Tuesday, March 18, 2008

This Guidance is not Guidance

MNST, which suddenly saw the light at the end of last year and decided it would no longer issue guidance, "corrected" analysts today on what number they should plug into their models for Q1 operating expenses. This "correction" should have the result of reducing the non-GAAP EPS by about half of what analysts currently projected for the quarter. Below are a rough snapshot of consensus estimates before the announcement.

Revenue: $369

Non-GAAP OPEX: $300


EBIT: $52

Interest Inc: $6

EBT: $58

Net Income: $38

EPS: $.30

And now my own estimates, using this announcement as guidance:

Revenue: $368


EBIT: $37

EPS: $.19

These are pro-forma estimates, which means they don't include one-time charges. Given the decline in business and the ongoing restructuring, I would not be surprised if actual GAAP earnings were to turn negative.

The important takeaway from this announcement is that we are finally starting to see the consequences of heavy investment in a business with declining growth. EBIT margins should decline by over half YoY. If this trend continues, as I expect it will, the affect on MNST's operating results, and share price, should be severe.

I also think this announcement speaks a lot to management credibility. If there was any doubt that management was withholding guidance on principle, those doubts should be put to rest. Their operating margin guidance (another form of guidance that apparently doesn't count) is now basically unattainable unless trends reverse themselves drastically in the back half of the year. Expect this to be the first of many "corrections" to come.

Author is short MNST. Above writing should not be construed as "guidance" of any kind. Do you own DD.

Saturday, March 15, 2008

Trouble brewing at GLG Partners?

Alternative investments have, over the past 3 years, attracted record attention from investors, the public markets, and eager business students eager to cash in on the boom. Over the past several months, as the financial markets have been rocked by credit issues and declining valuations, the fairy tale, in many cases, has begun to turn dark. GLG Partners is one of the leading hedge funds in Europe, with a strong investment track record, diversified assets across strategies, and a solid investor base. At the same time, the company's unsustainable FY07 results (driven largely by gains in emerging markets), and it's uncertain use of leverage, provide substantial catalysts for a sharp decline in revenue and earnings in FY08. If past performance is any indication, it is possible that a large chunk of GLG's performance revenue will dry up in 2008, resulting in a strong drop in revenue, margins, and profit.

GLG Incentive fees at risk
GLG is structured like a typical hedge fund, in that it earns revenue primarily based on a combination of incentive and incentive fees. Annual management fees equate to an average of about 1.9% of AUM. Incentive fees vary across funds, but typically average between 20-30% of all performance gains across most single manager products. Incentive fees accounted for 50% of revenue last year, but also tend to be higher margin, and so have a disproportionate impact on earnings.

As of the year end 2007, GLG managed approximately $24B in assets spread across over 40 funds. Though funds are widely spread, there are some concentration issues, particularly in regards to revenue:

Fund % of Gross AUM FY07E Rev % of rev Annualized net return*
GLG Emerging Markets Fund 17% 265 32% 70.6%
GLG European Long-Short Fund 13% 141 17% 13.6%
GLG Market Neutral Fund 10% 124 15% 20.0%

*Based on morningstar estimates

GLG's top three funds account for only 37% of AUM, but accounted last year for 64% of revenue. Most importantly, I think it's fair to say that the emerging markets performance is nowhere close to sustainable. This implies gross returns (returns before fees) of annualized 90% since inception in November of 2005, compared to ~35% for the emerging markets ETF. Given the tougher emerging market conditions (down about 13% YTD as of this write-up), and the high growth in AUM (which makes high performance more difficult), incentive fees are poised to come down substantially in 08'. Also, note that this one fund may have accounted for over 50% of GLG's performance fees in the 2nd half of the year. Many of GLG's funds were actually down in the 2nd half, so this fund in particular helped artificially keep the firm's profits afloat.

The Leverage Risk
The other two funds noted above (European L/S and market neutral) have components of hedging, making them less prone to market fluctuations. At the same time, these sorts of hedged funds are the most likely to use leverage. Leverage allows funds to amp of their performance, and was a particularly common practice over the last couple years, as low risk premiums and eager prime brokers would often loan funds capital at low interest rates. Over the last few months, and in particular over the last few weeks, prime brokers have begun reigning in this excess. The result varies from crippling to disastrous (see the Caryle Capital collapse). GLG is very hush hush on the extent of leverage it uses: I doubt it took on the sort of ratios that Caryle took, but analysts reports indicate that it has, in some documented cases, used leverage in excess of 4x. Also, anecdotally, there are two points worth mentioning:

1) GLG is part owned by LEH, which itself was an aggressive prime broker. You've got to think that at the height of the boom, there was a chance that LEH encouraged GLG to gorge itself with leverage to boost its prime brokerage business.
2) Freedom Acquisition, the SPAC that took GLG public, is run by the infamous CEO's of Jarden, who I have written about previously. If their own appetite for leverage and risk is any indication, the leverage in GLG's funds could be scary.

If the leverage at GLG is extreme, the downside is clear: funds could blow up, leading to mass redemptions, lawsuits, loss of key talent, and potential collapse. While possible, I have no reason to believe this outcome is likely.

Painful de-leveraging
The alternative and more likely scenario, while not as bleak, is still damaging to GLG's earnings prospects. Let's assume that GLG's market neutral fund conservatively used 4x leverage in 2007 and earned 13.7% net fees (according to morningstar), and charges typical hedge fund fees. Using those assumptions, you'd get an un-levered performance gross performance of only 8.2%, vs. the estimated 18.5% levered gross performance that was implied to get to a net performance of 13.7%. By borrowing 4x its money at 5% and earning 8.2%, GLG was able to return more than double on a net basis what it would have been able to do if no leverage was available. If it does continue to use leverage, and rates go up and/or gross returns go down, leverage could magnify the losses. Also, due to the nature of leverage (typically short term lending), these agreements must be negotiated often. Depending on GLG's terms, it's possible that de-leveraging could force a liquidity crisis and force GLG to liquidate positions and rapidly reduce its leverage, resulting in a sharp decline in the value of the stocks it holds. This is somewhat unlikely, but always a risk.

