Modern Dental Group

Description

Modern Dental Group Limited (HK stock code: 3600) manufactures and supplies custom teeth replacements, retainers, dentures, and fixtures, and sells them to dentists and dental labs through wholly owned distributors. Since 2011, Modern Dental strategically bought out its European distributors for 2-3x earnings and acquired 11 or more of its 21 original distributors it has known since 2001— spanning various geographies.

In 2016, expansion into North America through a USD 65-70 million acquisition for MicroDental/RTFP for 22 clinics, which was previously operated by a private equity firm, required fixing. Prior to the acquisition, MicroDental lacked industry knowledge and proper management—inventory for costly rare metals and ceramics in form of porcelain powder were wasted, and MicroDental kept on expanding at a loss. It has taken Modern Dental 3 years (2016-2019) to turn around the entire situation with MicroDental.

Due to this incident, the stock price fell from listing price of hkd 6.5 to 1.1.

Modern Dental’s CEO, Mr. Ngai, has been flying over to North America every 2 months to fix the situation, and in 2019, they managed to hire a new CEO, Laura Kelly, who previously worked 16 years at MicroDental as V.P of sales and left to start her own company. Since her arrival, 4 clinics have been shut down, and products or services which have lower margins were completely removed. As of 2020, MicroDental is now slightly profitable.

Modern Dental’s main manufacturing base is in Shen Zhen, but they recently bought a new piece of land and plan to relocate to Dong Guan, China, in 2019. Phase I saw a relocation of 1300 technical employees, from Shen Zhen to Dong Guan. Phase II will improve capacity with another 1500 technical staff, but is delayed by the Corona Virus. As of early 2020, the total number of technical staff is around 4350

Modern Dental’s products and services:

Fixed prosthetic devices— such as crowns and bridges, comprise of 70% of sales

Removable prosthetic devices—such as removable dentures (fake teeth for the elderly), comprise 20% of sales

Orthodontic, sports guards, and anti-snoring devices contributes 10% to sales – Modern Dental is the distributor for invis-align in Australia. They also have their own brand— Trio Clear Align, which is currently only in Hong Kong and Macau, but will be expanding to other countries once licenses and certifications are obtained. While Trio Clear only makes up less than 1% of sales, it is one of Modern Dental’s most promising products for future growth.

Replacements for teeth are due to aging, cavities, accidents, etc. These replacements come in the form of crowns, dentures, or fixtures. Crowns and dentures requires a specialist or technician to shape— the color is picked from a palette to match the client’s existing teeth, color, size has to be exactly right, etc.

This is not cost effective for small dental labs to produce and they would rather outsource and procure this service instead. For example, in North America, an order is made to Modern Dental—the specifications are obtained either

1.         through biting into a mold to prepare a cast
2.      or through an intra-oral scanner (digital copy);

 Results from CAD-CAM are either sent to local production facilities with 10 or more staff for urgent orders or specifications are sent to China. After production is tailor made-- parcel are shipped via air for immediate delivery. 

Casts of your teeth which harden to form a mold, are bulky but precise, but increase the weight and shipping cost. Intraoral scanners are adopted by 15% to 35% of most labs to reduce processing time and streamline the entire process to a digital one. Intra-oral scanners cost approximately USD 20,000-30,000 per model.

Industry/ Market Size

Modern Dental is a leading global dental custom-made prosthetic device provider in a growing (5-15%), but fragmented industry. In certain countries, consolidation is poor— obtaining 1-2% of the market automatically makes you the leader.

The total dental industry was a 25-29 billion market in 2019. Modern Dental focuses on abutments, implant dentistry, and orthodontics— a sector which makes up USD 4.6-5 billion of the dental market.

Accidents from sports or driving, teeth decay (cavities) and teeth replacement (elderly people) brings Modern Dental a consistent and growing revenue (USD 154M in 2014 and 309M in 2019) and cash flow (USD 23M in 2014 and 44M in 2019).

The Business/ Competitive Advantage

Modern Dental has four main processing centers which dentists send to after obtaining results from an intra-oral scanner or cast. The patient’s specifications are mainly sent to a lab in Dong Guan or Shen Zhen, China, and are shipped via a parcel to the dental lab. Urgent orders from Europe, such as France, are processed in Madagascar. There are processing labs in North America; Melbourne, Australia; and Emmerich, Germany.

The main manufacturing lab is in Dong Guan— as of now, only phase I has been completed; Phase II has been halted due to the Corona Virus. Tangible book value of Dong Guan(land, building, equipment and labs) are around USD 27 million.

Modern Dental’s operating model is not unique, but due to scale and CAD-CAM technology, they are able to facilitate dentists in reducing processing time and provide extra support for special cases.

Modern Dental’s true competitive advantage comes from pairing their fast turnover rate with impregnable distribution channel achieved through acquisitions of distributors and labs, and strategic partnerships. Since 2011, Modern Dental has acquired more than 10 of their 21 distributors from Europe, Australia and USA which they have collaborated with since 2001.

Other contributing factors include obtaining valuable patents and signing a J.V with the Swiss company Straumann (SWX:STMN), which produces state of the art dental implants and screws (fully tapered, BLX, two piece, and four piece implants).

As the industry begins to use less casts, and embraces digital technology with intra-oral scanners— Modern Dental should realize economies of scale. They will be the lowest cost producer with the highest quality, coupled with proper international training facilities.

Modern Dental is no longer just business to business— the entire manufacturing process for Modern Dental has been transformed into a vertically integrated assembly line.

Ownership structure

49.26% of the company is held by the Chan family

16.74% of the company is held by the Ngai family

28.9% is free float.

Negligible impact from Buybacks

As of 2020, 962.5M of shares were outstanding. So far, buybacks are too small and negligible (1% of float) to have a significant impact on contracting shares outstanding.

In 2016, 996M shares were outstanding. In 2019, after a miniscule 21.4M shares of buybacks, 967M shares were outstanding.

The four most important factors contributing to Modern Dental’s future prospects are:

1     Per Capita Income 

       Govt. Subsidies/insurance affecting dental penetration rate of countries 

       Growing Elderly Population

With very few exceptions, tooth replacement for your average family is an out-of-pocket expense. Certain non-economic factors, such as public healthcare schemes and private insurance policies influence the willingness to seek dental prosthetic treatment. Government subsidies and reimbursement plays a huge role in Modern Dental’s sales. Another factor is the number of dentists and per capita income. Estonia has the highest ratio of dentists compared to its entire population, yet since its per capita income is half of USA— Estonian locals don’t really have the excess income to for dental treatments— dental care account for 74% of out-of-pocket expense.

For example, South Korea has the highest penetration rate for dental implants in the world— more than 70% of the dentists in the country place implants. Since reimbursement in South Korea was gradually introduced for senior citizens in 2014, this resulted in many listed dental companies and a growing industry. With a population of 51 million, they have around 22,950 dentists. Despite a much smaller population than China or USA, subsidies have induced patients and elderly to fix their teeth.

