servicing business. When a mortgage is refinanced the right to service that mortgage no longer exists.  Of course this can be mitigated if PHH is able to originate the refinance and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one.  PHH has proven to be quite good at “recapturing” loans in this manner.  But there’s no guarantee.

When rates go up and the opposite situation occurs.  Origination suffers, no one is refinancing at the higher rates.   But mortgage servicing rights are not being lost either, and PHH is collecting cash on these rights for longer.

There are a number of developments happening in the mortgage business right now from which PHH stands to benefit.

Origination: Generating consistent earnings, but needs to grow

Since 2008 PHH has had a steady stream of earnings from the mortgage origination business.   However, probably not surprisingly in the current environment, they have not been able to grow the business substantially.  Below are earnings of the business over the past 5 years, as well as for the first quarter of this year.

I believe there are a few opportunities in the origination space that could change the growth profile of the business  The first is if the company could take advantage of the pricing opportunity that exists in correspondent lending.

Correspondent lending

So first of all, what is a correspondent lender?

Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have traditionally taken a large piece of.   Until now.  In August Bank of America reported that they were exiting the correspondent lending business.  Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis.  Met Life announcedthat they were winding down their origination business entirely in January.

This isn’t small potatoes.  The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.

There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:

One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”

Its a low margin, highly competitive business.   But the opportunity is that it could become less so with some of the big players moving on.

In the 4th quarter PHH announced that they would be reducing their own correspondent lending business.  But even at the time of the announcement they hedged their bet, saying they would remain opportunistic and take advantages of periods of high margins.  With so many other large lenders cutting back or completely exiting from the business, its a good time to be opportunistic.

Here is what management said about the correspondent business on the Q3 2011 conference call:

Yes I’m going let – yes the answer to the question is yes, we think there are better opportunities but once again we’re really pretty opportunistic in that channel. So we pay close attention to margins in that channel. As you know it’s probably the most cost competitive channel, it is the most cost competitive channel that we operate in and we’ve seen some really strange behavior in that market in terms of where margins are being priced. Some of our competitors are in the market, when they are in the market they’re very aggressive in terms of their pricing and then they back off and they’re out of market and that’s why we stay really opportunistic in that market.

On the Q1 2012 call, when questioned about the outlook of the correspondent business going forward, management began to change their tune.  CEO Glenn Messina said the following:

Right now we think by year end we’ll probably ramp it down to about 20% of the total, but yes, I do want to caution everyone. Last quarter I talked about managing the correspondent operations to a cash budget, and given where margins are today, cash cost origination tends to be very low.

So within the right quality parameters, and we’ve established defined quality parameters around who sells loans to us and the quality of their originations, we may flex up or down depending upon what the cash cost originations is.

So basically what Messina is saying is that margins are so good right now that while we originally figured to be ramping down correspondent lending,we would be crazy to do that in this environment.  Analysts have already ratcheted down estimates for the origination business as a whole based on expected declines in the correspondent segment.   PHH is in a good position to now beat those estimates.

Signing up new partners

The second possible growth vehicle for the origination business is a continuation of the success they had in the latter half of last year in signing up some big partners for their origination business.  From the Q3 CC:

We also made significant progress in growing our nationwide sourcing footprint over the past two quarters signing five new private label accounts. The new relationships include Barclays which we mentioned on last quarter’s call and today we’re pleased to announce that we’ve added Ameriprise and Morgan Stanley Private Bank along with two other financial institutions all as new PLS partners.

PHH did also lose one significant client in Charles Schwab last year, but overall the company expects to gain significant production from the new clients over and beyond the lost ones:

We expect the five new PLS accounts in the aggregate based on their 2011 production and taking into account ramp up time and anticipated launch schedules to produce about 7 billion in closing volume in 2012, about double what we predicted for Schwab.

There haven’t been any further announcements of major partnerships since the third quarter.  I imagine that these relationship get reviewed close to year end, so we will just have to wait and see.  Given the propensity for the big banks to scale back and outsource their mortgage business, it seems reasonable to me that PHH will be able to grow its book through further relationships.

HARP II could provide some short term support to origination

HARP stands for the Home Affordability Refinance Program.  HARP II is the name that has been coined for the new version of HARP.  It supersedes the original HARP.  HARP I was a total failure.

The HARP program has helped far fewer borrowers than its proponents estimated — roughly 894,000 borrowers since Aug. 31, 2011. — and many less than the estimated 11 million U.S. homeowners who owe more than their homes are worth.

