Magyar Telekom

Magyar Telekom (MTEL) is the principal provider of telecom services in Hungary, Macedonia, and Montenegro. Company provides a broad range of services including traditional fixed line and mobile telephony, data transmission, and telecom consulting. It is 59% owned by Deutsche Telekom. MTEL generates consistently high Returns on Invested Capital (25-30%) and stable EBITDA margins (38-41%) which are both signs of great business with high barriers to entry. It is trading at low multiples (2.9x '08 EV/EBITDA, 6x '08 P/E), multiples that usually reflect a rapidly declining business.The best thing about those earnings is that they are pretty much guaranteed to be fully paid out every year to company’s shareholders. The dividend that is coming up in April represents a 13% yield on current price. Future dividends should be even higher since the company is now at a lower bound of its target of 30-40% net debt/equity ratio and its cash generation is well in excess of net profit. Just as an example if 2009 profitability for the company is 23% down, the dividend should still be 16% higher in order to remain on the lower bound of this 30% net debt/equity ratio. I estimate that current purchase price for the company can be paid back within six year from dividends alone.
At the same time a lot of Eastern European fixed line telecoms are trading at low EV/EBITDA ratios and high dividend yields. Besides Hungarian Telecom this includes Lithuanian telecom, Estonian Telecom, and others. The main reason why these companies are so cheap is the fact that their subscriber numbers, and subsequently revenues, have been going down dramatically. They are being treated by the market as dying businesses without possibility of increasing revenues.
In addition to general fixed line telecom issues, Hungarian Telecom’s market perception is further amplified by an especially poor macro situation in Hungary. Hungary is one of the two Eastern European countries that had to be bailed out by IMF and it currency is down 35% against the dollar. As will be explained further, this fear is overblown creating attractive investment opportunity.
Unlike many other Eastern European countries that grew in double digits in 2006-2007, Hungary’s growth has been held back by their effort to reign in excessive government spending and budget deficit. As a result they had to take their hard medicine early on in the process in an environment that is slightly more forgiving than current situation. The latest IMF bailout put in strict controls on the country and is allowing the politicians to take the steps necessary to fix countries problems and prepare it for the next upturn. 2008 results for Hungarian Telecom and other companies in the sector suggest that economic downturn has little effect on people’s spending on telecommunications. The decline in country’s currency has no effect on company’s business since both revenues and costs are priced in Hungarian Forint. It is true that their dollar revenues are smaller as a result but the recent 35% decline should account for most of the eventual drop in the exchange rate.
To address the declining business concern, I believe that fears of the impending demise are overblown for fixed line telecom segment in general and Hungarian telecom in particular. It is a fact that these companies have been losing revenues and customers for the last five years. What market does not realize is that fixed line penetration decline has slowed down dramatically and voice revenues are being substituted by data revenues, from DSL and other services, at an increasing pace. Fixed to mobile substitution process is nearly complete as mobile penetration in most Eastern European countries has exceeded 100%. These investments are especially attractive, since the profits in the incumbent fixed line telecoms are usually protected by unassailable barriers to entry created during the period of infrastructure development under monopolistic conditions.
In the case of Hungarian Telecom fixed line penetration in its core market fell from 37% in 2003 to 26.9% in 2008. At the same time the rate of decline is going down from 5.4% in 2007 to 1.9% in 2008. Hungarian mobile penetration now stands at 122% and most customers who wanted to switch to mobile only service have already done so. Hungarian Telecom is also working hard on retaining the remaining customers by signing them up to service packaged that include TV, Voice and Internet offerings. Currently 40% of the remaining fixed line customers purchase more than one service from M-TEL.
The effect of company’s efforts is starting to take hold. In the last two years number of fixed line customers fell by 23%. At the same time fixed line revenues fell only 11% and EBITDA stayed approximately flat since company is able to get more revenues from each customer. Data revenues (internet and IPTV offering) have grown 10% and it is evident from operating margins that these revenues are just as profitable as existing voice business. Hungarian fast internet penetration stands at about 2/3 of western European levels and still has plenty of room for growth. While voice revenues are likely to fall further, but growth in data revenues is likely to reverse fixed line sales decline within next few years.
The beauty of Hungarian Telecom is that fixed line is only a part of their business. They also own largest mobile operator in Hungary, Macedonia and Montenegro. This business is growing, generates more revenues than fixed line (351B HUF vs. 290B HUF in 2008), and has higher EBITDA margins. In addition to that Hungarian Telecom controls second biggest cable operator in Hungary and a rapidly growing IT systems integrator. This range of services and their market share gives Hungarian Telecom confidence that even if a customer decides to leave their fixed line offering, there is more than 50% chance they will end up using one of their other services anyway.

