The conditions seem right to go contrarian and short financials.  These firms are going to raise more capital as the recession worsens and losses related to the U.S. mortgage crisis grow.  The sector is also likely to see more dividend cuts and lower returns as a result of deleveraging.  Morgan Stanley analysts Betsy Graseck, Cheryl Pate and Justin Kwong came out with a similiar assessment of the sector in a research note on Monday.  The analysts also said that the credit markets problem are leading to a situation that is worse than the recessionary environment of 1990 and 1991.

Given the continued disarray in the credit market and the other headwinds faced by the sector, like a U.S. recession and deteriorating consumer credit performance, the recent rise in financial stocks may be premature.  Financial stocks in the S&P 500 are up more than 15% since their lows in mid-March when Bear Stearns got saved.  The difficulties in the credit markets are not even half over and fixing these markets will take even longer.  There are still lots of risks to financial firms.  The prince believes that credit deterioration will accelerate and banks will dilute earnings by raising more equity capital.  With all the aforementioned risks to the downside The Prince thinks it makes sense to short financials.  As the Prince has written earlier, an easy way to sell short financials is by buying SKF.

Disclosure: The Prince owns no positions long or short in financial firms or related ETFs composed of financial firms.

Here are the details of the trade: There are many oil ETF’s that try to track the price of oil.  Macroshares created two such securities, UCR & DCR, which trade back and forth without using futures.  Gary makes this clear when he writes that, "they [UCR and DCR] simply pass the price changes back and forth between the two funds so they don’t have to deal with contango and backwardation. But they do have to deal with a different problem - trading at a premium or a discount."  The long oil security, UCR, tracks a barrel of light sweet crude on the NYSE.  The “Net Asset Value” per share of UCR is the price of oil divided by three.  DCR, on the other hand, is inherently short oil since it is structures so that DCR = $40 – UCR.  The NAV right now of the DCR is $4.97, and the stock is trading at $10.25, which is a 106% premium.  This means that investors are anticipating that the price of oil is going down.

We have to question why this security’s price is so far off the net asset value of its assets.  ETF’s trade off of their NAV’s all the time, but normally not to this extent.  These two linked ETFs, according to their prospectuses, only payout net present asset value if oil closes above $111 on the NYSE for three consecutive days.  If this happens the security terminates, and Macroshares pays out the NAV at the close of the third day (approximately ($120 – (Barrel of Oil))/3).  This eventual termination triggering a payout is the only mechanism that keeps the NAV close to the price of the ETF’s shares. We are very close to that trigger currently (with light sweet crude closing at $105.50 on Friday).

So the play is to sell short DCR with the thinking that the premium between the price of the ETF and its NAV will close.  If oil continues to move towards $111, the premium should close in a manner that is similar to the increasing value of a stock option approaching the at-the-money point.  Of course, to just short DCR or go long UCR you take on long exposure to the oil price when all you really want is exposure to the spread between the NAV and the price of the ETF.  Each share of DCR or UCR gives the buyer long exposure to 1/3^rd of a barrel of oil.  There are two ways to hedge this exposure.  The cheapest option is to go short one month oil futures.  An easier way to do this is to short USO (another ETF that tracks the price of oil much better). 

In summary here is the trade:

Short DCR or Long UCR, each will give us exposure to 1/3^rd barrel of oil long.

Hedge oil exposure by selling oil futures in the amount of:

DCR/UCR shares * 1/3 = Number of Barrels of Oil to Short

The payout if the spread closes is largest if you are able to short DCR since the spread is larger compared to the spread on UCR.  Some investors will have to settle for going long UCR since they will not be able to get available shares of UCR for short sale borrow.  Some prime brokerage accounts should be able to short DCR.

Why does this inefficiency exist?  It is worth nothing that market cap of DCR and UCR combined is only approximately $85mn.  So most hedge funds/institutions cannot exploit this mis-pricing at scale without substantially moving the price.  It is also worth noting that these two ETF’s were created when oil was much cheaper and the thought of oil hitting the $111 termination price was an afterthought.

