"Novastar" means it's collapsing and exploding

Herb Greenberg (not the MLB hall of famer Hank, whom I often confuse Herb with because they both hit so hard) wrote about the collapse of Novastar Thursday (trading at $27 in January, as high as $38 last spring, closed at $8.48 yesterday). The Bob O'Brien character is the same guy who supplied Patrick Byrne information about the "naked shorting" conspiracy.

" Much of the attempted deconstruction of criticism would spill over to a Web site run by an anonymous message board poster, who went by the name Bob O'Brien and who by then had also become pals with CEO Patrick Byrne - himself having gone on a "jihad" against critics of his own company. Both teamed up to also attack an illegal form of short-selling.

In spring 2005, O'Brien went so far as to post the address and names of the wife and son of one prominent short-seller of NovaStar in a message board post, with the tag line, "This is coming up on game over-time. Figure it out. Your playbook is known." In another post he wrote, "Anyone know Herb's wife's name, and his middle initial?"
...
The bravado was gone Tuesday in the wake of NovaStar's disclosures. "I have been body-slammed by this," wrote the anonymous poster, who has been identified by the New York Post as a former used-Cat Scan machine salesman named Phil Saunders. "Many of my friends are devastated by this. Some of my relatives, too. Personally, you bet. Very expensive lesson: Don't bet more than you can afford to lose. And don't bluff. I will not be buying anymore stocks in the U.S. markets, that's for sure. I'm quite done now. This casino has lost its allure."

I looked at Novastar back a couple years ago when some supposed "value" guys were trumpeting it as the next big thing. The yield was very juicy, at the time I think the dividend was $5 and the stock $30. But I could not understand it's financials, how it securitized loans and accounted for them, and essentially gave up. The critics said that the earnings were manufactured, that Novastar was using their REIT status and the tax code to front load earnings from the sale of their mortgages. As a REIT it was required to pay out 95% of these "earnings" as dividends. Since they hadn't recieved these "earnings" yet, Novastar had to borrow money to pay it's dividends and hope their front loaded earnings always turned out as estimated. Well today we know that they didn't.

Novastar illustrates two important principles. The first is, if something seems too good to be true, then be very, very, careful. Paying out illusionary dividends is a time tested marketing technique for attracting suckers to overpay for a stock. You can see it occasionally in the closed end fund business. Most close end funds trade at somewhere between a small and large discount to their net asset value (NAV). Some enterprising fund managers have learned they if they pay out very high large dividends their fund will begin to trade at a large premium to NAV. Where does the excess yield come from? By return of capital. Most investors don't understand why the fund is yielding 13%, they jump in thinking they've found a magic investment that will afford them high retirement income. As the NAV declines over time, they figure it out too late that it was their own savings they were spending.

The second principle is one of the bedrocks of value investing. If you can't understand it, don't invest in it. I couldn't understand Novastar, so I passed. It's clear now the "value investors" who were smitten by it's high yield never really understood how that yield was generated, and the risk Novastar took in writing those loans. At the time I figured I must just be too lazy to figure Novastar out. But because there is some virtue in focusing efforts on things that are easy to understand, my results were much better than I would have gained from Novastar even had it not collapsed. As Buffett says, figure out your circle of competence, and stick within that circle. You'll do much better there.

Still accepting expressions of interest

If you read about "The best way to track investment ideas, ever?" and are wondering where we are at, we are getting closer. I've been using the software and all I can say is I'm incredibly pleased and excited. I expect we will start outside testing within another month or two. Remember if you'd like to test the software or just be on the mailing list for when it's ready, send your name and e-mail address to "stocknotesinfo@gmail.com", and we'll let you know.

Sometimes you get what you pay for

Bancinsurance Corporation ( BCIS.pk ) is cheap. Hella cheap. Maybe you've also seen it come up on one of your screens. At $6 it's trading around 4.5x earnings, and slightly under tangible book value. It has an active insurance business that has been solidly profitable.

So why is it so cheap? Well I took a quick pass through it's latest 10Q to find out. First, it went through a period a couple years ago where it expanded into underwriting bail & immigration bonds and had to take some big writeoffs before they shut it down. It also lost an auditor during that period and had to refile financials to clean up the mess. But it's cheap for some other reasons as well.

