Gator Capital on Wealthfront — investors are free to contact me
Dec/110
Gator Capital’s Small Cap Portfolio has been available on Wealthfront for the past 15 months. With the launch of Wealthfront’s new service, they will no longer be offering premium money managers on their platform. If you are a Wealthfront client and would like Gator Capital to continue managing your portfolio, please contact us directly. We are waiving our minimum portfolio size for former Wealthfront clients.
My contact information is derek.pilecki@gatorcapital.com and (813) 282-7870.
I’ll need three things from you to continue managing your account:
1. Signed change of advisor form for InteractiveBrokers.
2. Signed Investment Management Agreement for Gator Capital.
3. A copy of your driver’s license.
You can scan and email all three items to derek.pilecki@gatorcapital.com or fax them to (813) 425-9168.
The switch is easy because you will not have to change you brokerage account. Thank you for investing with me on Wealthfront. We look forward to managing your portfolio directly.
Updated Newcastle Investment Liquidation Analysis 2011 Q2
Aug/110
The last few quarters I’ve written about Newcastle Investment’s (NYSE: NCT) liquidation value. I believe this estimate is conservative because it assumes assets are sold at market value, but the liabilities are paid at face value. The liabilities currently trade at a discount to the face value, so if Newcastle’s management were to liquidate the company they would try to buyback the liabilities at a discount before paying them off at face value.
Here the table showing the liquidation value updated for the current quarter:
| 2011 Q2 | 2011 Q1 | 2010 Q4 | 2010 Q3 | 2010 Q2 | 2010 Q1 | 2009 Q4 | |
| Recourse assets | $318.0 | $269.7 | $74.4 | $101.9 | $79.3 | $54.5 | $155.8 |
| Recourse liabilities | $256.4 | 144.5 | 59.5 | 56.3 | 55.8 | 77.9 | 183.6 |
| Net recourse assets | $61.6 | 125.2 | 14.9 | 45.6 | 23.5 | -23.4 | -27.8 |
| CDO note holdings | $409.8 | 367.7 | 348.5 | 80.0 | 25.7 | 1.5 | 1.0 |
| Borrowings from other NCT CDOs | $81.3 | 95.8 | 108.8 | 0.0 | 0.0 | 0.0 | 0.0 |
| MH deal equity | $92.3 | 70.0 | 71.2 | 65.8 | 64.6 | 63.6 | 26.0 |
| Preferred stock | $61.6 | 61.6 | 61.6 | 61.6 | 61.6 | 61.6 | 152.5 |
| Liquidation value | $420.7 | 405.5 | 264.2 | 129.9 | 52.2 | -19.9 | -153.3 |
| Shares outstanding | $79.3 | 79.3 | 62.0 | 62.0 | 62.0 | 53.6 | 52.8 |
| Liquidation value per share | $5.31 | $5.11 | $4.26 | $2.09 | $0.84 | -$0.37 | -$2.90 |
My estimate of liquidation value increased about $0.20 in the quarter, plus, shareholders also received a $0.10 cash dividend at quarter end. The main driver was the net interest income earned during the quarter and the earned discount from securities that paid-off during the quarter at par. The underlying collateral of the CDOs did not increase during the quarter as the market for non-agency mortgage securities softened during the quarter. This is ok because the lower prices gives Newcastle’s management opportunity to buy additional assets at attractive prices.
One interesting item is the liquidation value would have been $0.10 higher if management had not repurchased $25 million of CDO X, Class A-3. In my CDO liquidation waterfall analysis, I assume that Newcastle receives no proceeds for this asset, but in the earnings release, management claimed they expect to receive par for this security at maturity. They purchased the security in Q2 for $8 million. If the $8 million had not been spent on this security, my liquidation estimate would have been $0.10 higher in the quarter. If Newcastle does receive par for this security, it will add $0.31 to shareholder value.
