Thursday, December 27, 2012

Apple is No Polarioid, But...

I spent the last couple of weeks reading some books on Polaroid and took some notes that I thought were interesting and goes to the heart of my problem with Apple stock.

Of course, Apple is not Polaroid.  Polaroid was 'just' an instant camera, made irrelevant by digital technology.  Apple has a deep eco-system and the halo-effect of multiple products working with each other (iPhone buyers may buy a Mac, then a Macbook Air etc...).

The simple way value investors deal with something like Apple is simply that it goes into the "too hard" pile as it is in a fast changing, highly competitive industry.

Everyone seems to love Apple stores and Apple products now and they would never change to something else. But at one point in time, people felt that about the Palm Pilot and the "crack"-berry too.  Apple may be better off and more deeply entrenched than these, but that doesn't mean it's a permanent situation.

Someone said to me that Polaroid was made irrelevant by technology.  Well, of course it was.  It's easy to see what happened now in hindsight, but at the time it may not have been so easy to see, or they may have figured they have time to evolve into digital technology. As for Apple, there is no telling what will come next in the tech world, and Apple is not guaranteed it's current status forever.

In any case, my argument really isn't about "this is tech and it's too hard", or that Apple is a fad or some such thing.  My beef is quite a bit more specific than that, and that's why I am spending some bandwidth on this issue.

I'm not trying to convert Apple bulls into bears either as I don't think I necessarily have a strong bearish case.    The point would be more that we have seen this movie before.  Something gets so popular that's it's dominance just seems inevitable.   The stock price is cheap so it attracts all sorts of investors; from growth funds to value funds (due to the low p/e) and even income funds (thanks to the dividend).  Can it really be so simple?

The cheapness makes it a not so favorite short (although I know there is always a small group of bubble-callers on any popular stock; especially in the short-term trading world).

Anyway, my biggest problem is that Apple's success, to me, was a Steve Jobs story, not an Apple story.  When Jobs died last year, people were worried.  The rally in the year since his death reflected the continuing momentum at Apple, but also was a collective sigh of relief;  whew, Jobs is gone but Apple is still doing OK.  Maybe Cook can pull this off.

I tend to think that's the wrong conclusion.  Apple is still coasting on Jobs' creation so they haven't really been tested yet.  This is the thing that worries me.  It's not about market share of iPhones/iPads or anything like that.

Anyway, as I read the Polaroid books, I jotted down these very interesting points (which admittedly supports my view/concern).

The first book I read was Land's Polaroid: A Company and the Man Who Invented It, by Peter C. Wensberg (published in 1987).  It's a fantastic book.  It takes a good, close look at Polaroid and Land.  I do think Apple owners should read it.

Here is a snip from p. 235:

"In 1959, two years after the color work had first been shown to Kodak and several patent applications made for it, Land addressed the Boston Patent Law Association.  Characteristically, he extolled the importance of the individual's contribution - Ptolemy, Copernicus, Galileo, Newton, Faraday, Maxwell, Einstein - rather than science as a group effort.  He derided the notion of teamwork as the ideal framework for scientific endeavor.  "There is something warm and appealing and cozy," he said, "about this picture of the human race marching forward, locked arm in arm and mind to mind; and there are insecure ages in life and insecure people in life to whom this vision of progress by phalanx brings comfort and strength.  But I, for one, think this is nonsense socially and nonsense scientifically.  I think human beings in the mass are fun at square dances, exciting to be with in a theater audience, and thrilling to cheer with at the California-Stanford or Harvard-Yale games.  At the same time, I think, whether outside science or within science, there is no such thing as group originality or group creativity or group perspicacity."

While some in the audience grappled with the notion of Land having fun at a square dance, he went on.  "I do believe wholeheartedly in the individual capacity for greatness, in one way or another, in  almost any healthy human being under the right circumstances; but being part of a group is, in my opinion, generally the wrong circumstance Two minds may sometimes be better than one, provided that each of the two minds is working separately while the two are working together; yet three tended to become a crowd."

This supports my (and others) view that Polaroid was a story about Land, not a company.  I conclude that the recent Apple success was also a Steve Jobs story, not an Apple story.  Of course, Jobs couldn't have done what he did without the company and it's employees, but the key driver of the success was Jobs.  Land's above view supports this conclusion, I think.

 From the Epilogue, page 247:

...He had wanted to create new things; the polarizer and the instant camera would remain the best known.  But perhaps his most original invention had been his company.  It was no less the product of a conscious process of experimentation and insight and repeated failure and creation and ultimate success than had been the other inventions.  In the slough of the Depression he was already shaping the idea of a new sort of corporation whose characteristics were so unusual as to be bizarre, almost ludicrous.
  At a time when steel companies, automobile factories, and textile mills were slowing to a halt, spilling workers into the streets, he was talking and thinking and writing about a company founded on science that would design new products not imagined by the public, which would be attracted to the products because they filled a hitherto unperceived need.  He wanted a company to create an environment for art at a time when many were worried about meeting the next payroll.   He talked about a company where the work life would be so satisfying that workers would look forward to the day's beginning and regrets its end, while sweatshops were in their heyday and unions fought to establish basic rights on the job.  These were the ravings of a pioneer.
The italics are from the book, the underlines are mine.

Despite the above, it didn't quite work out.  Land thought he created the right company, but without him it went nowhere.  Jobs was pleased that he got the culture right at Apple while Sony got it wrong.  But I think he also said Land got the culture right.  And look what happened.

Another book (I just got whatever Polaroid book was available at the library) The Polaroid Story: Edwin Land and the Polaroid Experience by Mark Olshaker (published in 1978) was also an interesting read since it was published in 1978, when Polaroid was still doing very well.  (I read the paperback which was titled Polaroid Story, but the original hard cover was called The Instant Image.)

It gives us the sort of color/sentiment regarding Polaroid and it's post-Land future at the time:

Page 3, at the 1977 annual meeting, Land commented that:
...the corporation is currently involved "not with products and industries, but new concepts of what a company should be."

Page 47, a long time Polaroid employee said,
"Land told us what we were going to make, Bill McCune showed us how to make everything."
(Is Tim Cook the Bill McCune of Apple?)

Page 22, in 1937 when Polaroid Corporation was formed with Wall Street financing, they said:
"So even at this stage, the 28-year-old Land struck the Wall Street establishment as being so unique that they turned back control of the company they had just bought and made the man they had bought it from promise to stay for at least a decade.  Everyone acknowledged that the future of Polaroid Corporation would be determined by what went on in the brain of Edwin Land.  Unlike most new business ventures, what they had bought into was not a new technology, a product or an array of concrete assets, but one man's mind."  (my underline)

In the last chapter, "Conclusion", page 260, it says:

"Even at a time when the company is anxious to point out that the new generation of management has the situation well in control, Land's presence is still felt as strongly as ever.  Though Land is far from being the only inventor inhabiting the Polaroid research laboratories, his interests, confidence, and personal dreams have determined each direction the company has followed.  Will another individual emerge with both his inherent authority and his persistence of vision?  Or will Polaroid's corporate direction be determined by the committee system in the future?
     Regardless of Land's pervasive influence as Polaroid's single guiding force, the corporation will probably survive his loss at least as well as the Ford Motor Company survived the loss of Henry Ford and Eastman Kodak weathered the loss of George Eastman.  Whether the basic nature of the institution Land created will remain the same is a matter of speculation.  One corporate structure that is often compared with the relationship between Land and Polaroid is that of Walt Disney Productions.  In both cases, the product and social impact of the company arose out of the imagination of one master. 
     When Walt Disney died in 1966, numerous observers predicted that the organization would not long outlive the Mouse King, just as many predict that Polaroid cannot continue in the same spirit without Edwin Land.  But Disney Productions did survive, and continues generating both product and profit at an unprecedented rate.  On the other hand, while the company is still brilliantly successful - in television and films and the two theme parks - it has not moved out in any new creative directions since Disney's passing.  Instead, it has optimized what was already in the hopper when he died.  Polaroid's second-generation leadership must obviously be cognizant of the lesson in this for them.