Why was it a failure?  A few reasons:

1. Put back risk: Basically when a bank participated in the original program they were worried that they would get stuck with the original mortgage.  I think what happens here is that to rewrite the original loan to new terms, the loan is going to be scrutinized.  The banks and other underwriters know that the quality of many of those original documents are sketchy at best and they would rather not have to pull out the skeletons.

2. LTV Limits: This is probably the biggest problem.  The original HARP program dealt with current loans with LTV’s of 80-105.  That was expanded to 125 in 2009, but that still wasn’t enough.  I was surprised by that until I read this:

This should have a big impact in certain parts of Nevada, Arizona, and Florida where many borrowers owe more than 125% of the value of their homes. In Nevada, for example, two thirds of all loans backed by Fannie Mae are underwater, and half of all loans are above the 125% loan-to-value cut-off.

3. Appraisal costs: the borrower had to have an appraisal done to qualify for the original program.  That appraisal could cost $400.  Borrowers were reluctant to take this cost on when there was no guarantee they would be accepted by the program

HARP II aims to correct these mistakes.  The LTV limit is gone.  Appraisals are no longer required.  And banks are protected against the put backs.Says Brian Ye, analyst at J.P Morgan Chase & Co:

“We are of the opinion that there are enough changes to the program that bank servicers could really change their behavior, and this could be one of the first times that the administration has under-promised and over-delivered,”

There is one particular element of the new program that helps out PHH is that servicers get a head start over third party originators.   I confess I don’t know just what of impact this is going to have, but it is interesting and potentially significant, so I think its worth mentioning.  Servicers like PHH have been writing borrowers up for the program since the beginning of the year.   A third party originator cannot submit any documents to Fannie or Freddie until March.   This was done to entice the banks into the program, but the corrollary is that a company like PHH has been able to capture business up front without the competition.

More information on the new HARP program can be found here.

Will HARP II work?

This is, of course, the big question. The program is aimed to attract two million borrowers by the end of 2013.  This would be a little more than twice what the original program attracted.

However if the program works, and if JP Morgan turns out to be right and the administration “under-promised”, there is certainly a lot of room for upside.  According to CoreLogic:

10.9 million, or 22.5 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2011.  Eight million borrowers with negative equity, or nearly 75 percent of all underwater borrowers, have above market rates. The disparity is even greater for those with severe negative equity. More than 40 percent of borrowers with 125 percent or higher loan-to-value (LTV) ratios have mortgages with rates at 6 percent or above, compared to only 17 percent for borrowers with positive equity.

Apart from the obvious fact that these numbers show just how staggeringly bad housing has become, if you prefer to see the glass half full those numbers also suggest that there are a lot of borrowers out that could benefit from a program like this.

Mortgage Servicing Rights and the Mortgage Servicing Disconnect

I wrote a long article on Seeking Alpha (The Opportunity in Mortgage Servicing Rights) describing the factors that have caused the mortgage servicing industry to fall into disarray.  I am not going to repeat that thesis in detail here.  To summarize its conclusions by way of analogy, the opportunity in the mortgage servicing industry right now is similar to the opportunity in correspondent lending.   Many of the traditional big players in the industry are getting out of the business and that has left a void.  The void has caused servicing valuations to collapse and has opened up the potential for servicers like PHH to take on new business.

PHH Corp is perhaps not the best way to play the valuation gap in servicing rights.  There are other companies like Newcastle Investments, Nationstar Mortgage Holdings, and Home Loan Servicing Solutions that are actively purchasing 3rd Party portfolios of servicing rights on the cheap, and in my opinion stand to gain substantially from their eventual reversion to historical norms.

PHH, on the other hand, does not buy servicing rights outright from 3rd parties.  They do, however, keep the servicing rights of the mortgages they originate, and they do perform subservicing of portfolios owned by others. It is perhaps in the subservicing business where PHH can take advantage of the exit of other large players, developing new relationships as subservicer.  Right now the subservicing business is a fairly miniscule component of the overall servicing revenue (a little less than 3% of total fee revenue in the first quarter) so I am going to leave this as a possibility, but not one to count on.

The other potential opportunity for PHH lies with the effect rising interest rates will have on its existing servicing portfolio.

Interest rates have done nothing but fall for more than 20 years.

At some point this trend is going to reverse.  Rates are going to head upwards.  David Einhorn published an interesting opinion piece this week in the Huffington Post.  He argued that the Federal Reserves policy of zero interest rates and quantitative easing is counter-productive; that it is not enticing risk adverse investors into stocks.  He goes on to argue that if the Federal Reserve were to allow interest rates to rise, you would see investors begin to shy away from the bond market, as what has been a one way winning trade for 20+ years would show signs of waning.