By contrast, large economies like China and India remain heavily underpenetrated due to a lack of qualified dental professionals. For China, there are only 130 dentists per million head count. With a population of 1.4 billion people, there are only 137,000 - 140,000 dentists. You would think because of scarcity, salaries should be sky high. A dentist’s salary in China is about USD 100,000 annually before tax.

Australia has a population of 25 million and has approximately 13,250 dentists. Modern Dental has a large presence in Australia, but in 2012, the government’s dental medical care coverage called the “Chronic Disease Dental Scheme” (CDDS) was terminated. As a result, the year before implementation, Australians rushed to fix their teeth; the industry became relatively stagnant afterwards. This diminished sales right after Modern Dental acquired Southern Cross dental in 2015 was bruising to sales.

The U.S has around 300 million people and approximately 180,000- 200,000 dentists. The number of patients treated per 10,000 adult population in the US is only half that of Italy and only a third that of Spain, the largest European market.

Europe has a population of 740 million with approximately 400,000 dentists. For example, in Germany, France, and Belgium, dental prosthetic treatments are partially covered by the public healthcare schemes, but the Netherlands has only private insurances available for dental care. In addition, French and Belgian governments grant additional reimbursements for dental prosthetic treatments for underprivileged citizens.

This illustrates the considerable growth potential for Modern Dental with its huge acquisition of Micro-dental— claiming 18 clinics in the US. Penetration in other highly populated countries like the UK, India, China and Japan is also clearly below average, offering strong upside potential in coming years.

The last point would be the increasing number of elderly citizens globally—patients over 65 years old are increasing their dental expenditures by 20%, and due to quality of health, people will be living longer. In 2015, there were 901 million people who were over 60. By 2030, there will be 1.4 billion people over 60.

2       Managing 4200-4500 technicians— optimizing labor force and utilization rate

Capital expenditures on equipment and raw materials aren’t the main concern for Modern Dental. For milling and processing machinery, German suppliers such as Datron AG’s machinery sold to Modern Dental depreciates in 7-10 years.

55-60% of cost of goods sold primarily consists of labor costs, while 28-33% are raw materials in the form of ceramic and alloys mainly imported from Europe and the United States. As dentists and labs employ CAD-CAM technology, less expensive materials such as ceramic blocks rather than precious alloys.  Raw materials are mainly procured from Europe and USA. The prices for Cobalt chrome alloy, Zirconia, CAD blocks, porcelain powder, and gold are relatively stable.

Currently EBIT margins are at 7-10%. In 2013, it was as high as 21.5%. This is because SG&A is at 38% in 2019, in 2013, SG&A was only 30.5%. Therefore, controlling the headcount and making sure utilization rate is of the utmost importance— acquisitions can only improve the top line, while scrupulous management can improve cash flows and the bottom line.  

Modern Dental’s relocation from Shen Zhen to Dong Guan not only increases capacity, it also helps retain employees. Shen Zhen is similar to Silicon Valley, employees jump ship too often. Modern Dental trains 700 new technicians every year, but despite benefits and incentives, they get employed by bigger companies in Shen Zhen which aren’t even in the Dental Industry. It takes more than 2 years to train a successful and competent technician. Land, building, and equipment in Dong Guan was purchased for a total of USD27M. Turnover won’t be as rampant.

However, with Phase II completed, the head count will increase from 4500 technicians up to 6000.

North America        400

Shen Zhen          2,200

Beijing                    190

Dong Guan 1       1300

Dong Guan 2       1500 (halted due to virus)

Labor costs will only increase in China and utilization rate or the efficiency of technical staff is always a concern.

Modern Dental has 6139 employees, of those employees, there are 4300 technicians. Each technician has the capability to produce 1.8 cases per day. In 2019, 1,807,754 cases were manufactured; these cases represent USD 310M of revenue. Of this revenue, more than 60% comes from a stable base from Europe and USA, with higher ASPs (USD 165-215) and EBIT margins. China brings growth and scale, but the ASP is significantly lower USD 88 (half of Europe’s ASP).

Assuming 4300 technicians x 1.8 cases / day, that’s approximately 7,740 cases per day. 

If technicians work 260-275 days a year, 7,740 x 275 = 2,128,500 cases.

My estimates are that Modern Dental is currently at 70-80% utilization and can be ramped up to 85-90%. Management has also mentioned about the possibility of opening a factory in Vietnam to reduce labor costs.

3      Over reliance on acquisitions-- discipline to sit on cash and not to do foolish things

Acquisitions have been a doubled edge sword. Modern Dental can’t grow with an infinite amount of acquisitions—roll ups are not sustainable. Modern Dental’s market cap, as of July 2020, is close to USD 160-195M. Since 2013, Modern Dental has made 195M of acquisitions—66% of acquisitions were great to moderate prices—Modern Dental acquired some European distributors for 2-7x ebitda.

 In 2016, management was desperate to make a big acquisition to improve Modern Dental’s presence in the United States. This acquisition includes 22 dental labs, stretching from East Coast to West Coast, with labs even in Canada (Ontario and Vancouver). Modern Dental paid USD 65M for a RTFP from a private equity which had poorly managed, and was hemorrhaging cash at an annual loss of 10M.The last 33% or 65M, was for MicroDental/ RTFP, was painful and while it expanded their reach, required a lot of fixing.

Micro-dental was previously owned by private equity, hence the poor management due to a lack of understanding of the industry. They thought that if there was a fixed cost, if there were additional sales at a low price beyond the fixed cost, they would make a profit. It doesn’t work that way.

MicroDental was employing the wrong strategy- the company divided into different sectors based on quality and income. New CEO Laura Kelly is fixated only on high margin products while gradually phasing out low margin offerings. Laura Kelly was appointed as the new CEO; she previously worked for Micro-Dental as vice-president of sales for 17 years and founded her own company which was acquired by Dental Services Group. She understands the culture and knows what is like to start a company, but whether the culture can be changed and whether she can instill financial discipline is yet to be seen. She has appointed Robert Kreyer— an experienced technician, to be the director of implants and advanced dentures.

From 2016 to 2019, the number of cases (sales volume) jumped from 1.39 million cases to 1.8 million. Revenue is 300-310M in 2019, of which about 40-50% or 130-140M was from organic revenues, and 50-60% or 145-175M was from acquisitions.

During this entire period, Chinese customers had the largest contribution in terms of volume, but due to a low average sales price, the revenue contribution is minimal. For example in 2019, of the 1.8 million total cases, the aggregate revenue was USD 300M. 747,000 cases came from China, but at an ASP of only USD 88, only usd 65M was contributed to total revenue. Whereas Europe, an ASP of USD 205, or 574,544 cases, produces a revenue of USD 117M.

RTFP/ Micro Dental was purchased in 2016, and had a significant impact on the top line, even though it was not profitable. In 2016, RTFP/Micro Dental’s revenue contribution was not included—there were 214,810 cases at an ASP of USD 165, bringing in a revenue of 35M. With RTFP, in 2017, with the 22 dental labs, the number of cases more than doubled from 214,810 cases to 528,687 cases—bringing sales to USD 88M, with an ASP of USD 167.

 As of 2019, MicroDental has finally broken even with a marginal profit.

