Grants Interest Rate Observer Summer 2014 Issue

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Vol. 32 Summer Break AUGUST 22, 20Two 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 trillions

today 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 currengrowth (as the Fed reports that they in 2013), and if $20 bills account for rest, the green emission would we3.8 million pounds. More significfrom a pure monetary perspective is growth in deposits, which corroborathe surge in business lendingafter

loans create deposits.Nearly four million pounds of pamoney do create a sense of inflationanticipation. Wheres the thing itsThe Cleveland Fed, which calculates CPI every which way (median, trimmand otherwise), essentially comes up w2%. Two percent is supposedly what Fed is shooting for. Still, the Fed keon shooting. And as it fires, asset pridance. Measured year-over-year, S&P 500 is up by 17%, the Russell 2by 9.8%, the S&P/Case-Shiller Compite-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.

55

60

65

70

75

80%

55

60

65

70

75

80%

201320092005200119971993

Mountains of C-notes

value of $100 bills as percent of total currency in circulation

source: Federal Reserve

percentage

percentage


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Summer Break-GRANTS/AUGUST 22, 201SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994

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

Drug dealer

(March 7, 2014) Posterity, rubbingits 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 and

CEO, 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, Valegenerated revenue of $5.8 billionreported GAAP net income of min$866 million and non-GAAP caearnings of $2 billion. There are 33million shares outstanding; its an estock to borrow (thoughas the tr

of the share price suggestsnot easy short to manage, or to sleep wit

The closer you look, the more ysee what sets Valeant apart from pharmaceutical peers. R&D speing is one of these eccentricities. Lyear, Valeant invested just 2.7% ofsales into research and developmcompared to an average of 13.8%sales for Johnson & Johnson, PfiInc. and Merck & Co. Valeant dmost of its compound-hunting in stock market, not the laboratoryacquired more than 25 companieseach of the past two years.

Valeant is no ordinary pharcompany, observed BMO CapMarkets analyst Alex Arfaei last yeahis first report on the company. Tnotion that a pharmaceutical compawould essentially quit R&D and ron acquisitions for growth is still dcomforting, if not absurd for many rsons. Yet that is Valeants expertthe ability to identify inefficienciesits target companies, pursue them gressively while maintaining the displine to not overpay, and successfuintegrating the acquired companiesa more efficient, decentralized strture with a low tax rate. We argue t(now demonstrated) expertise is valuable as a productive R&D engbecause Valeant is applying the stregy in the right markets.

Certainly, the stock markets a liever. Since Pearson took the heon Feb. 1, 2008, the share price risen by 2,174%, an upsurge in whthe CEO has himself amply partpated. The former director and he

of McKinsey & Co.s global Pharmceutical Practice, Pearson owns million Valeant shares worth $48million today. Depending on tyears price action, the boss standsreceive between 120,000 (if the pris $83 on certain measurement datand 480,000 (if the price is $224 certain dates) performance-based, stricted stock units.

Enough saidfor nowabthe stock. What about the busineManaging the business gets halfmanagements time; M&A oppor

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 7

Total sales, same-store sales 0 10

From Valeants 10-K report:

Developed markets, same-store sales -10

Emerging markets, same-store sales 8

Total 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 five

different 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%. Tfact that same-store sales are declinat a more rapid rate suggests that longer a business is under the Valeumbrella, the worse it performs.

Its not as if Valeant isnt pulling levers to grow. It works hard to av

tax, and it methodically raises prion the products it acquires throuM&A. The latter policy, especly, has prompted some analytiquestioning: We previously raiquestions regarding adverse volugrowth and the sustainability of laprice increases for VRXs prescriptderm brands. . . , Bank of AmeriMerrill Lynch analysts noted lsummer. [W]e believe it is notathat volume trends have deteriorafor many of the large branded druthat VRX has acquired.

Always, the conscientious shaholder will ask, What do I own awhat do I owe? And what do I earnAs to the first point, in 2013, Valespent $5,323 million on acquisitioup from $3,559 million in 2012. year-end 2013, the balance sheet ristered an $8.2 billion jump in gowill plus intangibles to $22.6 billiNet debt, including pension oblitions, jumped to $16.9 billion fr$10.1 billion. In the fourth quartGAAP operating income of $223 mlion fell short of $260 million in intest expense. Since 2010, revenuthe share price and net debt plus pesion obligations have described silar fireball growth arcs, up at copound annual rates of 69.7%, 73.and 74.4%, respectively.