Here is an example of what this trade would look like with a $50,000 short position in DCR.

Short DCR with $50,000 at $10 per share which leaves the investor long 1666 barrels of oil.  Sell futures on 1666 barrels of oil or short 2080 shares of USO. (each share of USO longs approximately .795 barrels of oil). If the spread closed tomorrow, the investor would stand to make $5*5000 = $25000, or a 50% return on the long position. However, note that depending on the mechanics of the trade, the investor may get short proceeds back from the broker on the short position, which means the return on capital invested in the trade would be much higher.

Here is an example of a $10,000 long in UCR.

Long UCR with $10,000, which, at $30, makes the investor long 111 barrels of oil.  Sell futures on 111 barrels of oil or short 141 shares of USO.  If the spread closed tomorrow, the investor would stand to make $5*333 shares = $1667, or a 16.7% return on the long position.

The risk in this trade is that spread between the NAV and price on the ETF you decide to trade widens.  If Oil really shoots through the roof like some analysts in the WSJ article suggested you may loss more money on the oil short than you gain on the spread closing.

Figure 1: Sensitivity analysis assuming a $50,000 position, short 4,878 shares of DCR.

Figure 2: Sensitivity analysis if oil goes over $120 in 3 day Termination Period of DCR.

The loss on the short oil position could be protected by buying a call option on USO or Oil futures at 120 to 130.  You could probably buy a deeply out of the money call option on oil futures pretty inexpensively.  If an investor wants to go without the call option on USO or oil futures then you are taking a view on whether oil is going to explode above its current price.  If he or she doesn’t even go short oil to hedge your short of DCR then you have to express a view on whether oil is going up or down. 

Let’s turn our attention finally to speculation on the direction of the price of oil.  The Prince thinks the best oil analyst in the marketplace is T. Boone Pickens. Pickens sees the long-term trend for oil as up but he sees prices going back into the low 90s periodically this year.  Crude oil futures are firmly above $100 a barrel right now, so Pickens would seem to be on the other side of that trade.  Although he is not alone according to the WSJ:

Oil has traded at an average price of $95.12 a barrel this year on the New York Mercantile Exchange, up 65.5% from the start of last year. That has left many analysts’ forecasts in the dust. Lehman Brothers, for example, recently boosted its first-quarter forecast for benchmark Nymex crude to $93 a barrel, up $7 from its earlier outlook. The bank sees oil averaging $86 this year, but acknowledges the pitfalls it’s facing.  "We still expect a correction in the prices of several commodities, notably crude oil, but investors’ recent focus on longer-term bullish structural factors, many of which we agree with, make it difficult to call for anything other than a pause in oil’s rise," Edward Morse, Lehman’s chief energy economist, said in a letter to clients on Thursday.

The Prince agrees that oil, commodities, and other hard assets are being supported by unprecedented demand from China’s infrastructure needs.  Furthermore, these assets are a good place to put your money to try to escape a falling dollar or a dollar which will probably be up against some inflationary pressure as rates continue to be cut.  Furthermore, a recession in the U.S. and the slowing effect it would have on other export driven economies like China’s will certainly take some of the pressure out of the demand side.  Although the WSJ does point out that a team of Goldman analysts has contradictory scenario.  

A team of Goldman Sachs equity analysts, who three years ago made waves by predicting a price "super spike" to as high as a then-unheard of $105, weighed in again last week. They suggested prices could rocket as high as $200 a barrel if the U.S. economy regains momentum or a wrench is thrown in the world’s oil supply.

Mr. Wittner at Société Générale in London is on the other side of Goldman’s analysts.