Let's figure out what their real earning are. First, they sold a small publishing operation they had that did governmental and legal publishing. This is adding 50 cents per share (pre tax $2.5M "Net realized gain on sale of affiliate") to 2006 earnings. They've also taken $952k in losses from their discontinued bail bonds programs that probably won't recure in the future. This turns the 9 month after tax profit of $5M into something closer to $4M, or about $5.3M annualized.

Free cash flow appears higher than earnings with an annualized benefit of about $400k in depreciation over capex costs. So our P/FCF ratio is about 5.3. Still pretty cheap. Another way to look at it is to invert the free cash flow ratio to get a yield. That's how we would look at it were we to buy all the shares at $6, and distributed all of the free cash flow to ourselves. In that case, our investment would yield close to 19% per year. As Borat would say "very nice!".

But we aren't the owners, so we don't have any say on whether that free cash flow will be returned to us, or reinvested at a good rate. So how likely is it that the current management would do that?

That's where we start to find some hair. Let's start with the positives, Si Sokol and his family own over 50% of BCIS. It's nice to have a huge ownership stake in the hands of someone, because this should mean they'll ensure that profits are reinvested well, or returned to shareholders if they can't. But their track record isn't so good. They had majority control when that huge mistake was made with bail bonds. And in the 10Q, I find out than in only 9 months the company diluted shareholders 5% distributing stock options to employees. That's a huge level of dilution, if they did this annually it would reduce that juicy 19% yield to 14% in one fell swoop.

Let's move on to the remaining insurance business. Another red flag pops up as it's revenues declined almost 10% in the first 9 months of 2006 compared to 2005, primarily because they lost an agent. That's not the sign of a strong business with competitive barriers (a moat). Also, their combined ratio has increased lately to over 100%. That's not good.

For those who don't know what a combined ratio is, it's a measure of how profitably an insurance company is writing business. If the ratio is below 100%, it means the insurer is writing profitable policies. If it's above 100% it means they are losing money on each policy they write. In many cases it's okay to write at break even or even a little above 100% because insurance companies can make up the losses by investing the customers premiums and earning investment returns. BankInsurance has about $50M invested out of customer premiums, and is earning about $3.6M annually in interest. This means they could run their $50M in annual premiums at a 107% combined ratio and break even. Running at 100% would only give them about 40 cents per share in earnings. So they need to run below 100% for this business to be significantly profitable.

The good news is part of the cause of this last quarter increase in combined ratio is writeoffs from the defunct bail bonds business. Without it, the combined ratio would have been 95%, good, but still higher than last years 89%. But how accurate are their loss reserves? The biggest problem with valuing an insurance company is that management can have the ability to defer losses, and make the underwriting ratios look healthier than they really is. The strongest defense is a solid management team with impeccable ethics, and I don't yet know if we have that here.

At first glance BCIS seems to carry excess cash on the balance sheet, but when I look closer I see they are carrying 17M in expensive debt. This is probably a requirement for their credit rating, but carrying debt means that they aren't as well capitalized as one would hope. I don't know how much they need to carry, so one of my next tasks would be to analyse this and see if there is excess cash that shareholders might be able to see in a dividend down the road.

So to sum up, I would describe BCIS as a fair business at a good price, as opposed to the good business at a fair price we'd prefer. It's not a "cigar butt" a company super cheap but heading out of business, this is just a very cheap business that is in a slight decline without any clear tangible competitive advantages. Right now I don't have a good read on the management and ownership's goals and track records, and since I haven't read a 10K, their long term performance is unclear. I'll be reading that next and if it sheds any light, I'll post an update.

One bankruptcy isn't more efficient than two

Rumours recently swirled that Chrysler was in talks to be acquired by GM. Now while this makes a certain sense for Mercedes, er Daimler-Benz, which has finally come to the realization that it has to unload this horrible, horrible acquisition, it doesn't make any sense for GM.

This page pretty much summarizes GM and Chrysler's problems. Toyota is eating their lunch not by paying their workers poorly, on the contrary they are paying well in excess of typical manufacturing wages, about $30 per hour.. The difference is that the UAW contracts that U.S. automakers are under impose huge legacy costs, including a jobs bank to pay employees not to work, very lucrative medical plans, and very lucrative pensions.

And it can be argued, that the UAW has stood in the way of U.S. auto makers using their workers most efficiently, reflected in the extra hours it takes to build U.S. cars. The UAW has been so "successful" that they've killed hundreds of thousands of their own jobs, and the pension and medical costs for retired auto workers is about to kill GM, Ford, and Chrysler. Quite simply, the U.S. automakers business model doesn't work, and won't ever be competitive without a substantial change in their labor contracts.

