The S&A Digest: WCI - A Miami Gamble

Making ends meet with $160 million... Fed 'Tylenol'... Is Goldman bulletproof?... Another big mortgage downgrade... Where inflation comes from... WCI: A Miami Gamble...

Poor Stan O'Neal.

The CEO and chairman of Merrill Lynch was rudely thrown overboard yesterday, like ballast from a sinking hot air balloon. His handpicked board of directors seemed surprised that O'Neal had lost 20% of the firm's entire book value in one quarter, via losses in mortgage securities. Apparently from up in their Ivory Tower, Merrill's directors hadn't noticed housing prices had gone crazy over the last four years. Or perhaps they didn't even know Merrill was the U.S. housing market's single largest source of structured finance, thanks to its role in packaging and selling so-called "CDOs" – which are essentially mutual funds of mortgage debt. It doesn't seem fair to put all the blame on sad Stanley O'Neal. Now, he'll have to find a way to make ends meet on a $160 million retirement package...

Like a pig hunting for truffles, Merrill Lynch seems to have a nose for finding trouble... and then stepping in it. You may remember that during the last Wall Street crisis, Merrill woke up in bed with Enron the morning after the tech party. It had helped Enron hide its debts and rig its books. Before that, Merrill invested heavily in Long Term Capital Management, which then blew up and required a several-hundred-billion-dollar government-organized bailout. And now Merrill must deal with its mortgage hangover. Luckily for Wall Street's bankers, they've got Fed "Tylenol." More easy money is on the way.

What's most interesting to me about the whole mortgage mess is the shareprice of Goldman Sachs: It hit a new high yesterday. Which do you believe is more likely: The managing directors at Goldman Sachs are incredibly superior to every other investment bank in the world, or the firm simply hasn't come clean yet with the real value of its mortgage holdings?

Yesterday Fitch Ratings warned it would downgrade $36.8 billion of mortgage CDOs. Most of the downgrades will hit AAA-rated paper – the stuff banks and brokerages have loaded up on to fulfill their capital-ratio requirements. And most of these downgrades will send the paper from AAA into junk status immediately. How long can Goldman dodge the bullet?

As everyone "knows," the Federal Reserve will cut short-term interest rates this week – again. Doing so, we're told, will reduce the chance of a recession. Much less commonly discussed is the role the Fed plays in making sure the fools on Wall Street (most of whom, it seems, work at Merrill Lynch) don't go bankrupt. And even less well understood is how the expense of fixing Wall Street's balance sheets is passed along to you and me, via inflation.

So... here's a tip: As the Fed cuts, look for commodities of every stripe to soar, the dollar to fall, and truly outrageous stock market bubbles to form in the countries of our largest trading partners. Will the average American ever figure out the connection between the price of gas – and just about everything else – and the size of Wall Street's write-offs and Congress' budget deficits? Probably not in my lifetime.

Speaking of these matters in his latest newsletter, the most eloquent financial writer of our generation, James Grant, explains the mechanics of how inflation works in a highly integrated global economy:

[Owing to its reliance on foreign manufacturers and foreign credit,] The United States emits its dollars into the world's payment stream. Foreign central banks print the local currency with which to buy them. The motive force behind the transmission is the U.S. trade deficit. The motive force behind the buying is exchange rate manipulation – the desire on the part of the monetary authorities of America's creditor nations to suppress the appreciation of their own currencies and to brake the depreciation of the greenback.

The scale of these operations is evident from the volume of dollar-denominated claims that the foreign central banks acquire. Just last week, the total – or, rather, the visible total – passed $2 trillion. That is the volume of U.S. Treasury and U.S. agency bills, notes and bonds that the Federal Reserve holds in safekeeping for the accounts of the surplus countries, China not least. It was only four years ago that such custody holdings first passed the $1 trillion mark. In this fashion is the U.S. trade deficit translated into money. Rising prices of one kind or another are the logical upshot.

What does all of this mean for you and me? Jeff Matthews drew my attention to this remarkable comment, made by Whirlpool's CEO.

