The Fall of Semgroup & Its Impact on Oil

Anyone who follows the MLP sector is undoubtedly aware of the recent implosion of Semgroup Energy Partners (Nasdaq:SGLP). There have been several articles put out by the press that list this event as example #1 on why one should not be involved in the sector, I questioned that thought process in my previous article which can be found here. Today I thought I would briefly touch on the relationship between Semgroup’s demise and the decline in the price of oil. For those in need of a refresher, Semgroup Energy Partner's implosion was caused by the bankruptcy of Semgroup Energy Partne's general partner, Semgroup LP which recently lost nearly$3 billion dollars after positions in oil derivative contracts went against the firm. Prior to the bankruptcy filing, Semgroup LP provided over 90% of Semgroup Energy Parner's revenue.

Additionally, the market was expecting substantial asset dropdowns at Semgroup Energy Partners from the parent company over the next several years. Given the firm’s high level of customer concentration and the markets relatively large expectations for balance sheet growth it was only natural to see the stock plummet after the news broke.

It was disclosed on Tuesday that Semgroup LP's massive losses were not caused by the firm’s hedge book, which is fairly interesting as it shows management's aggressive nature and strong desire to deliver outsized profits via the commodity market for the company’s stakeholders. It is typical of most companies in Semgroup’s industry to keep a hedge book filled with derivatives to mitigate their exposure to commodity prices. However, Semgroup LP's massive losses were due to substantial speculative bets in the oil market that far exceeded the firm’s hedging needs. Semgroup LP's creditors had not authorized such speculative trading in oil futures, which is why Semgroup LP kept its activities secret until it was too late to rectify the situation. Semgroup LP disclosed it was facing a liquidity crunch during a conference call with creditors mere days before the crash in Semgroup Energy Partner's unit price. As you can see from the chart below, the unwinding of Semgroup LP's massive oil bets are correlated almost exactly with the fall in the price of oil. Is this a coincidence? I doubt it. First it is too coincidental and secondly we have seen this phenomenon before.

Back in 2006, the collapse of the hedge fund Amaranth Advisors caused a similar reaction. Amaranth as you may remember collapsed due to massive speculative bets in natural gas futures that went against the firm. Amaranth Advisor’s notified creditors of its liquidity crunch in early September of 2006 and on September 20 2006, Amaranth Advisors gave up control of its portfolio to creditors who began the liquidation process. As you can see from the chart below, this event had a significant impact on the natural gas market. The chart during the month September is nearly identical to that of the one above.

I strongly believe that Semgroup LP's bankruptcy is one of the main contributing factors behind the recent decline in the price of oil. In the short term, speculators clearly determine the price of oil. However, I still beleivve that the longer-term fundamental factors reign supreme. The current high price of oil is in my opinion clearly justified by fundamental factors and while short term factors such as the Semgroup blow up are important they should not detract from the story behind the oil run up, which I detailed here. Wednesday's bullish gasoline storage data further supports my idea that the recent decline in oil was due to the unwinding of Semgroup LP's leveraged oil bets instead of fundamental factors. The fact that gasoline and oil inventories continue to drop along with the price of oil can only be explained by disruptions in the energy market. The price of oil should continue to rise or at the very least remain steady until we reach a point in time where gasoline inventories stop dropping.

Disclosure: None

Steady Returns in MLPs

There was a negative Reuters story out on the MLPs over the weekend that has and will likely continue to pressure the sector for sometime given its relative small size and market position.  The article uses the example of SemGroup to weave a story that attempts to depict MLPs as risky investments where the potential returns do not compensate investors for the risks that they are taking.  A key point in the article was that the structure of the limited partnerships limits the unit holders ability to bring about change in the corporate governance of the company.  While this is of course true, it is largely irrelevant, after all how many minority shareholders are capable of bringing about change at your standard publicly traded corporation?  The SemgGroup situation is in my opinion clearly an isolated incident and while improved corporate governance may have helped, it would not have prevented the implosion of the parent company.     

Had SemGroup followed the typical business path of your standard general partner, its publicly traded subsidiary SemGroup Energy Partners (SGLP), would not be in the trouble that it is in.  The energy trading losses that occurred at the company's parent company should not be viewed as being indicative of the natural risks in the standard MLP business.  Instead, I believe that SemGroup's blowup should be viewed in the same light as managerial fraud.   

The generally bearish Reuters article also sighted the complex tax procedures for ownership as well as the fact that the general partner of the typical limited partnership receives an increasingly large share of the limited partner's earnings after a certain points as additional reasons as to why one should not own MLPs.  While these are all valid points, they do not change my opinion that MLPs, that if owned in a large variety  and in a diversified portfolio can represent a great alternative to fixed income investments.  The securities offer above market dividend, with yields approaching 10% in some cases, representing a smart way to boost a portfolio's yield.  In addition, the ownership of these units give's the holder the equivalent of a call option on domestic pipeline volume growth, rising oil and natural gas production and exploration as well as exposure to a general increase in the price of oil and natural gas.  It is this "call option" that gives these fixed income like investments the extra kicker that they need to be truly successful over the long-term.  

Below I have highlighted 10 of the best returning MLPs, their returns exclude the dividends that have been paid out on the units.  It should be noted that their returns are significantly higher then their more recently established peers.  I would imagine that this is the case because of the fact that the younger peers have not managed to participate in some of the industry's more intense growth phases; however, the surge in new shale plays across the U.S. will provide ample opportunities for the new MLPs to replicate the returns of their more established peers.                  

