Mortgage Backed Temptation

Is there anyone in Britain or America who still lives within his means? Does anyone know where their means are?

Only occasionally do they even bother to find out – like a middle aged man hunting around in closets for an old tuxedo. Then, when he puts on the pants, he realizes he has outgrown them…he spills over the top and nearly splits the seat.

Of course, you can’t blame people for not living within their means – the whole idea is as quaint as thrift…as antique as spats. New credit card offers come everyday. And when you can buy a house for no-money-down on a teaser-rate ARM…you can afford much more house than you thought you could – as least for a while.

Most of the time, most people get by – just as most of the time, most people don’t get themselves into serious trouble with the law. They know what they can get away with and what they can’t. But occasionally, the old standards and guideposts get knocked down. Then, they run into trouble.

What gets them into trouble is the subject of today’s reckoning.

Junk bonds, margin buying, program trading, portfolio insurance – each one eventually leads to trouble. People get excited about it…they think it is the answer to their prayers…they think it is going to make them rich. They do it. And then they over-do it.

The same is true for the innovation of easy mortgage credit. Now you can get a mortgage, apparently, over the Internet. Lender and borrower never meet. And then, of course, Wall Street created a whole industry – another new innovation – to take these mortgages and turn them into new and titillating products. Now, both the mortgages…and the securities derived from them are landing themselves in trouble.

Everyone knows that a man who wins the lottery is a threat to himself, his family and everyone around him. He runs wild, simply because he can get away with it. And yet everyone still hopes to win the lottery. That is why Christianity regards temptation as such a threat that we don’t even bother asking God’s help to resist it; we know that’s impossible. Instead, we pray to “lead us not into temptation.”

Here at The Daily Reckoning, we’ve had our fair share of temptation and enjoyed every minute of it. But what we’ve noticed is that temptation delayed is temptation denied. Things we would have found irresistible at 25 have only a passing attraction at 50. Fortunately, most people are spared too much temptation – at least, until they are old enough to resist it. Then, it isn’t so tempting anymore.

But to a huge number of people in the last 10 years…the innovation of easy credit – especially easy mortgage credit was like catnip. Not only could they not resist it, they reveled in it. They rolled around in it. They salivated over it.

And now they are praying for help to…well…not to God, but to as near an imitation of Him as we have these days – the government.

According to a Bloomberg analysis of data from the National Conference of State Legislatures, legislators in some 30 states have introduced about 85 bills to protect mortgage borrowers from deceptive lending practices, foreclosure, or fraud. Now, from Illinois to Maine, lenders will be banned from tempting borrowers with enticing loans.

Although the government is stepping in now – the damage in the housing market has been done. And really – no smart investor is going to count on the government to protect their portfolio…that’s something that we suggest you do yourself. Find out how you can protect your assets – and make some extra cash while you are at it – from the second wave of housing hurt.

Yes…a ban on temptation. We are glad we are not young now.

Imagine if there were a ban on…but, there – we’ll leave the rest to use your imagination, dear reader. We have to rush to the airport.

Bill Bonner
The Daily Reckoning
London, England
Thursday, July 12, 2007

In the meantime, more news:

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Addison Wiggin, Reporting from Baltimore…

“U.S. domestic airlines’ operational costs rose 10% in the first quarter of 2007…be prepared for more expensive plane tickets. Despite the fact that the 10 biggest domestic airlines are on track to double last year’s $1.5 billion profit, higher fuel costs will likely make their way to your wallet.

“This week, Southwest Airlines jacked up prices across the board for the third time this year and the ninth time in the last two. Industry rumors say other domestic airlines will follow suit.”

For more on this story, and for more market insights, see today’s issue of The 5 Min. Forecast

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And a few more thoughts…

*** Lady Bird Johnson died. Very seldom does anyone in government…or associated with government…really accomplish anything worth doing. In fact, we can think of only one example. It was Lady Bird Johnson’s campaign to beautify America. It changed people’s habits and actually did seem to make the place less trashy.

When we were young, you could drive home at night aided by the headlights reflected on beer cans along the road. People routinely threw these metal cans…along with all manner of trash…out of car windows. But then, in the ’60s, Lady Bird began to make people aware that the place would be a lot nicer if there weren’t so much trash everywhere. Her “Keep America Beautiful” campaign – mostly voluntary – is the only successful government initiative we can recall.