The acquisition of MicroDental has diluted the financial performance of Modern Dental in terms of operating and profit margins and has dampened return of capital. It was a bitter lesson learned by the management of Modern Dental. Since then, Modern Dental has slowed down the pace of its M&A activities and has held a much more cautious approach.

4      Quality Control and expansion of Trios Clear Align

When patients need a cast, denture, or crown made, there are a lot of errors due to technicians or faulty hardware or software. Modern Dental claims to have a re-make rate of 3%, while the industry is at 8-10%.

Malocclusion, or misalignment of teeth, affects billions of people or 60-70% of the world population. 12 million people seek treatment and 300 million people have yet to seek dental assistance. Invisible orthodontics makes up 8-11% of the entire market and grows 5-6% annually. Currently Invisalign has the lion’s share of the market and are selling treatments at USD 4000-6000. Once their 25 year patent expired, incumbents such as 3M, Modern Dental’s Trio Clear aligner, and Straumann are jumping on this opportunity. 

The standard price for Trio Clear is selling at USD 1950-2800 (HK$15,000 to 20,000) depending on location and geography. Modern Dental can leverage its distribution channel and existing customer base of 20,000 dentists worldwide for cross-selling. Depending on how fast Modern Dental can leverage on this opportunity to expand Trio’s clear aligner, USD 100M can be added to the topline.

If these 4 conditions above are resolved, below are the following facts as to why Modern Dental would be a good investment:

--    Adequate valuation for suitable growth: Modern Dental trades at a P/E of 8.9x and a TEV / EBIT of 8.2x (trailing 12 months). TEV / (Operating Cash Flow - Capex) is 11.4x  (FCF = Net income plus D&A minus Capex) Revenue has grown at 13.5% in the last 3 years while Tangible Book value has grown at 34.8%.

--    High ROIC: This consolidation naturally brings an increase in assets and head count, and Modern Dental is eliminating any excess staff or assets from the process, which should bring up return on capital. Return on capital is currently 5%, but if we discount goodwill from U.S and European acquisitions, we can take away 167M (HKD 1.3B) from capital employed. With 20M (HKD 165M) generated, the ROIC is actually 10-11%.

--    Teeth replacement a basic necessity: People will always need dentures and fixtures. The process of building a home has not changed materially in decades. Neither of these statements is likely to change in the next year, the next 5 years, or even the next 20 years. There is minimal technological or obsolescence risk. Also, since each individual requires a customized fitting, there is minimal inventory except for raw materials such as rare earth metals and ceramics.

--   Dominant in its markets: Modern Dental competes in 17 countries with over 70 sales and customer service centers and is the only multinational denture service —including Modern Dental Laboratory in Hong Kong (50% market share), Elysee, Permadental, Labocast in Europe, MicroDental and Modern Dental USA in North America, Yangzhijing in China, and Southern Cross Dental in Australia. It is in the top 5 in terms of market share despite the fragmented industry.

--    Modern Dental's profits and market dominance are all the more amazing when you
remember that the results have been achieved without significant R&D.

Capital Structure/Debt

A working capital of USD50M had been maintained for2015-2019. Leverage is now more conservatively financed— debt to equity has been decreased from 130% in 2014 to 50% in 2020.

Retained earnings has doubled from 62M in 2014 to 132M in 2019, while tangible book value hasn’t changed much at 250-270M despite large purchases of land, dental equipment, and hiring of staff. PPE has jumped from 17M to 88M from 2014 to 2019, but debt has held equity growth.

Modern Dental does not plan to carry out large scale re-financing on all bank loans of the Group.  Their plan is to use different bank loans facilities to gradually re-finance the outstanding bank loan due within 1 year (2021) or pay down loans using extra cash (USD 55M).  Modern Dental has around USD 95-100M (HK$700-800m) bank loans and USD25M (HK205m) in lease liabilities. In addition to this there is a 20M unused revolving credit for contingent needs. Modern Dental is repaying this sum gradually as there is still the expenditures of phase II of Dongguan plant in the near future.

Valuation:

Modern Dental has 10% operating earnings, and if they stopped with acquisitions and focused on cost control, especially on staff and overhead, they could easily have 20% operating margins. This is incredible cheap for a business with equity growing at 15%. Modern dental is mainly a B2B business, but vertical integration and acquisition of some dental labs and clinics invariably means they have to deal with clients directly and have to deal with the B2C segment.

Given that dentures and fixtures quality and response time are crucial to dental clinics, I believe a fair price for this business would be a market capitalization of hkd 3.5 billion or USD 400-500 million (currently, June 2020, HKD1.4B or USD179M) 14x underlying operating earnings (hkd250M or USD32-35M). Modern Dental now has the scale in America, but they have to fix the inherited poor management from the previous private equity owners, and they are dominant in Europe in Australia. China has poor margins due to fierce competition, but this is compensated with growth due to increased disposable and discretionary income from a large population (the entire industry in China is growing at 13% CAGR). 

Modern Dental currently trades at 0.8x trailing twelve months enterprise value to revenue, at a USD 450-500M valuation, if debt and cash remain at the same level, this would be 1.7x TEV/revenue. There aren’t any comparable operators of modern dental’s scale, since they are either in the manufacturing of dental machinery such as X-ray scan, curing guns, etc, or they are dental clinics. Based on a share count of 962.5million, this would result in hkd$3.6 per share. Consistent buybacks and reduction in debt makes Modern Dental have a 61% upside, but intrinsic value may grow if operations in America improve and when utilization rates improve after phase 2 of the Dong Guan factory in China is open.

  

Catalysts

-        Huge Runway for attacking the clear aligner market for the aesthetically pleasing crowd.

-       Once RTFP/ MicroDental becomes a cash flow contributor, assuming sales jump up from 65M to 110M; I assume that a modest 10-20M of cash flow is possible.

-        My base case assumptions is that some type of efficiencies of scale will start to take effect and affect the bottom line. Further increase in sales, capacity, and margin expansion is possible after Phase II of the Dong Guan factory is in operation.

-        Modern Dental has stable revenue from developed markets – N.A, Europe, and Australia.

-     N.A and Europe each bring in 200M of revenue to the top line. China only brings in 65M despite greater unit volume. The growth opportunity in a highly fragmented market with the ability to increase pricing over the future brings another long runway for compounding.

-         Leveraging a marketing and distribution network that serves over 200,000 dentists.

http://www.globalstockpicking.com/2018/12/16/dental-industry-part-3-modern-dental-group-3600-hk/

https://www.straumann.com/group/en/home/investors/financial-reports/annual-reports.html

HKEX announcements

http://www.moderndentalgp.com/html/index.php

https://www.youtube.com/watch?v=LNfhsegslYc

https://www.trioclear.com.au/

Forbes 2020 -- Inside the 2.5 Trillion Debt Binge

Original Article in link-- (all copyrights, content belongs to Forbes) 

https://www.forbes.com/sites/susanadams/2020/07/15/online-learning-platform-udemy-said-to-seek-funding-at-3-billion-valuation/#21a20f426fbc

In the boom years before the pandemic, the Fed encouraged S&P 500 titans to binge on trillions in debt, now the central bank is propping them up to avoid an economic catastrophe.

