Boring Portfolio

Boring Portfolio Report
Friday,  November 14, 1997
by Greg Markus (TMFBoring@aol.com)


San Jose, Calif. (Nov. 14, 1997) -- Benchmark stock indexes recovered nicely on Friday. The Boring Portfolio, alas, did not. It fell 1.70%, owing largely to 19% getting lopped off the top of Green Tree Financial (NYSE: GNT).

After the market closed on Thursday, Green Tree issued what might be characterized as a "good news/bad news" statement. The good news was that the company expected fourth-quarter operating earnings to be in the range of $0.84 to $0.94 per share, well ahead of the Street's consensus forecast of $0.81.

"However," the statement continued, "the company plans to make a supplemental non-cash addition to its reserves in the fourth quarter, currently estimated to be $125 million to $150 million on a pre-tax basis."

As indicated in the press release, the one-time charge reflects a reduction in the carrying value of certain parts of Green Tree's loan portfolio. Specifically, Green Tree is seeing higher than anticipated prepayments of manufactured housing (MH) loans made in 1994 and 1995.

The market's reaction to the news was a massive sell-off in Green Tree stock. GNT opened on Friday morning about 20% below where it had closed the day before -- and better than 30% off the stock's recently established all-time high. It ended Friday at $32 3/4, down $7 5/8. Trading volume totaled 7.8 million shares -- about 17-times the activity the stock experiences in a typical day.

Green Tree held a conference call at 11am Eastern time to elaborate upon the press release and to respond to questions from analysts.

Management explained that the MH loan prepayment activity is partly a result of markedly lower interest rates in 1997 as compared to what they were when the loans were made in late 1994 and early 1995. The recent rate drop has prompted many home owners to refinance their loans. The trend was exacerbated by the entry of competitors who have been contacting Green Tree's retail customers and luring some of them away with attractive refinancing offers.

Green Tree's management admits that they were slow in reacting to this targeting of their customer base. They say they've become far more aggressive in retaining customers, however, and that they've recently seen a marked reduction in prepayments as a result.

To understand what all of this means to a Green Tree shareholder, it may make sense to review quickly how Green Tree grows earnings -- because it's those earnings more than anything else that drive the price of the stock in the long run.

Green Tree makes a profit primarily through a continuous process of (1) making loans, (2) bundling the loans together and selling the expected income stream from the bundle to purchasers in the asset-backed securities market (a process known as securitization), (3) reaping a "gain on sale" profit from each securitization, and (4) using the proceeds from the securitizations as the source of capital with which to make new loans, thereby restarting the cycle.

Figuring out what the "expected" income stream will be for a loan portfolio is the tricky part. Fluctuations in rates of default and loan prepayments can affect those expectations significantly. Not surprisingly, holders of Green Tree's asset-backed securities are not particularly pleased by declines in the value of their paper, and Green Tree's ratings in the securities markets could be affected unless the company takes appropriate remedial actions. What Green Tree announced on Thursday is that it has taken such actions.

But what does all this have to do with holders of Green Tree's stock, as opposed to holders of its asset-backed securities?

The answer to that question remains unclear. I have a phone call in to Green Tree seeking clarification, but my provisional conclusion is that the sell-off in the stock is an over-reaction. You'll reach your own conclusions, of course, but here's why I say that.

First, we're talking about a one-time, non-cash accounting charge that relates to a fraction of a fraction of Green Tree's business. MH retail loans are an important but proportionately declining component of Green Tree's total operations. The company also makes loans to commercial MH dealers, it finances a host of other consumer and commercial purchases on everything from pianos to horse trailers, and most importantly it has a rapidly growing home equity and home improvement loan business. Green Tree said that those other business lines are performing according to its models, and that whenever they have departed from the models in the past, the company has added to reserves, as it is doing now.

Moreover, it is only one part of Green Tree's retail MH loans that is experiencing unusual prepayment rates: loans made in late 1994 and early 1995. Those loans make up a bit less than one-fourth of the MH portfolio, according to the company.

Second, Green Tree says they decided to take the large write-down now in order to minimize the possibility of having to make a second adjustment in the foreseeable future. Management said in the conference call that MH loan rates would have to drop more than two full percentage points -- and perhaps as much as 4.5 points -- in order to prompt a change from the newly revised assumptions.

Third, the prevailing low interest-rate environment is not at all an unmitigated negative for Green Tree. It stimulates new loan activity, and it widens the profit spread the company enjoys when it securitizes its loan pool. Also, should interest rates increase later on, that would work to the advantage of prepayment rate assumptions in the revised models, just as the declining rates disadvantaged them right now.