The auto makers have one shot to fix this in their next contract negotiation with the UAW. It seems clear they will get some compromises, even the UAW realises how close to the brink the big three are. But combining GM and Chrysler before those negotiations would be the worst possible mistake. It would create a single entity with deeper pockets and less leverage against the UAW, it that could be shut down by union fiat in any disagreement. This is why Daimler must get rid of Chrysler now, because the UAW will never compromise if it thinks ownership has deep pockets. This is why GM's leadership made a huge mistake in selling GMAC instead of spinning it off, they put more cash back into their dying business so the UAW would have less incentive to compromise.

The clear solution is a bankrupcty filing by each of the big three. A bankruptcy judge is likely to cancel the UAW contracts and make Ford, GM, and Chrysler competitive again. And current equity might even remain, and possibly even increase in value.

But so far we've seen no inclination by management to do the smart thing. Until then, an investment in a domestic auto maker is foolhardy. The automakers may have bounce backs during strong economic years, but the end result is inevitable. By the time the next management team decides to use bankruptcy court, it's unlikely common shareholders will have anything left.

My Russian Roulette Pick Of The Day

Like big, big, prizes? Unhappy with "moderate" returns like 10%, 20%, or even 30% per year? Ever hold a firecracker in your hand until the last second, because you're willing to take a risk? If you are ready to swing for the fences and don't mind a few catcalls from the crowd if you strike out and end up on your ass in the dirt, this idea is for you.

Three Five Systems (TFSIQ, on the pinksheets) is a local (Arizona) public company that entered bankruptcy about a year and a half ago to clean up a few issues with its subsidaries and (hopefully) pay out the remaining cash to shareholders. I got into this over a year ago, traded it several times for a profit, and then ended up getting stuck bad as it declined from 30 cents to 8. Right now it's trading between 10-11 cents.

There are two problems with investing in companies in bankruptcy. First is that typically, the common shares are worthless. Second is that if they aren't, it's very difficult to determine what they might be worth, esp. for the amateur investor. I invested in TFSIQ because I was convinced that this was one of those rare exceptions that might be worth something, and because I thought I had a good read on what it's worth. As of early 2006 it looked reasonable that Three Five would be able to pay out 32 cents and possibly more, given a bankruptcy plan with a shareholder equity of 6.9M for 21.8M shares (the 8k of November 7, 2006 that announces the plan's approval contains contains all the details in it's addendum). Despite the approval of this plan, things have gotten somewhat murkier since the plan was created in early 2006. The last operating report I have contains a balance sheet from September 10th with a shareholders equity of 5.179M, or 24 cents per share.

Specifically, Three Five is in disputes with several parties, and the outcome of those disputes will determine our end value, which will range from zero all the way up to 24 cents, or even possibly 32 cents. The biggest problem is with a subsidiary. To quote from the September operating report

"TFS has an investment of $2 million in TFS-DI, a wholly owned subsidiary, which is subject to litigation and compromise. TFS has filed suit in U S Bankruptcy Court against a party to a contract alleging among other things breach of contract. The defendant has filed a counter claim for $5.5 million which TFS denies. However, TFS and TFS-DI together have recorded liabilities of $4.5 million for note payments to and inventory purchases from the defendant. The outcome of this litigation cannot be predicted, and could materially affect the final cash distributions."

They also have disputes with their local landlord, and a suit (against Topsearch Printed Circuits Ltd. and Avocent Corporation) that might bring in additional upside. More details can be found on Pacer (Arizona Bankruptcy court, case #2:05-bk-17104) as well as in their SEC filings and their lawyers web site. If you don't have a pacer account, it's highly recommended as it will allow you to read all the legal filings on virtually any case, for a fairly reasonable price.

To keep the blog short, I'm not going to go into any more detail, so let me finish by summation. For 11 cents right it seems you can buy shares that might be worth more than twice as much, or nothing, later this year. I believe it's more likely they'll be worth something than nothing, so I'm holding my shares for now. But given the high risk level here I'd counsel caution and doing your own research. My rule of thumb for high risk positions is to limit each to 5% of my portfolio. If you decide to invest here, I'd caution you to do something similar.

If Three Five Systems still sounds interesting (and if it does you might be as crazy as I), have fun and enjoy the wild, wild, world of bankruptcy investing. And let me know if you find anything interesting.