Penn Virginia Resources (PVR)

Oneok Partners (OKS)

Dorchester Minerals (DMLP)

Magellan Midstream Partners (MMP)

Energy Transfer Partners (ETP)

Enterprise Products Partners (EPD)

Atlas Pipeline Partners (APL)

TEPPCO Partners (TPP)

Natural Resource Partners (NRP)

Kinder Morgan Partners (KMP)

For Further Review:

Reuters Article

WSJ Article 

Multiple, Margin Expansion at DOW?

There were several interesting tidbits in The Dow Chemical Company’s (DOW) second quarter conference call on Thursday that I thought I would share.  As we all know, the company is struggling to communicate effectively to the market its ability to navigate surging commodity prices while at the same time reinventing itself.  The company has raised prices considerably across the board on all of its products in an effort to protect its margins.  While it is still early, it appears that management has been fairly successful in this effort.  The price increases represent an effort by the company to price its products in a manner that takes into account higher input costs down the road.  While I wouldn’t go as far as to say that their pricing index is becoming forward looking it nevertheless has proven to be a lot more easily changed to protect margins then in the past.  Dow Chemical has also been burdened by the impression that it is just another, albeit larger, commodity chemical company.  As a result, the company trades at a very low earnings and cash flow multiple, especially in light of its successful joint venture operations.  The company has sought to rectify this situation and expand the company’s growth potential by purchasing Rohm & Hass (ROH).  While the company paid a terribly high price for Rohm & Hass, the synergies may just be enough to make the deal work.

The first interesting comment on the conference call came from a man by the name of Peter Butler who asked if the coming quarters could potentially be similar to 1974.  Apparently, 1974 so a huge earnings beat on the part of Dow Chemical after it was able to hold the line on its prices even as its input costs dramatically decreased following a long term run up.  If oil and natural gas prices were to retreat and Dow Chemical was able to maintain prices and prevent dramatic demand destruction the potential for margin expansion would be tremendous.  Such an action would drive the stock substantially higher on strong earnings.  The exchange between Mr. Butler and Andrew Liveris, CEO of Dow Chemical can be found below:     

Peter Butler - Glen Hill Investment       

“If this were 1974 instead of 24 years later, Dow would be looking at huge positive earnings surprises coming in the next couple of quarters. Is this management seeing the same things? In other words, is this management as tough as Dow's management back then in getting and holding price increases, even if oil does decline?”

Andrew N. Liveris - Chief Executive Officer & Chairman

“Peter, this is Andrew, yes. And you know me well enough to know that I have talked to the tough management of that timeframe. And what it takes to not only restore margins, but obviously get reinvestment grade pricing into the value creation that we all have to have to make the chemical industry robust, not just in United States, but globally. We have a lot of customers who are putting price increases through right now in their value chains. That would not have happened without Dow's leadership. And I think it is a good question to ask. And maybe I should just leave it with the one word, yes.”

Peter Butler - Glen Hill Investment

“That yes did include the acknowledgment that the earnings should be looking pretty splendid?”

Andrew N. Liveris - Chief Executive Officer & Chairman

“I think the very first question -- I can't remember if it was Don or Dave now -- but I would tell you this, we are going to move the earnings profile northwards, not just with how we have performed on financial discipline despite these horrendous increases, these huge unprecedented surges, but also because of our footprint shifts, the two big ones. The asset-light, which I know you are a fan of and we are a fan of and our partners in the low-cost feed stocks and the cash machine that we are generating out of our joint ventures, these are cash machine that no other chemical company on the planet will be part of.

Then second, the Rohm and Haas transaction and the value creation that will occur because we will be in solid downstream growth markets around the planet. Those two things will give this company a northeast earnings profile, heading to the right growth side of the equation.”

The second key driver for the stock, even if oil and natural gas prices stay high, will be the acquisition of Rohm & Hass.  The deal is rather pricey but should be accretive to shareholders in the long run, especially if it drives multiple expansion.  Rohm & Hass is a leader in specialty chemicals.  These chemicals are dramatically different from Dow Chemical’s because they typically have higher margin, are less cyclical and have potential for revenue growth well beyond GDP.  As a result, companies like Rohm & Hass tend to have higher multiples.  This deal was something that the analysts at HSBC have been suggesting for sometime and it has been fun to watch their hopes for Dow Chemical materialize over the last couple of quarters.  It is clear that multiple expansion is something that management is desperately trying to get at, as it represents the easiest way to build shareholder value.  During the past year, the company has been removing its focus from its legacy commodity chemicals and refocusing on specialty chemicals.  This has meant that the company has entered into a large number of joint ventures that have helped make the company much “lighter.”  While these joint ventures are good for the company in the long term, the analysts over at HSBC believe that they are only being valued by the Street at 3-4xs earnings.  The joint ventures provide a solid safety net for the company should it be unable to expand margins or make the most recent acquisition work.  The Rohm & Hass acquisition clearly speeds up the process of refocusing Dow Chemical into the specialty chemical business.  This new segment will give the company the growth conduit that it needs to convince the street that it deserves an earnings multiple equal to or greater then DuPont (DD). 

