GRANT’ ® S

JAMES GRANT EDITOR

Vacation delectation

To the readers of Grant’s: The attached anthology of recent you, but also for your friends—and co-workers,Grant’s pieces clients, is notclassmates, only for shipmates, brothers-in-law and maids-of-honor, too. Please pass it along, with our compliments, to any and all prospective members of the greater Grant’s family. We resume publication with the issue dated Sept. 3.

Sincerely yours,

James Grant

Subscribe today and save! Fax or mail the form below, go to www.grantspub.com/subscribe or call 212-809-7994.

Yes, I want to subscribe. Enclosed is my payment (check or credit card). Offer good until Dec. 15, 2010 I understand I may cancel at any time for a prorated refund on the remainder of my subscription. On the Web: Offer code: SB2010 o 1 year (24 issues) $910 U.S. /$950 Foreign This offer: $850 U.S./$890 Foreign—a $60 discount Questions? Call 212-809-7994. Fax your order: 212-809-8492 o 2 years (48 issues) 50 ISSUES for $1,660 U.S./$1,700 Foreign. We will add two free issues (an additional $140 value) onto the end of Name______your 2-year subscription. Best value yet! Company______o Check enclosed* Address______*Payment to be made in U.S. funds drawn upon a U.S. bank made out to Grant’s. ______#______Exp.______Credit card number ______Signature______(required ) CV number ______(3-digit code on back of VISA/MC/Disover; Daytime Phone______4-digit code on front of AMEX) T GRANT’S E-mail______WO W ALL S TREET INTEREST R A • N E W Y ORK TE OBSER Two Wall Street • New York,, NewNY York 1000 10005-22015 • www.grantspub.comVER • 212-809-7994 • [email protected] ®

Vol. 28 Summer Break Two Wall Street, New York, New York 10005 • www.grantspub.com AUGUST 20, 2010

Up the capital structure

(December 15, 2006) The not very market, they say, even the broad sub- default has risen. But there is some- shocking news that low-rated tranch- prime market, is hale and hearty. Bear thing about the sudden blight of delin- es of poorly underwritten mortgages Stearns, the top mortgage-backed se- quencies and foreclosures in the bot- on depreciating houses are suscep- curities underwriter, is an exponent tom of the 2006 mortgage barrel that tible to loss has nonetheless man- of this idea, as is Triad Guaranty doesn’t quite add up. Yes, the median aged to shock. The cost of insuring (Grant’s, June 16). Both are expand- house price has fallen by 3.5%. But the lowliest such slice on the stan- ing their businesses as if the bear the jobless rate stands at only 4.5%. dard subprime reference index has markets in mortgage debt and resi- Nominal interest rates—even follow- climbed by 25% in seven short days, dential real estate were already over ing 17 quarter-point jumps in the fed according to the guardians of the and done with—if, indeed, they ever funds rate—remain low. The Russell untransparent mortgage derivatives really got under way. 2000 Index the other day hit an all- market. Grant’s has had much to say The subprime arena is the Wal- time high. Blame for the distress at about mortgage credit this year. Fol- Mart Nation of American leveraged the fringes of subprime, we judge, lowing is a speculation on 2007, if we finance. Like the Wal-Mart customer, cannot be laid at the feet of the U.S. have our timing right. In preview, we it is a bellwether of financial distur- economy. It should, rather, attach to find that, under some not very ad- bance. Perhaps, it’s no accident that the lenders and borrowers who piled verse assumptions,even higher-rated the giant retailer’s sales have weak- debt on debt until the edifice sways mortgage structures are vulnerable to ened as the cost of insuring low-rated even in a dead calm. infestation by credit termites. Insur- subprime mortgage tranches against A common reaction to our descrip- ance on these supposedly safe and sound mortgage derivatives is avail- When not-shocking news shocks able for a song. 102 102 We write not only for the well- closing prices of double-A and triple-B-minus staffed professional investor who tranches of ABX.HE 06-2 index AA: 101 101 could actually buy protection on the 100.09 penthouse levels of an arcane mort- gage index. Our intended audience is, 100 100 equally, the curious investment ama- teur who ordinarily has no truck with 99 99 tranches and derivatives but is always price prepared to make an exception for a 98 98

$1 trillion market. Our hypothetical price layman should know that the experts, 97 97 so-called, are almost as confused as he is. Certainly, they are of many minds. 96 BBB-: 96 A few—a minority—believe that the 95.30 troubles now unfolding at the mar- gins of subprime are the leading edge 95 95 of much deeper problems. We are in that camp. The majority contend that 94 94 the derangement of the BBB-minus- 10/2/06 10/10 10/16 10/23 10/30 11/6 11/13 11/20 11/27 12/12 rated tranches is a fluke. The broad source: Markit Group, CDS IndexCo. SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 3

Home sweet mortgaged home September 30, overall U.S. mortgage 100% 100% issuance totaled a little more than breakdown of year’s total mortgage issuance $1.5 trillion, according to UBS. Of this grand total, no less than 22.2%, 80 80 or $342.4 billion, was subprime, i.e., speculative grade (meaning, gener- ally, a FICO score of less than 620, percentage of issuance 100 points lower than the national 60 agency: 60 median). Another 17.5%, or $269.5 43.9% billion, was Alt-A, the class between speculative and prime. At 39.7% of year-to-date issuance, the sum to- 40 subprime: 40 tal of subprime and Alt-A emissions 22.2% thus begins to approach the 43.9% percentage of issuance Alt-A: 17.5% of the higher-quality mortgages that 20 20 Fannie Mae and Freddie Mac are al- lowed to buy. prime: Credit quality in the U.S. residen- 11.2% tial mortgage market has been in a 0 0 long-term downtrend, which is an- 20052004200320022001200019991998199719961995 3Q06 other way of saying that house prices source: UBS and homeownership rates have been on a long-term uptrend. As recently tions of the elaborate design, and not Mortgage traders speak lovingly of as 1994, again according to UBS, especially generous yields, of asset- “the CDO bid.” It is mother’s milk to subprime issuance amounted to just backed securities (ABS) is amaze- the ABS market. Without it, fewer as- 5.6% of total mortgage issuance, with ment: “Who buys this stuff?” Grant’s set-backed structures could be built, Alt-A amounting to only 0.2%. Fan- readers want to know. Yield pigs and those that were would have to nie, Freddie, Ginnie et al. had the the world over, is the answer. “Who meet a much more conservative stan- mortgage-securitization field virtu- creates and promotes it—and what dard of design. The resulting pangs of ally to themselves—and because they would cause them to stop?” is anoth- credit withdrawal would certainly be stamped their issuance with a federal er oft-heard question. The answer to felt in the residential real-estate mar- guarantee (implied or actual), credit that is Wall Street. Its mortgage mills ket. So the musing of a knowledge- risk, from the investor’s standpoint, create asset-backed securities like able salesman to whom colleague was virtually nonexistent. “Since the kind featured on page one of the Dan Gertner spoke the other day is 1994,” observes Gertner, the Grant’s September 8 issue of Grant’s (“In- worth considering. “The CDO man- special vice president in charge of side ACE Securities’ HEL Trust, agers have certainly stepped back,” mortgage complexities, “agency-eli- Series 2005-HE5”). And the same said our source (so knowledgeable gible mortgage issuance has grown by mills issue collateralized debt obli- is he that he asks to go nameless). a factor of 2.5, subprime issuance by a gations, a.k.a. CDOs. It’s the CDOs He explained that what is worrying factor of more than 19 times and Alt-A that dependably buy the lower-rated the CDO managers has nothing to by a factor of more than 500 times.” ABS tranches. do with the macroeconomy. It is all The long vigil of the mortgage Constant readers will recall that about microeconomics, particularly a bears for signs that they have not CDOs are highly leveraged debt-ac- sudden paucity of buyers. “Clearly,” been imagining things has ended quisition machines (Grant’s, June 2). our source went on, “the end buyer with a succession of confidence-rat- So it is all important to the subprime of this rubbish—whether it be the tling news items. The first was the market that new mortgage-packed Middle East or, more likely, the Far shuttering of Texas-based Sebring CDOs continue to come tumbling East—has had second thoughts about Capital Partners, a subprime and Alt- down the Wall Street production lines home-equity loans and subprime in A originator, on December 1. Sebring, as, indeed, they have been: According general. I think that is key. If you with 325 employees and 10 years of to the latest data, year-to-date CDO follow the money trail, it has implica- operating experience, was forced to issuance totals $223.7 billion, no less tions for other asset markets as well.” turn off the lights after rising defaults than 89% higher than in the like pe- Perhaps, the flies on the wall at the left it without a banker. Ownit Mort- riod a year ago. upcoming talks between Chinese fi- gage Solutions, a California subprime To sustain this pell-mell growth, nance officials and Treasury Secre- lender founded in 2003, followed Se- the Street needs buyers, specifically tary Paulson will have the consider- bring into the darkness on Decem- buyers of CDO equity. The equity ation to leak the gist of any concerns ber 5. The Los Angeles Times quoted a tranche is like the understander in a Chinese analysts harbor about the valedictory Ownit press release that human pyramid. Without him, there subprime market. blamed Merrill Lynch for pulling the can be no show. Upon a CDO’s eq- The $1 trillion size of the market plug; Merrill held about 20% of Own- uity is loaded tranches of lower-rated should push it to the top of any inter- it’s equity. Two days later, Fitch Rat- ABS at a ratio of as much as 20:1. national financial agenda. Through ings placed a subsidiary of AMC Mort- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 4 gage Services under surveillance for We will proceed to identify a few one rating category?” Yes, the mort- possible downgrade, citing a plunge slices of fat that have not yet fallen off gages that pack the various tranches in origination volume, rising credit the griddle—colleague Gertner has are all subprime. But derivatives ar- problems and a consequent knock spotted some excellent candidates chitects convert subprime into invest- to the profitability of the firm’s ser- for sale. First, though, a few helpful ment-grade by armoring the higher vicing business. In remarks that bear words of background. tranches with extra collateral. A tri- on all subprime originators, the L.A. “ABX” is the basic index designa- ple-A-rated subprime tranche is one Times quoted John Bancroft, manag- tion, and that is simple enough. ABX. reinforced with enough mortgages to ing editor of Inside Mortgage Finance, HE is a fuller designation, and it is make it impervious—supposedly—to as follows: “These are companies that wholly misleading. “HE” signifies loss. Remember that, in all such struc- depend almost exclusively on new home equity, but you may put that tures, income cascades down from the loans for their earnings. That market out of your mind. This is an index top while losses infiltrate up from the grew rapidly in the last 10 years, but overwhelmingly of first liens; home- bottom. The higher-rated tranches it couldn’t last forever. Eventually, equity-type seconds may constitute get paid first; the lower-rated ones you reach just about every marginally no more than 10% of a given tranche. bear the first loss. qualified borrower you can.” The basic index consists of an equal- The ABX.HE index series is a joint That not one borrower was left weighted static pool of 20 credit de- production of CDS IndexCo and behind is increasingly evident in fault swaps, or CDS, that reference Markit Group Ltd. CDS IndexCo is the market for lower-rated subprime U.S. subprime mortgage securities. a consortium of 16 brokerage-house- mortgage tranches. An index that Have you tripped over the words cum-market-makers; Markit, which references a particular subspecies of “credit default swaps”? Pick yourself was founded in 2001, is a pricing, mortgage slices—the ABX.HE 06-2 up and dust yourself off. In effect, asset-valuation and risk-management BBB-minus—is the one that sudden- CDS are insurance policies on credit data vendor. On the occasion of the ly costs 25% more to insure against risks. They may, therefore, be viewed launch of the first index series last loss than it did at the end of Novem- as mirrors to the credit risk against January, Bradford S. Levy, a Goldman ber. Informants say that it is nearly which they offer protection. Sachs managing director and acting impossible to buy credit protection The basic ABX.HE index contains chairman of CDS IndexCo, explained on poorly performing tranches of the five subindices, each of which tracks what it was all about: “The CDS of mortgage stack. Mr. Market, though a different grade of mortgage credit [the] ABS market has grown at a sometimes slow on the uptake, does quality. Which may lead you to won- rapid pace over the past six months, not have to be told twice that the fat’s der: “If all the mortgages are sub- and we have seen increasing appetite in the fire. prime, how can there be more than among clients for a way to take a syn-

