Is U.S. Bancorp going to earn itself out of trouble?

It is not surprising to see U.S. Bancorp, or in fact, any other bank facing losses due to defaults, foreclosures, late payments, and so on. During the first quarter of 2009, investors feared that the U.S. Government was going to nationalize the banks. Since this did not happen, many banks, including U.S. Bancorp, saw their stock prices appreciate significantly.

The problems that banks face are far from being over, but can U.S. Bancorp survive and earn itself out of trouble? Before answering this question, let’s talk about banking in general.

The Banking Industry

Banks are in the business of selling a commodity product called money. Like other businesses, banks buy their raw materials for one price and resell them for a higher price. Banks mainly get their money from depositors who open a checking or savings account. People might not think of it this way, but by depositing money in the bank, the general public is simply lending money to the banks. Banks might pay 1 percent to depositors and lend it to consumers or businesses for 6 percent.

Banks are highly leveraged institutions: for every $100 in assets, $90 is borrowed from depositors or other lenders and only $10 is in the form of equity. Being leveraged so much makes banks vulnerable to economic downturns. Because of very thin margins, one bad loan may wipe out the profits of several good loans. A poorly managed bank can destroy shareholders’ wealth quickly. This was perfectly demonstrated by Citigroup, Inc.

U.S. Bancorp

Investors might throw all the banks in the same category, and say that they are all the same. Would they say that all restaurants are the same? Probably not. Each bank is a different company following a distinctive business model.

U.S. Bancorp has a reputation of being one of the most conservative banks in the industry. The bank was not involved in loaning money to the risky borrowers that other banks loaned. Instead, it followed strict underwriting criteria that kept it from getting into problems that other banks now face. But even though it was more conservative, it saw an increase in delinquencies, foreclosures, and write-offs. As unemployment kept getting worse, even the best borrowers defaulted.

Another important point that makes U.S. Bancorp different from other banks is the diversified nature of its business. The company operates in four separate business segments: consumer banking, wholesale banking, payment services, and wealth management & securities services. Consumer and wholesale banking contributed 60 percent of revenue. Payment services, and wealth management & securities services, contributed 27 percent and 13 percent, respectively. This diversification is important to point out that the non-banking segments can be used to offset losses from banking operations.

Conclusion

U.S. Bancorp has a high probability of earning itself out of their problems, and therefore, forcing its stock price to trade much higher in three to five years (notice the time frame is not three to five months). As people lost a significant amount of money in the stock market in 2008, many sold their holdings and converted them into cash. Because of this flight to quality, most banks, especially strong ones like U.S Bancorp or Wells Fargo, saw significant increases in deposits. As mentioned before, money is a raw material to banks and deposits are the way to get it. As more people are hoarding cash, banks are able to get this raw material more cheaply. Later, they can lend it out at much higher rates. In addition, as other banks facing more severe problems are not able to lend, U.S. Bancorp can cherry-pick borrowers and still charge enough to make good returns.

Some investors might argue losses are still going up and U.S. Bancorp is not even close to being on its way up. While this is true, the losses are mainly from loans made in the past. Nonperforming loans will finally get written off, meaning they will be taken off the balance sheet, and the collateral will be taken and sold off by the bank. It is just a matter of time before losses start trending down because the new loans are underwritten with even more care than ever before. Despite all the losses, the bank is still profitable. It just generates less profit than before.
The reason why the stock is trading at around $19 is because the majority of investors are not able to sleep at night knowing that the price could decline. Most mutual funds or hedge funds are afraid to acquire the stock because it is unlikely to show short-term gains which could lead to losing clients.
The stock is cheap because there is short-term uncertainty. Once the uncertainty is gone, the $19 price tag will be history.

Disclosure: I, or persons whose accounts I manage, own shares of U.S. Bancorp at the time of this posting.

Arctic Cat: Is this a SCREAMING DEAL or not?

Arctic Cat manufactures snowmobiles and all-terrain vehicles (ATVs) and sells related parts, garments and accessories. The company was formed in 1983 as a snowmobile manufacturer.

In 1995, the company entered the fast-growing market of ATVs. Because it had already established its brand among snowmobile customers, it was logical to cross-sell them and offer ATVs. In 1996, only 3 percent of revenue came from ATV sales. By 2007, 55 percent of revenues came from ATVs and only 32 percent came from snowmobiles. From the time that Arctic Cat entered the ATV market, its sales grew faster than the industry's. Based on several conversations with dealers of Arctic Cat, some of the reasons for Arctic Cat's success in the ATV business are:

• brand loyalty from the snowmobile clients
• superior suspension system
• high durability
• faster response time for customer demand as a result of the company's smaller size
• innovation where competitors, such as Honda, are too complacent

Arctic Cat has a better brand name in the snowmobile market and faces fewer competitors (Polaris, Yamaha, and Bombardier) than in the ATV market (Polaris, Honda, Yamaha, Kawasaki, Suzuki, and Bombardier).