The author didn't really mention the long period of time that Disney did have trouble after Walt's passing.  Steve Jobs famously warned Tim Cook not to sit around and ask what Steve Jobs would do (which is what post-Walt Disney had a problem with).

And on page 262,

     The most carefully Land has publicly addressed himself this issue was in the interview he gave Forbes in June 1975:  "There is only room for one of me in this company, and if while the one is there, all the others are growing and learning, the worst thing that could happen is that we could become one of the two or three best companies in photography and running along steadily.  The best thing that could happen is that we would not merely do that, but one or two or five of the young people around me - the apprentices in every sense - will take over and we might go three or four times as fast." 

This is a little off the topic, but there was a quote of Land's that is very inspiring from this book so I'll post it here:

The Five Thousand Steps to Success

If you dream of something worth doing and then simply go to work on it and don't think of anything of personalities, or emotional conflicts, or of money, or of family distractions; if you just think of, detail by detail, what you have to do next, it is a wonderful dream even if the end is a long way off, for there are about five thousand steps to be taken before we realize it; and start making the first ten, making twenty after, and it is amazing how quickly you get through those five thousand steps.  (Edwin Land to Polaroid employees, December 23, 1942)

Anyway, this book ended with optimism that Polaroid will do just fine without Edwin Land.  Again, we know that that wasn't the case.  It took until 2001 for Polaroid to go bust, but they had many bad years before that.

There is an interesting new book out written by a former Polaroid employee that takes a close look at Polaroid of the post-Land era up to and even after the 2001 bankruptcy.  It is quite an interesting read:

Fall of an Icon:  Polaroid After Edwin H. Land:  An Insider's View of a Once Great Company by Milton P. Dentch

Dentch lists all sorts of reasons why Polaroid failed post-Land and he feels that a different approach/managements might have been able to keep Polaroid viable.  After reading his book, I still think the main issue was that without Land, Polaroid was toast.   People will argue that Polaroid was toast way before Land was fired in 1982 as he was responsible for the Polavision fiasco.  But either way, I tend to think Polaroid had very little chance of success after Land.

Anyway, the book quotes from the Polaroid Handbook from the mid-60s,

    We have two basic aims here at Polaroid.  One is the make products which are genuinely new and useful to the public, products of the highest quality at reasonable cost.  In this way we assure the financial success of the Company, and each of us has the satisfaction of helping to make a creative contribution to society.
    The other is to give everyone working for Polaroid personal opportunity within the company for full exercise of his talents; to express his opinions, to share in the progress of the Company as far as his capacities permit, to earn enough money so that the need for earning more will not always be the first thing on his mind - opportunity, in short, to make his work here a fully rewarding, important part of his life.
    These goals can make Polaroid a great company - not merely in size, but great in the esteem of all the people for whom it makes new, good things, and great in its fulfillment of the individual ideals of its employees.

And about Jobs and Land:
     Jobs himself spoke about Land in a 1985 magazine interview with Playboy. "Eventually Dr. Land, one of those brilliant troublemakers, was asked to leave his own company - which is one of the dumbest things I've ever heard of," he said.  Jobs - a brilliant troublemaker in his own right, was pushed out of Apple months later.  Polaroid drifted after Land's departure, and eventually filed for bankruptcy.  Apple also fell on hard times after the Jobs exit, but the company revived when its founder returned to lead it again.  Jobs and Land shared a creative gift that gave the world products it had to have.  Call it genius or call it magic.  You can't replace that.  (Steven Syre, the Boston Globe, October 7, 2011)
(emphasis is mine)

In a previous post, I mentioned how the intense focus of Apple can be a risk post-Jobs since they may focus on the wrong thing; if whatever they focus on doesn't sell, they might get in trouble.

In the case of Polaroid, it seems like they lost focus after Land.  Here is the last two chapters from the Dentch book:

     The lack of focus was a bigger problem than I realized when I started my book.  When Dr. Land decided to produce instant color film, develop the perfect Instant photographic process, the SX-70, make Polaroid negative or Polaroid batteries, employees at all levels jumped on board gladly.  It was exciting to be part of;  we had focus and got the job done.
     The Polaroid Corporation was the embodiment of one person, Edwin Herbert Land; he was the founder, inventor and the protective father figure to his employees.  When Land was pushed out of his company by the board of directors in 1982,  his successors never found or maintained a viable focus again.

 (emphasis mine)

Yes, there have been great founders where the companies have survived for many decades after their passing or retirement.  Most of the S&P 500 companies would probably fit into that category.

So why not Apple?  I don't think they will necessarily go bust any time soon.  When Jobs left the last time in the 1980s, Apple survived and the Mac never went away; Mac fans were loyal and continued to use them.  It's just that the business trajectory shifted a bit without Jobs' 'magic'.

Sure, Cook is way better than Sculley so they may do better this time around.

But my thinking is that the Boston Globe reporter is correct from the quote above:
Jobs and Land shared a creative gift that gave the world products it had to have.  Call it genius or call it magic.  You can't replace that.   

After reading these Polaroid books, which Jobs may have too, I wonder if Jobs had any doubts about Apple.  I don't remember him expressing any doubt (except for him saying that the only problem is that Tim Cook is not a product guy), but I wonder if the Polaroid story hung in his mind in his last days.  I wonder what instructions he left to the trust that owned Apple shares (did they sell?).

Anyway, there may be no new information here, but I thought I'd post some of my notes on reading these books.  Some of it was very enlightening to me.


Friday, December 21, 2012

Why I Left Apple (Apple is a Speculation)

OK, this title is meant to mock the book about Goldman Sachs with a similar title.  I have never worked for Apple, so this is misleading.
Warning:  This post has no data or any analysis.  It's just opinion, like a dinner table conversation with family on what worries me as an Apple shareholder (or former shareholder, current shorter) so maybe it's more of a rant or lengthy rambling.
So those looking for spreadsheets, data, channel-checks and information from Asian expert networks on Apple supplier order trends can skip this post.

Anyway, first of all, I do admit that a long Apple position has been the biggest dollar contributor to my performance this year; I owned the stock for much of the first half of the year.   And then I got short starting in October or so when I posted about that here (and got more comments (or close to that) than any other post, ironically).
It was on October 11, in my post titled "Crash?!"
I'm not proud of trading, but I admit that October was very good for my portfolio largely thanks to the Apple short (which I covered in November).
I do understand the long story for Apple.  It is incredibly cheap and it does have tremendous momentum.  Yes, Apple is not Motorola or Nokia.  Yes, it's not just a gadget but it's the eco-system.  And yes, a large market-cap is not barrier to further gains.   I agree with all of that.

