To access a PDF version of the report, click here: The Dirty Dozen-12 Stocks with Fundamentally Broken Business Models
Introduction
Every business, no matter how great, at some point becomes not so great. Technologies change, laws shift and secular progress will take place regardless of how hard you try to stop it. And lest you think that you’re smarter than the average bear and will always recognizes problems, take the case of one Warren Buffett.
In 1970 the Sage of Omaha bought Blue Chip stamps, a company that issued loyalty rewards that companies could hand out to customers to incentivize them to keep coming back. Warren has remarked “When I was told that even certain brothels and mortuaries gave stamps to their patrons, I felt I had finally found a sure thing.” In 1970 there were 60 billion stamps in existence and the company had $126 million in revenue, about $700 million in today’s money; by 2005 that was down to $25, 920. That’s barely enough to charter one of Berkshire Hathaway’s Netjets for a weekend, let alone move the meter on a company with $100 billion in revenue. If Warren Buffet, the most legendary stock picker in history can make the mistake of not seeing where the world is headed, so can anyone.
Don’t despair though, there are ways to get through this. There are always signs when a business is headed downhill, such as whether they can’t pivot to a new technology, or management is stubbornly convinced that they need to fight old battles. Over the last couple years finding short cases has become an increasing part of what I do and we’ve had several substantial winners. In the case of A123 systems I targeted a company with a blazing hot IPO that was nothing more than shell to funnel off taxpayer money. Here’s what I said in December of 2010, before AONE’s 75% decline.
From the book ”14 Stocks That Should Double in 2011 (and 6 That Should Collapse)”:
Many of the targeted tax tricks, i.e., welfare, for these alternative energy companies are going the way of the dodo in coming quarters. It will be a very tough proposition for the politicians to extend and/or create new subsidies — though they do sneak some in every tax package that gets passed. Speaking of which, this stock and many others of the alternative energy companies that depend on those subsidies to stay in business, have rallied as the Republican/Democrat Regime come to pass their latest convoluted, but decidedly pro-business/pro-energy tax package.
In any case, these heavily-subsidized alternative energy companies need to have already established steady businesses and customer bases and profitability in these generous times, and this is one that is far from getting there. That said, the company’s got more than $4 per share in net cash, and even though the company’s burning lots of cash and had to admit that their customers are pushing out orders into next year, I probably will cover the stock if and when it falls back into the $5-$6 range, where it was soon after we shorted it the first time. I’d put a $11 or $12 stop loss on the short, just in case the stock goes bubblicious before it goes ugly.
Company Date We Published Price When Published Price Now %Gain
AONE – A123 Systems 12/15/2010 $9.04 $2.29 75%
Source: Yahoo Finance
In the case of Lender Processing Services (LPS) we spotted a company that was not acknowledging the huge legal cliff is was about to run off. In this report we talk about a company very much related to LPS that we think can match the 55% fall its seen since first wrote about it.
From the book “14 Stocks That Should Double in 2011 (and 6 That Should Collapse)” (new version):
LPS collects fees from referrals to the robo-signing services and legal mills that have exacerbated the latest crisis. Law firms that took their time with mortgage documents have seen their contracts terminated by LPS. LPS went so far as to setup a robo-signing operation for a client. And perhaps the greatest liability to LPS is that people are starting to look at their mortgage documents. This means that LPS could be on the hook for even performing loans, not just ones sloppily handled in bankruptcy court.
Just like the banks of the last decade, LPS has vertically integrated exposure to the housing market. LPS has been pitching itself as countercyclical and insulated from any putback nightmare scenario. Management has gone so far as to claim that a protracted foreclosure mess could benefit the Company. On it’s most recent earnings call, in response to an ongoing investigation by the Office of the Comptroller of the Currency, CEO JeffCarbiener stated “I just discussed and as previously disclosed, we have expressed our willingness to fully cooperate with any and all inquiries. We also continue to believe that the ultimate outcome of these inquiries will not have a negative material impact on our business or the results of operations.” Has a certain ring of Paulson’s “subprime is contained” doesn’t it?
With a stock price up 15% year-to-date, an LPS short offers the most effective equity exposure for playing the next leg of the housing mess. Shorting banks while they’ve been given a license to hide losses and print money by borrowing for nothing from the discount window has been a break-even proposition for us, despite the booming markets. I think we have an even purer play on the mortgage fraud/robo-signing/foreclosure fraud mess.
Company Date We Published Price When Published Price Now %Gain
LPS-Lender Processing Services 3/10/2011 $32.80 $15.02 54%
Source: Yahoo Finance
With Research in Motion (RIMM), the case is very different, they actually make a useful product and are amazing innovators (the co-founders practically invented mobile email). But their refusal to accept that Apple had built a product that everyone wanted cost their shareholders ten of billions of dollars. When I first told the readers of my book “50 Stocks for the App Revolution” to stay away from RIM the company hadn’t yet begun its 75% slide:
From the book “50 Stocks for the App Revolution”:
Apps and all things related to apps are in a huge growth cycle, and that while RIMM’s rightly been punished for losing market share in the smart phone market, especially in the US, it’s still going to show growth over the next few years — despite continuing to lose smart phone market share along the way.
The virtuous cycles that critical mass brings to a tech company, has recently ended for RIMM. RIMM had critical mass for the enterprise email solutions for a decade, but the technology has been creatively destructed by the very similar and more flexible (though still slightly less reliable) email/message/social-networking capabilities of the iPhone and Android…which, as I wrote yesterday, are just starting to see the virtuous cycles that come from critical mass.
How do you know when a company’s got critical mass, or for that matter, when they’re starting to get it or when they’re losing it? There’s not set formula, of course. You’ve got to watch the trends, the technologies, the companies, the consumers actions and where the developers are going.
