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Every couple of months, the author of this column answers questions from readers who implore, "Hey, Modelman!"
Hey Modelman: A couple of years ago, you wrote an eye-opening column about companies that would leverage RFID technology radio frequency identification. Can you update us on the status of that business now?
In the past two years, RFID technology has broken out of the realm of geeks and freaks and moved into the consumer and retailing mainstream. The term RFID began as a catch-all for tiny chip-based systems that allow companies to give digital signatures to all of the goods passing through their supply chain -- providing the ability to track items as small as a soda can from its birth on a factory floor through sale on a store shelf. In the past two years, however, inventive companies have broadened RFID to include human interactions as well -- opening up fascinating new opportunities to speed up payments and provide fine-tuned permissions at big events.
The original group of 10 companies that I recommended are up 32% as a group since mid-2003, vs. a 17% advance in the
Dow Jones industrials
. The leader has been intellectual property holder
( UNA), up 96%, followed by consumer-products giant
, up 66%, and tiny Toronto-based RFID systems manufacturer
, up 53%.
The coolest new mainstream use of RFID might be in MasterCard's new PayPass debit cards. These cards have a super-thin RFID antenna built into them in addition to the usual magnetic strip. To pay, a cardholder simply taps a PayPass-enabled MasterCard on a special terminal rather than handing the card to a store employee. In a couple of seconds, the cardholder's account info is transmitted through the MasterCard network for verification, clearing and settlement.
PayPass is targeted at low-value transactions at outlets such as fast-food restaurants, convenience stores, parking lots, gas stations and movie theaters where transaction speed is prized. If the payment is for less than $25, the customer does not need to sign a receipt or enter a personal identification number.
PayPass has already been implemented at hundreds of retailers in a broadening pilot program. The tests have included major fast-food franchises as well as at the NFL stadiums of the Seattle Seahawks and Baltimore Ravens, where quick, cashless transactions have slashed concession-stand lines. In a sign that the system is moving into the mass market, MasterCard has begun a magazine advertising campaign touting "tap 'n go" payments.
Because RFID chips are produced in mass quantities at low margin, major semiconductor manufacturers aren't making much on them. However, one new beneficiary that has emerged is
, which has moved away from selling cash registers and successfully embarked on the development and sale of the complex point-of-sale transaction terminals that, in part, make tap-and-go payments possible.
Micros has been on a roll, increasing revenue, earnings and cash flow at a solid 15%-plus clip annually; in the trailing 12 months, the company earned $48 million on $568 million in sales. Shares just cleared their all-time high and look good to go, as they are not overvalued. Consider Micros my new pick in this space.
RFID is also cropping up in mobile phones. Cellular giant
( MOT) has joined forces with MasterCard to field-test phones equipped with "near field communication" systems that will enable the handheld device to act much like a PayPass card for low-value payments.
has pushed a little farther out in front by building RFID antennas into the press-on "skins" of one line of phones. Its Mobile RFID kit enables consumers to "touch and browse" services such as directory assistance; commercial users can install RFID readers in their auto fleet dashboards to allow workers to "touch and record" mileage for expense reimbursement or to time-stamp their travel.
I wouldn't consider Nokia a perfect RFID pure play by any means, but its innovative effort shows how the technology is slowly creeping into the mainstream. Nokia has needed to shake up its surprisingly stodgy lineup of phones, and its move to leverage RFID reveals a willingness to take risks at the margins that is important for large companies. Technically, the stock looks good to $22, which would be a 30% move if it happens.
Hedge Funds and GM Bonds
Hey Modelman: Your article on the hedge funds' role in the erratic trading of General Motors (GM) - Get Report bonds was the best thing I have read on the subject. Concise and explanatory at the same time. I would bet many of the people in the hedge-fund business could learn a lot from reading it.
As it happens, there is still quite a lot I need to learn about it. I received a lot of additional insight from readers who deal with exotic debt instruments, as well as from capital structure research outfit CreditSights. They made me understand the layers of exposure that investors face because of the automakers' bonds, how the growth of hedge funds and the attempt to safeguard iffy positions has led to instability and unexpected consequences, and how the fallout for this whole thing may ultimately hit the major banks and brokerages.