Falling interest rates have been a plague on the mortgage servicing industry.  Every time a borrower refinances, the servicing right associated with the original mortgage ceases.  This has put companies like PHH on a treadmill of generating originations to replenish their servicing pipeline, and forced them to work hard to recapture the borrowers that are looking to refinance.

When interest rates begin to head back up, the opposite scenario is going to prevail.   PHH is going to be left with a servicing portfolio that is chaulk full of low interest rate loans that will not refinance for years.  Everyone who can refinance their mortgage will have already done so.  Meanwhile, the quality of the loans being originated since 2008 is some of the highest it has ever been.  No one has dared make a risky loan in the current environment.

There are 3 risks associated with holding a mortgage servicing right.  The first risk is the risk of refinancing.  The second risk is the risk of default.  The third risk is the risk that the house is put up for sale.  We are in an environment where the first two risks are likely to be lower going forward than they have been for quite some time.  A rise in the risk of the house simply being sold implies an economy that is recovering.   Thisis probably a positive for PHH, as higher home sales will drive it origination business.

The end result is that the servicing portfolio that PHH owns is going to be generating cash for longer than it has in the recent past.  This is going to help PHH grow its portfolio further, for the simple reason that the portfolio won’t have as much turnover.

A brief look at the effect of mortgage servicing rights on tangible book

Another effect of rising interest rates is that which it will have on the book value of the servicing assets.

PHH provides an estimate of its tangible book value every quarter as part of its investor supplementary material.  Below is the estimate at the end of the first quarter as well as at year end 2011.

The company is trading at a reasonably significant discount to tangible book, which in itself says something about the unrealized value.  But if you look at the book value a bit closer, you realize that there is a lot of hidden value within the assets on the books.

Baked into shareholder equity is the value of the mortgage servicing assets that PHH carries on their balance sheet.  The servicing asset was carried at $1.3B at the end of the first quarter.  As I already explained, this asset is marked to market every quarter based on interest rates and the perceived threat of prepayment and default of the mortgages underlying the asset.   The asset represents the future value of servicing an unpaid principle balance of $149.6B in mortgages.  According to the latest earnings release, the average yearly fee that PHH receives for servicing those mortgages is 30 basis points, or about $450M of servicing fees per year.  A simple ratio comparing the current value of the servicing right ($1.3B) to the expected income of that portfolio ($450M) tells you that PHH is valuing their servicing portfolio at about 2.9x its yearly servicing income.

I’ve done a bit of research into the matter, and while right now mortgage servicing rights are selling at multiples of anywhere from 1x to 3x the yearly income, in the past servicing rights sold at 4x to even 6x yearly income.  Once servicing rights return to the mean, the book value of PHH will rise substantially.  At 4x servicing book value would rise byapproximately $450M to $34 per share.  At the high end of 6x book value would be $50 per share.

Another way that higher rates help servicing revenues

There is another rather obscure way that higher interest rates are going to improve earnings at PHH.  As part of the mortgages that PHH services PHH is charged with managing escrow accounts that are used to hold funds designated for taxes and inusurance.  PHH receives a benefit for these services by way of receiving the interest on these accounts.  The interest benefit is recorded under the Mortgage Servicing segment accounting item Mortgage Interest Income.

Beginning in 2008 mortgage interest income collapsed.  Since then it has fallen to a fraction of what it was pre-2008.

Taking a look at the PHH 10-K for 2008, when the collapse began, PHH said the following about the reduction in mortgage interest income.

Mortgage net finance income decreased by $86 million (89%) during 2008 compared to 2007, primarily due to lower interest income from escrow balances. This decrease was primarily due to lower short-term interest rates in 2008 compared to 2007 as escrow balances earn income based on one-month LIBOR.

As interest rates rise, the interest associated with these escrow accounts are going to rise substantially.  In 2007 one month LIBOR averaged around 5.3%.  In 2011 it averaged around 0.3%.  When (perhaps if) the economy finally begins to show some strength, LIBOR rates will rise.  To give a sense of this affect on PHH, in 2007 PHH was pulling in almost $3/share worth of revenue from these escrow accounts.  In 2011 that had dropped to $0.30 per share.

The Fannie put back

Since 2007 PHH has had a continual drag on its mortgage servicing income caused by the put-back of mortgages from Fannie Mae.  Over the past couple of years Fannie Mae has been reviewing their loan book for the periods from 2005-present and looking for any breaches in contractual terms, poor underwriting or defective documentation.  When it finds a mortgage that has one of these flaws, it puts it back on the lender.