The reason I got nervous and dumped my Apple shares was simply because I couldn't see Apple ten years out.  I couldn't see that when I bought the shares, but I bought it thinking I can buy at 10x p/e and sell at 15x p/e or something like that and then enjoy the earnings momentum along the way.   Let's put it this way; it was not a high conviction, buy and hold for a long time position in the first place for me.
What triggered my starting to short it was the incredible run-up in the shares and the incredible attention to the stock.  It seemed like everyone was buying Apple stock including dividend/income funds and things like that.  I saw folks on CNBC ridiculing the people who don't get Apple and telling viewers that it's really simple; just buy the stock and enjoy the ride.   People who don't get it are fools.  These people were from some sort of Apple shareholders' club (another thing that set off alarm bells).  The tone was enough for me not to want to be on board with them.
Yes, I know.  Julian Robertson and David Einhorn and many other incredible investors like Apple and I don't have any information that they don't have so they are probably right.
And it's not a good idea to make investments or trades based on these "feelings".  I rarely do so.  But sometimes, I get such a strong feeling about something that I can't help myself.  And I allow myself to make these trades that I couldn't explain to Warren Buffett or Charlie Munger as long as I don't lose money doing it.
Anyway, here are some things that bother me.  I really don't care about iPhone5 sales in China or how many iPads they sell this holiday season.  My concern has nothing to do with these near-term issues that the pundits seem to always talk about when they talk about Apple.
I finally finished the book about Jobs by Walter Isaacson.  I read a lot of books simultaneously, so sometimes it takes me forever to finish a book.  Well, I finally did finish it and I was surprised by something; I am actually now much more bearish about Apple than before I read the book!
I think in many ways, the importance of Jobs may be underestimated by current Apple bulls:
Who's the Product Guy?
People say that Jony Ive is still there and Tim Cook is doing well running Apple.  This is true.  But what scares me is that Ive may create ten or twelve (or more) models of something and then Jobs would come in and take a look at them.  He would pick the ones that look good, demand changes here and there etc.
He is the editor that is instrumental in perfecting the product.  Does anyone do that there now at Apple?  Who has that sort of vision that Jobs had?  Who knows what the customer wants better than the customer?  Even Jobs says that Cook is not a product guy.  So who is the product guy there now?  Could Ive have created those great products without Jobs' input and choosing/editing?  
Jobs insisted on doing no market research.  That's because he had an uncanny ability to create products and ideas without that.  Who there can do that now?
Reality Distortion Field
The energy and charisma of Jobs allowed "impossible" things to get done.  There are many situations where Jobs threw a tantrum and wouldn't take no for an answer.  Who has that power at Apple now?  As I said in another post, it is very interesting to note that Samsung (which is run by a charismatic founder/leader) was able to get things done in a fast changing world while Sony lost it's way after the passing of the founder Akio Morita (one can argue that he lost his way too long ago).
Apple products that put Apple back on the map after Job's return were so revolutionary and much of it was possible due to Jobs insistence on all the various aspects he wouldn't give up on.  It is questionable if anyone else could have done the same thing even if they had similar ideas.
Apple is great because they focus on just a few things and just do it really, really well.  I have read Tim Cook's recent interviews and saw his interview on TV.  He is impressive to be sure. 
But here's what scares me.  He says that Apple is not going to go out and try to do a whole lot of stuff.  They just want to do a few things but do it really, really well. 
This is a good idea when you have such an amazing product guy like Jobs.  But what happens when you don't have someone like that?   Cook is not a product guy.  How do they choose what to focus on next?  What if they choose the wrong thing?
I am a portfolio manager (of sorts) so I can't help thinking of analogies in the financial world.  George Soros is a brilliant trader.  He has built (at one time) a great organization that performed incredibly well.  He built up, no doubt, a culture of hard work and deep analysis and an intense focus on risk management etc.  He hired the top people from the top schools and/or competitors.
But would Soros organization perform as well without him?  I think history has proven that that hasn't happened.
Even if you have the best staff, if the ultimate editor, the one who chooses what to focus on and where to put the resources, things may not work out as well without the 'visionary'. 
I know this is not a good analogy at all, but I can't not compare.
If Jobs was a CEO that managed a company that created great products, then it would be a different story (like being the CEO of Fidelity instead of the head of a hedge fund who makes the key investment decisions).

Jobs, to me, is so clearly more the product creator than CEO.  So in a sense, he is more like the talented hedge fund manager that puts up great performance figures with the help of a great staff.  He is definitely not the normal, CEO-type. 
This is a problem for Apple post-Jobs.
Anyway, back to the point.  For the next product, whether it's the iTV or whatever, they are going to focus intensely on something and if that something is not going to blow the world away, it can be hugely problematic.
I think there was a sense of relief after the first year post-Jobs, but all the developments since then were probably already planned out.  Perhaps there is more coming up that has already been planned for the next year or two. 

But what about after that?
I subtitled this post "Apple is a Speculation" because we don't know what comes after this.  I don't know that iPhone and iPad upgrades can continue forever like Windows was able to do for so long.  I do tend to think that the PC was much stickier than the iPhone/iPad.  Consumers love it, no doubt.  But it's not nearly as sticky, I don't think, as the PC.  The cost of switching out of a PC-based environment is huge (think of business use, not consumer use which is just emailing, internet etc.) 
Apple Got the Culture Right
The other thing that scares me is that Jobs loved Edwin Land of Polaroid and he told people that Land got the culture right.  Well, Land retired from Polaroid in 1982, died in 1991 and Polaroid was bankrupt by 2001.  Yes, that's almost twenty years, but still.  I don't know the financial history of Polaroid from 1982-2001.  I wish I had a tear-sheet from that period.  But I wonder how well they did after 1982.   And this is for a company that got the culture right.
Yes, people will argue that technology caught up to them.  But who is to say that can't happen at Apple?  I think Apple is terrified of Spotify, for example.   Many seem to like Spotify more than iTunes.

So Polaroid gets the culture right and goes bust in less than 20 years.  This may not happen to Apple.  But that doesn't mean Apple will keep doing as well for the next 20 years.

I keep coming back to Sony because it's so similar to Apple to me.  There is a lot that is different, but there are similarities.  People will argue that Sony made no-moat gadgets and didn't have the captive eco-system that Apple now has.  This is absolutely true. 

But the lead in eco-system seems to be shrinking versus competitors.  When I look at what people do on the iPhone/iPad, they seem to be either listening to music, watching a movie, shopping or playing games.  The interesting thing is that these things are very low cost.  What does that mean?  To me, it seems like that makes the cost of switching much cheaper.  When you only pay $2.99 or some such for a game, you will most likely easily abandon it if something more interesting comes along.

It's true that the iPad seems to be doing more and more in the business world; at my local 24-hour deli (NYC deli), they swipe credit cards on an iPad.   But at this early stage, they may not have a lock on any given area yet.

On the other hand, maybe Sony did well for a long time (it was founded in 1946) because they actually did do a lot of things. 

The annual reports from 1964 are available at the Sony website and it's fascinating to read through them; especially the old ones.

They were involved in many areas and were never really a one product company.  They had many failures but none killed them because they weren't so focused like Apple is today. 

Just for fun, I snipped some of these pictures from various old annual reports.

This is the laser disk that never really took off:

I don't know what this typecorder is.  I guess it's an early word processor.

Of course the big hit was the Sony Walkman.  This was created by the strong urging of Sony's CEO Morita.  People said there would be no market for such a product, but Morita, in a Jobs-like way, saw a market for this.

And here's a photo of the then largest color TV.  I thought it was funny given how big LCD screens are these days.

Anyway, Sony had the betamax fiasco and various format wars.  They have survived through the years precisely because they did a lot of things, I think.  (They would probably be bankrupt by now if they didn't have Sony Financial)
Of course, today, they may be involved in too much and may do nothing well.  But at this point, it's hard to imagine that they can do anything well.
Other Companies that Got the Culture Right
Recent cases where perfectionist, highly demanding, hands-on, detail-oriented founder/CEOs retiring that didn't go too well are Starbucks, Dell, Fast Retailing (Uniqlo).  Howard Schultz seemed to have gotten the culture right at Starbucks, and yet he had to come back to fix Starbucks.  Fast Retailing has a Steve Jobs-like CEO, Tadashi Yanai, who is highly demanding and has a good sense and feel for retail.  He retired once but since had to come back to fix Fast Retailing.   He too often talks about culture (he may not use that word); he often talks about developing employees etc.
I know there must be some successful cases, but these cases came to mind because of the style of the CEO; they were very hands-on.
In Apple's case, the runway of growth in front of them on existing products on upgrades and whatever was on the drawing board that Jobs put there may sort of mask this problem; Apple may very well be coasting on Job's achievement for now.
When people start to see this (which I think is already happening), it may be difficult for Apple to get a high valuation.
So, my thinking is that Apple will probably hit some bumps in the road in the not too distant future.  The stock price is cheap so it may not go down a whole lot, but it's only cheap if they maintain these high margins.  I have no proof, but I suspect that customers will see where all of their dollars are going and will eventually start to demand a better deal.  In an increasing competitive environment, why should Apple capture such fat margins?
I think Jobs was basically a genius product creator that was relentlessly demanding and would take nothing less than perfection.  He was the product guy of the century, maybe.  And Apple is very, very product dependent.  They don't sell a lot of products so whatever they come out with next MUST succeed.  Can they do this without Jobs?   This is yet untested. 
If H&M or Gap misses on their fashion for a season or two, they will suffer, but it probably won't kill them.
With Apple, they are like the portfolio manager that bets on two or three stocks.  When a genius is managing the portfolio, this can be incredibly successful.  But what happens when someone different takes over and still tries to manage a three stock portfolio? 