Company Date We Published Price When Published Price Now %Gain
RIMM – Research in Motion 11/20/2010 $58 $16 73%
Source: Yahoo Finance
So why did I write this report & why is it so important right now now? First off, there is no such thing as a bad stock, just bad a price. At some level everything has value, it all depends what you pay for it. But in all the cases I’ve outlined, the market is still willing to support these broken businesses, often at multibillion dollar valuations. If you look at some of the metrics I’ve pulled for you you’ll see some big cash flows and fat dividends; unfortunately for these stocks those numbers reflect a past reality, not the shifting future. The stock market is the ultimate objective judge and arbiter of value and the point is that we can make money getting out of and getting short these names before everyone else gets it.
But that alone isn’t enough; bad businesses can stay expensive for years—just ask anyone who tried to short the housing bubble before it ultimately collapsed. Timing is everything and the timing to target this Dirty Dozen is now. We are at the crossroads of huge technological, financial & regulatory shifts, many of which are well past their tipping point. Enormous tectonics moves have already taken place and lots of the low-hanging fruit has already rotted (think Blockbuster, Fannie & Freddie) but there is so much more yet to collapse. The world is never going to back away from iphones and remote data, so you need to avoid companies that are clinging to revenues that will be disrupted by the App and Cloud revolutions. You need to avoid investing in financial companies that have been living off the fat of government welfare and by exploiting the poorest in society; their ability to leverage shady practices is coming under more scrutiny than at any time in the past 50 years. And most of all you need to protect yourself from complacency and think about your portfolio of stocks in terms of owning whole businesses. Given the entire spectrum of the investment world would you really want to be the CEO of a student lender? A radio analytics company? A financial company that can be regulated out of existence? I wrote this book to help you avoid industries and businesses that have seen the world pass them by, and to make money by getting short uninformed optimism.
Company
ARB – Arbitron, Inc.
Summary
Arbitron Inc. is a media and marketing information services company. They offer radio audience estimates and related services to radio stations, advertising agencies, and advertisers in the United States; estimates national radio audiences and the size and composition of audiences of network radio programs and commercials; and provides software used for accessing and analyzing its media audience and marketing information data.
Balance Sheet
Cash and Cash Equivalents: 16 M
Short Term Investments: –0
Long term Investments: 13 M
Total Cash: 29 M
Total Debt: –0
Net Cash: 29 M
Outstanding Shares: 27 M
Net Cash / Share: 1
Share Price: 36.5
Enterprise Value / Share: 35.5
Total Market Cap: 1 B
Enterprise Value: 971 M
2012 Sales Growth: 5.5%
2012 Earnings Estimate: 2.27
Enterprise Value Multiple: 15.6 Times Forward Earnings
Dividend & Yield: .4 (1.1%)
Here’s my issue with Arbitron’s business model: it’s in radio. Yes, the market is still willing to pay a billion dollars for a company that tells advertisers how to engage people through radio. Now I generally like companies that package and sell data, but Arbitron deals exclusively in media that is background noise for most of us.
Consumption dynamics with regards to radio are changing rapidly, and the Arbitron’s existence is based on old habits. One of the most important metrics ARB sells is TSL or time-spent-listening. Advertisers up till now have been happy to pay to learn about the habits of a sample size of listeners and make assumptions on the rest. Radio is way more passive than TV; advertisers want to advertise on specific shows where the audience is content with just having their radio on for long periods of time, and maybe, just maybe, they’ll be caught by a 30-second jingle.
If it sounds really dated to try and treat an audience this way, it should. Radio has been going the way of elevator /customer-call-center-hold-music since the advent of cheap on-demand recorded media and now even its last strongholds are going up in flames. Just as with YouTube, the granularity of monitoring all media consumption enables advertisers to better target consumers. Would you rather pay Arbitron to learn that 25-49 year olds in a top 10 market listen to oldies stations for an average of 20-30 minutes three to five days a week, or would you rather pay Google for the right the sell a person the big band record you know they’ve been listening to specifically every day for the last month? Radio Apps have DVR-like functions built in—that’s data the app providers can sell directly to advertisers, bypassing Arbitron. And 2012 will see a spate of car manufacturers installing smart radios with greater on demand capabilities, furthering threatening one of the brightest spots of Arbitron’s business model. Right now advertisers fork over about $400M a year to Arbitron for their service, but that’s not going to last in a world when they can know exactly who they are engaging and for how long. Radio itself as a medium will adapt, and content of all kinds will be more valuable as it’s distributed over ever more platforms, but the advertising dollars will bypass ARB and head directly to the platform and app makers. The pie of radio advertising dollars is shrinking and I’d stay away from paying 16 times forward earnings for a business that’s going to have less & less to eat. 
Source: http://www.bridgeratings.com/press_09.11.07-WiFi%20Impact%20Upd%2012.29.09.htm
Company
FOSL – Fossil, Inc.
Summary
Fossil, Inc. designs, develops, markets, and distributes fashion accessories worldwide, offering a line of fashion watches under its proprietary brands, such as FOSSIL, MICHELE, RELIC, and ZODIAC.
Balance Sheet
Cash and Cash Equivalents: 231 M
Short Term Investments: 8 M
Long term Investments: 7
Total Cash: 246 M
Total Debt: 4 M
Net Cash: 242 M
Outstanding Shares: 62 M
Net Cash / Share: 3.9
Share Price: 91
Enterprise Value / Share: 87.1
Total Market Cap: 5.7 B
Enterprise Value: 5.5 B
2012 Sales Growth: 16.2%
2012 Earnings Estimate: 5.49
Enterprise Value Multiple: 16 Times Forward Earnings
Dividend & Yield: N/A
To use Fossil’s name against it and call selling watches a fossil-based activity might sound too convenient. But let’s go ahead and do that. Quick, look around you and see how many places you can get the time from. You’re almost certainly reading this on a computer and I’m guessing your phone is right next to you. Pick it up, call your broker (or use their mobile app) and sell any Fossil stock you might own. hey
This is a trend that’s going to play out over the next 3-5 years. Parents are still buying watches for their kids, but when you’re shelling out $200+ for the phone & $80 for the service, you’re likely to be ok with thinking of a smart phone as your kids time piece. Going forward watches are going to way down on the list of what kids ask Santa for, and their parents have been wearing them less for years. Consumers replacing “cheap” watches, what the industry calls the $50-100 range, has been a pretty reliable 2-year cycle. This behavior is in secular decline, with consumers choosing not to have a watch at all when the old one breaks. The only part of watches seeing any growth is the luxury segment, which Fossil is far removed from. And even on the high-end consolidation & roll-ups have been brutal; with revenues up from emerging economies, margins have been getting tighter at luxury conglomerates like LVMH. Fossil’s international business has been a strong driver of profits but you expect the rest of the world to choose smartphones over watches in the long haul.
