Friday, April 29, 2005

What's the Likelihood of "Making It" as a "Pure" Investor?

Anyone seeking to make a fortune should spend a few minutes scanning the Forbes 2004 list of the world's wealthiest people--for in the treasure hunt for riches, it helps to know where others are finding gold before starting to dig on one's own.

As well-publicized, the top 10 wealthiest people in the world are:

Name: Net Worth, Country (Residence), Source of Wealth

1. William Gates III: $46.5 bil., U.S.A., Software (Microsoft)
2. Warren Buffett: $44.0 bil., U.S.A., Diversified (Berkshire Hathaway)
3. Lakshmi Mittal: $25.0 bil., India (U.K.), Steel (Mittal)
4. Carlos Slim Helu: $23.8 bil., Mexico, Communications (America Movil)
5. Prince Alwaleed Bin Talal Alsaud: $23.7 bil., Saudia Arabia, Investments (incl. Citigroup)
6. Ingvar Kamprad: $23.0 bil., Sweden, Retailing (Ikea)
7. Paul Allen: $21.0 bil., U.S.A., Software/Investments (Microsoft)
8. Karl Albrecht: $18.5 bil., Germany, Supermarkets (Aldi)
9. Lawrence Ellison: $18.4 bil., U.S.A., Software (Oracle)
10. S. Robson Walton: $18.3 bil., U.S.A., Retailing (Wal-Mart)

(Source: The World's Billionaires, Forbes, March 10, 2005)

To understand where the world's most well-heeled people have obtained their riches, we can examine the breakdown of sources of wealth across industries. Extending a bit further down the Forbes list to include the top 50 wealthiest people, I find:

Industry: Percentage of Top 50 on Forbes List of the World's Billionaires

Providers of Products and Services (86%):
Retailing (discounters, supermarkets, apparel, home furnishings, mail order): 26%
Manufacturing (candy, cosmetics, autos, shoes, eyewear, packaging, aircraft): 22%
Technology (software, communications): 16%
Media (publishing, entertainment): 12%
Commodities/Materials (oil, steel): 4%
Financial (mutual funds): 2%
Construction: 2%
Casinos: 2%

Profit from Holding or Trading Assets (14%):
Investments (businesses, stocks, LBOs): 8%
Real Estate: 6%

I have separated out the most investor-oriented categories in order to gauge the likelihood of "making it" by being a "pure" investor who buys, holds and sells assets, as opposed to an operator of a business providing products and services.

Question: Is using one's acumen to make the right buy-sell decisions (as a value-hunting investor, arbitrageur or trader) a common road to riches with a decent chance of becoming successful, or is following a path in the manufacturing and service sector more likely to bear fruit?

As the above breakdown shows, the vast majority (86%) of the top 50 billionaires made their money primarily through traditional manufacturing and service businesses that depend on customers at the retail or wholesale level. A much smaller minority (just 14%) made their fortunes as investors in one of two categories:

1. Investments: Although only four (8%) of the top 50 billionaires made the bulk of their money directly from investments, two of these multi-billionaires appear among the top five, viz., Warren Buffett (#2) and Prince Alwaleed (#5). The other two individuals in the investments category are Kirk Kerkorian (#41) and Carl Icahn (#50), who made their money through various investments including casinos and LBOs;

2. Real Estate: The three (6% of the top 50) individuals in the real estate category are all Hong Kong citizens (by chance?, or are the rules of the real estate game somehow different in Hong Kong?)--Li Ka-shing (#22) with Hutchinson Whampoa; Raymond, Thomas and Walter Kwok (#31) with Sun Hung Kai Properties; and Lee Shau Kee (#38) with the Henderson group. Among these three, Li Ka-shing is the most diversified beyond real estate, now running a conglomerate including cell phone, retail and electricity businesses.

(Prior to tabulating this breakdown, I had expected to find more of the world's top billionaires with riches sourced from real estate, especially with the very substantial run-up in both commercial and residential real estate prices worldwide during the past five years. I plan to take a closer look at real estate wealth in another post.)

Here's my take from this quick survey of sources of wealth:

1. As American-style capitalism continues to thrive, consumer-oriented businesses (retail, manufacturing, technology) are likely to remain promising areas. There appears to be plenty of opportunity still for the next Wal-Mart or Ikea, more winning products like Mars bars and Nike shoes, or another Microsoft or Dell;

2. It is also possible--though "statistically" less likely--to make a fortune as a "pure" investor. However, for anyone with the resolve to try, an encouraging note is that "pure" investors are actually overrepresented (with Buffett and Prince Alwaleed occupying two of the top five slots--that's a hefty 40%!) among the ranks of the super-wealthy with net worth exceeding $20 billion.

Conclusion: Based on the list of the world's wealthiest people, the chance of "making it" as a "pure" investor may appear low, but spectacular success (as exemplified by the likes of Buffett and Prince Alwaleed) is certainly possible for those with the inclination and wherewithal to try.

Monday, April 25, 2005

Valuing Google and Yahoo

With advertisers currently paying an average of $1.75 per click-through (according to Fathom Online, March 2005 data), Google's reported gross revenue of $1.257 billion for first quarter 2005 is equivalent to 718 million total click-throughs during the quarter, or 240 million click-throughs per month. Given that the number of active Internet users worldwide far exceeds this 240 million figure, it is easy to understand where Google's revenue comes from: If the typical Internet user clicks through a Google paid search ad just once a month, Google's billion dollar (and rapidly growing) quarterly revenue stream can easily be accounted for.

Obviously, paid search is an amazingly lucrative business. In their enviable position as Internet search leaders, Google (GOOG) and Yahoo (YHOO) are raking in the lion's share of the profits. In this post I take a look at the valuation of both companies, to judge whether or not they make promising investments at current market prices.

First, here are the historical top-line and bottom-line growth numbers:

In $ Million (YOY % Growth) for 2001, 2002, 2003, 2004

For Google:
Revenue: 86 (353%), 440 (412%), 1466 (233%), 3189 (118%)
Net Income: 7 (---), 100 (1329%), 106 (6%), 399 (276%)
Profit Margin: 8%, 23%, 7%, 13%
Diluted EPS: $0.04, $0.45, $0.41, $1.46

For Yahoo:
Revenue: 717 (-35%), 953 (33%), 1625 (71%), 3575 (120%)
Net Income: -93 (---), 43 (---), 238 (453%), 840 (253%)
Profit Margin: -13%, 5%, 15%, 23%
Diluted EPS: -$0.08, $0.04, $0.19, $0.58

In $ Million (QOQ % Growth) for 2004Q1, Q2, Q3, Q4; 2005Q1

For Google:
Revenue: 652 (27%), 700 (7%), 806 (15%), 1032 (28%); 1257 (22%)
Net Income: 64 (137%), 79 (23%), 52 (-34%), 204 (292%); 369 (81%)
Profit Margin: 10%, 11%, 6%, 20%; 29%
Diluted EPS: $0.24, $0.30, $0.19, $0.71; $1.29

For Yahoo:
Revenue: 758 (14%), 832 (10%), 907 (9%), 1078 (19%); 1174 (9%)
Net Income: 101 (35%), 113 (11%), 253 (125%), 373 (47%); 205 (-45%)
Profit Margin: 13%, 14%, 28%, 35%; 17%
Diluted EPS: $0.07, $0.08, $0.17, $0.25; $0.14

Year-on-year revenue growth at both Google and Yahoo were a phenomenal 120% in 2004. Over the most recent five quarters, sequential quarterly revenue growth has averaged 20% at Google and 12% at Yahoo. 2004Q4 and 2005Q1 show that revenues have accelerated recently (especially at Google which depends almost exclusively on paid search). Expanding profit margins, now in the 20% to 30% range, are an indication of how efficiently the paid search business "scales" on high revenue growth and controlled fixed costs.

With the above historical growth trends as a guide, I now take a look at current market valuation using the following five-year pro forma assumptions:

Company: Remainder of 2005; 2006-2009

Revenue Growth:
Google: 15% QOQ in 2005; 30% YOY thereafter
Yahoo: 10% QOQ in 2005; 30% YOY thereafter

Profit Margin:
Google: 25% in 2005; 25% thereafter
Yahoo: 20% in 2005; 25% thereafter

Additionally, assuming 5% share dilution per year (largely from exercise of employee stock options) and five-year take-out pricing at the beginning of 2010 at a PEG of 1.5 (corresponding to a P/E of 36), I find:

Company: Current Price (as of 22-Apr-2005), 5-Year IRR
Google: $216, IRR = 18%
Yahoo: $35, IRR = 19%

In arriving at these pro forma returns, I have assumed that: a) the current momentum in Google's business allows its revenue and profit margins to run ahead of Yahoo's for the remainder of 2005; and b) beginning in 2006, the businesses "converge" on the same 30% YOY revenue growth and 25% profit margins.

The high double-digit pro forma IRRs indicate that, at their current stock prices, Google and Yahoo afford very attractive returns under moderate growth assumptions. With the Internet still in its early days (Google's founders compare their company to a first or second grader "born" in 1998), plenty of growth catalysts still lie ahead:

* Growing international user base;
* More time spent per Internet user as PC, TV and radio merge (broadband, RSS syndication);
* Higher relevance of information (assisted by search);
* More personalized content (think blogs);
* Greater community (I have high expectations for Yahoo!360, now in beta).