I don't know.   Apple may continue to do well for many, many years to come.

But I get the sense that the greatest asset at Apple was Steve Jobs, plain and simple.  Just as the best analysts and employees may help some star hedge fund managers achieve incredible returns, that doesn't mean that the analysts and employees will be able to continue posting those strong returns without the star.
And in anticipation of the people disagreeing, I understand the bullish argument.  Opposing views are always welcome here (or else why post publicly?).  But I just want to say that I am very well aware of the bull case! (Don't forget, it's the biggest dollar contributor to my portfolio this year).


Thursday, December 20, 2012

Markel - Alterra Merger

So, Markel (MKL) is buying Alterra (ALTE).   We know Markel is acquisitive and is looking for opportunities.  So here it is.

Of course Markel shareholders might have gotten sticker shock from the stock being down so much.  If the deal is accretive to book value, then why the heck does the stock price have to be down so much?  Markel was trading above book value, and they will buy Alterra for around book value.  But the way the market sees it, at least initially, is that on a sum-of-the-parts basis, nothing really changes on this deal.

Before the deal, the combined market cap of Markel and Alterra was around $6.9 billion, and now the combined market cap is around $6.8 billion, so the book value accretion to Markel (positive for MKL shareholders) is offset by the increasing exposure to reinsurance (negative; reinsurers are all trading below book).

Anyway, the merger presentation (which is always educational) is on the MKL website.

I like Markel, so I tend to like this deal.  It's a good idea.  Buy float for cheap and bump up returns by improving investment returns.

Here are some highlights:

First of all, Markel is a good company with decent historical results:

Markel's strategy is to do well on both underwriting and investing.  Most insurers work on the underwriting but invest mostly in bonds.  

This deal is accretive to book value.  After the deal, the book value per share of MKL goes from $395/share to $424/share.  The stock is now trading at $434/share, around 1.02x post-deal book value per share.  ALTE had $29.57/share in BPS at the end of September 2012 excluding $2/share in unbooked gains on fixed income securities held to maturity (booked at amortized cost).  So this $424/share post-deal is clean and simple (unlike the LUK post-deal BPS that included goodwill from the JEF purchase).

I don't believe MKL would do this deal expecting sub-10% return-on-equity for ALTE going forward, so MKL should be a decent buy at around book value.

Here is one of the keys to this deal.  ALTE's investment portfolio is mostly in cash and fixed income securities with a small allocation to hedge funds (more on that later).

ALTE has increased BPS year-to-date almost 10% (including dividends), which is not bad at all given the low interest rate environment and still weak insurance market.  ALTE's average ROE in the past five years is around 8%, and again, that's in a low interest rate environment and weak insurance/reinsurance market.

So we can see how there can be some pretty good upside from here just from:
  1. Increasing ALTE's allocation out of fixed income into equities
  2. Hardening insurance market
As for the insurance market hardening, here is an interesting slide from ALTE's 3Q2012 presentation:

So, insurance companies are trading really cheap these days because:
  1. Interest rates are low:  Insurance companies are leveraged due to float so their investment valuations are sensitive to interest rates and investment returns.  (At 3x float leverage, an 8% interest rate would mean a 24% pretax return on equity just for holding the float.  In a 3% interest rate environment, that goes down to 9%.  On an after-tax basis, that is the difference between a business valued at 1.5x book and 0.6x book; that's a 60% decline in value. (This assumes 35% tax rate and 10% required return).  Also, rising rates will cause bond prices to decline putting pressure on bond prices.  Some feel that owning insurance companies is owning bubbled up bonds on leverage (well, it is).
  2. Insurance market is soft:  As the chart above shows, the insurance market due to many factors (excess capital, weak economies around the world etc.) has been pretty weak.
  3. Economy is weak:   This overlaps with the other factors, but a weak economy obviously leads to lower activity and less demand for insurance overall.
  4. Weak investment returns:  This too overlaps with the others, but low stock market returns over the past decade has put a lid on valuations of insurance companies that do invest actively in equities.
If you believe the above factors are permanent, then obviously there is no reason to invest in insurance companies even if they are cheap.  But I tend not to think so, even though I do think interest rates will remain low for a long, long time. 

If MKL keeps doing well over time, book value is a great opportunity to get in.

But wait.  Before you go out and buy MKL stock, we have to think about buying ALTE instead.

ALTE shareholders will get 0.04315 shares of MKL and $10 in cash for each share of ALTE stock. Here are today's closing prices:

MKL:  $433.95
ALTE:  $28.04

So each ALTE shareholder gets:

0.04315 shares of MKL:  $18.72/ALTE share
Cash:  $10/ALTE share
Total:  $28.72/ALTE share.

The deal is expected to close in the first half of 2013, so let's call that 6 months.  Over that time ALTE will pay $0.32/share in dividends (I haven't seen a comment regarding dividends so I assume they will keep paying as usual.  This may not be the case).

So ALTE holders will receive through the deal closing a total of $29.05/share.

ALTE closed today at $28.04/share so that's a 3.5% discount.  On an annualized basis, that would come to a 7.0% additional return by holding ALTE now and getting MKL later rather than holding MKL now.

But one point is that since this deal is partially cash, you won't have 100% MKL exposure by owning ALTE instead of MKL.  You would own 64% MKL and 36% cash or something like that so if MKL rallies strongly towards the end of the deal, owning MKL outright might outperform.

As a merger arb, not that non-professionals can get 7x leverage at 100 bps funding spread (+50 bps for longs, -50 bps for short), this is what this deal looks like (I used 6x leverage to be conservative in the LUK / JEF post, but I'll use 7x as that is the figure commonly used in equity long/shorts):

If you buy ALTE and short MKL in the correct ratio (0.04315 MKL shares per ALTE share), and you put it on levered 7x and get funded at 100 bps, the above 7% annualized return would become 6% after funding cost and then 7x that would get you to a 42% annualized return.  This is not exact as you aren't long / short an equivalent amount (but I used 100 bps funding spread).

I don't know if that's right, but that's what you get with the above assumptions.  I may have missed something, but as usual, this is not the point of this post so let's move on.

Should you buy MKL or ALTE?
This gets tricky here as there is a cash component.   If you are sure the deal will go through and the deal was all stock, then it's a no-brainer to buy ALTE.  But that's not the case here.

Of course, with interest rates at zero and excess cash sitting in brokerage accounts, you can just lend yourself money and buy more ALTE to get the exposure to MKL.  So lend yourself $10/share of ALTE stock and then go out and buy MKL stock with it and you will have full exposure on the $28 worth of ALTE stock, or lend yourself $14/share of ALTE and buy more ALTE.  This makes sense if you have cash in the account earning nothing anyway; when the deal closes you will get that cash back and it will cost you nothing (as money markets are paying you nothing anyway).

But we don't always have cash lying around so we have to look at things with financing costs.  If you buy on margin, you will probably incur interest expense (which may be high in some accounts) so that may negate the edge you get from the discount.

So let's just look at owning $100 worth of MKL and $100 worth of ALTE.  It is simple math.  You have a discount advantage from owning ALTE, but you don't get 100% MKL upside.  So there is a payoff.   Here is what that looks like:

Owning ALTE versus MKL

The first column, 0.04315 is simply the number of MKL shares per ALTE share you receive on the deal.  Cash per share is the $10/share you get on the deal plus the $0.32 in dividends you would get (assuming ALTE keeps paying for the next six months).    MKL price is simply the different levels of MKL that it may trade at by the time the deal is done.    Return to MKL holder is the return you would get by owning MKL stock.  The bold figure is the current level.

The deal value is the total value of the deal per ALTE share.  The bold figure is the current stock price of ALTE and the last column is the percentage return you would earn by owning ALTE depending on where MKL is at the closing of the deal.

None of these return figures are annualized.