Termites gnaw performance of the constituents of the ABX.HE AA 06-2 index

—credit support— ——days delinquent—— real estate total months of ABS deal original current 30 60 90 foreclosure owned distressed seasoning LBMLT 2006-1 14.15% 17.38% 4.56% 2.47% 3.00% 4.91% 1.09% 16.03% 9 CWL 2006-8 12.95 13.45 3.10 1.25 0.29 1.67 0.05 6.36 6 MSAC 2006-WMC2 12.45 12.57 3.66 2.21 1.40 2.37 0.00 9.64 6 ARSI 2006-W1 14.84 19.03 2.77 1.57 1.45 4.95 0.79 11.53 10 FFML 2006-FF4 13.35 15.33 2.80 1.04 0.69 2.64 0.60 7.77 7 ACE 2006-NC1 14.65 18.97 2.60 1.21 1.17 2.68 0.64 8.30 11 SVHE 2006-OPT5 15.13 16.35 3.26 1.26 0.68 1.28 0.00 6.48 5 SAIL 2006-4 10.90 12.33 4.06 2.24 0.76 2.70 0.04 9.80 6 GSAMP 2006-HE3 17.20 19.14 4.43 2.94 1.76 3.75 0.62 13.50 7 MLMI 2006-HE1 18.35 22.94 4.71 1.56 2.31 2.45 0.81 11.84 10 JPMAC 2006-FRE1 17.45 22.18 5.08 1.95 0.24 6.16 1.35 14.78 11 RASC 2006-KS3 14.90 16.88 3.83 1.84 1.22 3.59 0.57 11.05 8 RAMP 2006-NC2 12.95 15.22 3.70 1.72 0.81 5.24 0.70 12.17 6 HEAT 2006-4 12.90 14.73 3.53 1.90 1.02 2.38 0.05 8.88 5 BSABS 2006-HE3 16.65 20.01 4.03 2.46 2.70 4.63 0.24 14.06 9 MABS 2006-NC1 14.30 17.56 3.51 2.11 1.20 5.29 0.68 12.79 10 CARR 2006-NC1 16.40 19.95 2.92 1.12 1.18 3.46 0.30 8.98 9 SASC 2006-WF2 13.55 14.98 2.04 0.25 0.08 1.04 0.02 3.43 6 SABR 2006-OP1 11.40 16.02 2.48 0.49 1.12 2.88 0.40 7.37 11 MSC 2006-HE2 3.90 14.14 3.84 1.97 1.92 3.13 0.36 11.22 7 Average 14.42 16.96 3.55 1.68 1.25 3.36 0.47 10.30 8.0 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 5 thetic view on ABS. ABX is a direct the 2005 subprime mortgage crop as course, there’s no telling when, or if, response to that demand, and gives well? Our replies are, respectively, the loans now troubled would go irre- clients an efficient, standardized tool “no,” “no,” and “yes.” trievably bad. But given the wretched with which to quickly gain exposure For evidence to support our affir- performance of the collateral to date, to this asset class.” mative response to question No. 3, the cost of insurance seems strik- In short, here was a new deriva- we invoke the September 28 Merrill ingly cheap. “Nor is a cash loss the tive index to fill the supposedly cry- Lynch “Review of the ABS Markets.” only way to get paid,” Gertner points ing need for a way to speculate on the In it, the Thundering Herd’s ABS re- out. “Spreads could widen—as the value of stacks of subprime mortgage search group posits that losses on re- spreads on lower-rated tranches have tranches. The first index series to cent subprime ABS issues could be big already begun to do.” be launched was the ABX.HE 06-1, enough to eat well into the structures’ For the time being, the bear mar- and the mortgages from which it de- mezzanine levels, i.e., a principal loss ket in subprime credit is tightly fo- rives its value were originated in the on the order of 6% to 8%. This could cused on the lowest tranche of the second half of 2005. The next index occur if house prices do no worse next 2006 index. It would, to repeat, cost made its appearance in July. This was year than move sideways. But the you 380 basis points a year to insure the ABX.HE 06-2; the mortgages to Merrill economics squad has forecast it against credit loss. Better value, as which it refers were originated in the a house-price decline of up to 5%. In Gertner points out, is protection on first half of 2006. The promoters say which case, the ABS researchers warn, the BBB-minus tranche of the earlier they intend to introduce a new series losses in subprime asset-backed struc- index, the ABX.HE BBB-06-1. “If every six months. tures would spike into the double dig- deterioration in subprime mortgage The index that keeps getting its its. Losses could infiltrate all the way quality finds its way into the loans name in the paper is the July edi- up to the A-rated mortgage stack, the originated late in 2005, and I believe tion. What makes it notorious is the researchers speculate. Just as rising it will,” Gertner winds up, “then the shockingly weak credit quality of the house prices tended to cover up afford- cost of insurance will only steepen.” early-2006 subprime mortgage co- ability and solvency problems, so fall- As bull markets are said to climb a hort. Not surprisingly, the weakest ing house prices would unmask them. wall of worry, bear markets grow on a of the five constituent subindices is It goes without saying that these trellis of complacency. Is Mr. Market the lowest-rated one, the BBB-minus excellent analysts are groping in the yawning? A good sign—for the mort- tranche. The aforementioned plunge dark. We all are. None of us, for ex- gage bears. of confidence in its creditworthiness ample, can be sure how long it might • translated into a spike in the cost of take for delinquencies and foreclo- insuring it against loss to 380 basis sures to translate into money losses. points per annum from 300, all in the But some things are certain. With only China channels space of a week. No doubt the move a glance at the tote board, for example, was exaggerated by the usual depop- we can know today’s odds on tomor- ‘Monkeybrains’ ulation of year-end trading desks. row’s possible outcomes. Specifically, The bad news is oddly unconta- the probability of a default on the AA (July 10, 2009) Too much debt got gious so far. Nothing like that loss tranche of the ABX.HE 06-2 subindex us into this mess, and too much debt has been registered in the higher- is reckoned to be close to zero. You can will see us out of it. Socialize the risk rated subindices of the same ABX. buy credit protection on the AA slice of a new cycle of open-throttle lend- HE 06-2; the AA-rated tranche is of subprime mortgage exposure for a ing and cling to the monetary system little changed. Neither has the mere 13.8 basis points. That is, the that assures a repeat crisis. Such, ABX.HE 06-1 index—which, to re- cost of insuring $10 million in notional approximately, is the global policy- peat, references the late-2005 sub- value of the AA index will set you back making consensus. Central bankers prime cohort—been dragged down. a mere $13,800 a year. “Pretty cheap and finance ministers have achieved The BBB-minus tranche of the 06-1 insurance,” Gertner notes. “But is an uncommon meeting of the minds. index trades around par. The an- there any chance of getting paid?” The cure for what ails us is the hair nual cost of insuring it against loss Gertner has made a study of the 20 of the dog that bit us, they prescribe, amounts to just 270 basis points, 110 ABS deals that constitute the ABX. though not in exactly those words. fewer basis points of risk premium HE 06-2 index. He pronounces their It’s no small thing that China is es- than assigned to the same tranche in performance to be lamentable. Af- pecially enamored of the shot-and-a- the 06-2 subindex. ter just eight months of seasoning beer-for-breakfast approach. Nothing Is the subprime mortgage class of on average, 10.3% of the constituent about China is small or insignificant 2006 uniquely blighted? Were the mortgages are delinquent, in foreclo- nowadays, since the Chinese economy underwriting standards prevailing sure or classified as real estate owned. is actually growing. It might, indeed, during the first six months of the year (The runt of the ABS litter, the Long account for 74% of worldwide GDP uniquely slapdash? Or, are the re- Beach Mortgage Loan Trust 2006-1, growth in the three years to 2010, the markable losses borne on the unsea- shows 16% of the loans in one state International Monetary Fund esti- soned 2006 vintage simply the con- of distress or another.) Now, credit mates. Since 2005, China has gener- sequence of a bear market in house support for the AA-rated tranches, at ated 73% of the global growth in oil prices (and the preceding riot in easy 17%, provides 6.7 percentage points consumption and 77% of the global credit) that sooner or later will corrupt of insulation against loss—and, of growth in coal consumption. By the SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 6 looks of things, it accounts for a fair er forms of financial artificial respira- ing managers’ survey registered 53.2, share of the growth in worldwide lux- tion by the governments of the G-20 its fourth consecutive month over the ury-car consumption, too: nations sum to the equivalent of 32% 50% mark that indicates economy- of last year’s combined G-20 gross do- wide growth. The Shanghai A-share FRANKFURT (Dow Jones)— mestic product, the IMF estimates. market jumped by 65% in the first BMW AG said Monday that sales at That is on top of average fiscal stimu- half, to a level that fixes its value at its core BMW brand in China were up lus equivalent to 5.5% of GDP. So the 31 times trailing net income, up from 46% on the year in June at 8,033 cars, United States, implementing fiscal 12.8 times at the October lows. Chi- fueled by strong demand for its X5 and monetary stimulus worth nearly nese M-2 was 25.7% larger in May and X6 models. 30% of GDP (Grant’s, April 3), is not than it was a year before. Chinese Sales in China for both the BMW far out of the interventionist main- officialdom is targeting 8% GDP and the compact Mini brand rose 44% stream. China is in a class by itself. growth this year, while the World on the year at 8,506 cars, a company In the 1930s, Western intellectu- Bank predicts 7.2%, of which, the spokesman said. als persuaded themselves that the organization says, six full percentage Soviet economic model was depres- points owe their existence to govern- Now unfolding is a preview of the sion-proof. Today, not a few investors ment stimulus. As between the 8% next, the future, credit collapse. Such marvel at the vigor of the modified government forecast and the 7.2% methods as China is employing—a communist economic model of the non-government forecast, our money borrowing binge centrally planned People’s Republic. Credit may con- is on the government. Not only do the and directed—will eventually come tract in the United States, but it ex- cadres print the money, but they also to grief, as the readers of Grant’s pands—nay, explodes—in China. “If calculate the GDP. So, falling in with know full well. Indeed, in money the rumored new lending figures for the Communist Party, we, too, pre- matters, nearly everything seems to June are accurate (for more, see Mi- dict 8% growth for 2009—barring an come to grief sooner or later. How- chael Pettis’s blog at mpettis.com),” early explosion in the Chinese bank- ever, it is equally true that, before the observes colleague Ian McCulley, ing system. grief, comes the laughter and levita- “Chinese banks will have lent 7 tril- New directives to Fannie Mae tion. Massive injections of money lion renminbi, or a little more than $1 and Freddie Mac to refinance cer- and credit are always unsound. But trillion, in the first half of 2009, com- tain mortgages at up to 125% of ap- for stocks, commodities and credit, pared to Rmb4.9 trillion in all of 2008, praised home value reaffirm the U.S. they are bullish before they are bear- Rmb3.6 trillion in 2007 and Rmb3.2 government’s membership in the ish. In the fad for “quantitative eas- trillion in 2006. New lending was ex- hair-of-the-dog bloc. But no credit- ing,” when might the laughter turn to ceptionally strong in the first three market intervention approaches the tears? How to prepare for that inflec- months of this year. It tapered off a one being mounted in Beijing. For tion point? How to see it coming? bit in April and May but appears to it, the world’s commodity producers China is not alone in seeding bad have roared back in June.” say daily prayers of thanksgiving, and loans right on top of the previous Complementary roars have issued their gratitude would truly be incalcu- cycle’s only partially harvested crop from China’s manufacturing indus- lable if only they knew how long the of desperate debts. Loan guarantees, tries and world commodity pits. Last Chinese could keep it going. Absent commercial paper purchases and oth- week, the People’s Republic purchas- Chinese stockpiling, where would commodity prices be? Without a Indispensable country? functioning Chinese banking system, 80% 80% where would the world economy be? China’s actual and projected contributions to global GDP growth; A superb primer on the risks of three-year moving average (PPP basis) 70 70 China’s go-for-broke lending drive threethree years years was published by Fitch Ratings on toto 2010: 2010: 74% 74% May 20. Is it not passing strange, the 60 60 agency asks, that Chinese lending is

GDP growth share accelerating even as Chinese corpo- 50 50 rate profits are shrinking? “Ordinar- ily, falling corporate earnings are met 40 40 with tightened lending, but in China, precisely the reverse is evident. . . .” 30 30 You would expect—and Fitch does

GDP growth share anticipate—that the borrowers of these trillions of renminbi are not so 20 20 profitable as they were in the boom, and some will therefore struggle to 10 10 service their debts. Reading Fitch on China, we think 0 0 of the author Mark Singer on Okla- 1970 1975 1980 1985 1990 1995 2000 2005 2010 2014 homa. In China, Fitch explains, credit source: International Monetary Fund losses don’t surface promptly on ac- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 7 count of “pervasive rolling over and Preview of tomorrow’s crisis maturity extension of loans when they 10,000 10,000 Chinese bank lending; rolling 12-month sums Rmb8.62 trillion fall due. This not only leads to under- capturing of NPLs and delayed credit costs, but also, by extension, inflated 8,000 8,000 capital. Consequently, in the short to

medium run, Chinese banks’ perfor- in billions of renminbi mance may continue to hold up well as rapid loan growth drives up the de- 6,000 6,000 nominator of NPL ratios and boosts profits via high volumes, but the me- dium-term risk of a deterioration in 4,000 4,000 corporate portfolios is rising.”

Neither did credit losses surface in billions of renminbi right away at the Penn Square Bank, Singer related in his 1985 tour de 2,000 2,000 force, “Funny Money.” Penn Square originated oil-patch loans at its head- quarters in an Oklahoma City shop- 0 0 ping center during the boom of the 3/01 4/03 4/05 3/07 5/09 late 1970s and early 1980s. Interests source: The Bloomberg in these credits it syndicated far and wide. An alert loan buyer might have taken a cautionary hint from Penn rates. The secret, fully revealed dur- already on the rise. Chinese loan offi- Square’s super-fast growth and evi- ing the subsequent bear market, was cers work to a quota. They take their dent undercapitalization, if not from that the default rates were a direct direction from their branch managers, the nickname of its chief energy- product of the issuance rates. Bor- who report to the senior management, lending officer—they called him rowers didn’t default because of—to which answers to the board of direc- “Monkeybrains.” But the Continen- adapt the Fitch formulation to that tors—and the directors hang on the tal Illinois National Bank & Trust earlier time—the “pervasive rolling words of the People’s Bank. Co., of Chicago, one of Penn Square’s over and maturity extension of bonds The trouble these days is that too top loan participants, seemingly sus- as they fell due.” Drexel failed when many motivated loan officers are pected nothing until the Oklahoma the junk market did. chasing too few creditworthy borrow- bank failed in 1982. When Continen- The idea that the government will ers. Net interest margins at Chinese tal Illinois itself became insolvent in finally pick up the pieces may or may banks are tightening on account of 1984—pulled down, in part, by its not drive the typical mid-size Ameri- the recession and the governmentally Penn Square participations—a new can bank to risk-taking from which sponsored drive to lend their way to chapter in the socialization of credit it would otherwise shrink. In China, prosperity. So loan officers push all risk was opened. To save the Federal however, there appears to be no doubt. the harder. “For example,” as Fitch Deposit Insurance Fund, the govern- “Prior to the global crisis,” according explains, “a branch manager is given ment nationalized Continental, then to Fitch, “domestic [Chinese] credit an annual profit target of Rmb35 mil- the nation’s seventh-largest bank, conditions had been fairly tight; strict lion. If the average loan margin is with assets of $41 billion. Pure and loan quotas had been put in place at 3.5%, he needs to lend Rmb1 billion simple, it was too big to fail. Indeed, the start of 2008 amid concerns about to meet this goal. However, if the av- Comptroller of the Currency C. Todd inflation, and [corporations] and banks erage margin declines to 2%, he now Conover subsequently hinted, the were increasingly employing off-bal- needs Rmb1.75 billion to meet the 11 largest banks in the country were ance-sheet transactions to complete same objective. This is not the first systemically irreplaceable. And so deals. However, since the rollout of time Chinese banks have faced a mar- was born the too-big-to-fail doctrine. the stimulus package [last November], gin squeeze, but in the past the abil- Whether or not it was an American the climate has dramatically changed. ity to raise credit volume was limited invention, the policy today belongs Projects that had been sidelined when by quotas [i.e., central-bank-imposed to the world. China, in particular, has quotas were tight have been put into quotas to restrict lending to combat taken the idea and run with it. action with the assumption that if inflation]. Now, in a quota-less envi- Examining, first, the track of Chi- problems arise, Beijing will likely step ronment, that restraint is gone.” nese bank lending and, second, the in with assistance.” China has its Sheila Bair as well trend in Chinese nonperforming If problems arise? As Fitch itself as its Ben Bernanke, and the safety- loans, the seasoned reader will re- implies, the only question is when: and-soundness bureaucracy in March member not only Monkeybrains but Nonperforming loans at foreign urged banks to set aside in reserve also Drexel Burnham Lambert. In banks in China, “which are generally 150% of the par value of their bad the mid-to-late 1980s, the American believed to have stricter risk manage- debts, up from 120%. But the direc- junk-bond market combined break- ment and oversight and are less will- tive seems more in the way of a sug- neck growth with muted default ing to roll over delinquent loans,” are gestion than a ukase. Certainly, the SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 8