Given the "network effect" with the "societal value" of Google and Yahoo's offerings growing as the square of the number of users, I find it very difficult to imagine a future scenario under which the intrinsic value (hence, market value) of these companies would not grow by leaps and bounds.

With Google and Yahoo playing increasingly indispensible roles in how we retrieve, organize, process and share information in our daily lives, I believe it very likely that my 30% revenue growth and 25% profit margin assumptions will turn out to be overly conservative, implying that significantly higher than 20% annual returns should be available to investors holding these stocks over the next five years.

(Disclosure: I am long YHOO and am giving serious consideration to buying GOOG following the one-year anniversary of its IPO.)

Friday, April 22, 2005

Illiquidity Preference and Risk Attraction

In the fixed-income world--the land of yield curves and quality spreads--two principles usually hold true:

1. Liquidity Preference: Based on their preference for liquidity, investors are willing to accept lower yields on shorter-dated investments (instead of risking possible loss of principal on the early sale of higher yielding longer-dated investments). Hence, the yield curve typically has a characteristic positive slope, with short-dated money market instruments yielding less than longer-dated notes and bonds.

2. Risk Aversion: Similarly, since investors are willing to pay a premium for safety, bonds of lower credit issuers often trade at even wider quality spreads (lower prices) than necessary to compensate for their additional default risk. The story goes that Michael Milken, the former "junk bond" king, noticed this behavior in the bond markets early in his career and was able to capitalize on it, prior to his slippage into illegal trading activity that prematurely ended his lucrative securities career.

To maximize returns in a fixed-income portfolio, it usually makes sense to extend out on the yield curve to longer maturities and to buy below-investment-grade credits to boost portfolio yield. I would even venture to say that for investors with very long time horizons (such as university endowment funds, or high net worth individuals), holding exclusively long-dated bonds and junk credits will produce better returns than a mix that includes shorter maturities and high-grade credits.

How about in the equity markets? Does it make sense to own more illiquid, higher risk stocks (and real estate)?

I tend to believe that, in long-run investing, "principles" analogous to those for fixed-income investing should hold true for equities, viz.:

3. Illiquid equities (e.g., small-cap stocks) ought to perform better than more liquid investments; and

4. "Risky" equities (i.e., high beta stocks and venture capital) ought to provide higher returns than less risky equities.

The basic reason is the same as for the fixed-income markets: Investors, who generally prefer liquidity and are risk averse, tend to "bid up" liquid, low-risk investments, while neglecting illiquid, high-risk investments. As such, illiquid, more risky equities are often available at a discount to "fair value."

So, for the investor with a very long-term time horizon, illiquid and high beta stocks should produce the best long-run returns. Sure, there will certainly be times when these high-risk investments perform very poorly versus market averages; however, patient investors who are able to ride out the downturns ought to come out ahead in the long run.

Wednesday, April 20, 2005

Don't Try to "Fix" the U.S. Trade Deficit

The U.S. trade deficit has ballooned from about $100 billion ($400 per person) annually in the mid-1990s to $617 billion ($2,000 per person) in 2004, reaching an all-time monthly high of $61 billion in February 2005. Many people comment that the ever-expanding U.S. trade deficit is a danger sign of the "hollowing out" of the U.S. economy, with manufacturing and service sector jobs being outsourced to China and India. Driving the process are complacent American consumers on their usual spending spree, refinancing their home mortgages (ultimately financed by Chinese investing in U.S. bonds, we are told) to pull out cash to shop at Wal-Mart (which buys at rock-bottom prices from manufacturers in China). Even Warren Buffett goes on record in his Berkshire Hathaway annual report, stating how foreign-made products flowing into the hands of U.S. consumers are balanced by a similar amount of U.S. assets flowing out into the control of foreigners. As Buffett sees it, without a government policy change, the longer-term implication would be the transition of America into a "sharecropper's society," with Americans effectively paying rent (to foreigners) in order to live on land that was once their own--a far from happy situation for ownership-oriented Americans, which "would undoubtedly produce significant political unrest."

Expressed this way, the trade deficit seems problematical. However, I question the above viewpoint, opting instead to take a more global, "border-free" perspective. Let me explain by starting with a domestic analogy:

Consider the relationship between California, with its fertile central valley, and Washington state, with its colder climate. I'll simplify the discussion by assuming that Washingtonians, with their riches obtained from owning Microsoft stock over the past two decades, buy all of their fruits and vegetables from Californians, who are able to grow produce at a much lower cost. To feed its troops of software engineers and their families, Washington state runs a large interstate trade deficit with California, exacerbated by the preference California residents have for open-source Linux products (i.e., little interest in buying the software that Washingtonians write). Californians use their profits from thriving farm produce sales to buy, among other assets, Microsoft stock and Washington real estate. As the years go by, certain Washingtonians begin to voice concern over the interstate trade deficit, saying that dividend and rent payments are now disproportionately escaping into the hands of out-of-staters, turning Washington into a "sharecropper's state," which undoubtedly will lead to political unrest . . . . All right, with some hyperbole, I think you get the picture.

My point is that, just as no problem should or would develop between Wahington and California based on interstate trade issues, the U.S.'s international trade imbalance likewise should not be viewed as a rampant disease that needs to be cured. The existence (or non-existence) of a problem with the trade deficit really is a matter of where we draw the line between "us" and "them." At a "micro," transactional level, the American consumer who buys the goods and the manufacturer in China who runs the factory that makes them are equally happy with the business deal that is run through middlemen like Wal-Mart. Also, American consumers are pleased with the low interest rates they achieve when refinancing their homes, and the Chinese are quite content buying U.S. mortgage-backed securities. Only at the "macro" level, when we start to distinguish between "Americans" as one group and "foreigners" as another does the accounting begin to look problematical.

With American consumer behavior and the U.S. trade deficit being deep-rooted structural issues in the U.S. and world economy, I believe that appealing to the government in an attempt to "fix" what really may not be a problem at all is unnecessary and even quite risky (as the saying goes: If it ain't broken, don't fix it!). In my opinion, what concerned Americans should do is adopt a "healthier" global view, by considering both "us" Americans and "them" foreigners as all part of the same "family." Under this viewpoint, the exchange of products for assets between "younger" and "older" member nations of the same global economy would be accepted as quite normal, similar to how a retired executive sells a few shares of stock to cover his discretionary spending since the paychecks are no longer rolling in.

Of greater concern than the trade deficit itself should be the rules of the economic game. If opportunities always exist for younger people, younger generations and younger nations to grow economically by offering products (and services) to their more established "brethren" nations, what generally will result is a very natural exchange of products for assets, i.e., a trade deficit. With individuals, this basic cycle runs its course over a lifetime, whereas with nations, as history shows, the transition from "young" to "old" can take centuries. Given all of the interdependencies and linkages between nations in today's global economy, it is also possible that (again quite naturally without government intervention) trade deficits might come and go, as exchange rates, GDP growth rates, local wages and other factors all adjust to drive the complex dynamics of the global economy. (Note that the U.S. ran a trade surplus in the 1960s.)

To sum up: Trade deficits are, by and large, normal occurrences in the development of nations and evolution of the world economy. Also, the presence or absence of a trade deficit is somewhat artificial, since it depends on where we draw our national borders, i.e., how we do the accounting. Instead of prodding elected government officials to implement policy changes to balance international trade, we should spend our time encouraging our government to enforce rules to give all nations equal economic opportunity. By focussing on growing the whole economic pie rather than dwelling on the parochial "us" vs. "them" dichotomy, we will all, as global family members, be better off in the end.

Monday, April 18, 2005

Picking the Internet Leader Using "Money Value of Time"

Among today's leading "pure play" Internet companies--Yahoo (YHOO), Google (GOOG), eBay (EBAY) and Amazon (AMZN)--which one will grow to become the largest over the next few decades?

Today these companies stack up as follows:

Company: Market Capitalization, Traffic Ranking (Source: Alexa)

Google: $51 bil., #3 in traffic
Yahoo: $45 bil., #1 in traffic
eBay: $43 bil., #5 in traffic
Amazon: $14 bil., #7 in traffic

(#2, #4 and #6 by traffic ranking are occupied by MSN, and Microsoft--all properties of Microsoft, which itself continues to gun for top spot.)

In my opinion, we are still early in the evolution of the Internet--technology, consumer habits, global usage, etc.--implying that revenues, profits and market capitalizations still have a long way to run. However, I also believe that we are far enough along, so that already very significant barriers-to-entry prevent more minor players from capturing sufficient market share to become top-tier. Since our four leaders are all profitable (Amazon became profitable in 2003) and have plenty of cash and financing available to them, they tend to make acquisitions to steer growth or to fill in areas were they are weak. These acquisitions "crowd out" other companies and keep the top-tier "oligarchy" intact.

