Did Gas Use Really Drop to Five-Year Lows?

This story is a few weeks old, but I came across a Wall Street Journal article dated July10th with the headline "Gas Prices Spur Drivers to Cut Use to Five-Year Low." I had mixed emotions when I read that. On one hand, lower gas use will ease the upward pressure on prices. On the other hand, as we have seen time after time, when prices go back down consumers ramp up use again, so the problem never gets fixed. Hence, many claim the solution for high gas prices is... even higher gas prices.

After reading that headline I wrongly assumed that U.S. gasoline use had actually fallen to levels not seen since 2003. After all, the article pointed out "gasoline consumption dropped 3.3% from last year to 9.347 million barrels a day."

The very next sentence, however, gave us the real picture. It reads "For the first week of July, that is the least drivers have used since 2003, when consumption was 9.05 million barrels a day."

Wait... what? Gasoline demand reached a five year low, but isn't 9.347 barrels per day a lot more than 9.05 million? In reality, gas demand has risen 3.3% since 2003. What the author was trying to say was that the year-over-year change in demand was the lowest in five years.

I only point this out because many people have quoted this data and would have you believe that Americans are really cutting back on gasoline use. In reality though, even though prices at the pump have more than doubled over the last five years, we are still using 3% more gas today than we did then. Demand destruction is happening this year, just not in any meaningful way if you look at the bigger picture.

Home Supply Nationwide Still Sky High, but CA Market Improving

Updating our running chart, existing home supplies were above 11 months worth of inventory in June, so no progress is being made generally speaking:

That said, some markets are showing signs of improvement. Fortunately, California is among them.

According to Bloomberg:

California led the U.S. in default notices and bank seizures for the 18th straight month in June and had seven of the 10 metro areas with the highest foreclosure rates, according to Irvine, California-based RealtyTrac Inc., which sells default data. That drove down prices and led to "discounted distressed sales,'' with two-thirds of transactions under $500,000, compared with 40 percent a year earlier, the California Association of Realtors said. The amount of time it would take to deplete the supply of homes decreased to 7.7 months from 10.2 months a year earlier, and the median price fell 38 percent to$368,250 last month, according to the Realtors.

If this trend continues, banks with large California exposure might just start to see metrics stabilize, which would be a relief for the market. If you are in the market for a home out in CA but have been wary, it might pay to start browsing for a bargain.

Merrill Lynch CDO Sale Proves Investment Bank Balance Sheets Can't Be Trusted

Trying to value the investment banks based on book value is not an idea I would suggest if investors want to have any confidence in their valuation work. Today we learned that Merrill Lynch (MER) is selling $30.6 billion in nominal value CDOs for $6.7 billion, or 22 cents on the dollar, but that price is not all that surprising. What is surprising is what level Merrill valued those CDOs on their balance sheet when they reported second quarter earnings 12 days ago on July 17th.

That number was $11.1 billion. In less than two weeks, the CDOs lost 40% of their value? Highly unlikely. Of course, some will say the $11.1 billion value was supposed to be as of June 30th, so it was really four weeks of time that had passed. At the very least, we know that Merrill had no idea what the CDOs were worth, on June 30th, July 17th, or perhaps even today (we won't know that for a long time).

There are some who think these ABS are being marked down too low and will eventually be written up. This could certainly happen in several years time as the underlying mortgages are repaid, but today's news from Merrill certainly should not give anyone confidence in that thesis. Beware of using book values when trying to value portfolios of ABS. The company might come out and sell the things for 40% less than they thought they were worth less than two weeks before.

Full Disclosure: No position in MER at the time of writing

A Lehman Sale of Neuberger Berman Should Be A Last Resort

Five years ago Lehman Brothers (LEH) was trying to shake the image of being mainly a bond house and acquired asset manager Neuberger Berman for $2.6 billion. The deal was a great idea, not only because it increased Lehman's equity exposure and was a very stable, predictable business, but also because NB is truly one of the best asset managers around.

Given Lehman's recent troubles, the company is considering a sale of the unit and some are speculating that selling the entire division could fetch as much as $8 billion. Tripling their money would clearly be a coup, but in reality Lehman should hold onto NB if at all possible. The acquisition was a brilliant move and the current state of the investment banking world makes it clear that having a Neuberger Berman is a solid foundation in an otherwise shaky world for pure investment banks.

Now more than ever, diversification is going to be crucial for the industry, but being forced to sell NB would be a step in the exact opposite direction.

Full Disclosure: No position in Lehman at the time of writing. Peridot was invested in Neuberger Berman when Lehman announced the acquisition in 2003.

Did Wall Street Forget About Chesapeake Energy's Haynesville Shale Monetization?