rates at the knees, central banks Bad debt comes later 20% 20% punish thrift. Prolonging the lives Chinese nonperforming-loan ratio of businesses that deserve to go out of business, they thwart the designs of the entrepreneurs who would, if 16 16 they could, build something better. There’s no end of mischief in quanti-

percent of total loans tative easing. On the other hand, it’s 12 12 an ill monetary wind that blows no portfolio any good. Beijing has been lifting prices in resource markets. “The round of oil-field auctions in 8 all banks: 2.04% 8 Baghdad last week,” McCulley points out, “is a sign of things to come, as percent of total loans China National Petroleum Co. was part of a winning BP-led bid, while 4 foreign banks: 1.09% 4 most other Western majors walked away complaining of unfair terms. (China National has a separate deal 0 0 to develop other Iraqi fields.) Sinopec 3/04 3/05 3/06 3/07 3/08 3/09 is buying Addax Petroleum, with re- source: The Bloomberg serves in West Africa and Iraq, in an $8.8 billion deal, and, according to stock market does not believe that the able for inflation projections, giving The Wall Street Journal, is paying $16 evil end to the new credit boom is yet priority to output gaps.” per barrel of proven and probable re- in sight. In Hong Kong, the big three So the economists give intellectual serves, more than triple the valuation Chinese banks—Industrial & Com- cover to the money printing. For the of other deals in the region.” Western mercial Bank of China, Bank of China “mature market economies,” we ad- companies may answer to their share- and China Construction Bank—trade vise a return to the basics, starting holders, but as an energy consultant at price-to-book multiples of 2.5, 1.7 with the very definitional threshold put it to the Financial Times last week, and 2.5, respectively. of the problem. Inflation is not “too “The Chinese companies are answer- We are as bearish on the multiples much money chasing too few goods,” ing to politicians who have an aggres- as we are on the stated book values. but too much money, period. What sive strategy of resource capture.” On the other hand, the stock market the fatal, redundant increment of cash The properly skeptical observer is is as sanguine about Chinese bank chooses to pursue varies from cycle to in a quandary. China holds perhaps stocks as economists are compla- cycle. In pursuit, however, it never $1.5 trillion of low-yielding Treasurys cent about Chinese inflation. The fails to distort something. Lately, the and U.S. agency securities. You’d ex- late Milton Friedman handed us not money has been chasing investment pect it to be edging out of two-year so much a postulate as a divine law assets rather than goods and services. notes and Fannies and Freddies into when he said that “[i]nflation is al- In Shanghai, it is chasing A-shares. resource investments, even if it had ways and everywhere a monetary Globally, this year, it has pushed up, no doubts about the dollar. But it does phenomenon.” But a new generation or contributed to the pushing, of the have doubts, which it has taken to ex- of central bankers and economists is prices of lead, copper and nickel by pressing in deeds as well as in words. having its doubts. “Some worry that 75%, 71% and 50%, respectively. On Monday, a Shanghai municipal the rapid growth of money and credit Who knows? Maybe the central banks government finance official called will lead to inflation,” the Beijing of- have prevented some prices from fall- a press conference to announce the fice of the World Bank advises in its ing further than they otherwise would decision of three local companies to June Quarterly Update. “However, have done. Central bankers, however, begin settling import and export con- with a lot of [spare] capacity in China to generalize across the profession, re- tracts in renminbi rather than dollars. and world-wide putting downward fuse even to imagine the problem in From offstage, a Singapore currency pressure on raw material prices un- these terms. They are content rather analyst declared, according to Bloom- likely to soar soon, substantial gener- to assert that, owing to the prodigious berg, “This is a first step on the long alized price pressures seem unlikely gap between output and potential road towards that target of making the any time soon.” An asterisk at the output in recession-wracked econo- [renminbi] a global reserve currency. end of that sentence leads the read- mies, their actions have instigated no That’s probably going to take five er to a footnote in which the World inflation but have forestalled defla- years or more.” Bank economists finish the argument: tion. Self-congratulations ringing in It could be a long, hard road if Chi- “The relationship between monetary their ears, they are prepared to crank na’s Monkeybrains banking system aggregates and inflation is complex. the presses even faster when duty follows the Penn Square-type trajec- That is why central banks in mature next calls. What’s the harm in it? they tory, as we expect it will. Besides, market economies have largely aban- seem to ask. Bloomberg News, in the very same doned using money as a guiding vari- In fact, by cutting off interest dispatch, relates that the dollar’s SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 9

share of official vault space climbed mulative trade surplus through May, Men-style vendor to the energy in- to 65%, or $2.6 trillion, up 100 basis which is actually ahead of last year’s dustry. points on an admittedly incomplete record-setting pace.” Lufkin, 107 years young, is a lead- sample set, in the first three months A good-size portion of the Trea- er in the field of artificial lifting—its of the year. And it quotes He Yafei, surys and agencies that America’s technology restores to aging wells China’s deputy foreign minister, creditor nations accumulate is held what nature is gradually taking away. speaking in Rome on Sunday: “The for safekeeping at the Federal Re- Its oil-field segment manufactures dollar will maintain its role for ‘many serve Bank of New York. We track pumping units, or “horse’s heads,” years to come.’” these custody holdings on pages six as the roughnecks affectionately call So saying, He came to the root of and seven of Grant’s; the Fed disclos- them. Lufkin installs pumping units, the problem. The dollar’s “role” in es them every Thursday. Strange to services them and fine-tunes them the world—its exalted status as a re- relate, they have grown, not shrunk, with computer automation equip- serve currency—is what has facilitat- in the past three months, at an annual ment. ed the piling up of debts on one side rate of 27%. A second Lufkin business segment, of the Pacific and U.S. Treasury as- All in all, the world is reverting the power-transmission division, sets on the other. It is the dollar’s role to pre-crisis form. Central banks are makes and services gearboxes for that has allowed the United States to monetizing dollars, subsidizing credit industrial applications. For energy- consume much more than it produces and socializing risks, and the People’s related work, it produces high-speed and to finance the difference in the Bank is outdoing all others in this gearboxes. An exacting work is this, as currency that it alone may lawfully direction. Certain it is that these un- the gearing runs at up to 4,500 revolu- print. China ships merchandise to us; precedented monetary maneuvers tions per minute. For less demanding we ship dollars to China. These dol- will come to a sorry and dramatic end. applications, there is a Lufkin line of lars wind up at the doorstep of the What we are struggling to divine is low-speed gearboxes. People’s Bank, which creates the the timeline. Watch this space. A little like the stock market itself, renminbi with which to absorb them. • Lufkin’s shares are neither very rich And what does the bank do with its nor very cheap. They are quoted at greenbacks? Why, it invests them in 10.8 times earnings (and peak earn- the securities of the U.S. government. Lift for Lufkin ings, at that) and 20 times the average Note, please, that the dollars might as earnings of the past 10 years. They well have never left home. Note also (August 7, 2009) It’s not only we, trade at 1.7 times book with a divi- that their transit instigates credit cre- the people, who are aging. Oil and gas dend yield of 2.1%. At $47 a share, the ation in China, some of which, though fields, too, are getting gray around the stock is half of its record-high price not all, may be neutralized, or “steril- temples. To erase unsightly blem- set almost 12 months ago. Revenues ized,” by the People’s Bank. Under a ishes and prolong productive life are and net income peaked in the fourth proper gold standard, creditor coun- yearnings that have launched many quarter of 2008 at $230.6 million and tries gain reserves while debtor coun- a profitable business. Following is a $26.6 million, respectively. Second- tries lose them. Built into that system bullish analysis of Lufkin Industries quarter revenues and net income, at is a balancing mechanism. New un- (LUFK on the Nasdaq), a Just-for- $123.7 million and $4.5 million, were der the paper-money arrangements of recent decades is a kind of intrinsic Counting down imbalance. The major debtor country 4,500 4,500 loses no reserves even as the debtor oil and gas rig count; North American average countries gain them. 4,000 4,000 Our Great Recession has restored a small measure of balance to the inter- 3,500 3,500 national financial traffic. U.S. imports have fallen further than U.S. exports, 3,000 3,000 thus reducing the U.S. current-ac- number of rigs count deficit for the first quarter to 2,500 2,500 $101.5 billion vs. the year-ago reading of $179 billion. The second-quarter 2,000 2,000 shortfall was the smallest in abso- number of rigs lute terms since the fourth quarter of 1,500 July 31, 1,500 2001, and the smallest as a percent- 948 age of GDP—2.9%—since the first 1,000 1,000 quarter of 1999. Yet, still, China accu- mulates dollar bills. “Despite a year- 500 500 over-year drop in exports of 26.4%,” McCulley notes, “and the American 0 0 consumer’s newfound taste for thrift, 1949 1959 1969 1979 1989 1999 2009 China has posted an $89 billion cu- source: Baker Hughes SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 10

Lufkin Industries down from year-earlier levels by 29% and 79%. They fell in a heap with the (in $ thousands, except per-share data) oil price and the rig count. One year 12 mos. to ago, according to Baker Hughes, 1,951 6/30/09 2008 2007 2006 rigs were at work in North America. There were just 876 in May. At last Sales $702,513 $741,194 $555,806 $526,122 count, in July, there were 948. Cost of goods sold (515,575) (527,120) (393,538) (374,922) “Compounding the fall in demand SG&A (75,256) (71,974) (57,582) (50,752) for our products,” CEO John F. Glick Other income (expenses) (10,864) (5,688) 4,772 1,474 told listeners-in on the July earnings Taxes (36,180) (48,387) (37,673) (30,650) call, “is the high level of inventory in Net income 64,638 88,025 71,785 71,272 our major customers’ storage yards. Earnings per share 4.35 5.92 4.92 4.83 Since customers purchased much of Sales backlog 162,260 317,486 199,032 183,929 that inventory and put it in place in the second half of 2008 in anticipation Cash and cash equivalents 86,300 107,756 95,748 57,797 of having a number of rigs under con- Receivables na 139,144 90,696 90,585 tract, the pace for drawing down that Inventories na 128,627 92,914 85,630 inventory will be slow. We believe it Total assets 519,092 530,718 500,656 429,069 may take at least two more quarters Current liabilities na 88,813 68,314 61,495 for those inventories to be worked Long-term debt 2,300 — — — down, assuming the rig count remains roughly at current levels. Until that Shareholders’ equity 418,928 413,937 384,653 328,140 happens, new orders will remain well below those record levels we saw last Share price $47.06 year.” To adjust, the front office re- Dividend 2.1% duced the oil-field manufacturing Market cap $699,349 head count by 38% in Canada and by Price/book 1.7x 68% in the United States. Price/earnings 10.8 Admittedly, the bull story may not be quite self-evident. Rather, we of gas, 4,500 feet of oil and 4,500 opening-day remarks by the host na- think, it’s implicit in the profile of the feet of water would, therefore, be tion’s minister of oil and gas. “Dr. world’s waning oil fields. In the full 3,500 psi (1,000*0.05+4,500*0.333 Ali Mirza,” said the press release, bloom of youth, an oil or gas well may +4,500*0.433). In order for the well “stressed the important role played exhibit what the engineers call natu- to produce via natural lift, the reser- by artificial lift in crude oil produc- ral lift. Whether or not a well can use voir pressure would need to be great- tion by pointing out that over 50% of a Lufkin pumping unit depends on er than 3,500 psi. If the reservoir the world’s oil wells currently utilize comparative fluid pressures. Pressure pressure were, say, 4,000 psi, fluids some form of artificial lift technology. within the energy-bearing reservoir is would flow toward the well bore and Citing the local situation, he added one such variable. Pressure created make their way to the surface—no that more than 60% of oil wells in by the column of oil or gas or water assistance required. If the reservoir Bahrain also use these technologies, inside the well bore is another. This pressure were only 3,000 psi, the col- contributing about 50% of the king- second kind of pressure is known as umn of fluid would need to be lifted dom’s total oil production.” the hydraulic head. When the hydrau- artificially out of the well bore by a How does Lufkin, with a market lic head is greater than the pressure in pump. New wells may or may not cap of only $699 million, shine in the reservoir, the oil or gas can’t get have sufficient pressure to produce the firmament of artificial lifting? to the surface under its own power. It naturally. But, as wells age, reservoir Customer satisfaction surveys hold a needs a lift, in the shape of a device pressure declines and artificial lift clue. Thus, in 2007, Lufkin earned a to reduce the hydraulic head to some becomes necessary.” kind of four-star honorable mention value lower than the pressure prevail- Oil fields may age, but they only in the biennial Customer Satisfac- ing in the reservoir. Enter Lufkin. reluctantly retire. Twenty-four mil- tion Survey published by Energy- “In an oil well,” colleague Dan lion barrels a day, or 35% of global Point Research. Specifically, it won Gertner advises, “there are gen- production, flow from fields that be- the maximum number of plaudits erally three fluids inside the well gan operations before 1970. It’s a sign for companies that did not garner bore—natural gas, oil and water. A of the times that artificial lifting has enough evaluations to be eligible for 100-foot column of gas exerts a force become a hot topic even in the Mid- the primary rankings. In 2005, when of about five pounds per square dle East, where, proverbially, once it did so qualify, Lufkin ranked third inch; a 100-foot column of oil ex- upon a time, black gold gushed from in a field of 28. erts about 33.3 psi; and a 100-foot a hole you just punched in the sand. “They are clearly a player in arti- column of fresh water, about 43.3 The fifth Middle East Artificial Lift ficial lift,” Doug Sheridan, manag- psi. The bottom-hole pressure in a Forum, a three-day event held in Ma- ing partner of EnergyPoint Research, 10,000-foot well bore with 1,000 feet nama, Bahrain, in February, featured tells Gertner. “[T]hat is a pretty nar- SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 11