Competitive Dynamics: Hungarian Telekom is a fixed line incumbent in Hungary and as is often the case with such companies enjoys dominant market share in fixed line communication - 77%. It also owns T-mobile Hungary which is the largest of the 3 mobile operators in the country with 44.5% market share. Its strong position extends to internet services as well where more than 50% of the market is served by MTEL either directly or through ISPs which use MTEL's backbone. Company is so powerful that Hungarian authorities had to take steps to increase competition in mobile segment. They have set interconnect charges in a way that would penalize MTEL and benefit other two operators. This regime has been in place for the last few years and was finally eliminated in 2008.

Valuation: I have already mentioned the high dividend payment and the value associated with it. Taking into account the dividend payments and a slight expansion of multiples to 4.5x EV/EBITDA an investment in Hungarian Telekom should generate IRR of over 30% on current price. Current market penalizes all stocks with any perception of risk. Hungarian Telekom is suffering from Hungarian macro and fear of declining revenues. As have been explained above I believe neither one of these things are justified which creates a very attractive investment opportunity.

Hudson City BankCorp

Hudson City Bancorp is NJ based thrift with nearly $50B in assets and over $27B of net loans. It operates primarily in NY tri-state area and is thought to have very conservative underwriting standards due to non-participation in sub-prime lending and low LTV ratios.

In the past five years bank’s loan book quadrupled to over 27B USD. At the same time provision reserve grew only 47% and now stands at a 39M USD. This is 0.1% of loans outstanding compared to ~1.5% average for other US regional banks. The bank says that their reserves are sufficient given high quality of their loan book and negligible charge offs. 98% of company’s loan book is linked to 1-4 family homes. I will make an argument that the bank has been under provisioning for years and current drop in NY area real estate prices will force it to catch up with significant negative effect on earnings, book value, and share price.

Between 1999 and 2006 HCBK record on net charge offs has been absolutely stellar with write downs never exceeding .002%. This statistic coincides with a period in which NY real estate prices have grown anywhere between 5% and 15% annually. This is very important since 69% of HCBK’s overall loans are in NY metro area.
Before 1999 the picture is somewhat different. Net Charge offs were much higher peaking at 0.04% of overall loans in 1996. During that period NY real estate prices stagnated and grew between 0 and 3%.

The reason that period is relevant right now is the fact that now real estate prices in NY area are actually falling for the first time since early 90s. Since Beginning of ’07 prices fell 9% and decline is likely to continue since economic activity is slowing down, rental yields are below mortgage rates, and unemployment is once again creeping up. In ’07 HCBK charge offs went up 10x and stood at 0.003% of the portfolio. Taking into account that current situation is significantly worse than in 1996 and HCBK’s portfolio is lower quality due to a significant increase in purchased mortgages, I believe that charge offs can easily go up another 10x or more. 1992 level of charge offs, as shown in FDIC filings, suggests a 20x increase to 0.06% of loan portfolio.

At the end of ’07 Hudson City kept a provision reserve of only $34M on a loan portfolio of over $24B. In 2007 bank grew provisions by only 13% while their troubled assets (loans that are past due by more than 60 days) have went up staggering 122%. At the end of ’07 provision/troubled assets ratio stood at 357% - a level much greater than normal 100-120% company has been carrying through the housing boom. HCBK does not report troubled asset levels in their quarterly filings but I seriously doubt this ratio has improved significantly since the company is still keeping provisions at very low level and real estate prices have continued to decline. Last time provision/troubled assets ratio stood at above 300% was 1992. In 1993 HCBK had to double its provision reserve to equal to 0.5% of loans outstanding or 4x greater than current level of provisioning.