Back on March 26th I pointed out that earnings estimates for Chesapeake Energy (CHK) appeared to be too low. At the time the company had just released a bold exploration and production plan for its leaseholds in the Haynesville Shale, but Wall Street was only expecting the company to earn $3.50 in both 2008 and 2009, which seemed way too conservative.

Since then estimates have increased to over $4 per share, which is closer to reality, and CHK stock soared from $47 in late March to north of $70 on July 2nd. Such a large move in the stock was prompted by two events; a sharp move in natural gas prices to above $13, but more importantly, Chesapeake's announcement on July 1st that it had successfully monetized its Haynesville Shale acreage.

Under a joint venture with Plains Exploration (PXP), Chesapeake will sell a 20% stake in its Haynesville Shale acreage (440,000 acres) for $1.65 billion in cash. Not only that, but PXP has also agreed to pay 50% of the development costs for the remaining 80% of the play (which CHK owns), up to an additional $1.65 billion. As a result, Chesapeake is swapping a 20% economic interest in the Haynesville shale for $3.3 billion, with half of the cash paid upfront, and the other half over the course of several years as the land is developed.

Considering that the Haynesville Shale was not even on investors' radar screens earlier this year, this deal is pretty astonishing. The Haynesville represents only 3% of CHK's net acreage, 0.3% of the company's proved reserves, and 21% of the company's risked reserves (proved reserves plus risked, unproved reserves), but the Plains joint venture values Chesapeake's Haynesville acreage at $16.5 billion.

That is especially impressive because even at the all-time high of $74 per share, Chesapeake's equity market value was only about $40 billion. Not surprisingly, those highs were achieved the day after the PXP joint venture was announced.

Over the last few weeks, however, natural gas prices have fallen from $13 to $10 per mcf. As I have written about many times before, CHK shares track gas prices in the short term despite the fact that the company hedges most of its production, thereby insulating it from the volatility of the near term spot market. As a result, CHK shares have fallen from the July 2nd intraday high of $74 to a closing price of $47 on Wednesday.

Is such a move down warranted, especially given the recent Haynesville announcement? Well, Chesapeake has hedged 81% of their remaining 2008 production and 54% of their 2009 production. I would have to say July 2008 prices really have little impact on CHK's financial performance. Still, traders will use the stock as one of their main natural gas trading vehicles, so investors need to live with this price action.

For those who are bullish on natural gas and are fans of Chesapeake, but missed getting in on the stock as an investment, short term market fluctuations have once again provided you a chance to purchase shares for 36% less than their level three weeks ago. CHK's market value is now only $25 billion, versus an implied valuation of more than $16 billion just for the company's Haynesville Shale acreage. Given that single play represents only a fraction of Chesapeake's natural gas assets, this recent collapse in stock price appears to be another case of stock market short term irrationality.

Full Disclosure: Long shares of CHK at the time of writing

Citigroup Q2 Earnings Release Reaffirms My Prior Projections

It's that time again. Our quarterly look at Citigroup (C) and how my breakup analysis is holding up. Citi reported a second quarter loss of $2.5 billion last week, halving its $5 billion first quarter figure. Due to continued writedowns and credit loss reserve building, it remains difficult to project what kind of profits Citi could have in a more normal environment.

That said, one way to look at it is to calculate Citi's net income by segment before accounting for asset writedowns and credit provisions. Here are some figures for Citi's 4 main businesses:

Citigroup - 2nd Quarter by Segment

Net Income/Reserve Build/Income ex reserve build

Global Credit Cards: $467M/$582M/$1049M

Consumer Banking: $(700m)/$1657M/$957M

Institutional Banking: ($2044M)/$367M/($1677M)

Wealth Management: $405M/$41M/$446M

The Institutional segment remains hard to project due to $7.2 billion of pre-tax writedowns for the quarter. The other segments, however, are tracking very close to my previous estimated ranges at ~$8 billion per year for banking and ~$2 billion per year for global wealth management. Institutional probably winds up in the $2-$4 billion annual range ultimately, which would peg Citi's annual earnings at between $12 and $14 billion.

Assign a 10 to 12 multiple on that and you get fair value of between $120 billion and $168 billion, or $21 to $29 per share, versus today's price of around $20 per share. In order for Citi to get back to the good ol' days of earning $20 billion+ annually, it appears the economy would have to improve markedly, but that environment is likely several years away at least.

Full Disclosure: No position in Citigroup at the time of writing 

Don't Think All Bank Earnings Will Be The Same

Have you noticed that bank earnings reports so far have been pretty good? Wells Fargo (WFC) reported a good quarter and raised their dividend 10% yesterday, which sparked the market rally, despite the company's large exposure to the California housing market. Today we got earnings above expectations from JP Morgan Chase (JPM) and PNC Financial (PNC). Does that mean that all the banks are out of the woods? Not really.