Fossil has become a licensor of its production capacity to brands like Burberry & Diesel; when they start seeing declines in watch sales you can bet that marquee brands are going to push back on the royalty agreements, all of which are expiring by 2013 (wholesale is 70% of FOSL’s revenues). At that point Fossil will begin relying much more heavily on its own brand and forced to make hay selling $150 watches as a direct competitor to $99 iphones. They do have revenue from other businesses like apparel and leather goods but those margins are much worse than on watches, which are 60% of top-line. Add in that Fossil has its own network of retail locations peddling watches, some of which have pretty expensive lease terms, and the stock looks like a story you really want to avoid.
Source: http://www.bulsuk.com/2011/05/wrist-watches-are-here-to-stay-despite.html#axzz1kLrzpIbF
Company
AM – American Greetings Corporation
Summary
American Greetings Corporation designs, manufactures, and sells greeting cards and other social expression products worldwide. It offers social expression products, including greeting cards, gift wrap, party goods, giftware, and stationery, as well as custom display fixtures.
Balance Sheet
Cash and Cash Equivalents: 86 M
Short Term Investments: –0
Long term Investments: –0
Total Cash: 86 M
Total Debt: 235 M
Net Cash: -149 M
Outstanding Shares: 38 M
Net Cash / Share: -3.9
Share Price: 14.1
Enterprise Value / Share: 18
Total Market Cap: 540 M
Enterprise Value: 687 M
2012 Sales Growth: 5.3%
2012 Earnings Estimate: 2
Enterprise Value Multiple: 9 Times Forward Earnings
Dividend & Yield: .6 (4.4%)
This one should be crazy obvious to even the most casual observer. For generations greeting cards have been a staple of gift giving; they won’t be in the future. Seems pretty low tech to tape a printed sentiment on to an ipad no? And while grandparents may keep stuffing $5 bills into them, there are much more elegant ways to show someone you love them with money (read: gift cards).
E-mail is the most readily available way to express an emotion but even if you have an old-fashioned streak, greeting cards are being displaced by better printed alternatives. Instead of an anonymous sentiment churned out by copywriters, why not send grandma a picture of the family directly from your iphone with custom text, mailed for $2.99? Yeah there’s an App for that, Cards, directly from Apple itself. About a dozen start-ups are working to disrupt the space as well. The current greeting card model of a $3.99 starting price point that you have to physically obtain from a store and then mail (postage extra of course) is just not sustainable. One of the biggest channels for American Greetings are dollar stores, where their margins are in perpetual squeeze mode.
Over time the business, save the premium end, is a dead end. I like getting a card as much as the next person; I also dislike sending them as much as you do. AM’s stock is actually up slightly over a ten-year period but there’s no chance it will be in the coming decade. The seasonal business American Greetings so relies on could take a big hit this year due to massive smartphone adoption. For half-a-billion dollars there are plenty of other businesses I’d rather buy. Watch for the dividend to dry up, that’ll be a sign that the business has begun its decline.
Company
NNI – Nelnet, Inc
Summary
Nelnet, Inc. is an education services company, focusing on providing fee-based processing services, and education-related products and services in the areas of loan financing, loan servicing, payment processing, and enrollment services.
Balance Sheet
Cash and Cash Equivalents: 141 M
Short Term Investments: –0
Long term Investments: 25.5 B
Total Cash: 25.6 B
Total Debt: 49 M
Net Cash: 25.5 B
Outstanding Shares: 47 M
Net Cash / Share: 542
Share Price: 24.3
Enterprise Value / Share: -518
Total Market Cap: 1.15 B
Enterprise Value: -24.3 B
2012 Sales Growth: -1.2%
2012 Earnings Estimate: 4.25
Enterprise Value Multiple: -121 Times Forward Earnings
Dividend & Yield: .4 (1.7%)
Nelnet’s story tracks the growth of the student loan industry pretty perfectly. It went from being a Midwestern processor of student loans to an originator of some of the most insidious kind of debt out there. If there’s a more morally bankrupt industry than student loans, I’d love to know about it. And speaking of Chapter 11, I’ve talked before about how student debt is different than other debt, in that it can almost never be whittled away, not by bankruptcy, not even by death.
It became a demographic imperative over the last 30 years to attend college, and high school seniors across the country became fodder for a loan industry that saw them as little more than a warm body that could carry a debt load. Education as a silver bullet became a bullet to the head as shady loan officers promised that life would be worse without a college degree. And when given federal guarantees were handed out, a for-profit industry sprang up, with increasingly lax academic standards, with the end result being millions of people billions of dollars in debt. The student loan industry has been lubricating not only 4-year degree programs but trade schools, massage schools, and test prep courses.