When chief executive Doug Parker took the pilot’s seat at American Airlines in December 2013, it seemed as though clear skies were ahead. His U.S. Airways had finally bagged a major partner by agreeing to combine with bankrupt American. The new company would emerge with modest debt as the nation’s largest airline, with only three domestic carriers left among its global competitors. 

The financial crisis was well in the past, the economy was humming and travel seemed to be entering a new golden age. Carriers like American had mastered the science of dynamic fare pricing, and now nearly every seat on every flight was full, maximizing revenue and efficiency. Hailing the arrival of a “new American” by early 2014, Parker was eager to please Wall Street. “I assure you that everything we’re doing is focused on maximizing value for our shareholders,” he said on a call with investors. 

Over the next six years, Parker borrowed heavily, tapping capital markets no fewer than 18 times to raise $25 billion in debt. He used the money to buy new planes and shore up American’s pension obligations, among other things. A host of passenger fees for additional baggage, more legroom, in-flight snacks, drinks and more helped swell the bottom line to $17.5 billion in combined profits from 2014 to 2019. Keeping his pledge, Parker declared a regular dividend in 2014—American’s first in 34 years—and began buying back billions of the airline’s stock. 

 “Holding more cash than the company needs to hold is not a good use of our shareholders’ capital,” he reasoned. That was music to hedge funders’ ears as they piled into American stock. Even Berkshire Hathaway’s Warren Buffett bought a chunk of the company. Out of bankruptcy, its stock took off almost immediately, doubling during Parker’s first year on the job. For his managerial brilliance, Parker was rewarded with annual compensation surpassing $10 million. 

Fast-forward to April 2020, and a contagion known as SARS-CoV-2 has leveled the travel industry. American Airlines is flat broke, in part because of Parker’s profligate spending. Now the U.S. government has agreed to advance it $5.8 billion in the form of grants and low-interest loans—the largest payment to any airline in the government’s $25 billion industry bailout package. Many hedge fund investors have sold their shares, as has Berkshire Hathaway. American stock is now worth just one-third of the $12 billion Parker spent on buybacks alone. 

Despite recent boom times, American’s balance sheet is a disgrace. Over the last six years, Parker added more than $7 billion in net debt, and today its ratio of net debt to revenue is 45%, about double what it was at the end of 2014. American says it plans to pay down its debt “aggressively” as soon as business returns to normal. 

Debt-laden American Airlines is not an outlier among the nation’s largest corporations, though. If anything, its financial gymnastics might well have been a playbook for boardrooms around the country. Year after year, as the Federal Reserve pumped liquidity into the economy, some of the biggest firms in the United States—Coca-Cola, McDonald’s, AT&T, IBM, General Motors, Merck, FedEx, 3M and Exxon—have binged on low-interest debt. Most of them borrowed more than they needed, often returning it to shareholders in the form of buybacks and dividends. They also went on acquisition sprees. Their actions drove the S&P 500 index ever higher—by 13.5% on average annually from 2010 through 2019—and with it came increasingly rich pay packages for the CEOs leading the charge. The coup de grâce was President Trump’s 2017 tax cut, which added even more helium to this corporate-debt balloon. 

Blue Chip Debt Junkies

Few companies have been able resist the lure of leverage. Below are some of the biggest borrowers.

According to a Forbes investigation, which analyzed 455 companies in the S&P 500 Index—excluding banks and cash-rich tech giants like Apple, Amazon, Google and Microsoft—on average, businesses in the index nearly tripled their net debt over the past decade, adding some $2.5 trillion in leverage to their balance sheets. The analysis shows that for every dollar of revenue growth over the past decade, the companies added almost a dollar of debt. Most S&P 500 firms entered the bull market with just 20 cents in net debt per dollar of annual revenue; today that figure has climbed to 38 cents. 

But as the coronavirus pandemic cripples commerce worldwide, American corporations face a grim reality: Revenues have evaporated, but their crushing debt isn’t going anywhere. 

A year ago, Federal Reserve chairman Jerome Powell sounded an alarm, but he could barely be heard above the roar of the ascendant stock market. “Not only is the volume of debt high,” said Powell last May, “but recent growth has also been concentrated in the riskier forms of debt. . . . Among investment-grade bonds, a near-record fraction is at the lowest rating—a phenomenon known as the ‘triple-B cliff.’ ” Powell was referring to the fact that a large number of companies’ bonds were dangerously close to junk status. “Investors, financial institutions and regulators need to focus on this risk today, while times are good.” 

Powell has stopped preaching. Facing the frightening prospect of widespread corporate insolvencies, the Fed on March 23 announced a credit facility designed to support the corporate bond market. Two weeks later, the central bank stunned Wall Street by saying it would go into the open market to buy some junk bonds as well as shares in high-yield bond ETFs. 

In the last two months alone no fewer than 392 companies have issued $617 billion in bonds and notes, piling on still more debt that they may not be able to pay back.

All told, the Federal Reserve is now earmarking $750 billion, supported by $75 billion from taxpayers, to help large companies survive the pandemic—all part of its $2.3 trillion rescue package. 

“We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market,” groused Howard Marks, the billionaire cofounder of Oaktree Capital, in a memo April 14. “When people get the feeling that the government will protect them from [the] unpleasant financial consequences of their actions, it’s called ‘moral hazard.’ People and institutions are protected from pain, but bad lessons are learned.” 

The lesson to corporate-debt junkies is clear: Taxpayers be damned, the federal spigot is wide open. In the last two months alone, according to Refinitiv, no fewer than 392 companies have issued $617 billion in bonds and notes, including a record number of triple-B issues, piling on still more debt that they may not be able to pay back. As Warren Buffett observed during Berkshire’s annual shareholder meeting on May 2, “Every one of those people that issued bonds in late March and April ought to send a thank-you letter to the Fed.” 

America’s foremost corporate citizens—companies found in nearly every retirement account—did not become debt dependents all by themselves. It took some prodding, mostly by Wall Street’s savviest participants. Take the case of McDonald’s, known for restaurants in nearly every town in the U.S., its iconic golden arches offering fast, budget-friendly meals to billions. 

It all started before the 2008 crisis, when billionaire investor Bill Ackman began agitating the Chicago-based burger behemoth, demanding that it divest most of its 9,000 company-owned stores to independent operators in order to buy back $12.6 billion in stock. McDonald’s successfully repelled the hedge fund activist, but during the recovery, its growth stalled. 

Starting in 2014, McDonald’s chief executive, Don Thompson, began piling on leverage to fund share repurchases. A year later his successor, Steve Easterbrook, amped up Thompson’s strategy by selling company-operated restaurants to franchisees, just as Ackman had wanted. Today, 93% of the 38,695 McDonald’s worldwide are operated by small entrepreneurs who cover maintenance costs and pay the parent company rent and royalties for the privilege of operating in its buildings, using its equipment and selling its food. 