Analysts say there are plenty of actual tensions to underpin prices. Michael Wittner, global head of oil research at Société Générale in London, acknowledges the impact of financial flows on commodities. But he says strength in futures prices for delivery dates years into the future demonstrates that real concerns about supply and demand underpin today’s market frenzy.   Contracts for delivery four years from now, for example, settled at about $97 a barrel on Friday. "The long-term argument is strong Asian-led demand growth meets maturing supply," he said. Mr. Wittner’s last forecast, made in December, saw crude prices averaging $81 a barrel this year. "I am in the process of revising the forecast," he said. "I’m not revising it down."

The Prince is going to have to side with Mr. Pickens and Mr. Wittner on this one.  He sees spot oil going to $90 over the next three months and possibly as low as $85 periodically throughout 2008.  The trade discussed above if this forecast happens as the NAV to price spread closes while money is made on the oil short.

Disclosure: The Prince does not have a position in UCR, DCR, OIL, USO, or the oil futures market.

In case you haven’t been following the BAC-CFC deal closely, here is a summary of the shareholder actions that have transpired since the deal was announced.  First, there was SRM Global Fund with a 5% stake in Countrywide opposing the BAC deal .  This wasn’t big news because all the aforementioned reasons for deal to go through still held and it was accepted that SRM did not have enough allies to make its wishes come to fruition.  Then Legg Mason told us last week that they received approval to raise their stake in Countrywide to 25%, and their stake has already been increased up to 15% of the company.  Also, Capital World bought a 6.1% stake in Countrywide recently.  Capital World hasn’t specified whether they will take an activist role in trying to stall the deal but taking a stake that large must mean that they believe that the spread of the current price to the offer price (or the higher offer price if it is revised upwards) is attractive. 

Additionally, Bill Miller of Legg Mason in a note to investors indicates that he is not in favor of Countrywide sale at the current prices believing that Countrywide’s infrastructure/market position/market share are worth more than what BAC is offering.  The Prince has said that the deal consummated at such a low price will be long-term accretive to BAC.  So he can see Miller’s argument that BAC is getting CFC too cheaply but the strongest argument that Countrywide is being sold too cheaply is the absence of any other bidders.  Miller, whose Legg Mason Value Trust fund is already the single biggest investor in Countrywide, said the Office of Thrift Supervision gave him the right to raise the fund’s stake on January 18.  Oddly enough, CFC has put a so-called poison pill in place that makes it potentially prohibitive for Miller to raise his stake above 15 percent, he said in a letter released on Tuesday.  If CFC wants to discourage activist investors or new bidders then putting a poison pill defense in would make sense for CFC management but not for CFC shareholders (The Prince doesn’t find this surprising since CFC has regularly done right by management at the expense of shareholders, witness the share sales that are now be investigated by the SEC).  What does trouble me about Miller’s logic and my own is that if CFC was such a great turnaround candidate why wouldn’t be see the PE shops (even absent financing), other banks, other mortgage originators, and even foreign investors making higher bids for Countrywide.  The lack of competing higher bids does suggest that Countrywide may actually be valued properly by Bank of America’s offer price.

Obviously given the fact that CFC’s powerful institutional shareholders are willing to go activist on the deal there is room for investors to buy CFC and short BAC in hopes that a new higher bid will emerge or BAC will be forced to raise its bid.  Even if a higher offer isn’t made an investor could still benefit from appreciation in CFC as other investors interpret the actions of the large activist investors or if the deal closes at the offer price.  Arohan points out that he see the most likely result is that BAC sweetens it offer by offering more BAC shares per share of CFC.  He also reminds us that the possibility for CFC to declare bankruptcy is still looming out there.  The Prince tends to disagree with this argument.  CFC wouldn’t go bankrupt with an offer from BAC on the table.  CFC might become insolvent if it losses its ability to obtain short term credit especially if the FHLB cuts it off.  The Prince doesn’t see the FHLB cutting CFC off.  Also, for other debt holders in CFC forcing CFC into bankruptcy if it became insolvent would not serve their interests, since they would recover less on their bonds if bankruptcy is forced than if the left the company alone to be subsumed by BAC.  Some of CFC’s corporate debt may actually be paid off at higher par values than it is currently trading in the secondary market by BAC as part of the merger.

