April “Idea of the Month” from the VIC

by Travis Johnson, Stock Gumshoe | April 18, 2014 5:48 pm

A Two-fer of ideas from the Congress, one for growth and one for income

Whenever I attend the Value Investing Congress, which I try to do twice a year, I tell folks to expect me to pick my favorite idea from that conference to share as the “Idea of the Month” not long after — and that’s what we’re doing again today.

There were a passel of interesting ideas at the Congress, and a refreshing lack of media coverage meant that we didn’t see half the stocks get driven up in price while the conference presentations were underway (partly because this one was in Las Vegas, not NY, and partly because they didn’t allow the media in — folks who wanted to write about the ideas, like me, had to buy a ticket). So I had a lot to choose from.

And these do not tend to be urgent ideas that are driven by a near-term catalyst, so there’s usually plenty of time to stop and consider. In fact, one of the ideas that I shared from the Congress a year ago, Rosetta Stone (RST), has been down for a while as the revamping of its business takes time to cycle through… and it got recommended by a completely different money manager this time around. I still own that one, I have gotten more comfortable with it despite the decline in price, but haven’t done anything to grow or shrink my holdings recently… I’m just watching patiently for now.

So what do we have to share with you today? Well, I know readers are looking for a variety of different kinds of investing ideas, from wild speculation to income to growth, so while I do actually have a favorite I’m going to suggest that you look at two different stocks.

The income idea is Cherry Hill Mortgage (CHMI), the first mortgage REIT I’ve had any interest in in many years — but if a 10% yield and very little potential for big growth beyond that anytime soon don’t thrill you, it’s not so enticing. Presented by Chris Mayer at the Congress, the original notes I shared are here[1].

The growth idea is SodaStream (SODA), largely because it’s not priced for any growth and doesn’t get any credit for the stable, cash-gushing nature of its valuable core businesses. This one was presented by Whitney Tilson (my notes here[2]), who has also generated a fair amount of press for the idea (the other two have gotten essentially no attention, probably because they’re not nearly as high-profile, consumer-facing, or controversial as companies).

I’m putting SODA on our tracking spreadsheets as a speculation and a good buy around $40, and CHMI on the speculations list as an appealing income buy up to a 10% yield (that would be a $20 share price). I don’t own either of these personally and won’t be trading any of them for at least three days per my trading rules.

Let’s take a little look at each — I’m not going to overwhelm you with blather today, because we’ve also got new stock ideas from Dr. KSS and Myron this week, but I’ll try to get to the important details.

Cherry Hill Mortgage (CHMI) is an externally-managed mortgage REIT with a 10%+ yield. That right there is enough to turn off some people, because mortgage REITs are extremely volatile when interest rates change and almost everyone thinks interest rates are going to climb eventually, which is likely to squeeze the core profits of most of these financial companies.

But CHMI is a little bit different. They invest not only in regular mortgage bonds (agency RMBS, which are sort of the plain vanilla government-sponsored repackaged mortgages), but also in excess servicing rights. That provides balance to the portfolio, and gives their book value some ballast when rising rates might otherwise hurt them (or, indeed, when falling rates might bring refinancings of their bonds, which no mortgage REITs want to see).

What are excess servicing rights? Built into each mortgage created and sold are both the principal, which is familiar to most of us, but also the servicing rights and some fees associated with those rights.

Servicing rights owners earn the actual servicing fee, which a servicing company charges for essentially sending out the statements, collecting money, processing the payments through to the bondholders, tax authorities and, sometimes, insurance companies … it’s really a payments processing business, which at scale doesn’t cost much. Unless the loans are non-performing or start defaulting, in which case it is much more work (manual, individual, and labor-intensive) to manage the delinquencies, work-arounds, adjustments, etc. or, eventually, refer loans to foreclosure.

In the case of Cherry Hill, they were spun out of a private mortgage originator (Freedom Mortgage) in part as a way to monetize the mortgage servicing rights and get a little bit cheaper equity capital from the public markets — they went public last fall at close to the price they trade for now (it has mostly traded between $17.50-$19 since going public), and they are a play both on levered-up mortgages (like any other mortgage REIT) and on excess mortgage servicing rights… with the two together making a much more stable income-generating investment in a fluctuating interest rate environment than either could on its own.