PHH can fight these repurchase requests, but only up to a point.  Bank of America has been probably the most vigilant in fighting Fannie, and in return Fannie decided not to renew their contract to buy loans from BoA.  Fannie holds the trump card in this battle, and so PHH is going to be pretty much stuck with paying up for many of the repurchase requests put back to them.

Since 2008 PHH has been taking significant writedowns due to the repurchase requests including a big charge at the end of the most recent quarter.

The topic was discussed in depth on the first quarter conference call.  Messina had the following comments:

Based on our ongoing discussions with the GSEs, we believe that by the end of 2012, they may be substantially complete with their review of our seriously delinquent and defaulted related to origination years 2005 and prior, and by the end of 2013, they may be substantially complete with their review of our seriously delinquent and defaulted loans related to origination years 2008 and prior.

Almost 78% of our standing repurchase requests at quarter end are related to the 2005 through 2008 origination years. Given the results of the first quarter, our ongoing discussions with the GSEs, we believe it’s reasonably possible that future losses related to repurchase and indemnification requests may be in excess of our recorded foreclosure-related reserves.

Assuming that the elevated level of repurchase demands that we have recently experienced continues through the end of 2013, and the company’s success rate in defending against such requests declines, and that loss severities on repurchases remain at current levels, the estimated amount of possible losses in excess of our foreclosure-related reserves is $140 million.

The bottom line is that repurchase requests are likely to be a drag on earnings for the next two years.  The company is outlining $140 million in addittional charges, presumably broken up over the next 7 quarters.  This works out to about $20 million a quarter, which is fairly consistent with the level of charges over the past 3 years.

When core earnings matter

Whenever a company publishes core earnings you have to look good and hard at why they are doing so.  You never know what they might be trying to gloss over by eliminating some of the more unsavoury elements of the income statement.

PHH reports core earnings every quarter but they do so for a very good reason.  Core earnings are a far better representation of the company’s profitability than are GAAP earnings.

The problem with GAAP earnings is that they are obscured by changes in the mark to market value of the mortgage servicing right portfolio.  The accounting nature of the servicing right is such that PHH has to write up and down the mark to market value of each right with changes in interest rates.  A servicing right is in many ways no different than an interest only mortgage security.  The biggest risk is the prepayment of the security and with most mortgages this risk is closely tied to interest rates. When rates go down mortgage servicing rights have to be written down in value to reflect this increased risk of prepayment.

The fluctuations on the income statement caused by these mark to market moves are huge.  Up to $400M in some quarters, which for a company the size of PHH (there are only 55M shares outstanding after all), leads to massive moves up and down.  If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart.  Below is a chart of earnings from the mortgage servicing segment that includes the effects of the mark to market adjustment.  With interest rates having fallen so precipitiously in the last few years, PHH has had to take pretty massive GAAP writedowns on their servicing portfolio.  Below are the before tax earnings per share from the mortgage servicing segment.  Much of the swing is the result of the mark to market adjustments to the servicing portfolio.

The reality of the mortgage servicing right is that as long as the company is replenishing the existing pool with more rights from new originations and recaptured refinances then its losing to payoffs, its all good.  As I already noted, PHH is doing that and then some.

The core earnings number that PHH reports is quite simply GAAP earning less this mark to market effect. And if you look at that core earnings over the last few years you can see that they have have been growing consistently and that the current stock price of $17 is not expensive relative to earnings.

So what did Bass see?

Let’s review the core elements of the thesis with PHH:

  1. The company is trading at about 65% of a tangible book value that perhaps undervalues the servicing assets by 25-50%
  2. Core earnings, which are a relevant metric of company profitability, are over $3 per share and growing
  3. The Fleet business itself has the potential to earn $1 per share in 2012 and provides a reasonably steady earnings stream even during recessions
  4. There is upside potential for PHH to take advantage of the current disconnects in the mortgage market, both in servicing and in originations
  5. The potential of a divestiture or spin-off of Fleet from Mortgage or vice versa

The downside is that the stock has moved well off its lows and that because of the sensitivity of the mortgage business to overall economic activity, the share price is volatile.  Bass bought his shares at around $10 and in full disclosure I bought most of my shares in the $12 range, though I have added recently with the break-out above $16.  While I can’t say for certain that PHH will eventually divest the Fleet business, I think that the story has enough elements that even if they don’t, there is plenty of room for upside appreciation in the share price.

PHH Corporate Presentation

I think this (Ryan here) is a situation where it helps to understand recent changes in context of history, and I think its actually critical to putting all the pieces together and connecting the dots, so I would recommend heading over to Value Investors Club and reading the handful of older write-ups for further context and understanding, as well as the Pennant Capital 2009 proxy statement embedded below.

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