Among the top four companies, I see a shuffle ahead over the next decade as the Internet grows and the way we use it evolves. Long term, I believe that there is a high correlation between time and money, i.e., where consumers spend their time correlates with where they spend their money. With this concept in mind, I comment on our leaders:

Google has raced into number one position by market capitalization following its IPO last fall. As search leader and "librarian of the Internet," Google has grown rapidly through selling advertising alongside search. With its high reach, high-margin business, global presence and corporate culture of innovation, Google is well-positioned to continue growing by leaps and bounds. Google has the potential to morph into a web-based on-demand software company, competing more directly with Microsoft's traditional shrink-wrapped product. However, I see a handful of weakness that could limit its growth: a) search is a "basic utility" that is not "sticky" enough--I might search using Google but I do not "hang around" on the site; b) the Google properties are not well-integrated--I use Google for search and Blogger for this blog, but I hardly know that the two are properties of the same company; and c) Google depends on a single revenue stream (advertising).

Following a revenue and profit slump in 2001 and 2002 with the dearth of online advertising spending during the dot-com fallout, Yahoo has come roaring back over the past two years. Yahoo has the broadest and most well-integrated content offerings. It has the highest traffic, widest global audience, solid profit margins and most diversified revenue sources (advertising, subscriptions, commerce). Yahoo has "sticky" content such as its Yahoo!Finance message boards, Yahoo!Groups community site, and free email. The only significant holdup I see to continuing stellar growth is its second-rate track record as an innovator--still trying to catch up to Google in search, never caught eBay in auctions (except in Japan), behind Amazon in shopping, slow to get into blogging (though finally entering with Yahoo!360, now in beta).

eBay has been the most successful in "monetizing the network effect" through its auctions, where buyers gather because that's where the sellers are, and sellers go because that's where the buyers are, ad infinitum. Early profit came from its "clean" e-commerce business of providing the transaction platform without ever touching the "dirty" garage-sale goods. The result is a high-margin business operating in a niche with a very high barrier-to-entry. Internationally, eBay has been successful in Germany and the U.K., failed in Japan (too late to start and never caught Yahoo!Auctions), bought its way into Korea, and is competing for leadership in China. eBay's primary weakness is that it does not exhibit the breadth necessary to become the "leader of the leaders" long term.

From its inception, Amazon's objective has been to become the "Wal-Mart of the web." With a market cap just 7% of Wal-Mart $200 billion, Amazon is still nowhere close to realizing this dream. The problem has been overcoming high shipping costs and a low profit margin, as Amazon has had to provide discounts to encourage more consumers to buy online. International revenue is growing but the U.S. will long remain the largest market in total consumer dollars spent. Over the years, Amazon has "built community" through hosting book, movie and product reviews. My sense is that Amazon has developed a very valuable customer-friendly franchise that has tremendous potential for monetization of its trusted brand name and reach as the way we use the Internet changes. DVD rentals, E-books and online yellow pages are areas that might bring additional revenue.

Grading the Internet leaders across the factors that matter most, we have:

Company: Breadth of Content, Depth (Stickiness), "Warmth" of User Experience (Integration, Navigation, Customer Service); International Presence, Innovation, Profit Margin

Google: B, B, B; A, A, A (overall: 3.5/4.0)
Yahoo: A, A, A; A, B, A (overall: 3.8/4.0)
eBay: C, A, B; B, B, A (overall: 3.2/4.0)
Amazon: B, B, A; B, B, C (overall: 3.0/4.0)

As I see it, in the long run, Yahoo finishes first, ahead of Google, as breadth of content, stickiness and warmth of user experience win out over innovation. Interestingly, eBay and Amazon would make a good marriage to create an e-commerce superpower, with Amazon delivering the breadth of e-commerce, and eBay the strong profit margins from its auction vertical. With this combination, I can see the pecking order becoming: Yahoo #1, Amazon-eBay #2, and Google #3. It is also possible that Google evolves to become a true competitor of Microsoft in the desktop personal utility software area, in which case Google should run ahead of Yahoo, eBay and Amazon; however, with the open-source software movement being as fragmented and decentralized as it is, I do not see Google as the clear winner here.

Since the growth of Internet companies is ultimately determined by what consumers do online, what's most important is how to monetize consumers' time. In the long run, the websites offering the best content and user experience will be where consumers spend their time and, in turn, their money. In other words, just as "time value of money" matters in traditional finance, it is "money value of time" that really counts on the Internet.

(Disclosure: I am long Yahoo, eBay and Amazon, but not Google, largely based on my policy of not buying IPOs until after one year of market "seasoning.")

Friday, April 15, 2005

My Guess: Stock Market Bounce Coming

Today the Dow, S&P 500 and Nasdaq ended the trading day down, as they had yesterday and the day before that. All stock indices are significantly off their recent highs:

Dow: 10,088 (recent high: 10,941 on March 4)
Direction: Down 8%

S&P 500: 1143 (recent high: 1225 on March 7)
Direction: Down 7%

Nasdaq: 1908 (recent high: 2178 on December 30)
Direction: Down 12%

However, macro indicators seem to be pointing in a more bullish direction:

Interest Rates:
General Market Belief: Higher interest rates are bad for stocks.
Spot: 10-year Treasury yield at 4.27%
Recent High: 4.62% on March 28
Direction: Interest rates are DOWN 35 b.p.

General Market Belief: Higher oil prices are bad for the economy.
Spot: NYMEX Light Sweet Crude at 50.49
Recent High: 57.27 on April 1
Direction: Oil is DOWN 12%.

General Market Belief: Higher gold prices signal lack of confidence in "paper" assets.
Spot: 426
Recent High: 447 around March 10
Direction: Gold is DOWN 5%.

General Market Belief: A weaker dollar means foreigners have less confidence in U.S. assets.
Spot: 1.292 USD/EUR, 107.8 JPY/USD
Recent Low: 1.360 USD/EUR around December 30; 102.5 JPY/USD around January 20
Direction: The dollar is STRONGER by 5% against both the Euro and the Japanese yen.

To the extent that:

* Lower interest rates mean a lower borrowing cost for corporations and consumers,
* Lower oil prices mean reduced inflation fears,
* Lower gold prices mean more confidence in government policy, and
* A stronger dollar means a stronger appetite by foreigners for U.S. assets,

shouldn't U.S. stock prices be rising, not falling?

Taking a look at just how negative investor sentiment has become:

Sentiment Index: Investors Intelligence Bull-Bear Percentage Spread (data available at
Current: 17% (bull 46% vs. bear 29%) as of April 13
Recent High: 43% at end-December
Recent Low: 10% at August 2004 market low,

I think that stocks are due for a bounce soon.

Wednesday, April 13, 2005

Is Mobile Mini (MINI) Turning Capital Spending into Profits? (V)

I expect this to be my final post in this series on the portable storage leasing company, Mobile Mini (MINI).

In prior posts, we have seen that both a) data from container sales by the company, and b) regular appraisals (when appraisal dates and book value dates are property aligned), support the negative statement that "The lease fleet does not appear to be overvalued on the books, and the company does not appear to be capitalizing costs that should be expensed." We have also identified the mechanism--discretionary capital spending on expensive additions to the lease fleet--that accounts for the period-to-period rise in net book value per unit.

The question for this post is: How effective has Mobile Mini's management been in turning this capital spending into profits?

As measured by total-dollar top-line and bottom-line operating figures, growth of the company’s leasing business is accelerating again, following the recession-driven slowdown in 2002 and 2003:


Leasing Revenue (in $ mil.): Q1, Q2, Q3, Q4 (YOY Changes)
2000: 15.1, 18.2, 20.5, 22.3
2001: 21.1, 23.7, 26.2, 28.6 (40%, 30%, 28%, 28%)
2002: 25.1, 27.6, 30.9, 32.6 (19%, 16,%, 18%, 14%)
2003: 29.7, 30.9, 32.8, 35.1 (18%, 12%, 6%, 8%)
2004: 32.1, 35.7, 38.9, 43.1 (8%, 16%, 19%, 23%)

EBITDA (in $ mil.): Q1, Q2, Q3, Q4 (YOY Changes)
2000: 7.4, 8.7, 10.0, 11.2
2001: 10.0, 11.6, 13.1, 14.2 (35%, 33%, 31%, 27%)
2002: 11.9, 12.4, 13.9, 15.4 (19%, 7%, 6%, 8%)
2003: 12.1, 13.0, 15.1, 15.7 (2%, 5%, 9%, 2%)
2004: 13.2, 15.6, 18.0, 20.4 (9%, 20%, 19%, 30%)

However, since at the same time the lease fleet has been growing both in number of units and in net book value per unit:

Number of Units (in thousands): Annual Year-End (YOY Change)
2000: 55.5
2001: 70.1 (26%)
2002: 83.6 (19%)
2003: 89.5 (7%)
2004: 100.6 (12%)

Net Book Value Per Unit:
2000: $3,532
2001: $3,953 (12%)
2002: $4,030 (2%)
2003: $4,277 (6%)
2004: $4,490 (5%)

with variable lease fleet utilization:

Lease Fleet Utilization: Q1, Q2, Q3, Q4 (Annual Average)
2000: 82.5%, 85.0%, 85.0%, 88.0% (85.3%)
2001: N/A, N/A, N/A, N/A (82.5%)
2002: 75.9%, 77.5%, 78.0%, 84.2% (79.1%)
2003: 75.5%, 77.3%, 78.4%, 83.3% (78.7%)
2004: 76.2%, 78.7%, 81.5%, 85.6% (80.7%)

we really need to look at growth of relevant ratios (per-unit-on-rent and revenue-to-NBV) to measure the underlying efficiency of the business:


Leasing Revenue Per Month Per Unit On Rent (in $): Q1, Q2, Q3, Q4 (YOY Changes)
2000: 158, 166, 168, 160
2001: 157, 164, 168, 162 (-0.6%, -1.5%, 0.5%, 1.6%)
2002: 155, 159, 168, 157 (-1.2%, -2.6%, -0.3%, -3.3%)
2003: 156, 156, 160, 158 (0.5%, -2.4%, -4.7%, 0.8%)
2004: 156, 164, 167, 170 (0.0%, 5.3%, 4.2%, 7.1%)

EBITDA Per Month Per Unit On Rent (in $): Q1, Q2, Q3, Q4 (YOY Changes)
2000: 77, 79, 82, 80
2001: 74, 80, 84, 81 (-3.9%, 0.9%, 3.0%, 0.5%)
2002: 73, 72, 75, 74 (-1.2%, -10.6%, -10.3%, -8.0%)
2003: 63, 65, 74, 71 (-13.6%, -8.6%, -2.5%, -4.6%)
2004: 64, 72, 77, 80 (0.9%, 9.4%, 4.7%, 13.3%)


Ratio of Leasing Revenue (Annualized) to Net Book Value: Q1, Q2, Q3, Q4 (YOY Changes)
2000: 0.47, 0.50, 0.50, 0.48
2001: 0.42, 0.44, 0.43, 0.43 (-12%, -13%, -12%, -11%)
2002: 0.36, 0.37, 0.39, 0.39 (-15%, -14%, -10%, -8%)
2003: 0.35, 0.35, 0.36, 0.37 (-2%, -6%, -8%, -6%)
2004: 0.33, 0.36, 0.37, 0.39 (-5%, 2%, 3%, 5%)

Ratio of EBITDA (Annualized) to Net Book Value: Q1, Q2, Q3, Q4 (YOY Changes)
2000: 0.23, 0.24, 0.24, 0.24
2001: 0.20, 0.21, 0.22, 0.21 (-15%, -11%, -10%, -12%)
2002: 0.17, 0.17, 0.18, 0.19 (-15%, -22%, -19%, -13%)
2003: 0.14, 0.15, 0.17, 0.17 (-16%, -12%, -6%, -11%)
2004: 0.14, 0.16, 0.17, 0.18 (-4%, 6%, 4%, 11%)

The above figures exhibit the following growth trends:

1. Total-Dollar Amounts: From single-digit lows in 2002 and 2003, leasing revenue and EBITDA growth have picked up during the past year, reaching 20% to 30% growth during the past two quarters. The margin (EBITDA/leasing revenue) of the business is also improving, with EBITDA (30% growth in 2004Q4) accelerating faster than leasing revenue (23% growth in 2004Q4).

2. Leasing Revenue Per Unit On Rent: Backing out the growth in the size of the lease fleet by looking at per-unit-on-rent figures, we find that growth of both leasing revenue and EBITDA (per unit on rent) turned negative in 2002 and 2003. During 2004, growth picked up, and by 2004Q4, leasing revenue per unit on rent was growing at 7% and EBITDA per unit on rent was doing even better at 13%.

3. Ratio of EBITDA to Net Book Value: Correcting also for increases in net book value per unit coming from the increased number of more expensive containers management has been adding to the fleet, we find that growth of both revenue/NBV and EBITDA/NBV had been strongly negative during 2001 and 2002. During 2003, this negative trend began to ease up, and by 2004Q2, both leasing revenue/NBV and EBITDA/NBV started to exhibit positive growth. In 2004Q4, leasing revenue/NBV grew 5% and EBITDA/NBV grew 11%.

In short, examination of the top-line and bottom-line operating figures reveals that the recent acceleration in growth is coming from ALL of the following sources:

a) Increase in the number of units in the lease fleet;
b) Increasing lease fleet utilization;
c) Increase in average leasing revenue per unit on rent;
d) Increase in average leasing revenue per dollar of net book value.

During 2002 and 2003, revenues and EBITDA grew with the increase in the number of units in the lease fleet, but utilization was deteriorating, rent per unit was falling and rent per dollar of capital invested in the lease fleet was plummeting even faster. It appeared that the company’s investment in its lease fleet was producing excess capacity but no longer generating profits.

However, during the course of 2004, operations have turned around: total-dollar revenue, utilization, rent per unit, and rent per dollar of capital invested are all growing. For the first time in at least four or five years, the company’s leasing business is “accelerating on all four cylinders” (cf., items a through d above). This acceleration suggests that money the company has been pouring into capital spending on refurbishment, customization and purchases of both generic ISO containers and more expensive manufactured units is finally driving higher profits. Not only are more expensive units being added to the lease fleet (increasing net book value per unit), the fleet has also begun to perform with increasingly higher productivity (accelerating ratios).

The above trend in fundamentals is clearly reflected in the company’s stock price, showing a sharp dip in 2002, the year when EBITDA growth slowed markedly:

Year: Closing Stock Price at Year-End (% YOY return), Diluted EPS, Year-End P/E
2000: 23.0 (7%), $1.11, P/E = 21
2001: 39.12 (70%), $1.34, P/E = 29
2002: 15.67 (-60%), $1.26, P/E = 12
2003: 19.72 (26%), $0.41, P/E = 48
2004: 33.04 (68%), $1.40, P/E = 24
2005: [38.01 as of 13-Apr-2005 (15% YTD)], [$1.83 (consensus est.)], [P/E = 21]

In my opinion, with business fundamentals accelerating, Mobile Mini will most likely continue to surprise on the upside for the next few quarters. From a valuation point of view, I find the PEG of 0.68 (based on 31% YOY forecast EPS growth from 2004 to 2005) attractive. Near-term, I see more reasons to be long than short this stock.

Monday, April 11, 2005

How Depreciating Assets CAN Rise in Book Value (IV)

More on Mobile Mini's lease fleet . . .

One of the concerns that bears raise about Mobile Mini's balance sheet is that the net book value per unit (i.e., average net book value per container) of the company's lease fleet keeps on RISING in value, even though the lease fleet consists of depreciable portable storage containers whose net book value instead should be FALLING over time. The implication, according to the short-sellers, is that the company is capitalizing costs that really should be expensed.

To understand how the lease fleet can both depreciate AND rise in book value, we need to look carefully at period-to-period changes in the composition of the fleet. Referring to the 10-Ks for 2002, 2003 and 2004, I summarize cumulative changes in the lease fleet over the past three years:

Item: Book Value = Number of Units x $/Unit

Lease Fleet at Dec. 31, 2001: $277.0 mil. = 70,070 units x $3,953/unit

Purchases: $23.9 mil. = 14,764 units x $1,616/unit

Manufactured Units:
-Steel: $92.1 mil. = 12,408 units x $7,420/unit
-Wood: $46.1 mil. = 2,267 units x $20,351/unit

Refurbishment and Customization:
$46.0 mil. = $29.4 mil. + 6,291 units x $2,639/unit *

Other: ($1.2 mil.) = (358 units) x $3,366/unit
Sales: ($12.6 mil.) = (4,813 units) x $2,624/unit

Depreciation: ($19.5 mil.)

Lease Fleet at Dec. 31, 2004: $451.8 mil. = 100,629 units x $4,490/unit

[* I allocated the $46.0 mil. total cost as follows: $29.4 mil. for refurbishment and customization of 28,769 units (at $1,023/unit), plus $16.6 mil. for the 6,291 additional units (at $2,639/unit) resulting from splitting containers into shorter ones and moving units from finished goods to lease fleet. I select this allocation to achieve self-consistency on an average per-unit basis: cost of purchased units ($1,616) plus refurbishment cost ($1,023) equals cost of additional unit ($2,639) from refurbishment process.]

During the past three years, the company's lease fleet has increased from about 70,000 units at year-end 2001 to about 101,000 at year-end 2004. The additional 31,000 units are accounted for as follows:

1. Purchases and Sales: The company purchased about 15,000 units for $24 mil. ($1,616/unit) and sold about 5,000 units for $13 mil. ($2,624/unit).
(Net: 10,000 additional units)

2. Manufactured Units: The company added two types of manufactured units:

a) steel containers, storage-office combo units and security offices ($92 mil. spent on 12,400 units, at $7,420/unit), and
b) new wood mobile offices ($46 mil. spent on 2,300 units, at $20,351/unit).
(Net: About 15,000 additional units)

Note that these new manufactured units are considerably more expensive than the generic used ISO shipping containers that the company purchases.