row area of expertise, so what hap- was the office Natco bull, and he has The burden of the following anal- pens is they have to live and die by this to say, in closing, about Lufkin: ysis is that Mr. Market was a little their success with that product and “I view Lufkin much as I did Natco. hasty. Iconix, which owns and li- service. So it has to be good. As op- Both companies have a narrow fo- censes a portfolio of established con- posed to an integrated service pro- cus and highly satisfied customers sumer brands, may yet have a future, vider, like Schlumberger, [which] (Natco was ranked fourth in the 2005 assuming the consumer does. About can really say, ‘Well, we may be aver- EnergyPoint survey), and both are this contingency, admittedly, there age in some areas, but we are really positioned to capitalize on the engi- are doubts. In a recent single edition good in others, so we accept the aver- neering problems associated with the of The Wall Street Journal—that of Oc- age or below-average areas and look aging of the world’s oil production. tober 8—there’s fully a week’s worth at us from an entire package.’ A guy Like Natco, Lufkin has the financial of bad news. Thus, holiday spending whose job is focused on trying to in- strength to survive lean times. I have will be 1% less than last year’s, which crease production at a well using ar- not seen Lufkin mentioned as a take- was 3.4% lower than the prior year’s, tificial lift ends up being frustrated over candidate, but it would be a good according to the National Retail Fed- with some of the integrated provid- fit with a larger oil-field service com- eration; this year’s tally of retail-store ers. Lufkin does not suffer from that. pany. After all, none of these fields is closings (8,300 through September) is As a matter of fact, they execute very getting any younger.” greater than all of last year’s (6,900), well. They are very well regarded, not • according to the Federal Reserve; and only in terms of sales, but also execu- 10.3% of retail space at U.S. shopping tion. One of the things that you see centers was vacant in the third quar- that is really important in this sector is House of brands ter, up from 8.4% in the third quarter after-sales support. Meaning, how did of 2008, according to Reis Inc. it work out? What do we need to do (October 16, 2009) Into Mr. Mar- Iconix, we are about to contend, to make sure you get the results you ket’s quavering hands, the manage- is likely to ride out the slump and were looking for? And what can we do ment of Iconix Brand Group (ICON prosper in the upturn. What the com- to be accountable to you for what your on the Nasdaq) consigned a press pany does for a living takes a little ex- expectations were for us?” release dated September 30. “The plaining. It buys intangible things— London-listed John Wood Group company,” the text read, “is revising brands—and licenses others to sell (with a market cap of $2.5 billion) and its full year 2009 revenue guidance to them. It is the beau ideal of the “tan- Weatherford International (valued at a range of approximately $215 million gible-lite” business highlighted in the $13.3 billion on the Big Board) are to $220 million from prior guidance of April 17 issue of Grant’s. Brands may Lufkin’s principal investor-owned $223 million to $230 million.” Actu- or may not endure, but at least they comps, and there’s not much differ- ally, management added, the evident don’t require painting, new software ence in valuation among the three. revenue miss represented a 5% rev- or retrofitting with new power trains. Lufkin’s principal distinguishing fi- enue increase from the comparable They are lighter than air. Some 77% nancial feature is its balance sheet. As period a year ago. But it was no good: of Iconix’s assets are of this nature— against $419 million in book equity, it The confession drilled the share price goodwill, trademarks, etc.—which ob- has just $2.3 million in long-term debt. for 21%, wiping out $237 million of viates the risks associated with inven- Wood and Weatherford show debt-to- stock-market capitalization. tories and manufacturing operations. equity ratios of 37.5% and 65.7%, re- What’s in a brand? spectively. Such debt as Lufkin has is $27 $27 not homegrown but imported. It was, Iconix stock price specifically, affixed to International 24 24 Lift Systems, a maker, installer and servicer of so-called plunger lift sys- 21 21 tems, which Lufkin acquired for $45 million in March—a month when not 18 18 many other companies had the cour- price per share age or wherewithal to shop for acqui- 15 15 sitions. “They provide an entry for Lufkin into the offshore market for 12 12 artificial lift wells,” said the buyer’s price per share press release, “including deepwater 9 9 plays, and they expand our reach into the artificial lift market.” 6 6 We write in praise of Lufkin a little more than two months after 3 3 Natco Group (Grant’s, January 23) was scooped up by Cameron Inter- 0 0 national at a 30% premium to the 1/30/04 1/31/05 1/31/06 1/31/07 1/31/08 1/30/09 10/13/09 prevailing Natco share price. Gertner source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 12

The tangible-lite business model is Iconix brand has been around for 52 doubled, to 71 million from 28 mil- geared to producing high EBITDA years), and the company works to lion shares, and its debt has grown to margins (in the 70s in this case) and keep them fresh. Gisele Bundchen, $576 million from $25 million. Among lots of cash. Management forecasts Britney Spears, Brooke Shields and these obligations are $240 million of free cash flow this year of $125 mil- Tony Romo are among the celebrities convertible notes, the 1.875s of June lion or so on revenues of $225 million who have sprinkled stardust on Ico- 2012, unsecured and convertible at or so. Of course, there are correspond- nix’s wares. $27.56 a share. “Balancing that debt,” ing risks. Brands, like the ether, can Iconix may license a wholesale sup- observes colleague Dan Gertner, “is go pfft, and there is only so much plier to sell authorized products to $500 million of guaranteed minimum comfort in knowing that the company stores within an approved channel of royalty payments for current licenses, is quoted in the stock market at book distribution. Or it may license a sin- excluding any renewals, and $216 value. By writing down its $1.2 billion gle retailer to sell a range of branded million of cash. Guaranteed minimum of intangibles to zero, management products within a certain geographi- royalty payments are due regardless would eliminate that book value 1.4 cal area. For instance, Kohl’s has an of the amount of sales. Such guar- times over. exclusive license to sell the Candie’s anteed payments have recently ac- Iconix owns 18 brands with $8 bil- brand in the United States across two- counted for 70% of royalty payments. lion in annual sales. The list is as dozen product categories. Similarly, Besides Kohl’s, Target and Wal-Mart, follows: Candie’s, Bongo, Badgley Target has Mossimo and Wal-Mart top licensees include K-Mart/Sears Mischka, Joe Boxer, Rampage, Mudd, has Ocean Pacific, Danskin and Start- and Li & Fung. The expiration of the London Fog, Mossimo, Ocean Pacific, er. Direct-to-retail licenses accounted licenses is staggered over the next Danskin, Rocawear, Cannon, Royal for 50.5% of Iconix’s revenues in the five years.” Velvet, Fieldcrest, Charisma, Starter, first half of this year, almost double On the second-quarter conference Waverly and Ed Hardy. These brands the year-ago volume. Retailers like call, Iconix management talked up the company licenses to designers, holding the proprietary rights to a na- its ambitions to make acquisitions manufacturers, distributors and re- tional brand without the risk of being and to expand overseas. “On the in- tailers. Licensees pay a royalty based undercut by a nearby competitor. ternational front this quarter,” said on net sales and a certain amount, in Brands don’t come for free, as the CEO Neil Cole, “we signed our third addition, for marketing and adver- growth in Iconix’s balance sheet at- deal in China for our Rocawear brand. tising. Brands may not literally rust, tests. Since year-end 2004, the com- Between Rampage, London Fog and but they do grow stale (the average pany’s share count has more than Rocawear, we epxect our brands to have well over 500 stores in China within the next three years. To reiter- Iconix Brand Group ate our China strategy, we are target- (in $ thousands, except per-share data) ing the masses. And rather than open- 12 mos. to ing up a handful of stores in a few major cities, our partners anticipate 6/30/09 2008 2007 2006 opening up hundreds of stores in the Licensing $216,303 $216,761 $160,004 $80,694 densely populated non-major cities SG&A (70,423) (73,816) (44,254) (24,527) all over greater China.” This sound- Other income (expenses) (365) (1,421) 6,039 (2,494) ed bullish, indeed, although Cole is Net interest (30,151) (32,598) (25,512) (13,837) not so personally bullish that he did Taxes (41,425) (38,773) (32,522) (7,335) not choose to sell 650,000 of his own Net income 73,939 70,153 63,755 32,501 shares in connection with a recent Earnings per diluted share 1.14 1.15 1.04 0.72 secondary offering (the sale leaves him with 2.6 million shares, or 3.6% of Cash and restricted cash 216,057 83,145 68,458 68,458 the outstanding; insiders collectively Receivables 57,909 47,054 29,757 14,548 hold 7.1% of shares outstanding). Prepaid advertising 13,406 14,375 5,397 2,704 Iconix trades at 12 times its down- Property and equipment 6,067 6,719 1,293 1,384 wardly revised 2009 earnings estimate Goodwill 165,001 144,725 128,898 93,593 and 10.9 times the Street’s 2010 fore- cast of $1.20 per diluted share, i.e., Trademarks and intangibles 1,056,966 1,060,460 1,038,201 467,688 roughly half the multiples command- Total assets 1,592,251 1,420,259 1,336,130 696,244 ed by the larger retailers with which Current liabilities 74,051 103,193 76,410 35,705 Iconix does business and roughly half, Long-term debt 516,700 594,664 649,590 140,676 as well, of the valuations of such de- Shareholders’ equity 864,539 613,526 527,920 465,457 sign houses as Polo Ralph Lauren and Guess? Inc. “The Iconix share price,” Share price $13.02 Gertner winds up, “moves up grudg- Market cap 928,316 ingly on good news and is thrown Price/book 1.1x for a loop by bad news (witness the Price/earnings 11.5 reaction to the slight revenue miss). SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 13

There are plenty of signs urging cau- its rate of rise was too fast. The cen- bills because they were worth $100. tion when it comes to the American tral banks of India, Mauritius and Sri General Electric commercial paper, consumer, but the stock seems to be Lanka had very publicly bought gold on the other hand, was worth par with priced for worry. Add the safety of a instead of U.S. Treasurys. The Indian a Treasur y guarantee, a little less— guaranteed royalty stream to a reason- government, first of the three out of perhaps a great deal less—without able valuation, and a bullish investor the gate, had relieved the Interna- one. Way back when, under our be- may be allowed to contemplate the tional Monetary Fund of 200 metric loved gold standard, monetary value possibility of something going right.” tons at an average price just below was intrinsic in the money itself. Un- • $1,050 to the ounce. China must be der the law, you could exchange dol- next in line, some bulls reasoned. lars for gold, and gold for dollars, at Others took a simpler approach to the a fixed rate. Growth in the world’s Warm thoughts on a cold valuation problem. The charts looked monetary base was under the control good, they said. of mining engineers as much as it was metal Then the price stopped going up of bankers. The dollar was anchored and started going down—and now and so, to a degree, was dollar-denom- (February 19, 2010) Earnings sea- we’re bullish again. Our approach to inated credit. But not since 1971 has son is almost over, but for GLD it the valuation question is different any currency been so endowed. Mon- never began. Not since the earth’s from the chart readers’ but almost as etary value, rather, is conferred by crust cooled has the 79th element in simple. Gold is a monetary asset, we governments under the direction of the Periodic Table earned a dime. reason. It competes with other mon- the kind of people who participate in Yet that hasn’t stopped SPDR Gold etary assets, notably with paper cur- the panel discussions at Davos, Swit- Trust, a.k.a. GLD, from becoming an rencies. And it competes, too, with zerland. Gold may be hard to value, institutionally recognized investment credit, which is the promise to pay but you can tell it’s worth something asset. Still, the question hangs in the money. In Europe, especially, gold just by looking at it. The euro, too, air: What’s an ounce worth? shines brighter every day next to the is hard to value, but it is inherently Now begins a reappraisal of our competition, either to the coin of the worth nothing, absent a government Nov. 27 reconsideration. That es- realm or to the sovereign obligations to stand behind it. say, skeptical in tone, ran under the denominated in that coin. By this line of argument, the crisis headline, “Cool thoughts on a mol- Money is intrinsically valuable, of the euro should be hugely bullish ten metal.” Its thesis was not that the which sets it apart from credit, which for the gold price, denominated ei- gold price was too high (who knows may or may not be valuable. During ther in dollars or euros. What could be how high is too high?), but rather that the late crisis, people wanted $100 better for bullion than trouble for the

Those devilish Cartoons. Everyone has a favorite—order yours!

4”x4” cartoon size, signed by Hank, matted and suitable for framing, $150. Own a print of a Hank Blaustein masterpiece. Find your favorite in the Grant’s cartoon treasury: www.grantspub.com/cartoon SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 14

made-up European money that not Flatline at Wiki central bank only circulates on the Continent but 1,200 1,200 also claims a 28% share of the world’s SPDR Gold Trust holdings central-bank vault space (compared Feb.Feb.9, 9, 2010: with 62% for the U.S. dollar)? But 1,000 1,1061,106 metric metric tonnes tons 1,000 the euro’s weakness is the dollar’s reciprocal strength, and an appreciat- ing dollar exchange rate convention- 800 800

ally implies a depreciating dollar gold in metric tons price. Then, again, not much about this juncture in world monetary af- 600 600 fairs is conventional.