The new and improved “asset light” McDonald’s no longer manages cumbersome assets; instead, it receives those payments and is sitting on tens of billions in debt. From 2014 through the end of 2019, McDonald’s issued some $21 billion in bonds and notes. It also repurchased more than $35 billion in stock and paid out $19 billion in dividends, returning over $50 billion to shareholders, far in excess of its profit ($31 billion) over that period. 

That was just fine by Wall Street. McDonald’s became a hedge fund darling, its shares more than doubling during Easterbrook’s tenure, from 2015 to 2019. His reward was $78 million in generous pay packages over five years. 

The risk added to McDonald’s balance sheet has been dramatic, however. In 2010, the company carried just 38 cents in net debt per dollar of annual sales, but by the time Easterbrook was fired in late 2019 amid news of a workplace affair, it had $1.58 in net debt per dollar of revenue. 

Today its net debt stands at $33 billion, nearly five times greater than before the financial crisis. Its bonds are rated triple-B, two notches above junk, down from their A rating in 2015. 

A prolonged recession could push some overleveraged firms toward insolvency, especially if interest rates rise and the Treasury’s multitrillion-dollar “save the economy at any price” plan makes inflation do the same.

With most of its restaurants nearly empty during the pandemic, McDonald’s stock initially fell by almost 40%. Thanks to the Fed’s intervention, though, McDonald’s debt, which at first slumped to 78 cents on the dollar, recovered along with the stock, as the company quickly raised an additional $3.5 billion. McDonald’s insists that it entered the crisis with a strong balance sheet and overall financial health. It recently suspended its share repurchases. 

The startling truth, though, is that the burger giant’s leverage is actually modest compared to one of its foremost competitors, Yum Brands, the $5.6 billion (revenue) owner of Pizza Hut, Taco Bell and KFC. After Greg Creed took charge as CEO in 2015, activist hedge fund managers Keith Meister, of Corvex Management, and Daniel Loeb, of Third Point, took big positions. By October of that year, Meister was on Yum’s board of directors; days after his appointment, the company said it was “committed to returning substantial capital to shareholders” and spinning off its Yum China division, which generated 39% of its profits. 

Over the next year, Creed borrowed $5.2 billion to fund $7.2 billion of stock buybacks and dividends. Yum retired some 31% of its common shares, and as expected, its stock price doubled to over $100 by the end of 2019. Shareholders were thrilled, but Yum’s financial staying power was severely compromised. In 2014, Yum had just $2.8 billion of net debt, accounting for 42% of net revenue; by 2020, that figure had swelled to $10 billion, or 178% of net revenue. Heading into the coronavirus economy, Yum was a basket case, but thanks to the Fed and a $600 million bond issue in April, it will live to see another day. 

Yum management scoffs at the idea that the Fed helped in any way. “We’re not aware of Federal Reserve intervention in the high-yield market or in our ability to issue $600 million of high-yield bonds,” the company says. 

Like McDonald’s, Yum sold many of its company-owned outlets to independent franchisees. Without access to capital markets and the Fed’s largesse, their future isn’t so certain. Yum is giving some of its franchise owners a 60-day grace period to make their royalty payments. David Gibbs, who replaced Creed as CEO in January, speculated at the end of April that if need be it would take over the franchises and sell them off. 

Of course, some argue that the de facto leveraged buyouts of publicly traded companies like McDonald’s and Yum were actually prudent given the Federal Reserve’s decade-long easy-money approach to monetary policy. “As a corporate finance matter, it was almost irresponsible to overfinance with equity given that [debt] was unbelievably cheap,” says Arena Investors’ Dan Zwirn. 

According to the St. Louis Federal Reserve, as of the end of 2019, non-financial business debt totaled $10 trillion, climbing 64% from the beginning of the decade. “Every penny of the quantitative easing by the Fed translated into an equal match of corporate debt that went into share buybacks, which ultimately drove the share count of the S&P 500 to the lowest level in two decades,” says economist David Rosenberg. “This was a debt bubble of historic proportions. . . . Then again, nobody seemed to mind as long as the gravy train was still operating.” 

If there were an award given for corporate recklessness, however, few would challenge mighty Boeing, the world’s largest aerospace and defense manufacturer and the nation’s single biggest exporter. Once the pride of industrial ingenuity in America, Boeing has been hypnotized by the lure of financial engineering. 

Starting in 2013, the Chicago-based company decided it would make sense to commit nearly every penny of profit, and then some, to its shareholders. It sent $64 billion out the door—$43 billion worth of buybacks and $21 billion in dividends—saving little under CEO Dennis Muilenberg to cushion against the industry’s expected hazards, such as manufacturing difficulties, labor disputes and recessions. 

After two of its 737 MAX planes crashed within five months and the FAA grounded the aircraft in 2019, Boeing’s aggressive financial policies were exposed, and it was forced to turn to debt markets for emergency cash. The company, which had essentially no debt in 2016, ended 2019 with $18 billion in net debt. This March, Boeing drew fully on a $13.8 billion credit line to contend with the grounding of air travel, and Standard & Poor’s downgraded its credit rating to the lowest rung of investment-grade. 

Boeing flirted with a bailout, initially asking the government for $60 billion for the aerospace industry. But in late April, chief financial officer Greg Smith told investors the Defense Department was taking steps to bolster its liquidity, and that the Coronavirus Aid, Relief and Economic Security (CARES) Act had helped it defer some tax payments. Boeing also began weighing funding options from programs run by the Treasury and Fed. “We believe that government support will be critical to ensuring our industry’s access to liquidity,” said Boeing’s new CEO, David Calhoun, on April 29. The next day, Boeing launched a $25 billion bond offering, eliminating the need for a direct bailout. The issuance, which includes bonds that aren’t redeemable until 2060, was oversubscribed, as institutional investors no doubt assumed that Boeing’s recovery was a matter of national importance to the government. 

While delivering cash back to shareholders was an obsession of Boeing’s CEO, becoming a giant in entertainment via acquisitions has been the hallmark of Randall Stephenson’s 13-year tenure as CEO of AT&T. Since his start atop the 143-year-old company once revered as Ma Bell, Stephenson has spent more than $200 billion—mostly on acquisitions of DirecTV and Time Warner, among others, but also on stock buybacks and the telecom’s $2 annual dividend. All told, Stephenson piled on almost $100 billion in new net debt. “AT&T is the most indebted non-financial company the world has ever seen,” says telecom analyst Craig Moffett. 

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Race To The Top 

Corporate debt has skyrocketed to more than $10 Trillion, according to the St. Louis Fed, but it may ultimately be overtaken by the government. Said Fed Chairman Jerome Powell on 60 Minutes recently: “We’re not out of ammunition by a long shot.” 

 

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Hedge fund shareholder Elliott Management minced few words when it comes to Stephenson’s antics: “It has become clear that AT&T acquired DirecTV at the absolute peak of the linear TV market,” Elliott said of the $67 billion purchase in a September 2019 letter to the board. As for the $109 billion Stephenson spent on Time Warner, “AT&T has yet to articulate a clear strategic rationale for why AT&T needs to own Time Warner.” 