Here’s how it works according to Chris Mayer, who presented this idea:

Freedom Mortgage services the mortgage and takes their fee off the top, eight basis points out of the 28 basis point base fee for servicing (as in, multiply the unpaid principal of the mortgage by 0.0028, that’s your annual servicing fee — so, for example, a $200,000 mortgage might have a servicing fee of a bit over $500 a year). Freedom takes those eight points, then the remaining 20 points are split between Freedom and CHMI 15/85 (CHMI gets most). If a mortgage is refinanced, then the servicing fees aren’t there anymore (just like if a mortgage refinancing leads the original mortgage bond to be repaid, sometimes at a loss for the bondholder if it’s a newer or above par bond)… but if Freedom refinances the loan and keeps the servicing, then CHMI gets to keep their servicing rights bite as well. CHMI has bought a couple pools of excess servicing rights since going public, though there’s no guarantee that they’ll be able to buy more such pools at decent prices in the future.

CHMI does not lever up the servicing rights, but they don’t have to because they get a pretty high return on equity on those as it is — they aim to get a ROE of 13-16% on the servicing rights investment, which is all equity. Then the rest of their equity, roughly 25% (after holding on to some cash), they lever up 8X (borrow eight times the equity, at short term rates) to buy mortgage backed securities, which is the core business of most mortgage REITs.

That part of their business, the mortgage bond portfolio, with leverage, can also get a ROE of up to 10-15%, which is why mortgage REITs can pay yields of between 10-20% (the mechanics are thus: put in $1 of equity, borrow $8 at 2% short term rates, earn 3.5% on the bonds in the $9 portfolio, and that gives you about 14 cents of profit on the $9 portfolio, or a 14% return on the $1 in equity you put up).

But the reason people fear mortgage REITs, rightly, is that they are entirely dependent on the rate curve — the steeper, the better — for their ongoing profitability, which means they need short term rates to stay low so they can borrow, and long-term rates to stay higher because their profit is based on what they can earn by borrowing short-term and lending long-term. If they’re earning a coupon of 4% and suddenly their cost to borrow jumps from 2% to 3%, then their profit just got cut in half (roughly speaking). They also own large portfolios of bonds that shift in value as long-term interest rates move, so there’s also a balance sheet risk … if long term rates climb, then they can’t sell their bonds at par because newer bonds have higher coupon rates.

So CHMI gets around that by having the two-part portfolio: servicing rights and mortgage-backed bonds. Mortgage servicing rights are not interest-rate sensitive, so they cushion the portfolio agains the movement in value of the MBS — which is how the book value per share actually improved in recent quarters, the value of those rights had gone up by the time the deal closed.

Beyond the risks of being in the mortgage market, with the danger of losing some of their servicing rights portfolio to refinancing if mortgage rates fall again and there’s another refinancing wave, or losing some book value on the bond portfolio if rates rise considerably, there’s also the risk that this is a captive entity to some degree — it is controlled by Stanley Middleman, who controls Freedom Mortgage, which is a good-sized mortgage originator. Freedom paid most of CHMI’s listing fees and owns ~13% of the company, so there’s no reason to think that Middleman has a nefarious motivation here, but Freedom does earn a 1.5% management fee from CHMI and have a partnership to share in the mortgage servicing rights they buy (from Freedom or elsewhere).

I’m pretty comfortable with that, partly because we can buy CHMI at a decent discount to book value of 10-15%. They have so far paid just two dividends, the first quarterly in December at 45 cents and the first payment of 2014 at 50 cents, but there’s no real reason to expect substantial dividend growth unless they make large acquisitions of more servicing rights — I expect this to be a pretty steady 10% yielder, and think it will probably still be close to $20 a share in a year and, importantly, I think it will substantially outperform any “normal” mortgage REITs if we have an upside shock to interest rates.