Another interesting point is my estimate of liquidation value increased only $0.20 in the quarter but GAAP book value increased $1.18. The main increase in GAAP book value was the deconsolidation of CDO V. I already accounted for this gain by assuming the CDO is non-recourse and shareholders will not lose additional money on Newcastle’s underwater CDOs. Eventually, my liquidation estimate and GAAP book value will converge to the same number.
At Friday’s (August 5, 2011) closing price of $4.77, I don’t see much downside given my calculation of a $5.31 liquidation value. I believe there is a meaningful margin of safety in buying Newcastle at these prices. It seems like the commercial mortgage REIT stocks are not performing well in the current market sell-off. Hopefully, management will continue to add value by buying back the CDO notes at a discount to face value. With the low stock price, management could also increase shareholder value by repurchasing the stock at current levels.
Disclosure: Long NCT
Disclaimer: There is no guarantee that the stock price will rise to my estimate of liquidation value. The value of the company’s assets could reverse course and start declining in value. Management could execute another follow-on offering. There is also a large conflict of interest between management and common equity holders of Newcastle because Newcastle managed by a third-party who make more money if Newcastle is a larger company rather than a more profitable company. There are other reasons the stock may not perform. Please do your own analysis. Maybe this analysis could be a starting point for your own analysis.
10 Best Business Models in Financial Services
Mar/111
As a hedge fund manager who specializes on the financial services sector, I often run into investors who say, “I would never invest in a financial company because it is impossible to analyze them.” While there are many banks and insurance companies with opaque balance sheets, these investors are over looking many good business models within the financial services sector. These businesses have transparent revenue models, are not capital intensive and have strong competitive moats. Plus, several of these businesses operate in markets with significant growth prospects.
I developed the following list of my 10 favorite business models in financial services. You won’t see commercial banks or traditional insurance companies on this list. These are companies with business models that use their balance sheets sparingly. (Please note – I wouldn’t necessarily buy the stocks mentioned in this discussion, but I would add them to a watch list.)
10. Multi-level marketing insurance sales – That was a mouthful, but I am referring to Aflac and Primerica. These companies use captive salesforces of independent contractors to sell their insurance. The models depend on hire many, many people who sell insurance. Of course, not all of the new hires are successful, but they unsuccessful ones quickly weed themselves out. Both of these companies sell insurance that is low volatility and low severity because the risk are predictable and spread out across huge a population of policy-holders. Some analysts would argue they sell overpriced insurance policies.
9. Traditional Asset Management – Traditional asset management is a great business. Assets are sticky, so the revenue is recurring. No capital is at risk on the asset manager’s balance sheet. Business grows without capital investment. All cash can be paid out to shareholders. The risks are non-diversified asset managers can suffer from performance related outflows (like Janus in 2001-02 and Artio Investors currently). Look at the compounded returns of some asset managers for the last 15 years (not including dividends): Eaton Vance 20%, T. Rowe Price 16%, and Franklin Resources 13%, which compares favorably to the S&P 500 at just under 5%.
8. Retail Stock Brokerage – This entry may surprise some investors, but retail stock brokerage is very good business model. The business does not require much capital. The income generated by the business can be paid out to the shareholders or used for acquisitions. Customers have high switching costs because of their relationships with their brokers. Revenues grow as clients add money to their investment accounts or when the stock market rises. The problems with the business are the ongoing regulatory scrutiny, the cyclicality due to the stock market cycle and the potential for legal losses when customers lose money in the market and blame their advisors. Examples of how good the returns from these businesses can be are Stifel Financial which has compound its stock price at 27% annually for the last 10 years and Raymond James which has compounded at 19% annually since it came public in 1986.
7. Credit Card Network – The credit card networks are great businesses, specifically Visa and Mastercard. The business is an oligopoly where competitors can’t drive volume by cutting price. Visa and Mastercard don’t have capital at risk from lending. Instead, the bank that issue their cards have the lending risk. Even with the current regulatory scrunity, Visa and Mastercard don’t have a ton at stake with declining interchange because they capture such a low percentage of the interchange fee with the rest going to the issuing bank. The businesses grow minimal capital spending. Almost all cashflow can be paid to shareholders. On one hand American Express might be an even better business because it has reinvestment opportunities through credit card lending, but it also has higher risk because of its credit exposure. Plus, American Express has higher risk to interchange legislation.