We say we are bullish, but we have in metric tons no idea where the price is going. And 400 400 neither do you, whoever you are. The gold price, it has sometimes seemed to us, is the reciprocal of the world’s 200 200 faith in the judgment of Ben S. Ber- nanke. The greater the trust, the lower the price, and vice versa. You 0 0 would suppose, after all the blood, 11/18/04 11/30/05 11/30/06 11/30/07 11/28/08 11/30/09 sweat and tears of the past three source: The World Gold Council years, that the market would not trust the chairman of the Federal Open with research coverage. Trained to A recent report from one of the gov- Market Committee further than it divine the net present value of a fu- ernment-supported New York banks could throw him. Yet the gold price ture stream of earnings, the analysts lays out the bearish case on the metal is not $3,000 but one-third of that. It have cast around for a quantitative that used to line that institution’s makes you humble, if you happen to approach to a sack of Krugerrands. vaults in the days when it was inde- be in the soothsaying business. The “Undaunted,” colleague Ian McCul- pendently solvent. The authors of dollar system will come a cropper, we ley notes, “the sell side, needing to the study—who, let the record show, believe, but it will evidently do so on fill pages with ‘rigorous’ analysis, has were not the ones who ran the bank its own schedule, not ours. Maybe cooked up all manner of correlation into the ground—argue that the gold the euro system will lead the way to and regression studies connecting the market has lost a number of its bull- chaos. The outer limit on the preci- gold price to real interest rates, mon- ish props. “Investors and speculators sion of our forecast is contained in the ey supply, inflation, inflation expec- are the main driver of the gold price,” phrase, “We are bullish on gold.” tations, investment demand and the they write. “There is no support at The gold bull market is a decade dollar exchange rate. But no matter current prices from mine and scrap old, but only recently has the Street how hard the analysts try, gold still supply (which is rising), or fabrica- begun to flatter the barbarous relic doesn’t yield anything.” tion demand (which is plummeting), in our view. U.S. dollar weakness and increased money supply has been the After the pullback $1,200 $1,200 main driver of investment demand gold price and speculative flows, we believe, Feb.Feb.12, 16, 2010: and any strength in the U.S. dollar is 1,100 $1,117$1,083 1,100 the main risk to prices.” And if the rising dollar exchange rate isn’t bad 1,000 1,000 enough, the bulls confront benign in- flation, rising mine supply, a rhetori-

900 900 price per ounce cally stern Fed, a worrying swoon in U.S. monetary growth and an evident 800 800 peaking in the level of gold reserves held in the London vaults of the SPDR Gold Trust.

price per ounce 700 700 “Wiki central bank,” this publica- tion has coined the GLD hoard. Even 600 600 if no government has the courage of our convictions, any brokerage-house 500 500 customer can choose to go on his or her own personal gold standard. And 400 400 it seemed as if a people’s gold stan- 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10 dard were in the making during the source: The Bloomberg pounding heart of the financial crisis. SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 15

On the day the Fed bailed out AIG, Old faithful $8,000 $8,000 Sept. 16, 2008, GLD held 614 metric worldwide monetary reserve assets tons; by March 2009, the stockpile $7.62 trillion had nearly doubled, to 1,127 metric 7,000 7,000 tons. In dollar terms, it more than doubled in those six months, to $33 6,000 6,000 billion from $15 billion. But, lately, in billions of dollars there has been stagnation, or shrink- 5,000 5,000 age: to 1,106 metric tons at last report from a peak of 1,134 metric tons in June 2009. In point of fact, the GLD 4,000 4,000 vaults have relinquished relatively lit- tle bullion compared to losses in pre- 3,000 3,000 vious bouts of gold-price weakness in billions of dollars (thus, from March to May 2008, they 2,000 2,000 surrendered 12%, compared to just 2.4% from June 2009 to this point in 1,000 1,000 2010). However, the analysts whose work we have been quoting see the vault as half empty, not half full. In- 0 0 3/03 3/04 3/05 3/06 3/07 3/08 3/09 12/09 vestors, they contend, “are no longer source: The Bloomberg concerned with counterparty risk and collapse of financial systems, but con- aged, lurking in the shadows) that is International Settlements, German tinue to want exposure [to] gold as a prone to inflation and deflation at one banks have exposures of $43 billion to U.S. dollar hedge, inflation hedge and and the same time. The greatest gen- Greece, $47 billion to Portugal, $240 interest-rate hedge.” eration? In devising infernal financial billion to Spain, $193 billion to Ire- While we can’t speak for all inves- machines, we’re the one. land and $209 billion to Italy. French tors, we can speak for ourselves. We The United States properly takes banks have exposures of $79 billion to buy gold as an investment in mon- top honors for frenzied finance, but Greece, $36 billion to Portugal, $185 etary disorder. Fractional-reserve Europe is no slouch, either. “The real billion to Spain, $69 billion to Ireland banking systems are historically prone problem on the Continent,” McCul- and $489 billion to Italy. For compari- to runs and deflationary contraction. ley relates, “is not so much the ability son, the German banks have $625 bil- Paper-money systems are inherently of France and Germany to backstop lion of capital, the French banks, $620 prone to inflation. Our modern finan- the debt of some of the weaker euro- billion. As a percentage of GDP, Ger- ciers have created something new zone sovereigns, but, rather, whether man banks’ exposure to the weaker under the sun. They have devised a France and Germany can backstop euro-zone members amounts to 22%; paper-money-cum-fractional-reserve- the various exposures that their banks for the French banks, the equivalent banking-system (with yet another have accumulated. According to figure is 32%. Of course, one could credit structure, also highly lever- third-quarter data from the Bank for calculate the exposures of Citi and J.P. Morgan to California. The point After a drought, a gush is that throughout this crisis, govern- 15% 15% ments have moved an ever-growing change in global mine supply of gold body of liabilities to public-sector 12 12 balance sheets from private ones. At some point, there isn’t much more 9 9 debt you can pile on already over- burdened national treasuries. The annual rate of change burden might eventually have to fall 6 6 on central banks, which—unlike gold miners—can create money on a com- 3 3 puter keyboard.” Many a discouraged gold bull is 0 0 tapping his or her foot for the return

annual rate of change of last autumn’s thrilling season of -3 -3 central bank gold buying. Two weeks ago, when the price fell within $20 of the $1,042-to-$1,049-an-ounce -6 -6 range that India had paid the IMF, Andy Smith, analyst at Bache Com- -9 -9 modities Ltd., London, raised a ques- 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 tion: If the price broke lower, would source: U.S. Geological Survey the Indian authorities buy more? “If SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 16 they don’t,” he replied in anticipa- skew,’ as the options adepts express for instance, constitute a speculation tion, “then November’s purchase was the foregoing concept, is the flattest, on a certain kind of economy, not more a trade than an expression of or most favorable towards call buy- an investment. The yield is too low long-term intent.” ers, since the fall of 2008. It can’t be to afford a margin of safety. So, too, So far, the gold price has forced said that the options market is exactly with Lufkin. At 58.3 times trailing neither India’s hand nor China’s. bearish on gold, at least compared to net income and 2.9 times book (and Chinese monetary authorities own the S&P 500, where June SPY puts at a yield of just 1.2%), the shares are 1,054 metric tons of the shiny, not- struck at 25% out of the money are a speculation on higher oil prices and/ dollar monetary asset, worth $37 bil- some 15 times more expensive than or on the continued growth in the lion at today’s prices, or 1.5% of over- equivalent calls. But the gold options population of aging, lower-quality oil all foreign-exchange holdings of $2.4 market is definitely less frothy than it fields. If the economy collapses in a trillion. So the People’s Republic of has been in a while. Even John Paul- deflationary heap, or if the oil price China and Grant’s Interest Rate Observ- son’s new gold fund apparently raised revisits $150, you’ll be glad you hung er are once more at loggerheads. We only $90 million, a huge whiff from on to your long bonds and LUFK. are betting heavily on fractures in the the whisper number.” Texas-based Lufkin, 108 years old, world’s dollar-centric paper currency We don’t whisper but speak out makes equipment to boost the per- system. China, on the other hand, is loud: Expecting monetary turmoil, formance of superannuated oil wells. betting rather more heavily on stabil- we’re bullish on the legacy monetary It produces and services gas lift and ity. Then, again to judge by the re- asset. plunger equipment as well as horse’s cent 13-F filing of China Investment • heads, a.k.a. pumping units. Sepa- Corp., a sovereign wealth fund under rately, it manufactures and services the wing of the State Council, the gearboxes for industrial applications, Chinese may be reconsidering. The Goodbye, good Lufkin including high-speed units for en- filing disclosed ownership of 1.45 mil- ergy-related operations. High speed lion shares of GLD and noted further (April 14, 2010) “A little like really means “high,” i.e., more than that 42% of the portfolio is invested the stock market itself,” said we of 4,500 revolutions per minute. Oil- in metals stocks. Lufkin Industries in the issue of field equipment accounts for 70% of To our mind, however, central Grant’s dated Aug. 7, 2009, “Lufkin’s revenues, power-transmission devic- bank buying of gold is not the world shares are neither very rich nor very es for the rest. monetary authorities’ main contribu- cheap.” Update: Lufkin’s shares are Lufkin and its shareholders thrive tion to a higher gold price. Rather, very rich. While this fact does not on high oil prices, economic growth— they do their part just by going to necessarily make them an imperative and dissipating oil deposits. Whether work in the morning—by targeting sale, it does—by the lights of Graham or not the so-called peak oil thesis is interest rates or inflation rates or im- and Dodd—transform them from an on the mark, it’s music to the ears of plementing what is euphemistically investment into a speculation. the Lufkin bulls. No coincidence that known as quantitative easing. Global These days, every thinking inves- only one month separated the 2008 mine supply rose by 4% in 2009, and tor—Lufkin bull or not—wrestles oil-price high ($147.27 a barrel, in July large North American-headquartered with the treetop valuations widely 2008) from the Lufkin share-price miners are expected to boost output in place. Treasurys at today’s levels, peak ($95.23, in late August). And it at a compound annual rate of 2.6% until 2016, according to data from On the rebound Deutsche Bank. Compared to the 4,000 4,000 1%-per-year rate of decline in global average North American rig count supply since 2000, Deutsche is fore- 3,500 3,500 casting a veritable gusher. But no geological monetary asset has ever gushed like the paper or electronic 3,000 3,000 kind. Thus, worldwide foreign ex- number of active rigs change reserves, which consist mainly 2,500 2,500 of dollars, are currently showing year- over-year growth of 16%. 2,000 2,000 Cheering, too, are signs that the gold bulls are on the defensive. At the 1,500 1,500 frothy November peak, out-of-the- money gold calls were three times number of active rigs more expensive than out-of-the- 1,000 1,000 money puts. Months of discouraging price action has bled away much of 500 500 that premium. “Indeed,” McCulley ends up, “now the equivalent out-of- 0 0 the-money calls trade at less than two 1949 1959 1969 1979 1998 1999 2010 times the price of puts. The ‘volatility source: Baker Hughes SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 17 was around that time that the domes- and 2008. But the Lufkin share price eral, we are bullish on Asian curren- tic rotary-rig count hit 2,031, the most appears to have internalized that pos- cies in terms of the U.S. dollar, and we since early 1985. The financial crisis sibility already. It trades at 14.5 times are bullish on gold, the legacy mon- cut all three data—share price, oil all-time peak earnings, compared to etary asset that nowadays doubles as price, rig count—down to size, but all 7.9 times last August, and 35.3 times an option on monetary upheaval, in have recovered from the 2009 lows, the average earnings of the past 10 terms of all currencies. On monetary LUFK bouncing especially high. years, compared to 20 times last Au- tumult, we are especially bullish. Thus, while the share price is only gust.” Though widely separated by dis- 10% below its all-time high, the oil Lufkin is a top-flight company, all tance, the two dollars, Hong Kong’s price and rig count are 27.1% and right—and now with valuations to and Singapore’s, are linked by the 27.9%, respectively, below their lev- match. rules and conventions of the reserve- els of August 2008. “And as far as • currency system. At the beating Lufkin goes,” colleague Dan Gertner heart of the system is a certain North points out, “margins, prices received American power unto which is given and order backlogs have yet to rescale Three-dollar tale the right to print the world’s main the lofty heights of 2007-08.” Gross money in such quantities as it finds margins in the oil-field segment were (April 30, 2010) The readers of convenient to its own purposes. Be- 20.6% in the fourth quarter, an im- Grant’s already know what the Fed- cause other countries choose to coun- provement from 15% in the third but eral Open Market Committee said ter these monetary emissions with significantly below the 28.9% posted on Wednesday. The editor of Grant’s more printing of their own, the finan- in the fourth quarter of 2008. On a happens to know in advance what the cial world is susceptible to alternat- consolidated basis, gross margins FOMC didn’t say. “Recognizing its ing cycles of inflation and deflation. for the fourth quarter were 20.8% responsibilities as the steward of the As best as can be ascertained, the vs. 30.5% a year ago and 21% in the world’s principal reserve currency,” it world today is celebrating its deliver- third quarter of 2009. Listening to the certainly didn’t say, “the committee ance from deflation by embarking on February earnings call, you can hear has voted to raise the funds rate to 3% a new inflation. Pleasantly, the initial the analysts trying to coax the right from 0% to 0.25% to relieve the in- symptoms of the new cycle are taking encouraging words from a somewhat flationary pressures building in those the form of higher prices for stocks, reluctant front office. They were not Asian economies whose currencies bonds and real estate. The monetary wholly successful. In response to a are linked to the dollar.” Probably, mechanics of these ebbs and flows are leading question about margins, for the thought never crossed its mind. well known to constant readers. For example, CEO John F. Glick replied Now unfolding is a report on those late arrivals, a short refresher course that the expected pickup in utiliza- pressures and a speculation on what follows. tion rates might restore one-third of they mean. In preview, we expect the Living large, the United States pays the lost margin. “But I think there’s Singapore dollar to appreciate and the its bills in the green money that only still going to be pricing pressure out Hong Kong dollar to appreciate—or, it may lawfully print. America’s for- there that will keep us from getting just possibly, to depreciate. Holding eign vendors exchange those pieces back to the level we saw in ’08.” a certain kind of currency option, one of paper for local currency at the first Prices received in the oil-field seg- would be paid in either case. In gen- opportunity. If you were the CFO of ment of the business, said Glick in re- sponse to another question, have fall- Currency management 101 en by 15% to 20%, and in some cases $2,800 $2,800 as much as 25%, from the boom-time China’s foreign-exchange reserves highs. Concerning the companywide 2,450 2,450 order backlog, it stood at $140.3 mil- lion at year-end 2009, up by $6.4 mil- lion from the third quarter, but down 2,100 2,100

by $177 million, or 55%, from year- in billions of dollars end 2008. 1,750 1,750 “Last August,” Gertner observes, “Lufkin was trading at 10.8 times 1,400 1,400 near-peak earnings and at 1.7 times book (and at a yield of 2.1%). Af- 1,050 1,050

ter an 82% price levitation, today’s in billions of dollars valuations might be characterized as stretched. A believer in higher oil 700 700 prices stemming from a growing con- tribution to world oil production from 350 350 lower-quality and aging fields (count me in this group) would assume that 0 0 margins, prices and backlogs will re- 3/05 9/05 3/06 9/06 3/07 9/07 3/08 9/08 3/09 9/09 3/10 turn to the high-cotton days of 2007 source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 18