Elliott, long known for rattling corporate cages, contended that Stephenson’s worst deal was his $39 billion run at T-Mobile in 2011. “Possibly the most damaging deal was the one not done,” Elliott said in the same letter, referring to the year-long waste of corporate resources capped by AT&T’s ultimate withdrawal from the deal, which forced it to pay T-Mobile a record $6 billion breakup fee. “[AT&T] capitalized a viable competitor for years to come,” Elliott’s letter said. 

Elliott and other investors were no doubt feeling ripped off by AT&T. Unlike Boeing, whose debt gorging and buybacks caused its stock to soar, AT&T’s shares have gone nowhere for a decade. What the debt-dependent duo do have in common is that financially, at least, they bear little resemblance to their former blue-chip selves. 

Shocking as the pandemic of 2020 has been to the global economy, the fallout from a decade of debt binges by corporate giants might be only beginning. The landscape is littered with companies suffering from self-inflicted wounds. A prolonged recession could push some overleveraged firms toward insolvency, especially if interest rates rise and the Fed’s multitrillion-dollar “save the economy at any price” plan makes inflation do the same. 

Altria, the seller of Marlboro cigarettes, increased its net debt from $10 billion to $26 billion over the past decade, spending most of its operating cash flow on dividends and share repurchases and wasting $15 billion on stakes in Juul Labs and cannabis company Cronos Group with little payoff. The cigarette merchant now holds $1.31 of net debt per dollar of annual revenue, up from 58 cents in 2010. 

For most of its 118-year history, Minnesota’s 3M, the maker of N95 masks, Post-It notes and Scotch tape, carried almost no leverage. From 2010 to today, however, its net debt has swollen 17-fold to nearly $18 billion, or 55% of revenue. Standard & Poor’s downgraded 3M’s bonds in February, and it was among the first issuers to tap unfrozen bond markets in late March. 

O’Reilly Automotive, the $10 billion (revenue) Missouri-based auto-parts retailer, has been one of the decade’s stock market darlings. The family-run business discovered cheap debt in the 2010s, using it to buy back $12 billion in stock and retire nearly half its outstanding shares. Over the decade, its net debt ballooned almost 12-fold to $4 billion. O’Reilly took on another $500 million, just in case, on March 25. 

General Dynamics, known for its Navy ships, Gulfstream jets and government contracts, had little debt in 2010, but since CEO Phebe Novakovic took over in 2013, it has bought back about $13 billion in stock and paid out $6 billion in dividends, finishing last year with $11 billion of net debt. 

IBM has been a buyback champion for years, paying 90% of its free cash flow to shareholders to return $125 billion to them from 2010 to 2019. Big Blue’s debt, including customer financing, has grown from 17% of net revenue to 70%, with $52 billion in net debt currently outstanding. 

Even Berkshire Hathaway got caught up in the great debt binge. In 2013, Buffett teamed up with Brazilian private equity firm 3G Capital, cofounded by billionaire Jorge Paulo Lemann, to buy H.J. Heinz for $28 billion and, two years later, Kraft Foods for $47 billion. The resulting company was stocked with brands of yore such as Jell-O, Velveeta and Oscar Mayer—as well as $30 billion of debt. After floating a $143 billion takeover of Unilever that would have reportedly required $90 billion of additional debt, business at the massive food conglomerate began to spoil. 

Kraft’s market capitalization has plunged from $118 billion at its peak in February 2017 to $38 billion, and Berkshire Hathaway’s shares, which are carried on its books at $13.8 billion, now trade for just $10 billion. In February, both S&P and Fitch cut Kraft’s bonds to junk. Kraft Heinz maintains that its balance sheet, and the demand for its brands, are strong. 

In the oil patch, meanwhile, many are too sick even to take advantage of the Fed’s generosity. Vicki Hollub, the CEO of Occidental Petroleum, has increased its net debt nearly fivefold since she took over in 2016, to $36 billion, not counting the $10 billion in preferred financing Hollub took from Buffett. Her $55 billion takeover of Anadarko Petroleum closed last August—just in advance of the worst oil-price plunge since the 1980s as Russia and Saudi Arabia flooded markets with supply early this year. With West Texas Intermediate crude hovering near $30 a barrel as of press time, Occidental looks to be heading for restructuring or even bankruptcy. 

If Oxy is allowed to go bust, though, it will probably be the exception. The U.S. government can’t afford to let market forces alone dictate the future of too many companies. Already, retailers Neiman Marcus, J.Crew and JCPenney have filed for bankruptcy. The Federal Reserve has made it clear that to try to avoid global economic devastation worse than that seen during the Great Depression, it regards the nation’s largest publicly traded companies as, basically, too big to fail. “The Fed and Treasury have essentially created a new moral hazard by socializing credit risk,” wrote Scott Minerd, CIO of Guggenheim Partners. 

BlackRock is predicting an expansion of the Federal Reserve’s balance sheet by a “staggering” $7 trillion by the end of the year. 

In some ways, it seems, the Fed’s actions are tantamount to trying to cure addiction by increasing the dosage of the very substance the addict is abusing. 

Speculative Bubbles and Fraud- Notes on Jim Chano's interviews

Here are some notes from different interviews Jim Chanos gave:


China's Speculative Real Estate Bubble

We looked at things like Japan in 1989. We looked at Ireland and Spain in 2007, and what stunned us was the size of the Chinese residential real estate market. To this day it still stuns us in China. It is the biggest real estate bubble in history.

They're still building a 1.8 billion square meters a year of residential, which is 20 million apartments because the average Chinese apartment is 90 square meters. We've long gone past ‘We’ll build it and they will come.’ The rural people won’t move into it because these apartments aren't affordable for people who are moving from rural to urban. They are only being built at this point for speculation. Depending on how you want to figure out the ancillary real estate stuff, it's anywhere from 20% to 25% of their GDP.

The problem is that the government policy has been loose in China regardless. The one restriction they have in place is the House Purchase Restrictions (HPRs), which apply for second and third homes. But people who own more than a couple homes are almost always speculators. The bulls are saying the government will loosen the HPRs, but the problem is that the government doesn’t want speculation in real estate. So I think that’s a pretty bad argument. Secondly, the flood of construction has continued apace, and the unsold inventory is piling up. What if the speculators turn into sellers as opposed to buyers when the HPRs are relaxed?

-Shadow Financing Loans

-Similarities with Japan in the 80's and 90's

Anyone who is counting on the government to fix that market is, I think, counting on hope rather than analysis. This is a bubble that has a long way to go on the downside. Residential real estate prices, in aggregate in China, at construction cost, are equal to 350% of GDP. The only two economies that ever saw higher numbers at roughly 375% were Japan in 1989 and Ireland in 2007, and both had epic property collapses. So the data does not look good for China.

 I also think the renminbi is overvalued. If there is some depreciation of the currency, that could lead to cheaper products from China, which could actually help the U.S. economy. Places like Australia and Canada and Brazil would be hit pretty hard, however, because they rely on exporting commodities to China.

It was a once in a lifetime build out of infrastructure in the most populous country of the world. After you have your third international airport in Hainan, China, you probably don’t need a fourth one — especially when no one is using the second one. In this case, things are really two or three standard deviations from the norm, and that’s what you need to be looking for. If iron ore prices were $50, I really wouldn’t care, but at $140-$180 with more capacity coming on and lower demand in the future, I think we’re in for a disaster.

