The S&A Digest: WorldCom, Enron

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 07/02/2013

Why GM will certainly go bankrupt... The Gators win big, your editor suffers... More negative developments in Thailand... Apple’s Edsel... Why we didn’t recommend VNT... More questions about our integrity, having ‘skin’ in the game...

On Monday night, the Florida Gators football team won the national championship bowl game in Tempe, Arizona. Both your editor and Steve Sjuggerud attended the University of Florida. Both your editor and Steve Sjuggerud watched the game and celebrated the victory together at your editor’s home on Monday night. And your editor celebrated... a bit too much.

Hopefully that serves as enough explanation for the "mystery" of yesterday’s missing Digest. If you need details: Several bottles of 2001 Lisini, a stupendously good red wine from Montalcino, Italy.

"Honey... what’s the matter? Were we too noisy last night? Did we keep you up?" I asked my wife on Tuesday morning. She was clearly fed up with me, making sure to clang the pots and pans as loudly as possible as we straightened up the kitchen. When I imbibe alcohol, something funny happens to my hearing: I lose my internal volume control. I begin to talk like a deaf man using a cell phone.

"No, ‘everyone’ was fine. Your friends are wonderful people. It was YOU that was too loud and got too drunk."

D.R. Horton (DHI) announced Tuesday that first-quarter home sales dropped 23% year-over-year. Looking forward, it announced that its cancellation rate dropped from 40% to 33%. The stock is up – 7% – since Sjuggerud recommended it in True Wealth late last year.

Oil prices dropped $2.04 a barrel Tuesday to $54.05, the cheapest point since June 2005.

Anheuser-Busch and Budejovicky Budvar struck a historic alliance this week... Anheuser will be the U.S. importer of its Czech rival’s Czechvar beer, known as "Budweiser Budvar" abroad. The two companies have been in a legal battle for nearly a century over rights to the Budweiser name.

The Thai government has officially approved another plan to limit foreign investment in its country. In telecom and other sectors, foreign investors must sell off their shares and give up any voting rights that exceed 50%. Investors will have one year to disclose holdings and another year to reduce their holdings.

Big week for Apple... there’s the new iPhone, plus Apple will start distributing movies from a second major studio, Paramount Pictures, on iTunes. The stock reached a new high yesterday, gaining 8%.

Prediction: The new iPhone will flop, and the stock will end the year lower than it’s trading for today. Trying to compete against mobile phone makers puts Apple in a very high-cost, low-margin game where it’s completely outclassed.

Subscriber Joseph Zadeh wrote it... thankfully we didn’t buy it. "Your pick of Verizon is crap. A true contrarian is investing in the largest telephone company in Venezuela, VNT. To most investors, they hear Venezuela, think of Chavez, and then tune out. That is the defintion [sic] of something being hated." Monday, Hugo Chavez, president of Venezuela, announced that he would nationalize the power and telecom companies, including... VNT, which has fallen 39%. Verizon is up 26.7% since our 2006 recommendation.

New highs: AutoZone (AZO), American Real Estate Partners (ACP), Consolidated Tomoka (CTO).

We found some pretty good questions in the mailbag today. Ask yours here: feedback@stansberryresearch.com.

"I noticed in your last PSIA you have stocks in the ‘no risk’ category but in the far right column they are given risk numbers. I think Lexmark was in the ‘no risk’ stocks and has a risk rating of 7 if my memory serves me right. Is this a ‘no risk’ or a high risk (7) stock?" – Paid-up subscriber Frank Batmale

Porter Comment: When we recommended Lexmark, its price qualified it for my "no risk" status. It’s gone up 54% since then. Thus... it has gotten riskier to buy, hasn’t it?

"What the hell is it these days that everybody wants to play the race card? If your detractors in that area would put as much effort into analyzing the market as they do your writings, they would be much better off. Can’t we just call a spade a spade and go on with life?" – Paid-up subscriber John Fritchey

"In Steve S’s DailyWealth [Monday] he says he buys what he recommends and comments on three of those purchases specifically. I’m a little confused by your letter today as I thought Dr. S. was an analyst working at Stansberry & Associates? I also thought that Steve S. did buy what he recommended and I always liked that about him." – Paid-up subscriber Tracy Miller

Porter Comment: Yes, Steve works for us. And yes, he follows our investment rules. He does not buy the same, specific stocks that he recommends to his subscribers. What Steve wrote about and what he does do is to buy investment vehicles that are very similar to his recommendations. For example, Steve recommended the best large-cap homebuilder, D.R. Horton. For his own account, he bought the homebuilder ETF. Both investments should go up along with the rebound in housing stocks. But, frankly, D.R. Horton is likely to outperform the ETF. For now, that’s the cost of doing business for us personally.

"While I understand your cautious approach regarding trading in stocks you recommend while the court case is still going on, I’d like to see you and the other editors with skin in the game, if you win the case. Steve, you and maybe some of the other editors have praised Marty Whitman as a guy you trust because he puts his money where his mouth is. Granted, Marty is a mutual fund manager and you’re not, but the principle is the same – you’ll have more credibility if you have something at risk. Obviously some precautions would have to be in place, e.g. you couldn’t buy or sell for 5-7 days after publishing a buy or sell recommendation." – Paid-up subscriber Mark Connors

Porter Comment: Not being allowed to invest in my own recommendations has cost me a significant amount of money. For example, I recommended Elan three times, originally at $2 per share. It went to $20. Believe me, when we can buy what we write about, we will.