Unfortunately, the first banks to report were the better managed banks in the country (you can add U.S. Bancorp (USB) to the aforementioned three). Those four banks are very good at managing risk, hence their strong relative performance. The Wells Fargo report yesterday does not mean that other California-heavy mortgage lenders will be as fortunate. Wells simply had stronger underwriting criteria during the boom than other banks such as Washington Mutual (WM), National City (NCC), and Wachovia (WB), which can easily be seen in the underlying performance of their loan books.

Investors should continue to refrain from treating all banks the same. Companies like PNC, WFC, JPM, and USB are going to outperform the likes of WM, WB, and NCC for the second quarter and beyond simply because they have much better lending practices.

Full Disclosure: Long PNC and USB at the time of writing

Newsflash: SEC Might Slowly Start to Enforce the Law

From MarketWatch:

"The Securities and Exchange Commission said Tuesday that it will try to limit so-called "naked" short selling of shares in Fannie Mae, Freddie Mac and big brokerage firms. The SEC will issue an emergency order stating that all short sales of shares in these companies will be subject to a "pre-borrow" requirement, said Christopher Cox, chairman of the SEC. This will last for 30 days, he said. The SEC is also planning more rule-making focused on short selling in the broader market, Cox said."

Is this some sort of joke? Naked short selling is illegal, and for good reason. Short selling involves borrowing shares from holders who are willing to lend them out, selling them, and promising to repay the shares at some point in the future. So called "naked" short selling, or selling shares without actually borrowing them, is illegal because it can result in constant selling pressure due to the sale of more shares than are available for sale.

Now the SEC is saying that "naked" shorting will be illegal for 30 days for certain financial stocks. Seriously? So they are admitting that "naked" shorting is running rampant (a position that has been claimed for years) and they have not been enforcing the law? Add that to the list of reasons why this market could be taking it on the chin. First the SEC eliminated the "up-tick" rule, and now they are allowing "naked" shorting. Shameful...

Despite Recent Weakness, Buffett's Berkshire Hits Buyout Trifecta

UPDATE: 7/14 11:45AM

It has been brought to my attention that Berkshire does not own shares of Rohm & Haas. For some reason I incorrectly thought it did. Maybe Buffett used to own some of it, or maybe I just got confused some other way. At any rate, my apologies. Obviously, 2/3 of this post still applies, but just ignore the ROH part. Sorry for the confusion!

Things have not been great lately for Warren Buffett and Berkshire Hathaway (BRKA) shareholders. BRK stock has dropped more than 20% since December and large Buffett holdings in the financial services area such as American Express, Wells Fargo, Moody's, and U.S. Bancorp are hurting his equity portfolio. Buffett has also taken some heat for publicly bashing the use of derivatives, but privately writing billions in credit default swaps.

Despite the recent headwinds, you may have noticed that Buffett is still hitting some home runs. Just this year three Buffett investments have received takeover offers, all at significant premiums of 50% to 80%. What is amazing to me has been the prices offered for some of these companies. For instance, Mars is paying 32 times 2008 earnings for Wrigley (WWY). Dow Chemical (DOW) just offered a staggering 11.5 times EBITDA for chemical company Rohm and Haas (ROH).

Those are hefty prices by any measure, so I will be interested to see how smart those deals turn out to be several years from now. Buffett, for one, seems to think $80 per share is a bit steep for Wrigley. He is selling his stake to Mars for $80 per share, providing financing for the deal, and after the deal closes he inked a deal to buy a stake in the Wrigley subsidiary at a discount to the $80 purchase price. Not a bad deal if you can get it.

Full Disclosure: The author and/or his clients were long shares of Anheuser-Busch and U.S. Bancorp for investment purposes, and Wrigley as a merger arbitrage play, at the time of writing

Anheuser-Busch Lawsuit Appears Defensive, Friendly Deal More Likely

News this week that beer giant Anheuser-Busch (BUD) was suing InBev, claiming that its hostile takeover attempt was illegal, looked surprising desperate to me this early in the game. A report out of the New York Times insists that A-B is now in friendly negotiations with InBev about a merger.

What this tells me is that shareholders are lining up with InBev, most likely including Warren Buffett. If that is the case, A-B probably realizes that it would have little chance of convincing 51% of its shareholders to rebuff InBev. If after putting feelers out there that is the conclusion A-B has reached, the friendly negotiations reported by the Times make sense.

Here's why. The biggest worry in St. Louis is what type of cost cutting program InBev has in mind for the brewer's headquarters and other brand building attractions that don't necessarily contribute to the bottom line. If A-B's board accepts a seat at the table, they can directly negotiate these important points and get promises, in writing, as to what will happen if the two companies were to merge.

If shareholders are really on board for this deal, and they have the final say in this case since A-B has little in the way of takeover defenses, you may as well go out on your own terms.

Full Disclosure: Long shares of Anheuser-Busch at the time of writing