I’m not counting on regulators doing the right thing here; it’s more that there just isn’t oxygen left for student loan companies. The outcry is building and the mindset is shifting away college as a necessity. And I do expect some kind of legal challenge to student debt, it cannot enjoy Most Favored Nation status in perpetuity, especially at a time when people are walking away from mortgages and credit lines. I like Nelnet specifically as a short over behemoth Sallie Mae as I believe their loan quality is way worse; over the years they been forced to live on the scraps their former GSE cousin didn’t want. YoY revenues are crashing and while it NNI throws off plenty of cash right now, the story will look much worse once its borrowing costs start to rise. Nelnet is a classic value trap with basically no takeover premium. The net interest it earns on its federally guaranteed portfolio will persist for the near future, but revenues from value-add services like enrollment & loan administration, which it’s been trying to pivot into, will dry up. The new revenues will definitely not pay for the sins of the old loan book.
Company
FNF – Fidelity National Financial, Inc.
Summary
Fidelity National Financial, Inc. provides title insurance, mortgage services, specialty insurance, and information services in the United States. The company provides title insurance, escrow, and other title related services, including collection and trust activities, trustee sales guarantees, recordings, and reconveyances.
Balance Sheet
Cash and Cash Equivalents: 601 M
Short Term Investments: 50 M
Long term Investments: 5 B
Total Cash: 5.6 B
Total Debt: 1 B
Net Cash: 4.6 B
Outstanding Shares: 217 M
Net Cash / Share: 21
Share Price: 17
Enterprise Value / Share: -4
Total Market Cap: 3.8 B
Enterprise Value: -800 M
2012 Sales Growth: -3.7%
2012 Earnings Estimate: 1.13
Enterprise Value Multiple: -3.5 Times Forward Earnings
Dividend & Yield: .48 (2.8%)
The vagaries of the U.S. housing market are no where near as silly as in some countries, but they still have their quirks. One of the property market’s most anachronistic aspects is title insurance, and Fidelity Financial Inc is the purest play on betting against its continuing existence.
Just as with so many other financial “innovations”, title insurance was originally a response to a perceived deficiency. While most of the western world had long-held principles to determine just who owned a property, America was comparatively (and literally) the Wild West. Determining liens, encumbrances and titles have historically been the domain of individual states in America, where as these are considered central government functions in the rest of the world. In the late 1800s corporations sprang up to sell policies that would insure a purchaser if it turned out years later the seller didn’t own the house, their lawyer signed documents without reading them, or there were unpaid debts. And if that sounds like a line of insurance you wouldn’t want to be in these, I’m right there with you.
FNF is by far the largest title insurer; they are on the hook for much more of the put back mess than they are acknowledging, even more than the extra reserves they’ve put aside for legal expenses. As the title insurance industry likes to point out, the registration system in the rest of the world is prone to fraud by a single deed being manipulated, and that the U.S. system has inherent safeguards and redundancies. But it is the functionally the same as banks and lenders have been complicit in the sloppiness of the foreclosure mess, robo-signing documents and kicking people out of houses who have been current on payments.
But the real risk to FNF is that title insurance is ripe for disruption. Most people simply buy the title insurance their broker picks out; shopping around can save you thousands of dollars but few do so because they’ve never even heard of title insurance before they make that 1st down payment. And the way FNF has kept it like that has been by paying hefty commissions to real estate brokers & mortgage brokers. Now it is already technically illegal for an agent to insist a buyer use the service they’re getting paid to recommend, but in practice that is absolutely what happens. HUD and other government housing agencies have already dinged FNF for these practices, auguring a future where the market is much more competitive.
On top of that, the fact is that title insurance is a relic legal practice that exposes the insuring company to huge tail risk for a comparatively puny premium. One of my best short calls last year was LPS, which got crushed when legal claim wiped out almost 2/3rd’s of its market cap. Oh and LPS is a spawn of FNF, a 2008spinoff; when you know the kid is a rotten apple you have to wonder how far away the tree is. If you want to make a bet on a recovering housing industry buy a beaten up builder with strong liquidity or regional bank without toxic vintages on its balance sheet; stay away from the low-margin, low-quality business of Fidelity National.
Company
WDC – Western Digital Corporation
Summary
Western Digital Corporation provides solutions for the collection, storage, management, protection, and use of digital content primarily audio and video worldwide. The company’s principal product includes hard drives comprising 3.5-inch and 2.5-inch form factors.
Balance Sheet
Cash and Cash Equivalents: 3.7 B
Short Term Investments: –0
Long term Investments: –0
Total Cash: 3.7 B
Total Debt: 100 M
Net Cash: 3.6 B
Outstanding Shares: 233 M
Net Cash / Share: 15
Share Price: 37
Enterprise Value / Share: 22
Total Market Cap: 8.6 B
Enterprise Value: 5 B
2012 Sales Growth: -3.8%
2012 Earnings Estimate: 4.05
Enterprise Value Multiple: 5.4 Times Forward Earnings
Dividend & Yield: N/A
At a glance, this disk storage maker looks like one of the cheapest tech stocks on the planet, trading at less than five times this year’s earnings. But there’s a reason the market isn’t willing to pay up any more this company’s current earnings — because those earnings are likely unsustainable.
Even as there’s a relentless march of endless demand for ever more storage capacity, Western Digital is caught selling the operator-controlled switch of the digital storage world. Inside the network, at the server level, in our smartphones, our computers, our DVRs — everywhere along the network, we see the need for more storage. But disk drives are full of actual movable components, that require much more energy to store, access and retrieve every bit than the increasingly popular flash storage systems that the Sandisks and Samsungs of the world have developed.
Indeed, within just the last couple years, the cost per bit for flash storage has indeed dropped below the cost per bit for disk drive storage — and cost was the last reason for using storage. Flash costs are continuing to plummet and capacity of the factories that crank out Flash storage are soon to swamp the total capacity of Western Digital and the other disk drive makers.
Compounding problems for Western Digital in particular is that continued problems with bringing capacity back on after the horrible weather disasters that have plagued its factories. Seagate is a much better play on any rebound that the disk drive industry will have as its factory capacity hasn’t been hit nearly as hard as Western Digital and the rest of the industry have been. Western Digital will have to spend a lot of money simply bringing their old capacity online instead of investing in the future of storage or increasing capital investment on new factories.