What do I earn? On a GAAP bin 2013, Valeant showed a loss of $2.7share vs. a GAAP loss of $0.38 a share2012. Management asks that you avyour eyes from those unsightly datafocus instead on cash EPS, a forging metric of its own creation. Cash E

subtracts from income acquisition-reed expenses, goodwill and intangiamortization costs; also, write-dowlegal settlements stemming from acqsitions and other one-time costs. this bespoke basis, Valeant earne$6.21 in 2013 vs. $4.51 in 2012.

Valeant can say it earned $10share. If you buy growth in the stomarket (and in the debt market), the aforementioned attendant costs real enough? In Valeants case, escially, are they not recurring enough

So, then, what does Valeant

4Q131Q131Q121Q11

Borrowing prosperity

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


inmillionsofdollars

freecashflowpershare

4,000

7,000

10,000

13,000

16,000

$19,000

net debt and pension obligations

free cash flow per share

0.00

0.20

0.40

0.6

0.80

$1.00


5/2


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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 common

share, 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 valedictoryto 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 familiar

by 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 Grantstheme, 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 a

positive 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 consumptiMoney printing is inflationary. It l

some prices, but in the current cycnot all of them. Banks have been ipaired. Borrowers have been reluctaThe dollars that the Fed has conjurmost of them, take the shape of unmbilized bank reserves. They are iner

The central bank is egging on intion with one hand but suppressingwith the other. It materializes the dlars that drive some prices higherfosters the debt formation that prescertain other prices lower. What it fuses to do is let markets clear.

Since December 2007, the Fed, Peoples Bank of China, the EuropeCentral Bank, the Bank of Japan athe Bank of England have collectivmaterialized the equivalent of $8.9 tlion. The five central banks have flated their balance sheets to $15.1 tlion, or to 20.6% of global GDP, fr$6.3 trillion, or 11.1% of world GDPDecember 2007. Yet measured ra

of inflation have dwindled. In neitthe euro zone nor the United Stawill the rise in the chosen price inces in 2013 (stocks, bonds, commercreal estate, etc. not included) hit central banks 2% target.

Anxieties are rising in the ezone that deflationthe phenomenof persistently falling prices across economy that blighted the lives of mlions in the 1930smay be startingtake root again as it did in Japan in mid-1990s, reported Mondays WStreet Journal. The deflation bulle

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

assetsinb

illionsofdolla

rs

0

750

1,500

2,250

3,000

3,750

$4,500

0.0

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1.0

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2.5

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Fed

PCE index


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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 living

rose 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 19th 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 meantjust 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 leaders

of 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 Princeeconomist intended to lift averaprices without distorting certain, vspecific priceshouse prices, for stancehe didnt say. Nor did he sto define terms. That job fell to as follows: Inflation is not too ma

dollars chasing too few goods. Pand simple, inflation is too many dlars. What the redundant dollars chis unpredictable. In recent montthey have chased stocks, commoditeuros, junk bonds, emerging-mardebt and houses.

As for deflation, what it isnt, said, is falling prices. That is a symtom of the thing, not the thing itsWe defined deflation as too few dolchasing too much debt: Dollars extguish debt; too few dollars in relatto the stock of debt is the preconditfor what, these days, is euphemisticacalled a credit event.

In a debt crisis, people throw asson the market to raise cash. The weiof this new supply, not offset by ndemand, broadly sinks prices. Thto us, is deflation. If, on the contraprices fall because the world is becoing more efficient, we would call tcircumstance everyday low prices,progress. In no public utterancewhich were aware has any senior Fofficial addressed this critical distition. We had our hopes for the chmans goodbye address, but the professor let us down.

Whatever the source of deflatithe central banks of the world pledged to resist itby the meof creating more debt. They are fighting fire with fire. They are figing fire with gasoline.

Bloomberg on Monday was with the projection that debt aspercentage of the worlds 34 laest economies (i.e., members of OECD) will climb to 72.6% in 20

from 70.9% last year, and from 3in 2007. In addressing the economin Philadelphia, Bernanke defendthe radical policies of the past fyears by alluding to the depressthat wasnt and the recovery thatHe failed to mention that the meto the end of salvation was the ndoubling of the worlds debt burdNor did he choose to acknowledthe truism that debt and deflationtogether like PB and J.

