Allstate is All-star

In an earlier post (3/20/06), I commented that the "good hands" people at Allstate (ALL) seem to be in Good Hands themselves. ALL's good fortune continues as illustrated by the following graph:

The graph illustrates that an investment in ALL would have produced results superior to the property and casualty insurance industry and the market overall no matter when the investment was made. This is a stunning result. While certain years produced better results than others, the ability to achieve superior returns through an investment in ALL was not dependent on picking the right year.

It appears that ALL's results were due to three factors. First, ALL has a generally low expected return because its enormous market share means slow growth. This low expected return shows up by its average valuation being 60% of the stock market's metrics. Second, ALL has not squandered its returns by reinvesting in "growth opportunities." Instead, ALL has returned 68% of its earnings to shareholders over the last ten years. Third, ALL has not followed Wall Street's siren call to compete aggressively. ALL has focused on profitability by discontinuing new homeowners coverage in California, Connecticut, Delaware, Florida, New Jersey and eight coastal counties in New York.

Of course, one payoff for ALL's unwillingness to lose shareholder money is consumer and political outcry. But ALL's discipline actually contributes to a more sensible assessment of risk in catastrophe-prone zones.

Aircraft Leasing

Despite my affection for aircraft, I have always viewed the aircraft leasing business apprehensively. As a long-term holder of AIG, I had preferred that the aircraft leasing division (named International Leasing Finance Corporation or ILFC) was not part of the package (as well as the derivative trading division). However, today's NYT article changed my mind.

Steve Udvar-Hazy runs ILFC and, as the article showed, has always run it. In my analysis of AIG, I had believed Mr. Hazy to simply be another "corporate guy" who had climbed the long ladder of corporateness to success. Was I ever wrong. He is a billionaire who created the industry entrepreneurially and still dominates it.

The aircraft leasing industry, as the article states, "leases airplanes for the same reason that cash-short consumers lease cars - they can get new models for lower payments." Aircraft leasing works particularly well because the fuselage of an aircraft has significant longevity. Mr. Hazy's early love for aircraft helped him understand the relatively strong residual values of an airplane. As a car-man friend of mine said about car finance, "the car's got to outrun the note."

Mr. Hazy exploited this structure, turning $150,000 in 1973 into a multi-billion dollar business for himself, two partners and AIG. IFLC has 824 Boeing and Airbus aircraft with another 254 on order. IFLC has 35% more aircraft than American and more than Air France, Lufthansa and British Airways together.

The aircraft leasing model is used extensively for airlines who prefer the latest models and can precisely estimate its costs. But the following graph shows an interesting issue - an almost complete lack of participation by U.S. airline companies:



If there are any "cash-short consumers," it would seem to be U.S. airline companies. Their underrepresentation at ILFC would appear to be the result of two factors: cheaper money elsewhere and little concern that ILFC's deep pockets will be needed later. Mr. Hazy expressed some frustration at their unwillingness to buy ILFC's tougher terms, commenting that U.S. airlines "act almost like superior beings." Nevertheless, Mr. Hazy has been disciplined and not loosened ILFC's terms. The shareholders of AIG have a real gem in Mr. Hazy and ILFC.

It's a Mad, Mad World

Graphs like this one "melt it down" (to use some Marvinology) for me. As I read about U.S. companies piling investments into a communist country in which property rights are unclear, where fraud is rampant and where using the word "democracy" can land one in jail, I am baffled. Yet this graph shows why China is compelling. U.S. wages are 30X higher, not including benefit structures, meaning a company can either hire a U.S. worker for an hour or a Chinese worker for one week.

In addition, the Chinese worker saves half of his salary, effectively lending it to the U.S. Little wonder the U.S. Government has difficulty putting pressure on Chinese practices. Is it only me who senses something very wrong that the individuals making the most money are, in essence, borrowing from the people who make the very least?

Moody's World

The recent expansion of debt may be good or bad, depending on your point of view. For Moody's (MCO), the expansion has been highly profitable as their traditional business has been rating issues. However, their non-traditional business of structured finance has also profited from and heavily contributed to the expansion of debt.

Structured finance is the "largest, least understood area in finance" according to Brian Clarkson, Co-COO of Structured Finance and Public Finance for Moody's. Originated in 1984, structured finance now makes up over 52% of their ratings business. Extrapolating growth rates out, MCO will basically be in the structured finance ratings business. So, what is causing such extraordinary growth?

When MCO begin work in structured finance, "securitization" (which is the essential work of structured finance) was described as "the transfer and pooling of cash flows and assets to remove operating risks of the originator from (or by means of) issued securities." In this way, securitization allowed for "originators," such as banks to remove operating risks, such as credit cards, so that they would not be clawed into bankruptcy by retention of concentrated risk. So far, so good; banks could diversify their risk.

By the mid-90s, the description of "securitzation" has evolved to "the pooling of current or potential cash flows which may or may not be transferred and may or may not remove operating risks of the originator from issued securities." Securitization began to allow for the monetization of such assets as film or music royalties. At this level, exposure to certain types or risks and/or cash flows could be calibrated.

Currently, Moody's describes "securitization" as "an ever-changing set of financial techniques, engineering or modeling using by market participants to achieve a specified goal." In the same way that paper money ultimately became the means to transact between widely differing products over differing periods of time, so too has "securitization" produced securities which are tailored to the needs of the investor, the lender and the borrower.

Look at the growth rates of collateralized debt obligations (CDO) done by MCO alone:

MCO is not only profiting from the advances in financial technology and debt demand, but is creating growth by "blessing" these complex structures. Apparently, MCO does not have any real "skin in the game" as MCO has no actual financial investment in these structures.Questions do remain about the level of MCO's responsibility: is it as a journalist or as an auditor?