From their last quarterly press release[3], you can get a pretty good idea of what they’re doing to build the company — the question for me, really, is whether they’ll be able to keep it up. If they can continue buying these excess servicing rights, they call them Excess MSRs, at 2-3X the annual cash flow from those MSRs, then they can build a really successful business that moderates the risk of their mortgage portfolio and makes a lot of money. Here’s what they bought in their first quarter:

“Excess MSR Investments – Invested approximately $99 million, to acquire:

“The $15.6 million increase in the fair value of the Excess MSR pools during the fourth quarter was related, in part, to the difference between the prices at the time the prices were negotiated and the fair value of the Excess MSRs on the acquisition closing date. The purchase prices for the pools were negotiated by Cherry Hill and Freedom Mortgage Corporation in the mid-third quarter of 2013 and the acquisitions closed concurrent with the IPO on October 9, 2013.

“Agency RMBS Investment – Acquired approximately $293 million of Agency RMBS, including TBAs, with the following characteristics at year end 2013:

I think a portfolio that can grow with acquisitions like that is worth a little more than book value, at least … but it’s early days and there’s no way to pitch this as rock-solid — it isn’t, that’s why it has a 10% yield. But I think it’s a good buy for those who seek income, particularly if you think we’re going to have a “muddle through” economy for a couple years without a lot of dramatic movement on interest rates, which I think is probably the most likely scenario.

I’d buy it around $19 and put a pretty tight stop loss (maybe in the neighborhood of $17 or a bit below) on this particular holding — if something bad happens I think it’s likely to move down more slowly than some competitors, but it’s also not likely to go to $25 and give you a big surprise capital gains boost, so you don’t want to risk a lot more than the annual expected dividend from these shares if you can help it. (Not that the whole investment in any stock isn’t at risk of going to zero overnight, you can always have the freak scandal or other crisis — but assuming they’re not crooks and that the regulation of the mortgage business doesn’t suddenly do away with their business model, which are the two big theoretical risks I can imagine, both with low probability, I think we can limit our risk a bit with stop losses on this stock even though I’m not a big proponent of stop-loss orders in general).

If you want to do something more aggressive in the income investing world, by the way, look at my old favorite Seadrill (SDRL), I’ve recently been inclined to believe management when they say there’s no reason they’d have to cut the dividend (it yields about 12% now), which meant I thought it would gradually be moving up to $40 a share for a more typical 10% yield. It certainly hasn’t done so yet, it’s been moving gradually down instead (below $33 now) because investors are in a kerfuffle over what will happen to deepwater rig rates in 2015 with energy companies pulling back on exploration budgets — I think Seadrill knows more than the analysts do about what rates will do in recovering in 2016 and 2017, and that their balance sheet can handle this dividend rate for a couple years of flat business, so I think the stock is overreacting with this move down and I’m sticking with my holdings… and actually considered adding a bit this past week (I didn’t do so yet, and now I won’t do so for at least a week since I mentioned it in this space, but I’m tempted). Imagine what will happen if the global economy spikes into real growth again next year and oil prices drive higher — exploration companies would go crazy trying to restart some of the expensive offshore projects that they might be a bit tepid about today.

Second on the list for consideration, we’ll call it the “co-idea of the month” is SodaStream (SODA). SODA has been a controversial stock for a while now, in part for political reasons (it’s an Israeli company, and one of its factories is in a settlement in the West Bank, causing a flap with Oxfam and some boycotts — though they would likely be fine if boycotts caused them to shut down the West Bank factory and move their production to one of their other facilities … much of their stuff is already made in China), but as an investment it’s been more troubled of late because they’ve been investing so much into trying to grow their US buisiness.

SODA sells home carbonation machines, and has for decades — they are clearly the global leader in this business, and it’s not a complicated business. They sell machines that you can use to make carbonated water at home, they sell the CO2 tanks that are used in those machines (you have to swap out the tank every 40-60 bottles and replace it with a new, recharged one), and they sell a huge variety of flavorings if you want to add syrup to your carbonated water to mimic a soft drink of some kind (colas, sparkling lemonades, etc).

