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Vol. 32 Summer Break AUGUST 22, 2014Two Wall Street, New York, New York 10005 www.grantspub.com

(July 25, 2014) The annual summer-time monetary hoedown at JacksonHole, Wyo., wont be the same this year,Bloomberg reports. The Kansas CityFed, host of the August fiat-fest, is cut-ting Wall Street dead. Economists fromthe TBTF banks, longtime schmoozersin Jackson Hole, are this year being in-vited to stay home.

Maybe thats a good thingthe cronyfinanciers were especially thick on theground at the 2006 proceedings, wherethey collectively seemed no more alert tothe looming mortgage-cum-credit-crisisthan the government employees did.Then, again, the Fed has a job of work onits hands. Its balance sheet is too big andits interest rates are too low. It may needsome help in strategizing.

With money-supply growth tickinghigher and the rate of producer-price in-flation accelerating, How to exit? is onequestion. Which rates are relevant inthis zero-percent world? is another.

Before QE, the funds rate was thecentral banks one and only. However,colleague Evan Lorenz observes, withexcess reserves measured in the trillionstoday vs. in the billions pre-crisis, thefed funds market has ceased to func-tion. On to the next rate, then: Thenew reverse-repurchase rate, perhaps?Maybe or maybe not, the thinking goes,given the not-so-farfetched risk thatthe mere existence of the RRP facilitymight invite a bank run ( Grants , May 2),or maybe the interest rate on excess re-serves, now fixed at 25 basis points? Ora new funds rate that encompasses morethan the funds market?

Accompanying the technical debateis the continued growth of the monetary

bills represent 77% of the currencygrowth (as the Fed reports that they didin 2013), and if $20 bills account for therest, the green emission would weigh3.8 million pounds. More significantfrom a pure monetary perspective is thegrowth in deposits, which corroboratesthe surge in business lendingafter all,loans create deposits.

Nearly four million pounds of papermoney do create a sense of inflationaryanticipation. Wheres the thing itself?The Cleveland Fed, which calculates theCPI every which way (median, trimmedand otherwise), essentially comes up with2%. Two percent is supposedly what theFed is shooting for. Still, the Fed keepson shooting. And as it fires, asset pricesdance. Measured year-over-year, theS&P 500 is up by 17%, the Russell 2000by 9.8%, the S&P/Case-Shiller Compos-ite-20 Home Price Index by 10.8%.

aggregates. M-1 rose by $282 billion inthe 12 months ended July 7, paced byan $87 billion increase in currency anda $196 billion jump in deposits. If $100

Fiat-fest 2014

Well I, for one, am going to miss QE.

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Mountains of C-notesvalue of $100 bills as percent of total currency in circulation

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Summer Break -GRANTS/AUGUST 22, 2014 2 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994

Neither, for the 31 st consecutiveyear, did Grants cop a Jackson Hole in-vitation. Still, we contribute a questionfor the guests to bat around: What isinflation, anyway?

Drug dealer (March 7, 2014) Posterity, rubbing

its eyes, will marvel at many thingswe now take for granted. Financialposterity may look back with par-ticular amazement at Valeant Phar-maceuticals International (VRX onthe New York and Toronto stockexchanges). The rise andwe nowtip our analytical handfall of thisrazzle-dazzle deal-doer is the subjectunder discussion.

In Valeant, a financialized age hasproduced a financialized pharma com-pany. You hear great entrepreneurssay that they didnt set out to achievewealth or a towering share pricefi-nancial success simply followed com-mercial achievement. Valeant, underthe leadership of CEO and Chairman

J. Michael Pearson, gives pride ofplace to stock market capitalization inexpressing its grand strategic vision. Inthe January guidance call, Pearsonvowed to make Valeant one of thetop-five most valuable pharmaceuti-

cal companies as measured by marketcap by the end of 2016. This equatesto roughly $150 billion of market cap.

Grants is bearish on Valeant. Todeclare an interest, Kynikos Associ-ates, which employs your editors el-der daughter and whose founder andCEO, James S. Chanos, has subscribedto this publication for 30 years, is thesource of the idea. Not that we blameKynikos of any errors or misconcep-tions that might have crept into thefollowing analysis. Here at Grants, wemake our own mistakes.

Anyway, we are confidently bear-ish, which, in view of the opacityof the corporate structure, is sayingsomething. As you will presently see,Valeant grows by serial acquisition.Accounting for those acquisitionsleaves all but the most determinedanalystin this shop, that would beEvan Lorenzwondering which cor-porate end is up.

At a glance, nothing about Valeantseems too far out of the ordinary. Itsan international (not, managementemphasizes, global) pharmaceuticalcompany that focuses on dermatol-ogy, ophthalmology, branded gener-ics and over-the-counter medicines.It sells over 1,500 products, directlyor indirectly, in over 100 countries. Inthe fourth quarter, the United States,Canada and Australia together con-tributed 76% of revenue, emerging

markets the balance. In 2013, Valeantgenerated revenue of $5.8 billion; itreported GAAP net income of minus$866 million and non-GAAP cashearnings of $2 billion. There are 333.1million shares outstanding; its an easystock to borrow (thoughas the trackof the share price suggestsnot aneasy short to manage, or to sleep with).

The closer you look, the more yousee what sets Valeant apart from itspharmaceutical peers. R&D spend-ing is one of these eccentricities. Lastyear, Valeant invested just 2.7% of itssales into research and developmentcompared to an average of 13.8% ofsales for Johnson & Johnson, PfizerInc. and Merck & Co. Valeant doesmost of its compound-hunting in thestock market, not the laboratory; itacquired more than 25 companies ineach of the past two years.

Valeant is no ordinary pharmacompany, observed BMO CapitalMarkets analyst Alex Arfaei last year inhis first report on the company. Thenotion that a pharmaceutical companywould essentially quit R&D and relyon acquisitions for growth is still dis-comforting, if not absurd for many rea-sons. Yet that is Valeants expertise:the ability to identify inefficiencies inits target companies, pursue them ag-gressively while maintaining the disci-pline to not overpay, and successfullyintegrating the acquired companies ina more efficient, decentralized struc-ture with a low tax rate. We argue this(now demonstrated) expertise is asvaluable as a productive R&D enginebecause Valeant is applying the strat-egy in the right markets.

Certainly, the stock markets a be-liever. Since Pearson took the helmon Feb. 1, 2008, the share price hasrisen by 2,174%, an upsurge in whichthe CEO has himself amply partici-pated. The former director and headof McKinsey & Co.s global Pharma-ceutical Practice, Pearson owns 3.4million Valeant shares worth $486.5million today. Depending on thisyears price action, the boss stands toreceive between 120,000 (if the priceis $83 on certain measurement dates)and 480,000 (if the price is $224 oncertain dates) performance-based, re-stricted stock units.

Enough saidfor nowaboutthe stock. What about the business?Managing the business gets half ofmanagements time; M&A opportu-

Pick your 2013 corporate metricValeants year-over-year growth rate

including excluding generics genericsFrom Valeants press release:Developed markets, pro forma -1% 6%Developed markets, same-store sales -5 9 Emerging markets, pro forma 12 12

Emerging markets, same-store sales 11 11 Total sales, pro forma 2 7Total sales, same-store sales 0 10 From Valeants 10-K report:Developed markets, same-store sales -10Emerging markets, same-store sales 8Total sales, same-store sales -5

Total sales, pro forma 0

source: company reports


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nities absorb the rest, according tothe chief financial officer, HowardBradley Shiller. So much in thrall isthe Street to Valeants alleged deal-making prowess that one analyst, atleast, goes to the remarkable lengthof penciling in unannounced dealflow as a major source of future Va-leant earnings power.

So many deals, so much confusion.You begin to wonder if anyone out-side the front office actually under-stands what the companys about orwhat it earns (about which more ina moment). Consider, says Lorenz,the 2012 Valeant purchase of Medi-cis Pharmaceutical Corp. for $2.4 bil-lion cash (Valeant always pays cash).Pre-acquisition, Medicis had recog-nized revenue not when it shippedits products to its distributor, McKes-son Corp., but when McKesson soldthose products to doctors. Post-acqui-sition, Valeant began booking sales assoon as the McKesson-destined prod-ucts went out the door. In response toa query from the SEC, managementdefended the new practice. (Vale-ants pricing policy, as distinct fromMedicis, allowed greater certaintyas to revenue was the essential re-sponse.) One is left to wonder whatchanges Valeant has chosen to effectin the numerous smaller acquisitionsthat never produced a similar regula-tory paper trail.

Not even Valeant always knows ex-actly what its getting. How could itwhenfor instanceBausch & Lomb,

a 2013 acquisition for which Valeantpaid $8.7 billion, has not undergone anoutside check on internal controls since2007, when private-equity buyers tookB&L private?

Implicit in the bull case for Vale-ant is that good things happen tothe companies that Valeant buys.We dont see the data to support thecontention. Thus, Lorenz observes,Valeant talks about organic growthexcluding drugs that lose patent pro-tectionanother variation on theold earnings-before-the-bad-stuffmethod. Management also confus-ingly tabulates year-over-year organicgrowth in different ways. One way isas if Valeant controlled all acquisi-tions for both the current reportingperiod and the year-ago period. An-other is on a kind of same-store-salesbasis, which measures year-over-yearperformance without the impact ofacquisitions. Indeed, in any givenperiod the company may present fivedifferent growth rates: headline,organic same-store sales includinggenerics, organic same-store sales ex-cluding generics, pro forma organicgrowth including generics, and proforma organic growth excluding ge-nerics. Any questions?