In my opinion the company will have little choice but to significantly increase their provisions when they report 2008 annual results. Normal level of provisions for US regional banks is around 1-2% and to bring HCBK provisioning level to 1% level they would have to report a loss equal to 4% of their equity value. While this does not sound like much, I believe it will have a very negative impact on company’s share price.
Despite carnage in broader financial services market, HCBK stock is actually up around 20% in the last year due to believe that company is immune to housing problems and endorsements from people like Jim Cramer. Company is trading at 1.7x book value which is a significant premium to its peers. Analysis of other regional bank stocks shows that whenever company had to significantly increase its provisions its book value multiple fell by approximately 0.8x BV over next 6 to 12 month.

Based on the facts outlined above I believe that HCBK will have to significantly increase its provisions will cause market price to decline by around 40-50%.

Why did it get so bad so quickly in credit markets?

In the last couple of weeks we have been witnessing neat cataclysmic events shaking debt markets. Let's first look at the facts:
- Major hedge funds are failing and are being forced to sell down their positions with huge losses to their investors
- Financial markets for all types of debt instruments - Mortgage backed securities, CDOs, Commercial paper, etc... are practically at a standstill
- The same debt markets are experiencing an unprecedented flight to quality with yields for treasuries moving a full percentage point in a day - practically unheard of before
- Anything that is not guaranteed by US government is considered toxic and uninvestable
At first glance looks pretty scary, doesn't it. While i cannot claim any special expertise in the fixed income area, one cannot help but think that things are not as bad as financial media would lead us to believe.

The whole thing started once many of the subprime mortgages started resetting and were causing a bunch of foreclosures which directly impacted investors in such exotic instruments as Collateralized Mortgage Obligations (CMOs). The default rates on these mortgages have taken out a lot of investors in the riskier tranches of these securities and at the same time threatened supposedly unflappable AAA rated tranches created from the same potentially toxic subprime loans. The people who were most hurt by this are hedge funds that used high to improve their returns from these securities. As an example a hedge fund that uses a 10x leverage can suffer only a 5% in their asset values but lose 50% of their investors equity. I believe this is exactly what happened to funds run by BNP Paribas, Dillon Read, and Bear Stearns. Pretty messed up for funds investors but the lenders of these funds are still not experiencing any real losses.

This got people thinking. Lenders that have in the last couple of years lost risk aversion due to extremely benign economic environment realized that maybe that loan of 8x EBITDA to a private equity buyout with no covenants at Libor+200bps actually could be riskier than it looks. If these sub-prime mortgages could go bad this quickly, maybe their corporate equivalents, LBO loans, could suffer the same fate. As a result that market dried up as well.

While so far the events described are quiet logical what happened next no longer is. Investors in all these other new exotic debt instruments created by slicing and dicing pools of different debt securities started thinking that they might be at risk too. Many of those investors are not allowed to hold anything that is not AAA rated. Those instruments were never tested in the economic downturn. Are they really AAA rated? So they tried to sell everything they can and move to the safest thing out there - Short term treasury notes. If one person would do this it would not be so bad. But financial markets became very adapt at spreading risk using these exotic instruments. Since everyone held them---everyone was trying to get rid of them. As a result all credit markets completely ceased up....

I strongly believe that this was a huge overreaction. Holders of this AAA rated papers would only face defaults if practically ALL LOANS that were made would go into default. It is extremely difficult to imagine such scenario even in sub-prime mortgage backed papers - not even talking about instruments backed by relatively high quality corporate debt or prime mortgages. It will take a little while for people to figure this out but once they do - debt markets will come back and start functioning again. The major difference though will be that for at least little while risk appetite would go down to more reasonable levels - and this is a good thing.