3. Refurbishment and Customization: The company refurbished about 29,000 units already in its fleet, a process that generated about 6,000 additional units.
(Net: 6,000 additional units)

Now, having detailed all of the sources of additional lease fleet units, we can examine how the various components have contributed to changes in net book value per unit:

Year-End 2001: $3,953/unit

Component: 3-Year Change in Net Book Value (% annual change)
Depreciation: -$278/unit (-2.4%)
Refurbishment and customization: +$277/unit (+2.3%)
Purchases, sales, other: -$350/unit (-3.0%)
Manufactured units: $946/unit (+7.4%)

Year-End 2004: $4,490/unit (+4.3% annual)

This component analysis shows that:

1. For a hypothetical "static" fleet (i.e., no additions, subtractions or refurbishment of units), the net book value per unit would have fallen from depreciation by about 2% per year;

2. Refurbishment and customization have contributed about 2% per year to net book value per unit, essentially offsetting the impact of depreciation;

3. Driven by purchases of containers occurring at prices ($1,616/unit) below the average net book value per unit (around $4,000/unit), the impact of actual purchases and sales has been to reduce net book value per unit by about 3% per year; and

4. Manufactured units (costing about $7,000/unit for steel units and $20,000/unit for wood units) contribute an increase of about 7% per year to net book value per unit.

The overall result has been an increase in net book value of 4.3% annually for the past three years.

To conclude, the answer to the question of how a depreciating asset can increase in book value is:

If the size of Mobile Mini's leasing fleet were static, with no refurbishment and customization, no generic ISO additions and no new manufactured units, the net book value per unit would gradually fall about 2% per year through depreciation. However, the fleet is not static--instead it is dynamic, reflecting the growth of the company. As a strategic initiative, management has been adding expensive manufactured units ($7,000 for steel units and $20,000 for wood units) to its fleet, thereby driving up the average net book value per unit. The net result is an approximate 4% annual increase in net book value per unit (between 2002 and 2004).

As mentioned in the company's 2003 annual report, "Product differentiation is a critical competitive advantage for us and the reason why we can and do stay on the sidelines when our competitors battle for commodity-driven, low margin, price sensitive storage business." The 10-K lists certain products introduced over recent years:

1998: 10-foot wide storage unit ("proven to be a popular product with our customers")
1999: Records storage unit, for "highly secure, on-site, easily accessible storage"
2000: Wood mobile offices (which are purchased from third parties) as a "complementary product" that "helps make Mobile Mini the single source for storage and office units"
2001: Improved security locking system (patented)
2002: 10-by-30-foot steel combination storage/office unit

"Currently, the 10-foot-wide unit, the record storage unit and the 10-by-30-foot steel combination storage/office unit are exclusively offered by Mobile Mini." (2004 10-K)

Given that we now know where the increase in net book value is coming from, the remaining question is: How effective is the company's capital-intensive spending on product differentiation and customization in driving profits? I will address this topic in my next post.

Saturday, April 09, 2005

Re-Interpreting Management's Written Statements (III)

Upon further review of Mobile Mini's 10-Ks, I come up with a revised interpretation of what management really is communicating about the appraisals of their lease fleet. The purpose of this post is to present what I see as the "most likely" set of circumstances behind management's statements, which unfortunately, as written, leave room for ambiguity.

Below, I quote from the 10-Ks the relevant sections relating to the appraisals:

"The most recent fair market appraisal, by an independent firm chosen by our lenders and completed in January 2002, appraised our fleet at a fair market value in excess of 120% of net book value. An appraisal of orderly-liquidation value was completed in September 2002." (p. 6)

"Our most recent fair market value appraisal, conducted in January 2002, appraised our fleet at a value in excess of net book value. An orderly liquidation value appraisal . . . was performed in March 2003, and the value was determined to be $314.1 million, which equates to 82.4% of the lease fleet's net book value, at December 31, 2003." (p. 2)

"Our most recent fair market value appraisal appraised our fleet at a value in excess of net book value. At December 31, 2003, the net book value of our fleet was approximately $382.8 million." (p. 7)

"Our most recent fair market value appraisal, conducted in March 2004, appraised our fleet at a value in excess of net book value. At December 31, 2004, the fair market value of our lease fleet was approximately 110.6% of our lease fleet net book value. An orderly liquidation value appraisal . . . was performed in March 2004. At December 31, 2004, the orderly liquidation value of our lease fleet is approximately $357.0 million, which equates to 79.0% of the lease fleet net book value." (p. 2)

"Our most recent fair market value appraisal appraised our fleet at a value in excess of net book value. At December 31, 2004, the net book value of our fleet was approximately $451.8 million." (p. 7)

Here is a summary of the appraisal information as reported:

Fair Market Value (FMV) Appraisals:
Jan-2002: In excess of 120% of net book value
Mar-2004: $500 mil. (which is equiv. to 110.6% of NBV at 31-Dec-2004)

Orderly Liquidation Value (OLV) Appraisals:
Sep-2002: Value undisclosed
Mar-2003: $314 mil. (which is equiv. to 82% of NBV at 31-Dec-2003)
Mar-2004: $357 mil. (which is equiv. to 79% of NBV at 31-Dec-2004)

I believe that, in reporting the results of the appraisals in the 10-Ks, the company unfortunately has slipped into making a confusing "apples vs. oranges" comparison--equating dollar amounts figured ON THE APPRAISAL DATES with percentages of NBV figured AT REPORTING YEAR-END. With the appraisal results stated this way, it appears that both FMV and OLV, expressed as percentages of NBV, have fallen over the past two years, as I remarked in my previous post.

Now for my re-interpretation: To make an "apples vs. apples" comparison, we need to equate dollar amounts with percentages of NBV--all figured consistently using amounts available on the appraisal dates. Referencing the most recent then-current NBV figures at the time of each appraisal (e.g., using NBV at 31-Dec-2003 (not 31-Dec-2004) to express results of the Mar-2004 appraisals), I arrive at the comparison below:

Fair Market Value (FMV) Appraisals:
Jan-2002: In excess of 120% of net book value
Mar-2004: $500 mil. (which is equiv. to 130% of NBV at 31-Dec-2003)

Orderly Liquidation Value (OLV) Appraisals:
Sep-2002: Value undisclosed
Mar-2003: $314 mil. (which is equiv. to 93% of NBV at 31-Dec-2002)
Mar-2004: $357 mil. (which is equiv. to 93% of NBV at 31-Dec-2003)

Net Book Value (NBV):
31-Dec-2001: $227.0 mil.
31-Dec-2002: $337.1 mil.
31-Dec-2003: $382.8 mil.
31-Dec-2004: $451.8 mil.

Based on this re-interpretation, I conclude that:

1. The appraisals consistently show that fair market value of the lease fleet is in excess of 120% of net book value (i.e., even better than the "apples vs. oranges" 110.6% reported in the 2004 10-K), and that orderly liquidation value is above 90% of net book value (i.e., even better than the as-reported numbers around 80%);

2. The valuation cushion (i.e., FMV above NBV, and OLV above total debt) appears to be quite stable; and

3. The appraisal information, as reported in the 10-Ks, does not provide grounds for construction of a lease fleet overvaluation argument.

(However, I do believe that the company can benefit from being more careful in preparing its writting remarks in the 10-Ks relating to the appraisals. Greater clarity should help prevent any misinterpretation of the numbers by the investment community.)

To summarize: At this point, "the preponderance of evidence" continues to support the opinion that Mobile Mini's lease fleet is not overvalued on its books, and that the company does not engage in a practice of inflating earnings by flagrantly capitalizing costs that it should be expensing. The rising stock price, from $10 to $40 in two-and-a-half years, indicates that most investors believe the company's earnings to be authentic. However, the stock's persistently high short ratio continues to show that one or more short-sellers, correctly or not (are they crazy or not?), still have more than "a reasonable doubt."

Friday, April 08, 2005

More on Lease Fleet Valuation (II)

Continuing with the Mobile Mini (MINI) debate . . .

If, as the short-sellers say, the company is capitalizing costs that it really should be expensing, eventually the net book value of the lease fleet will rise higher than market value, resulting in an overvaluation crisis.

In my prior post, I reviewed the company's actual lease fleet sales data for 2003 and 2004 and found that very consistently the containers are being sold at an average price that is 1.5 times net book value. This is an indication that the containers are not overvalued on the books.

We can also extract appraisal information from the 10-Ks, since the company's lenders require periodic third-party appraisals of both fair market value (FMV) and orderly liquidation value (OLV) of the lease fleet. Below I summarize FMV, OLV and total debt as percentages of net book value (NBV):

NBV: $337 mil., or $4,030/unit (Dec. 31, 2002)
FMV: "in excess of 120% of net book value" (Jan. 2002)
OLV: Appraisal completed in Sep. 2002 but value undisclosed
Total Debt: $213 mil. (63% of NBV)

NBV: $383 mil., or $4,280/unit (Dec. 31, 2003)
FMV: Appraisal not updated from Jan. 2002
OLV: 82.4% of NBV, or $314 mil. (Mar. 2003)
Total Debt: $241 mil. (63% of NBV)

NBV: $452 mil., or $4,490/unit (Dec. 31, 2004)
FMV: 110.6% of NBV, or $500 mil. (Mar. 2004)
OLV: 79.0% of NBV, or $357 mil. (Mar 2004)
Total Debt: $277 mil. (61% of NBV)

In absolute terms, with fair market value generally above 110% of net book value and orderly liquidation value around 80% of net book value (well in excess of total debt as a percentage of NBV), the appraised values look healthy enough. However, the above numbers also exhibit a year-to-year trend with a curious shrinkage of the valuation "cushion" above net book value:

1. FMV as a percentage of NBV has fallen from "in excess of 120%" in 2002 to 110.6% in 2004; and

2. OLV as a percentage of NBV has slipped from 82.4% in 2003 to 79.0% in 2004.

Since appraised values are only estimates of value, we should try to avoid reading too much into these numbers, especially since they represent only two or three years of data. Nevertheless, using the appraised values as stated, it IS possible to begin to construct a case for overcapitalization: To achieve "steady state" ratios without shrinkage of the valuation cushion (i.e., to maintain FMV/NBV in excess of 120% and OLV/NBV around 82%), it would be necessary to reduce stated net book value by about 3% to 5% annually, effectively by reclassifying as expenses a portion of the costs that the company has capitalized in its reporting to date. The impact of this hypothetical reclassification would be as follows:

Year: 2003, 2004
Original Net Income: $5.9 mil., $20.7 mil.
Original EPS: $0.41, $1.40

Expense Reclassification (3% of NBV): -$11.5 mil., -$13.6 mil.