In 2013, Lorenz proceeds, or-ganic same-store sales growth, includ-ing generics, was a negative 5.1%,driven by a 10.4% decline in devel-oped markets and an 8.5% gain inemerging markets. On a pro formabasis including the impact of gener-

ics, total sales declined by 0.5%. Thefact that same-store sales are decliningat a more rapid rate suggests that thelonger a business is under the Valeantumbrella, the worse it performs.

Its not as if Valeant isnt pulling thelevers to grow. It works hard to avoidtax, and it methodically raises priceson the products it acquires throughM&A. The latter policy, especial-ly, has prompted some analyticalquestioning: We previously raisedquestions regarding adverse volumegrowth and the sustainability of largeprice increases for VRXs prescriptionderm brands. . . , Bank of America/Merrill Lynch analysts noted lastsummer. [W]e believe it is notablethat volume trends have deterioratedfor many of the large branded drugsthat VRX has acquired.

Always, the conscientious share-holder will ask, What do I own andwhat do I owe? And what do I earn?As to the first point, in 2013, Valeantspent $5,323 million on acquisitions,up from $3,559 million in 2012. Atyear-end 2013, the balance sheet reg-istered an $8.2 billion jump in good-will plus intangibles to $22.6 billion.Net debt, including pension obliga-tions, jumped to $16.9 billion from$10.1 billion. In the fourth quarter,GAAP operating income of $223 mil-lion fell short of $260 million in inter-est expense. Since 2010, revenues,the share price and net debt plus pen-sion obligations have described simi-lar fireball growth arcs, up at com-pound annual rates of 69.7%, 73.1%and 74.4%, respectively.

What do I earn? On a GAAP basisin 2013, Valeant showed a loss of $2.70 ashare vs. a GAAP loss of $0.38 a share in2012. Management asks that you avertyour eyes from those unsightly data tofocus instead on cash EPS, a forgiv-ing metric of its own creation. Cash EPSsubtracts from income acquisition-relat-ed expenses, goodwill and intangibleamortization costs; also, write-downs,legal settlements stemming from acqui-sitions and other one-time costs. Onthis bespoke basis, Valeant earned$6.21 in 2013 vs. $4.51 in 2012.

Valeant can say it earned $100 ashare. If you buy growth in the stockmarket (and in the debt market), arethe aforementioned attendant costs notreal enough? In Valeants case, espe-cially, are they not recurring enough?

So, then, what does Valeant re-

4Q131Q131Q121Q11

Borrowing prosperityValeants net debt and pension obligations (left scale)vs. free-cash flow per share (right scale)


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ally earn? Cutting through GAAPand non-GAAP earnings, Lorenzproposes, lets settle on free cashflowthat is, cash flow from opera-tions less capital expenditures. In2013, free cash flow amounted to$927 million, or $2.89 per commonshare, up from $549 million, or $1.80a share, in 2012. The 2013 readingwould give Valeant a less-than-lordlyfree-cash flow yield of 2%. UnlikeR&D expenses, which are debits inthe free-cash-flow calculation, fundsspent on acquisitions dont impactfree-cash flow. As Valeant conductsits R&D via M&A, free-cash flow, ifanything, flatters Valeants ability togenerate cash.

On the fourth-quarter earnings calllast week, an analyst asked the Va-leant CEO about a possible mergerof equals between his company anda player to be named. First of all,Pearson replied, in terms of thenumber of opportunities out there,we would say, its not five, 10 or 15,its probably closer to 50 in terms ofopportunities. . . . [W]ere in multiplediscussions and we always have beenand will continue to be. And when anopportunity iswhen the opportuni-ty comeswell move on it.

To that prospective merger partner,we would ask this simple question:Are you quite sure you know whatyoure getting yourself into?

One last gasp for Treasurys? (January 10, 2014) In his valedictory

to the nations economists in Philadel-phia last week, Ben Bernanke reiterat-ed his commitment to a price level thatnever falls but always rises: a rate of 2%a year would be nice, the chairman af-firmed. That sentiment, made familiarby years of repetition, scarcely raised aneyebrow, let alone a controversy. Its adeficit we undertake to correct. To putthe conclusion ahead of the argument,the Fed will discoverwe all will dis-coverthat nothings so unstable as astabilized price level.

As we read the new year consen-sus of investment sentiment, peoplelove stocks, hate bonds and feel sorryfor gold. In the many years Ive beensurveying experts for their predictionsfor the coming year, writes New YorkTimes columnist James B. Stewart, I

cannot recall another time when op-timism about the stock market, theeconomy and corporate profits was sowidespread. As is pessimism about thebond market.

Perhaps the traders maxim applies:If its obvious, its obviously wrong.If so, it may behoove us, aged and griz-zled bond bears, to imagine a contraryscenario. We ground these imaginingsin a longstanding Grants theme, name-ly, there ought to be deflation.

There ought to be inflation, too, thispublication has maintained at intervalssince the dawn of QE. Let us rather nowfocus on the march of progressand onthe accretion of debt. As technology ad-vances, prices should fall. As it costs lessto make things, so it should cost less tobuy them. In the case of TV sets, wash-ing machines, refrigerators, cell phones,etc., prices have been falling for years.Not since 1996 has the durable goodssegment of the personal consumptionexpenditures price index registered apositive year-over-year change.

Debt, like progress, is a force for de-flation. Encumbered firms produce toremain solvent. Heavily encumberedfirms overproduce. Overproductionpresses down prices. Easy access todebt prolongs the life of marginal firms.They dont go broke but, finding readyaccess to speculative-grade credit, carryon, thus adding to the physical volumeof production and therefore to the over-head weight on prices. Debt is deflation-ary the more it drives production, orinthe case of governments and individu-

alsthe more it constricts consumption.Money printing is inflationary. It lifts

some prices, but in the current cycle,not all of them. Banks have been im-paired. Borrowers have been reluctant.The dollars that the Fed has conjured,most of them, take the shape of unmo-bilized bank reserves. They are inert.

The central bank is egging on infla-tion with one hand but suppressing itwith the other. It materializes the dol-lars that drive some prices higher. Itfosters the debt formation that pressescertain other prices lower. What it re-fuses to do is let markets clear.

Since December 2007, the Fed, thePeoples Bank of China, the EuropeanCentral Bank, the Bank of Japan andthe Bank of England have collectivelymaterialized the equivalent of $8.9 tril-lion. The five central banks have in-flated their balance sheets to $15.1 tril-lion, or to 20.6% of global GDP, from$6.3 trillion, or 11.1% of world GDP inDecember 2007. Yet measured ratesof inflation have dwindled. In neitherthe euro zone nor the United Stateswill the rise in the chosen price indi-ces in 2013 (stocks, bonds, commercialreal estate, etc. not included) hit thecentral banks 2% target.

Anxieties are rising in the eurozone that deflationthe phenomenonof persistently falling prices across theeconomy that blighted the lives of mil-lions in the 1930smay be starting totake root again as it did in Japan in themid-1990s, reported Mondays Wall

Street Journal . The deflation bulletin

12/131/131/121/111/101/091/081/071/061/05

QE causes what?

Federal Reserves total assets (left scale)vs. y-o-y change in core PCE index (right scale)

source: The Bloomberg

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shared page A2 with a dark ponderationon the threat of secular stagnation,another homage to the 1930s.

As for us, we find the 1920s moreinstructive. Between 1922 and 1927,wholesale commodity prices fell by 0.1percent a year, while the cost of livingrose by 0.7 percent a year. In that timeof hurtling technological progress, onemight have expected prices to fall, asthey persistently fell in the final quar-ter of the 19 th century. The FederalReserve was happy to take credit forthe fact that they didnt. The centralbank seemed to germinate enoughcredit to resist the gravitational pullon prices of falling production costsand rising productivity. Business andprices have both become more stable,asserted a Herbert Hoover-sponsoredvolume entitled, Recent EconomicChanges in 1929. There is evidencethat our economic system is moving inthis direction.

Price stability was the ideal, agreedIrving Fisher, professor of economics atYale University, and Benjamin Strong,governor of the Federal Reserve Bankof New York. Fisher, hugely influen-tial, contended that there was no suchthing as a business cycle; price distur-bances were rather to blame for boomsand busts. Iron out the price level andyouve conquered the cycle, heandmany luminous otherscontended.

Theres more than an echo ofFisher in the words and deeds of our21st-century mandarins. One notabledifference is how the moderns define

stability. For Fisher, stable meant just that, neither inflation nor defla-tion. For Bernanke and Yellen andthe rest, stable means no deflation.To prevent what earlier ages took asa sign of progressbargains are good,the primitives reasonedthe leadersof the Fed, like their forebears of the1920s, have had to create enough cred-it to prop up the price level.