So you notice that owning ALTE is better in most scenarios as long as MKL doesn't rally more than 11-12%.   Up to a stock price of $484, you are better off owning ALTE and above that the MKL shareholder does better.  On the downside, due to the lower 'delta', ALTE is better off in all scenarios.

Of course, this assumes that the deal gets done.  If it doesn't, then ALTE can go back down to the pre-deal price and MKL stock would rally back up so the MKL shareholder would do better.   But I think most would see this as a done deal.

History of ALTE
This deal is very interesting when you think about the history of ALTE.  This is an entity that resulted from a previous merger, but the main entity goes back to 1999 when it was formed by Moore Capital (and other investors) as Max Re Capital.  Moore Capital is the hedge fund firm run by the supertrader Louis Bacon.  You can google him and read all about him.  He has a great track record over time, but hasn't done too well recently.  He is known more as a macro trader than for the strategies represented in the multi-strategy hedge fund portfolio ALTE has invested in.

This deal is similar to Einhorn's Greenlight Re; he set up an insurance company to generate float which the hedge fund would invest.

Max Re's idea was to invest 20-40% of the "float" in hedge funds run by Moore Capital.  It sounded like a good idea at the time.  A multi-strategy portfolio is designed to be uncorrelated to the stock market and other investment strategies within the portfolio.  This was to deliver returns that were uncorrelated and much stabler than the stock market with hopefully similar returns.

A lot of hedge funds are doing or planning on doing these things and the fear is that the insurance company would blow up; they would be too eager to write policies to increase float for the hedge fund to invest and then screw up the underwriting.  That's usually the worry.

In this case, it turns out that the underwriting/insurance business did well, but the investments didn't really pan out too well.   The investments didn't blow up and it did do much better than the stock market with lower volatility, but the returns were not so exciting.

Over the years since 2007, they reduced their allocation to the alternative investments from a range of 20-40% to 20%, to 10-15% and then to below 10% (or some similar reduction over time since 2007).

ALTE Hedge Fund Returns
So this may not be relevant to this deal, but it does show you why this deal makes sense.  And it's also pretty interesting to see what happened here in terms of investments.

Here's the list from the 10K which shows the usual suspect strategies in these typical portfolios:

...and here are the returns for the hedge funds since 2000 through the end of 2011.  This is a multi-strategy portfolio run by Moore Capital.

The annualized returns were:

                       Alternatives         S&P 500
12 years:        +4.7%                   +0.3%     
10 years:        +4.6%                   +2.6%
5 years:          +1.3%                    -0.2%
2011:              -3.6%                      2.1%

If Buffett made his "S&P 500 would beat any group of hedge funds" bet back in 2000, he would have lost in this case because the stock market went nowhere and this hedge fund portfolio did OK.   It has done much better than the stock market over most of these time periods and with much less volatility.

But these funds are supposed to be uncorrelated to the S&P 500 index, and they didnt' even return 5% over time.  That doesn't look too exciting.  Of course, the stock market went nowhere, but that's because it was coming from a very high valuation back in 2000.

The interesting thing is that Max Re started to decrease their exposure to hedge funds back in 2007 when their annualized returns was around 8.4%.  I guess that wasn't good enough either.  (I think people tend to expect 10-15% in these sorts of strategies.)

So, the story is that ALTE (or Max Re) was set up as an insurance company like GLRE (but much earlier) to generate float for Moore Capital to manage.  They probably figured they could earn 10% on their hedge fund investments and do well even with so-so underwriting results, and maybe do very well if they also underwrote well.

It turns out that the investments weren't working out so they ditch the hedge fund strategy and focus on underwriting and invest the float in conservative fixed income.

And then interest rates go down and keep going down and their fixed income strategy suddenly doesn't look too hot.  Going back to hedge funds doesn't look like a good idea as they lost -3.6% in 2011.   Plus the hedge funds only earned 1.3%/year in the past five years.  Not an exciting option.

And then here comes Markel with a more dynamic investment strategy.

Anyway, let's take a quick look at ALTE ROE historically for a second.

2000       2.7%
2001       0.4%
2002      -1.0%
2003      19.1%
2004      17.0%
2005        0.9%
2006      16.8%
2007      20.4%
2008     -12.3%
2009       17.6%
2010       12.3%
2011         2.3%

Average:  8.0%

So ALTE earned an average ROE of 8.0% since 2000.  The five year average is also around 8.0% so it's pretty consistent.  During the good years of 2003-2007, their ROE was close to 15%.

Of course, with subpar investment results and a pretty weak insurance market, they were still able to earn 8% consistently over time.

Just think what can happen if investment results were improved a little bit.

So how much can investment results improve?

Here is the history of investment leverage at ALTE since 2000:
              ALTE Investment leverage
2002            3.1x
2003            3.5x
2004            3.9x
2005            3.6x
2006            3.3x
2007            3.2x
2008            4.2x
2009            3.4x
2010            2.7x
2011            2.8x

Investment leverage has averaged 3.4x since 2002 and 3.3x in the last five years.  It has been trending down due to a soft insurance market, but this may head back up if markets do recover.

Anyway, let's just use 3.0x investment leverage to see what impact investing in equities would have on returns at ALTE.

This may be a little small; if you can't see it, it's from the Alterra earnings supplement on their website for the third quarter of 2012.

It seems like the hedge funds continue to not do too well, returning less than 3.0% year to date, 1.14% in the past year and -0.49% in the past 60 months.  (Only the past 60 months figure is annualized in the above table).  

Cash and fixed maturities are earning 4.7% year to date.

With an investment leverage of 3.0x, a one percentage point increase in the performance of investments would mean a 3.0% improvement in the ROE (since this is Bermuda based, I assume zero taxes).  With a 10% discount rate, a 3.0% improvement in ROE would lead to a 30% increase in the value of ALTE.

Can this be done?  Previously, ALTE had more than 30% of investments invested in hedge funds.  If we take the 30% and invest it in stocks instead, and we assume a 6-8% return in stocks over time, that would lead to an improvement of 4 - 6% over treasuries which yield less than 2% now.  The cash and fixed income portfolio above shows a return of 4.7% year-to-date and annualizes to over 6.0%.  I haven't looked at the portfolio in detail, but I don't think we can bake that into the cake for prospective returns as they are probably largely due to higher bond prices due to lower rates.

So if you can get a 4-6% improvement in investment returns on 30% of the portfolio (assuming much of it is invested in treasuries or low risk securities), that's a 1.2% - 1.8% improvement in portfolio returns, and with 3x leverage, that's 3.6% - 5.4% improvement in ROE.  At a 10% discount rate, that's worth 36% -54% increase in value.

(Yahoo Finance says that even single A-rated corporates yield only 1.5% or so out to five years).

Is Markel's Equity Investing That Much Better Than Hedge Funds?
OK, so after thinking about all of this, the obvious question people will ask is, well, will MKL's equity investment team do much better than ALTE's hedge funds? 

Let's take a quick look at some figures (from the various data above):

                  MKL equity              ALTE 
                  portfolio                    hedge funds
20 years:    +8.1%                       
10 years:    +6.7%                       +4.6%
5 years:      +1.9%                       +1.3%
2011:          +3.8%                       -3.6%

So looking at this, MKL's equity portfolio has done better over time than ALTE's hedge funds;  it has done better in all of the above time periods.

But some may argue that it doesn't look that much better.

Well, to that I will have to remind them that the stock market has been flat recently and that is really not expected to continue forever.

I can see how the stock market, over time, will tend to do OK.  I don't know if that argument can be made with the hedge funds, particularly when they haven't done that well in a period that they would have been expected to do really well.  They are supposed to benefit, usually, from volatility and we had a lot of that in the past decade.

So yes, I would tend to be far more comfortable with an equity portfolio run by MKL than this particular group of hedge funds, especially in light of the fact that institutions seem to be rushing out of equities into alternative investments (and maybe that is why many hedge funds aren't doing too well; too much money chasing the same trades!).

Anyway, I have more to say and I may put together a quick earnings model for ALTE to show how ROE may change with increased investments in equities (but don't hold your breath!  Holiday season coming up and I don't plan on sitting in front of the computer all day!).