They offer a pretty good value proposition for people who drink a lot of sparkling water, or who want to have a variety of flavored sodas available at any one time, at a discounted price — this is a lot cheaper than buying your bottles of seltzer at the grocery store, and more convenient than storing a half dozen flavors of soda in your pantry. I would temper growth expectations somewhat because, regardless of what optimists think, SODA is not going to supplant individual cans of Coke or Pepsi. The flavor can’t match what they sell, and those are large and addicted populations who aren’t likely to switch habits — and they also don’t have the exact branded syrups for that extremely brand-loyal niche, I’m sure habitual Diet Coke drinkers would find SodaStream’s diet cola syrup unpleasant. I drink a lot of seltzer water but haven’t tried out one of these machines — so I’ll make a pledge to you now that I will go buy one and try it out, and if it’s a pain in the neck or I have other troubles with it, I’ll let you know.

Right now, SODA is a company that’s been showing decent revenue growth but faltering earnings, largely because they have been reinvesting the fantastic earnings they make in Europe, where they have a mature and very profitable business, into marketing and capacity building to grow their small US business.

Whitney Tilson recommended SODA because it’s a stock with a solid brand that’s beaten down, and with high short interest, because short sellers and critics think it’s a fad. When we all realize that it isn’t, and that SODA can either tame their marketing costs in the US or grow the US business and make us realize that a couple weak quarters don’t define their potential, the stock should do very well. The problems they’ve been having are eminently fixable, they have a “moat” business, and you can now buy the stock — formerly a growth darling with a nosebleed price — at a very reasonable valuation.

SODA had a bad US holiday season — but they still grew revenues by 16% in the US and 26% globally. Their marketing was not successful in really boosting sales, as it had the previous holiday season, so investors assume that the product is a fad. That seems largely to be a US-centric position, since they grew sales by 38% in their core, mature Western Europe markets — Tilson claims the real big issue for investors was the big crunch to margins because SODA was “very promotional” in the fourth quarter, like many companies, in a somewhat desperate attempt to boost holiday sales in a very competitive environment. That meant they sold a lot of machines at much lower gross margins than usual, more like 15% instead of the 30%+ they had enjoyed previously.

Think about that for a minute. This is a “razors and blades” business, where you would assume that they take a loss on the sale of the machines, or maybe break even, so that they can make it up with the very high margin sales of CO2 tank refills and flavorings. That’s what Green Mountain does, they typically lose money for each Keurig machine they sell and try to make it up with K-cup sales. But actually, SODA has been making 30 cents on the dollar for their machine sales… so the fact that the margins fell on those machines in the quarter doesn’t bother me that much — those are machines that will need high-margin refills, so as long as they can continue building the US business to a critical mass, as they have in Europe, to keep up the retail presence that handles their CO2 refills for them, this only helps. Their sales of soda maker machines jumped 39% in the fourth quarter, so there are more and more machines now that need refills and flavorings.

You can see Tilson’s full presentation, which he made publicly available, here on the Tilson Funds site if you’d like to see more of his argument and numbers. Essentially, the company can either fix their inventory overhang from the fourth quarter and get growth restarted, with gradually increasing margins, or they can dial back on growth expectations and enjoy a very strong base business with good recurring revenues and much higher profit margins. Either path would work, and I think that we’ve most likely got a company in the middle of a slight growth hiccup but with a massive installed base of seven million machines around the world (more than half of which were sold last year alone).

If you think the home carbonation business has any legs at all and is not a fad, then SODA is dirt cheap — they are completely unassailable unless Coke or Pepsi decides to invest a couple billion dollars in home carbonation machines, and after some failed attempts along those lines in the past I think that’s incredibly unlikely. Keurig and Coke are cooperating on the possible new “Keurig Cold” system that would use something other than CO2 to create bubbly water, but I suspect that’s not going to work at all and is likely to be dramatically more expensive (and may be dropped entirely if Coke risks connecting its brand to something that tastes lousy). And there are other possible similar “chemical carbonation” systems that folks are trying to develop, but over the last 100 years no one has been able to come up with a better carbonation system than pressurized CO2 cartridges … and another company would have to put years and billions of dollars into building a distribution network to sell, recycle, and refill CO2 cartridges if they wanted to eat into SODA’s business.

