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It pays to save

I just saw an ad for Guaranteed Consumer Funding, which offers to sell electronics (they were hawking a computer) for cheap payments to people with bad credit. For the computer they were offering (worth about $400 on a good day, although it is easy to find a computer for $500 that is far superior), the consumer would have to pay $1569 over one year. This works out to a 400% APR. Ouch. The company hides this fact in its ads and mentions only the $30 weekly payment without saying how many payments are owed.

In comparison, buying a superior computer for $500 and then paying 30% on credit cards for one year would cost $650. Of course, my favorite method, saving the money in a bank account, would cost only $500. It would only take 17 weeks of saving at $30 per week to be able to pay cash for a superior computer than the one issued by Guaranteed Consumer Funding.

Some people wonder why many poor people are poor. Medical problems and job problems are often reasons, but the largest single reason is an unwillingness to delay gratification and save. While income matters, avoiding spending matters even more. I know a man who makes $200,000 per year as a financial adviser who has saved less for retirement than a woman who never made more than $30,000 per year (and who put a kid through college as a single mother).

The best way to save is to make sure you are not tempted to spend. If you get a raise or a better-paying job, increase the proportion of your income that you put into your 401(k) and IRA. You do not need a fancy house or a new car. As for myself and my dear wife, we are taking my advice. My wife will be putting 50% of her income at her new job into her 401(k) and I am putting 100% of my eligible income into a solo 401(k). We will also contribute the maximum to our IRAs. From income that we are not eligible to stick in a tax-deferred account we will have just enough left over for living expenses. That way we will not be tempted to buy unnecessary things such as my next car.

How can we afford that? We have a modest home, drive a 4.5 year old compact car, and because I work from home, we only need one car (that saves us about $5,000 per year). We still have plenty of money left for the good things in life, such as a 7-year old $60 bottle of Tokaji wine I just opened today (which is rated 95 by Wine Spectator; I find it to be marvelous).

Fredrick’s of Hollywood: Reverse Merger Mania in Microcaps!

It is merger time! My favorite micro-cap reverse merger is going to happen in just one month. Movie Star Inc. [[msi]] will buy the larger, private Fredrick’s of Hollywood. I previously wrote about this transaction back in August when MSI’s stock price was around $2.20 per share. It currently trades at $1.60.

After everything is done, the combined company will have no net debt (or net cash), $215 million in annual sales, and 55.75 diluted shares outstanding (including conversion of preferred stock). Given the current price of $1.60, the implied diluted market cap is $89 million. There is a rights offering in mid-January that will raise $20 million. That is priced at $1.76 (only shareholders as of late November can participate). At that price, the implied diluted market cap of MSI/Fredrick’s is $98 million.

Given the combined company’s proforma price to sales ratio of .41, it seems a bit cheap. For comparison, Limited [[ltd]] is priced at .65. However, considering that $64 million (30%) of the combined company’s sales will come from the low-margin manufacturing / distribution business of MSI, the company seems to be price about right (subtracting out the sales of MSI, the P/S ratio rises to .6).

In terms of earnings, I come up with estimated proforma earnings for the year ended last June for the combined company of $2.8 million. I do not include the preferred stock dividend because I assume conversion to common stock (this will not happen, but I must avoid double counting the cost of that preferred stock and I count it as diluted common stock). I take out all direct merger-related costs and I do not include interest expense (most of the debt will be paid off, and there will be $20 million in cash on the balance sheet when the merger goes through).

This gives a proforma P/E of 32. However, it is likely that there will be some significant cost savings of the merger. Assuming that SG&A is cut by just 5% (a modest assumption), I come up with proforma earnings of $5.5 million and a proforma P/E of 16.2. This is a reasonable multiple, especially considering the growth the company should see.

Here are the drivers of growth in sales:

  • 50 anticipated new Fredrick’s stores over the next three years will increase the number of stores by 38%
  • organic growth in same store sales and online/catalog sales will be about 8% per year as old stores are remodeled, Fredrick’s brand regains some cachet, and concentration of stores increases as the store total increases. Fredrick’s averages only about $400 in annual sales per square foot. This should increase to at least $500. For comparison, Victoria’s Secret averages somewhere between $600 and $700 per square foot.

Furthermore, costs should decrease:

  • Cost of goods should decrease as the company’s greater size increases its bargaining power with suppliers and as Fredrick’s sources more of its product from MSI.
  • SG&A as a percentage of sales should decrease due to cost cuts and an increased number of stores and greater sales per store.