Its stock is extremely attractive because of the trading price. As of the date of this posting, the market capitalization (total # shares x price per share) for the entire company was approximately $70 million. Its inventory cost the company more than the price tag of the entire company. But some might argue that the inventory value is declining because fewer customers are buying snowmobiles and ATVs in this economy. While this is true, it does not mean that the stock is not a good deal.

Let's say we want to get into the business of manufacturing snowmobiles and ATVs because we believe that eventually the economy will be better than it is today. What things do we need to start? Besides technical knowledge, we would need a factory, equipment, tools, raw materials (inventory), etc. These are all the things that are listed on Arctic Cat's balance sheet. Let's say we spend a total of $100 million, of which $50 million is spent on inventory and the other $50 million on equipment, tools, and a factory. Would it make any sense for us to say, "Well, we are losing money this year so we will sell it all for $25 million, which is half of what we spent on inventory?" Clearly, it would not make any sense, but this is what Arctic Cat is selling for.

But even if we could produce these snowmobiles and ATVs, how are we going to sell them? Most of these products are sold by dealers and trying to convince them to carry our product would not be easy. Without an established brand name, building a network of dealers is extremely hard and it would take a significant amount of time and money. The Arctic Cat brand has been around for 45 years, and the company established itself as a leader in snowmobiles and a significant player in the ATV business.

The company already has a strong dealer network. It is not hard to see that its brand name and dealer network are assets to a company such as Arctic Cat. Since they are assets, they must be included on the balance sheet, right? Actually, they are not, even though they probably are worth more than any single item listed on the balance sheet. A balance sheet mainly includes historical costs such as inventory, equipment, and properties. Arctic Cat did not purchase its brand or its dealer network but built both by promoting and advertising over many years. Promotion and advertising are expensed as incurred, and they flow through the income statement and do not create an asset. The only way for Arctic Cat's brand and dealer network to appear on the balance sheet would be when an outside company such as Polaris or Kawasaki purchases the company outright. Then, all the tangible assets such as inventory, equipment, and property would be recorded on the acquirer's balance sheet and the difference between the purcahse price and tangible assets would be recorded as goodwill.

Even if the brand and dealer network were worthless, buying the stock of Arctic Cat is still below net working capital (current assets - current liabilities). Anybody buying Arctic Cat outright could liquidate the company by selling inventory, equipment, and properties and still end up with more money than the $75.5 million dollar price tag.

So, why is the stock so cheap? As a start, Arctic Cat is bleeding cash. Because the economy is weak, people tend to postpone purchases of discretionary items such as snowmobiles and ATVs. Also according to the article "Thin Ice at Arctic Cat" by Dee DePass (http://www.startribune.com/business/11903626.html), some institutional holders bailed out, selling 12 million shares on the market. Keep in mind that there are only about 18 million shares outstanding and Arctic Cat's stock does not trade on huge volume. Imagine what can happen to the price of a stock when 66 percent of shares are being sold. Driving the price to the current levels is beyond logic. Professional money managers are people and just like individual investors, when the fear of losing money is present, logic goes out the window. The good news is that when the stock is purchased before some of the institutional investors return as the economy improves, the stock price has a chance to take off like a rocket.

But since the company is losing money, it can go bankrupt, right? What is the requirement for a company to go bankrupt? It first must have debt, and Arctic Cat has no debt. Arctic Cat learned its lesson in 1981 when it went bankrupt after lenders called all the loans due. The original founder and some key managers went to the auction and bought up the company in pieces and started Arctco, which later became Arctic Cat.

Even though Arctic Cat has no debt, it is still losing money because of large fixed expenses associated with the manufacturing business. To preserve cash, the company already suspended share buybacks and divideds. From my estimation, the company will lose anywhere from $30 to $50 million in 2010, and it does not have enough cash on hand to weather this situation. But just because the company is losing money does not mean that the stock price will drop more or is not a good buy. As of this posting, the market knows the company will continue to lose money, so this information is already priced into the stock.