Revised Net Income: -$5.6 mil., $7.1 mil.
Revised EPS: -$0.39, $0.48

(The above figures are a "zeroth-order" approximation of the impact of the hypothetical expense reclassification, ignoring first-order effects such as tax savings from having lower taxable income, reduced depreciation from having a lower lease fleet book value, etc.)

Clearly, the hypothetical impact of this type of expense reclassification on reportable earnings would be devastating, with potential for cutting earnings by more than half, crushing the stock price, and forcing the longs to surrender and turn the keys to the party house over to the shorts!

Admittedly, the above analysis is a "back-door" approach to constructing a case for earnings overstatement through overcapitalization, since what really needs to be done is to review each cost item and determine whether it should properly be capitalized or expensed--which, of course, is the job of the CFO, his staff accountants and outside auditors. However, because public information does not give me access to the company's books at this level of detail, I have only simple consistency checks such as this at my disposal.

I must say that the trend exhibited by the appraisals is somewhat disturbing. To examine this matter further, I have requested from Mobile Mini the results of any more recent appraisals that may have been completed. Since appraisals were done in March 2003 and March 2004, it is possible that another appraisal was completed earlier this year (2005). I will post again with any new findings.

Thursday, April 07, 2005

Case Study: Expensing vs. Capitalizing at Mobile Mini (MINI) (I)

In any capital-intensive business, such as in the telecom industry (think Worldcom) and real estate (e.g., REITs), management must decide how to allocate costs between current expenses and capital improvements. New fiber optics cables and new office towers, of course, are capitalized and become assets on the balance sheet, while repairs are expensed through the income statement.

The distinction between what constitutes a "repair" and what qualifies as an "improvement" often requires a judgment call on the part of a company's CFO and accountants. Sometimes, too, this discretionary power leads to outright fraud or "cooking the books," as was the case with certain "line items" that Worldcom improperly capitalized rather than expensed, in order to boost net income to meet pre-determined earnings targets and keep the stock price high--inevitably precipitating Worldcom's inglorious collapse. When REITs report quarterly earnings, management provides information on funds from operations (FFO) and capital expenditures, which may be either recurring or non-recurring. As the terminology itself indicates, there is plenty of room for obfuscation and connivery--since, strictly speaking, shouldn't the term "expenditures" mean an expense item that really should not be capitalized, and, particularly if a "capital expenditure" is "recurring," shouldn't it really be expensed rather than capitalized?

I bother to introduce this expensing vs. capitalizing debate because it has become a key issue in the trading of small-cap stock, Mobile Mini (MINI) (Disclosure: I am long this stock and considering taking profit on part of my position). Short-sellers have pushed Mobile Mini's short ratio up (see my March 7, 2005 post, "Waiting for the Short Squeeze"), even while the stock has risen over the past few years from a low of $10 (Oct-2002) to its all-time high around $40 today, on improving fundamentals in the portable storage container leasing market.

The company's basic reported financials for the past six years are:

(Dollar figures in millions)

Year: 1999, 2000, 2001, 2002, 2003, 2004

Income Statement
Revenues ($ mil.): 67, 90, 115, 133, 147, 168
Net Income ($ mil.): 9, 13, 19, 18, 6, 21
Diluted EPS ($): 0.85, 1.11, 1.34, 1.26, 0.41, 1.40

Lease Fleet (mostly steel containers)
Utilization (%): 86, 85, 83, 79, 79, 81
Units (thous.): 37, 55, 70, 84, 89, 101
Net Book Value ($ mil.): 121, 196, 277, 337, 383, 452
Net Book Value/Unit ($ thous.): 3.27, 3.53, 3.95, 4.03, 4.28, 4.49
YOY Change in Net Book Value/Unit: ---, 7.9%, 11.9%, 1.9%, 6.1%, 5.0%

Longs argue that Mobile Mini is a growth company with improving margins, whose business is now powering through a recovery following the recession that depressed fleet utilization and earnings in 2002 and 2003. In support of this view, management just last week raised guidance (to $1.80, from prior guidance of $1.72 for 2005 EPS), lifting the stock to a new high.

Shorts have a different view, claiming that earnings are being inflated through management's nefarious practice of capitalizing lease container-related "refurbishing" costs that really should be expensed each year through the income statement. The result, the short-sellers contend, is a lease fleet that is grossly overvalued on the books.

To resolve this dispute, we really need to understand the market value of the storage containers that comprise Mobile Mini's lease fleet. However, historical market price information for customized storage containers is not readily available (as least I do not know where to find it), and the variety of containers in Mobile Mini's lease fleet makes valuation difficult without having more specific inventory information.

Fortunately, since Mobile Mini also sells a number of storage units each year, it is possible to gauge the approximate market value of their lease fleet based on actual sales figures for the units that are sold. Using cumulative data that the company provides for sales from 1997 through each reporting year in their annual reports (10-K) for 2002, 2003 and 2004, I am able to back out average unit sales prices for 2003 and 2004:

For Lease Fleet Units Sold During Period: 1997-2002, 1997-2003, 1997-2004; 2003, 2004

Sales Revenue ($ mil.): 25.2, 28.6, 33.9; 3.4, 5.3
Net Book Value ($ mil.): 16.6, 18.9, 22.4; 2.3, 3.5

Number of Units Sold (thous.): 6.89, 7.93, 9.02; 1.04, 1.09

Average Sales Revenue/Unit ($ thous.): 3.65, 3.61, 3.76; 3.29, 4.86
Average Net Book Value/Unit ($ thous.): 2.41, 2.38, 2.48; 2.16, 3.21

Average Sales Revenue/Net Book Value: 1.52, 1.52, 1.52; 1.52, 1.51

During 2003 and 2004, the average sales prices for lease fleet units were $3,290 and $4,860, respectively. These units carried average net book values of $2,160 and $3,210, respectively, indicating average sales prices about 1.5 times net book value in both years. With year-end 2003 and 2004 average net book values of the company's entire lease fleet being $4,280 and $4,490 (vs. the lower figures of $2,160 and $3,210 for lease fleet units sold during these years), respectively, we can infer that during the past two years the company happened to sell units from its lease fleet sitting towards the lower end of the price spectrum. (Skeptics might doubt how the company just "happened to sell" units carried on the books at lower prices, pointing out how this raises the prospect that the company could be "cherry-picking" by selectively assigning sales to units with low, as opposed to representative, book prices, in order to realize gains and boost earnings. If this is the case, then the market value of the company's lease fleet might actually be quite a bit less than the 1.5 times net book value that the lease fleet sales data otherwise indicate.)

To summarize our evidence: According to the figures in the annual reports, units that the company sold consistently fetched prices much higher than (i.e., 1.5 times) net book value. Also, the company's 2002 annual report cites an appraisal dated January 2002, that assessed the fair market value of the entire lease fleet to be "in excess of 120% of net book value" (the company mentions that "An appraisal of orderly liquidation value was completed in September 2002" but does not detail the results). Further, last year's sharp run-up in steel prices only works to enhance container prices and the value of the lease fleet. The preponderance of evidence, then, absent intentional false reporting by the company, indicates that the lease fleet carries a net book value that, instead of being overvalued, could be conservatively low.

Frankly, I think that the shorts are wrong. It is possible that management has a practice capitalizing certain items that really should be expensed, but one could also argue that, if management were to mark the value of their lease fleet to market, they would more than recoup whatever net income they would lose through expensing rather than capitalizing certain lease fleet costs.

Unless steel and container prices collapse, or the margins that the company realizes on its lease fleet sales relative to net book value begin to fall, or it becomes evident that management has improperly reported their financials--none of which I see as imminent--my educated bet is that the longs will win the war (just as they have been consistently winning battles on the way up from $10 per share). Given the rumor that a single hedge fund is behind more than 85% of the outstanding short of 1.7 million shares (12% of float), the fireworks at the longs' victory party will commence if (or when?) continued improvement in Mobile Mini's earnings force this lone hedge fund, ever so humbly, to run for cover.