MSI/Fredrick’s still remains a risky play. That being said, Fredrick’s has a well-known brand, and it is available on the cheap to the public markets for the first time in about a decade.

Disclosure: I am long MSI and I am a customer of Fredrick’s. I have a disclosure policy.

I do not like your CDO!

Broker Joe!
Show me some flow
I need the dough!
I’m Broker Joe!

That Broker Joe!
That Broker Joe!
I do not like
That Broker Joe!

Would you buy my CDO?
I do not like them, Broker Joe
I do not like your CDO!

For the rest of this Dr. Seuss inspired poem, see the PDF at the Wall Street Journal (free). The WSJ economics blog found the author of the poem, Cameron Crise.

Byrne Baby Byrne!

I encourage you to stop by The Motley Fool and take a look at my Dueling Fools article with Rick Aristotle Munarriz, in which we debate Overstock.com [[ostk]]. I obviously take the bear side of the debate. Overall, I think Rick did a better job arguing his case, but I have the truth on my side (and Patrick Byrne’s paranoid conspiracies).

For direct linkage, see
Bull Argument
Bear Argument
Bull Rebuttal
Bear Rebuttal

Disclosure: I have no position in OSTK. The title of this post was appropriated from Rick, who is much wittier than I. My disclosure policy is practicing to become a Sith Lord.

Kiplinger’s list of 15 ways to lower your 2007 taxes

See the article. Below are the suggested moves and my comments (see the article for the reasoning behind each move or click on the link for a separate Kiplinger’s story on each move).

1. Beware the AMT
2. Offset Taxable Gains
3. Avoid Mutual Fund Dividends
4. Donate Your IRA Distribution
5. Boost State Sales Tax Deductions
6. Close on Your Mortgage in 2007
7. Who Pays the Gift Tax?
8. Fund a Kid’s Roth IRA
9. Score an Energy-Saving Tax Credit
10. Last Chance Tax Break
11. Max Out Your Retirement Savings
12. Wait for 0% Capital Gains Tax
13. Trim taxes with Flex Accounts
14. Get a Receipt for Holiday Giving
15. Give More and Pay Less With Securities

My Comments

1. Good point. If you have too many deductions you can get hit with the AMT and you will lose all or most of the deductions.
2. It is not too late to tax-loss harvest.
3. I’ll do them one better: avoid mutual funds. Only invest in low-cost broad-based index funds or ETFs. They are more tax-efficient and have better before-tax returns too.
4. There are lots of different ways to give certain moneys or items to charity that will reduce your tax bill more than by just giving taxable cash.
5. This would be a hassle to account for. Generally not worth it unless you live in a state without the income tax or unless you bought a few high-priced items (e.g., cars).
6. This is not something most people can really time.
7. Talk to an estate attorney to set up a plan so that you do not have to pay gift taxes.
8. Excellent idea. Even better, make the kid put some of their earned money into it.
9. Not worth it for the money alone.
10. Not familiar with that one.
11. I like to do this at the beginning of the year to maximize tax-free growth. Also, if you can, do a Roth instead of a normal IRA or 401(k). It only makes sense to wait if your income may be too high to do a Roth or normal deductible IRA.
12. Only works if you won’t make much money.
13. Sure. They can be a hassle, though.
14. I think it is best to give in large amounts and to only a few organizations. Then they will automatically send a receipt. Plus, it is easier for everyone involved.
15. Excellent idea.

Disclosure: I am not a tax, legal, or accounting professional. This is not to be construed as legal or tax advice and represents only my opinion.

Avoid debt-laden companies

In the search of Goode value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. We must never combine those three, however. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.

For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap. If they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.

Movie Gallery is a great example of stupid management harming a company. The company’s stock traded as high as $30 in 2005; it now trades at $0.55. Movie Gallery runs a chain of video rental stores. They have historically been profitable. However, early in 2005 the company took on much debt to buy Hollywood Video. The company now has a market cap of $17 million and debt of $1.1 billion. The company’s bankruptcy is imminent. I would argue that the movie rental business is one of the best businesses to be in. People like watching movies, new movies cost a lot to see at movie theaters, and the competition (satellite and cable movies on demand) are not that great.