*** People take money far too seriously. Our household is living proof that you don’t need a lot of money to be happy. Our son Jules has no money; he is happy. Our son Henry has no money; he is perfectly happy too. Our son Edward hasn’t a dime; he is very happy. Danielle, the cleaning woman, is poor too, yet she seems perfectly happy. The gardener is poor and happy. The painter, who is working on the apartment in Paris seems to have no money; he is happy. The plumber, who pretends to work on the apartment; he is the happiest of the lot. The baker is happy. The butcher is happy. Even our lawyer, who charges $500 an hour for tax advice – “get out of France,” he says – seems happy; of course, he may actually have some money.

Down on the ranch, Jorge and his wife seem almost giddy with happiness. They probably have a net worth close to zero. But they have good meat to eat…good wine to drink…and a sun that shines almost every day of the year. What more could they ask for?

Alphonzo, too, seems perfectly happy…or at least as happy as a man with a serious drinking problem can be. The gaucho drinks so heavily that if he wakes up in the morning, he considers himself lucky…and he’s happy about it.

But just as every man in jail imagines that every free man is as happy as a blue jay, every man without a dollar in his pocket imagines that if he could just get his hands on a rich man’s money then he’d be happy too. But the rich man is not necessarily any happier than the poor man. He is merely more comfortable in a worldly kind of way…and more self-assured. He sits on a loftier pole in the hen house…and so is able to look down on the rest of the birds with a superior air about him.

Nevertheless, this great boom of ours is, in a sense, nothing but a great chase after money. Everyone seems to want it so badly that they are willing to put aside leisure time, solvency and dignity…and prudence as well as sanity…in order to have a go at it. How else can you explain low-doc, neg-am, adjustable rate mortgages? How else can you describe 2 and 20 – the standard hedge fund rates? And why would professional moneylenders lend money to people who clearly can’t pay it back? And how could investors be persuaded to put millions into an “enhanced leverage” fund, based on a stream of income from people who’ve told tall tales on their loan requests?

Down among the trailer trash, people signed documents they did not read, after furnishing figures they made up, in order to buy houses they didn’t need, with money they didn’t have.

And up among the professionals, people bought investments they didn’t understand, based on loans to liars, on houses they knew were over-priced, to fund mortgages they knew wouldn’t be paid back.

What a world!

*** “What sort of people are these fat and greedy bastards and what to they believe in?”

The question was put by an Englishman; he was writing about Americans.

“The Americans, a bunch of unreconstructed crypto-fascist reactionary imperialists,” writes Vernon Coleman, “have no sense of style or taste (look at the clothes they wear) and not much of a sense of humor. Nor do they have much in the way of brains (whenever there is a well-publicized violent death in Europe, Americans cancel their air tickets and choose to remain in a country where the daily death rate is comparable to the annual rate in Britain). The Americans have the biggest, worst prisons in the world, and they practice and approve of torture.”

“…largely through greed, theft and thuggery a small number of them have accumulated a fair amount of wealth…”

“When England conquered the world we gave our victims cricket, pageantry, our heritage and a sense of style. The Americans have given the world cancer-inducing hamburgers and, not having any of their own, they have stolen everyone else’s heritage.”

Mr. Coleman has a point. But we think that for the British to lecture anyone on the amassing of wealth at the expense of the world is a bit thick. As for prisons, it was the Brits who invented the concentration camp. It seems that at least one of the things we Americans must have stolen in our pillaging around the globe is the famous Anglo-Saxon irony.

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The Daily Reckoning PRESENTS: With the rising levels of childhood obesity and Americans on health kicks, isn’t the soda business one to avoid? Well, yes and no – Greg Guenthner explains, below…

THE NEW AGE BEVERAGE REVOLUTION

This is one of the only hippies I’d hand $1 million over to, let alone $8 million…

He eschewed private equity guys and declined venture capital offers.

This is no average hippie. In fact, he’s not even your average small-business entrepreneur. How many people can figure out on their own how to raise $400,000 from a small corporate offering registration and then do an IPO of a then-19-year-old gourmet soda business?

Well, Chris Reed can.