But since it's been a while since my last post, I want to hurry up and get this out.

Thursday, November 29, 2012

Fiscal Cliff Doesn't Matter

So the markets now are driven by the fiscal cliff.  What will happen?  If they don't do something, the markets will plunge.  If they come to some sort of agreement, the Dow would be up 1,000 points. 

Nobody wants to be long on a failure to come up with a solution, and nobody wants to miss the boat on a 1,000 point Dow rally.   OK, 1,000 points is not much.  Maybe I should say 2,000 points.

In any case, this reminds me of a recent Howard Marks interview where he talked about the European situation.  He says there are three things he can say for certain about the situation:

  1. He doesn't know what will happen in Europe
  2. Nobody knows what is going to happen in Europe
  3. If you ask an expert what they think will happen and take their advice, it would be a mistake.

So to apply this to the current situation:
  1. I have no idea what will happen in Washington with the fiscal cliff
  2. Nobody knows what will happen in Washington with the fiscal cliff
  3. If you ask an expert what they think will happen and take their advice, you are making a mistake.
Of course, ths fiscal cliff matters in many ways.  But what I am talking about is within the context of investing for the long term.

If you believe that the U.S. and the world is drowning in debt and the Fed is out of silver bullets and the economy is peaking out and won't recover for years to come, then you shouldn't be invested in the stock market fiscal cliff or not.

If you believe that the U.S. and the world will eventually recover and be fine (maybe not as 'hot' as back in 2007, but some growth and stability), then you should be invested in businesses you like at reasonable prices fiscal cliff or not.

Here are some things you might want to think about:
  • Selling stocks now because you are worried about the fiscal cliff is a mistake.  This is not a rational decision; it is driven by emotion (fear).  And emotions should never drive investment decisions.
  • Buying stocks now because you think the fiscal cliff will be resolved is a mistake.  This is not investing; that's speculating.  Nobody knows what will happen with the fiscal cliff.  Betting on single event outcomes is speculating, not investing.  (One should invest in businesses or situations because they are priced right etc...)  Betting on single outcomes if the odds are reasonably calculable and the stock is priced or mispriced accordingly, that's different.
  • Shorting stocks or hedging against the fiscal cliff is also a mistake as it is not too different from selling your stocks out of fear (although hedging may be tax efficient as you don't have to realize capital gains like you do when you sell out longs).  This may seem 'prudent' and responsible, but it's still speculating.  Nobody ever knows when the markets go up or down.  Hedging or buying puts in anticipation of a sell-off, to me, seems more like speculating than rational investment behavior.  
...which leads me to the something that I thought about that is related to Buffett's frequent comments about not selling a good business you own just because of what is in the headlines.

Why People Make Money in Real Estate
OK, so this title seems odd given that we are trying to recover from the biggest real estate bubble/collapse in history.  Real estate has a history of big booms and busts, and there have been big real estate bankruptcies (Reichmann, Trump etc...) not to mention the disaster that is Japan and the most recent U.S. real estate bust.

But on the other hand, why is it that so often the biggest gain that many people have ever made in their lives have been in real estate?   (I know tons have been lost in real estate too)

Just thinking about family, relatives and friends (very small sample size, but...), it seems that the biggest winner has been their house or some other property, and not a stock.  I don't live in Omaha so I don't know anyone in person that has owned Berkshire Hathaway since the 1970s.

I have always noticed this and thought about it but never really expressed it out loud. 

There are a lot of reasons for this, of course.  Your primary residence is a big asset; if there is inflation, of course it's going to be your biggest winner.  Tax-incentivized leverage also helps.  Nobody is going to take out a 20% down loan and spend a good portion of their disposable income paying interest/principle on a stock investment.

But for me, what I often thought about was the illiquidity of the house.  This is why individuals were able to do so well in real estate over time while they get clobbered in stocks. 

Check this out. Compared to stocks, in real estate:
  • You can't get a quote on your house every day.  You can't look up the price of your house on Yahoo Finance.  OK, you can Zillow it, but it's not the same as seeing a firm bid and offer that is hittable instantly.
  • The evening news doesn't start by telling you that your house price was marked down by 2% that day due to some event that happened in Europe, or because of what some politician in Washington said.
  • You can't push some buttons on your iPhone and liquidate your house in less than five seconds.
  • Pundits are not on TV, the internet or in magazines telling you every minute of the day to sell your house and buy the one across the street because it will go up more, or tell you to sell your house because it will go down because of some fiscal cliff, canyon, valley or whatever...
  • People don't talk about how much their house went up at cocktail parties (well, this did happen during the housing bubble) and tell you to buy a house next to theirs (unless you are so wealthy that you buy and sell homes like people buy and sell stocks).
  • Financial Advisors don't tell you to sell some of your house and put more in bonds as the economic outlook isn't as good as it was a few months ago.
  • People don't pound the table and tell you to sell your house because it has been raining in your neighborhood for the last five out of seven days.
  • People don't tell you to sell your house because it is worth 10% less than it was last week and it may go down more.  Or because your house value, as of yesterday, is now below the 200-day moving average.
  • You don't have some crazy guy on CNBC every day waving his arms around spitting into the camera telling you to sell your house and buy the one across the street one day and then doing the exact opposite the very next day.  But I already said this in bullet point three, but I thought it's important enough to say it again.
  • Most people can only afford to own one or two houses at a time, so each purchase is done very, very carefully (like the Buffett 20-hole punchcard*; only most people have a 2-hole punchcard).  They spend days, weeks, months and even years looking and researching their house before they buy as it is a huge commitment (unlike people buying 100 shares "for fun" just in case someone's 'tip' proves correct.  Many people can afford to do this very often; so often as to build up a really crappy portfolio of stocks they know nothing about).
Anyway, we can go on and on with this list.  Surely, there are some negatives too.

But my point is that many people have done really well in real estate over a long period of time, but it's not so common to hear the same about stocks.  And that's because of the curse of liquidity.  I think liquidity is actually a good thing, of course.  But it can have it's drawbacks.  When it's right there at your fingertips, it's hard not to want to do something. And everyone around you including the professionals are constantly telling you to do something!

I was stunned when a "professional" investor on CNBC was telling people with a straight face that you can't ignore this stuff (fiscal cliff); this stuff is very important and it will move markets.   Well, if you are a professional fund manager being evaluated on a daily, weekly and monthly basis, I guess he is right; you can't ignore this stuff.  But if he thinks people can trade in and out based on what is going on in Washington, I think he's nuts.

Anyway, with the fiscal cliff approaching, everybody talks about what to do with the stock portfolios, but nobody ever talks about what to do with their houses (OK, I admit some people must be thinking about it and I'm sure personal finance magazines, websites and blogs probably do consider that too as they would make good 'filler' content).

But no real rational person is going to buy or sell their house on this issue.  And that's what Buffett keeps saying about stocks.  You have to look at it like a business (or a house).

What businesses are thinking about selling out because of fears of the fiscal cliff?  If you own and run a profitable restaurant at a great location, why would you sell just because of this near term issue?   If you love your house, why would you sell just because of this?

So What's Going to Happen?
Well, I said I have no idea and nobody really knows.  Anyone who claims to know has something to sell you.

Having said that, this is a blog and we are allowed to say anything we want.  So if I had to guess, my guess is that they go to the very end of the line, the market plunges, people freak out and they come to some sort of kick-the-can-down-the-road agreement.

You know at the end of the day they will come to some agreement.  The only question is when it will happen and how far the market has to go down to convince Washington that something has to happen.

It's just like what happened with TARP.  First, they said "no", the market plunged 700+ points (or whatever it was) and they all suddenly rushed in, "where do I sign?!".

This doesn't mean that's the way it's going to go this time around.  It's just my guess.

To do anything based on that scenario (buy puts, sell out with the intent of getting back in cheaper later etc...) is pure speculation so don't do it. 

Ignore all this noise.

*Buffett's 20-hole Punchcard
Value investors know what this is, but I realize this blog is read by a wide range of people.  For those who don't know what the 20-hole punchcard idea is, it's Buffett's way of telling students to choose investments carefully.  In a lifetime, people will find only very few really good ideas. And having just a few very good ideas is going to be enough to get very rich.