Over the next 12-18 months, if everything falls into place, I have no doubt that The Dow Chemical Company could potentially be trading at as much as twice its current price.  To achieve this lofty goal the company needs to only hold prices should oil and natural gas fall considerably, as such an action would allow margins to expand considerably.  In addition, the company needs to ensure that multiple expansion occurs in its stock beyond what would occur because of the growth in margins.  This can be achieved if the Dow Chemical’s management team can show to the Street and the investment community that the Rohm & Hass acquisition was not nearly as expensive as it appeared at first glance and that the new segment will help to dramatically lift the company’s potential revenue growth both here and abroad in the years ahead.  

Disclosure: None  

 

Waiting for the Call Reports

Nearly every major commercial bank has reported earnings over the last week.  The results have ranged from an $8.8 billion dollar loss at Wachovia (WB) to a $3.4 billion dollar profit at Bank of America (BAC).  The bank’s capital ratios have stayed adequate for the most part, even if it has meant changing the charge off procedure, as in the case of Wells Fargo (WFG).  The perceived improvement, or for that matter the perception that the loses have peaked, has caused one of the greatest short-term rallies in the history of financial stocks.  Yet, I still worry that the hardships facing the commercial banks are nowhere near complete and as a result the current rally will prove to be merely a painful remainder of how much further the bank stocks have to fall to account for the near continuous addition of delinquent loans to their books.

I strongly believe that the amount of loans that are between 30 and 89 days delinquent are a great indicator of future issues in any banks’ loan portfolio.  Unfortunately, these figures are never included in the bank’s quarterly press release and are rarely included in the banks’ 10-Qs.  As a result, individual investors must search out the call reports put out by the FFIEC, these reports can be found here. it should be noted that these reports show the health of the bank only and not the holding company.  These reports are tremendously detailed and allow for a much more detailed examination of any banks books.  The one drawback however is that the banks typically take over a month to file the reports; as a result, investor’s are left in the dark in the time period immediately following the standard quarterly release.   For long term investors I believe that it is imperative that one waits until the call reports are filed with FFIEC in early to mid August before taking a position in any bank as we will then be able to see the trouble that the banks have gotten themselves into over the summer.  As of 3/31/08 the following major banks had a substantial number of loans that were 30-89 days delinquent:

Wachovia (WB): In excess of 5.3 billion

Washington Mutual (WM): In excess of 5.2 billion

Wells Fargo (WFC): In excess of 5.4 billion

Bank of America (BAC): In excess of 8.3 billion

JPMorgan Chase (JPM): In excess of 6.9 billion

U.S. Bank (USB): In excess of 1.3 billion

Citigroup (C): In excess of 13 billion

These figures should remind us that there are still considerable losses in the pipeline, on top of those loans that will become delinquent in the second quarter.  As banks do not have to start reserving for loses in these loans until after 90 days it is possible that the worst is yet to come for these banks, especially if a significant number of loans become delinquent over the summer.  Generally speaking these loans do not start to bring about a deterioration in the capital base and capital ratio of banks until after 90 days.  The possibility of increased delinquencies and the potential capital raises that could follow is why I would advise waiting until the second quarter call reports come out in mid August before investing in any bank stock.  I have talked a little bit about how these early delinquencies can be included in calculations to figure out the strength of a particular bank here, I believe my article on a potential “California Ratio” is worth a review going into the release of the second quarter call reports.  Especially if one is considering taking a long term position in one of our country’s many regional and national banks.

For Further Review:

FFIEC Website

Disclosure: None

GSE Rescue Finally Materializes

It appears that a Fannie Mae (FNM) and Freddie Mac (FRE) “rescue” plan is finally on the verge of being passed by Congress, months after it became apparent that the two would be in need of significant capital injections.  The plan, as reported by Bloomberg, calls for the U.S. Treasury to inject any amount they feel appropriate as long as the total exposure keeps the U.S. federal debt ceiling below 10.6 trillion (the current limit is 9.815 trillion).  The Treasury’s investment will be in the form of equity, loans and a line of credit.  In all likelihood, the current shareholders of the two GSEs will see their ownership stake dramatically reduced through rampant dilution.  Nevertheless, it is now apparent that these two companies will survive the current crisis and will be unable to bring about a global financial collapse.  In approving the plan and raising the federal government’s debt ceiling the country has also moved closer to explicitly guaranteeing the companies’ gargantuan debt load.

In looking back at the past six months, it is painfully apparent that the government, along with the GSEs and the marketplace took far too long to act.  There was simply no leadership taken by any of the parties involved.  The struggle for the future of Fannie and Freddie began in late 2007 and early 2008 when the companies began to see their loan portfolios and the mortgage securities that they guaranteed become increasingly burdened by problematic loans.  In an effort to remain well capitalized, the GSEs undertook significant capital raises.  

They were however undermined when in February the government raised the limit on the number and size of the loans that both Fannie Mae and Freddie Mac were able to hold.  While this is something that the GSEs had wanted for sometime, the government was mistaken in carrying out this action at the time that it did.  In raising the limit on the number and the size of the loans Fannie and Freddie could hold, the government managed to allow the two companies to expand their loan portfolios at precisely the wrong time and in precisely the wrong areas of the country.  The higher value loans were centered in the overheated housing markets and in all likelihood have managed to put the companies’ portfolios under tremendous amounts of stress over the last quarter.