Who will win? Banks that will be able to get higher interest rate on their loans.
Who will lose? Hedge funds and private equity funds that have depended on cheap leverage for their performance.

But in a meanwhile we will likely have a pretty horrible third quarter results from a lot of companies especially ones that produce large industrial equipment. I seriously doubt that firms that suddenly started worrying about their ability to finance themselves wouldn't delay some of their large investment projects.

Freight Car America

Anyone who read Joel Greenblatt’s wonderful “Little Book that beats the market” and subsequently went on http://www.magicformulainvesting.com/ had to come across company with ticker RAIL. Freightcar America has over 100% ROIC (350% to be exact), trades at only 2.1x EV/EBIT and seems to be one of those old economy companies that many value investors dreams are made of. Unfortunately, similar to most dreams, if something is too good to be true it probably is.


FreightCar America is a manufacturer of open hopper railcars that are used in US primarily for transportation of coal. It has 80% market share in its segment due to products that are more energy efficient, cheaper and easier to handle than competitors. The company is well run, conscious of shareholder values (currently performing a 50M USD buyback) and in general one of those organizations that you want to be a part-owner of. It has a misfortune of operating in a highly cyclical industry with very uncertain cash flows. You can see from the graph on the left that overall railcar industry continuously goes through periods of peaks and valley.


It is obvious that last couple of years was exceptional for the industry and Freightcar America. It has produced 13,000 and 18,700 cars in 2005 and 2006 respectively and put out profitability numbers that make current valuation seem ridiculously low. The trick to figuring out intrinsic value is as usual normalized earnings and that’s where the company falters.
Through conversation with industry experts I have established that normalized level of replacement demand for current railroad stock is approximately 8 to 9 thousand railcars per year. This takes into account the total of 250,000 open hopper cars that are on the roads today and the fact that their average age is over 25 years old. On top of that we can add cars that will be necessary to satisfy future US energy needs which is anywhere between 3 to 5K depending on the metric you use. With total demand of approximately 13 thousand cars and RAIL’s market share of 80% I estimate the normalized demand for coal cars to be somewhere around 10,400 per year.

The other question is Freightcar America’s operating leverage. Based on results from last few years we can see that significant proportion of their costs are fixed and when production goes down significantly profitability can easily become negative. The company put a lot of effort into de-levering its cost structure and moved a large chunk of its production from inefficient Johnstown plant to newer Denville and Roanoke facilities. Through conversations with the company, guesstimates and a fair degree of black magic I think I came up with more or less reasonable calculation of company’s profitability at different levels of production. Calculation shows that at normalized level of demand of 10,400 the justified price per share is only $38 and company needs to produce around 11,000 cars per year to justify today’s share price.


This is why I believe that unfortunately the company does not represent an attractive investment at today’s prices. Since I like the management and its dominant market share I will continue to monitor the company and look for an attractive entry point. Any good research usually cannot happen without friends and I want to thank everyone who helped me gather this info.

Wonderfully Bloated exchanges - continued...

I am not afraid to admit that so far my predictions of demise of all exchange stocks have been to put it mildly...inaccurate. My personal investment in NYX LEAP put options is down 40% as underlying shares rose from $55 to $78. Euronext and other exchanges are also continuing their blissful rise to unreasonable heights.

One of the reasons NYX shares are rising is upcoming introduction of full electronic trading for most of NYSE listed stocks. The popular thought is that this will lead to explosion of volumes as all quant strategy funds would finally be able to exploit minor variations in price since trade processing would take less than a second vs. the usual nine for floor specialists.

While there might be some truth to this theory i believe the market is not taking into account the following things:
- Quant funds had plenty of opportunity to trade NYSE traded stocks on Nasdaq which suggests that rise in volumes will not be as dramatic as people think
- By introducing wider electronic trading NYSE puts itself in direct competition with Nasdaq and the many regional exchanges that are popping up with full electronic trading capability
- A trade in essence is a commodity product and with introduction of RegNMS next year it is difficult to imagine an environment in which NYSE will be able to increase their fees as market currently assumes
- Majority of the volume in the market is driven by hedge funds the number of which cannot continue to increase indefinitely

For reasons above combined with a certain degree of stubbornness i am still extremely pessimistic about the stock. I've recently increased my negative exposure to NYX hoping that all the potential upside from upcoming launch of electronic trading is already priced in 34x FORWARD P/E ratio and its failure to materialize will serve as a catalyst.