The world is a cornucopia, thispublication observed in the issue dated

Jan. 14, 2005. Thanks to the infernalmachine of American debt finance, theInternet and the economic emergenceof India and China, among other mil-lennial economic forces, goods aresuperabundant. More and more ser-vices, too, are globally traded, thereforecheaper than they would be in the ab-sence of international competition. Yetthe measured rate of inflation in theUnited States is positive, not negative,as it was in so many prior eras of freetrade and technological progress.

At the time we wrote, house priceswere rising by 13% and the core per-sonal consumption expenditures defla-tor was rising by 1.6% (both measuredyear-over-year). Household debt wasexpanding by 9.7%, personal dispos-able income by 2.1% (also measuredyear-over-year). The fed funds rate wasquoted at 2.29%, up from 1.27% in No-vember 2002, when the then-Gover-nor Bernanke gave his famous speechabout the bogeyman from the 1930s.Deflation: Making Sure It doesntHappen Here, he entitled this effort.

Exactly how the former Princetoneconomist intended to lift averageprices without distorting certain, veryspecific priceshouse prices, for in-stancehe didnt say. Nor did he stopto define terms. That job fell to us,as follows: Inflation is not too manydollars chasing too few goods. Pureand simple, inflation is too many dol-lars. What the redundant dollars chaseis unpredictable. In recent months,they have chased stocks, commodities,euros, junk bonds, emerging-marketdebt and houses.

As for deflation, what it isnt, wesaid, is falling prices. That is a symp-tom of the thing, not the thing itself.We defined deflation as too few dollarschasing too much debt: Dollars extin-guish debt; too few dollars in relationto the stock of debt is the preconditionfor what, these days, is euphemisticallycalled a credit event.

In a debt crisis, people throw assetson the market to raise cash. The weightof this new supply, not offset by newdemand, broadly sinks prices. That ,to us, is deflation. If, on the contrary,prices fall because the world is becom-ing more efficient, we would call thatcircumstance everyday low prices, orprogress. In no public utterance ofwhich were aware has any senior Fedofficial addressed this critical distinc-tion. We had our hopes for the chair-mans goodbye address, but the oldprofessor let us down.

Whatever the source of deflation,the central banks of the world arepledged to resist itby the meansof creating more debt. They are notfighting fire with fire. They are fight-ing fire with gasoline.

Bloomberg on Monday was outwith the projection that debt as apercentage of the worlds 34 larg-est economies (i.e., members of theOECD) will climb to 72.6% in 2014from 70.9% last year, and from 39%in 2007. In addressing the economistsin Philadelphia, Bernanke defendedthe radical policies of the past fiveyears by alluding to the depressionthat wasnt and the recovery that is.He failed to mention that the meansto the end of salvation was the neardoubling of the worlds debt burden.Nor did he choose to acknowledgethe truism that debt and deflation gotogether like PB and J.

If the Food and Drug Adminis-tration were monitoring Bernankes

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Progress of the agedurable goods sub-index from PCE measured year-over-year

source: Bureau of Economic Analysis

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speeches, as maybe it should, the Fed-eral Reserves anti-deflation pledgewould include some frank talk aboutside effects. People who take QE orZIRP may suffer from giddiness anda loss of financial perspective, theFDA-mandated disclaimer would say.They may experience nausea, short-ness of breath, hair loss, impotence,bankruptcy and heartburn.

The Feds price stabilization pro-gram is no one-off policy. Its the verymission of the modern central bank.Committed to stabilizing some prices,the Fed is reciprocally (though tacitly)dedicated to distorting others. In the1920s, an economist at the New YorkFed devised a price index encompass-ing real estate prices and security val-ues as well as rents, wages and whole-sale prices. The Carl Snyder Index ofthe General Price Level rose by 2.7%a year between 1922 and 1929. An up-dated edition would certainly presenta very different picture of todays sta-bility than the indices that omit assetprices. Inflation is where the centralbankers arent looking for it.

It strikes us as not a little ironic thata central bank under the leadership ofa supposed historian of the Great De-pression lives in ignorance of the de-cade preceding the Great Depression.The best of the contemporary postmor-tems of the years 1929-33 harped on theunintended consequences of artificialprice stability.

Banking and the Business Cycle,produced in 1937 by the trio of C.A.Phillips, T.F. McManus and R.W. Nel-son is the gold standard of the genre,to our mind. As the book is long out ofprint, well quote from it; the authorsseem almost to be addressing the editorand the readers of Grants. The prin-cipal shortcoming of price level stabi-lization as a primary goal of monetarypolicy, Phillips et al. write, is foundin the fact that the freezing of any oneset of prices tends to establish resis-tances to the readjustments that needto be made continually within the pricesystem if that system is to be kept inbalance in the face of a highly dynamiceconomic setting: stabilization of allprices is, of course, quite impossiblein any nation other than one having acompletely frozen economic struc-ture. Nor is an unchanging price levelany insurance against depression, as theevents of recent monetary history haveabundantly proved.

The authors go on to enunciate a lawof unintended consequences. Theydont use the word bubble, but youcan tell what theyre driving at. As longas economic progress is maintained,they continue, resulting in increasingproductivity and an expanding total out-put, there will be an ever-present forceworking for lower prices. Any amountof credit expansion which will offsetthat force will find outlets unevenly insundry compartments of the economicstructure; the new credit will have aneffect upon the market rate of interest,upon the prices of capital goods, uponreal estate, upon security prices, uponwages, or upon all of these, as happenedduring the late boom. A policy whichseeks to direct credit influences on any single index, whether it be of prices, ei-ther wholesale or retail, or production, orincomes, in the interests of stabilization,will result in unexpected and unforeseenrepercussions which may be expected toprove disastrous in the long run.

Disastrous grabs the reader by thecollar; long run rather loosens thegrip. How to apply the preceding ideasin the here and now?

By resisting deflation, todays centralbankers will ultimately create one, webelieve. But when? Before or after theyinstigate an unscripted 3% or 5% infla-tion rate? We dont know, nor do they.

At last report, Novembers, the PCEexpenditure index registered a year-over-year rise of 0.9%. Its not so far-fetched to imagine monthly readingsbelow the zero markerthere wereseven of them in 2009. In five consecu-tive months between 1961 and 1962,there were year-over-year readings ofless than 1%. In 12 consecutive monthsbetween 1954 and 1955, there wereyear-over-year readings in the CPI ofless than zero. Nobody seemed to objectvery much in 1954-55 or in 1961-62. Forthat matter, the deflation of 2009 couldbe explained away by the financial crisis(that, actually, was deflation). But now?A more than passing slip into official de-flation territory would send the Fed togeneral quarters. Then what?

Action, of course. The Bank of Yel-len is as constitutionally incapable ofinaction as were the Banks of Greens-pan and Bernanke. The Fed would pawaround in its tool kit. It would discovernew, seemingly sharper-edged instru-mentsnominal GDP targeting, per-haps, or some literal application of theBernanke helicopter-money metaphor.

How would the world interpret anadmission of the failure of monetarypolicy to prevent this imagined lurchto deflation? We suspect it would buyTreasurys. Maybe the government se-curities market has another big rally init, and maybe that hypothetical rallywill reward this years contrarians.

Where would all this lead? If we werewriting the script, it would lead to a be-lated but well-reasoned loss of confi-dence in the institution of modern cen-tral banking. It would produce a flightfrom paper money into tangible things.That is, it would lead to inflation. Weexpect that it will. And we expect thatcome that historic moment, people willstop feeling sorry for gold.

Yield to worst(April 4, 2014) The food is ter-

rible, to quote the famously am-bivalent restaurant reviewandthe portions are so small. Much thesame can be said of todays junk-bondmarket. The yields are terribleandtheres not enough new supply to sat-isfy the clamoring demand.

The subject at hand is the world-wide yield famine; the special pointof focus is how to turn that distress toprofit. You know that income-seekingAmericans are scraping the bottomof the barrel. Its the same on theother side of the Atlantic. Accordingto Fridays Financial Times, income-deprived Continental investors arebidding up speculative-grade debtfrom the European periphery toprices higher than comparably ratedsecurities emanating from the Euro-pean core. Yield is the thing, evenif youll never get it. All in all, we con-clude, the junk marketwe are nowback in North Americais ripe forthe risky art of short selling.

Even in what the adepts call acrowded trade, the short sellersway is lonely. You, the man or womaninside the bear suit, conceive a pointof view that usually does not comportwith authorized institutional think-ing. Let us say that you believe thatstunted yields, receding credit qualityand rising interest rates (or the threatthereof) have delivered an opportuni-ty to sell short junk bonds or the mu-tual funds and exchange-traded fundsthat house them.


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market is diligently closing the gap.Its getting junkier, says MichaelE. Lewitt, CIO of Eccles Street As-set Management LLC and editor ofThe Credit Strategist . The ratings areslipping more. In terms of covenantlite, [loans or bonds issued with aminimum of restrictions intended toenforce financial discipline on theborrower] a couple of years ago whencovenant lite really started picking up,it really was just the strongest borrow-ers that the market would grant thatkind of package to. Thats no longerthe case. Anybody can get a covenantlite package. The market is much lessdiscriminating. The complacency hasset in. Covenants are weakening inthe loan market.