6. Insurance Reciprocal – Insurance reciprocals are unique corporate structures that very few investors know about. An insurance reciprocal is like a mutual insurance company because it is owned by its policyholders. However, the insurance reciprocal has a management company that manages the business of the reciprocal for a fee. The management company is a great business because it earns a fee from a captive customer. All of the management company’s earnings are free cash flow because it doesn’t require capital to grow. The management company does not have any capital at risk. The only publicly-traded manager of a reciprocal is Erie Indemnity (ERIE). USAA and Farmers are well-known companies that are reciprocals, but their management companies are either private or are small divisions of much large insurers. Marsh McLennan’s private equity division has funded a start-up reciprocal, Privilege Underwriters Reciprocal Exchange. Without knowing the details of their financials, I’ve been hoping this company would have an IPO sometime soon.
5. Pawn Shops – Pawn Shops are a terrific business. The stores take in collateral for loans, charge high rates, and still make money if the loan defaults. The stores are able to make strong margins with almost no leverage compared to 12 times leverage at a commercial bank.
4. Alternative Asset Management – Alternative asset managers are great businesses. They are a step up from traditional asset managers because they earn an incentive fee, which makes them more profitable as a percentage of assets under management. Within the alternative asset management space, there are three tiers of attractiveness based on the stickiness of the assets under management. The lowest of the tiers are straight hedge funds. Hedge funds assets are the least sticky and the most vulnerable to performance driven outflows. Example of publicly traded hedge fund managers are Och-Ziff and Mann Group. On the next higher tier are funds with defined lies such as private equity or venture capital. Assets in this tier are sticky because they have a 5-year investment period and a 10-year harvesting period. The best tier are vehicles managing permanent capital, such as external managers of publicly traded companies. Some of these external managers are also publicly traded, such as Brookfield Asset Management, Fortress Investment, NuStar Holdings, Targa Resources Corp, Alliance Holdings GP, Kinder Morgan, and Energy Transfer Equity.
3. Ratings Agency – This will be the most unpopular entry on the list. The only companies more hated than Standard & Poor’s and Moody’s are Fannie and Freddie. The ratings agencies still have a strong competitive position. They receive fees for issuing opinions. The customers are often forced to get ratings. The volume of ratings increases with the growth of the capital markets. Most of the ratings agencies earnings are free cash flow and available to make acquisitions or return to shareholders. There are some lingering legal issues, but any legislative or regulatory changes look benign. These companies will continue to gush cash.
2. Discount Stock Brokers – The discount brokers are similar to retail brokers with the added benefits of faster growth and less legal issues in bear markets. Customers do not switch brokers often. There is an oligopoly among Schwab, Fidelity and Ameritrade. The industry is better positioned today than eight years ago because the pricing umbrella provided by Schwab is gone. Discount stock brokers are better businesses than traditional asset managers because they do not have performance risk and they own the customer relationship.
1. Futures Exchange – Operating a futures exchange is a great business because of the liquidity effect creates a competitive moat that blocks competitive threats from other exchanges. Buyers and sellers want to trade where there is the most liquidity, and their arrival at the most liquid markets creates more liquidity. Another important factor in the competitive barriers around futures exchanges is a futures contract be continuously margined through a clearinghouse, so to close a position, the contract must be sold on the same exchange it was bought. This is an important difference from a stock exchange where shares of a stock can be bought on one exchange and sold on another exchange. Futures exchanges have fixed costs and historically have had rising volumes. Futures exchanges, such as the CME Group, have demonstrated pricing power. The stock exchanges are still good businesses, but their competitive barriers are not as strong as the futures exchanges.
This list is an attempt to get you thinking about different business models within financial services. Financial services is not a homogenous sector where all companies respond to the macro environment identically.
Gator Small Cap Portfolio – Quarterly Review November 2010
Nov/100
Join us for a Webinar on November 18
Space is limited.