Debt Still A Four Letter Word

Despite the growing belief (and widespread evidence of proof) that we may borrow our way into heaven, McGraw-Hill Publishing (MHP) still retains its debt-free status. MHP is a powerhouse company with three divisions: the financial services of Standard and Poor's (S&P), the educational division and the information/media section owning Businessweek. MHP's financial metrics are superb.

MHP's debt-free status is especially noteworthy, as MHP has a steady stream of income and thus is highly "leverageable." Further, MHP arguably employs the best and the brightest analytical minds in its S&P business who could capably access this leverage. After all, MHP rates over 90% of U.S debt issued. (Most debt issues require two rating agencies, so MHP and Moody's generally get the nod.)

Interestingly, while Wall Street cries for higher leverage and employs S&P analysts to ascertain and bless these "optimal" capital structures, these same analysts are employed by a company that remains steadfastly debt-free. When it comes to employing debt, it may be good to remember the country music lyrics, "all that glitters may not be gold."

American Express Hiding?

Typically I get a more indepth understanding of a company the longer I study it; this is part of the joy of learning. Not so with American Express (AXP).

Last year, AXP spun off American Express Financial Advisors (AEFA). I supported this move believing the narrowed focus and less capital intensive business model would benefit AXP. But I never imagined that the financial statements would become more opaque.

The first baffling issue is AXP's focus on increasing the return on equity (ROE). In the first paragraph of the 2006 shareholder letter, CEO Kenneth Chenault writes, "In the fourth quarter, we raised our ROE range from 28-30% (to 33-36%), reflecting both our performance since the spin-off and continued confidence in our growth potential."

While ROE provides an excellent way to gauge the capital efficiency of a business, the measure has some real limitations. The most severe limitations of ROEs occur when share issuance or repurchase is high. If large share repurchases occur at a market value in excess of book value, the ROE is raised, almost regardless of business performance. I can point to numerous examples of a poorly performing business with a rising ROE.

Later, in the same letter, the CEO points out that billed business grew by 16%, driven by a 9% increase in cards accompanied by an increase in average spending per card of 7%. From this information, many calculations are straightforward. Yet, my computed numbers increasingly vary from those reported by AXP.

In 2006, AXP reported spending per card to be $11,201 versus my calculation of $8,984. Starting in 2001, my calculation was less than 10% apart, but is now 15%. The same widening has occured in the reported discount rate (2.57%)versus the computed discount rate (2.31%) In 2001, my variance was 8 basis points, but has now moved to 26, resulting in the average discount revenue per card reported at $288 versus a computed $208 per card!

Yet, the worst discrepancy is between reported net fees per card ($35) versus my computed net fees per card ($32). In 2001, my variance was $6 more, but that has now moved to $3 less. This example seems very strange. The net fees on the income statement has not moved significantly for the last six years, and yet the number of basic cards issued has grown strongly. How is it possible that net fees per card have not moved down then?

Despite these issues which have arisen during their transition, I continue to believe that AXP has one of the best franchises in the world and have included a picture of myself happily using My Blue Card in Moorea.

Fairwell to First Data Corporation

In September 2006, First Data Corporation (FDC) spun off Western Union. Then a few weeks ago, FDC announced that it was being bought out by KKR. Now I am moving FDC to the "gone (private), but not forgotten (or public yet - again)" category.

I have studied FDC since the Great Tech Bubble. As we saw the use of more plastic and less cash, a colleague of mine asked, "who makes money on that?" I found out that FDC did - in a big way.

FDC dominates merchant-processing, processing over 50% of the U.S. Visa and Mastercard transactions. FDC's market share in a high fixed cost business gives FDC an enormous competitive advantage. On top of that, FDC is in the best business in Texas (besides Dallas and Houston tollways): helping Mexicans send U.S. earned money back to Mexico. FDC's Western Union dominates this business.

Unfortunately, I never became an owner of FDC stock. My ailment might be considered psychosomatic: I get nosebleeds at p/e ratios over 20. With FDC's average p/e ratio hovering above 25, "bargain" opportunities arose when the p/e dropped all the way to 19 - twice in six years. Nevertheless some investors dove in where I feared treading. One of my cachamim was among them: David Swensen.

Most people had not heard of Mr. Swensen until a recent NYT article featured him. The article told how Yale's endowment had generated an investment return of 16.3% per year under Mr. Swensen's leadership. Such an investment record would send lesser individuals into managing a hedge fund with at least a "2 and 20" fee. Rather than working for Yale for a little over $1 million, he could get paid tens or hundreds of millions of dollars.

But that's not Mr. Swensen. He has explained that his motivation is a "mission" to "make money for financial aid for students." Last year, Yale University's president analyzed their top donors and put Mr. Swensen at the top with a "donation" of $7.8 billion. That sum is the amount of outperformance he has generated relative to his peers at Harvard et al.

His sense of mission translates to what he expects of others. When evaluating a money manager, Steve Cohen, who received a 50% performance fee, he commented "the fees alone are enough to say that I don't want a meeting and there are enough people who put together fair deals." Further, he doesn't go for the "trust me" method of "black box" investing, such as ESL Investments.

The article also describes Mr. Swensen as "not afraid to go where other people don't" which is exactly what I found with his investment in FDC.

Equipped with perfect knowledge of what happened, I went back to my research and reevaluated my calculations. For 2007, Western Union still looks like it's worth $24. The rest of FDC still looks like it's worth $28. Together, they're worth $52. 75% of $52 is $39 - a p/e ratio of 15 - something it never got close to. Maybe it will next time around or maybe, by then, I'll better understand why Mr. Swensen thought he could pay a higher price.