Whitman Throws Down the Gauntlet

The latest shareholder letter from The Third Avenue Fund has Marty Whitman firing back at William Ackman, a hedge fund manager I have written about previously, over MBIA:

"...invested in MBIA Surplus Notes at a yield to call of slightly over 14% per annum. The MBIA Surplus Notes appear to carry very small, or non-existent, credit risk, and thus are considered by management to be a near-cash investment (albeit the MBIA Surplus Notes, unlike cash equivalents, are subject to market price fluctuations)."

"On February 11th, TAVF acquired from MBIA, 10,610,425 shares of MBIA Common at $12.15 per share. This brought the Fund’s holding to 23,148,845 shares of MBIA Common, or about 10% of the issue outstanding.MBIA is now strongly capitalized. It ought to qualify easily for an AAA rating with a $17 billion claims paying ability. If so qualified, MBIA would be in a position to underwrite a large amount of profitable new business."

And then Whitman gets the knives out:

"Ackman does not seem to understand the Property and Casualty (“P&C”) Insurance business and its sources of profitability. Ackman believes that the Bond Insurer Model does not work because the insureds are able to buy an AAA credit rating so cheaply. The facts are that Bond Insurance is one of the more profitable P&C businesses."

"(Ackman) argues that prices, as determined by marks to market, or mark to model, always deserve 100% weight. This is arrant nonsense. Market prices do deserve dominant weight in an analysis where the portfolio consists wholly of common stocks and non-performing loans held in trading accounts. Market prices deserve little or no weight, when the portfolio consists of performing loans, and in force policies, to be held to maturity."

"(Ackman) pays little attention to the rules of seniority and priority of payment in evaluating, or understanding, senior tranches of debt. The argument that if an entity is in trouble, every liability on the balance sheet of that entity is also in trouble is strictly “amateur hour”. Frequently, senior issues sail through troubles unscathed."

Here is my post on MBIA from February 2008.

Ackman and MBIA Inc.

William Ackman, of Pershing Square Capital Management, has brought the act of monoline insurance bashing to new heights, elevating it to that of an Olympic sport. He has been all over the news the last few months, talking his book up, or down in this case. So I decided to go through his bear case thesis line by line to see if he in fact knows what he is talking about, or is he just trying to scare fellow investors out of the stocks he is shorting.

His case is made up of several arguments. I will attempt to analyze each one of them down to its simplest form, since insurance is well known for the density of its financials. I am using the data from the 149-page massif that he posted on his web site, dated November 20, 2007, and I am focusing on MBIA Insurance. I was inspired to look into this matter after I heard Marty Whitman of the Third Avenue Value Fund dismiss Ackman with the simple phrase “he doesn’t understand insurance.” There’s no better sport to watch than a battle of the “smart money.”

Ackman has made many claims:

1) The holding company will be insolvent by the second quarter of 2008.

2) Channel Re, a captive reinsurer that is 17% owned by MBIA, and that reinsures $43 billion in exposure is not an adequate backstop and these exposures will be brought back into MBIA.

3) MBIA has a "GIC business" which invests money held by municipals received from bond issuance. They invest that money for municipalities and pay a fixed fee to the municipalities. MBIA is restricted to AA or better investments but the spread earned implies they are taking too much risk.

4) MBIA is understating its losses by using a mark to model rather than a mark to market system.

5) MBIA's investment portfolio has more risk than it seems because the company owns triple AAA bonds that are insured by itself.

6) MBIA raises money to fund itself through an SIV called Global Funding and the company is having difficulty finding buyers for the medium term note paper that this entity issues.

Claim #1

Ackman states that the holding company will be insolvent by the second quarter of 2008.

A little background first. MBIA Inc. is a holding company that is a publicly traded entity under the symbol MBI. The holding company owns an insurance subsidiary called MBIA Insurance Corporation. The holding company has no actual operating businesses. It receives income in the form of dividends from the insurance subsidiary, and another business that is involved in investment management. The dividends paid are subject to approval by the New York State Insurance Department, which is responsible for regulating the insurance entity.

Ackman uses a cash balance as of 9/30/07 (slide 125) of $464 million and states that MBIA will be insolvent in somewhere between 2.2 and 4.9 quarters. This has already been proven incorrect as the company ended the year with a balance of $434 million at the holding company level (MBIA conf call 1/31/2008). His predicted cash burn of $95.4 million turned out to be only $30 million. Now in his defense, he did put a disclaimer in there that if MBIA raised more capital then the insolvency would be postponed. However, this capital was downstreamed to the insurance subsidiary so it is not clear how this capital would help the holding company except to the extent that it makes the insurance subsidiary stronger.