Inflatable houses intracorporate accounting to see that 200 200 something is wrong with our bubble- Hong Kong and Singapore house price index (December 1995=100) propagating monetary system. Its main blemish is obvious (that is, its 175 175 main non-euro-related blemish). It is the fact that Asian central banks find it necessary to keep stuffing their 150 Hong Kong: 150 vaults with dollars. They buy them 126.4

index level because, absent such purchases, the dollar would weaken. Or, to say the 125 125 same thing, Asian currencies would appreciate. At year-end 2007, China index level held forex reserves on the order of 100 100 $1.5 trillion. One year later, its hoard totaled $1.9 trillion. At last report, which was at the end of March, it 75 Singapore: 75 amounted to $2.4 trillion. Such is the 106.1 pattern throughout Asia, relates the Asia Development Bank. During the 50 50 panic of 2008, the pace of dollar buy- Q495 Q497 Q499 Q401 Q403 Q405 Q407 Q110 ing tailed off. But it picked up in the source: The Bloomberg second quarter of 2009, “and the re- gional stock of foreign exchange has the Shanghai Garden Hose & Lawn the American people, have our cake become even higher than before the Ornament Corp., what would you do and eat it, too. crisis. . . . This trend suggests a high with a wad of Ben Franklins? You No schematic diagram of transpa- degree of exchange rate management need renminbi. It’s in the course of cific monetary flows can capture every in the region.” that exchange, dollars for renminbi, detail. You may object, for instance, Mark well the previous sentence. that the inflationary impulse begins that although America collectively Asian central banks and their govern- to throb. imports more than it exports, no small ments buy dollars to please them- As likely as not, the dollars in part of those imports is essentially selves. They buy them to manage which America’s vendors are paid American, being produced in Asia by the value of their currencies against wind up in the vaults of the local cen- U.S. multinationals. The problem, if the dollar and, therefore, the com- tral bank—for instance, the People’s there is one, you may therefore con- petitiveness of their exports denomi- Bank of China. Though China’s is an clude, lies not with American con- nated in dollars. If America consumes authoritarian government, the PBOC sumers but with macroeconomic stat- much more than it produces, its Asian does not just commandeer the busi- isticians. They can’t keep up with the creditors willingly produce much nessmen’s greenbacks. Rather, it fast-changing global economy. more than they consume. The tightly buys them with renminbi, which it But it takes no special insight into grouped appreciation of a half dozen gets in the same way the Fed gets dollars. It prints them. What the People’s Bank does with Up, up and away 1.55 1.55 its newly acquired dollars constitutes Asian currencies vs. the dollar (Jan. 1, 2009=1) another jolt of monetary electricity. 1.50 1.50 It invests them in U.S. Treasury and Singapore dollar Thai baht 1.45 1.45 agency securities. It might not choose Taiwanese dollar Malaysian ringgit to invest in U.S. securities so readily 1.40 Japanese yen Indonesian rupiah 1.40 if the United States paid its bills in Korean won 1.35 1.35 gold. But we do not. We pay in our own special money, which our oblig- 1.30 1.30 index level ing Asian creditors return to us in the 1.25 1.25 shape of dollar-denominated invest- ments. It’s as if the dollars never left index level 1.20 1.20 home. Meanwhile, the newly printed 1.15 1.15 renminbi circulate in China (less whatever portion of that currency the 1.10 1.10 central bank chooses to neutralize, or 1.05 1.05 “sterilize,” through open-market op- erations). So the Chinese money sup- 1.00 1.00 ply grows and the American money 0.95 0.95 supply doesn’t shrink. Asset prices 3/6/09 5/1 7/3 9/4 11/6 1/1/10 4/163/5 climb on both sides of the world. We, source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 19

Asian currencies, the Singapore dollar Residential mortgage loans show In the 12 months to March, Singa- included, is the expression of these 16.5% growth in the 12 months, dur- pore’s consumer prices were higher facts in the foreign exchange market. ing which time an index of house and by just 1.6%. However, since infla- Conferring our highest monetary residential property prices increased tion takes many forms, there is only accolade on the Singapore dollar, we by 25%.” so much consolation to be taken have pronounced it one of the least In Singapore, as, indeed, through- from that fact. “Interest rates are low bad paper currencies (e.g., Grant’s, out Asia, prophets of a V-shaped, rip- enough that nearly any size mortgage April 16, 2009). Forex traders rubbed roaring recovery look like geniuses. can be made to seem affordable,” their eyes last week as the city-state Top to bottom, 2008-09, the city- McCulley reports. “I went to the disclosed that first-quarter GDP state’s exports fell by 42% and its im- United Overseas Bank’s Web site to bounded higher by 13.1%, measured ports by 41%. But collapse has given play with the calculator that lets you year-over-year, or by 32.1% measured way to resurgence, with container see how much you can afford to bor- sequentially, quarter to quarter, at an traffic showing 16% year-over-year row based on your income. I plugged annualized rate. With an open econo- growth in the first quarter. Over the in S$8,000 a month—the equivalent my heavily engaged in trade, Singa- past 12 months, non-oil exports have of US$5,800. I indicated that I had pore manages its monetary policy not soared by 27%, tech exports by 39% no debt (i.e., no non-mortgage debt) with interest rates but with a compos- and industrial production by 43%. and chose a 35-year repayment term. ite foreign exchange rate. The Sing “With the Q1 expansion,” observes The maximum amount I could bor- dollar’s nominal effective exchange the MAS, “the Singapore economy row was S$800,000, which means the rate, a.k.a. “S$NEER,” is that trade- has now fully recovered the output bank is comfortable making a mort- weighted rate, and in the wake of the lost during the recession, and eco- gage loan exceeding eight times my stupendous GDP news, the Monetary nomic activity in a broad range of indicated annual gross income. Even Authority of Singapore disclosed that industries has exceeded its peak. As in the United States, back in the roar- it would allow S$NEER to creep a result, the economy’s output gap ing mid-2000s, a ratio like that would higher. As an immediate effect of this turned positive in Q1 2010.” have made a WaMu lending officer policy, the Sing dollar gained 1.4% on That means, the MAS estimates, blink. What makes this stretch ‘af- the greenback. It’s only the start, we the Singapore economy is humming fordable’ is that the bank is charging believe. fast enough to risk overheating. Spe- an interest rate of roughly 125 to 150 Before the MAS’ disclosure on cifically, it is growing fast enough to basis points over the three-month April 14, zero-percent appreciation tax the existing structure of produc- swap rate, or less than 2% all-in, for was the policy. Coupled with an over- tion to the point of generating a rising a monthly payment of only S$2,500 a night interest rate of just 0.1%, the rate of inflation. Let us assume that month—until rates go up, of course.” city-state’s monetary policy was fabu- the diagnostics are on the beam. In Then, again, McCulley relates, un- lously accommodative. Consequently the face of this inflationary red light, usual are loan-to-value ratios above fabulous in their turn were local mon- the little-city-that-could continues to 80%, and the ratio of household etary growth, the local residential maintain that 10 basis-point money debt to GDP, at 72%, is well below real-estate market and a host of lo- rate that it willingly (now, perhaps, the peak reading of 95% set in 2003. cal economic indicators that, like the reluctantly) imports from the United Besides, this is Singapore, where new GDP data, look for all the world States. the government bosses the citizenry like typos. Thus, relates colleague Ian Mc- Money printing has consequences Culley, “M-1 shows year-over-year 10% 10% growth of 17.5%, M-2 of 9.8% and do- consumer price indices for Hong Kong, Singapore and China mestic credit of 8%. Forex reserves, China: which stand at $196 billion—im- 8 2.4% 8 mense for an economy with a $177 billion GDP—have climbed by 16% Hong Kong: in the past 12 months. While these 6 2.0% 6 year-over-year change numbers don’t exactly rise to the lev- el of China’s, they are notable for a Singapore: financial and trading center that suf- 4 1.6% 4 fered a 10% GDP decline in the re- cession. Especially striking is the re- sumption of bank lending, something 2 2 that Europe and the United States change year-over-year have been unable to achieve. In the past 12 months, Singaporean loans 0 0 have risen by 5% and overall banking assets by 8%. Stock-market margin loans pace lending growth, up by 78% -2 -2 year-over-year, a period in which the 3/05 9/05 3/06 9/06 3/07 9/07 3/08 9/08 3/09 9/09 3/10 Singapore stock market rose by 61%. source: The Bloomberg SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 20 in ways unimaginable even to the by exchanging dollars for the local of HSBC in Hong Kong, as saying busybody mayor of New York City. monetary product. The Sing dollar, that local economic growth is accel- But rules and regulations—such as as the accompanying graph points up, erating and that first-quarter GDP prohibiting the sale of certain kinds is part of an exchange-rate grouping growth, due for unveiling on May 14, of apartments until the owners have that includes the yen, Taiwanese dol- will likely come in at 8% (in calen- occupied them for three years—can lar, Thai baht and Malaysian ringgit. dar 2009, it contracted by 2.7%). In stem only so much of the monetary Each has appreciated against the dol- the past 12 months, Hong Kong M-1 torrent. Visible even from Wall Street lar on the order of 10% since March has grown by 36% and its mortgage is a glaring disparity between the in- of last year. loans by 12.2%. Foreign exchange visible bank rate and the white-hot Which brings us to the Hong Kong reserves—read “dollars”—are higher economy. If the FOMC on Wednes- dollar, in which we believe we have by 39%. Property prices are on fire, day astounded the world by saying identified a speculation high on po- up 6% so far this year after a 27% what we previously insisted it would tential and low on risk. As you know, gain in 2009, reaching their highest never say in a million years, Singa- under the currency-board system in level since the 1997-98 Asian finan- pore’s monetary problems would be place in the former Crown colony cial meltdown. Yet, on account of well on their way to a solution. But since 1983, the Hong Kong Monetary the zero-percent fed funds rate, the because the chances of that are, let Authority backs each one of its dollars Hong Kong wholesale funding rate is us say, remote, the MAS must weigh with one of Ben Bernanke’s. For all also approximately zero percent—just other options. If the local economy intents and purposes, the Hong Kong what a boomtown needs. continues to thrive and if the Fed re- and American currencies are inter- And what do the city fathers have fuses to budge, Singapore will have changeable. to say about this combustible state of little choice but to put its dollar on a Is that system an anachronism? affairs? “The rise in property prices faster track of appreciation. Hong Kong, after all, is today a “spe- since last year,” John Tsang, Hong In exchange-rate policy, Asia is cial administrative region” of the Peo- Kong’s financial secretary, told law- split between countries that cast their ple’s Republic. Like mainland China, makers on April 21, “is largely attrib- monetary lot with the U.S. dollar of which it is a political and economic utable to an environment with ex- and those that have chosen to keep appendage, Hong Kong references tremely low interest rates, abundant some distance from it. Thus, since the value of its currency to the dol- liquidity and a relatively low supply March 2009, the South Korean won lar. The difference is that China, by of flats coinciding together.” Tsang has appreciated against the green- dint of its tightly controlled capital called this alignment of the stars an back by 40% and the Indonesian ru- account, does not import, in toto, the anomaly. “As the global economy piah by 34%. These currencies are, policy of the Federal Reserve. recovers,” he went on, “countries however, outliers. The Sing dollar, Hong Kong’s dilemma is, there- around the world will start exiting ahead by just 10%, is more typical fore, greater and more pressing than from their measures against the finan- of the region’s exchange-rate expe- Singapore’s. Like Singapore, Hong cial tsunami. Liquidity will be with- rience. Most Asian currencies have Kong is not a natural candidate for a drawn and interest rates will reverse crept, rather than zoomed, higher, zero-percent funds rate. Earlier this to a more normal level.” Tsang may because the relevant monetary au- month, Dow Jones Newswires quot- so hope, but the western-most Fed- thorities have suppressed their rise ed Mark McCombe, chief executive eral Reserve district is San Francisco. Exactly no part of the Fed’s councils Drama to follow is concerned with the overheating of 5% 5% foreign economies that choose to im- implied volatility of Hong Kong dollar two-year options port American-made interest rates. Echoing his counterparts in Singa- pore, Tsang sought to cut the intoxi- 4 4 cating power of minuscule interest rates with cautionary words. “I appeal to citizens and small investors who implied volatility 3 3 would like to buy a flat,” he said, “to carefully assess the impact of future interest rate hikes on their ability to repay their mortgages. . . . Small in- 2 2 vestors should assess their own capa- implied volatility bilities and future incomes, including the stability of their jobs, before mak- 1 1 ing what is possibly the biggest in- vestment decision of their lives.” Still and all, Bank of China Hong Kong is advertising floating-rate mortgages at 0 0 loan-to-value ratios of up to 95%. 4/05 4/06 4/07 4/08 4/09 4/26/10 No FOMC hawk is more impatient source: The Bloomberg than Tsang to get on with the job of SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 21