"This is the first year ever where we have seen a significant decline in demand in the U.S. and significant raw material inflation," Whirlpool CEO Jeff Fettig told analysts during his company's most recent conference call. "In essence, we have had both a demand decline and a cost spike at the same time..."

Someone should send a note to Dick Cheney – sooner or later, deficits matter.

Buffett watch: Rumors are flying on the Street that Buffett will buy all or most of Home Depot.

New highs: Advisory Board Company (ABCO), BHP Billiton (BHP), Covanta (CVA), EnCana (ECA), streetTRACKS Gold (GLD), Google (GOOG), Harvest Natural Resources (HNR), Coca-Cola (KO), McDonald's (MCD), Markel (MKL), Arcelor Mittal (MT), Petrobras (PBR), Pogo Producing (PPP), Royal Dutch Shell (RDS-A), Sangamo BioSciences (SGMO), Silver Standard Resources (SSRI), Taiwan Fund (TWN), Provident Energy Trust (PVX), Westshore Terminals (WTE-UN.TO).

In the mailbag, someone doesn't like reading our Digest. We're not surprised. Publishing genuinely useful information (as opposed to lifeless, ad-driven magazines and newspapers) to a mass audience is like trying to hug a cactus. To be useful, we have to make predictions and take a point of view. You surely won't agree with us much of the time. We'd rather be useful to some people than popular to many. Let us know which category you're in: feedback@stansberryresearch.com.

"After signing up for your 'tip sheets' I find you mostly are in the business of selling additional newsletters. With this in mind perhaps you would cancel my subscription to your S&A Digest." – Paid-up subscriber James Marta

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"You know Porter, they sell fresh wine at the liquor store." – Anonymous

"The good news is Stansberry Focus may be the best, most sensible idea you've ever had. The bad news is, I doubt Ann Coulter was all that impressed with you, either." – Paid-up subscriber Daryl

Porter comment: Oh, I don't know... We did our best to talk her out of buying more real estate in L.A. and buying some gold instead. She seemed interested...

"Porter, you very much remind me of Ann Coulter. You both make outrageous comments to provoke your audience; you both are quick to belittle, discredit, and disparage others you don't really know well; you both are appalled of big government's interference in our life, liberty, and pursuit of happiness; you both have a great following of admirers and a great many others that pity you. Are you related? I also attended the New Orleans conference, and heard Libertarian Doug Casey with whom she debated, agreeing with her on many points. After the debate, he said he also had lunch with her, and was expecting to get the Nazi SS treatment from her, but found her to be very delightful company. I believe they must have picked on you over lunch, and hurt your tender feelings." – Paid-up subscriber Terry

Porter comment: No, no... Doug was as much amused with Ann as I was, but he was trying to talk her into buying a lot down at his new development in Argentina, so he was playing nice. If you saw the debate, did you notice the way Ann reacted at the very end when Doug gave her a compliment and put his hand – in a friendly way – on her shoulder? I thought for a minute she was going to slap him.

"If you keep talking negatively about Ann Coulter, I will be taking this publication for the shortest amount of time possible. Either stick to investments and forget politics or I will not be sticking with U." – Paid-up subscriber Mary Barth

Porter comment: The shortest amount of time possible? I don't think you're in the running. Once, a few years ago, I hired a new analyst to work with me. On his first day in the office, he left early for lunch... and never came back. Didn't say bye. Just left. I had to call him the next day to make sure he hadn't been killed or something.

Regards,

Porter Stansberry

Baltimore, Maryland

October 30, 2007

Editor's note: As a former resident and a frequent visitor to Miami, I watched the building boom there with fear and awe. I have written several times about the likely collapse of real estate prices... and now I've begun to speculate on when prices might be cheap enough to warrant an investment. As you know, equities tend to discount bottoms before they occur. So, I asked 12% Letter editor Tom Dyson to go down to Miami, look around, and try to figure out if WCI Communities is likely to survive the debacle. WCI Communities is probably the biggest "pure play" stock on the Miami condo market. It is also the leading luxury builder there, and its share price is extraordinarily low. If it can survive, it might be a great stock to buy. – P.S.