The bottom line is this - Arctic Cat will have to get the cash to cover the shortfall. Some market participants are worried that Arctic Cat will not be able to raise any cash because no one will want to lend them money. I have a different view. If the company cannot secure any conventional financing, it still has many options. First, it can get an asset-based loan against accounts receivable and inventory. Second, the company owns some real estate: manufacturing/corporate office (558,000 square feet), distribution center (220,000 square feet), test & development facility (3,000 square feet), and manufacturing facility (60,800 square feet). Many investors overlook real estate. Having experience in commercial real estate, I know that Arctic Cat could easily sell these facilities to raise cash and lease them back from the buyer. This is called a sale-leaseback transaction. Third, even if all of the above fail, the company may sell itself to the bigger players such as Polaris, Kawasaki, Suzuki, etc. All of these players would love to acquire the brand name of Arctic Cat.

Last time I invested in a similar situation where financing was in question, I more than quadrupled my money. The company was called Teck Resources (TCK), and I bought it for $3.32 and sold it for $14.35.

Arctic Cat is a great company with a recognizable brand name. Currently it is going through tough times due to the economic recession. Patient investors might find the stock to be attractively priced. But before investing in the company do you own research and consult your financial advisor.

Disclosure: I, or persons whose accounts I manage, own shares of Arctic Cat at the time of this posting.

Stocks versus Businesses

Even though there is so much information available about intelligent investing, the general public has limited understanding of investment basics. When people think of the stock market they see ticker symbols moving across computer screens. The media and investment professionals often make the subject of investing overly complicated. Perhaps they want to create something out of investing that it is not. Or maybe it is easier for money managers to get clients when they confuse them and make them believe that investing is only for rocket scientists.

Investors should be aware of the difference between stocks and businesses. Stocks are certificates of ownership in particular businesses. Stocks cannot exist without the underlying businesses. Businesses, on the other hand, are enterprises whose purposes are to manufacture products or provide services for compensation.

How Do Businesses Come Into Existence?

To keep things simple, let's take a look at an easy-to-understand business. Tom, an entrepreneur, want to use his grandmother's lemonade recipe to open a lemonade stand close to a university stadium. He estimates that many people who come to watch sporting events will spend money to buy his lemonade. If he sells enough lemonade, he will earn a good return on his investment.

To has $1,000. To launch his business he will need the following:

1) $100 for ingredients - inventory
2) $300 for tools - equipment
3) Place of production is at home. So ignore cost related to this item for simplicity.
4) $400 for a cart - equipment
5) $100 for cups - inventory

After spending $900 for equipment and inventory, he is left with $100 in cash. Tom's business will have the following balance sheet.
















*Note that Assets must equal Liabilities + Owner's Equity. Because Tom used his own money, he does not have any liabilities.

If Tom had left his money in the bank, he would have earned 2% per year on his money ($1,000 x 2% = $20). Today banks don't even pay 2%, but let's just assume they do. If Tom cannot generate $20 per year of net income after expenses from his business, he would be better off having left his money in the bank.

Tom believes he can make $100 per year operating his business. Since his equity shown in the above balance sheet is $1,000, he will earn 10% on his investment. This is equivalent to a Return on Equity (ROE) of 10%.

Return on Equity = Net Income/Equity

This is much better than 2% at the bank. In order to see if Tom can achieve that, we need to find out what his revenues and expenses are while he operates his business.

During the full year of operations, he sold $800 worth of lemonade and it cost him $700 to operate his business. Tom's estimation was correct because he earned a net income of $100. His income statement is shown below.

















*Note that wages are included. If Tom hires somebody to make and sell lemonade, he will have to pay wages. If Tom decides to make and sell lemonade himself, he will pay himself wages. Because he is also the owner of the company, he will collect the net income in addition to wages.

Tom's Lemonade Enterprises only has one owner. The business produced a net income of $100 for the first year in operation. Tom's business has value and Tom could technically sell his entire business or part of it to one individual, many individuals, or the general public through an Initial Public Offering (IPO).

If Tom does sell his business to the public, investors can buy shares of stocks in his business and have a small percentage of ownership in his enterprise. If the IPO is offered to a total of 100 investors, the $100 of net income would belong to those investors. Each share would be assigned $1 ($100 net income/100 investors). Over the long-term the value of the shares is directly correlated with earnings assigned to each share, just like a private business that is worth more when it generates more money. In the short-term price and value might not correlate, but in the end the company's earnings must be high enough to support the price.

The most important concept to learn is that stocks are a way to be part of businesses. If an investor is part of a great business that does well over time, the stock price will appreciate on its own to reflect the value of the underlying business.