While Netflix (NFLX) has made it harder for bricks and mortar stores, I feel its impact has been drastically over-rated. I subscribe to the Netflix service, but there are plenty of people who do not. A bricks and mortar store can do good business because those that rent more infrequently will never subscribe to a Netflix-type service. Therefore, I think that Movie Gallery’s two chains, Movie Gallery and Hollywood Video, will still be around in one form or another fifteen years from now. The problem is that the debt of the current company will prevent it from responding to challenges. Bankruptcy is therefore almost certain

General Motors faces much the same problem. Unfortunately for the careless investor, their full debt his hidden in details in their financial statements about their union contracts and the number of retirees for whom they provide pensions. Some have estimated that GM will have to pay out over $70 billion in pensions and health care benefits to its current and future retirees. For a company that has consistently lost a few billion dollars per year over the last few years, this is a problem. In addition to its debt, GM has too many brands, too much production capacity, an unfavorable union contract, and shrinking sales. Without such a sizable debt, GM would stand a chance of restructuring and saving its stockholders. As it stands, it has no room to maneuver. Unless it can become highly profitable within a year or at most two years, it will go bankrupt.

So does debt matter for stock returns? Yes, at least according to this study (scroll down on the page to which I link to download the PDF). While the data are from the UK, the results are logical and should apply in the USA as well. While the correlation of debt ratio with stock returns is lower than the correlation of P/E with stock returns, there is still a definite negative correlation: the stock of those companies with the least debt did the best. The 30% of companies with the lowest debt showed a consistent advantage over those with higher debt. Those companies had leverage ratios of under 20%, meaning that total debt represented less than 20% of enterprise value. For comparison, MOVI has a leverage ratio of 99%, while GM has a leverage ratio of 96%.

Disclosure: I have no interest in any company mentioned. Since I wrote this article last spring both GM and MOVI have seen their stocks decline. MOVI looks like it is about to enter bankruptcy. I have a disclosure policy.

Welcome to the Remote MDX Bashing Party, Andrew

Andrew Left of Citron Research posted an article slamming Remote MDX (OTC BB: RMDX) back on December 4th. He got a decent amount of attention for it, too. Yet he is a little late to the party: I have been on that company’s case since August 20. See my two posts from that date on why Remote MDX is a horrible company and an incredibly bad investment.

Andrew did find out some information I had missed, but he missed the fact that Remote MDX does not even wholly own their ‘wholly-owned subsidiary’ SecureAlert. They only own 80% (see my previous articles for more information).

Left probably ran across my articles when researching his, so I would have appreciated a bit of credit for doing prior research on the company. If he did not see my articles, then he should probably start reading my blog. Another reason he should read my blog: almost one third of the visits to my blog have been for people searching for information on Mr. Left.

See my posts about Left:
Can You Trust the StockLemon: Part 1
Can You Trust the StockLemon: Part 2
Can You Trust the StockLemon: Part 3
Can You Trust the StockLemon: Part 4

Disclosure: I am short RMDX. I have a disclosure policy. I would have posted this sooner, but I re-balanced my position in RMDX just after Left’s piece came out and I thus had to wait a week to publish this.

You can be an activist investor

TSR Inc. [[tsri]] just announced a stock buyback of about 6.7% of its shares outstanding. This may come as a surprise to some investors. It is not a surprise to me, however. I was the one who recommended it, in a letter (pdf) that I sent to TSR directors back in late June 2007. TSR is a tiny computer staffing firm with a highly under-leveraged balance sheet (they have a lot of cash).

Did my actions directly cause the stock buyback? Probably not. The directors were not afraid of an investor with less than 0.5% of the shares outstanding in his possession. But it certainly did not hurt that I wrote and suggested that the company buy back stock (for a good reason, I might add). Perhaps that was just the push the directors needed to get them thinking about ways to deal with TSR’s cash hoard.

Perhaps TSR will take my other advice and declassify its board of directors. If not, I may not just sit back and wait. I might even try to get that on the next proxy ballot myself.

If you are too lazy to read my letter, here is my strongest reason for a buyback (which would reduce the company’s cash): “We of course do not need an academic study to prove the obvious point that the key driver of shareholder value is the ability of the company to provide a return on investment. A 5% yield in treasury securities that comprise the majority of a company’s equity is ipso facto inadequate for any corporation.”

Disclosure: I am long TSRI. I have a disclosure policy that generally does nothing until an unhappy reader writes it a letter.