Wednesday, April 06, 2005

A Longer-Term Look at Oil Prices and Stock Prices (II)

Using annual data for as far back in history as figures available on the U.S. Energy Information Administration's website take us, I find:

(Oil prices are from:

Data Period: 1862 to 1999

Average Annual % Change
Oil: 7.9%
S&P 500: 6.7%

Correlation: -0.07
Percent of Years with "Same Sign" Price Change: 66/138 = 48%
Percent of Years with "Opposite Sign" Price Change: 72/138 = 52%

Quintiles Sorted in Order of Decreasing Annual % Change in Oil Price
Quintile: Average Annual % Change in Oil vs. S&P 500
I: 63.3% vs. 2.0% (correl. = 0.08)
II: 10.4% vs. 5.6% (correl. = 0.01)
III: -0.3% vs. 8.6% (correl. = 0.16)
IV: -8.1% vs. 8.0% (correl. = 0.15)
V: -28.6% vs. 9.3% (correl. = 0.23)

The data show lower (higher) stock market returns when oil prices rise (fall). However, the correlations are low, indicating only weak reliability of this inverse relationship. Also, as we had seen with the daily data, the frequency of opposite-directional price movement is close to what we would expect based on chance alone.

Below I list the years showing the most extreme oil price movement:

Date: % Change in Price of Oil vs. S&P 500

Years with Largest RISE in Price of Oil
1974: 252% vs. -30%
1863: 200% vs. 38%
1864: 156% vs. 6%
1979: 121% vs. 12%
1862: 114% vs. 55%

Years with Largest FALL in Price of Oil
1878: -51% vs. 6%
1873: -50% vs. -13%
1986: -48% vs. 15%
1931: -45% vs. -47%
1921: -44% vs. 7%

Similar to what we saw when we looked at the impact of inflation and interest rates on stock prices in prior posts, the relationship between oil prices and stock prices does not appear to have much regularity to it. In other words, rising oil prices might make eye-catching headlines and induce traders to sell stocks in the short run, but in the longer run oil prices are not a good indicator of stock market direction.

Tuesday, April 05, 2005

Do Higher Daily Oil Prices Mean Lower Stock Prices? (I)

Previously I took a look at the historical relationship between stock prices and inflation (, and stock prices and interest rates ( Based on the past couple of centuries of data, I concluded that the cause-and-effect relationship is quite weak in both cases: Neither high inflation nor rising interest rates have consistently led to lower stock prices.

With oil touching new highs (light sweet crude at $58 per barrel), typical financial reporting these days reads like the example below:

"Sellers show some resolve as $58/bbl oil pushes the indices back to session lows . . . Rising crude oil prices continue to dictate overall market action and underpin widespread nervousness . . ."

(Quote from Yahoo's Market Update:

Just how true is it that higher oil prices "cause" stock prices to fall?

To provide an objective historical answer to this question, I downloaded oil prices and closing levels of the S&P 500 index for the past year. Here's what the data tell us:

(Oil prices are NYMEX Light Sweet Crude prices from the U.S. Energy Information Administration's database:

Data Period: April 1, 2004 to April 1, 2005

Index: Starting Price, Ending Price, % Change
Oil: 34.27, 57.27, 67% rise
S&P 500: 1132, 1173, 3.6% rise

Average Daily % Change
Oil: 0.23%
S&P 500: 0.02%

Correlation: -0.15
Percent of Days with "Same Sign" Price Change: 127/250 = 51%
Percent of Days with "Opposite Sign" Price Change: 123/250 = 49%

Quintiles Sorted in Order of Decreasing Daily % Change in Oil Price
Quintile: Average Daily % Change in Oil vs. S&P 500
I: 3.3% vs. -0.2% (correl. = -0.26)
II: 1.3% vs. 0.1% (correl. = 0.01)
III: 0.3% vs. 0.2% (correl. = -0.15)
IV: -0.8% vs. 0.0% (correl. = -0.11)
V: -2.9% vs. 0.0% (correl. = -0.36)

The data indicate a mixed message:

1. The overall correlation is negative (-0.15), and the quintile data exhibit this negative correlation most strongly on trading days with more extreme changes in oil prices (-0.26 in quintile I and -0.36 quintile V);

2. However, during the past year, 51% of the trading days have shown crude oil prices and the S&P 500 moving in the same direction (i.e., either both up or both down), while 49% have shown price movement in opposite directions (i.e., one up and the other down).

So, the negative correlation (i.e., higher oil prices and lower stock prices, or lower oil prices and higher stock prices) is most evident on the days with the largest change in oil prices. However, as the list below indicates, even within these days showing the most extreme oil price movement, oil prices and stock prices move in the same direction as frequently as they move in opposite directions:

Date: % Change in Price of Oil vs. S&P 500

Days with Largest RISE in Price of Oil
01-Jun-2004: 6.1% vs. 0.0%
22-Feb-2005: 5.8% vs. -1.5%
15-Dec-2004: 5.7% vs. 0.2%
06-Jan-2005: 5.0% vs. 0.4%
19-Nov-2004: 4.8% vs. -1.1%

Days with Largest FALL in Price of Oil
01-Dec-2004: -7.4% vs. 1.5%
27-Dec-2004: -6.5% vs. -0.4%
02-Jun-2004: -5.6% vs. 0.3%
21-Apr-2004: -5.0% vs. 0.5%
02-Dec-2004: -4.9% vs. -0.1%

My sense of what is going on here is that when traders see oil prices rising, they sell stocks, and, similarly, traders buy stocks when oil prices fall. Essentially, the behavior of market participants, based on their pre-conceived notions of how markets are "supposed" to move, exacerbates market price movement itself--at least on an intra-day time scale.

I would guess that, in the longer run, this type of short-term momentum trading gets washed out by more fundamental economic forces, leading to a significantly weaker cause-and-effect relationship between oil prices and stock prices. I will take up this study using annual data in my next post.

Monday, April 04, 2005

Opinion: Why I'm Bullish on Real Estate in My Neighborhood

Here's a snapshot of recent occurrences in the real estate market where I live (Bellevue, WA):

* With the rebound of the local economy following the 2001-2002 dot-com doldrums, office vacancy rates in the urban core (Bellevue CBD) have fallen dramatically from above 25% in 2002 to 8.5% currently;
* An office tower (Civica) with Class A office space sold last week for a record $462 per sq. ft. This is the highest price per sq. ft. ever paid in the Seattle area for office space;
* A luxury 148-unit condo development (One Lincoln Tower) slated for completion in 2006 is almost entirely pre-sold. The lowest priced units sold for $540,000. Among the four units that remain, the "most affordable" is priced at $1.3 million for 1844 sq. ft. of living space, or $705 per sq. ft.(!);
* Year-on-year house price appreciation based on median resale prices (in King County) has been accelerating. It is currently about 15%, up from single-digit year-on-year price appreciation in 2001, 2002 and 2003;
* Anecdotal evidence suggests that residential real estate prices in my close-in neighborhood are rising at an annual clip of 20% or more, faster than the county average.
* This year's fundraising auction at my kids' elementary school brought in twice the "budgeted" amount from donors. Apparently, parents are feeling more generous this year, reflecting the improved local economy. Last Friday, for the first time, the PTSA hosted a fully catered evening carnival at the school, complete with free rides, inflatable play gyms for the kids, dinner for everyone and snacks--all paid for using "surplus" auction funds.

Despite the current strength of the local market, there is one exogenous negative factor: With interest rates rising (10-year Treas. is now 4.45% after touching a 3.98% low in early Feb.), mortgage rates are also up about 50 b.p. This rise in interest rates could put a damper on house price appreciation both nationwide and locally.

How will the list of positives fare against rising interest rates over the next year or two? With real estate all about location, a few important underlying considerations are:

* Proximity: My residential neighborhood, zoned for single-family detached homes and parks, is an easy ten-block walk from the urban core, with its Class A office towers, quality shopping mall (Bellevue Square), and growing number of restaurants and cultural amenities;
* Liveability: The city is encouraging development of a more liveable downtown, with more street retail and housing in comfortable, human-scale, "pocket" neighborhoods co-existing with CBD skyscrapers. The eventual outcome of this city planning effort is uncertain, but at least there is activity with good intention in the right direction;
* Schools: The local school system, which is arguably the best in the state based on academic measures, is a magnet for families who place education and a stable neighborhood environment high on their list of priorities;
* Housing Demand: With the office vacancy rate on the mend and more offices being planned, demand for housing will only increase as the number of local office jobs grows. Residential condos are also springing up in the CBD to meet some of this demand. However, no land is available close-in for building more detached homes;
* Density: Increasing density of development will continue to push land prices up at and near the urban core faster than further out in the fringes;
* Commute: As car and pedestrian traffic increases, so will demand for close-in housing, as many workers choose to live close-in rather than commuting through rush-hour traffic to get to work.

Although it is difficult to quantify the impact of all of these underlying factors on the price of local real estate, it is very clear that the neighborhood where I live has the "winds of growth" at its back. The house next door was built for $60,000 in the late 1970s and has seen a ten-fold price run-up in 25 years (9.5% per annum, compounded). (Disclosure: My wife and I are in escrow on this house.) With continued growth of the local economy and development of the CBD, I believe that similar price appreciation is likely over the next 25 years, even if rising interest rates temper market price appreciation in the short-term.