He’s the self-labeled hippie and natural health fanatic behind Reed’s Inc. (REED:OTCBB). The company is best known for producing arguably the best ginger-brewed sodas in the world. It’s leveraged the ginger niche into sodas featuring six different ginger flavors, along with ginger ice cream and candy.

So-called “gourmet soda” growth is the story here. A few years ago, you could only buy Jones Soda products at record stores, surf shops and tattoo parlors. Now this maker of so-called “alternative” sodas with pure cane sugar has bottles in Starbucks, Target and 7-Eleven. The packaging is pretty distinctive – customers send in personal photos to Jones, and the best get printed on the soda labels.

Hansen markets itself as a natural soda maker and also markets bottled smoothies and various energy drinks. The company dates back to the 1930s, when the Hansen family was a juice supplier to the Hollywood film industry.

What these two companies have in common financially, though, is tremendous top- and bottom-line growth. Jones has averaged 20% revenue growth for the past seven years, with earnings making the turn to the plus side in 2003, and posted 254% net income growth just last year. All the while, Jones has been consistently expanding margins, as well. Bigger brother Hansen has been even more impressive. Sales have grown an average of 31% over the last seven years, with last year posting a 94% jump. But that wouldn’t be impressive without a jump in profitability…and Hansen hasn’t disappointed. Earnings have grown an average 53% for the last seven years.

The Beverage Marketing Corp. has the carbonated soda pop business pegged at $65.9 billion in total annual sales last year. But traditional soda growth has been spotty and lackluster for many years this decade.

While Jones’ and Hansen’s products are called “sodas” and are definitely competing for Coke and Pepsi consumer dollars, industry insiders refer to these niche drink companies as “New Age beverages.” And this segment hasn’t been sliding in recent years. The most recent data we have show that this is an almost $17 billion industry at the wholesale level, and growing.

Investors have noticed, too.

Jones is up 103% in just the last two months alone. Hansen is up 281% since June 2005.

While Reed’s is trading at close to double its IPO price from January 2007, there is still growth left to come from what is considered a sexy penny stock with good fundamentals.

Sodas are still the biggest segment in the entire beverage industry. And of course, the old giants in the business are still the giants: Coca-Cola and Pepsi are clearly still at the top, followed by Cadbury Schweppes and the lower-profile Cott and National Beverage.

Today, we enter the niche soda producers. They’re smaller and have focused product portfolios. They convey exclusivity, and while typical sodas compete on price, the niche category is not afraid to put a premium-priced product into the channel. This is an exercise in psychographic pricing, in which you may or may not actually get value for your soda-paying dollar.

In the case of Reed’s, it plays on history, as brewed drinks, like the brewed ginger drinks, were around well before sodas existed. It also plays upon the health benefits of ginger, an angle most mainstream soda players don’t even touch. In fact, playing up the health benefits of products people intuitively feel are unhealthy is working well for several companies of late. Hershey’s, for example, has been marketing its dark chocolates as potent antioxidants.

It’s Chris Reed’s passion for natural health that led him to ginger. The former chemical engineer was taken by ginger’s ability to remedy motion sickness and its anti-cancer properties. But none of the ale on the market was actually made with real ginger. So Reed set off to brew his own.

In the late 1980s, Chris Reed rented out space at a small brewery and made a small batch of ginger beer. He bottled the concoction himself with a funnel, and even glued his own labels that read “Reed’s Ginger Brew.” He then hit the streets, where he peddled his product to local grocery stores and cafes. Little did he know his small venture would turn into a fiercely growing $55-million enterprise.

Within a couple of hours, all of the stores had sold out. After 18 months, Reed’s Ginger Brew became a national brand.

Reed’s has been public only since January of this year, so we have limited trading data to go on as far as liquidity. This $55-million company is currently trading at about $8.50 per share. Volume so far today has been about 22,000, and average volume numbers for the last three months have yet to be posted. Its spread is not terrible – no 18-wheelers will fit through this one, fortunately. It’s about 24 cents at the moment.

The company’s rapid growth should continue, as well. Reed’s Ginger Brew is outselling natural soda leader Hansen at Whole Foods, Trader Joe’s and Wild Oats stores. And believe it or not, this has all been possible, for the most part, through organic growth.

For the first 15-plus years of its existence, Chris Reed allowed his soda company to grow passively. Store reps would approach him at trade shows, or distributors would seek him out for new deals. His ginger brews had a growing cult following, so he let the business come to him.