In the bond market, Lewitt con-tinues, covenant packages are weak-er and there has been some erosion incall protection. Historically, there hasbeen five-year, non-call protection onbonds; were seeing episodes of threeyears. In general, most deals thatare coming to the market are not fornewly minted LBOs. The bad newsis they are often to pay dividends toequity sponsors to re-lever companiesand that is never a good thing.

At current ground-scraping inter-est rates, high yield is an oxymo-ron. Many regret this state of affairs,though not the bears. A 15% couponmakes for a prohibitively expensiveshort sale (remember, the bearishspeculator must pay the securitieslender the interest he or she would

Yield Master II Index fetched 5.24%.The subsequent scare over the pos-sible end of QE quickly pushed theaverage yield to 7.02%178 basispoints in only 33 trading days. Hav-ing sold the tapering rumor, the junkmarket proceeded to buy the news.So here we are at 5.63% on the sameBofA Merrill Lynch index, a quarterpoint above the old lows in yield.

The contention here is that todaysmarket is bereft of absolute valueand low on the relative kind. The2007 market was, we think, zanieron account of the higher incidence ofleveraged buyout debt, but todays

You take a walk around the blockto interrogate yourself: Do you re-ally want to do this thing? Normalpeople buy first and sell later. Shortsellers reverse the order by sellingborrowed securities first with the in-tention of buying later to close outthe transaction (or, in the idealizedshort sale, never having to cover be-cause the securities they shrewdlysold have become worthless). Itsnot always easy to get the borrow.Nor is it usually expedient to remitto the securities lender the dividendor interest payment on ones bor-rowed stock or bonds. You, contem-plating the advisability of becominga short seller, take the measure ofthe known risksrising markets,Federal Reserve stimulus, peaceand prosperity, etc. You add, as well,the high personal costs that shortselling sometimes exactsinsom-nia, heartburn, hair loss, paranoia.And having duly considered thepros and cons, you gamely exclaim,Heck, yes!

We write not mainly for theseblithe, intrepid spiritshow manycan there possibly be?but for allwho lend or borrow. As leverage isubiquitous, so is credit topical. Be-sides, todays junk-bond market is aliving laboratory in the consequencesof radically easy monetary policy.

At the highs of junk-bond priceslast May 9this was on the eve ofthe 2013 tapering frightthe Bankof America Merrill Lynch U.S. High

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Then theres the debt Isle of Capri Casinos stock price


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Not so highBofA Merrill Lynch U.S. High Yield Master II, effective yield

source: Federal Reserve Bank of St. Louis

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have otherwise received through or-dinary corporate channels). A 5%coupon alone wont make for a profit-able short sale, but it gives the bears afighting chance.

We serve up four vignettes in sup-port of this thesis. No. 1 concerns atransaction that captures the mar-kets manic mood. No. 2 is about aliquid, overpriced, vulnerable bondthat seems ripe for a short sale. No.3 is a case study in what a CharteredFinancial Analyst might call heavycompetition overlaid on lousy funda-mentals. No. 4 is an update on Intel-sat, an over-leveraged borrower withan underachieving income statement.

The first evidentiary item concernsa February financing by BlueLineRental for the purpose of enablingthe promoters of a private-equitydeal to take out 100% of their equitynot two weeks after theyd put it in.According to Matthew Fuller of theLCD unit of Standard & Poors, notsince 2007that fateful yearhasany dividend recap deal followed soquickly on the heels of the closing ofthe acquisition as has BlueLines.

BlueLine Rental, successor to theVolvo equipment rental business,rents backhoe loaders, skip loaders,track dozers, trenchers, skid steers,wheel loaders, boom trucks, knuck-le lifts, electric man lifts, towablebooms, welders, light towers, pumps,heaters and other capital items suit-able for an expanding economy. Thecompany does business at 132 rental

locations; it serves 45,000 customersin 44 states, Puerto Rico and a pair ofCanadian provinces.

BlueLine is a rollup, the prod-uct of the consolidation of scores ofequipment-rental franchisees into acentrally owned retail network. Plati-num Equity, a Beverly Hills-basedprivate equity shop, did the rolling.The price tag was $1.1 billion.

A senior bank line and $760 mil-lion of single-B-rated, 7% second-lien notes of February 2019, offeredat par, financed the acquisition. Thatis, those borrowings financed the firstphase of the acquisition. Demandfor the 7s being unslaked, inves-tors asked for another opportunity toparticipate in the leveraging up of acyclical, macroeconomically sensi-tive business. BlueLine obliged with$252.5 million of triple-C-rated 9 3 /4sof 2019 at 99.

Here was a double homage tobooms gone by. Beyond the use ofproceeds (a dividend for PlatinumEquity) was the fact that the 9 3 /4sare payment-in-kind, or PIK, notes;toggle, too, is a part of the descrip-tion. In certain circumstances, theborrower may choose to pay interestnot in cash but in additional securi-ties (in so choosing, it is said to togglebetween one form of payment and an-other). Like the crocus or snowdrop,PIK securities are seasonal heralds ofwarmth and optimism. Their appear-ance in the capital markets is a signthat cyclical winter is past and that a

new season of lending and borrowingis bursting forth.

The 9 3 /4 notes pushed leverage forthe borrowing entity to 5.9 times thefavored, if not officially sanctioned,measure of cash flow called pro for-ma, adjusted EBITDA. That was upfrom 4.6 times before the new PIK is-sue came into the world. (EBITDA,you know about: net income beforenet interest expense, taxes, depre-ciation and amortization; the adjust-ments applied to EBITDA includethose related to other non-cash charg-es, brand license royalties and esti-mated costs we expect to incur oper-ating as a stand-alone entity, insteadof, as before, a collection of franchisedbusinesses.) This 5.9 times leveragecompares to 3.2 times net leverageat double-B-rated United RentalsInc. (URI on the NYSE), BlueLineslarger and publicly traded competitor,and to just under four times debt-to-EBITDA for the entire high-yieldbond universe, according to a March28 report by Morgan Stanley.

No mystery whats in this transac-tion for the private-equity investors.A more interesting question is whatsin it for the bondholders? Under pre-vious management, BlueLines com-ponent businesses suffered operatinglosses in each of the prior three years.Then, too, according to the auditors,the process of integrating the dozensof acquisitions has revealed mate-rial weaknesses in the companys fi-nancial controls and information tech-nology systems.

No doubt, Platinum Equity, withmore than 150 acquisitions under itsbelt and 30 companies in its portfo-lio, means to fix the problems andreturn BlueLine to profitability.And if it succeeds, the creditors, too,would succeed, as success is modestlyreckoned in the fixed-income world:They would get their money back,with interest.

As the BlueLine 9 3 /4s are callableat 103 on Feb. 1, 2016, an investorspotential gains are hardly limitless.From todays price of 106.1, the se-curities would deliver a yield to call,or worst, of 7.63%. To be sure, thatwould be a handsome gain for a fixed-income security. It would be less thanoverwhelming for an equity.

The PIK toggle notes buyers aretaking true equity risk, but their up-side is capped, a paid-up subscriber

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In orbit

Intelsat senior unsecured notes, 7 s of October 2020


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the ETFs likeare the most vul-nerable right now, Craig Kelleher,a partner in Boston-based MillstreetCapital Management, tells Lorenz.We saw it in May last year. Whenthose guys hit the sell button, thoselarge liquid namesthey were per-ceived as liquidcan hit four- to five-point air pockets. ETFs now make upbetween 8% and 10% of the marketand are predominantly in those large-cap names. Dealer inventories, as weknow, are also at 10-year lows. Yet thehigh-yield market is multiples biggerthan it was 10 years ago.

Though Americas economy, too,has grown over the past decade, ithas lost that characteristic Americanoomph. Notably lacking in dyna-mism is, for instance, the regionalgambling business. According tothe Mississippi Gaming Commis-sion, casino-generated tax revenuedropped by 4.7% in Decemberfrom the like month a year earlier,to $18.2 million from $19.1 million.That is 37.5% less than the haul pro-duced in December 2007 at the startof the Great Recession.

When casino licenses were hardto come by, therefore precious, pub-lic gambling businesses commandedfancy valuations, as our previouslyquoted anonymous source recalls.Well, he says, that is quicklyeroding as more and more states, ina desperate grab for tax revenue, arewilling to sell themselves to the deviland open up casinos. Isle of CapriCasinos (ISLE on the Nasdaq) is anexample of an established gamingbusiness that must regret the law-makers surrender to sin. Pricing ofthe companys single-B-rated 5 7 /8sof March 2021they trade at 102 toyield 5.52% to maturityseems notto reflect that the house is facingmore difficult odds.

Isle of Capri owns and operates 15small casinos in Colorado, Florida,Iowa, Louisiana, Mississippi, Mis-souri and Pennsylvania; only four ofthem generate more than $20 millionin annual operating profit. The aver-age Isle of Capri customer, not a mem-ber of the 1%, doesnt have much togamble with, let alone to lose.

And now comes more competition.A new Golden Nugget casino is slatedto open late this year near the LakeCharles, La., property that accountedfor $7.9 million in Isle of Capri oper-

ating profit over the past 12 months,or 12.5% of the grand total. Accord-ing to a new report by Susan Berlinerof J.P. Morgan, the Golden Nuggetopening will likely skim 25% fromIsle of Capris take at Lake Charles.