 It’s all about incentives. In China, everyone's incentive is GDP. They are fixated on growth. In the West, we go about our economic lives, and at the end of the year the statisticians say, this year your growth was 3%. But in China, it’s still centrally planned. All state policy goes through the banking system. They decide what they want growth to be and then they try and figure out how to get there. The easiest way to do that, in an economy where consumption is only 30% of the total economy and net exports are determined by the world markets, is to stick a shovel in the ground and build another bridge, since that contributes to GDP. So a random party chief knows they will never be sacked if they make their GDP targets.

On his first few jobs and Banker's incentive to maximize fees-- not helping clients

There was a defining moment, however, when I realized investment banking wasn’t for me. A year into my stint at Blyth, we were working on a recommendation for McDonald’s to issue a bond. At that point in its history, McDonald’s was generating a lot of cash and reinvesting it back into its restaurants, each of which generated high returns. But the stock market was valuing McDonald’s at only 8 or 9x earnings despite the company growing at 20–25% a year pretty consistently with real cash earnings.

This was at a time when interest rates were at double-digits. I ran some numbers independent of the blue book that the associate, the senior banker and I were compiling, and determined that instead of the debt deal, we should recommend that McDonald’s buy back stock with some of its cash flow and cut back its expansion slightly. This could lead to a larger EPS increase relative to the bond issuance and they wouldn’t have to add leverage to the balance sheet.

Given where rates were, the impact on EPS from buying back stock rather than issuing debt was dramatic. When I made this case to the associate, he turned white and said he wanted no part of presenting this idea to the senior banker. Being pretty naïve and not realizing the political implications of such a recommendation, I handed out a two page memo to the senior banker discussing the impact of buying back stock. The senior banker looked at me with an icy stare and stated that we were not in the business of recommending share buy- backs to our clients; we were in the business of selling debt. This was my first douse of cold water regarding Wall Street and I became pretty disillusioned after that episode. I had learned that Wall Street wasn’t necessarily doing things in their clients’ best interest but was instead focused on maximizing fees.

On finding the right sources and being intellectually curious

The CFO will always have an answer for you as to why a certain number that looks odd really is normal, and why some development that looks negative is actually positive.

A second mistake some people make is not reading all of the documents. I guide people to always start with the SEC documents, and then go to other sources for information. It’s amazing how few analysts actually read SEC filings. It blows me away. We have the greatest disclosure system in the world and people by and large don’t take advantage of it. I am a big believer in looking for changes in language in a company’s filings over time. During the year we were short Enron, each successive filing had incrementally more damning disclosure about the company’s off- balance sheet entities. It was obvious that internal lawyers were pushing management to give investors more detail on these deals that were being done, as they felt uncomfortable about them. Language changes are not accidental. They are argued over internally.

G&D: What are some characteristics of the best analysts that have worked for you?

JC: The thing I look for most is intellectual curiosity. One of the best analysts we ever had was an art history major from Columbia. She had no formal business school training. She was so good because she was very intellectually curious. She was never afraid to ask why and if she didn’t understand something she would go figure out everything she could about it. This is almost something that you can’t train. You either have it or you don’t.

On for-profit education

I think for-profit education business is a flawed business model. The outcomes are very poor, as I feel that these degrees are sold, not earned. Anyone that wants to sign up for these things can get in, but tuition is up there with many private schools. People are coming out of these schools with $20,000-$50,000 in debt and many don’t even graduate but incur the debt nonetheless. Some of the technical schools do good practical training, but most of the business has now shifted to online degree granting because it is more lucrative. I remember a couple of years ago, the head of human resources at Intel was quoted in a front page New York Times article saying that if someone came in from an online college, they won’t even look at them. The types of jobs these graduates get are no better than if they just had a high school degree, and yet they are incurring all of this debt.

Ultimately defaults will go so high in the student loan area that the federal government will see mounting losses and will change the student loan program guarantee to force institutions to take a bigger chunk of the risk. Once this happens, the business model is broken. The only reason these companies exist is because of the federal loan guarantee on student debt.

 Baldwin-United

One of the first stocks they had me look at was insurance holding company called Baldwin-United. Baldwin was growing very rapidly by selling annuities that were uneconomic. To plug the hole that was developing within their insurance subsidiaries, the holding company was closing acquisitions. In exchange for the insurance companies’ cash, the holding company was providing the subsidiaries with overvalued securities. However, the regulators of the insurance subsidiaries were becoming wise to the development as Baldwin-United’s stock shot up. We acquired a copy of the insurance department public files and we were able to see from regulators’ letters that they were becoming increasingly concerned about the valuation of those affiliated assets held by the insurance company. They went as far as to imply that if Baldwin-United didn’t downstream additional capital to its insurance subsidiaries, they would have to declare the subsidiaries insolvent. While this was occurring, every brokerage house was recommending the stock. Although the company was rapidly growing earnings, those were all non-cash earnings because Baldwin-United was using gain on sale accounting when it sold annuities. This fictitious “gain” was based on the expected persistence of the policies and the present value of the estimated spread generated by their returns on investment in excess of the annuity pay- outs. The problem was that they were paying 14% on the annuities and were far too optimistic on their investment return estimates. My first research report was published in August of 1982. I recommended a short position in Baldwin-United at $24 based on language in the 10-K and 10-Qs, uneconomic annuities, leverage issues and a host of other concerns. The stock promptly doubled on me.

This was a good introduction to the fact that in in vesting, you can be really right but temporarily quite wrong. I put another report out in early December of 1982 with the stock at $50 and reiterated my thesis while pointing to additional evidence that had come out in the interim. I went home to visit my parents for Christmas and received a phone call from Bob Holmes telling me that I was getting a great Christmas present — the state insurance regulator had seized Baldwin-United’s insurance subsidiaries. Baldwin filed for bankruptcy shortly thereafter.

On Shorting and Valuation

Valuation itself is probably the last thing we factor into our decision. Some of our very best shorts have been cheap or value stocks. We look more at the business to see if there is something structurally wrong or about to go wrong, and enter the valuation last.

On hedge fund structures and hierarchy 

From an approach point of view, one of the things that distinguish other hedge funds from us is that a typical hedge fund has the intellectual ownership of an idea separate from the economic ownership of that idea. By that I mean you have the partners and the portfolio managers at the top and you generally have the analysts, who are more junior at the firm, at the bottom. The way the model works at most firms is that the guys at the top command the people at the bottom to come up with good ideas from which the portfolio managers ultimately select the additions to the portfolio. The problem with this model is that the profits go disproportionately to the people at the top of the pyramid but the risk — or the intellectual ownership of the idea as I like to call it — resides at the base of the organization with the most junior, inexperienced people. Consequently, if things go right, everyone makes money, but if things go wrong, the person at the bottom dis-proportionally shares the blame and the risk. This is why turnover is so high in the hedge fund industry. People try to do carve-outs, which I think are very bad policy.