In March, the government reduced the surplus capital requirement for the companies.  It was hoped that this would allow Fannie and Freddie to better handle the pressure being put on their capital base by a weakening portfolio.  In addition, the government believed that such an action would allow the two companies to expand their lending operations and help to rescue the U.S. mortgage market from near collapse.  The dramatic reduction of required surplus capital made it possible for the two companies to potentially increase their portfolios by over $200 billion dollars and to expand the number of mortgages that they guaranteed by over $2 trillion.  While we do not know yet, we will likely see in their next quarterly report that such an action, if taken, has caused the portfolio to come under tremendous stress for the same reasons mentioned above.  In a time when commercial banks were frantically raising capital and trying to conserve it, Fannie Mae and Freddie Mac were out throwing precious pieces of their balance sheet into the mortgage market, were it promptly vanished in a sea of losses.  While they were undoubtedly fulfilling their federally funded mandate they were also likely attracted by the possibility of ever growing profits down the road as a result of an ever growing portfolio.    

Had the government taken a stronger stance and limited the expansion of the portfolio and refused to reduce the surplus capital margins we would likely have avoided the calamities caused by the near failure of Fannie Mae and Freddie Mac, at least for a time.  The time for the Treasury’s plan was in February when the two companies still had some shred of integrity and respectability in the investing community, now they are unfortunately just another troubled institution that is on the brink.

It would appear that my suggestion on the future of Fannie Mae that I made in May has largely been proven correct.  In my article I stated that while Fannie Mae and Freddie Mac would not fail their shareholders would in all likelihood be diluted significantly.  The rescue plan assures this outcome, although it potentially leaves more on the table for current shareholders then I originally expected.  The GSEs, as I suggested in May, still have several things going for them.  Namely, that the two companies borrowing rate has been kept artificially low because of the government's near explicit guarantee of the companies’ debt.  This should allow net interest margins to continue to expand well beyond that of a typical mortgage company.  The income from servicing and guaranteeing mortgage securities should also continue to climb higher as investors will continue to have faith in Fannie Mae and Freddie Mac due to the renewed support of the two companies by the federal government and the belief that if the two companies cannot meet their obligations that the federal government will do so for them on their behalf. 

While it is clear that the Treasury’s rescue plan should have come into place much sooner, it’s implementation will undoubtedly remove a significant headwind from the U.S. financial markets. 

For Further Review:

Forbes Article from February

Bloomberg Article form March

Details of Rescue Plan    

Disclosure: None

Is there a Marcellus Shale Driller Pure Play?

The Marcellus Shale is quickly becoming the biggest thing in the U.S. natural gas industry since the Barnett Shale.  You can hardly watch CNBC without hearing Jim Cramer talk about the Marcellus Shale and his “wildcat drillers.”  As investors, we know that if you want exposure to the Marcellus you cannot just buy any company with Marcellus acreage.  You need to buy the company with the greatest exposure to the Marcellus if you want to maximize your investment gains.  Unfortunately, I have not been able to find any publicly traded company that is a true pure play on the Marcellus Shale.  But, after looking at the different companies involved in the play, some clearly stand out as having more exposure than their peers.   The following table shows the enterprise value per acre of the Marcellus Shale drillers.

	Marcellus Acreage	Debt	Market Cap	Enterprise Value	EV / Marcellus Acres ($)
ATN	516,000	925M	2.4B	3.3B	6,574
RRC	1,150,000	1.7B	9.2B	10.9B	9,564
REXX	57,000	81M	880M	961M	16,860
QRCP	119,000	339M	313M	652M	5,484
CHK	1,200,000	14.5B	30.6B	45.1B	37,643
XCO	415,000	2.9B	3.4B	6.3B	15,320
COG	100,000	448	5.4B	5.9B	59,380
EQT	300,000	1.9B	7.4B	9.3B	31,157
XTO	152,000	7.3B	29.5B	36.9B	243,204
EOG	700,000	1.1B	26.9B	28.1B	40,164
NFG	700,000	1B	4.4B	5.4B	7,847
CXG	161,000	151M	5.5B	5.6B	35,286

Natural Fuel Gas (NFG) and EOG Resources (EOG) have a joint venture that is developing Natural Fuel Gas’s 700,000 acres.  However, they refuse to release details about the joint venture.  As a result, I believe that you should assume that National Fuel Gas has exposure of far less than 700,000 acres.  Cabot Oil & Gas (COG) is another company that refuses to say just how many acres it has and will only say that it has more than 100,000 acres.  The companies’ hesitancy to reveal their true acreage should be considered a red flag in any due diligence proceedings. 

Atlas Energy Resources (ATN) and Quest Resources (QRCP) seem to be the clear standouts with the most exposure to the Marcellus Shale.  Both Atlas Energy Resources and Quest Resources have had recent share offerings and the current market caps are reflected in the chart above.  But despite the dilution that occurred as a result of these offerings these two companies still represent some of the most compelling investments in the Marcellus Shale play.

An important footnote for Quest Resources is that it one should remember that the company operates with two subsidiary companies, Quest Energy Partners (QELP) and Quest Midstream Partners.  Quest Resources is required to consolidate the balance sheets of Quest Energy Partners and Quest Midstream Partners on its balance sheet, even though they are entirely separate companies.  Below is a breakdown up the company's debt structure. 

	Total Debt
	339,000,000
QRCP less limited partner’s debt	35,000,000
	Subsidiary Debt
QELP	198,000,000
QMLP	106,000,000

As you can see, most of the debt on Quest Resource’s balance sheet is actually debt at its subsidiaries.  Quest Resource only has $35 million of its own debt. This of course impacts Quest Resource’s enterprise value and the amount you are paying for the exposure to the Marcellus shale that you would get from buying Quest Resource’s shares.  As a result the line on the graph above for Quest Resources should instead look like the line below.