(The rising young investor Ber-nard M. Baruch once talked himselfout of an opportunity to do businesswith the elder J.P. Morgan by usingthe word gamble in the great manspresence; how times change.)

Then, too, Lorenz relates, morecompetition is on the way in Iowa,home to three of Isle of Capri proper-ties, which together chipped in $37.6million, or 60%, of the companystrailing 12 months operating profit.Operating profit generated by Islesprofitable casinos sums to more than100% of total operating profit owingto losses from casinos in Pennsyl-vania, Missouri and Mississippi. AMarch 2 story in the Quad-City Times made reference to plans for a newcasino in Linn County, Iowa, a 47-mile drive from the Isle of CaprisWaterloo location. Even without newconstruction, the newspaper reportsaidhere it cited a pair of indepen-dent research studiesa saturatedmarket is already under threat fromIllinois rapidly expanding video pok-er in taverns, stores and restaurants.

Our informant is short the Isle ofCapri debt, despite the not remotechance of a change in corporate con-trol. Some 40% of the outstandingshares are held by the family of thefounder, Bernard Goldstein, whodied in 2009. Assume, our sourcebegins, that the family does sell,would you, the hypothetical buyer,be inclined to refinance a coupon aslow as 5 7 /8%? No, you would not, oursource answers his own question,especially if you are potentiallyadding more leverage to it. Besides,an observant buyer could hardly failto notice that, in the fiscal quarterended Jan. 26, Isle of Capris $17.9million in GAAP operating incomefailed to cover the companys $21.9million in interest expense.

We close out this bears beautycontest with an update on Intelsat SA(I on the NYSE). For the full chap-ter and verse, see the issue of Grants dated Jan. 24. You may recall that thecompany operates 51 fixed satellites,a hugely expensive and time-con-suming line of work (to launch one of

these birds can cost up to $400 mil-lion and take from design to launch,three years). You may also rememberthat the satellite business requiresgrowing revenue to leverage the highcost of operation. It doesnt help mat-ters that various governments arebuilding a dozen new satellites andcontemplating the launch of severaldozen more.

Fourth-quarter results, releasedon Feb. 20, featured operating in-come for 2013 in the sum of $1.2 bil-lion, good enough to cover full-yearinterest expense by 1.08 times. Forthe year, revenue was $2.6 billion,a slight decrease from 2012. On theconference call, CEO and Chair-man David McGlade said that, ow-ing to reduced spending by the U.S.government and excess capacity inAfrica, 2014 revenue is expected tototal between $2.45 and $2.5 bil-lion, a 4.9% year-over-year declineat the midpoint from 2013 results.Not to worry, the chief counseleddialers-in: We remind our investorsof our commitment to a two-phaseinvestment model. The first severalyears of this plan is not dependentupon revenue growth but insteadon the use of increasing cash flowsto reduce our debt. We are sharplyfocused on de-levering to create eq-uity value.

As of Dec. 31, there was $15.3 bil-lion in total debt outstanding. Onthe call, the company announcedplans to repay $400 million of thatbalance this year. Investors mustbet that McGlade can do more withless revenuein 2013, free cashflow amounted to $116.1 million andthere is only $247.8 million of cashon the balance sheet.

To judge by the yields on Intelsatdebt, bond investors have every con-fidence in McGladeand in JanetYellen, Jack Lew, Barack Obama andVladimir Putin, besides. Thus, thesingle-B-plus-rated 7 1 /4s of 2020 ($2.2billion in par outstanding) changehands at 108.75, a yield to maturity of5.63%. Inasmuch as the 7 1 /4s are call-able at 103.625 on October 2015, theyield that an optimistic holder mayreceive is likely to be closer to theyield to call, or worst. That wouldbe just 3.64%.

The best of timesthe worst oftimes.


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Fuel least popular

(November 29, 2013) The Environ-mental Protection Agency makes waron it, people of any shade of greendespise it, and the advent of cheapnatural gas threatens to marginalize it.Coaland a flourishing, $217 millionmarket-cap coal minerare the topicsunder discussion.

With the Nov. 14 news that theTennessee Valley Authority will shut-ter eight coal-fired electricity-generat-ing plants, the suspicion deepens thatif anything could disprove the cheerfuladage that all P.R. is good P.R., thatsomething just might be coal. Even so,the official mineral of the state of Ken-tucky continues to generate 40% ofAmericas electricity. Clean-burningnatural gas accounts for just 27%.

Nor is coal likely to relinquish its leadin what is sometimes optimistically re-ferred to as the foreseeable future. Itwill, by 2040, continue to claim as muchas 35% of the electricity-generationmarket, compared to 30% for naturalgas, projects the U.S. Energy Informa-tion Administration. That is, coal wontsoon be going the way of the dinosaurs,from whence it came.

For connoisseurs of contrary opin-ion, Hallador Energy Co. (HNRG onthe Nasdaq) ticks not one box, buttwo. Not only does it mine coal, butalso its coal is the high-sulfur typethats linked to acid rain. To the ques-tion: Why on earth would any utility

choose to burn itor be allowed toburn it? There is this answer: Federalregulations long ago required utilities,at heavy expense, to neutralize thosepollutants. Counter-intuitively, Lu-cas Pipes, analyst with Brean Capital,advises colleague Evan Lorenz, theincreasing environmental standardshave forced utilities over the tippingpoint to where it makes sense forthem to burn higher-sulfur coal afterthey have installed higher-emission-standard technology.

So it is that high-sulfur coal is en- joying a renaissance. Its found inabundance in the so-called IllinoisBasin, which encompasses the Landof Lincoln and parts of Indiana andKentucky. Reserves in this locale arerelatively accessible and extractioncosts are relatively lowon the orderof $30 a ton, about half the cost of thelow-sulfur coal buried in the immenseCentral Appalachian Basin, a regionstretching as far north as the Canadianborder and as far south as Alabama.

Coal is in a steep bear market; theprice of central Appalachian coaltraded on the Nymex has declinedto $54.93 per ton, down from $143.25on July 1, 2008. But even at $44.50 aton, the average price for all regionsin 2013, mines like Halladors oper-ate in the black. Not so their CentralAppalachian counterparts. Since 2005,according to Pipes, annual productionin the Illinois Basin has expanded to135 million from 93 million tons, whilethat in the central Appalachian zone

has contracted to 75 million tons from216 million tons.

Within the coal industry, Lorenzpoints out, there are lots of losersand one or two winners. Conspicuousamong the former are the companiesthat leveraged to expand at the top ofthe 2007-08 energy cycle. Arch Coal,Peabody Energy Corp. and ConsolEnergy are among these encumberedunfortunates. James River Coal Co.,which had a market cap of $704 mil-lion at year-end 2010, is quoted to-day at $54 million. Patriot Coal Corp.,which had a market cap of $1.8 billionat year-end 2010, filed for bankruptcyprotection in July 2012.

A very different proposition is Hal-lador, a lightly leveraged, low-cost,pure play on the Illinois Basin. Whollyowned Sunrise Coal is Halladors prin-cipal business unit; its responsible forall but $4.2 million of the companys$25.2 million in trailing 12-month op-erating income. Savoy Energy LP, aprivate oil and gas exploration com-pany in Michigan, and Sunrise EnergyLLC, a private oil and gas explorationcompany in IndianaHallador owns45% of the first and 50% of the sec-ondround out the corporate stable.As of Sept. 30, the parents balancesheet showed $11.4 million of debtagainst $13.7 million of cash.

Hallador, via Sunrise, extracts coalat a cost of less than $30 a ton, thelowest cost of any public miner (onlyclosely held Foresight Energy LLC,controlled by the farsighted ChrisCline, posts a lower cost per ton).The great bulk of the companys coalcomes from the Carlisle mine, situat-ed near the Indiana town of the samename. The Carlisle is a high-sulfur,underground deposit from whichcontinuous mining machinery cansurface as many as six tons of coal perminute. Carlisle has a capacity of 3.3million tons a year and identified re-serves of 43.5 million tons.

While Halladors Ace-in-the-Holemine, 42 miles northeast of Carlisle,a low-sulfur surface project, chips in ahalf-million tons in annual productivecapacity and 3.1 million tons of reserves,and while management is developinga pair of much larger deposits on theIndiana-Illinois border (the so-calledBulldog and Russellville Mines), thefact is that, for now, Hallador is a one-mine company, with all the risks thatconcentration entails. For instance, in

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Mining the good coalHallador Energy share price (left scale)vs. price of Central Appalachian coal (right scale)


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the first three quarters of this year, thecost of production at Carlisle jumpedto $28.37 a ton from $26.53 in the 12months of 2012. It was the discoveryof a pocket of high gas (the same heatand pressure that transforms organicmaterial into coal also produces highlyflammable methane) that caused thebump up in cost; mining operations hadto be moved to less productive parts ofthe mine while ventilation shafts weresunk to address the gas problem. Theresult: Cash flow in the 12 months toSept. 30 declined to $27.8 million from$37 million in calendar 2012.