WCI: A MIAMI GAMBLE

By Tom Dyson

Dozens of companies build condo towers in Florida, but WCI Communities is the only one traded on the stock market. Its stock price is down roughly 80% in the last 18 months. Many people think it's going bankrupt. What do I think? I'm still trying to figure that out...

Today, I spoke with CFO Jim Dietz... I asked him a series of questions:

1. Times are tough, WCI has almost $2 billion in debt, and cash flow is meager. I wanted to know why it is planning a new tower near Bronxville, N.Y. (and borrowing another $80 million). Shouldn't it be retrenching?

The project is small he told me, only 54 units. It will only go ahead if WCI can pre-sell at least 50% of the units. Also, the New York market is much stronger than the Florida market. WCI should make a nice profit on it, he said. But it still has plenty of time to think it over.

2. A buyer defaults when he refuses to buy the finished condo he agreed to purchase preconstruction. He loses his deposit. The condo developer must back out the revenue it had already banked in the accounts and hope to sell it again. To reduce the sting, accountants make developers put aside cash to cover potential defaults. It's called the "default reserve."

According to its disclosure filings with the S.E.C., WCI reserved for an 11% default rate at the end of June. Given the higher rates at other homebuilders and on completed WCI projects, isn't that a little optimistic?

Dietz told me he couldn't give me any numbers, but implied the reserve for defaults rate would go up in next quarter's announcement (which should come next Friday). Anyway, he said, WCI calculates the default rate by averaging expected default rates on all the buildings in progress. Right now, it is working on One Bal Harbour, Oceanside Pompano Beach, and The Watermark in New Jersey. The Watermark will have strong demand, and WCI expects a low default rate. This pulled the overall default rate in the accounts lower, he said.

3. One Bal Harbour is WCI's most important project. Located in one of the most sought-after locations in Miami, it is the height of condo luxury. You could say, WCI bet the farm on this project. Dietz said the company will begin closing units next month. Having seen the construction still in progress, I'd say it's more likely to be next year, but we'll see. The MLS is the database realtors use to list their properties. I pointed out the huge number of listings in the MLS for One Bal Harbour condos. Then I asked Dietz about the default rate at One Bal Harbour.

Jim said the MLS isn't a reliable indicator of default rate. Just because people want to sell doesn't imply people will default, he said. He reminded me WCI has been working on this project for a long time. It first made sales in 2003. So even though buyers may have given up some gains in the last year or so, many are still sitting on three years of appreciation.

Backlog is an important number in homebuilder accounts. Backlog is the sum of units reserved but still under construction. The final sale is pending in other words. WCI has a backlog of $636 million. Think of this as future cash flow – assuming no buyers default. Falling prices, however, mean the risk of a much higher-than-normal default rate is growing. I saw one WCI Florida development offering units at a 40% discount.

An impairment occurs when a company writes down the value of its assets in the balance sheet and then takes the hit in its profits. Impairments look ugly in the financial statements.

WCI only impaired $37 million in the second quarter, equal to about 1% of its total asset base. That's nothing when you consider Florida condo prices could be down as much as 30% and raw land is down even further. Other homebuilders have impaired much more.

Dietz says WCI only impairs existing inventory, not its raw land or work in progress. Accounting regulations don't require impairments on work in progress or raw materials. Only finished inventory. Most of WCI's land prices are "no bid," Jim told me. But it doesn't get impaired. The true impairment should be much higher. He hinted impairment would rise significantly in the third-quarter results.

All said and done, it looks to me like asset values in WCI's statements are massively inflated. Two thoughts:

Icahn joined the board in the third quarter. The imminent quarterly report will be the first that reflects his leadership. I bet Icahn will want to sweep out the cockroaches. It's best to get them out when sentiment is bad already, when the market won't punish the bad news so severely. Icahn knows this. Third-quarter results will be terrible.

Secondly, WCI's stock price already knows the accounting numbers are inflated. That's why WCI trades at 30 cents on the dollar in terms of book value. So even though the third-quarter results will be awful, I bet the stock price goes up the day they come out...

What happens after that? Right now, no one knows. The future of the company probably depends on the default rate at One Bal Harbour.

Good investing,

Tom Dyson

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