	Marcellus Acreage	Debt ($)	Market Cap ($)	Enterprise Value	EV / Marcellus Acres ($)
QRCP	119,000	35,000,000	344,960,000	379,960,000	3,193

If you back out the debt at Quest Resource’s subsidiaries the amount of exposure you get to the Marcellus Shale is in fact substantially higher.  Most important though, Quest Resource’s low debt level and significant cash flow from its subsidiaries will make the speedy development of its Marcellus Shale properties easy to finance.  If you want exposure to the Marcellus Shale, Quest Resources is clearly the company that you want to own.

Another note worth mentioning is that QELP recently announced that it anticipates being able to increase its distribution from $1.64 per year to $2.00 - $2.20 per year based on the accretion from the recent acquisition of PetroEdge Resources.  This transaction represents exactly the type of value creation that can occur in the MLP capital structure.  My previous articles on Quest Resources and Atlas America (the parent of Atlas Energy) can be found here and here.  

Disclosure: Long ATLS & QRCP

IndyMac Failure Priced in at Alesco

When news of the failure of IndyMac Bancorp (IMB) broke over the weekend, I feared that it would provide yet another opportunity for the shorts to pull down Alesco Financial (AFN).  I was pleasantly surprised though on Monday when the stock finished down only a penny in a brutal market.  While the majority of the financial stocks in my investing universe were down around 5%, Alesco’s relative strength was rather surprising and revealed something that I had not expected given the current market conditions.  I believe that Alesco’s strength on Monday shows that the market is finally pricing in all of the company’s issues both those that are real and those that are perceived, with the IndyMac failure being almost certainly priced into the stock.   

I am not going to go into any detail on Alesco at this time, as there are already several great articles on the company out there.  The most recent one can be found here.  Brian King, the author of the piece does a great job of outlining the case for Alesco.  As we all know, IndyMac has been in trouble for sometime and Alesco with its small stake in financial securities tied to the mortgage bank’s trust preferred securities was viewed as being particularly risky, even though the direct impact of these securities was minimal.  As a result of IndyMac situation, the failure of Kleros mortgage backed securities and the general fear of financial stocks the share price of the company has fallen dramatically over the last year.  The company is currently sitting on a little over 100 million dollars in unrestricted cash after paying out it’s most recent divided, has zero short term debt, a relatively strong leveraged and commercial loan portfolio and some of the best connections in the business.  As a result, the company is uniquely positioned to profit from the current turmoil in the credit market after it undertakes significant changes to its corporate structure. 

The future for Alesco will be interesting to watch.  As the Kleros securities deteriorate, the company will likely be forced to drop its REIT status and its current high dividend payout.  I am currently estimating that this will occur at the start of 2009, giving current shareholders two more dividend payments for a total of 40-50 cents a share.  Once these dividends are paid and the fiscal year is closed out, I would hope to see Alesco drop the REIT status and convert to a standard C-Corp. 

If this were to occur it would allow the company to invest its significant unrestricted cash, which will likely be somewhere near 85 million dollars at the end of the year as well as its future free cash flow into investments capable of generating significant returns for shareholders.  Examples of such investments could be the purchase of commercial mortgage backed securities, leveraged loans and normal mid-size commercial loans that have been shunned by your typical commercial bank.  Such a change would allow the company to begin to develop into a pre-deposit CapitalSource (CSE). 

Another possibility for the company is to become one of the premier asset gathers in its field of expertise.  The company’s large and diversified collection of trust preferred securities could potentially allow them to raise and manage investment partnerships that invest and lend money to smaller community and regional banks in either the form of a direct equity or trust preferred investment by their managed portfolios.  As the trust preferred market is currently nonexistent, any Alesco managed funds could likely garner significantly higher interest rates on their investments then the rates available before the credit crunch.  If the company were to find this too difficult, they could become an asset gather specializing in the management of leveraged loan portfolios.  Such a shift in company focus would eliminate much of the risk from the company, as it would have no direct exposure to the portfolios that it would be managing for its clients.  It would instead begin to receive management fees tied to its assets under management.     

If the company wanted to ratchet up returns and was willing to deal with increased regulatory oversight the company could purchase a deposit-based institution such as an Omni Financial (OFSI).  Such a deposit base would allow the company to fund its leveraged and commercial loans at lower rates then would otherwise be available to it.  There are quite a few community banks with large deposit bases and low market capitalization that the company could purchase to expand its funding base with relative ease, such an action would be the most positive in my opinion as it would symbolize management’s commitment to the company for the long-term.  If the purchase were to resemble that of CapitalSource’s and follow the CapitalSource model, it would be particularly positive for shareholders.

The final possibility for the company would be its sale to RAIT Financial (RAS).  The company’s are related through their ties to the Cohen Family and their sharing of the same office complex so such a deal would likely be positive to both groups of shareholders, especially if it were an all stock offer.  RAIT Financial shareholders would own a company with a stronger balance sheet while Alesco shareholders would join a company with a much stronger dividend platform.