Moving Markets in Microcaps

Sometimes a large investor makes their presence known and it becomes fairly obvious who is causing a stock to move. This is particularly true in microcaps. So when the price of Noble Roman’s (OTC BB: NROM) stock jumped up 46% a week ago, it was not too hard to figure out that it was largely because of one large individual investor buying a chunk (although my initial guess was completely wrong). How do I know? He just filed a form 13G with the SEC, indicating that he now owns 10% of Noble Roman’s.

That buyer was none other than Robert P. Stiller, chairman of the board of Green Mountain Coffee [[gmcr]] (and for those old hippies out there, founder of E-Z Wider). Bob has owned the stock of Noble Roman’s since early in the spring of 2007. See his 13G filing on March 6, 2007, where he stated that he owns 1,000,000 shares. He increased that earlier this month to just under 2,000,000 shares. Green Mountain has a $900 million market cap. What does Bob want with a $40 million pizza company? And should anybody follow his example? That is the $4 million dollar question (for Bob at least).

So far, Bob has not done well on his Noble Roman’s investment. His average price on the earlier purchases in February and March 2007 was probably around $4.15. At a recent stock price of $2.40, he has lost 43%.

Microcaps will often see random individuals that buy large stakes. Sometimes the large investors are right, sometimes not. In this case, like with others, only time will tell.

Disclosure: I am short NROM. I have a disclosure policy.

Citigroup’s $49 billion ‘mistake’

If something looks like a duck and acts like a duck, especially if it quacks like a duck, then it is almost certainly a duck. If something looks like an asset and acts like an asset, than it should be treated as an asset and put on the balance sheet of the company that owns it. What is ownership of an asset? Ownership implies control and the ability to profit from an asset. In terms of consolidated subsidiaries on audited balance sheets, ownership implies the ability to suffer losses from the asset. Recent credit market problems have revealed hundreds of billions of owned assets and related liabilities that banks such as Citigroup [[c]] and insurance companies such as AIG [[aig]] kept off their balance sheets. This was in clear violation of the spirit (if not the letter) of GAAP. Simply put, these companies fooled their investors by skirting the intent of GAAP while remaining true to the letter of the GAAP rule on consolidation of special purpose entities. One clear result: Citigroup finally consolidated $49 billion of SIVs that supposedly it never owned and did not deign to put on its balance sheet.

Anatomy of a Structured Investment Vehicle (SIV)

A SIV has one purpose: interest rate arbitrage. Via financial voodoo and certain guarantees that a SIV usually obtains from its sponsoring institution (aka owner), SIVs can borrow money at extremely low rates, such as LIBOR. After borrowing a ton of money at or near LIBOR, a SIV will then buy various securities that yield more than LIBOR. The interest rate spread is split between the nominal owner of the SIV and the sponsor or real owner (such as Citigroup). SIVs usually have very little equity and are levered greater than 10x and up to 14x. That means that for every $1 of equity in the SIV (provided partially by the sponsoring institution and partially by various investors), the SIV can have $10 of assets and $10 of debt. This leverage is in itself dangerous, but is not much different from the leverage inherent in all banks. However, SIVs are structurally insolvent, as they owe short term debt but own long-term debt assets. They rely upon the short-term commercial paper market to sell their debt. Their assets are long-term debt such as CMBS, RMBS, CDOs, along with plain-vanilla corporate debt.

For more information on SIVs, I suggest the excellent article on them by Randy Kirk on SeekingAlpha. The problem with the SIVs is that to get their high credit ratings, without which they would have been unprofitable, they required backstop funding agreements from their bank sponsors. So Citigroup, for example, agreed to provide up to $10 billion in backup funding to its $49 billion worth of SIVs if they could not sell their debt. This meant that if trouble came, Citigroup would be on the hook for $10 billion (most of which it lent to its SIVs a couple months ago). If times got really bad, the SIV could become completely insolvent and it is theoretically possible that Citigroup could have lost the entire $10 billion. Yet despite this risk (which I will admit was remote), Citigroup did not consolidate the SIV on its balance sheet as it should have done. Its Tier 1 capital ratio was artificially inflated (duping banking regulators), its investors were left in the dark, and it earned essentially free money from the SIV that artificially pumped up its ROA and ROE.

This is one case where GAAP fails and IFRS did a much better job. GAAP consolidation rules need to be quickly amended to prevent future shenanigans of this sort.

Disclosure: I have no direct interest in any stock mentioned. My disclosure policy has a 0% debt to total capital ratio.