Fourth, Green Tree continues to originate new loans at a fine pace. Continued strength in Green Tree's retail-oriented home equity and home improvement loan operations, its expanding co-branded credit card business line, and its nicely growing office-equipment leasing and finance operation (acquired late last year from Finova) lead management to conclude that 1998 will be a record year. They said they are entirely comfortable with the Street's 1998 earnings projections of around $3.65 per share.

Based on that forecast, the stock today is selling at around 9-times next year's earnings. Nine.

Fine, but what could go wrong?

Well, in light of the Borefolio's recent experiences with ill-starred Oxford Health (Nasdaq: OXHP), one must certainly consider the possibility that rather than this write-down being an idiosyncratic event, it presages a more basic shift in the company's profitability. As one analyst wondered aloud on the call, "Is there a cockroach problem here: when you see one, you know there must be others?"

Green Tree strenuously says otherwise, as detailed above. But you pays your money and you takes your choice.

Second (and not unrelated), it's possible that securities rating companies might decide to trim Green Tree's credit ratings. The result of that would probably be that Green Tree would have to offer fatter returns in order to attract buyers of its asset-backed securities, thereby reducing its profits. As it is, Fitch Investor's Service today issued a press release stating that it had put Green Tree in a temporary "negative" status until it can review financial details with the company. On the conference call, Green Tree said they've already been in touch with credit rating agencies and that the reason the company is taking the actions as described in its press release is to preserve its high ratings.

Third, one could conclude that the ability of competitors to steal away some of Green Tree's retail MH customers indicates that the company faces a more challenging competitive environment going forward and may thus see its impressive rate of growth slow considerably. To that, Green Tree points out that it continues to increase its already hefty share of the MH finance market and that its newer business lines are growing dramatically.

One last consideration: Green Tree's management said that the company has approximately 1.8 million shares left on its 5 million-share buyback authorization and that it has the desire to repurchase shares whenever market conditions make that appropriate. When the stock sank early this spring, Green Tree repurchased 3.2 million shares.

On other matters, I'm pleased to say that I enjoyed a very interesting and informative day at Cisco Systems (Nasdaq: CSCO) Thursday -- attending the shareholders' meeting, chatting with CEO John Chambers briefly, and getting to spend some time learning more about the company from its Director of Investor Relations, Mary Thurber.

My intention is to say much more about that next week. But the Borefolio fell out of a Tree today, and attending to that took precedence.

                  Today's FoolWatch -- all the latest in Fooldom.


TODAY'S NUMBERS
Stock  Change    Bid
CGO   +  3/8   25.44
BGP   -  1/4   27.56
CSL     ---    41.94
CSCO  +1 13/16 81.31
FCH   -  1/4   37.00
GNT   -7 5/8   32.75
ORCL  +1 1/16  34.38
PMSI  -  3/16  12.88
TDW   +2 1/4   64.25
                   Day   Month    Year  History
        BORING   -1.70%  -3.70%  13.08%  30.12%
        S&P:     +1.28%   1.50%  25.33%  49.34%
        NASDAQ:  +1.66%  -0.62%  22.66%  52.13%

    Rec'd   #  Security     In At       Now    Change
  2/28/96  400 Borders Gr    11.26     27.56   144.86%
  8/13/96  200 Carlisle C    26.32     41.94    59.31%
  6/26/96  100 Cisco Syst    53.90     81.31    50.86%
 12/23/96  100 Tidewater     46.52     64.25    38.10%
   3/8/96  400 Prime Medi    10.07     12.88    27.87%
   3/5/97  150 Atlas Air     23.06     25.44    10.32%
   2/2/96  200 Green Tree    30.39     32.75     7.77%
 11/21/96  150 Oracle Cor    32.43     34.38     5.99%
  11/6/97  200 FelCor Sui    37.59     37.00    -1.57%

    Rec'd   #  Security     In At     Value    Change
  2/28/96  400 Borders Gr  4502.49  11025.00  $6522.51
  8/13/96  200 Carlisle C  5264.99   8387.50  $3122.51
  6/26/96  100 Cisco Syst  5389.99   8131.25  $2741.26
 12/23/96  100 Tidewater   4652.49   6425.00  $1772.51
   3/8/96  400 Prime Medi  4027.49   5150.00  $1122.51
   2/2/96  200 Green Tree  6077.49   6550.00   $472.51
   3/5/97  150 Atlas Air   3458.74   3815.63   $356.89
 11/21/96  150 Oracle Cor  4864.99   5156.25   $291.26
  11/6/97  200 FelCor Sui  7518.00   7400.00  -$118.00

                             CASH   $3021.10
                            TOTAL  $65061.73


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