However, now that the firm has gone public, Chris Reed is looking to take a more active approach to growing the brew business. He’s seeking out new deals with major supermarkets and other mainstream stores. And you can bet that when he does land his brews in some of the bigger chains, it’s going to have a major impact on the bottom line.

IPOs are typically priced about 18% below their intrinsic values. At least that’s what the market tells us about 24 hours after new issues are priced and begin trading. We’ve all seen it – most of the time when a new offering goes public, its shares shoot through the roof.

Sixteen percent of IPOs don’t jump at all on the first day. REED was pretty much one of those…However, the company has since become a media darling, and the stock has rocketed.

Don’t get scared of the run-up. And don’t anchor yourself to the bygone days of $4 a share.

Hansen started trading over the counter on Nov. 8, 1990, before moving to the Nasdaq. Jones has been trading OTC since 2000 and on the Nasdaq since November 2005. Both provide good bases for comparison for REED.

Don’t be misled into thinking that since these companies have been around for so long that they’re not in an initial growth phase. Beverage companies like these can be making respectable sums and growing furtively without much notice, but when they go public, it’s well and truly “off to the races” time.

Let’s take Hansen. This one ticks off all the boxes for being in initial growth mode, despite its roots being established in the 1930s. Earnings growth is very high: 214% in 2004 and 199% in 2005, to be exact. Capital investment is higher than it has been in previous years. Profit margins, in the 17% range, are much higher than the paltry 3% net margins we saw as recently as 2003. Free cash flow right now is negative, not so much from capital expenditures as from high-dollar acquisitions. Return on equity is high, greater than the stock’s required rate of return. Dividend payout is zilch. All of these factors are stereotypical for an initial-growth-stage company.

Jones Soda – same thing across the board, but the size of this company is much more in line with Reed’s. These two companies make interesting comparisons for Reed’s.

They are clearly the models for our ginger company, and Reed’s should follow along a similar path.

But let’s face it. This is a risky proposition. “Speculative” should be the operative word for Reed’s. It’s a great business with a great portfolio of products, no doubt, but it’s got a little over a million-and-a-half bucks in cash in the company coffers. And at the current rate, it is being burned at about $250,000 each quarter, so there’s not much cushion here, and it’s our biggest risk. That’s about six quarters in cash left, if the company doesn’t accelerate the burn rate. At the end of 2006, Reed’s had $1.4 million in borrowings, and it has the ability to borrow a total of about $2 million under currently negotiated lines.

Assuming additional financing is tapped into and/or cash flow levels surpass our estimates for the next two years, we’ve modeled a consistent turn to profitability by 2009. And our discounted cash flow forecast, as usual, is based on some fairly softball assumptions. First, we’re modeling 15% revenue growth per year – less than half of what Hansen has achieved and 7% less than Jones. We think operating margins long term will trend toward what Hansen has achieved, and we’re also sharing its beta coefficient as a proxy for risk. All of this points to a $10 value for Reed’s today.

The company itself is forecasting 2007 sales to rise 20-40%. Our 15% is a long-term average, so we’ll need several strong early years like this to justify our $10 target. Jones and Hansen prove that it can be done, and the beverage market is clearly moving in Reed’s favor.

Regards,

Greg Guenthner
for The Daily Reckoning
July 12, 2007

P.S. Reed’s trades only a few thousand shares per day. If I wanted to recommend this stock to my Penny Stock Fortunes readers, I could not do so to an audience of thousands without greatly affecting the stock’s pricing.

That said, this won’t be the last time I’ll be writing about bulletin board stocks…but for dealing specific recommendations in this micro-stock universe, I’ve had to seek out another venue. You see, most of the time, the bulletin board stocks we will be writing about will be so illiquid that we could only bring them to a select audience.

In the coming weeks, however, we will be giving some of our loyal readers the chance to join a small, privileged group that will be able to receive regular recommendations of bulletin board and Pink Sheets stocks. However, space will be extremely limited. That’s the only way we can deliver you the best bulletin board stocks no one else can talk about.

If you’re interested in this opportunity, send an e-mail to psfortunes@agorafinancial.com. We’ll be sure to send you all the information you’ll need to sign up as soon as it becomes available. We’ll also make sure you are the offered a special deal once this service is officially announced.