“removing excess stimulus.” What to dollar options. With prices so cheap, $5.08 from $8. No, come to think of it, do? The unthinkable is one possibil- you could make money simply from not “unfortunately.” From the Gra- ity. By abandoning the dollar peg, an increase in implied volatility, per- ham and Dodd vantage point, a good Tsang could raise local interest rates, haps as a result of a Chinese revalua- investment has become cheaper. The thereby getting a jump on the next tion or—to return to thoughts outside word is “fortunately.” inflation before it has had a chance the box—devaluation.” Make no mistake: It’s the destiny to get out of control—if that time has On Wednesday, the FOMC will ut- of PDLI to become much cheaper. not already passed. ter its pronouncements as if it were The company’s business is managing In the prior issue of Grant’s, we al- setting interest rates for the 50 states and licensing a patent portfolio. Since lowed ourselves to speculate that the alone. The truth is that it makes the patents expire in 2013 and 2014, renminbi/dollar exchange rate might monetary policy for most of Asia. the company, along with its share as easily move to the downside as to That Asia is booming isn’t exactly the price, will finally dry up and blow the upside. But let us say, for argu- Fed’s problem. But it could be the away. What might happen on the road ment’s sake, that the conventional currency speculator’s opportunity. to extinction is the question before view is correct. We’ll assume that an • the house. upward revision is in the cards. What, PDLI got its start in 1986 as Pro- then, for the Hong Kong dollar? A re- tein Design Labs, “a biopharmaceuti- ciprocal upward adjustment? An end Profitably wasting away cal company focused on discovering, to the beloved currency board? developing and commercializing in- “The possibility of a change in (June 11, 2010) Some manage- novative therapies for severe or life- currency regimes,” McCulley notes, ments suffer a bear market in silence, threatening illnesses.” And those “is something to consider, especially but not the front office of PDL Bio- things it did do. It was issued seven given the clear focus the authorities Pharma (PDLI on the Nasdaq). It patents between 1996 and 2000, cov- in the government and monetary would like you to know that, unlike ering the humanization of antibodies. board have placed on preventing the typical biotech company, PDLI The “Queen et al.” patents they are bubbles in Hong Kong. Even better earns a profit, pays a dividend and called after Dr. Cary L. Queen, from is that the market thinks there is no refuses to invest in R&D. “Also, whose brain they principally sprang. chance of fundamental change. U.S. frankly,” CEO John McLaughlin re- Certain rights under those patents are dollar/Hong Kong dollar volatility marked at a JMP Securities research what PDLI licenses to biotechnology on currency options is within a hair’s conference last month, “if somebody and pharmaceutical companies. The breadth of all-time lows. You can wants to make an attractive offer for business model is simplicity itself: buy two-year calls struck 10% out of the company, it’s for sale.” In come the royalty payments; out go the money for 17 basis points (going Now resumes the bullish analysis the dividends. out five years will cost you 47 basis begun in the issue of Grant’s dated The science behind the royalty points). Or, taking an agnostic view July 24, 2009. “High-yield equity” income is a little more complex. An- of the direction of change, you could was the headline over the first install- tibodies are the company’s stock in buy a strangle with strikes set 10% ment, and the sentiment was right as trade. An antibody is a protein found out of the money on either side, up far as it went. From that day til this, in blood and bodily fluids that com- or down, two years out for 33 basis PDLI paid out $2.67 a share in divi- bats invading bacteria and viruses. In points. HSBC and Barclays, among dends. Unfortunately, in the same 11 the laboratory, scientists can create others, make markets in Hong Kong months, the share price dropped to antibodies by injecting tumor cells into mice. The object of the exercise A picture of health is to produce mission-specific anti- $350,000 $350,000 bodies, e.g., ones that attack cancer PDLI royalty revenues cells. Because the mouse-bred anti- 300,000 300,000 bodies are tailor-made for mice, they must be adapted for use in people, other i.e., “humanized.” Which is where 250,000 Tysabri 250,000 in thousands of dollars the PDLI patents come in. Lucentis The humanized antibodies are used 200,000 Synagis 200,000 in therapies for the treatment of can- Avastin cer, blindness, multiple sclerosis and Herceptin 150,000 150,000 rheumatoid arthritis. They are embed- ded in seven marketed drugs (see the

in thousands of dollars nearby table) and in drugs undergoing 100,000 100,000 Phase 3 trials for the treatment of Al- zheimer’s and Type 1 diabetes. 50,000 50,000 The PDLI investment story could be a case study in the attention span 0 0 of markets. An April 29 disclosure 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 of flat revenue in the first quarter, source: company measured year-over-year, was the SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 22 apparent catalyst for a 22% drop in the record show, owns the stock) has to pay down debt, and, second, to re- the share price. Revenues were flat updated the earnings model he pro- turn cash to shareholders in a timely because PDLI has stopped receiv- duced last summer. “The major inputs manner (i.e., to avoid building a cash ing royalty income for Synagis, an are the same,” he relates: “royalties/ mountain). infectious-disease-preventing drug license-agreement revenues, general “The major driver of PDLI’s re- manufactured by MedImmune. The and administrative expenses, inter- sults is revenue growth,” Gertner royalty income stopped because est expenses, taxes and dividends. I continues. “In the past four years, MedImmune, which had been duti- made my projections out to 2015, the royalties and license-agreement rev- fully paying PDLI and its predeces- year after the last of the patents ex- enues have grown by 26% a year. For sor for 10 years, decided to contest pire. I assumed 5% annual growth in my base case, I assumed no revenue the patent. “Nobody could have seen G&A expense and a 35% federal tax growth in 2010 on account of the this coming,” the now-standard line rate (in Nevada, where the company aforementioned MedImmune dis- spoken by the great and the good of is domiciled, there is no corporate pute. And I assumed that revenues in American finance to excuse them- income tax). I assumed that the com- 2015 will be one-quarter of 2014 rev- selves for culpability in the debt col- pany will repurchase its debt—two enues, since the company is paid with lapse, cannot reasonably be invoked convertible bonds outstanding worth a one quarter lag. Thus, drug sales in in the case of the PDLI revenue miss. $344 million that it has been buying the fourth quarter of 2014 would gen- Management itself warned about it in the open market and a $300 million erate royalty income in the first quar- on the 2009 first-quarter conference securitization outstanding—over the ter of 2015.” call (Grant’s, July 24). The real news next three years, thereby reducing To earn back today’s share price in PDLI’s first-quarter financials was and finally eliminating interest ex- in dividend payments alone, Gertner its 35% year-over-year increase in rev- pense. And I assumed that dividends finds, revenues would have to grow enues apart from Synagis. were paid with two tactical objectives by an annual rate of 5.6%, or less Colleague Dan Gertner (who, let in view: first, to build up enough cash than one-sixth of the year-over-year growth shown in the first quarter, ex- Synagis. A second table indicates the PLDI royalties interplay between revenue growth and expected rates of return. Thus, product licensee status indications with a 15% annual increase in PDLI’s top line, an investor would earn a 11% Avastin Roche approved colorectal cancer return on his or her dwindling prin- lung cancer cipal, dwindling because PDLI, like metastatic breast cancer a gold mine, is a wasting asset. Top- glioblastoma line growth of 25% would generate an metastatic renal cell annual return of 19%. Phase 3 ovarian cancer “[T]he most important of our pat- gastric ents expire in December of 2014,” prostate cancer said CEO McLaughlin at the confer- adjuvant settings ence last month, “but, in fact, we an- ticipate we will get paid longer than Herceptin Roche approved breast HER2+ cancer that period of time, and the reason for HER2+ stomach that is, under patent law, you are paid and gastro-esophageal cancers for product that is made or sold. So if Trastuzumab-DM1 Roche Phase 2 and Phase 3 Breast HER2+ cancer our product is sold after the patent expiry, but made prior to it, we get Lucentis Roche approved macular degeneration paid.” To cook up a bulk batch of an- Phase 3 vein occlusion tibodies requires five months. Qual- macular edema ity-tested and frozen, the material is held in inventory. No just-in-time Xolair Roche approved moderate-severe asthma for the consumers of this commodity; label expansion pediatric asthma they typically keep 12 to 24 months’ Tysabri Elan approved multiple sclerosis worth on hand. It’s therefore not un- reasonable to expect that PDLI will Actemra Roche/Chugai approved rheumatoid arthritis continue to receive royalties through 2015 and into 2016. Gertner’s base Mylotarg Wyeth approved acute myeloid leukemia case makes no allowances for this pos- Bapineuzumab Elan/J&J/Pfizer Phase 3 Alzheimer’s disease sible source of out-year dividends. Another potential source of pleas- Solanezumab Eli Lilly Phase 3 Alzheimer’s disease ant surprise is the demonstrated Teplizumab Eli Lilly Phase 3 newly diagnosed Type 1 diabetes growth in the sale of Genentech drugs from which PDLI draws royalty in- Synagis MedImmune approved in legal dispute come. Measured at annual rates over SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 23 the past three years, revenues are up Potential PDLI returns the customers would not stint on in- by 38.2% for Avastin, 20.8% for Her- ventory building. In that happy case, ceptin, 132% for Lucentis and 23.2% annual break-even PDLI’s financial extinction could be for Xolair. With Genentech, PDLI has revenue growth discount rate pushed back a couple of years. Phase 2 struck a tiered royalty agreement for results were positive for the Alzheim- products sold or manufactured in the 0% -6% er’s drug produced by the Elan/J&J/ United States. The rate is 3% for the 6 0 Pfizer consortium. Results featured first $1.5 billion in sales, declining to 10 6 a 9% reduction in amyloid-beta, or 1% for sales over $4 billion. However, 15 11 plaque, deposits for treated patients for products sold and manufactured 20 15 vs. a 15% increase in plaque deposits outside the 50 states, Genentech pays 25 19 for placebo-administered patients. a flat 3% rate. Happily, for PDLI and 30 23 What else might go right? Or, to ask its shareholders, the foreign-made the question in the CFA-approved and sold share of Genentech products source: Grant’s estimates fashion, how many other free options jumped to 19% in the first quarter might be embedded in that $5.08 from 7% in the first quarter of 2009 for new Alzheimer’s drugs are under share price? One is the potential for a and from 12% for the full 12 months way under the aegis of Elan/J&J/Pfiz- revenue-generating resolution in the of 2009. Hopeful, too, is the fact that er and Eli Lilly. Results are expected MedImmune affair. Before PDLI, Roche Holding AG, Genentech’s in 2012. The Alzheimer’s drugs have MedImmune had dealt with three parent, is building plants in Singa- blockbuster potential, Larson reck- other licensors on Synagis (i.e., Ge- pore and Germany. Concerning the ons. Royalties—to make that specu- nentech, Celltech and Centocor/J&J). growth in the overseas portion of Ge- lative leap—would be less than 5% It sued each of them for one reason or nentech’s sales, Cris Larson, PDLI’s of sales. Based on the indications of another and settled each case, either chief financial officer, tells Gertner, experimental success, the sponsoring on the courthouse steps or on appeal. “I will say that the trend is continu- companies would build inventories Maybe it will settle with PDLI. ing and from everything that we can of some of the antibodies covered by Altogether, from where we sit, the tell, it will continue.” PDLI royalty agreements. “The good risk/return calculus over the next four Besides the applications for which news, again,” Larson advises Gertner, years is little changed from last sum- the drugs have been accepted, one or “as they build inventory, we will con- mer. The downside is a mid-to-high more may be approved for new appli- tinue to get royalty after the patents single-digit return, the upside some- cations. Thus, Avastin is in Phase 3 expire, because of the inventory in the thing along the lines of 30%. A kind trials for four new cancer indications. freezer.” In the expectation of heavy of gold mine, perhaps. Lucentis is in Phase 3 trials for two sales—assuming the kind of success • different eye diseases. Phase 3 trials that one can’t reasonably assume—

See you at the GRANT’S® ® Conference

No spring or fall would be complete without a Grant’s event

Our speakers are as provocative, stimulating and unexpected as an issue of Grant’s. To find out about our next conference—or to read about prior events—go to www.grantspub.com/conferences or email us at [email protected] SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 24