If the Food and Drug Admintration were monitoring Bernank

-6

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14%

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14%

11/131/101/051/001/951/901/851/801/751/701/651/60

Progress of the age

durable goods sub-index from PCE measured year-over-year

source: Bureau of Economic Analysis

year-over-yearcha

nge

yea

r-over-yearchange


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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 found

in 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 anysingle 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 could

be 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 admission of the failure of monetpolicy to prevent this imagined luto deflation? We suspect it would bTreasurys. Maybe the government curities market has another big rallyit, and maybe that hypothetical ra

will reward this years contrarians.Where would all this lead? If we w

writing the script, it would lead to a lated but well-reasoned loss of codence in the institution of modern ctral banking. It would produce a flifrom paper money into tangible thinThat is, it would lead to inflation. expect that it will. And we expect tcome that historic moment, people wstop feeling sorry for gold.

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

rible, to quote the famously abivalent restaurant reviewathe portions are so small. Much same can be said of todays junk-bomarket. The yields are terribleatheres not enough new supply to sisfy the clamoring demand.

The subject at hand is the worwide yield famine; the special poof focus is how to turn that distressprofit. You know that income-seekAmericans are scraping the bottof the barrel. Its the same on tother side of the Atlantic. Accordto Fridays Financial Times, incomdeprived Continental investors bidding up speculative-grade dfrom the European peripheryprices higher than comparably rasecurities emanating from the Eupean core. Yield is the thing, evif youll never get it. All in all, we cclude, the junk marketwe are nback in North Americais ripe

the risky art of short selling.Even in what the adepts calcrowded trade, the short selleway is lonely. You, the man or wominside the bear suit, conceive a poof view that usually does not compwith authorized institutional thiing. Let us say that you believe tstunted yields, receding credit quaand rising interest rates (or the thrthereof) have delivered an opportuty to sell short junk bonds or the mtual funds and exchange-traded funthat house them.


9/2


market is diligently closing the gIts getting junkier, says MichE. Lewitt, CIO of Eccles Street Aset Management LLC and editorThe Credit Strategist. The ratings slipping more. In terms of covenlite, [loans or bonds issued withminimum of restrictions intendedenforce financial discipline on borrower] a couple of years ago whcovenant lite really started picking it really was just the strongest borroers that the market would grant tkind of package to. Thats no lonthe case. Anybody can get a covenlite package. The market is much ldiscriminating. The complacency set in. Covenants are weakeningthe loan market.

In the bond market, Lewitt ctinues, covenant packages are weer and there has been some erosioncall protection. Historically, there been five-year, non-call protectionbonds; were seeing episodes of th

years. In general, most deals tare coming to the market are not newly minted LBOs. The bad neis they are often to pay dividendsequity sponsors to re-lever companand that is never a good thing.

At current ground-scraping intest rates, high yield is an oxymron. Many regret this state of affathough not the bears. A 15% coupmakes for a prohibitively expensshort sale (remember, the bearspeculator must pay the securitlender the interest he or she wo

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 out

the 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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BofA 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, not

since 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 of

proceeds (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 borrowis bursting forth.

The 93/4notes pushed leverage the borrowing entity to 5.9 times tfavored, if not officially sanctionmeasure of cash flow called pro fma, adjusted EBITDA. That was

from 4.6 times before the new PIKsue came into the world. (EBITDyou know about: net income befnet interest expense, taxes, depciation and amortization; the adjuments applied to EBITDA incluthose related to other non-cash chaes, brand license royalties and emated costs we expect to incur opating as a stand-alone entity, insteof, as before, a collection of franchibusinesses.) This 5.9 times levercompares to 3.2 times net leverat double-B-rated United RentInc. (URI on the NYSE), BlueLinlarger and publicly traded competiand to just under four times debt-EBITDA for the entire high-yibond universe, according to a Ma28 report by Morgan Stanley.

No mystery whats in this transtion for the private-equity investoA more interesting question is whain it for the bondholders? Under pvious management, BlueLines coponent businesses suffered operatlosses in each of the prior three yeThen, too, according to the auditothe process of integrating the dozeof acquisitions has revealed marial weaknesses in the companysnancial controls and information tenology systems.

No doubt, Platinum Equity, wmore than 150 acquisitions underbelt and 30 companies in its portlio, means to fix the problems areturn BlueLine to profitabilAnd if it succeeds, the creditors, twould succeed, as success is modesreckoned in the fixed-income wor

They would get their money bawith interest.As the BlueLine 9 3/4s are calla

at 103 on Feb. 1, 2016, an investopotential gains are hardly limitleFrom todays price of 106.1, the curities would deliver a yield to cor worst, of 7.63%. To be sure, twould be a handsome gain for a fixincome security. It would be less thoverwhelming for an equity.

