CIM -- Michael Farrell & Annaly Capital Management Inc.

At this point CIM has been in existence for just over 1 month. The company has not filled a single financial statement. There have been no conference calls or presentations beyond the IPO road show. The only piece of tangible news out of the company is the first minuscule dividend of $0.025 per share announced last week.

So why is the stock trading at $17.75 while it has an estimated book value of just over $14 per share?

The only explanation is that the market believes the involvement of Michael Farrell and his associates at FIDEC warrants a premium.

While CIM has no operating history, we can certainly use Farrell’s 10 year track record at the publicly traded Annaly Capital Management (NLY) as a guide. NLY has the same structure and business model as CIM with the big difference being that NLY’s assets are of the highest quality while CIM will invest at the lower end of the quality spectrum.

Looking back to 2006 with NLY shares slightly off the lows after being cut almost in half and the great credit orgy reaching its climax, here is the key quote from the 2005 annual letter (published in March 2006)

“As 2005 played out, we prepared our business for the inevitable change in sentiment and shape of yield curve. While other stretched for returns in the form of credit risk, mortgage derivatives, new business models or extra leverage, we stuck to our discipline of using AAA mortgage backed securities. It cost us some earnings …..but I believe this discipline will only be appreciated by investors when viewed through history’s rear view mirror.”

While this scenario benefiting NLY seems “inevitable” today, it certainly was not so in early 2006. This group stuck to their guns despite earnings and share price plummeting while it seemed like everyone else in the mortgage business was printing money.

NLY’s net interest spread – the main source of NLY’s and CIM’s income -- shrunk from 1.51% to 0.53% meaning that all other things being equal NLY would earn $1 in 2005 for every $3 earned in 2004. This happened because the yield curve flattened and this is a risk of being in this business.

One way to deal with a flattening yield curve is to buy less credit worthy assets which have a higher stated yield. The name for this strategy that clients and shareholders never hear is “reaching for yield.” The problem with this approach is while your net interest spread benefits initially, you are exposing your portfolio to bigger problems later if these higher yielding, less creditworthy borrowers start defaulting. Instead of buying, NLY was selling.

In the fourth quarter of 2005, NLY took a substantial loss by selling assets that they felt were unlikely to meet return expectations. Also, they did not buy any of the most recently issued loans made at higher yields but to less creditworthy borrowers. They cleaned housed. They shrunk their book of business just as the environment was at its most euphoric and it seemed like borrowers could refinance or sell their constantly appreciating homes forever.

By now Farrell and his group have been proven right and NLY is now growing and in a position to buy when everyone else is selling. The stock has regained much of what it lost in 2005.

What does all this have to with CIM?

CIM will make money the same exact way as NLY and will be run by the same exact people that manage NLY. The actions this group took in 2005 show that they are willing to sacrifice earnings, share price, and their reputations in the short term to protect and reward shareholders in the long term. This is a rare quality that certainly deserves a premium and should be a key consideration for every potential CIM shareholder.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

CIM -- Business Model

In this last “background” post on CIM, I am going to talk about how CIM actually makes money and the risks of investing in this stock.

How will CIM actually make money?

The company will take the $520M of cash it raised last month in the IPO (this is called equity) and buy real estate backed loans (these are CIM’s assets) that will produce an income stream in the form of interest and principle paid to CIM. It’s a bit confusing, but CIM’s assets are loans made to someone else. So at this point the company’s balance sheet essentially looks like this …….

$520M in assets yielding lets say $25M in income to CIM
($520M in equity raised as part of IPO)

Then CIM will use its assets as collateral to borrow money and will pay X% as interest expense to the lenders. The company will than use this borrowed money to buy more assets hoping that its assets will yield X%+Spread. So now CIM goes from having $520M in assets yielding $25M, to ……

$520M in assets yielding lets say $25M in income to CIM
$5,000M in additional assets yielding $250M in income to CIM
($5,000M in new liabilities which cost CIM $200M in interest expense)
($520M in equity raised as part of IPO)

So, by leveraging its equity CIM goes from earning $25M or 5% return on equity for shareholders to earning $75M ($25M on equity raised in IPO + $50M in difference between interest income on $5B in assets and interest expense on $5B in liabilities used to pay for those assets) and ROE jumps to almost 15%. Since this is a REIT, 90% of the income gets paid to shareholders in form of a dividend so the shares will have a much higher yield than other equities.