There’s an old saying that if it the sink ain’t broke you shouldn’t try to fix it. Well, Western Digital’s sink is broken, their industry’s drain is broken, and they have no choice but to try to fix the whole house.
Source: http://www.realworldtech.com/page.cfm?ArticleID=RWT123009125025
Company
WU – Western Union Company
Summary
The Western Union Company provides money transfer and payment services worldwide. The company’s Consumer-to-Consumer segment offers consumer-to-consumer money transfer services through a network of third-party agents using multi-currency and real-time money transfer processing systems.
Balance Sheet
Cash and Cash Equivalents: 2.6 B
Short Term Investments: –0
Long term Investments: –0
Total Cash: 2.6 B
Total Debt: –0
Net Cash: 2.6 B
Outstanding Shares: 619 M
Net Cash / Share: 4.2
Share Price: 19
Enterprise Value / Share: 14.8
Total Market Cap: 11.7 B
Enterprise Value: 9.1 B
2012 Sales Growth: 7.5%
2012 Earnings Estimate: 1.8
Enterprise Value Multiple: 8.2 Times Forward Earnings
Dividend & Yield: .32 (1.7%)
The history of Western Union is a study in modern capitalism. Takeovers, spinoffs, tech seed investing, restructurings, divestitures and bankruptcy, WU has seen it all. There are few brands that have had so many incarnations, first as a telegraph service, then telegrams (including, for a while, singing ones) and, in the 80s, moving from communications to its most recent form, a money transfer service. Today Western Union operates its business with nearly half-a-million retail partners around the world who process cash in 95 different currencies, which can then be sent instantly to almost anywhere on the globe. And while Western Union has grown with the global economy, its core business will almost certainly decline over time.
See, Western Union isn’t cheap, nor is it as convenient as some new alternatives. Sending $1000 from New York City to anywhere in the United States for the same day starts at $86. The receiver has to show up at an agent location that is 1st, open, and second is willing to process the transaction. (Western Union says officially that all money transfer agents can handle their service’s $3000 maximum, but in my research this just isn’t true; agent locations are often rarely operated franchises that businesses bought on the cheap but might not have that much cash on hand.) But outside of the extreme examples, picking up cash after presenting two forms of ID just isn’t as convenient as about a dozen other forms of money transfer. In an emergency Western Union may still have some value, but that’s mostly because of its entrenched position and that people know about it.
And that position is weakening all the time. The biggest existential threat is from online money transfer services like PayPal & Dwolla, both instant and almost free alternatives to Western Union. Paypal will give you a free debit card to use the cash in your account & Dwolla’s mobile app is a generational leap forward in money transfer. The backbones of the global payment network, Visa & Mastercard, have rolled out services that let cardholders transfer available credit to each other at little or no cost (American Express has their own version of this). If you are one of the millions of unbanked customers I suggest you look at Wal-Mart’s Moneycard partnership with Greendot, where two debit cards can be linked at reloaded remotely for $3—a much cheaper way to bailout Junior at college than to send him cash at Western Union you can’t track. Even old-school relics like checks work much faster these days thanks to the Fed modernizing the way it clears at regional banks (Yes, Virginia, I just gave the Fed some credit). And If you have the same bank as the person you’re sending money to, you can transfer a certain amount internally (and instantly) for free every month, without incurring a $35 bank draft fee (Ok, last time, thanks Fed). Almost all these payment innovations are cross-border or have foreign equivalencies, especially Visa & Mastercard’s money transfers. Western Union is going to have to cut its rates at some point in the next 3-5 years, its pricing power over immigrant communities & those emergency situations, is waning. Layer on the currency risk inherent to its business model, and Western Union is one stock you should definitely transfer out of.
Source: http://nfcrumors.tumblr.com/post/8361818811/verizon-and-american-express-serve-mobile-wallet
Company
MCO – Moody’s Corporation
Summary
Moody’s Corporation provides credit ratings; credit and economic related research, data, and analytical tools; risk management software; and quantitative credit risk measures, credit portfolio management solutions, training, and financial credentialing and certification services worldwide.
Balance Sheet
Cash and Cash Equivalents: 854 M
Short Term Investments: 13 M
Long term Investments: –0
Total Cash: 867 M
Total Debt: 1.2 B
Net Cash: -333 M
Outstanding Shares: 222 M
Net Cash / Share: -1.5
Share Price: 36
Enterprise Value / Share: 34.5
Total Market Cap: 8 B
Enterprise Value: 8.3 B
2012 Sales Growth: 6.3%
2012 Earnings Estimate: 2.62
Enterprise Value Multiple: 13 Times Forward Earnings
Dividend & Yield: .64 (1.8%)
Before subprime, before the Internet Bubble, the S&L crisis, the Great Depression, before the 1900s even got into its teenage years, there was the 1907 Banker’s Panic. When an attempt to corner the market went disastrously wrong, it triggered the collapse of a venerable trading house, which sparked bank collapses, the trust companies of the era refusing to lend each other money, a stock market panic and ultimately a bailout by J.P. Morgan (the man not the bank). By the way, this is when the Federal Reserve was created, as the ultimate backstop. Next time someone tells you about the good old days, tell them the people back then weren’t any smarter.
An entrepreneurial John Moody saw that the crisis had almost spread to industrial companies & started publishing a report rating railroad bonds. Within 15 years Moody and competing bond rating companies were publishing their analysis on the entire U.S. bond market. In 1936 the newly created SEC declared that financial companies could only hold bonds that the credit rating agencies had determined to be ‘investment grade’.
It’s been like that ever since, the idea that a centralized rating agency, could, with the imprimanteur of the Federal government, determine what’s risky and what’s not. In 1975, banks were feeling particularly rambunctious and asked their regulators to let them loan out more money. The solution of the SEC was to designate several of the ratings agencies as NSROs (Nationally Recognized Statistical Rating Organization). As long as an NSRO was willing to call their bond investments safe & liquid, financial companies could have those lower capital requirements.