Another thing for the would-be in-vestor to consider is the inescapablycapital-intensive nature of the min-ing business. Capital expenditures,which totaled $40.5 million over thelast 12 months, up from $26.2 millionin 2012, have been inflated by $9 mil-lion for the purchase of Ace-in-the-Hole, $4 million for land around Car-lisle and Bulldog and costs to permitthe two new mines. To bring eitherinto production at Carlisles three-million-ton-per-annum rate wouldrequire an additional $150 million.Management estimates that mainte-nance capital expenditures will runbetween $3.50 and $4 per ton of ca-

pacity, or approximately $12-$13 mil-lion for the Carlisle mine.

We dont operate on a factory floorwhere it is the same every day, BrentK. Bilsland, president of Sunrise Coal,reminds Lorenz. Mining is aboutfollowing the geology. From time totime, we have all four of our miningunits in great conditions, and fromtime to time, we have three out of fourin bad conditions.

Theres no confusing Hallador withExxon in the stock-market liquiditydepartment; management, the boardand affiliates own two-thirds of the28.6 million HNRG shares outstand-ing. One-half of this chunk of insideholdings is persistently shrinking.Yorktown Energy Partners LLC,owner of 9.7 million shares, or 34%of the outstanding, has been distrib-uting blocks of 750,000 shares to itslimited partners every quarter or so.Many of the recipients turn rightaround and sell their Hallador in theopen market.

Yorktown tells Lorenz that its exitfrom Hallador is no reflection on thecompany or its management. The factis, rather, that the investment fundsholding Hallador shares are nearingthe end of their respective lives. We

wouldnt distribute a stock we thoughteither had issues or we thought washighly overvalued, Yorktown part-ner, Peter Leidel, says. We want todistribute stocks we think people canhold and do well with. We think thestock ought to be higher than it is, butcoal is out of favor.

Perhaps this overhead supplyweighs on the share price. Certainly,the coal bear market does the stockprice no good. In any case, the sharestrade at 10.2 times trailing net incomeand yield 2.1%; theyre quoted at amultiple of enterprise value to EBIT-DA of five times.

Whether you consider Halladorcheap at the price will depend, inpart, on your view of natural gas. Onthis score, its notable that gas pricesweighed in at an average of $2.73 permillion Btus in 2012 but have aver-aged $3.58 per million Btus so far in2013 and are tipped to rally to $3.81in 2014 (so, at least, tips the gas fu-tures market). Its not inconceiv-able that coal, in relation to gas, is ascheap as its going to get for a while.When the ratio of natural gas pricesto coal prices is approximately 1.5 orlower [per million Btu], a typical gas-fired combined-cycle plant has lowergenerating costs than a typical coal-fired plant, the EIA noted in itsAnnual Energy Outlook 2013. Coal,according to the agency, is expectedto command $2.20 and $2.29 per mil-lion Btu in 2013 and 2014, makingthe black mineral cheaper to burnthan natural gas.

Hallador gets credit for what itis, Lorenz observesthat is, alow-cost producer in a geologicallyfertile region. But it gets little, ifany, credit for its two oil and gas de-velopment businesses, or for whatits coal-mining operations might be-come. What management hopes tobecome is much biggerand couldbe. To bring either Bulldog or Rus-sellville into production would takenine months and the previouslycited $150 million. Either one ofthose projects doubles our compa-ny, Bilsland tells me. We are try-ing to get into a position where fiveyears from now, we can bring threeor four more new projects and triplethe size of our company. Thats ourgoal. The financing would appear tobe available: Hallador has in place arevolving credit facility of $165 mil-

Hallador Energy Co.(in millions of dollars, except per-share data)

12 mo.9/30/2013 2012 2011 2010 2009 2008 2007

Coal sales $136.2 $138.0 $129.0 $117.4 $70.3 $27.2 $0.0Other revenue 3.4 2.3 (0.8) 0.5 0.4 0.5 0.0Coal operating expenses 118.6 105.8 99.3 90.7 78.3 51.2 28.4Coal operating income 21.0 34.6 28.9 27.3 (7.6) (23.4) (28.4) Equity income (Savory) 3.5 2.0 5.5 1.0 (1.7) (2.3) 0.0Equity income (Sunrise Energy) 0.6 0.2 0.9 0.0 0.0 0.0 0.0Total operating income 25.2 36.8 35.3 28.3 (9.3) (25.7) (28.4) Interest expense 1.5 1.1 1.3 1.9 2.0 4.0 4.1Profit before tax 31.1 34.5 56.7 36.6 36.0 13.6 (2.8)Net income 23.5 23.8 35.8 22.4 20.2 8.9 (2.4) Diluted shares (in millions) 28.8 28.8 28.7 28.6 24.4 19.3 13.3EPS $0.82 $0.83 $1.25 $0.78 $0.83 $0.46 ($0.18) Cash $13.7 $21.9 $37.5 $10.3 $15.2 $21.0 $7.0Debt 11.4 11.4 17.5 27.5 37.5 40.0 35.4Net debt (2.3) (10.5) (20.0) 17.2 22.3 19.0 28.4

Oper. income/int. expense 17.1 33.5 27.4 14.7 (4.5) (6.4) (6.9) Cash flow 27.8 37.0 60.1 45.5 45.2 18.8 (1.5)Capital expenditures (40.5) (26.2) (33.0) (35.6) (43.5) (21.9) (17.2)Free cash flow (12.7) 10.8 27.1 9.9 1.7 (3.1) (18.8)



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lion, of which $153.6 million remainsuntapped. Halladors covenants limitthe companys borrowings to 2.75times EBITDA. Management takesa dim view on diluting ownershipvia an equity raise and would preferto fund growth via cash flow and itscredit facility, even if that means ittakes longer to ramp up a new mine.

What I like about this managementteam is that they are rational deploy-ers of capital, Mat Klody, managingpartner of the Chicago-based hedgefund, MCN Capital Management, anda Hallador shareholder, tells Lorenz.They didnt do a lot of stupid thingsat the peak of the cycle and now theyare seeing a lot of potential M&A op-portunities pop up. Theyve been cau-tious to date about deploying capital,in particular with the great organicopportunities in place. They are defi-nitely opportunistic.

Opportunisticin capitalist cir-cles, its the highest praise.

The art of inflation(April 18, 2014) A seven-foot shiny

steel rendering of Popeye the sailor manby the sculptor Jeff Koons is tipped asthe piece de resistance of next monthsevening auction of postwar and contem-porary art at Sothebys in New York.Its expected to fetch $25 million. Thecycles and vagaries of taste and value arethe topics at hand. We approach themby way of 21 st century London and 17 th century Seville.

Connoisseurs of pictures and collec-tors of securities may profitably reflecton the respective fortunes of the paint-ers Oscar Murillo (b. 1986) and EstebanMurillo (1617-1682). The current Muril-lo, Oscar, is the creator of the work shownat the bottom left, Untitled (Burrito).It brought 194,500, or $322,870, com-mission included, in February at Chris-ties in London. The price was 10 timesthe low end of the pre-auction estimate.

The 17 th century Murillo paintedthe picture at the lower right. EcceHomo depicts the scourged figure ofChrist in the moments before his cru-cifixion. Mater Dolorosa, a renderingof Christs anguished mother, whichaccompanies it, is not shown. The twopictures were offered together for saleby Sothebys in December. Failing to at-tract a bid suitably close to $320,000, the

low end of the pre-sale estimate (whichhappened almost exactly to anticipatethe inclusive Burrito price), the workswere withdrawn.

Oscar Murillo, 28-year-old formeroffice cleaner, is one of the hottest ofthe so-called emerging artists. EstebanMurillo, a shining light of Counter-Reformation Spain, is one of the colderof the submerging Old Masters (thereis no claimed family connection be-tween the two). At the Christies OldMasters auction in New York in Janu-ary, 109 paintingsall the works on of-ferfetched a combined $19.1 million,or not quite four-fifths of the expectedvalue of one Popeye, observes col-league Charley Grant. In the languageof Wall Street, Oscar Murillo is a kindof momentum stock. Esteban Murillois a kind of value stock.

Before listening to Cliff Asness holdforth at last weeks Grants Conference,we might have glibly proposed a con-ceptual pair trade: shorting Oscar while

going long Esteban. Asness, a Ph.D. infinance from the University of Chicago,advised the Grants audience not to dis-parage momentum investing. Scholarlystudies, including his own, show thatone can profit by being long what hasbeen going up and being short what hasbeen going down. Its not that value in-vesting doesnt work, Asness said, onlythat momentum deserves a place in theprofessional canon, too.

Well and good. Oscarlet us sayistrading above his personal 200-day mov-ing average. He is going up and has beengoing up. Perhaps his bull market is onlybeginning. Maybe one of his canvasseswill make a new record at the May auc-tions. Possibly, one of Estebans devo-tional paintings will make a new low.

This publication is in receipt of a se-lection of pointers for any who wouldcompete in the red-hot, momentum de-partment of the contemporary art mar-ket. The fundamental concept, advisesour well-connected informant, is to heedthe buzz. Buy with your ears, she ad-vises, as opposed to your eyes. Hearwhat the insiders are sayingcurators,dealers, artists and collectors.