The first thing to grasp is that hedge funds are relative newcomers to the corporate bond world. In the past, they dealt mostly with highly leveraged positions in sovereign debt (like U.S. Treasuries or U.K. gilts), commodities or equities.
But the development of a new range of products, known as collateralized debt obligations -- which bundle corporate debt of various maturities and risks into single instruments -- played into hedge fund managers' interest in securities whose changing relationships could be arbitraged and leveraged to the hilt. In these "correlation trades," managers try to find closely related issues whose value relationships sometimes get out of whack. Then they borrow a lot of money to buy one and sell the other and make money with the relationship's return to normal.
Normally, large funds prefer debt instruments with a lot of liquidity, or trading volume, but as interest rates declined, they had to move into less and less liquid products to find the kind of yields that made their strategies work. CreditSights says that shops that used to focus on investment-grade bonds moved into high-yield bonds; shops that once focused on high-yield moved into distressed debt and leveraged loans; shops focused on distressed debt moved down into private equity; and shops focused on emerging markets, such as Latin America, moved down into more low-grade "local" markets, like Peru. As they did so, they each have moved out of their safety and strong-knowledge zones.
In the case of collateralized debt obligations, you are talking about some pretty complex securities that are cut up into pieces, called tranches, for individual trading and hedging. CreditSights notes that a typical CDO consists of up to 0%-5% equity, 5%-7% "junior mezzanine," or high risk; 7%-10% "mezzanine," or median risk; 10%-13% "senior," or modest risk; and 12%-100% "super senior," or lowest risk.
The more senior tranches get the most cash flow from the underlying bonds and suffer the fewest losses; the more junior or equity tranches get the least cash flows and are thus subject to the greatest losses. The pools of underlying bonds can either be static or fixed through the life of the CDO, or dynamic, which means that new bonds can be substituted for deteriorating ones.
At first, hedge funds mostly bought the equity and junior mezzanine tranches, while insurance companies bought the senior tranches. But the decline in rates led to a compression of yields, pushing each group into the others' turf.
In part as a result, banks began to create single-tranche CDOs that were highly illiquid contracts, essentially, between the fund manager and their brokerage. The risks were all hedged out through the purchase of those credit default swaps I mentioned earlier, which are essentially an insurance policy against the risk that any given tranche would blow up, leaving it worthless. These particular instruments have become so popular that the market for them actually dwarfs the underlying bond market; it's estimated at $6 trillion in the U.S., and an order of magnitude more than that in Europe and Asia.
Now, the trouble with the automakers' bonds was that all these levels of tranches, and the default swaps written as insurance against them, were expected by everyone to work in a particular way, according to mathematical models that have become standard. But when Kirk Kerkorian announced his bid for the nation's largest automaker's equity earlier in the month, and the debt-rating agencies then downgraded the automaker's debt, it led to a ripple effect among all the risk levels that few expected -- and has left many of the credit arbitrage funds, and the bankers that lend to them, at risk of a big blowup.
Now that a month has gone by, it looks like no major funds are going to go under as a result of misbehaved credit arbitrage trading. And last week, several big broker-dealers announced that they did not suffer major losses as counterparties to hedge funds that have been hurt in the trading of automaker bonds. But the situation has made one surprising thing clear: Hedge-fund trading has become a very large part of major brokerages' commission revenue stream, with estimates now ranging into the 25%-plus range.
To the extent that credit arb funds, or big institutions with credit-arb arms, will find themselves trading less this quarter or next while they lick their wounds, estimated revenue will decline. And as a result, many analysts suspect that brokerages such as
Goldman Sachs Group
J.P. Morgan Chase
could suffer a revenue shortfall. Look there for the next level of fallout.
One of my readers, who went by the initials R.B., said: "Don't blame the quants, the hedge funds or even the MBAs on the sell side for arb-ing the rating agencies and insurance companies. No one forced anyone to buy this crud. The CDO market would never have existed in any size had the rating agencies done a better job and had the insurance companies and dumb hedgies who bought all those BBB tranches had any clue what they were buying."
At the time of publication, Markman did not own any shares of the companies mentioned in this column. Please note that due to factors including low market capitalization and/or insufficient public float, we consider Samsys to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Jon Markman, writer of TheStreet.com Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;
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