This model puts all of the power of the idea generation, and therefore the alpha generation, with the most junior people in the firm, whereas the senior people are just doing portfolio allocation. We’ve always viewed it the opposite way. We have six partners at Kynikos who have 150 years of experience in the securities business among us and we have been together 100 years in aggregate. For example, my number two has been with me for 20 years. Because of our experience, we generate ideas up at the top. We are looking for the new ideas and we’ll do the first read-through of a company’s 10-K and other research in addition to talking to people in the industry.

The next step is to then send the idea down the chain to our research team to process. I will never blame the analyst for a stock that goes against us. Putting the stock in the portfolio is my responsibility and the other senior partners’ responsibility. I think this leads to a better intellectual environment at the firm. So we get analysts who love working here and will stay for 10 or 15 years. It’s a much more stable model in terms of process than some other models.

On the EU

Clearly the European Union has made an example out of the country. As has been said, the problem with the EU is that it’s a currency union without a fiscal union. The incentives are all skewed. People who say that Germany suffers from having to share the EU with these Southern countries like Greece are missing the point. Germany is very happy to have those Southern countries in the EU, because it keeps the currency lower than otherwise. If Germany had its own currency, it would go through the roof, and harm German exports, which are the big driver of that economy. So in effect what’s happening is that German taxpayers are bailing out European banks, who’ve lent money to the Southern European countries, which are buying German products. The problem is that it’s a political issue and so many people just want to look at it as a financial and economic issue. There’s an interesting alignment of interests where the taxpayers in the donor countries are upset, and rightly so. In other words, the typical German taxpayer is saying, why should I pay for this? The other thing is the recipient countries are upset, too. It’s not as if the typical Greek citizen wants this money. They’re not seeing any positive results from the money — it just goes right to the European banks. It’s not financing any new growth initiatives. I’m not going to apologize for Greeks who didn’t pay their taxes or retired at 42. The stories are out there and they’re all true. But be that as it may, there are an awful lot of law abiding Greeks who are being destroyed by what is going on in Greece now. The new twist in 2011 is that the donor countries installed their technocrats in Greece’s ministries to oversee tax collections and interior policy, and that has really hit a nerve. Now Germany is basically dominating Europe. You ignore that political calculus at your peril. All of this connects to historical issues, such as how the Germans treated the Greeks in World War II. Greece lost one million people in World War II out of a population of eight million. The only country with a comparable (and higher) ratio was the Soviet Union. In the fall of 1941, after the Germans invaded Greece, they left the Greek government intact but they put Reich’s ministers in charge of all the ministries to oversee them.

One of the things they did was to loot the country of its harvest. Eight hundred thousand Greeks died in that famine of 1941. Almost every Greek family has someone who died in that famine. So this twist has opened up a 70 year old wound. Keep an eye on Spain and Portugal because they’re next. The other issue that is coming about is cutting your way to growth. Is austerity key to getting these countries back on track? So far the evidence is pretty poor that it is. We may look back and say, wow, what a policy mistake.

 2012 short on natural gas

Currently we are short the natural gas industry in the U.S. for a few reasons. First, there has been a major technological innovation — fracking — that has created displacement. This has driven prices from high single digits per MCF of natural gas down to $2 per MCF. Most of the companies in the natural gas area began an exploration boom that has created this glut. These companies counted on the price to remain above $6–7 per MCF. A number of companies that had structured their balance sheets and paid up for acquisitions with this expectation of higher prices are now struggling. So they’ve got weakened balance sheets in a commodity business that is in oversupply, and on top of that, many of them are engaged in some pretty egregious accounting games, like hiding negative cash flows in various ways. I think this area will be a very fertile area on the short side for a number of years. The good news is that this happens to be an amazingly positive development for the U.S. because energy prices have dropped so much.

As an ancillary development, the other industry that gets killed by this is coal. Natural gas prices are now half the price of coal. Coal used to be one of the cheapest sources of energy, but it was the dirtiest. Now it’s becoming one of the most expensive fuels and is still the dirtiest. Utilities and others are rapidly transforming from burning coal to burning natural gas, which I do not think bodes well for the coal industry.

On Capital Structure

You have to remember that if you are shorting a leveraged company, with 90% of the capitalization in debt and 10% in equity, a 50% decline in the stock price only wipes out 5% of the total capitalization. You have to look at the total capitalization. In some of these cases the total capitalization is only down a little while cash flow has been cut by 75%. This is the reason that some investors get killed in value traps. They look at the stock and they don’t look at the total capitalization. They don’t realize that the debt burden is forever, meaning it’s not shrinking, whereas the equity capitalization may fluctuate in the market. If the cash flows have diminished dramatically the company’s ability to service the debt, then the stock going down by half doesn’t mean anything. You could still be at risk of losing all you capital.

Macro model for analyzing fraud, which is the Kindleberger-Minsky model

We look at the macro environment and what we found down through the historical narrative is that the fraud cycle follows the financial cycle with a lag you know like really with a lag and often is amplified by markets in which disruptive technologies are the main factors.

 So what you'll see is that for example the dot-com we saw interestingly much more idiosyncratic fraud after that bull market then previous or even the immediate the bull market immediately after and so part of it is is that people begin to suspend their sense of disbelief.

 And as the bull market goes on and more people are sucked in you begin to believe things that aren't true and companies and or management's begin to proliferate that are happy to sell you stories that aren't true and so it's why most frauds are revealed after a market rolls over.

Think about Madoff or others because at their core a lot of frauds of Ponzi schemes and when people close up their pocketbooks and demand their money back. Most frauds can't deliver. 

We've seen this down through the centuries quite literally the wrongdoing doesn't get exposed until after the peak ---same in the dot-com era ---we saw Enron and WorldCom  at the tail end be revealed.

So I think that that you'll be interesting to see in this bull market if that plays out similarly but it's been a consistent it's been a consistent macro observation and over the 300.

It makes pro cyclical sense to me because you need a revenue slowdown to reveal you know whether you have revenue fraud expense fraud or balance sheet fraud--
you have to have that rate of change slow down to reveal also easy credit creation

The banks will take their loan last position the provisions after the fact companies will start to go down then you'll see the issues. You'll  also tend to be much more suspicious after you've started losing money you pull open the file again.

 I've often said that that stock prices are the very best defense councils and prosecutors for fraud because when stock prices are going up companies are bulletproof. It's not till they start going down that people begin looking close or law enforcement government gets involved because there's political pressure for them to get involved yep I've lost a lot of money it's not my fault they defrauded me 

On world credit

I call it the ‘pig-in-the-python’, where the python is the world credit situation. If the pig at the end of the snake is the U.S., the pig in the middle is Europe, and the pig being eaten now is China and Asia.

https://medium.com/graham-and-doddsville/jim-chanos-rooting-out-fraud-6eca8e6387adhttp://portal.som.yale.edu/sites/default/files/files/MGT%20848-01%20Financial%20Fraud%20A%20Forensic%20Approach%20-%20Spring-2%202015.pdf

Keith McCullough interview

https://www.youtube.com/watch?v=Hq0lbW2rJbw

https://www.youtube.com/watch?v=StybwIP8O8k&t=1824s