Here, according to Carol Vogel, writ-ing in The New York Times last month, iswhat one noted collector has said. MeraRubell and her husband had arrived at9 A.M. at the Independent Art Fair inNew York to meet Murillo. This wasin March 2012. [H]e looked dishev-eled, exhausted, like a homeless per-son, Rubell is quoted as saying. Hedstayed up for 36 hours straight andmade seven or eight paintings, so hehad something to show us. They blewus away. We ended up spending fourhours talking to him. . . the last time Isaw that kind of energy was Keith Har-ing or Jean-Michel. It was so intense. Idont even think he was on drugs.


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Maybe the central bankers are ondrugs. Maybe modern money sets theprices on modern art. We shall nowclimb down, slightly, from that approachto the valuation question. We have beenreading Gerald Reitlingers The Eco-nomics of Taste: The Rise and Fall ofPicture Prices, 1760-1960 (the first vol-ume of what turned out to be a three-volume work was published in Londonin 1961). Its a history of cycles.

In the early Victorian era, EstebanMurillo was a hot artist. To be sure, hewas long dead, but the taste-makers ofthe day, including a Bonaparte princeand the Czar of Russia, appraised him agenius. In 1852, Murillos ImmaculateConception fetched 24,600 in a privatesale, the highest price that any picturewould command until the mid-1880s. Intodays gold value, the painting brought 3.9 million or $6.6 million. Nine feethigh, it shows the Virgin surroundedwith a tumbling torrent of corpulentcherubs, as Reitlinger puts it. Victoriantaste died hard, the author relates, butdie it did, and Esteban Murillos workentered a long bear market. In 1950, avery good Murillo, Christ Healing theParalytic, cost Britains National Gal-lery 8,000 fiat pounds sterlinga deepdiscount from the gold pounds fetchedby Immaculate Conception.

Nearby you see a rendering of Un-titled #93., a photograph by CindySherman, which sold for $96,000 atChristies in 1998 and is expected tobring between $2 million and $3 mil-lion when auctioned next month at theSothebys contemporary art extrava-ganza in New York.

No. 93., as far as we know, wascreated to be viewed. To describe atype of work whose evident purposeis to be sold, The New York Times corre-spondent Scott Reyburn has coined theterm Flip Art. Murillo, among others,he writes, make abstract painting thatare a clever play on the act of painting.These abstracts often employ novelnot to mention cheappainting tech-niques, such as using a fire extinguisher.. . or home improvement products. . . .Theyre often big, and have significantwall power.

Time will tell about their stayingpower. Fifty years ago, on April 21, 1964,Andy Warhol unveiled Brillo Boxes. Itdid not seem obvious to the establishedart world that those ever-so-familiar-looking packages were art or that the art-ist who produced them would become acult figure.

Claude Gelle (1600-1682), knownsimply as Claude, the most perfectlandscape painter the world ever saw,according to John Constable, was a cultfigure in the early 19 th century. He wasamong the highest-priced painters onthe market until the cultists found oth-er immortals to venerate. In 1808, oneClaude landscape had fetched 12,600;in 1895, another made just 472.

Now Claude is rediscovered. At aChristies sale in New York in January,the artists A Wooded Landscape,a drawing of an unidentified vista inthe Roman countryside, brought $6.1million, more than seven times theestimate. If it can happen to Claude,why cant it happen to MurilloEs-teban, that is? And if could happen toEsteban, why couldnt it happen, inreverse, to Oscar?

Tastes change, money cheapensand cycles turn.

Introducing the Grants Story Stock Index(November 15, 2013) No bull stock

market is complete before the debut ofthe kind of equity thats valued on thequality of its narrative. Its the anticipa-tion of earnings, not their actual arrival,that sets the speculative heart flutter-ing in the late stages of a proper levita-tion. The road is better than the inn,wrote the immortal Cervantes centu-ries before the Twitter IPO.

Now unfolding is a review of thenew crop of story stocks. We write forthe not-so-far-receptive members ofthe Federal Open Market Committee,as well as for the sainted paid-up sub-scribers. Nothing flatters distantly pro-

jected earnings more than an ultra-lowdiscount rate, as Evan Lorenz, our ownin-house Chartered Financial Analyst,points out. Here, then, is a story of in-terest rates as much as of stocks.

One hundred dollars of earnings 10years in the future are worth $38.55 to-day if discounted at 10%, CFA Lorenzreminds us. At a 5% discount rate,they are worth $61.39. But at a zero-percent rate, they are worth $100andwould be worth that much from here toeternity. So while each of the 15 com-ponent companies in the Grants StoryStock Index has its own story to tell, theunifying theme is ZIRP.

Not just any shooter, to reclaim aterm from the great garbage marketof the 1960s, qualified for the Grantsindex. Lorenz screened for stocks thatare expensive on multiples of earn-ings, EBITDA (i.e., earnings beforeinterest, taxes, depreciation and amor-tization), or that show no earnings buttrade at high multiples of revenues.When possible, our candidates exhibitother characteristics of a good short-sale specimen, including insider sell-ing and an adequate supply of sharesto borrow (the exceptions on this latterscore are Zillow and ChannelAdvisor).All but one of the names is a memberof the Russell 2000, the exception be-ing Sprouts Farmers Market, which wedeal with elsewhere in this issue. Letshave a look at what the bull dragged in.

Tile Shop Holdings (TTS on theNasdaq), our first exhibit, ticks themost critical story-stock box: Its val-ued not on what has happened butwhat may come to pass in the farreaches of the future. Founded in1985 by the incumbent CEO, Rob-ert A. Rucker, Tile Shop went pub-lic only in 2012. The company oper-ates 83 stores that average more than22,000 square feet. It operates them in28 states, mainly in the Midwest andMid-Atlantic regions, in which it sellstiles, both stone and ceramic, as wellas setting and maintenance products.It buys straight from manufacturers;58% of its tile comes from Asia.

Chinese quality control not beingall that it might be, the heavy relianceon Asia raises concerns about product


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integrity. Indeed, Rucker conceded onthe Oct. 30 earnings call, that some ofthe companys merchandise may con-tain trace amounts of inorganic met-als. He said that, to nip a potentialproblem in the bud, URS Corp. hasbeen retained to investigate the com-panys supply chain.

Quoted at 48 times the 2013 earn-ings estimate, Tile Shop would likethe world to know that it means togrow to 140 to 150 stores in the nearterm and to more than 400 stores inthe long term.

And the worlds a believer, to judgeby the track of the share price. HomeDepot and Lowes Cos., which also car-ry tile products, change hands at an av-erage of 21.8 times their 2013 estimates.Has Mr. Market, under the influence ofMr. Bernanke, perhaps gotten a littleahead of himself? As it is, Tile Shoptrades at a $1.1 billion equity marketcap. Let us assume that it achieves itsnear-term goal of 145 or so stores. Andlet us further assume that, having builtthem, the company watches its earn-ings multiple contract to match themore mature valuations of Home De-pot and Lowes (the road is better thanthe inn, after all). In that case, if one ap-plied Tile Shops current tax rate andmargins, a $1.1 billion equity marketcap would be in order. In other words,you could argue, Tile Shop is alreadyvalued as if it has done what its CEOhas only promised it will do.

If Tile Shop commands a muchhigher valuation than its mega-box,do-it-yourself comps, a bull might in-terject, its because Tile Shop earns somuch higher margins than they do. Infact, the would-be national tile super-store chain reported a 27.7% EBITDAmargin in 2012, more than double thoseof Home Depot and Lowes.

One might suppose that the cost ofbeing a public company would whittleTile Shops EBITDA margin, say bytwo or three percentage points; thelaw of diminishing returns may proveanother source of margin compres-sion. The store count grew to 53 from42 in the three years through 2011. It

jumped 28%, to 68, in 2012, and itsexpected to rise by an additional 29%,to 88, in 2013.

In years past, says the front office, anew store would generate sales of $1.9million in Year 1, whereas recent open-ings produced revenues of $1.8 millionin the first 12 months of operation. Not

that that fact is cause for concern, CFOTimothy C. Clayton assured dialers-inon the third-quarter earnings call. [T]he performance of our stores in subse-quent years is growing at a faster ratethan previously discussed, said Clay-ton. We now find that, on average, ournew stores grow at a 22% to 23% ratethe second year, 12% to 14% the thirdyear, at 7% to 9% in the fourth year.How Clayton can be so sure of yearsthree and four, we dont know; TileShops recent growth spurt only startedtwo years ago.

That its no easy thing to manage anexpansion like the one Tile Shop envi-sions is obvious on its face. But for anywho doubt it, consider managementsabout-face on advertising outlays. Anote in the 2012 10-K report boasts:Unlike many of our competitors, wedo not rely on significant traditionaladvertising expenditures to drive ournet sales. We establish and maintainour credibility primarily through thestrength of our products. . . .

Compare and contrast Ruckers re-marks on the Oct. 30 call: Right now,were testing television advertising ina few select markets to replicate a na-tional advertising budget. All in all,we are going to venture that not sincethe great mosaics of the churches ofConstantinople has anything havingto do with tile been so richly valuedas Tile Shop is in the zero-percentBernanke stock market.

Health is the narrative of our secondStory Stock Index component com-

pany. Boulder Brands (BDBD on theNasdaq) is the top maker of gluten-freefoods in North America and a leadingmaker of buttery-like spreads withouttrans fat. Udis and Glutino and EarthBalance and Smart Balance are amongits brands. Its customers may be vegan,or gluten-intolerant, or trans-fat averse,or just fashionable. Whoever they are,management is betting therell be moreof them, and the stock market seemsto agree. The shares are valued at 50times forecast 2013 earnings.