It may seem odd to predict that house prices will continue to appreciate at a multiple of the annual 3% or so increase in the average salaried worker's pay, when these workers are the ones who are driving much of the demand for local housing. What I believe is happening is that the "target class" of buyers of close-in homes is gradually ratcheting up to buyers in higher and higher income brackets. In other words, with the development of Class A office towers in the CBD, the neighborhoods adjacent to the CBD are being transformed into more upscale residential enclaves. Older homes built in the 1950s are, one-by-one, gradually being replaced by 3000 to 4000 sq. ft. new homes starting at $1 million, now aimed at executives and manager-level employees instead of rank-and-file workers.

With local job creation fueling demand for housing in an environment with a very limited supply of close-in detached homes, house prices will likely continue their ascent. From our perspective today, it seems almost ludicrous to imagine that the house next door could be valued at $6 million in 2030 (assuming the trend of ten-fold appreciation in 25 years continues unabated). Yet, the onward and upward build-out of the CBD, in conjunction with renewed interest in close-in urban living, makes continued above-average appreciation of local real estate a near certainty.

Today's absolute level of house prices in my neighborhood may feel bubble-like compared to where prices have been in years past. But, considering how consistent historical price appreciation has been during the work-in-progress, multi-decade transformation of Bellevue's urban core, I would characterize the city as being more in the middle of a prolonged build-out than in the middle of a price bubble.

Saturday, April 02, 2005

An Example of Typical Price Behavior (II)

As an example of a stock with large price swings, I select Research in Motion (RIMM), maker of the BlackBerry handheld text messaging device. Research in Motion is a large-cap company ($14 billion market capitalization) with good liquidity (average daily trading volume of 9 million shares) and a high beta (3.1).

Based on the time series of daily closing prices from the past six years (February 1999 to the present), I find the following basic statistics:

Distribution of One-Day Price Movements
Average Daily Price Movement: 0.3%
Standard Deviation: 5.8%
Skew: 0.65
Kurtosis: 8.4

3 Days Prior vs. Today: -0.01
2 Days Prior vs. Today: 0.02
1 Days Prior vs. Today: 0.01
Today vs. 1 Day Later: 0.01
Today vs. 2 Days Later: 0.02
Today vs. 3 Days Later: -0.01

This information tells us that:

1. The distribution of daily price movements has fat tails (kurtosis sigificantly greater than zero);
2. The time series as a whole does not have memory (autocorrelations all close to zero).

However, because it is still possible that predictable behavior occurs only in certain regimes (e.g., when large price movements occur), I sort the data by magnitude of the daily price movement and calculate statistics for individual deciles:

Decile: Average Daily Price Movement, Prior 20-day Historical Volatility
I: 11.6%, 6.3%
II: 5.1%, 5.7%
III: 2.9%, 5.2%
IV: 1.7%, 4.4%
V: 0.5%, 4.4%
VI: -0.5%, 4.4%
VII: -1.5%, 4.7%
VIII: -2.7%, 4.7%
IX: -4.4%, 5.7%
X: -9.1%, 6.8%

Decile: Average One-Day Price Movement 3 Days Prior, 2 Days Prior, 1 Day Prior; 1 Day Later, 2 Days Later, 3 Days Later
I: -0.3%, -0.3%, 0.4%; 0.4%, 0.0%, -0.3%
II: 0.7%, 0.6%, 0.9%; 0.9%, 0.0%, 0.6%
III: 0.8%, 0.6%, 0.2%; 1.5%, 0.1%, 0.4%
IV: 0.6%, 0.2%, 0.7%; 0.6%, 0.5%, 0.4%
V: -0.1%, 0.3%, -0.2%; -0.2%, 0.7%, 0.5%
VI: 0.5%, 0.7%, 0.5%; 0.5%, 0.3%, 0.4%
VII: 0.0%, 0.4%, -0.2%; -0.2%, 0.6%, 0.5%
VIII: 0.4%, 0.5%, 0.5%; -0.1%, 0.4%, 0.3%
IX: 0.6%, 0.5%, 0.8%; -0.2%, 0.8%, 0.9%
X: 0.2%, -0.1%, -0.3%; 0.2%, 0.1%, 0.0%

Decile: Volatility of Decile Data 3 Days Prior, 2 Days Prior, 1 Day Prior; 1 Day Later, 2 Days Later, 3 Days Later
I: 7.4%, 7.0%, 7.5%; 7.5%, 6.6%, 8.0%
II: 5.7%, 6.0%, 5.3%; 5.2%, 4.9%, 5.3%
III: 6.0%, 5.0%, 5.2%; 6.5%, 5.4%, 4.7%
IV: 4.6%, 5.1%, 4.0%; 4.9%, 4.6%, 6.2%
V: 5.9%, 5.0%, 4.6%; 4.5%, 4.4%, 4.4%
VI: 4.3%, 6.4%, 4.2%; 4.3%, 4.3%, 4.6%
VII: 6.0%, 3.8%, 4.4%; 4.7%, 6.9%, 4.7%
VIII: 4.9%, 4.9%, 6.7%; 6.5%, 5.0%, 5.8%
IX: 5.5%, 6.1%, 6.6%; 4.8%, 6.4%, 6.6%
X: 7.5%, 8.0%, 8.2%; 8.0%, 8.5%, 7.1%

I have not listed autocorrelations for the deciles above, but these are all low, indicating lack of any reliable relationship between price movement on a given day and price movements a few days earlier and later.

The conclusions I draw from the data are:

1. Large price movements tend to occur more frequently when historical volatility is high;
2. There is a lack of any clear same-directional (momentum) or opposite-directional (reversal) behavior following large price movements;
3. Volatility tends to persist, i.e., large price swings tend to be followed by larger-than-average price movements.

Unfortunately, I do not see any predictable directional price behavior anywhere in the data, even in the "fat tail" deciles comprised of the data points representing the largest price swings (deciles I and X).

Based on this very limited examination of just one stock, it is premature to draw the conclusion that the time series of price movement for stocks in general provides no information about the direction of future price movement. However, I must say that this study is yet another indication that whatever predictability exists within the time series itself is likely to be quite weak.

In short, although big price moves tend to be both preceded and followed by larger-than-average price movements (i.e., occur more frequently in volatile regimes), predictable directional behavior is absent. Without directional predictability, neither long nor short stock positions can be relied on for excess profits. Further, with volatility tending to persist rather than fade or surge, neither long nor short option trades can be expected to generate excess profits either.

Friday, April 01, 2005

Are Big Price Moves Predictable? (I)

A large body of evidence in academic studies and more practical undertakings indicates that market prices do not undergo a "random walk" as once thought. The classical "random walk" assumptions of normality (i.e., price changes fit a Gaussian distribution) and independence (i.e., the market has no memory) do not agree with "real world" observations of market price movement. Books such as Benoit Mandelbrot's The Misbehavior of Markets (I have read about this book but have not read the book itself) review this topic, explaining how distributions have non-Gaussian "fat tails" and how volatility tends to cluster.

(Footnote: During my graduate student days in the 1980s, I served on our department's seminar committee and had the privilege of inviting Mandelbrot to deliver a lecture. I found him to be a pleasant man to converse with. During his visit, he showed us many fractal charts that, to the human eye, were indistinguishable from market price charts. I recall asking him about predictability of future price movement but do not recall getting a useful answer.)

From a practitioner's point of view, what the academic discussion boils down to is two statements: a) large price swings occur more frequently than we might think, and b) a volatile market tends to remain volatile for some time. Academics have applied chaos theory to describe this price behavior, pointing out how markets tend to be bi-modal, with "chaotic" periods (like an earthquake with its aftershocks) interspersed between "quiet" periods with comparatively little price movement.

The shortcoming of all of this research is that it is descriptive rather than predictive. It describes the nature of the market but does not offer any insight into how one might go about trying to use what we know today to predict where prices will go in the future. In other words, the theory is interesting, but it does not tell us how to make a profit based on the new insight.

So, we are left on our own to attempt the (presumably formidable) task of trying to find pockets of predictability in the market. (I imagine that this problem is no simpler than trying to predict earthquakes.) Because random price behavior is a priori unpredictable, my guess is that any predictability of market price behavior is likely to show up in the non-random, "fat tail" part of the distribution where price behavior is most erratic. Consequently, I think it may be fruitful to focus on large price swings.

Everyday in the market, there are a number of stocks that rise 10% or 20% or more, and others that fall a similar percentage. If we could predict when any of these big price moves are about to occur, we could, of course, become zillionaires by going long or short if we know the direction of the upcoming price swing (or buying puts and calls if we know that higher volatility is imminent but do not know the direction of the upcoming price movement). Alternatively, rather than searching quiet periods for signs of impending volatility, it may easier to turn the problem "on its head" and look for predictable behavior in the wake of large price swings.

The general problem is: Does the price time series itself have any information that tells us when big price movements will occur and what their direction will be? In particular, at the extremes of large price movement, which of the following is more correct?

1. Momentum: A large price advance (decline) indicates that prices will advance (decline) further, or
2. Reversion: A large price advance (decline) indicates prices will decline (advance), reverting to the mean after having overshot.

If either of the above is significantly more likely than the other, we will have directional information on price movement that we can exploit to generate excess trading profits.

In subsequent posts, I will report on my progress as I proceed with this study.