This worked until it didn’t. Moody’s, S&P and Fitch were basically given a license to print money, banks and insurance companies had no choice but to come to them for ratings. That’s oligopoly pricing power. And the SEC didn’t give their blessing to new ratings agencies very easily, not approving a single new NSRO from 1990 through 2003. But all of that’s over now.
The subprime crisis exposed the ratings agencies as incompetent. The conflict of interest of “issuer-pays”, where the entity that wants the rating pays for the rating, became glaringly obvious. The big three credit raters were willing to stamp almost any mortgage product AAA, no matter what the loan quality in the bond was. And the very kinds crises they were created to prevent were actually exacerbated by the ratings agencies when, tails between their legs, started downgrading vast swaths of not only paper, but companies and countries. If you live by a rule, you die by the rule.
All of this means that the party is over for the credit rating agencies. The U.S. government is allowing new players into the market, foreign competitors have sprung up, and they’ve become targets of central bankers because of the sovereign debt crisis. The model that has provided Moody’s with such healthy margins, a complete reliance by financial companies on their product, is near collapse from regulatory and legal scrutiny. As far as I’m concerned the ratings agencies as in a kind of run-off mode, purgatory before their license to operate is revoked once and for all. 
Source: http://housingdoom.com/2007/07/10/downgrade-o-rama/
Company
FICO – Fair, Issac Inc.
Summary
Fair Isaac Corporation provides analytic, software, and data management products and services to automate, improve, and connect decisions for businesses worldwide. They offer analytical solutions, credit scoring, and credit account management products and services to banks, credit reporting agencies, credit card processing agencies, insurers, retailers, and healthcare organizations.
Balance Sheet
Cash and Cash Equivalents: 135 M
Short Term Investments: 105 M
Long term Investments: 15 M
Total Cash: 255 M
Total Debt: 504 M
Net Cash: -249 M
Outstanding Shares: 35 M
Net Cash / Share: -7.1
Share Price: 38
Enterprise Value / Share: 45.1
Total Market Cap: 1.3 B
Enterprise Value: 1.5 B
2012 Sales Growth: 3.6%
2012 Earnings Estimate: 2.47
Enterprise Value Multiple: 18 Times Forward Earnings
Dividend & Yield: .08 (.2%)
The concept of caveat emptor, or buyer beware, is embedded in us from a young age. We learn that the prize in the cereal box isn’t that cool, that hot wheels don’t go that fast and that you can’t see gleam any tantalizing insights with x-ray glasses. As we enter adulthood this attitude translates to all of our purchasing habits, we are biased to thinking the washing machine agitator will break down and that getting an extended-warranty is rational (it rarely is). Plenty of products don’t do what they advertise, and Americans are more skeptical than ever about financial ones. That’s why FICO, the credit analytics provider, is primed to fall.
What FICO sells is basically a formula that is supposed to tell lenders just how likely a borrower is to repay. The three credit bureaus, Experian, Transunion & Equifax take FICO’s analysis, layer their own data, and come up with your credit score. From what FICO has publicly disclosed, their score is comprised about 1/3rd payment history, 1/3rd how much of your credit you use and the rest pretty equally split over how long you’ve had credit, what kinds you have & how you apply for new credit. The problem is that this captures a view of consumers that is no longer valid.
Borrowers who have defaulted on a mortgage or credit line have seen their credit scores decimated. When you add on that loan forgiveness or short sale has dire tax consequences for a FICO score, it’s failings become obvious. The standardized lending world, where FICO was the bulk of what a lender needed to know before writing a mortgage, is over. Sensing this shift the credit bureas have been adding more and more granular data, such rental history, and that doesn’t come from FICO. Scariest of all for FICO is that the credit bureas have banded together to start their credit score service; right now it has about 6% percent of the market but you can expect that to grow.
The best way to put it is how FICO describes the risks to its business in its 2011 annual report:
“We rely on relatively few customers, as well as our contracts with the three major credit reporting agencies, for a significant portion of our revenues and profits. Certain of our large customers were negatively impacted by the recent financial crisis. If these customers continue to be negatively impacted, or if the terms of these relationships otherwise change, our revenues and operating results could decline.
Most of our customers are relatively large enterprises, such as banks, credit card processors, insurance companies, healthcare firms and retailers. As a result, many of our customers and potential customers are significantly larger than we are and may have sufficient bargaining power to demand reduced prices and favorable nonstandard terms.”
And there you have it, a fancy way of saying that FICO is completely at the mercy of its customers. Right now the market is happy to pay 18 times forward earnings and support FICO’s market cap at $1.3 billion. Just wait till the credit bureas and large banks start squeezing FICO. Ideally the business should be jointly shared by financial institutions, not a public company.
Source: http://creditcardforum.com/blog/vantagescore-vs-fico-score/
Company
DLLR – DFC, Global Corporation
Summary
DFC Global Corp. provides retail financial services to unbanked and under-banked consumers, and small businesses. Its primary products and services include short-term consumer loans, single-payment consumer loans, check cashing services, secured pawn loans, and gold buying services.
Balance Sheet
Cash and Cash Equivalents: 196 M
Short Term Investments: –0
Long term Investments: 333 M
Total Cash: 529 M
Total Debt: 44 M
Net Cash: 485 M
Outstanding Shares: 44 M
Net Cash / Share: 11
Share Price: 17.5
Enterprise Value / Share: 6.5
Total Market Cap: 768 M
Enterprise Value: 283 M
2012 Sales Growth: 35.1%
2012 Earnings Estimate: 2.09
Enterprise Value Multiple: 3.1 Times Forward Earnings
Dividend & Yield: N/A
Some of the picks in this book are nuanced ideas, long-term secular trends that need to be grasped on more than a visceral level to be actionable. Not so with DFC Global, previously know by the more accurate Dollar Financial (DLLR) . The company is engaged in one of the shadiest corners of the consumer finance industry, payday lending, and their practice of exploiting the poor is about to come to an end, or at least get way less profitable.