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

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In orbit

Intelsat senior unsecured notes, 7 s of October 2020


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who prefers to go unnamed tells col-league Evan Lorenz. This is the in-verse of a normal bondholders posi-tion. You have all the downside risk,whether it is the economy slowing,rates moving higher, whether peoplestart selling high yield because of the

fear of all of the above. Looking backat the BlueLine 9 3/4s, our source sug-gests, the buyers will rue the day whenthey heard the words, Sold to you.

From what we see, our infor-mant goes on, it is probably thebest time to be a long-short creditmanager rather than just a long-only,buying new issues and hoping thingsgo well. From the short sellers van-tage point, the BlueLine PIK togglenotes have much to commend them.There are two problems, the couponandperhapsthe economy. Oursource says that he does not intend topull the trigger until business activityshows signs of decelerating.

On now to evidentiary sighting No.2, which features our new best friend,Valeant Pharmaceuticals International(VRX on the Big Board). We wontrepeat either our bearish analysis orour declaration of an interest (see theissue of Grantsdated March 7). Suf-fice it to say that Valeant is an acqui-sition machine, that the businessesit acquires tend not to prosper underValeant management, that the Vale-ant front office is partial to non-GAAPmeasures of financial performance andthat the company has generated posi-tive GAAP net income in only three ofthe past eight quarters. Free cash flowin the fourth quarter amounted to $216million, which, as Lorenz notes, is ac-tually less than the $241 million thatValeant generated in the second quar-ter of 2012this despite a 152% jumpin sales from the second quarter of 12through the fourth quarter of 13.

A bear on Valeant might sell short

the companys equityor the op-portunity to which we now turn,the companys single-B-rated, 63/8%senior unsecured notes of October2020. Theres much to be said for thelatter approach.

Bulls and bears will go round andround on the nuances of purchase ac-counting as Valeant employs it, buttheres no debating the debt; it bal-looned to $16.9 billion at year-end2013 from $6.5 billion at year-end2011. Maybe Valeants managementcan pull off the merger of equals

its been talking about. It would bea convenient way to de-lever theValeant balance sheet. Or maybeValeants prospective merger part-ners will see the situation as we do.While pharmaceutical executiveshave been happy to sell businesses

and divisions to Valeant for cash,Lorenz points out, my admittedlysmall sample of pharma contactsleads me to suspect that Valeant willhave a hard time persuading a dis-cerning appraiser of value to acceptits stock. Then, too, creditors mightbegin to notice that Valeants GAAPoperating income in the fourth quar-ter failed to cover the companys$260.2 million in interest expense.

Whatever you may think of Vale-ant, the company, the Valeant 63/8sseem to offer only a modicum of up-side. The notes change hands at 108.4to yield 4.86%; that is the yield to ma-turity. The yield to the Oct. 15, 2016,call, a price of 103.19, works out to

just 3.92%. As far as we can see, thecreditor stands to be a loseror, atleast, not much of a winnerno mat-ter how Valeant may fare in the next21/2years. Who would commit capitalon these terms?

Why, the junk-bond funds would;they have to. The SPDR Barclays

High Yield Bond ETF (JNK on NYSE Arca) and the iShares iBo$ High Yield Corporate Bond ET(HYG on the same exchange) couthe Valeant note as their 17thand largest holding, respectively. Jufunds need paper, especially the

sues that weigh in at $2 billion-plas Valeants does. Over the past fweeks, observes Martin Fridson, CEof FridsonVision LLC (anda featuspeaker at the April 8 GrantsConfenceadvt.), net inflows into hiyield mutual funds enlarged the assof those funds by 1.2% (this figexcludes inflows into the high-yiETFs), whereas in February, the est period for which data are availabthe universe of non-investment-grabonds expanded by only 0.3%. Tbig picture, says Fridson, is tthere is not enough supply.

As every gold bull can atteETFs buy in bull markets and selbear markets. In the case of goldmitigating feature of the 37% prdecline between Sept. 5, 2011, aDec. 19, 2013, was the persistpurchase of physical bullion by Cnese and Indians. Its not so clwho would take the other side o

junk-bond liquidation.Big, liquid issuesthe ones t

Call today for group and bulk rates to GRANTS.