The bull case for Boulder is that thegluten-free diet is going mainstream,Lorenz relates. A certain number ofAmericans suffer from celiac disease,a disorder in which eating glutenfound in wheat, barley and ryetrig-gers an immune reaction. The Nation-al Foundation for Celiac Awarenessputs the figure at three million, and itreckons that another 18 million may begluten-sensitive. Boulder Brands esti-mates the combined ranks of celiacsand the gluten-sensitive at 43 million.It does Boulder no harm that the No.2-ranked male tennis player, NovakDjokovic, ascribes his professionalsurge to a gluten-free diet.

I have a number of relatives who aregluten-sensitive, Lorenz continues.While gluten-free is rapidly expand-ing from a low base, there are manyreasons to doubt it will catch on withthe mainstream like the Atkins diet inthe 2000s, the low-fat diet in the 1990s,or even bran muffins in the 1980s. Rea-son No. 1, gluten-free bread lacks the

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Its the narrativeStory Stock Index; indexed to 100 on July 31, 2013


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Nov. 12,133.33Nov. 12,133.33


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taste and texture of bread made fromwheatif you have to eat it, be sure totoast it and slather it with cheese. No. 2,gluten-free recipes are typically higherin calories than ordinary ones. No. 3,gluten-free is more expensive.

As for Boulder, you wonder aboutthe quality of its revenue growth. In thethird quarter, it achieved a 17% bumpin sales with a 40.4% leap in accountsreceivable. It was the ninth consecutivequarter in which growth in receivablesoutpaced growth in revenues.

One wonders, too, about the SmartBalance division. In the third quar-ter, it chipped in 35% of sales and46% of earnings, and it did so on theback of declining revenuesdownby 4.4% after adjusting for discontin-ued product lines. Nor will competi-tion likely be less intense after thescheduled April 7, 2015, expirationof the patents that protect the SmartBalance approach to heart-healthyspread manufacture.

Boulder Brands grew out of SmartBalance, but that core business alonecould never have landed the com-pany in the kicky Grants Story StockIndex. Failed attempts to leveragethe Smart Balance brand, in fact, ledto a $130 million write-down in 2010.Source of the current corporate sparkleis rather the gluten-free business. Itcontributes the lions share of the 65%of revenue and 54% of profit that SmartBalance brands did not provide in thethree months to Sept. 30.

How does the gluten-free businesslook from outside the corporate wallsof Boulder Brands? To the CEO of An-nies Inc., John M. Foraker, who spokeat the Barclays Back to School Consum-er Conference on Sept. 4, it seems tolook a little faddish.

Those [gluten-free] items are do-ing exceptionally well, said Foraker.Theyve been growing much fast-er than the total business for quitesome time, but we are also cognizantthat some consumers are in gluten-free maybe for diet reasons and otherthings, which may be not as sustain-able. So we want to make sure thatwe have products that taste great. Sothats limited what weve done therein terms of SKU proliferation.

Net of cash, Boulder Brands showsdebt of $242.1 million, or 3.9 timestrailing 12-month EBITDA. Overthe past 12 months, operating incomecovered interest expense by 2.4:1.Debt is a fad, too.

A storied story stockthats Lo-renz talkingis our specimen No. 3,Opko Health (OPK on the Big Board).Founded in 1991 as Cytoclonal Pharma-ceuticals and known at other times aseXegenics, Opko has apparently nevergenerated net income. It has tried butfailed to produce cures for cancer, in-fectious diseases and macular degen-eration. Still at it, the company is todaytrying to diagnose prostate cancer, toproduce a long-lasting human growthhormone and to cure nausea related to

chemotherapy. It owns a portfolio ofmiscellaneous businesses distributingand/or manufacturing veterinary andpharmaceutical products in Mexico,Spain and Israel.

Bulls are rooting hard for the suc-cess of an Opko test for prostate can-cer; a clinical trial of the device, called4Kscore, is slated for the first quarterof next year. A lingering cloud over thetest is a critical editorial that appearedin the May 2010 edition of ClinicalOncology. In this report, said theeditors of an article detailing the per-formance of the Opko product, 24%of all cancers and 14% of high-gradecancers would be missed . . . it seemsthat a change in screening practices thatmisses any high-grade cancer cannotbe considered an improvement overstandard screening. In other words, itwould seem, here is a cancer test thatmisses cancer.

What remedial action, if any, Opkohas subsequently taken to address theconcerns of its critics, we dont know.Some, the bulls must expect. An es-timate by Jefferies & Co. ascribes $4out of the $10 share price to the valueof the 4Kscore test. On a hopeful note,the company launched the product inthe U.K.; it did so in October 2012. Ona somewhat less hopeful note, no traceof any 4Kscore-derived revenue is tobe found in the companys subsequentfinancial filings.

To be clear, we do not insist thatOpko will not succeed in one or more ofits myriad undertakings; a new growthhormone is said to look promising. Allwe are saying is that this particular lot-tery ticket, valued at 42 times estimat-ed 2013 revenues, says as much aboutthe stock market as it does about thepresent value of any reasonably likelyfuture cash flows that Opko might oneday actually generate.

Reviewing the flyaway stock marketof 1968-69that great garbage mar-ketthe author John Brooks, in hishistory, The Go-Go Years, had thisto say about stocks like the ones in thenew Grants index:

[W]hat a promoter needed to launcha new stock, apart from a persuasivetongue and a resourceful accountant,was to have a storyan easily graspedconcept, preferably related to some cur-rent national fad or preoccupation, that

sounded as if it would lead to profits.Tiles may not yet be a national pre-

occupation, and the top of this par-

Story Stock Index(in $ millions)

EV/est. mkt. short int. price to est. 2013 2013name ticker cap. float 2013 earn. sales EBITDADemandware DWRE $1,888 5.2% x 17.6x xChannelAdvisor ECOM 841 6.7 13.9 Tile Shop Holdings TTS 1,072 15.0 47.7 4.9 19.8Opko Health OPK 4,081 16.2 42.4 Boulder Brands BDBD 917 13.4 49.8 2.5 15.4Sprouts Farmers Market SFM 7,058 3.4 101.8 3.1 39.2Infoblox* BLOX 2,274 3.9 80.5 8.0 50.98x8 Inc.* EGHT 720 5.7 49.2 5.2 37.3Constant Contact CTCT 858 8.7 38.6 2.6 16.4Mobile Mini Inc MINI 1,785 4.1 33.6 5.8 15.2Cornerstone OnDemand CSOD 2,449 5.7 13.1 2125.3Shutterstock SSTK 2,569 11.9 87.8 10.5 49.1Textura* TXTR 709 18.7 18.4 Yelp YELP 4,578 12.1 350.2 19.5 155.1Zillow Z 3,056 22.1 5188.0 14.8 121.4

*non-financial yearssource: The Bloomberg


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ticular stock market may not yet be insight. So be it. At Grants, the watch-word is vigilance.

Paycheck to paycheck(January 24, 2014) A slight emen-

dation: Amazon isnt the most highlyvalued company by any and everyreckoning of value. By the standard ofenterprise value to sales, Conns Inc.(CONN on Nasdaq) ties the EverythingStore, 2.60 times to 2.60 times. Now un-folding is a bearish analysis of a stockthat only seems to want to go up.

This may not be news you think youcan use. We understand that preciousfew investors, even Grants readers, willsell anything short. Federal Reservepolicy actively discourages the practice.The normal human desire for a goodnights sleep likewise militates againstselling an asset you dont actually ownbut must go out and borrow. We are of-fering up more short ideas because wecant find enough suitable long ideas (re-ciprocally, in 2009 through 2012, we fea-tured many more longs than shorts). Wemake no representation that the stockmarket has peaked. We only judge that,based on our idea of what constitutesvalue, the evident rewards of being longincreasingly pale before the evidentrisks. Journalistically and analytically,we are tilting to the bear side of the boat.

Back to Conns. Based in The Wood-

lands, Texas, the company operatesmore than 70 clean, well-lit and well-stocked stores in Texas, Louisiana,Arizona, Oklahoma and New Mexico.Conns sells Samsung washers and dry-ers, Serta mattresses, Sony televisionsand HP laptops, among myriad otherproducts and brands. Many others do,too, of course. But not every retailerprovides financing solutions to a large,underserved population of credit-con-strained consumers who typically areunbanked and have credit scores be-tween 550 and 650, to quote from oursubjects SEC filings. Conns is a sub-prime retailer, and creditso we sayisits Achilles heel.

Conns, observes colleague Da-vid Peligal, essentially allows thesecustomers to make an aspirational pur-chase. The lucky aspirants just have tobe prepared to pay an 18% interest ratefor the privilege. Depending on wheth-er youve been long or short, Peligaladds, Conns has either been one ofyour best investments or one of yourworst investments.

Conns is an outlier in many respects.Its growth is supersonic, its sponsorshipis first class (Stephens Inc., the closelyheld Little Rock investment bank, isamong

jim grant: summer break issue 2014

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