So instead of just buying stocks left and right promiscuously (as many novices tend to do), do solid research, look hard and look for only the best ideas.  When that is found, then invest big in the idea and try to go on to the next one.   And invest as if you only have 20 times you are allowed to invest.  Once you invest in one thing, one hole in the punchcard will be punched out. 

This will make you think very carefully about what you buy as you can't afford to make too many mistakes.

This also reminds me of Peter Lynch's comment that he is baffled that people spend more time researching and shopping for a refridgerator or car than they do a stock even when their stock investment is much larger than their fridge or car.

Going back to my house argument, if people did as much work on stocks they buy as they did shopping for a house, more people would do better.

Even if they did, though, since this is not Lake Wobegan, we can't all become better than average investors.

Wednesday, November 21, 2012

Leucadia-Jeffries Merger Loose Ends

So after posting my initial look at the merger, a couple of points have been raised.  Or I should say one was raised (in the comments section in the previous post) and that lead to another point.

One is the issue of dilution.  I said that this merger would have a 4.7% or so dilutive effect at the prices on the LUK presentation.  This is correct on a pro-forma, post-merger stated book value basis. 

But someone pointed out correctly that the book value of JEF in that calculation uses LUK's acquisition price for JEF and not the book value of JEF; the post-merger book value of LUK would include the premium to book value that LUK pays for JEF (which would end up as goodwill).

Is this fair?  I will get to that in a moment.  I don't think it's a bad analysis because we still look at Berkshire Hathaway, for example, using book value per share even after the Burlington Northern acquisition (we don't adjust the BNI value down to the pre-merger book value of BNI).   Book value is only a rough guide and there are other models to look at BRK, but still, BPS is an important measure for BRK's value; important enough for Buffett to use 1.1x book as a buyback level.

But anyway, when we look at financials, we do tend to look at if it is dilutive or accretive to book, and we do often look at stated book value of the respective firms.

"Real" Dilution
OK, so let's recalculate the dilution to LUK shareholders of this deal excluding the goodwill that may arise from it.  In order to do that, I will use JEF's current book value instead of LUK's purchase price of JEF, add it to LUK's current book value and get a post-merger BPS.

Here is the page from the presentation.  If you can't see it, it's page 32 of the merger presentation available at LUK's website.


So instead of using the LUK share price times 0.81 x JEF shares outstanding to calculate JEF's adjusted book value, let's just use their stated book value.

According to JEF's latest 10Q, JEF's adjusted shareholders' equity is $3,515 million.  So let's use that instead of the $3,782.1 million adjusted JEF equity value.  To calculate this quickly, all we need to do is adjust the combined book value for all of LUK down by the difference which is $267 million ($3,782 mn - $3,515).

The adjusted combined book value for LUK in the above table is $9,325 million.  Deduct $267 million from that and you get $9,058 million.  Divide that by the adjusted LUK shares outstanding after the merger of 377.7 million and you get a post deal book value per share of $23.98/share.

According to the above table, LUK's current BPS (less Crimson) is $25.91/share.  That means that excluding the goodwill from the deal, dilution to LUK shareholders is close to 7.5%.

So that looks like a lot of dilution!

Obviously, if you think JEF is worth only book value, then you would be pretty unhappy with this deal.  Not good.  

But wait a second.  All the time we have been valuing LUK, we have marked the LUK holdings to market.  When JEF was trading far above book value, we didn't adjust book downward to JEF's stated book value.  We marked the position to market.

So in that sense, we don't need to force the value of JEF to book value just because they own all of it.  Why mark to market when partially owned and then force a mark to book value (and exclude acquisition goodwill) when wholly owned?  That is not consistent. 

Of course, recently, JEF has been trading lower and LUK's deal has pushed the stock price up so one can argue that appreciation in price is artificial.    But let's take a closer look at this and see what JEF might be worth (or at least what maybe the LUK folks feel it's worth).

JEF Value
When LUK first bought into JEF in April of 2008, the deal was priced on April 18. The closing price of JEF on that day was $14.98/share.  As of the end of the most recent quarter at the time, JEF's book value per share was $13.03 and the adjusted BPS was $12.10 (adjusted for RSU's).  

So that was done at 1.15x BPS and 1.24x adjusted BPS.  Granted, at the time, LUK's share price was $53.36/share against a BPS at 2007 year-end of $25.03/share.  So they issued stock at 2x book to buy something at 1.2x book.  Nice trade.

But LUK has also bought stock in the open market over time.  They have said previously that JEF is a good buy at close to book value.

So JEF has been on the LUK books since 2008.

I just jotted down the BPS, adjusted BPS and stock price of JEF since 2009 to see how JEF has been valued in the market.  I figured 2008/2009 stock price would be depressed due to the financial crisis and not really that representative and anything before that of course may be even more unrealistic as financials were valued pretty high pre-crisis.

Anyway here is the data:

JEF Valuation

Common BPS is the GAAP BPS that most people see.   This is the figure people see when they think the LUK deal was done at below book value.  The adjusted BPS is adjusted for RSU's and is more accurate since it is fully diluted for RSU outstanding.

Anyway, since the first quarter of 2009 (the panic low during the crisis), JEF has traded at an average of 1.56x adjusted book value per share.  1.56x is not a bad benchmark as it is mostly a post-crisis valuation and it includes the MF Global contagion/JEF panic in late 2011.

If you exclude the early 2009 panic low and the MF Global panic and only include the quarters 2Q2009 through 2Q2011 (labeled "average*" in the above table), JEF traded at 1.96x adjusted book value per share.

So that is sort of the market evaluation of the JEF business model post-crisis excluding the effects of the Euro-meltdown/MF Global panic. 

JEF has not recovered from that, and the market is now undergoing a fiscal cliff panic.  So excluding these effects, JEF may be reasonably be valued at 1.5-2.0x BPS.

Going Back to the Dilution Issue
So the first point would be, if we didn't adjust downwards the value of JEF to it's stated book (when it traded above book) and we calculated LUK's book value using the mark-to-market value of JEF when it was partially owned, then it doesn't make sense that we do so now post merger just because this "goodwill" is artificial. 

The part that is artificial is that LUK's acquisition did push up the price of JEF; it doesn't reflect pre-merger mark-to-market of JEF itself.   But it didn't do so beyond the previous range of where JEF has traded in the recent past.

With LUK trading at around $21/share now, that makes the deal worth $16.35 per JEF share. Since the adjusted BPS of JEF is $15.63/share, that's a 4.6% premium, not much.   Even at the presentation value for JEF of $17/share (when LUK was at $21.80), that's a 9% premium, or a value of 1.09x book value for JEF; not an unreasonable valuation at all given it's recent trading history.

You can argue that this very deal will reduce or eliminate the liquidity concern that arose about JEF after the collapse of MF Global; there is no reason why after this deal that JEF should be worth less than book.  As an independent, there was always a concern of an MF Global-type run triggered by a European collapse or some other event.

So I would be inclined to say that the LUK presentation post-merger valuation (including goodwill) is fine for looking at dilution.  I think it's important for shareholders to understand all of this, though, and realize that there is another way too look at it (7.5% dilution).

And By the Way
Also, there is a circular aspect to this dilution calculation and what LUK is trading at now versus a post-merger BPS.

Since the deal is not fixed in terms of price (no price floor/collar or anything like that), we don't really know what the dilution is going to be.

Calculating the above LUK presentation dilution (using LUK acquisition price as JEF adjusted equity), the dilution changes as follows at various price levels of LUK:

LUK Price           post-deal BPS        dilution
$25                       $26.21                   1.1% (accretive)
$24                       $25.73                   -0.7%
$23                       $25.25                   -2.6%
$21.80                  $24.68                   -4.8%  (price on presentation)
$21                       $24.30                   -6.2%
$20.32                  $23.98                   -7.5%  (price at which deal value is equal to JEF adjusted BPS)

There would be no further dilution under $20.32/LUK share because if the deal price was worth less than adjusted JEF BPS, there would be a bargain purchase gain, and JEF will be booked at the original JEF book value.