If you interpret the developments on the ground the same way The Prince does and you have a high tolerance for risk then you should short BAC and buy CFC.  If you want an alternative strategy for playing this strategy check out this post by Arohan.

A relevant quote from Bill Miller:

"What makes the decision puzzling is that the company was seeing solid deposit growth, has no apparent capital problems, was not forced by the regulators to seek a merger partner, and is in sufficiently sound condition to have declared its regular quarterly dividend at the end of January," Miller wrote. The portfolio manager said the Federal Reserve cutting interest rates sharply after the deal was announced was "quite beneficial to Countrywide by reducing its costs of deposits, and by setting off a wave of refinancings that should significantly increase its loan production." Miller said Legg Mason Capital Management has increased its holdings to about 86 million shares of Countrywide, or 14.9% of shares outstanding. "We will support the deal if we believe it is in the best interests of shareholders to sell to Bank of America, and we will vote against it if we believe greater value can be achieved by having Countrywide remain independent," he wrote.

An excerpt from a news story by Marketwatch (bold and underline added by The Prince):

Countrywide reported a loss of $422 million for the fourth quarter on Tuesday, a more than twice the consensus view of analysts the previous week. The loss was the first in the company’s 25-year history, with overdue loans increasing to 7.2% from 4.6% and more than a third of its subprime loans in active default.  That was a marked departure from Mozilo’s pledge two months ago that he would return the lender to profitability by the end of the year.  But is Countrywide getting out just as conditions for lenders begin to improve?  The company has recently seen an uptick in deposits at its savings bank and should reap the rewards of Fannie Mae and Freddie Mac’s new ability to purchase jumbo loans.  In addition, a spate of new interest rate cuts introduced by the Federal Reserve could make the borrowing environment even more hospitable to strapped lenders. Gordon also points out that the value of Countrywide’s existing loan origination and loan servicing platforms alone make it a very valuable asset.  "There is a big shortage of loan servicers right now, and at this price, they basically gave it to them for nothing," Gordon said.  The infrastructure and existing loan portfolio that Bank of America inherit as part of the deal would make it the nation’s largest mortgage lender, a significant leap from the fifth place spot the bank held in 2007. Analysts estimate that if the deal does go through, B. of A. will eventually oversee or originate close 25% of all home mortgages.  Close to 90% of the mortgage business is now in the hands of the top 25 lenders, making an acquisition on the scale of Countrywide’s unlikely to come along any time soon. Still, there are opportunities for smart bargains.  "A lot of the consolidation that happens in ‘08 will be through bankruptcy," he said. These could provide valuable sales of piecemeal assets, allowing many banks and lenders to snap up essential origination and servicing platforms at bargain basement prices.  It may be for this reason precisely that Bank of America is staying firm in its resolve to go through with the deal. CEO Kenneth Lewis told a New York audience that despite the significantly larger losses, the bank will forge ahead with the acquisition, saying that the original deal is still "a go."  Lewis’s confidence could be rewarded, analysts said, as there are few possible suitors sitting on the sidelines.  "I’d be hard pressed to say there’s a better buyer out there," Gordon said.

 
In October 2007, Platinum Equity (a respected Los Angeles PE shop) agreed to buy Covad (DVW) for $304 million in cash, or $1.02 a share.  This deal’s rationale for Platinum was an attempt to capitalize on growth in high-bandwidth services.  Covad agreed to a $12 million termination fee, amounting to 3.95% percent of the equity value of the transaction.  Covad sells voice and data systems to companies.  This includes Voice over IP services and high broadband connections like T1 connections in major U.S. cities.
Covad currently trades at $0.83 and the deal is expected to close at the end of the 2nd quarter of 2008.  If you do the math that is a roughly 23% return in six months if the deal closes as planned. This deal is so small that it will not be hurt by the lack of credit financing.  Platinum could do this deal solely with its own equity. 