Ackman also states that MBIA won’t be able to access its credit line if it takes a writedown in excess of $2.4 billion (slide 126) since it will be in violation of its covenants. This was also proven incorrect as the credit line is intact and available as of the end of January (MBIA conference call 1/31/08). Of course the capital infusion helped here as well.

Furthermore, the cash flows that the holding company could expect in 2008 include the statutorily permitted insurance company dividend and the net income of the asset management business if MBIA decided to stop growing the asset liability management business. That total would be $639 million. (MBIA conference call 1/31/2008)

Perhaps this is why Ackman is so desperately lobbying the New York State Insurance Department to restrict payment of the dividend to the holding company. Also, keep in mind that the holding company pays a discretionary dividend to shareholders and did pay $43 million out to shareholders in January 2008. It could also cut this back if needed to save money.

According to MBIA at its conference call on 1/31/2008, the holding company has $1.2 billion in debt. Two issues are due in the next three years - $143 million in 2010 and $100 million in 2011. Interest expenses on the debt are $80 million a year, and other miscellaneous expenses of the holding company bring the yearly expenses to $250 million.

It does not seem that a liquidity crisis is at hand for the holding company.

What is Value Investing? – Part II

I think that it is safe to say that when William Ackman, the renowned Hedge Fund Manager that runs Pershing Square Capital, says that Target is “undervalued,” and when Warren Buffett, the equally renowned value investor says that Burlington Northern is “undervalued,” they mean two very different things. And yet both are very successful at what they do and very rich. So who is right?

Ackman is not your typical stereotyped “value investor,” and Target is not your typical stereotyped value stock. Target’s enterprise value is 9.5 times its trailing 12 month EBITDA. Its forward price to earnings is 15.5 times, while it trades at 3.5 times tangible book value. It is not cash rich, holding $550 million in cash, or about $ 0.55 per share according to Yahoo Finance. The performance has been great as well. Target is up 12.3% year to date and has beaten the S & P 500 by 700 basis points.

So what’s going on here? Why is the stock “undervalued?” according to Ackman. Well, in a sense there is the effect of what is known as “cult investing.” When a well-known and successful investor announces that he is buying a stock, the herd moves onto it en masse pushing up the price. Ackman enjoyed that effect as rumors hit the market a week before his filing was done on 7/16/2007.

Buffet and other traditional value investors look for a “great business selling at a great price” in his words. He doesn’t seek to change anything at the company he buys. In fact he wants nothing to change, that’s the entire point. Management usually stays in place.

Ackman wants the company to change, to restructure in some way. Not because it will help the company long term, but because the market will pay more for your company if it looks the way I tell you it should look. For Target, that means sell or spin off your credit card division and try to unlock the value of your real estate somehow. For other companies that are being targeted it might mean something else - sell the entire company, split in two, issue debt and use the money to buy back stock. He doesn’t really care if 2 or 3 years down the road Target is a weaker or stronger company because he probably won’t be a shareholder by then.

I hesitate to say that Ackman is price indifferent to what he pays, because everyone cares about what they pay for something but in a sense he is price indifferent. He creates value at the companies he owns not by making its business stronger or better, but by shuffling parts of the puzzle around. Call it financial engineering if you like. If earnings grow faster than they did before he got there, its not because he helped them become better at retailing, its probably because its share count will decline due to some huge buyback that the company announces. When Ackman sits down with Target management is he going to say that they should work on their merchandising or that they should cut back on the number of SKU’s at their stores?

The Ackman strategy then is this simply put –

1. Find a large cap stock where the market is valuing the stock exactly at what it should be valued at based on the company’s profile.

2. Quietly accumulate a large stake in the company over a period of several months.

3. Leak word on the street that you are building a stake in the company and receive the cult effect.

4. Make your public filing of ownership and send letter to management.

5. Meet with and pressure management to do what you tell them to do to get the stock price up.

6. Wait for management to cave in and see the stock rise even more.

7. Sell quietly in a few months after the general public piles into the stock.

8. Give part of profit to charity but only in years when Hedge Fund manager wealth is getting really bad press.

Now I am not criticizing Ackman for what he does. Everyone has to create value for their investors and if it can be done this way then so be it. I was only trying to demonstrate how two investors who are very different can utter the same word and do it with a straight face.