There is obviously less dilution the higher the LUK price upon the closing of the deal because the JEF adjusted equity value will include "goodwill"; it will be booked at a higher value on the balance sheet in proportion to how high the LUK stock price is.

With LUK shares trading now at $21/share, the immediate dilution to LUK shareholders (including acquisition goodwill) would be -6.2%, more than the -4.8% calculated according to the presentation (due to the lower LUK price since then).

Post-Deal BPS and LUK Valuation
One other thing is that since the post-deal BPS is dependent on the price of LUK at the closing of the deal, the post-deal BPS on the LUK presentation is not current since the stock price has changed.

I said that the post-deal LUK BPS is $24.69, and if you add back Crimson Wine, then the value is $25.50.   Against that, it looks like LUK, which closed at around $21.00 today is trading at a 17.7% discount to post-deal BPS.

But this post-deal BPS is only good with LUK priced at $21.80.

With LUK trading at $21.00/share, the post-deal BPS is actually $24.30, and with Crimson added back in, that's $25.11.

So the actual discount is 16.4%, not 17.7%.  Not that big a difference.  It's still pretty cheap.

Anyway, here is a table that shows how the discount changes according to LUK's price:

LUK                          post-deal                     
price                          LUK BPS                  discount
25                              27.02                           -7.5%
24                              26.54                           -9.6%
23                              26.06                         -11.7%
21.80                         25.50                         -14.5%
21                              25.11                         -16.4%
20.3                           24.79                         -18.1% 

The above post-deal BPS includes Crimson Wine to make it comparable to the current price.
Below around $20.30/LUK share, JEF would be valued below book, so there would be a floor there because JEF would be recorded at their own book value with the difference recorded as a bargain purchase gain.

Of course the other way to look at the post-deal BPS is to use JEF's current book value instead of LUK's purchase price.  This would not change because of changes in the LUK stock price.

From the above calculation, this would be around $24.00/share.  So even with JEF booked at the old book value and not including goodwill that may arise, LUK's post-deal BPS would be $24.00/share.  Adding back Crimson Wine's $0.81/share value and you get $24.81/share.  With LUK trading at $21/share, that's a 15.4% discount.  Not bad.

LUK is Still Cheap
So even with the above adjustments and high dilution due to a lower LUK stock price, LUK stock is still pretty cheap, and even if with no acquisition goodwill, LUK is trading at a 15% discount to the post-deal BPS. 

So Why'd They Do It?
If you asked them why they did this deal despite the dilution, I bet they would say that they think that the deal is accretive to LUK on an intrinsic value basis.  They will tell you that they are not too concerned with conventional accounting, GAAP book values and things like that.

They did say that they really like JEF at close to book value, which means they think it's worth much more.  They were comfortable owning this at 1.5x-2.0x book for much of the post-crisis period.

If you think JEF is worth 1.5x book, for example, then this deal may not be dilutive at all.  The trick is figuring out what LUK is worth, of course.

Dilution Based on Instrinsic Value
Just for fun, I will fill in some of the above tables and see what the dilution would be if JEF was in fact worth 1.5x book value.  I know some of you will think I am reaching here and trying too hard to make this deal look reasonable.  But that's OK.  I am just looking at this from different angles and I'm not trying to argue one way or the other.

Using the LUK presentation table, let's just wave a magic wand and change the number in the adjusted JEF equity value to 1.5x JEF adjusted book value.  Adjusted book value of JEF was $3,515 million at 3Q-end, so 1.5x that is $5,273 million.

Now the post-merger LUK BPS comes to $28.63/share.  The current LUK BPS (excluding Crimson) is $25.91/share, so now the deal is suddenly 11% accretive.

And then adding back the value of Crimson, LUK BPS would be $29.44, so that would make LUK at $21/share trading at a 29% discount!

OK.  So there are problems here. I used an intrinsic value of JEF against the book value of LUK.  To be totally fair, you have to look at intrinsic value versus intrinsic value.  But for me, since I usually value LUK at book value (adjusted for some things), it is not too far off.

This is just an illustration of why this deal is not as simple as "it's 8% dilutive so it's horrible!".  Technically it's dilutive, but there is more to the story than that.  And that's what I tried to illustrate with this example.  I don't mean to say that this deal is 11% accretive, or that LUK is now trading at a 30% discount.

I just point out that it can be seen this way if one thinks JEF is reasonable worth 1.5x book value.  And that's not a stretch at all, again, if you think that this deal will reduce the risk of an MF Global-type run, or someone Egan-Jonesing them again.

Of course, if you think JEF is worth 1.5x book, then JEF has been a great value in the past year or so.  Well, maybe that's why LUK is buying them out.

Can We Really Get to 1.5x Book for JEF? 
One last thought.  I think the smaller investment banks do tend to trade at higher multiples than the large ones.  Recent history of JEF trading when not being Egan-Jones-ed tends to support higher valuation for a company like JEF.

Many of us make fun of investment bankers all the time, but I do like to read merger proxies as they do tend to have valuation comps that can be interesting (and silly at times too).  So we may get more insight into valuation for JEF.

But we may be able to get 1.5x valuation on our own.  We know that the LUK folks want to get 15% pretax return (or much better).  So let's use a pretax 15% return.   Since I already did the work, we can use book value growth plus dividends as a proxy for long term return-on-equity (it will serve as a sort of comprehensive return on equity over time)

From the other post, here is the growth in book (plus dividends) of JEF over time (annualized):

                            Growth in BPS+DVD            Pretax Comprehensive Income
1996 - 2011         +15.4%                                 +25.7%
1999 - 2011         +13.9%                                 +23.2%
2007 - 2011           +5.6%                                 +  9.3%

So since 1996, JEF grew book value including dividends at a rate of +15.4%.  On a pretax basis (using a 40% tax rate), that's +25.7%/year.

From the 1999 peak, they earned 23.2%/year pretax.

If they need 15% pretax returns, JEF can be worth 1.5x book (at 1.5x book, this 23.2% pretax return turns into 15%).

Now this too is not so simple.  Yes, the previous ten to twelve years has not been the greatest time for financials but there is no guarantee that the next ten or twenty will be as good for JEF.

This, again, is just to get my arms around a 1.5x valuation.  Is it reasonable or not?

I don't do this to convince anyone either way; I just present the facts and analysis as food for thought.

So I fine tuned some stuff from my other post here and there were some adjustment/changes that had to be made, but I don't think the conclusion changes much.

The deal is dilutive looking at it conventionally. But who said these guys are conventional?

For me what's important is that I do like the people involved on both sides, the deal is not ridiculous (this is not Time Warner / AOL) and in fact might be a great deal depending on how you look at it (1.5x book value scenario), and the LUK stock is currently pretty cheap either way.

The 1.5x book value scenario and analysis is just illustrative and shows that this can be a a totally reasonable deal depending on what you think JEF is worth.  1.5x is just a figure I plucked out of the air as it seemed to be at the lower end of the range of JEF's stock excluding periods of panic (and it's the average since 2009).

I know many people assume investment banking is dead and that's why JEF is trading cheap.  But I tend to disagree with that.  I don't think investment banking is dead at all; I do think it will come back.  And I think JEF was trading cheap mostly for fear of another MF Global-like run.  This is clear from the valuation pattern through 2011; it traded well until MF Global collapsed and a bad (and wrong) report about JEF came out.

Of course, if you think investment banking is dead and the low valuation is the correct valuation, then obviously we will disagree on what we think about LUK going forward, and about this deal.

You can easily make a similar but more moderate argument using 1.1x book, 1.2x book etc.

So my opinion remains the same.  Good deal, but of course it would've been better if it wasn't dilutive, but then again, from a value gained perspective, it may not be as dilutive as it at first appears.

Also, this is not a complicated deal at all.  It's pretty simple.  But there are a lot of numbers involved in the stuff I wrote, so I may have missed something (hopefully nothing big!).  If so, I apologize in advance.

In any case, we all have to do our own work so do your own work and make up your own mind!