212-809-7994

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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-

ceivedas 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 Timesmade 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 Grantsdated 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 mlion and take from design to launthree years). You may also rememthat the satellite business requigrowing revenue to leverage the hcost of operation. It doesnt help mters that various governments

building a dozen new satellites acontemplating the launch of sevedozen more.

Fourth-quarter results, releason Feb. 20, featured operating come for 2013 in the sum of $1.2 blion, good enough to cover full-yinterest expense by 1.08 times. Fthe year, revenue was $2.6 billia slight decrease from 2012. On tconference call, CEO and Chaman David McGlade said that, oing to reduced spending by the Ugovernment and excess capacityAfrica, 2014 revenue is expectedtotal between $2.45 and $2.5 blion, a 4.9% year-over-year declat the midpoint from 2013 resuNot to worry, the chief counsedialers-in: We remind our investof our commitment to a two-phinvestment model. The first seveyears of this plan is not dependeupon revenue growth but insteon the use of increasing cash floto reduce our debt. We are sharpfocused on de-levering to create uity value.

As of Dec. 31, there was $15.3 blion in total debt outstanding. the call, the company announcplans to repay $400 million of tbalance this year. Investors mbet that McGlade can do more wless revenuein 2013, free cflow amounted to $116.1 million athere is only $247.8 million of con the balance sheet.

To judge by the yields on Inteldebt, bond investors have every cofidence in McGladeand in Ja

Yellen, Jack Lew, Barack Obama aVladimir Putin, besides. Thus, single-B-plus-rated 71/4s of 2020 ($billion in par outstanding) chanhands at 108.75, a yield to maturity5.63%. Inasmuch as the 7 1/4s are cable at 103.625 on October 2015, yield that an optimistic holder mreceive is likely to be closer to yield to call, or worst. That wobe just 3.64%.

The best of timesthe worsttimes.


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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 cheap

natural 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, the

increasing 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 fr216 million tons.

Within the coal industry, Lorpoints out, there are lots of loserand one or two winners. Conspicuamong the former are the companthat leveraged to expand at the top

the 2007-08 energy cycle. Arch CPeabody Energy Corp. and ConEnergy are among these encumbeunfortunates. James River Coal Cwhich had a market cap of $704 mlion at year-end 2010, is quoted day at $54 million. Patriot Coal Cowhich had a market cap of $1.8 bilat year-end 2010, filed for bankrupprotection in July 2012.

A very different proposition is Hlador, a lightly leveraged, low-cpure play on the Illinois Basin. Whowned Sunrise Coal is Halladors pcipal business unit; its responsibleall but $4.2 million of the compan$25.2 million in trailing 12-month erating income. Savoy Energy LPprivate oil and gas exploration copany in Michigan, and Sunrise EneLLC, a private oil and gas exploratcompany in IndianaHallador ow45% of the first and 50% of the sondround out the corporate staAs of Sept. 30, the parents balasheet showed $11.4 million of dagainst $13.7 million of cash.

Hallador, via Sunrise, extracts cat a cost of less than $30 a ton, lowest cost of any public miner (oclosely held Foresight Energy LLcontrolled by the farsighted CCline, posts a lower cost per toThe great bulk of the companys ccomes from the Carlisle mine, situed near the Indiana town of the saname. The Carlisle is a high-sulunderground deposit from whcontinuous mining machinery surface as many as six tons of coal minute. Carlisle has a capacity of

million tons a year and identified serves of 43.5 million tons.While Halladors Ace-in-the-H

mine, 42 miles northeast of Carlia low-sulfur surface project, chips ihalf-million tons in annual produccapacity and 3.1 million tons of reservand while management is developa pair of much larger deposits on Indiana-Illinois border (the so-caBulldog and Russellville Mines), fact is that, for now, Hallador is a omine company, with all the risks tconcentration entails. For instance

11/26/131/4/131/6/121/7/111/1/101/2/091/4/08

Mining the good coal

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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 thoueither had issues or we thought whighly overvalued, Yorktown pner, Peter Leidel, says. We wantdistribute stocks we think people chold and do well with. We think stock ought to be higher than it is,

coal is out of favor.Perhaps this overhead sup

weighs on the share price. Certainthe coal bear market does the stoprice no good. In any case, the shatrade at 10.2 times trailing net incoand yield 2.1%; theyre quoted amultiple of enterprise value to EBIDA of five times.