The Prince can identify a few risks already that the deal may not close.  The deal has not been voted on by shareholders and there is a  shareholder lawsuit  claiming $1.02 is too low an offer.  However, if the deal fails because of the lawsuit then $1.02 should prove to be a floor for the stock price in the near term.   Covad emerged from bankruptcy in 2001 and made deals with SBC and Earthlink which carried obligations coming due in 2008-2009.  Covad has been issuing shares to pay these obligations so know Earthlink owns 30% of Covad and SBC owns 5%.  It would seem that Earthlink and SBC must approve the deal for it to go through and they are not part of shareholder suit.  Of course, SBC or Earthlink could come forward with a higher offer for the entire company.

 
Also, aside from the merger arbitrage play there is the possibility that another higher bidder will emerge.   If you read the 144 Proxy see that there were 4 other strategic buyers that made offers and some these offers were above $1.02.  According to the proxy, these bidders wanted more time to evaluate the books before signing an official term sheet.  The deal with Platinum might be a way for Covad to start the bidding at 1.02 rather than announce they are “exploring strategic alternatives”.  This puts pressure on strategics to come forward with serious deals that are superior to the $1.02 all cash offer.  Rumors say that the strategics are ATT, DirecTV, Earthlink and Qwest.

Here are some links that may answer my readers questions.  You can find the 144 Proxy through 10-K Wizard or the SEC’s Edgar system.

http://www.covad.com/web/about/faq.html
http://www.covad.com/web/about/newsroom/pressroom/pr_2007/news_release_102907.pdf
http://www.platinumequity.com/site/action/aboutplatinum/

The Prince doesn’t see much downside for this trade.  If the deal doesn’t close because of a shareholder lawsuit he believes another buyer will emerge with the $1.02 all cash offer serving as a floor for a new bid.

My short ideas to play this idea are Urban Outfitters (URBN) which primarily focuses on women’s clothing.  The stock is richly valued on an P/EBITDA and P/E basis considering its low EBITDA margins and low ROE.  Seems like high multiples given how crowded and competitive their niche is and a buyout of this company is impossible now given the state of the debt markets.

Saks (SKS) is also richly valued and I would suspect that their same store sales will be down significantly.  They did have a phenomenal 3rd quarter but I can’t see them sustaining momentum in a slowing economy especially since they have publicly said that they have seen pressure on lower income clients.  I know global luxury spending is growing but SKS only has stores in the U.S.  The wealthy will also be cutting back on purchases this holiday facing smaller bonuses, smaller home equity, and less job security.

Macy’s (M) also would seem like a good short since the company has really scaled back its forecasted sales.  However, the stock is pretty oversold and has taken a beating recently.  There may be some bargain hunters jumping on this one.  This post from Customers are Always about Macy’s is interesting.  An LBO of Macy’s is off the table, it is just too big given the leveraged loan markets weakness.  The LBO math also doesn’t work even if you set up a separate entity to issues CMBS on the real estate holdings.  Although, if the price of the stock falls further it may begin to work.

The New York times suggests Chico (CHS) which seems fairly valued given the bad forward outlook and Ann Taylor (ANN).  Both focus exclusively on women’s clothing aimed at the middle and upper class.  

Obviously the bigger story in The Times story is that the consumer is under pressure.  If households are worried about losing their house the last thing the mother is going to do is spend money on clothes for herself. 

The index is 200% of the inverse of the performance of the top financial firms in the U.S. found in the DJ U.S. Financials Index.  Given the subprime mortgage mess, the closed down credit markets, closed leverage loan markets, and recession fears does anyone really think that financial stocks are ready for a rally.  SKF is very volatile since it is twice the inverse exposure.  I have been buying SKF in the low 90s and high 80s during weeks when I think there will be significant negative market news for financial stocks.  SKF also is a great hedge on financial stock exposure.  For example if you owned $10K of GS and $10K of MS you would only need to be 10K short of SKF to be market neutral on the financial sector with these names.