Many states have usury laws, rates at which to lend above is illegal. Credit card companies have bumped up against these for years, charging rates of anywhere from 20-29% (and in one extreme case 79%) for carrying a balance. A landmark 1978 Supreme Court case gave credit card issuers the right to domicile in one state and export the maximum interest rate to cardholders anywhere. After all these people had willingly entered into a contract correct?
While the Fed has lately tried to cap rates on credit card balances I don’t want to bet against the ingenuity of the Discover Financials & J.P Morgans of the world in getting around the rules. They’ll likely start levying annual fees on cardholders who are able to pay their balances off monthly or impose all-kinds of new charges for previously free services, like online bill pay & replacement plastic.
Payday lenders don’t have the wiggle room for these options, their customers are already pretty maxed out. And most payday lending takes place at a physical location, meaning they cant transport the laws of one domicile to another. The states that outright ban payday lenders super high interest rates are totally unlikely to back down and become enablers. While they tell consumers that they can borrow against their paychecks for 12-20% (and it’s rarely broken down so clearly) on an annualized basis the charges are many multiples of that, reaching into the 300-400% range. The 33 states that still protect payday lenders are almost all considering legal action and more regulation. Even the pawnbroking and gold-buying services that DLLR offers are coming under new federal scrutiny as financial products.
Large banks & retailers have started to subsume some of the low-hanging fruit of payday’s lenders revenue. You can now cash a check at Bank of America for a $5 fee without a bank account & for $3 at Wal-Mart (free if it’s a government benefit check that you load onto a debit card). Wells Fargo has begun floating its customers in good standing $500 at a lower rate than what an overdraft fee would cost them. The era of DFC charging 1-2% of the value of a check are rapidly coming to an end. But the largest problem hanging over Dollar Financial’s head is how it funds all these activities: credit lines from some of the nation’s largest banks.
A low-interest rate environment has meant that banks can provide DFC credit at rock-bottom prices. Wells Fargo for example, has extended $200 million revolving credit line to DFC (which can be raised to $250 million ) at 4 points over LIBOR. How long would that arrangement continue after any public relations malestorm? Not very, you can be sure of that. As we’ve seen with Bear Stearns, Lehman Brothers and most recently MF Global, the large backs are completely unsentimental about putting a long-standing client out to pasture at a moments notice if they think their core business is being hurt. Get out of DLLR, or better yet get short, they have no long-term allies looking out for them, and there will be no bailout of any kind.
Company
RRD – R.R. Donnelly & Sons Company
Summary
R.R. Donnelley & Sons Company provides pre-media, printing, logistics, and business process outsourcing products and services to private and public sectors worldwide. The company operates primarily in the commercial print portion of the printing industry, with related product and service offerings designed to offer customers solutions for communicating their messages to target audiences.
Balance Sheet
Cash and Cash Equivalents: 368 M
Short Term Investments: –0
Long term Investments: –0
Total Cash: 368 M
Total Debt: 3.4 B
Net Cash: -3 B
Outstanding Shares: 187 M
Net Cash / Share: -16
Share Price: 12.2
Enterprise Value / Share: 28.2
Total Market Cap: 2.3 B
Enterprise Value: 5.3 B
2012 Sales Growth: 0%
2012 Earnings Estimate: 1.74
Enterprise Value Multiple: 16 Times Forward Earnings
Dividend & Yield: 1.04 (7.2%)
There’s a great scene from ‘The Sopranos’ where Junior Soprano is complaining about legal fee, saying “Why can’t we all just have one piece of paper, pass it around?”. The image of an elderly Mafia Don complaining about his overhead is comical, but it belies a larger truth: printing stuff out is pretty wasteful. And R.R Donnelly & Sons is the best pure play on this waste.
It can be a really bad idea to take vast macro concepts and try to shrink-ray them down to support an individual stock idea. Traders in the 90s got carried out the door shorting paper companies; the idea was that as everything moved to digital there would be less demand for paper and the share price of companies like International Paper would collapse. Instead the global economy expanded and the bulk of IP’s capacity went to packaging & shipping products. With RRD however, a short position is a very specific bet on a fundamental change in how corporations do business.
The domain of R.R. Donnelly is the corporate glossy print job and the printing of magazines, books, phonebooks, and advertising inserts—they are the largest commercial printer in the world. The challenge to RRD’s book & magazine business is fairly obvious, ebook sales already outnumber traditional book sales, and the periodical business has been in secular decline for some time now. Major publishing houses like Penguin have already begun cutting back orders as they transitions to selling ebooks, leaving RRD to close facilities across the country. And while R.R. Donnelly’s talks a good game about its 60,000 clients, 275 corporate customers make up the majority of the firms topline.
The other 59,725 are going to be using RRD less & less to print out glossy materials for internal use, when ipads and smart phones do a much better job at a much better long-term value. And lest you think RRD can pivot into technological corporate solutions, remember that this is the firm spun off its profitable cartography division, now known as Mapquest. RRD’s debt levels and the fact that it has most of its cash overseas give it little wiggle room. While the downdraft in corporate orders may happen over several years, the company can’t easily handle quarterly declines. A 7% yield on the dividend will be the 1st to go, at which point shareholders will give heave-ho to a company with $3.4 billion in debt and declining proscpects.
Company
SCI – Service Corporation International
Summary
Service Corporation International provides deathcare products and services in the United States, Canada, and Germany. Its funeral service and cemetery operations consist of funeral service locations, cemeteries, funeral service/cemetery combination locations, crematoria, and related businesses.