This is a very simplistic example but this example give a good example of where the cash will actually come from and how a company with $500M in equity can have 10x the buying power.

Seems easy enough, but what could go wrong?

The first problem is that CIM’s business model is exposed to the yield curve because CIM will borrow using shorter term loans like commercial paper but will buy long term assets with that money like 30 year mortgage loans. There is a mismatch in maturities that creates a big risk of the yield curve flattening. If the yield curve flattens than the difference between costs and revenue will shrink and CIM will earn less money. This is exactly what happened in 2005 and CIM’s parent Annaly Capital Management got whacked as a result, more on this later.

The second problem is that the company will use a lot of leverage, that’s part of the business model, and is sensitive to what is happening in the credit markets beyond the shape of the yield curve.

For example, if the banks CIM borrows money from all wake up one day and say that they want their money back at the same time or the assets that they are holding as collateral are now worth less than they were yesterday, CIM could be in some series trouble. At this point, CIM either has to find someone else to lend them money, issue more stock which dilutes current shareholders, or have a fire sale on its assets to pay off its lenders. This is called a “credit crunch” and is exactly what happened in early August and is happening right now.

The third problem is that the value of the CIM’s assets is uncertain and changes every day while the cost of its liabilities is written in stone. CIM’s assets are loans to others either in the form of actual loans it buys from a major bank that originated them or in the form of a credit security backed by mortgage loans. Since these are long tem loans there is always a risk that borrowers will default and CIM does not get all the interest/principle it expects to get so the actual yield they realize on their assets is lower than expected.

The other risk is that one day the market can simply decide that its assets are worth much less than originally thought but the liabilities CIM owns will stay the same. If this happens there is a mismatch between loans and assets and that mismatch will be made up buy shareholder equity and will kill the stock. This is by the way exactly what is happening with just about any financial institution that owns any mortgage related assets.

So this is why CIM’s business model is a “catch 22” proposition. On one hand its extremely simple – just borrow short at X and lend long at X+Spread—and leverage that trade up 10 times and you are printing money.

On the other hand, CIM is exposed to the yield curve as well as the gyrations in the credit markets which can change overnight. If CIM takes on to much leverage or can’t sell its assets to raise money in a credit crunch, the company can go out of business overnight or suffer a serious impairment to shareholder equity and therefore the stock price. Also, the company may simply overpay for assets and not earn as much as it expected on them.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

CIM -- Investment Structure

As I wrote in the previous post, CIM is essentially a publicly traded hedge fund structured as a mortgage REIT which means they have to pay at least 90% of their income out as dividends every quarter.

For shareholders this structure exhibits two of the most attractive aspects of investing in hedge funds and one very unattractive aspect.

The first attractive aspect is that the group at FIDAC that will be managing Chimera will be paid on a standard hfund 2/20 structure. Particularly, FIDAC will charge 1.75% of book value as a base fee and will take 20% of anything CIM earns beyond LIBOR + 50 bps. The incentive fee makes perfect sense because FIDAC needs to earn a premium to LIBOR (which any shareholder can get themselves) before they start sharing in the bounty. Also with this structure, FIDAC’s interests are directly aligned with shareholders’ interests.

It also appears that all fees that CIM pays to FIDAC will be adjusted downward to exclude any fees paid on Annaly sponsored products that Chimera might buy. This eliminates the possibility of FIDAC double dipping on fees and benefiting NLY shareholders at the expense of CIM shareholders.

The second attractive aspect of CIM’s structure is that FIDAC has “skin in the game” along with other CIM shareholders. As part of the IPO, FIDAC bought 9.8% of CIM’s stock spending roughly $50M dollars of its own money. Technically, it was Annaly that bought the stock but I am using FIDAC and Annaly interchangeably. Having a large chunk of their own money invested along side fund investors is very common with hfunds and is a substantial advantage to shareholders as interest are perfectly aligned.