Reserve your Webinar seat now at:
https://www3.gotomeeting.com/register/424618182
Derek Pilecki, the portfolio manager of the Gator Small Cap Portfolio, will review the performance of the portfolio. He will also review the trades made within the portfolio during the quarter and will share the investment thesis behind each trade. He will review stocks that added and detracted from performance. Finally, he will answer questions from the audience.
The Gator Small Cap Portfolio is one of five long-only portfolios offered by Gator Capital Management. The portfolio has an inception date of December 29, 2008. The minimum investment is $100,000. The portfolio is also available on the WealthFront investment platform at https://www.wealthfront.com/gator-capital.
Gator Capital’s website is http://www.gatorcapital.com/
Please register early as capacity is limited.
Please forward this invitation to friends and colleagues who you think would be interested.
Title: Gator Small Cap Portfolio – Quarterly Review November 2010
Date: Thursday, November 18, 2010
Time: 2:00 PM – 2:30 PM EST
After registering you will receive a confirmation email containing information about joining the Webinar.
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Citibank Should Have Split-Off Student Loan Corp with an Exchange Offer
Oct/100
This post is an excerpt from my 2010 3rd Quarter investor letter. If you would like to see the entire letter, please send me an email at derek.pilecki@gatorcapital.com.
In early August, I posted an article on the Internet arguing that Student Loan Corp was undervalued. I did not have to wait long as seven weeks later the company was sold to Discover Financial. The gain was 24%. I had purchased Student Loan because it appeared abnormally cheap for a profitable lending company. At the time of purchase, it was trading for 35% of tangible book value. Credit quality appeared manageable given that 75% of the loan portfolio was government guaranteed.
The question surrounding STU was: How desperate was its 80% owner, Citibank? Citi had stated that Student Loan was part of its CitiHoldings and therefore on the block to be sold. I thought the market was too pessimistic about how desperate Citi was to sell down its CitiHoldings assets. I thought Citi would not sell STU unless they received a price higher than the current stock price and potentially at least at book value. My thesis was that Citi could extract at least the current stock price from earnings and release of capital in as little as 10 quarters if they put STU into run-off. My model was the Primerica transaction earlier this year where Citi created a growth company from a slow growing life insurer by retaining most of the existing term life policies on its balance sheet and allowing the policies to run-off naturally. In the Primerica example, Citi showed that it was not desperate and structured a smart transaction that created value for its shareholders.
I was both right and wrong about Citi’s desperation. Citi did sell Student Loan for higher than the then current stock price, but they still sold it for only 45% of book value. The acquisition which will close in Q4 is a complex four-party deal between Student Loan, Citi, Discover and Sallie Mae. To make it simple, Citi essentially gave the government guaranteed student loan portfolio to Sallie Mae for little premium. Then, Citi gave Discover about $400 million, a perfectly good private student loan lending platform that had scarcity value and a portfolio of the recently originated, pristine-quality private student loans at par. Finally, Citi booked a $500 million loss and still kept all of the risk by retaining questionable quality 2006-07 vintage private student loans.
There was a better solution for Citi shareholders that could have still moved the assets off of Citi’s balance sheet without Citi retaining the same risk. Citi should have made STU an independent company. STU is too small relative to Citibank to spin-off the shares directly to Citi shareholders because a Citi shareholder would only receive 1 share for every 1,500 Citi shares held. Instead, Citi should have proposed an exchange offer where Citi shareholders could choose to swap 4.5 of their Citi shares for 1 share of STU owned by Citibank. This would have put STU into the hands of shareholders who made an active decision to own STU. This exchange transaction would have moved STU’s assets off of the CitiHoldings balance sheet and Citi shareholders would have benefitted from 72 million share reduction in Citi shares outstanding, but Citi would have still had a $6 billion loan outstanding to STU. After the exchange offer was completed and STU was independent, STU’s management and shareholders could have decided on the best way to pay off Citi’s loan to STU and create value for STU shareholders. Either they could have found another lender to take out Citi’s loans to the company and continued to originate new student loans, or they could have run-off STU’s loan portfolio and paid-off Citi from the natural pay-down of their loans. Either way, both STU’s and Citi’s shareholders would have been better off with an exchange transaction than they are with the deal to sell STU’s assets to Discover and Sallie Mae.