Balance Sheet
Cash and Cash Equivalents: 127 M
Short Term Investments: –0
Long term Investments: 3.9 B
Total Cash: 4 B
Total Debt: 1.8 B
Net Cash: 2.2 B
Outstanding Shares: 228 M
Net Cash / Share: 9.6
Share Price: 10.9
Enterprise Value / Share: 1.3
Total Market Cap: 2.5 B
Enterprise Value: 300 M
2012 Sales Growth: 2.1%
2012 Earnings Estimate: .7
Enterprise Value Multiple: 1.8 Times Forward Earnings
Dividend & Yield: .2 (1.8%)
With all the talk of uncertainty around tax policy (carried interest, top marginal rates, payroll taxes) that other certainty in life was never up for debate. You, me, your Aunt Milly, we’re all going to die. Life spans may be increasing but we;re no closer to immortality than Ponce de Leon was. The way we process death however is undergoing a radical transformation that threatens Service Corporation International’s business model.
SCI goes by such an innocuous corporate name, probably to obscure the morbid nature of its enterprise; they run 1500 funeral homes and 43 cemeteries for profit, and somehow I don’t think Death Corp or Embalmers Inc has a pleasant ring to them. Service Corp is one part rollup, one part networked businesses with common standards, like the floral industry. Beginning in the 60s, founder Richard Waltrip, who is still Chairman, began gobbling up mom & pop funeral operations, eventually swallowing his two of his biggest rivals after some FTC concessions. Today SCI sits on more than $2 billion of revenue a year, owns a vertically integrated funeral services production line, and prestigious funeral homes like Frank E. Campbell in Manhattan.
The slow death SCI is facing is one of changing tastes. The American public is increasingly secular, the result of which has been an explosion in cremation vs. burials. SCI and other funeral providers never used to think much about cremation, but it now makes up half of end-of-life services in the Northeast and Pacific Northwest. The real tipping point was this year when the industry’s biggest conference was, for the first time, a joint venture with the main cremation trade group. The funeral industry is attempting to move cremations from the low-cost alternative they are now to a high-cost new-normal, even going so far to pitch cremation as a “green” alternative to burial.
And try as they might the funeral industry will never be able to capture the glory days when they had total information asymmetry. The gambit has always been one of up-selling, subtlety telling those carrying out the arrangements that the deceased would be more dignified in a mahogany casket and with a double-wide headstone. Today the bereaved are coming into funeral homes better prepared than ever (one funeral director I spoke with said it wasn’t uncommon for his customers to whip their iphone to try to get him to match prices), shopping ahead of time online, even pre-buying caskets at Costco. And the regulatory environment hasn’t been kind to SCI, with more states decreeing that cemeteries necessarily be non-profit. The segment that has held up the best thus far, the 1%, are starting to embrace the cremation trend as it lets them really indulge a jetset lifestyle into the afterlife. The rich would rather spend eternity on the links at Pebble Beach and on a beach in the South of France than a crypt their ungrateful heirs will never visit. I like SCI as a short because everyone loves it as a play on the aging baby-boomers, but I’m betting that a tricked out funeral will be less of a desire for them than it was for their parents.
Source: http://purplejunction.com/2009/06/08/fewer-people-dying/
Conclusion
I am extremely worried about the ability of neer-do-well politicians to take us right back to 2008. Instead of using the crisis to fix long-standing problems they are negotiating minisculue bond haircuts & debating legal arcana. And that’s why I wrote The Dirty Dozen: 12 stocks with Fundamentally Broken Business Models, so that we can act even if the bureaucrats won’t.
Don’t get me wrong, I’m a fundamentally optimistic guy, and I think a lot of really great things are happening in the U.S. economy, but there are signs that any error or mini flash crash or hummingbird flapping its wings could send the stock market into another tailspin. When I hear money managers starting to believe central bankers, I get worried. Really smart people are significantly under pricing just how quickly credit can dry up. And that when banks stop trusting each other, as the commercial paper market is coyly winking they might be, stuff gets ugly really quickly.
And that’s why I wrote this book, because when the you-know-what hits the fan, it will be the inherently flawed companies that go down. You can beat em’ and you don’t have to join em’, by getting short the The Dirty Dozen. Lets profit on a big downdraft, not be paralyzed by it.
I’ve laid out the case for 12 different companies and different business models that are geared for a reality that has already passed us by. These are brand new names that myself and my crack team have done a thorough top-down analysis on, and I haven’t shared any of them yet with my readers. Each of these stocks generates revenues and profits by engaging in activities that I essentially consider to be run-off operations. The managements of each of these stocks are unwilling (or unable) to realize just how at risk they are, and I’ve selected companies that are highly unlikely to pivot into a new direction. This isn’t a book about some syllogism like “If the Euro breaks up, then…..”,. This is about huge long term secular trends and companies that are dead in the water. And it just happens that there’s a nice macro crisis that should catalyze their demise.
Most investors, especially retail ones are hugely levered to the long side. And I’m not just talking about your stock or bond portfolio. If you own a house, have a job, have income producing property or anything that does better when the economy is booming, then you are naturally extra long. To balance that out I’ve picked companies that will give you long-term exposure to not only their own flailing prospects but ones that should show some nice returns if the larger market falters. The shifts in thinking and reality that underpin my choice of these stocks are along some of the same lines I’ve been talking about for years, themes that have helped my readers hit plenty of doubles & singles and even some homeruns. I’m talking about the Cloud Revolution, the App Revolution and the upheaval in the financial world; these are all huge negatives for our dozen picks aka positives for us. So right now, in this moment of calm before the storm, it’s a great time to read up and add some exposure to the short side of businesses that can’t possibly survive in the Brave New World.
Disclosure: At the time of publication, Cody Willard was net short LPS and net long STX; Ashwin Deshmuk was net short MCO and LPS and net long BRK.A, BRK.B, BAC Tarp Warrants; William Fox was net short LPS and net long STX.