Any of the above scenarios would be beneficial for Alesco’s shareholders and while they all involve the elimination of the dividend after this year’s payments, the long-term benefit of changing the nature of the business will be more then enough to offset the dividend elimination.  I talked early about the the stabilization of the Commercial REIT's financials and I think it is now fairly safe to say that the stocks have begun to stabilize as well.  The failure of the stock to collapse on the headline provided by IndyMac’s failure is a sure fire sign that the stock has reached bottom and now offers decent value and potential upside to investors willing to take on the company’s speculative nature. 

For Further Review:

Brian King's Article on Alesco

Disclosure: Long AFN              

Betting on a Banker's Bank

I have found over the years that one of the most successful investments that one can make is to put a little money in a privately held community bank at its inception.  A common strategy taken during the start up of a community bank is for a group of local investors to acquirer a state bank charter from a small rural bank and then to move that charter to a larger urban area within the same state.  Another strategy used to create a community bank is for a group of investors to apply for a de nova state or national charter, while this may allow for clean start it is usually more expensive.  Either strategy assures a large return on investment for the original investors.  Community Banks are generally much safer then their larger peers as management is usually more conservative in its lending methodology and does not take positions in opaque financial securities or instruments.    

Typically, the life span of a community bank follows two paths.  Both paths start with the bank growing exponentially as it successfully uses the connections and deposits provided by its original investors to fund high return commercial loans.  After several years to a decade the bank will reach 400-500 million in deposits, it is here where the investors will have to make a decision as to whether they wish to remain independent or be acquired by a larger regional bank.  In remaining independent, the investors are hoping that the bank’s current management team has what it takes to grow the bank into a competitive but likely smaller regional bank.  If they choose to be acquired, they generally see returns of between 200-400% on their original investment and typically receive stock in the acquiring bank.  Both paths are extremely profitable but are unfortunately unavailable to the typical retail investor.  That is why I find the story of Mercantile Bancorp (MBR) to be particularly interesting.

In an earlier article, which can be found here, I talked about what are some important attributes that investors should look for when looking at regional banks.  Many of the criteria that I discussed in that article can be seen in Mercantile Bancorp, as I believe it to be the only example of a community/regional bank hybrid that is publicly traded.  Mercantile Bancorp is a bank holding company out of western Illinois.  Along with its main subsidiary, Mercantile Bank out of Quincy, Illinois, the company also has five other wholly owned community bank subsidiaries.  They are Marine Bank & Trust out of Carthage, Illinois, Perry State Bank out of Perry, Missouri, Brown County State Bank out of Mt. Sterling, Illinois, Royal Palm Bank out of Naples, Florida and HNB National Bank out of Hannibal, Missouri.  These banks are all doing quite well as they have managed to ride the strength of the agricultural economy in the Midwest.  The one exception is of course Royal Palm Bank, which has had some trouble recently in the Florida market.  Nevertheless, these banks provide the holding company with a diversified geographic footprint that is rare for a bank of its size.

In addition to these holdings, the bank also has a tradition of taking minority and majority stakes in newly established privately held community banks.  While the timing of the company taking its stakes varies, they have all for the most part been wildly successful over time.  Currently the company has ten such stakes.  Below I have listed out the banks in which they have a stake, their percentage ownership and my own estimated value as to what these stakes are worth at one times book value.

-5% of Integrity Bank out of Jupiter, Florida.  Integrity was founded in the first part of this decade and while it has a large number of construction loans, its balance sheet has remained in decent shape.  This stake could be worth as much as $750K dollars at one times book value. 

-.8% of Premier Bank out of Jefferson City, Missouri.  Over the last decade Premier was one of the fastest growing privately held banks in the state of Missouri, since 1996 its assets have risen from 25 million to over 1.3 billion.  The bank is currently expanding into Illinois and Texas. This stake could be worth as much as 1.2 million dollars at one times book value.

-5% of Premier Community Bank out of Crestview, Florida.  This Florida bank is doing surprisingly well; this can be attributed to its location in the panhandle region, which is seeing a large influx of retirees who do not default on their mortgages.  The loan quality at this bank is impeccable.  Mercantile Bancorp’s stake could be worth as much as 1 million dollars at one times book value. 

-4.1% of Paragon National Bank out of Memphis, Tennessee.  Paragon arose out of the ashes following the purchases of Union Planters, National Commerce and Trust One by larger regional banks.  It has grown rapidly since it’s founding driven by a strong commercial loan base and a great management team.  This stake could be worth as much 1.3 million dollars at one times book value. 

-.1% of Integrity Bank (ITYC) out of Alpharetta, Georgia.  This investment has been a disaster; fortunately, it is the smallest holding in the company’s bank portfolio with a value of 60K dollars at one times book value.

-1.3% of Enterprise Financial (EFSC) out of St. Louis.  Enterprise is in my opinion the best small regional bank in existence.  Its loan portfolio is flawless; management is superb and they are uniquely aware of the opportunity that they have to create a large amounts of shareholder value.  Mercantile came into possession of this stake through its ownership interest in a bank by the name of Northstar, which was acquired by Enterprise in an effort to get into the Kansas City market.  This stake is worth as much as 2.25 million dollars at one times book value.  On a side note, Enterprise’s stock has declined recently in part as a result of the expiration of the shareholder lockup agreement with the former Northstar shareholders.

-4.4% of Solera National Bank (SLRK) out of Denver.  Solera is a unique story, it is one of the few banks in the Denver area that caters almost solely to the Latino marketplace.  As a result, it has the ability to show tremendous growth in the years ahead.  While the bank itself is currently in some trouble, the holding company is quite strong.  This is the result of the holding company’s recent IPO, in the next several quarter I would not be surprised to see the holding company contribute more capital to the bank.  Mercantile Bancorp’s stake is currently worth as much as 750K dollars at one times book value.