Whether you consider Hallacheap at the price will depend, part, on your view of natural gas. this score, its notable that gas priweighed in at an average of $2.73 million Btus in 2012 but have avaged $3.58 per million Btus so far2013 and are tipped to rally to $3in 2014 (so, at least, tips the gas tures market). Its not inconceable that coal, in relation to gas, ischeap as its going to get for a whWhen the ratio of natural gas prito coal prices is approximately 1.5lower [per million Btu], a typical gfired combined-cycle plant has lowgenerating costs than a typical cofired plant, the EIA noted in Annual Energy Outlook 2013. Coaccording to the agency, is expectto command $2.20 and $2.29 per mlion Btu in 2013 and 2014, makthe black mineral cheaper to buthan natural gas.

Hallador gets credit for whatis, Lorenz observesthat is,low-cost producer in a geologicafertile region. But it gets little,any, credit for its two oil and gas velopment businesses, or for wits coal-mining operations might come. What management hopes

become is much biggerand cobe. To bring either Bulldog or Rsellville into production would tanine months and the previoucited $150 million. Either one those projects doubles our comny, Bilsland tells me. We are ting to get into a position where fyears from now, we can bring thor four more new projects and trithe size of our company. Thats ogoal. The financing would appearbe available: Hallador has in placrevolving credit facility of $165 m

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 its

credit 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 shinysteel 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 21stcentury London and 17thcentury 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 17th 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 GrantsConference,we might have glibly proposed a con-ceptual pair trade: shorting Oscar while

going long Esteban. Asness, a Ph.Dfinance from the University of Chicaadvised the Grantsaudience not to dparage momentum investing. Scholstudies, including his own, show tone can profit by being long what been going up and being short what

been going down. Its not that value vesting doesnt work, Asness said, othat momentum deserves a place in professional canon, too.

Well and good. Oscarlet us saytrading above his personal 200-day ming average. He is going up and has begoing up. Perhaps his bull market is obeginning. Maybe one of his canvaswill make a new record at the May ations. Possibly, one of Estebans detional paintings will make a new low.

This publication is in receipt of a lection of pointers for any who wocompete in the red-hot, momentum partment of the contemporary art mket. The fundamental concept, adviour well-connected informant, is to hethe buzz. Buy with your ears, she vises, as opposed to your eyes. Hwhat the insiders are sayingcuratdealers, artists and collectors.

Here, according to Carol Vogel, wing in The New York Timeslast monthwhat one noted collector has said. MRubell and her husband had arrived9 A.M. at the Independent Art FairNew York to meet Murillo. This win March 2012. [H]e looked disheled, exhausted, like a homeless pson, Rubell is quoted as saying. Hstayed up for 36 hours straight amade seven or eight paintings, so had something to show us. They blus away. We ended up spending fhours talking to him. . . the last timsaw that kind of energy was Keith Hing or Jean-Michel. It was so intensdont 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 fetched24,600 in a privatesale, the highest price that any picturewould command until the mid-1880s. Intodays gold value, the painting brought3.9 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 work

entered 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 that

are 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 19thcentury. 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 GrantsStory Stock Index

(November 15, 2013) No bull stockmarket 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 new crop of story stocks. We write the not-so-far-receptive members the Federal Open Market Committas well as for the sainted paid-up suscribers. Nothing flatters distantly p

jected earnings more than an ultra-

discount rate, as Evan Lorenz, our oin-house Chartered Financial Analypoints out. Here, then, is a story of terest rates as much as of stocks.

One hundred dollars of earningsyears in the future are worth $38.55 day if discounted at 10%, CFA Lorereminds us. At a 5% discount rathey are worth $61.39. But at a zepercent rate, they are worth $100awould be worth that much from hereeternity. So while each of the 15 coponent companies in the GrantsStStock Index has its own story to tell, unifying theme is ZIRP.