"I worked for three companies that, save for the hybrid car, had essentially the same benefits [as Google offers its employees]. Having the facilities to eat (breakfast, lunch, or dinner), get a haircut (or a perm), oil change and/or car wash without ever leaving the campus seemed to put people behind their desks for many more hours than average. Those companies? BMC Software, Compaq, aaaand, the never to be forgotten Enron!" – Paid-up subscriber John Fritchey

Porter Comment: Exactly. Companies that spend endless amounts of capital providing perks for their employees typically provide very little return for their shareholders.

WorldCom, Enron... and GM?

Let me begin at the end, as my favorite writers often do.

It is commonly believed that WorldCom and Enron were criminal conspiracies whose failures were impossible to predict because of the fraud perpetrated at both companies.

This is a myth. It’s a useful myth, which has protected the institutional investors and the bankers that didn’t do their jobs and failed to protect their fiduciaries. This criminal negligence was the only crime committed in this saga.

Here are the facts: WorldCom and Enron were not criminal conspiracies. They were poorly run businesses led by men who believed in accounting rather than economics. The failures of these businesses, far from being impossible to predict, were highly anticipated by a wide number of different market participants – from college students to hedge funds.

While I am deeply interested in the accounting and the ethics of the argument that follows, I am not a cruel man. If you only wish to know the financially relevant conclusion, you may stop reading after the next paragraph.

GM will go bankrupt within the next five years, probably much sooner.

It will be taken over by its senior bondholders, led by Wilbur Ross. These men will pay pennies on the dollar for the assets of the business. After shedding its pension liabilities and getting rid of its enormous health-care obligations (which will be foisted on you as a taxpaying American), the company’s remaining debts will be converted into equity in the new GM. As with the steel companies, which went through this process between 2001 and 2004, the new GM will prove to be a wonderfully profitable business to own. Wilbur Ross and his investors will reap billions in profit on this transaction, which will probably be the biggest of its kind, ever.

There’s a little-known way to position yourself now in Wilbur Ross’ automotive investment vehicle. You won’t have to get Ross’ approval to buy in, and you won’t have to pay Ross a management fee. I’ll tell you more about this over the next few days.

First, though, I want to show you some numbers. These figures offer a comparison between WorldCom, Enron and... GM.

Malcolm Gladwell – who is easily the most insightful, widely published author on current events – wrote about Enron recently in The New Yorker.

"If things go wrong with a puzzle, identifying the culprit is easy: it’s the person who withheld information. Mysteries, though, are a lot murkier: sometimes the information we’ve been given is inadequate, and sometimes we aren’t very smart about making sense of what we’ve been given, and sometimes the question itself cannot be answered. Puzzles come to satisfying conclusions. Mysteries often don’t... If you sat through the trial of Jeffrey Skilling, you’d think that the Enron scandal was a puzzle. The company, the prosecution said, conducted shady side deals that no one quite understood. Senior executives withheld critical information from investors. Skilling, the architect of the firm’s strategy, was a liar, a thief, and a drunk. We were not told enough – the classic puzzle premise – was the central assumption of the Enron prosecution... . But the prosecutor was wrong. Enron wasn’t really a puzzle. It was a mystery."

Gladwell demonstrates that, despite what the prosecution claimed, the weaknesses of Enron’s business were widely known. In fact, he points out that as early as 1998, a Cornell University business class recommended selling the stock short because of its serious cashflow problems. The report was available for free on the Internet.

I also don’t think Bernie Ebbers (CEO of WorldCom), Ken Lay (chairman of Enron), or Jeffery Skilling (CEO of Enron) are criminals because their actions don’t pass a reasonable definition of fraud. Fraud is using false pretenses to get something you’re otherwise not entitled to receive. These men’s actions were NOT taken under false pretenses – they were the rightful leaders of these businesses. And they didn’t get anything they weren’t entitled to receive: Ebbers went bankrupt, as did Lay. Skilling’s reputation was destroyed.

What went wrong at Enron and WorldCom was simply a series of horrible business decisions. These decisions were legal and publicly disclosed. Their likely consequences were widely known.

Really? Yes, absolutely.

Using the company’s publicly reported information, I’ve put together a very simple analysis showing what Enron’s capital deficit was for the years leading up to its bankruptcy. All I’ve done is take the company’s gross profits and subtract the capital it required to continue operations (selling, general, and administrative expenses; net interest expenses; and capital investments). The numbers are in millions.

As you can see, the business lost $7.5 billion in the 10 years leading up to its collapse. Looking at these figures, it’s not hard to believe the business went bankrupt. It’s harder to believe it didn’t go bankrupt sooner.

Here are the same numbers, for WorldCom.

As you can see, WorldCom lost a total of $19 billion over a 10-year period. And once again, there’s nothing surprising at all about WorldCom’s bankruptcy. What is surprising is that so many "professional" investors and so many bankers enabled the company to go so far into debt. I’ll discuss why and how this happened tomorrow. And you’ll see how this links directly to what’s happening at General Motors right now. Until then, I’ll leave you with these numbers. It’s the same analysis done on GM’s ongoing capital deficit.

In the last 10 years, GM has lost a total of $18 billion dollars...

Regards,

Porter Stansberry

January 10, 2007

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