-5.0% of Bank of Manhattan (MNHN) out of Los Angeles.  While the bank’s location should be of a concern, it is important to note that this is a de nova bank that was founded in mid August of 2007.  As a result, they have no loan issues of note.  In fact, they are growing exponentially due to their competitors’ inability to lend to high quality customers because of the credit crunch.  I believe that this holding has the real potential to be a huge winner for the company, given some time.  This stake is worth as much as 1 million dollars at one times book value.

-5% of Brookhaven Bank out of Atlanta.  While Atlanta’s banks are a mess because of their large residential construction exposure, Brookhaven is too new to be in any significant trouble.  I would imagine that its story is going to shape up much like the Bank of Manhattan, which I mentioned above in the previous bullet.  The company’s stake is worth as much as 1.1 million dollars at one times book value.

-54.6% of Heartland Bank out of Leawood, Kansas.  Heartland is Mercantile’s loan majority owned bank and likely one of its best prospects for growth in the future.  Heartland is run by a local banking family with a long history with North America Savings Bank (NASB) as a result their ties and connections to the community will help to drive tremendous growth down the road, even if they are struggling with certain issues right now.  The Kansas City market is extremely competitive and as a result, breeds well run banks.  Another local bank, Metcalf Bank, was taken out at over three times book value.  This purchase goes to show you the multiple at which prime community banks can be purchased.  Mercantile Bancorp’s stake in Heartland is worth as much as 9.5 million dollars at one times book value.

These stakes have a total book value of nearly 19 million dollars.  While this may not seem like much in relation to the company’s total market capitalization of nearly 140 million dollars it is important to remember that the 10 stakes that I laid out above are all likely worth 3 to 4 times the current book value down the road.  In five years the value of its minority and majority subsidiaries is likely to be somewhere between 60 and 80 million dollars.  In order to see these returns, the only thing that Mercantile must do is ride these investments through the current trouble in the banking industry.  There is always a regional bank willing to pay top dollar for a niche community bank located in an area where the regional currently does not have a presence.  It is only a matter of waiting for them to come a long.  If Heartland Bank and the Bank of Manhattan pan out in the way I think they well it is very possible that the total bank portfolio well be worth in excess of 100 million dollars.   

The company’s six core wholly owned subsidiaries are all likely worth 2 to 2.5 times book value as well, once the cycle turns.  This gives these banks a potential value of between 210 and 270 million dollars.  Greater returns are possible if management were to follow a Hawthorn Bancorp (HWBK) strategy and merge all its different wholly owned subsidies under one operational structure, as the synergies would likely be tremendous.  Even if they keep the banks separated they should all do fine as a result of the strength in America's agricultural areas.   It should be clear by now that Mercantile Bancorp offers a safe way to play the return of multiple expansion in the community bank subsection of the banking industry.  I believe that it is possible that Mercantile could be worth as much as 350 million dollars or 2.5 times its current price within the next five years.  

For Further Review:

MBR's 10-Q

Disclosure: Long EFSC

Fed Mandated Capital Ratios for Investment Banks?

This weeks news that the Federal Reserve will likely be given a hand in the regulation of investment banks marks a new era for stand alone investment banking firms.  The agreement between the SEC and the Federal Reserve, once formalized by congress, will ensure that greater regulation of the financial markets occurs.  Whether this new bout of regulation will protect the economy from the fallout of a failure of another investment bank, increase general market transparency or encourage rampant risk taking is yet to be seen.  One thing though is certain, Goldman Sachs (GS), Lehman Brothers (LEH), Morgan Stanley (MS) and Merrill Lynch (MER) as the last significant remnants of a once highly fragmented industry will face considerable pressure over the next several years to revamp the way they support and run their businesses.  While it is too early to suggest that they will cease to exist as independent entities, it is reasonable to conclude that their business model will be significantly altered.   

If the Federal Reserve were to regulate the investment banks in the same manner that they regulate commercial banks significant restrictions would be placed and the firm’s capital and liquidity positions.  Government regulators would monitor the investment banking firm’s capital and liquidity position at all times, something I imagine the executives of the investment banks must just be dreading.  The regulators would without a doubt make it nearly impossible for these firms to carry out their business in a manner similar to the way they have operated over the last several decades.  Whether or not this is a good or bad thing is entirely too long of a discussion for this article but it is nevertheless something that should not stray too far from the back of our minds as it has profound implications on the financial markets.  The investment banks by and large, with the exception of Goldman Sachs, have made every effort possible to prevent industry wide pro-transparency measures.  It is profoundly difficult to calculate the capital ratios for the investment banks.  While they may enjoy the allusion of invincibility that this gives them, it ensures that investors, analysts and regulators can only rely on rough calculations to construct a picture of the bank’s financial soundness.  In times of turmoil, such as last March, such a lack of transparency can result in failures similar to what occurred at Bear Stearns.