The High watermark and hurdle risk:
Relationships between performance and incentive fees are not linear. It's impossible to know without reviewing the incentive structure of each fund, but we do know that certain of GLG's funds are subject to high watermarks, which means a fund that declines in one period must reach its prior highs before incentive fees can be charged again. Some funds are also subject to hurdle rates, meaning a certain performance benchmark must be exceeded before incentive fees can be charged. These measures should hurt GLG in tougher stock market times.

2008 Update:
The bulk of GLG's funds had an abysmal January. The flagship European L/S fund was down over 4% in January and the Market Nuetral fund was down 3%. The emerging markets fund was flat, which is impressive on a relative basis, but will not be particularly helpful in repeating GLG's outstanding emerging markets performance last year. If GLG's performance in a tough January is any indication of its ability to weather a tough 2008, flat YoY performance (and, consequentially, little/no performance fees) is not out of the question.

What does this all mean financially?
Barring stellar out-performance by GLG in these tough economic markets, GLG should experience somewhere between a rough and devastating 2008, cases that are not currently reflected in the stock price. If GLG does not keep up it's rabid performance, and, worse, if performance turns flat or even negative, much of GLG's revenue and profitability will dry up. Performance turning flat or negative is not out of the question, and has occurred before. Let's take a look at GLG's historic performance:

The image quality isn't great (blogger is giving me trouble), but you can see that performance in 2000-mid 2002 remained relatively flat. Also, before the incredible launch of GLG's emerging market fund in late 2005, GLG's overall performance was not very impressive. GLG returned 10.4% and 8.2% net fees in 2005 and 2004, well below its most recent performance, driven primarily by its emerging market returns.

Best Case Scenario:
In my best case scenario, GLG sees half of its AUM rise an average of 20% gross, and the other half of its fund experience losses. This could be possible if Emerging markets and a few other big funds do exceptionally well, despite losses in most other funds. In this scenario, GLG earns about $1/share, at the high end of estimates.

Base Case Scenario:
A more likely outcome given the market turmoil is a scenario under which 65% of assets perform negatively or otherwise do not hit the rate required to charge performance fees. The other 35% of assets return 15% gross of fees. In this case, GLG earns $.65, well below estimates.

Bear Case Scenario:
In another likely outcome, if January is indicative of how the year will turn out, it's entirely possible that about 75% of assets end up negative or below the rate at which performance fees can be charged. The other 25% return 12% gross returns, meaning earnings around $.40.

I believe the best case scenario for GLG is that they meet or slightly exceed expectations, while the likely scenario leaves them under performing by a wide margin. Slap a 10-15x P/E on the base and bear case scenario and we can see downside between 25-55% to the stock price, or 50-80% to the warrants.

Note: Author is short GLG common and warrants.

Friday, March 7, 2008

Divergence in Staffing Stocks?

I have written at legnth on MNST, KFY, and HSII in the past few months, arguing that the upcoming turmoil in the economy and, eventually, the job markets will reveal the underlying cyclicality of these businesses, resulting in massive decreases in earnings, earnings estimates, and share price. So far, my thesis has begun to play out nicely with MNST, which has seen pressure in both US and international MEI (a good proxy for business going forward). In the US, MNST has not only seen the MEI fall, but has also seen it's pricing fall as well due primarily to fewer sales to small and medium size businesses, which on average pay more per listing. This trend accelerating in the recently announced February numbers, which saw MEI fall 7% YoY. The same deterioration, however, has not been seen in the executive search companies, KFY and HSII in particular.

MNST serves as a broad proxy for the larger employment market. It is not surprising, then, that current weakness in the employment market in the US (and, increasingly, abroad) has and will continue to erode its business. KFY and HSII, however, focus on a very small niche of the job market: that of executives, and higher level management. The market for executives and high level management is driven primarily by the creation of new management jobs and increased turnover in management. Factors that influence these two drivers are tighter markets for talent, increases in poaching from other companies, reductions in promotion from within, business creation, and general economic conditions.

My original thesis was that all the aforementioned factors would be negatively influenced in deteriorating economic conditions. I believe I misjudged a couple key elements which have delayed but not prevented an eventual drop. These develops include:

1) Continued robust growth abroad, which should begin to slow noticeably as the US drags down international economies with it. Also, keep in mind that most of HSII & KFY's business is from multi-nationals, not country domiciled businesses, which means that many of these businesses country growth plans could be harmed by issues in the US.
2) Increased mandatory turnover as companies (especially financial companies) clear house, firing scapegoats and bringing in fresh blood. This has the effect of increasing demand for HSII & KFY's services. I believe this affect is temporary. Once house is cleared, the impact of decreased turnover should be revealed. In tough economic times, employment opportunities tighten, leading to less voluntary turnover as people are presented with less opportunities to move elsewhere.
3) HSII alluded to strong demand in financial services for risk managers that offset much of its weakness elsewhere. The financial markets turmoil has, it appears, at least temporarily created demand for new management positions. I believe this shock is one time in nature and that, eventually, we should see new job growth at the management level slow noticeably, both domestically and abroad.

MNST should continue to experience pressure to its earnings and stock price nicely mirroring declines in US and abroad job growth. Whether or not these same pressures will eventually hit KFY and HSII remains to be seen, but I for one believe they will.

Author is short MNST, KFY, and HSII.