The only unattractive aspect of this type of structure is one that is unavoidable and not unique to CIM. Whenever investors hand money over to professional asset managers whether it’s to a stock broker, a hfund, a mutual fund, or a vehicle like CIM the asset manager always has higher incentive to take greater risks than warranted by the mandate. The reason for this is simply that the career/financial benefits to a professional asset manger of taking big risks and being right are almost always much greater than the downside of being wrong.

Every professional money manager knows that if they take unnecessary risks and underperform or even blow up they might get fired or will have to shut down their firm. But professionals also know that if they get fired they can go hide out at a trust department or an insurance company somewhere. If they really screw up, they might have to get out of the business for a couple of years. But everyone knows that things will be forgotten in a few years and they will get another chance to manage money.

But if the managers take the big risks and are right ....... they will become superstarts.

For professional money mangers -- like the people that will be managing CIM -- taking big, unessasary risks is like buying a call option on your career. If you are wrong you lose the small premium (maybe your job or some bonus money) but if you are right, you win big. The problem for investors is that while the manager might lose a little they might lose a lot.

The incentive fee and having the manager’s money along side shareholders is there to minimize the negative aspect that can never be completely eliminated. In subsequent posts I will also make the argument that looking at the track record of Annaly provides substantial evidence that this management team will be very good stewards of shareholder’s capital and CIM’s hedge fund like structure is a net benefit to shareholders.


* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

CIM (Chimera) – First Look

I was initially introduced to this company at 3:00 pm on November 16^th, 2007 when I was getting ready for a conference call and overheard one of the CNBC anchors say “Michael Farrell celebrates Chimera IPO by ringing the closing bell at the NYSE.” At that point I have never heard of Chimera but I have certainly heard of Farrell and immediately downloaded Chimera’s S1.

This analysis will be a bit different than those in the past and I will spend less time talking about Chimera and more time talking about Michael Farrell and Annaly Capital Management which is Chimera’s parent and Farrell’s main investment vehicle.

Currently:
Share price: $15.25
Market Value: $564M
Enterprise Value: $520M (this is book value for CIM)
Investment Type: Time Arbitrage

CIM completed its IPO almost exactly 1 month ago on November 15, 2007. Per the filling on the day of the IPO, CIM planned to sell 33.3M shares at $15 per share raising $500M with an additional 5M shares optioned for overallotments. Off the $500M raised, $31.25M would be paid to the investment banks doing the IPO so CIM would received $14.0625 per share in actual proceeds.

Based on the 11/30/07 13D filling, Annaly owns 3.62M shares representing 9.8% of total shares outstanding, a maximum percentage of shares outstanding allowed to be owned by any shareholder under this structure. This implies that the final number of shares sold was 36.94M for a net proceeds after selling expenses of $520M.

CIM is basically a publicly traded hedge fund managed by an asset management group called FIDAC which is led by Michael Farrell (Annaly technically owns FIDAC but the same people that manage FIDAC also manage Annaly). The company is structured as a REIT which means at least 90% of its income will be paid out as dividends and virtually all of its investments will be real estate backed mortgage loans and structured products backed by mortgage loans.

I will spend more time in the next post on the company’s business model and may do a quick primer on the basic accounting of mortgage REITs.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Some real evidence of a slowdown .......

One of the drawbacks of working for a traditional institutional asset management firm with a decent amount of assets under management is that I get a ton of Wall Street research and I am expected to read most of it and regurgitated it to colleagues, clients and prospects.

Needless to say that reading this stuff gets old fast so I get particularly excited when something useful/interesting/contrarian comes across my desk. Here is the most relevant excerpt from a recent morning note from Merrill Lynch …..

"Mr. Rosenberg, I have been reading your economic reports since your arrival at Merrill. Last night I began my evening by tuning into Kudlow on CNBC. The topic was as usual "Will the slowdown in the housing sector send us into a recession?"