At the end of the day, Citi did not help its own shareholders with this transaction. They had an undervalued asset and gave it away to competitors, but Citi still kept all of the risk. They sold STU at such a cheap price in order to demonstrate that they are making progress in reducing the assets of CitiHoldings. However, this is a bill of goods because Citi kept all of the risky assets and gave away capital that could have covered the losses from those risky assets. I would argue that this transaction increased the risk at CitiHoldings. If regulators were awake and truly concerned about risk instead of asset size, they would stop Citi from consummating this transaction. Of course, it is deplorable that Citi’s management doesn’t recognize the poor economics of this transaction and stop the transaction themselves.
Texas Capital Bancshares: Credit Trend is Not Good
Aug/100
Texas Capital Bancshares (TCBI) is an interesting organic growth banking story, but the bank’s declining credit metrics make it a better short from here. The bank is 12 years old and has grown by lifting out relationship bankers from the big banks. These relationship bankers bring their best customers over to TCBI. This is an efficient and capital friendly growth strategy. This strategy also allows the bank to grow even in periods of weak loan demand.
However, the credit metrics of the bank have deteriorated significantly over the past 4 quarters. The only potential catalyst that matters is a sign stability in the bank’s credit metrics. The next data point won’t be for another 7 weeks when the bank releases Q3 numbers.
Here’s a look at the credit numbers for TCBI
| 2009 Q2 | 2009 Q3 | 2009 Q4 | 2010 Q1 | 2010 Q2 | |
| Loans Outstanding | $4,211 | $4,290 | $4,457 | $4,443 | $4,463 |
| Loan Loss Provision | 11.0 | 13.6 | 10.1 | 13.1 | 15.7 |
| Net Charge-Offs | 6.8 | 2.8 | 8.0 | 9.3 | 12.6 |
| Loan Loss Reserve | 54.3 | 65.8 | 67.9 | 71.7 | 74.9 |
| Non-Accrual Loans | 49.6 | 85.3 | 95.6 | 115.9 | 138.2 |
| Other Real Estate Owned | 31.4 | 34.7 | 27.3 | 28.9 | 42.1 |
| Non-Performing Assets | 81.0 | 119.9 | 122.9 | 144.8 | 180.3 |
| Non-Accruals/Loans | 1.18% | 1.99% | 2.15% | 2.61% | 3.10% |
| Reserves/Loans | 1.32% | 1.54% | 1.55% | 1.63% | 1.68% |
| Reserves/Non-Accruals | 109% | 77% | 71% | 62% | 54% |
| Tangible Common Equity | 456 | 466 | 473 | 491 | 504 |
| Texas Ratio | 16% | 23% | 23% | 26% | 31% |
TCBI’s numbers are showing a disturbing trend. Non-accrual loans have accelerated the past two quarters. Plus, it looks like management has not been adding to the loan loss reserve aggressively as non-accruals have climbed.
One could argue that TCBI has been under reserving for loan losses during the past 4 quarters. The loan loss reserve to non-accrual loan ratio has declined from 109% to 54% over the past 12 months. If management had kept this ratio constant, TCBI would have report a losses instead of profits over the past 4 quarters.
TCBI shares trade 1.15x tangible book. I think the profitability of the bank is questionable given the declining reserve ratios. If you add in the worsening credit metrics, I think TCBI will have a lid on its stock price until it reports a quarter with stable credit metrics. Since TCBI is well-capitalized, the viability of the bank is not in question. But, the decline in the credit quality suggests that the credit issues are open-ended. I think investors should demand a discount to book value to own a bank stock with credit quality continuing to worsen at rate like this. At 70% of tangible book, the stock would trade at $9.50 or a decline of 35% from the current price.
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