It’s also a business that can’t be “stolen” online very easily — empty CO2 cartridges are a hazardous material that can’t be easily shipped, so unless you have an on-the-ground retailer network it’s inconvenient for consumers to ship their monthly or bi-monthly refills back to the company for refilling (this works kind of like the propane tank networks, you get a charged CO2 cartridge with the machine then and can always buy full spares at full price, but when you’ve emptied one you turn in the used cartridge to get a price break on each new one you buy, then the retailer ships the empties back to SodaStream for recycling).

The goal, really, is to get SodaStream into grocery stores. If they can get to enough critical mass that grocery stores are accepting CO2 tanks for refill and selling new tanks in the beverage aisle, this business takes care of itself and will be a tremendous cash gusher. Tilson also supplies, as further evidence of the value of SODA’s vast network of CO2 refill retailers, that none of the new carbonation appliances being sold by the big brands, like KitchenAid or Samsung, have tried to establish their own refill networks — they all use SodaStream cartridges (including the new Samsung refrigerator that dispenses sparkling water).

So I think we have a likely growth story once they work through probably one more bad quarter (you may get a price break on shares if you wait until they report in a few weeks, though it could easily go the other way), but the floor under the shares is pretty solid because of their core European business. Tilson’s assessment, and I think it’s correct, is that “The startup costs of entering new markets is masking the profitability of SodaStream’s European business and/or of its established active user base.”

Or, in other worse, either the Western Europe business or the CO2 refill business, as stand alone enterprises, would be worth close to SODA’s $900 million market capitalization. Western Europe, SODA’s core region, would be earning something like $2-2.50 per share by itself, and if the CO2 business was a separate business Tilson forecasts it as earning something like $112 million a year after taxes (SODA gets about $7 per exchanged cartridge, the rest is shared by retailers, and they can refill and redistribute them at something like an 85% gross margin), and a business that stable and inexpensive could, Tilson says, be worth more than 8X profits.

That’s just an exercise in valuation, they’re not going to break up the company and the stock will continue to fluctuate based on their earnings versus estimates, and on the vacillating margins and machine sales, but it’s a good exercise to remind you that yes, this is a spectacularly successful business on a lot of fronts… and if they figure out how to make it just a little bit better in North America it could easily reignite the stock and get a more reasonable valuation. I am hoping that investors are again disappointed in the current quarter and the stock gets down to $35 or so, but I think that’s pretty unlikely so I’ll be considering a purchase of the shares in the $40 neighborhood once my trading restriction expires late next week… assuming the stock is anywhere near that point then.

I’ll let you know if I end up buying shares of either SODA or CHMI personally — I’m most likely to buy SODA because I don’t have a strong need for yield right now, but I will wait probably a week before doing anything. I’ll also let you know if I’m delighted with the SodaStream machine after I buy one, we’ll see how that goes (yes, I know plenty of you have probably already tried it — but whenever possible I like getting my hands on investments).

P.S. I’m also a bit tempted by Avid Technology (AVID), but I really can’t recommend it with a straight face because they’re in the process of restating their financials. Zack Buckley recommended this one, largely on the strength that he thinks they will have with the next upgrade cycle in televisions from HD to Ultra HD or 4KTV. There’s a good story about the “Ultra HD” experience in the Wall Street Journal from last week here[4]. If the world moves to adopt this new technology (ie, if it’s not a flop like 3DTV), then Avid should do well because their customers will all need to upgrade to new suites of their editing software to handle UltraHD, says Buckley, and that could create a massive business. AVID went from ~$10 to $60 in the early 2000s when HD programming and TV sales boomed, and he thinks it can happen again. I’m on the fence, and I can’t think clearly about them until they release actual financials, but if you’re a risk taker it might be interesting.


Endnotes:
  1. original notes I shared are here: http://www.stockgumshoe.com/2014/04/chris-mayer-investing-by-the-c-o-d-e/
  2. my notes here: http://www.stockgumshoe.com/2014/04/whitney-tilson-my-favorite-ideas/
  3. last quarterly press release: http://investors.chmireit.com/phoenix.zhtml?c=251861&p=irol-newsArticle&id=1912302
  4. “Ultra HD” experience in the Wall Street Journal from last week here: http://online.wsj.com/news/articles/SB10001424052702304572204579503540257173348

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