Any capital ratios imposed by the Federal Reserve would likely use the current ratios established for commercial banks as a base.  Currently the Federal Reserve requires that commercial banks in the United States have a tier one capital ratio, which is the most basic of the ratios used, to be in excess of 4%.  If the ratio is between 4% & 6%, the bank is considered to be “adequately capitalized”; however, if the ratio is above 6% the Federal Reserve deems the bank to be “well capitalized.”  While such a distinction may seem minor, it is actually incredibly important, as the Federal Reserve tends to prefer banks with ratios well in excess of 6%.  In my own personal experience, I have found banks with tier one capital ratios lower then 8% tend to be particularly nervous about the possibility of increased oversight by the Federal Reserve.  Such a policy helps to create a non-mandated but market preferred ratio.  Investment banks with their increased asset and liability volatility, continuous trading and thorough use of their own balance sheets will likely be required to have significantly higher capital ratios then their commercial bank brethren, should the Federal Reserve win ultimate control over the capital and liquidity regulatory framework for investment banks.

While it is quite difficult to come up with the current tier one capital ratios for the investment banks, a guess can be made based on their quarterly and annual reports.  Of the four major U.S. investment banks only Goldman Sachs does a decent job of breaking out its capital ratio, the others tend to guard theirs intensely.  Based on my rough calculations Goldman Sachs has a tier one capital ratio of between 10.5% & 11%, Lehman a ratio of between 7.8% & 8.3%, Morgan Stanley a ratio of between 7.1% & 7.6% and Merrill Lynch a ratio somewhere between 7.75% and 8.25%.  As you can see, Morgan Stanley, Lehman and Merrill Lynch would all be of concern to Federal Reserve regulators, if they were commercial banks instead of investment banks.  However, given the Federal Reserve and SEC’s new cooperation agreement the Federal Reserve will likely up its pressure on the investment banks to raise more capital to shore up their capital ratios and strengthen their financial position.  The capital raises are likely to be significant as the firms are already in danger of falling below the “well capitalized” benchmark should the current streak of losses continue into the next several quarters.   The situation would become more perilous should the Federal Reserve mandate a minimum capital ratio for investment banks of in excess of 6%.  I would personally not be surprised to see a “well capitalized” ratio for investment banks of 8% and a “preferred ratio” of 10%.  Such a preferred ratio would force Lehman Brothers, Merrill Lynch and Morgan Stanley to go out and either raise tens of billions of dollars or to somehow become affiliated with a deposit based institution.  Regardless, the investment banks and the individuals who follow them are in for an interesting next 8-12 months.              

For Further Review:

Bloomberg Article on the Federal Reserve/SEC Agreement

Disclosure: None 

Following the Coopermans

While it is important to always undertake a large amount of due diligence when researching an investment idea, it is just as important to make sure that after a period of time you’re not the only one who has come to the conclusion that your particular investment is so extraordinarily undervalued.  That is why I have been thrilled that one of the premier father-son duos in value investing has been investing along side of me in the Resource America companies (REXI, RSO) and the Atlas America companies (ATLS, AHD, ATN, APL).  For those who are interested my investment thesis on Resource America can be found here, my Atlas America thesis here and my Atlas Energy Resources thesis here. 

Leon Cooperman, founder of Omega Advisors and former head of Goldman Sachs Investment Management along with his son Wayne Cooperman founder of Cobalt Capital Management have built considerable stakes in the Atlas and Resource America companies along with nearly every other company ran by the Cohen family.  The Cooperman’s through their separate hedge funds control in excess of seven billion dollars; as a result, they are incredibly deep-pocketed investors and have the ability to act as stable components of any company’s shareholder base.  The Cooperman’s, as seen in their large ownership stakes, clearly have a considerable amount of faith in these companies prospects and in the ability of the Cohen family to run them.  I view their ownership stake as an affirmation of my investment thesis.  Below I have outlined the stakes of both Leon Cooperman and his son Wayne Cooperman in the Cohen companies.

Leon Cooperman’s Omega Advisors:

-       1,566,100 shares or 9% of Resource America

-       3,449,333 shares or 13% of Resource Capital Corp

-       555,556 shares or 2% of Atlas Pipeline Holdings

-       2,189,618 shares or 6.5% of Atlas Pipeline Partners

-       2,219,666 shares or 8% of Atlas America

-       3,727,627 shares or 6% of Atlas Energy Resources

-       3,444,763 shares or 5.5% of RAIT Financial Trust

-       654,358 shares or 1% of Alesco Financial

Wayne Cooperman’s Cobalt Capital Management:

-       128,240 shares or >1% of Resource America

-       24,500 shares or >1% of Resource Capital Corp

-       194,445 shares or >1% of Atlas Pipeline Holdings

-       689,936 shares or 2% of Atlas Pipeline Partners

-       2,447,307 shares or 9% of Atlas America

-       4,721,185 shares or 7.5% of Atlas Energy Resources

From these holdings we can see that between the two they control over 17% of Atlas America, nearly 14% of Atlas Energy Resources, 8.5% of Atlas Pipeline Partners, a little over 10% of Resource America and 14% of Resource Capital.  Given the similarity of their portfolios, especially when it comes to their holdings in the Cohen companies I would not be surprised to see Cobalt Capital boost its stake in Resource America just as Omega Advisors did this last week.  As they increase their stakes in Resource America, I have no doubt that other value investors will begin to piggyback on their trades.  It is my hope that this will give the stocks of Atlas America, Resource America and their publicly traded subsidiaries the momentum they need to move dramatically higher.  The Cooperman’s large stakes in the Cohen companies clearly gives support to many of their companies and their unique operating models.  I am more then content on continuing to profit alongside of these two great value investors. 

Disclosure: Long ATLS, AFN, REXI