On a related note, two of the executives related to launch of electronic trading unexpectedly left NYSE (see article here). This could mean absolutely nothing, or signal some kind of implementation difficulties.

Is Carlos Ghosn right for GM?

A few years ago when Carlos Ghosn was leading Nissan turn around business newspapers were speculating what would happened if Mr. Ghosn would leave Nissan and join GM as its CEO. Some opinions suggested that this move could immediately add $10B to GM's market cap. Now this speculation is closer than ever to becoming reality. Based on Kirk Kerkorian's suggestion GM is starting merger talks with the two companies lead by Carlos Ghosn, Nissan and Renault.

It is difficult to question the success that Mr. Ghosn achieved at Nissan. In 2000 before he came in company lost 7B USD. Since he became the CEO in 2001 company's profitability steadily improved and reached impressive 2.1B USD in FY that ended in March 2006. He has done all the right things, renewed a tired product line, cut jobs where necessary, streamlined production and in the process became a cult figure with books and even comic books written about him.

Unfortunately, i believe Nissan's recovery is only skin deep. I am one of many Nissan car owners that are complaining about quality of the vehicles. Consider this a form of disclosure since i am obviously biased. Even people who have bought Nissan's luxury Infinity vehicles are complaining about poor design and electronic malfunctions. I think Mr. Ghosn focused on design, but sacrificed quality for profitability. Nissan is very profitable with operating margins in excess of 10%, however poor product quality will catch up with the company in the long term. We could be seeing first signs of crumbling with Nissan's June sales falling 19% at the time when both Honda and Toyota continued to show gains.

Mr. Ghosn now has two jobs as a CEO of Nissan and Renault. He may be an excellent turn around artist but i don't think he is a good long term operator. While it is early, he is still yet to show significant progress at Renault and could be spreading himself to thin. It is difficult enough to run one car company but running two, not even talking about three, could prove impossible for any man.

GM has a solid history of destroying shareholder's value. If someone would invest money into the company in the '50s they would actually lose money over this time while S&P increased more than 10 times. I believe the potential link up with Carlos Ghosn is another wrong step in the direction GM is too used to going.

Is the commodity boom over?

Gold is down $40 of its highs! Oil is below $70!! Copper is off around 5% in the last three days!!! Even sugar is down!!!! After meteoric rise over the last couple of years many commodities see their first significant downturn in a while. Just like many bubbles that came before that we saw prices reach meteoric heights in a very short time because of speculative buying. Is current situation a pause or a beginning of an end of the latest commodity cycle.

I am leaning towards the earlier. The fundamental need for natural resources of China, India and other growing economies have not changed in the last week. What we saw is hot money coming out of the market due to liqudity tightening around the world. At the same time Japanese steel producers agreed to another 19% increase in iron ore prices on top of a 70% increase last year. This means that commodities are still scarce and still needed. Industrial buyer's pattern is a much better indicator of the health of a market than momentary swings of spot prices driven by fast money looking for quick return.

This commodity cycle will end, but the reasons for it will be global economic downturn and overcapacity. I think this situation is a still couple of years away so investments in steel, oil, and mining companies are safe.....for now.

On a similar note
Russian stock market lost over 15% of its value this week. Anything that is up 200% in the last couple of years is bound to have its corrections. Some might compare this developing situation with what happened in Saudia Arabia and other middle east stock market earlier this year. Saudi market is off 50% by now from the beginning of the year but Russia will not face the same faith. The main reason for it was Saudi market P/E was close to 40 and Russia is still in mid teens. So the correction like this week is good and healthy and in no way it should stop anyone from looking at opportunities in emerging markets.