Not just any shooter, to reclaimterm from the great garbage markof the 1960s, qualified for the Graindex. Lorenz screened for stocks tare expensive on multiples of eaings, EBITDA (i.e., earnings befinterest, taxes, depreciation and amtization), or that show no earnings trade at high multiples of revenuWhen possible, our candidates exhother characteristics of a good shosale specimen, including insider sing and an adequate supply of shato borrow (the exceptions on this latscore are Zillow and ChannelAdvisAll but one of the names is a memof the Russell 2000, the exception ing Sprouts Farmers Market, which deal with elsewhere in this issue. Lehave a look at what the bull dragged

Tile Shop Holdings (TTS on Nasdaq), our first exhibit, ticks most critical story-stock box: Its vued not on what has happened bwhat may come to pass in the reaches of the future. Founded

1985 by the incumbent CEO, Rert A. Rucker, Tile Shop went plic only in 2012. The company opates 83 stores that average more th22,000 square feet. It operates them28 states, mainly in the Midwest aMid-Atlantic regions, in which it setiles, both stone and ceramic, as was setting and maintenance producIt buys straight from manufacture58% of its tile comes from Asia.

Chinese quality control not beall that it might be, the heavy reliaon Asia raises concerns about prod


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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 whittle

Tile 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, our

new 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 Nasdaq) is the top maker of gluten-ffoods in North America and a leadmaker of buttery-like spreads withtrans fat. Udis and Glutino and EaBalance and Smart Balance are amoits brands. Its customers may be veg

or gluten-intolerant, or trans-fat averor just fashionable. Whoever they amanagement is betting therell be mof them, and the stock market seeto agree. The shares are valued attimes forecast 2013 earnings.

The bull case for Boulder is that gluten-free diet is going mainstreamLorenz relates. A certain numberAmericans suffer from celiac diseaa disorder in which eating glutenfound in wheat, barley and ryetrgers an immune reaction. The Natial Foundation for Celiac Awarenputs the figure at three million, andreckons that another 18 million maygluten-sensitive. Boulder Brands emates the combined ranks of celiand the gluten-sensitive at 43 milliIt does Boulder no harm that the N2-ranked male tennis player, NovDjokovic, ascribes his professiosurge to a gluten-free diet.

I have a number of relatives who gluten-sensitive, Lorenz continuWhile gluten-free is rapidly expaing from a low base, there are mareasons to doubt it will catch on wthe mainstream like the Atkins dietthe 2000s, the low-fat diet in the 199or even bran muffins in the 1980s. Rson No. 1, gluten-free bread lacks

90

102

114

126

138

150

9

10

11

12

13

15

11/12/110/139/138/137/13

Its the narrative

Story Stock Index; indexed to 100 on July 31, 2013


index

level 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-healthy

spread 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 portfoliomiscellaneous businesses distributand/or manufacturing veterinary apharmaceutical products in MexSpain and Israel.

Bulls are rooting hard for the scess of an Opko test for prostate c

cer; a clinical trial of the device, cal4Kscore, is slated for the first quarof next year. A lingering cloud over test is a critical editorial that appeain the May 2010 edition of ClinOncology. In this report, said editors of an article detailing the pformance of the Opko product, 2of all cancers and 14% of high-gracancers would be missed . . . it seethat a change in screening practices tmisses any high-grade cancer canbe considered an improvement ostandard screening. In other wordswould seem, here is a cancer test tmisses cancer.

What remedial action, if any, Ophas subsequently taken to address concerns of its critics, we dont knoSome, the bulls must expect. An timate by Jefferies & Co. ascribesout of the $10 share price to the vaof the 4Kscore test. On a hopeful nothe company launched the productthe U.K.; it did so in October 2012. a somewhat less hopeful note, no trof any 4Kscore-derived revenue isbe found in the companys subsequfinancial filings.

To be clear, we do not insist tOpko will not succeed in one or moreits myriad undertakings; a new growhormone is said to look promising. we are saying is that this particular tery ticket, valued at 42 times estimed 2013 revenues, says as much abthe stock market as it does about present value of any reasonably likfuture cash flows that Opko might oday actually generate.

Reviewing the flyaway stock mar

of 1968-69that great garbage mketthe author John Brooks, in history, The Go-Go Years, had tto say about stocks like the ones in new Grantsindex:

[W]hat a promoter needed to launa new stock, apart from a persuastongue and a resourceful accountawas to have a storyan easily graspconcept, preferably related to some crent national fad or preoccupation, tsoundedas if it would lead to profits.

Tiles may not yet be a national poccupation, and the top of this p

Story Stock Index(in $ millions)

EV/est. mkt. short int. price to est. 2013 2013

name ticker cap. float 2013 earn. sales EBITDA

Demandware DWRE $1,888 5.2% x 17.6x x

ChannelAdvisor 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 years



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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 stock

Documents

Grants Interest Rate Observer Summer 2014 Issue