With that topic on my mind I ended the evening with a group of High School students meeting with a local cement contractor. He began his career 20 years ago with one truck and a second mortgage for capital. He now has 85 trucks that cost $175,000 each and 100 employees with salaries of $40,000 to $100,000. Business has been good the last 20 years. We began asking questions: How is business going? We have some road contracts but the housing business has almost stopped. Will you be buying any trucks this year? No. Will you be hiring in the next 6 months? No. Is there a cement shortage? 2 years ago there was a shortage but no shortage now. How much fuel do you use each month? 20,000 gallons. How much do you spend on benefits and insurance? About $10,000 per employee. Other questions were asked and my conclusions were these. This small businessman will not be buying any trucks this year. His employees who love to buy their own large 4 wheel drive trucks will not be buying either. Less fuel will be bought. Less cement will be purchased. Less money will go into retirement plans. Less money to insurance providers. The only expense that was going up was the legal expense for liens on contractors not paying.

Looks like the housing recession is affecting more people than I thought."

I believe that this is relevant since it provides more evidence in two particular areas of interest to investors……

1) The housing market slowdown is decreasing the amount being spend by Americans in real time and not just because they can’t tap the equity in their home, and

2) it says something when the most relevant piece of Wall Street research I have seen in some time (and I am not singling out Merrill who to their credit have been sounding this alarm for a while) is contributed by a reader.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

Things that make me happy......

Ran across this great line in this Financial Times article. The article is your boiler plate summary of the current problems in the credit markets but this opening line blew me away and really made me happy.

"As the technology bubble imploded, fund managers stopped pretending to know what ethernet routers did and started asking what life would look like if all tech stocks halved in value. The structured credit market has yet to reach this moment of clarity. As is typical when the sky falls in, many specialists, obsessed with complexity, point to the impossibility of generalizing about the weather.


I have a perverse pleasure of seeing investment industry bullshit get exposed to the public. One of the most frustrating for me is the often voiced idea that portfolio managers and their army of analysts at trust departments or a mutual funds know something about advancements in technology or biotechnology.

Also, the tech bubble and the subsequent explosion holds a special place in my heart as I had the experience of being an equity analyst intern in 2000 and 2001 for a manger of a $1 billion tech fund who thought that it was actually his skill that was responsible for the 5 star Morningstar ranking and the doubling in NAV and assets over the previous 2 years.

I was also there when the music stopped and it became painfully apparent that none of us, me least of all, knew anything about ethernet routers. I am glad to see that I am not the only one who feels the current credit meltdown feels exactly the same as the tech bubble popping.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.

“Best Case Scenario Valuation” for CPY …….

In the previous post I laid out a valuation framework using what I feel are very bearish assumptions with the conclusion being that buying the stock anywhere between $21 and $34 per share provides for expected rate of return of 15% to 10%.

Today I will silence my inner and ever present skeptic and will try to put some numbers on what the upside looks like assuming some good things happen over the next few years:

BEST CASE SCENARIO assumptions ……

-EBITDA at Sears would stay flat over the next two years (not all that bullish as EBITDA has been growing over the last 2 years)

-immediate incremental improvement in Wal-Mart EBITDA (not all that bullish as EBITDA can be drastically improved by simply closing underperforming stores)

-Wal-Mart would eventually achieve similar margins as Sears and FCF would double (very bullish assumption as the Wal-Mart business serves a lower end consumer at lower average sales price)

-PCA is not sold under this scenario, so the NOL’s that came with the acquisition can be included in the valuation analysis

Under this best case scenario, the CPY shares would trade at $90 per share assuming a 10x EV/FCF multiple. At a 7x EV/FCF multiple the shares would trade at $60 per share.

The best and worst case valuation scenarios I laid out highlight why I am so bullish on CPY over the next 3 years. Based on worst case assumptions, the stock has very little downside of 20% at which point you would be buying the CPY business at 7x free cash flow. However, the upside is up to 200% assuming the company’s management can do with the Wal-Mart business what they did with the Sears business.

As I see it, as an investor in CPY shares for every $1 in downside risk I am getting $9 in upside potential ….and that’s pretty damn attractive.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.