Mobile payout pean business moderated as the year munications remain an essential ele- wore on, to 2% in the fourth quarter ment in most people’s lives.” from 5.4% in the second. Not so long ago, even a Great Re- (June 25, 2010) To the list of big-cap “Unquestionably,” continues Sir cession might not have slowed the cell stocks that may produce a better return John, “this has been the most difficult phone business’ meteoric growth. But than the obligations of America’s mega- economic environment in which your now that most people in most coun- cap government, we hereby add Vo- company has ever operated. Against tries have a phone seemingly growing dafone Group Plc, the London-based this background, I am very pleased out of their ears, the macro economy mobile telecom giant. Vodafone is a to report that the group delivered an comes more into play, as does regula- globe-girdling blue chip that happens adjusted operating profit of £11.5 bil- tory policy, especially in India. Voda- to gird a little too much of the euro zone lion (down 2.5%) and generated £7.2 fone bought its way into India with its for the stock market’s liking. For that billion of free cash flow (up 26.5%). . $10.7 billion purchase of Hutchison reason and others, the shares (listed in . . The telecommunications sector as Telecom International’s Indian sub- London, VOD LN, and in New York a whole has seen declining revenue sidiary in 2007. It was a hearty price, via an ADR, VOD US) are quoted at through this period, but we have not as we said at the time (Grant’s, Oct. nine times earnings and at a ratio of en- seen the extremely steep declines in 19, 2007), though—as Vodafone must terprise value to earnings before inter- revenue experienced by some other have reasoned—the growth opportu- est, taxes, depreciation and amortiza- sectors of the economy—mobile com- nity was hearty, too. And so it turned tion of 7.3; they yield 5.8%. We say “they yield” without mean- ing to imply that there is anything Vodafone Group Plc firm, settled or contractual about the (in millions of British pounds, except per-share data) dividend rate. It’s contingent on forc- Year ended es too numerous to imagine, let alone 3/31/10 3/31/09 3/31/08 3/31/07 mention, even if the chairman of the Revenue £44,472 £41,017 £35,478 £31,104 Vodafone board, Sir John Bond, writ- Cost of sales (29,439) (25,842) (21,890) (18,725) ing in the new annual report, did go Gross profit 15,033 15,175 13,588 12,379 on record saying, “The Board is . . . Selling and distribution expenses (2,981) (2,738) (2,511) (2,136) targeting to maintain growth in divi- Administrative expenses (5,328) (4,771) (3,878) (3,437) dends per share at no less than 7% per Share of result in associates 4,742 4,091 2,876 2,728 annum for the next three years.” You Impairment losses, net (2,100) (5,900) - (11,600) don’t hear Timothy Geithner making Other income and expense 114 – (28) 502 that kind of pledge. The Treasury’s Operating profit 9,480 5,857 10,047 (1,564) principal aspiration, as a matter of Nonoperating income and expense (10) (44) 254 4 fact, appears to be that the U.S. dol- Investment income 716 795 714 789 lar should command fewer and fewer Financing costs (1,512) (2,419) (2,014) (1,612) units of the Chinese renminbi. Profit before taxation 8,674 4,189 9,001 (2,383) Though Vodafone operates in Income-tax expense (56) (1,109) (2,245) (2,423) Western Europe, Eastern Europe, Profit for financial year 8,618 3,080 6,756 (5,297) Africa, the Middle East, Asia and Minority interest (27) 2 96 129 North America (by dint of its 45% Profit to shareholders 8,645 3,078 6,660 (5,426) Diluted earnings per share 16.36p 5.81p 12.50p (9.84)p ownership of Verizon Wireless), it’s old Europe that furnishes 67% of its Goodwill £51,838 £53,958 £51,336 £40,567 £44 billion top line and 74% of its £15 Property, plant and equipment 20,642 19,250 16,735 13,444 billion EBITDA. Germany, contrib- Investments in associates 36,377 34,715 22,545 20,227 uting 18% of companywide revenue Non-current assets 142,766 139,670 118,546 96,804 and 21% of EBITDA, is the No. 1 Trade and other receivables 8,784 7,662 6,551 5,023 market. Italy is No. 2, followed by Cash and cash equivalents 4,423 4,878 1,699 7,481 Spain and the United Kingdom. As Current assets 14,219 13,029 8,724 12,813 investors do not need to be reminded, Total assets 156,985 152,699 127,270 109,617 these are not the world’s growth mec- Long-term borrowings 28,632 31,749 22,662 17,798 cas (nor are the Netherlands, Greece, Non-current liabilities 37,559 39,975 28,826 23,378 Portugal, Albania and Malta, in which Short-term borrowings 11,163 9,624 4,532 4,817 Vodafone also operates). European- Trade and other payables 14,082 13,398 11,962 8,774 generated revenue did grow by 0.8% Current liabilities 28,616 27,947 21,973 18,946 in the fiscal year ended March 31. Total liabilities 66,175 67,922 50,799 42,324 Shareholders’ equity 90,381 86,162 78,043 67,067 However, before the flattering effects of currency movements and other Shares outstanding (millions) 52,663 nonoperating factors, it fell by 4.1%, Price per share £1.43 with Spain and the U.K. leading the Market cap 75,308.09 downside charge. But—a mitigating Price/earnings 8.71x fact—the rate of decline in the Euro- Price/book 0.83 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 25 out to be. Post-acquisition, Vodafone’s Low margin, high volume Indian subscriber population has in- 700 700 creased to more than 100 million from India’s cellular telephone subscribers 601 million 28 million. The trouble is that, un- 600 600 der the Indian government’s licens- ing policies, as many as 15 cell phone providers compete in the same Indian 500 500 market. Thus, in the past year, while number of subscribers Vodafone’s subscribers jumped by 60%, its Indian revenues were up by 400 400 only 18%. Referring to the ferocious competition implied by those num- 300 300 bers, as well as to looming outlays for cap-ex, an analyst quoted by Bloom- number of subscribers berg last month characterized Voda- 200 200 fone’s Indian adventure as a “fiasco.” Fiasco or not, Vodafone remains the 100 100 No. 2 entrant in a country that is add- ing 20 million new subscribers a month and has only just crossed the 50% over- 0 0 all penetration mark, compared with 5/02 5/03 5/04 5/05 5/06 5/07 5/08 5/09 4/10 100% and more penetration in devel- source: The Bloomberg oped markets and 70% or less in most emerging markets. “Looking out over of debt. As its outstanding obligation businesses would have to be valued at a longer time horizon,” colleague Ian totals $23 billion, it would take only a 3.6 multiple. On a global basis, mul- McCulley observes, “the current price six or seven more quarters to extin- tiples have compressed in the past war should eventually lead to weaker guish it—if that were the goal. But it three years. Big mobile phone opera- players exiting the field, leaving Voda- makes no sense to de-lever the com- tors trade at between four and five fone’s business in good shape. There pany completely given its growing times EBITDA in developed mar- are worse things in the world than be- cash flow and healthy margins. From kets and at six or seven multiples in ing the No. 2 mobile provider in a 1.2 this line of thinking, it would follow emerging ones. Still, an implied—and billion-person country growing GDP that there could be action on the Veri- very hypothetical—multiple of three at 7% a year.” zon Wireless dividend within the next or so does seem cheap.” If India is not Vodafone’s crown nine to 12 months. The market would It will be said that big, dividend-pay- jewel, Verizon Wireless just might likely begin to mark up the value of ing brutes like Vodafone have cheap- be. As noted, Vodafone owns 45% of Vodafone’s stake in the Verizon sub ened in the stock market because, the Verizon mobile provider (Verizon if Vodafone began to receive a regular when the Bush tax cuts die their ex- Communications, the parent, has the cash distribution. Any M&A—Veri- pected death in 2011, dividend income rest). For good reason, Verizon Wire- zon Communications buying out Vo- will be taxed as ordinary income, not at less is an investor fan favorite. Its dafone, a spin-out, a merger—would the current favored 15% rate. Those in subscriber base is growing, its finan- also likely lead to value realization for today’s top 39.6% federal bracket are, cial health is glowing and its average the Vodafone shareholders. therefore, staring at a meaningful cut monthly revenue per user—no less “Note, please,” McCulley goes on, in dividend income. In the case of Vo- than $50—is amazing. For perspec- “that the 45% Verizon Wireless inter- dafone, one’s after-tax dividend return tive, Vodafone’s German operations est goes unreflected in Vodafone’s would drop to 3.6% from 4.9% (without pull in $20 per user per month. So far EBITDA line and thus in that mea- regard to state income tax). Then, again, iPhone-less, Verizon Wireless would sure of valuation. As it is, Vodafone corporate managements are nothing if shine even brighter were it to obtain changes hands at 7.3 times enterprise not adaptive. If dividend income holds that shiny new Apple toy. value to EBITDA. Say that the Ve- less after-tax allure than capital gains, “While Vodafone booked over £4 rizon sub could generate $25 billion share buybacks might return front and billion of operating income as a result of EBITDA this year. At a multiple center. Besides, Treasury coupon pay- of its 45% share in Verizon Wireless,” of six, that would be worth $150 bil- ments are already taxed as ordinary in- McCulley notes, “it received divi- lion. Subtract $22 billion in net debt, come and that hasn’t slowed down the dends worth only £1 billion, roughly and you’re left with an equity value of bond bulls. Tuesday’s two-year note enough to cover its tax liabilities. $128 billion. Vodafone’s share would auction was hammered down at a yield It’s Verizon’s corporate policy to pay be £39 billion. The implication of of 0.74% (the coupon was five-eighths down debt with free cash flow, not that number is that the rest of Voda- of 1%, the lowest on record). Whatever return it to the shareholders. But fone’s businesses trade at a 4.6 times that yield amounts to after tax, it’s low- there’s only so much debt to repay. In multiple (and not the 7.3 multiple at er than the payout that the board of Vo- the first quarter, the Verizon sub gen- which it does trade). If Verizon Wire- dafone is striving so mightily to deliver. erated $4.8 billion in free cash flow, less were valued higher, say, at an • with which it paid down $3.2 billion eight multiple, the rest of Vodafone’s SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 26

For the long run If next decade’s growth in book value and dividends match previous decade... (July 9, 2010) “Nobody is going to price/book at annual dividend yield buy cigarettes anymore,” Nasir Ess, current price dividend at current price the owner of a Harlem deli, com- Exxon Mobil 0.94x $3.27 5.80% plained to the New York Daily News Johnson & Johnson 1.02 6.83 11.60 the other day about crazily spiraling United Technologies 1.05 6.24 9.72 tobacco taxes. “You can buy crack Intel Corp. 1.63 5.69 29.84 for $10.” So saying, Ess put his fin- 3M Co. 1.89 3.72 4.81 ger on the investment conundrum Kraft Foods 1.14 7.55 27.27 of the cycle. “Safety first,” your not- General Dynamics 0.45 4.81 8.20 so-helpful investment adviser may Kimberly-Clark 3.40 5.53 9.12 admonish, but what’s safe, and why? ConAgra Foods 1.17 0.77 3.33 Bonds, stocks and gold are the items Coca-Cola Co. 2.02 3.89 7.79 under consideration. In 2003 or thereabouts, tax-exempt source: Grant’s calculations bonds secured by anticipated rev- enues from the Master Settlement Agreement (MSA) with Philip Morris But the smokers’ addiction to needs to be reminded how rarely and other tobacco companies seemed nicotine met its match in the states’ the light of prediction illuminates as safe as houses (houses were not addiction to taxing and spending. the darkness of the future. But if we then known to be unsafe). The ciga- Excise taxes have risen to the point can’t predict, we can at least observe. rette companies had pledged to pay where smokers are buying cigarettes In recent issues, we have ob- 46 states a king’s ransom, perhaps as one at a time or doing without. In served that the equities of well- much as $200 billion over 25 years, New York City, a loosie will set you financed, high-yielding U.S. multi- depending on tobacco consumption, back 75 cents, a legal pack by $13 nationals are selling at some of the inflation and other imponderables. and up, including $6.85 in taxes, of lowest valuations in years. Many Eager to realize the present value of which $1.60 per pack was slapped outyield the 10-year Treasury note. this anticipated windfall, Ohio, Cali- on only last week. “Most of the You may object that a dividend yield fornia and New Jersey, among other bond structures they support were is hostage to its volatile share price states, refashioned their claims on the devised assuming modest declines and that big, long-established, div- MSA into bonds; $56 billion came to in tobacco consumption over time idend-paying companies are forever market. “[T]here was a widespread and rising settlement payments,” reinventing themselves as shrink- belief,” as The Bond Buyer noted last The Bond Buyer said. “That scenario ing, dividend-cutting corporate has- week, “that demand for cigarettes is now in doubt, with cigarette con- beens. Five years ago, what seemed was inelastic—meaning smokers sumption plunging 9.3% last year a surer thing than AIG? were so hopelessly addicted that they by one measure—about five times Let the record show, therefore, would keep buying cigarettes even if more than forecast.” that there are no sure things. But prices rose.” No constant reader of Grant’s there are cycles, and blue chip eq- uities are in that phase of the cycle J&J for the long run technically known as “the outs.” A $100,000 $10 J&J’s sales, earnings, equity (left scale) CFA will tell you that lower interest and dividends (right scale) rates imply higher price-earnings multiples, not lower ones. That is 10,000 1 so, doctrine has it, because lower in- sales terest rates, when used to discount net earnings future earnings, make that stream of

1,000 dividend per share shareholders’ equity income look larger than it would if 0.1 annual dividends a higher rate of interest were used 100 to discount it. But, in recent years, P/Es have been falling in tandem 0.01 with interest rates. It could be that 10 this multiple compression presages in millions of dollars lower profit margins, slower growth or a more punitive regulatory envi- 0.01 1 ronment. Or it could be that sagging P/Es are simply the mirrors to a de- moralized world. Or it might just be 0 0.0001 that the world is at last coming to re- 1897 1907 1917 1927 1937 1947 1957 1967 1977 1987 1997 2007 alize that P/Es were previously too source: Johnson & Johnson, Moody’s 2009 high. In any case, today’s multiples, SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994 Summer Break-GRANT’S/AUGUST 20, 2009 27 in comparison with decades of his- another blue chip, Johnson & John- keep up with JNJ’s 12.1% per annum tory, look low. son’s business has been running record of internal compounding? “At When Grant’s served up Johnson & rings around its share price. Thus, 3%,” Gertner ventures, “it would be Johnson a couple of issues ago as an since 2000, the company has seen arithmetically impossible—unless, example of a blue chip bargain, we annual growth in sales, net income of course, one successfully traded in did not have at hand the statistical and book value of 8.5%, 11.5% and and out of the market. Just to get a treasure trove that we subsequently 12.1%, respectively, while the divi- 12.1% capital gain on the current, on- discovered. Thus, from the compa- dend grew by 13.5% per annum. In the-run 10-year note would require a ny’s founding in 1886 to 2009, sales contrast, the share price inched up plunge in the 10-year yield to 1.6%. increased to $61.9 billion from $0.1 by only 3.3% a year. Another year or two of 12.1% capital million, or by 11.6% a year. Report- And how would it look in 2020, you gains could be had, but before long ed earnings, which began a decade may be wondering, if the next decade the wall of zero percent would loom. later, mounted to $12.2 billion from delivered business results identical Here is another way to think about $0.19 million, or by 10.4% a year. to those of the 2000s while the share it: Say that you bought a 3%, 10-year JNJ, which paid a maiden dividend price stood still? We present the re- Treasury at par and that the 10-year in a split-adjusted sum of $0.00015 sults nearby. Johnson & Johnson yield immediately dropped to zero. per share in 1944, the year it went would be selling at a hair higher than Why would anyone pay more than public, paid $1.93 a share in 2009, a book value and yielding 11.6%. To $130 for that 10-year note? That is, rate of growth from point A to point keep up with the projected internal for the privilege of receiving 10 years B of 15.7% per annum. Shareholders’ compounding of JNJ’s book value, of $3-per-$100 coupons plus prin- equity grew to $50.6 billion in 2009 the gold price would have to reach cipal over the allotted decade, dis- from $38 million in 1943, or by 11.5% $3,777 an ounce from today’s $1,200. counted at zero percent?” per annum. To match the previous 10-year com- Never say never, we say. Our all Johnson & Johnson, in fact, is the pounded growth in the book value of too fallible central bankers could archetype of an increasingly familiar General Dynamics, to pick another easily send the gold price to heaven type, namely, the lightly leveraged, example, the gold price would have or the 10-year Treasury to the moon. time-tested corporate giant that to reach $4,897 an ounce. But the world turns and Armageddon looks as if it has another couple of And Treasurys? How might these is usually a no-show. Cast-off blue decades of life in it (at least) but is darlings of our Age of Anxiety fare chips, you have friends at Grant’s. valued as if for trouble. Like many over the next 10 years? Could they •

Grant’s Interest Rate Observer Online Archive Now, completely searchable with Search Technology.

Hundreds of issues from the past 25 years, all the way back to Vol. 1, No. 1—all at your fingertips using Google Search. Available now at www.grantspub.com. Free for paid-up subscribers; all others pay per download.

Some reading to keep you cool? Click on the “Archives” link on www.grantspub.com. Stroll through our extensive treasury of past issues, searchable by date or keyword. Download an issue, reach for an iced tea, and enjoy!