In this blog post, I’ll give my thoughts on industries that will almost certainly see many bankruptcies. In general, the stocks with the most bankruptcy risk have some combination of the following:

A fall in revenues because consumers don’t want to go out in public and possibly die. Some industries will continue to be impacted even after a vaccine is developed (if it is developed). Fixed cost leverage. Some businesses such as restaurants are locked into leases that will cause them to burn a substantial amount of cash. Debt.

These situations may be very difficult to analyze. However, there may be opportunities in the mispricings such as going long restaurant franchises and shorting airlines, E&Ps, and the lowest quality lenders. If an industry such as airlines has high bankruptcy risk, I will also talk about related industries even if they do not have high bankruptcy risk.

Airlines

Current air traffic is roughly 5% of what it once was- see the TSA website for passenger data. Historically, a few airlines went bankrupt following the Sept. 11 terrorist attacks due to a small dip in air traffic. High leverage and low margins are not a good combination. I would expect that the fear factor will be even greater with COVID-19 in the years to follow, causing air traffic to be hit harder than Sept. 11.

Currently, the airlines are trading at high valuations given their bankruptcy risk and future drop in passengers. Presumably, the market expects that they will be bailed out again once their current bailouts run out. Some of the notable features of the current US bailout include:

The airlines have been bribed into flying empty planes around the country. This will employ airline employees and the companies that fix planes. Wear and tear on the planes means that parts will need replacement. The airlines are receiving grants to cover payroll costs. The airlines are basically being paid to lose money. No excise taxes on jet fuel. Loans are on highly favourable terms. The warrants that the airlines issue in conjunction with the loans are mostly cosmetic as the dilution is extremely minimal. The loans are essentially a small amount of free money.

I am shorting the most leveraged airlines because I don’t think that they will make money in the next few years. The high levels of leverage at certain airlines make them fragile and will push some of them near bankruptcy. The American airlines may not go bankrupt if the American government decides to prop them up as zombie companies; I nonetheless expect their share prices to plummet.

Aircraft parts (e.g. Heico)

Because of the massive drop in air traffic due to COVID-19, I would expect demand for replacement parts to plummet. After September 2020, it is not clear if American airlines will continue to be paid to fly empty planes in the sky.

Plane builders (Boeing, Airbus, Rolls Royce)

If I am right about excess capacity in the airline industry going forward, then the airliner business segments of these stocks will see a demand hit.

In the US, the Democrats attempted to give Boeing a subsidy by having the airlines buy new planes. The argument is that new planes are more fuel efficient and therefore better for the environment. However, their plan met political opposition and seems to have failed for now. The AEI, a lobbying group that works with corrupt politicians, provides some arguments against the “cash for clunkers, airplane edition” plan.

*Disclosure: I am short Boeing and I don’t really know what I’m doing.

Cargo planes (CJET.TO, FDX, UPS)

In a normal environment, passenger flights will carry a small amount of cargo (e.g. mail) with the passengers. Because there are very few passenger flights while COVID-19 is raging, there is a mild shortage of cargo capacity. I would expect the situation to reverse dramatically as passenger planes are converted into cargo planes. These conversions regularly occur and a glut of planes will be bad for the cargo plane companies. However, in the meantime, they are enjoying high demand. FDX and UPS are clearly not pure plays on the cargo plane industry so the industry dynamics will not impact their stock much.

Subprime lending to consumers

The lenders don’t actually know how unemployment translates into loan losses. In the Credit Acceptance shareholder letter, the CEO states that the company has very little data on how sharp rises in unemployment affect loan losses- Credit Acceptance only has good data from the 2008/2009 recession. Their experience (profits rose dramatically in 2008 and 2009) likely will not apply to their competitors, many of which saw profitability drop dramatically in ’08/’09. At the end of the day, nobody currently knows how bad the COVID-19 loan losses will be.

Unemployment has shot up by 13.5% so far, which may cause a huge amount of pain for all lenders. In theory, most newly unemployed subprime borrowers will soon default on their loan payments because subprime borrowers rarely have savings. Borrowers can only pay if they get a new job (highly unlikely in a COVID-19 environment), if they borrow money from family/friends/fools, or if they use government loans/grants. If they fall too far behind on their payments, they usually will not catch up and the subprime lender will suffer loan losses. For auto lenders, selling the underlying collateral will reduce the loss severity (how much money is lost on a bad loan). Santander Consumer assumes a loss severity of 55% in normal environments. If there is a huge wave of bad loans at once, then loss severity will be higher if there is an oversupply of repossessed cars hitting the auction market. If unemployment ultimately rises by 20% and it translates to 60% loss severity, then subprime auto lenders may have an unexpected loss of 12% on their loan book. Credit card lenders might experience a loss severity of 95%. However, I really don’t know what the right numbers would be.

For subprime auto lending, most borrowers need their car to get to work. This makes it less likely that they will default on their loan. In the current work-from-home environment, many borrowers do not need their car. If they experience a financial setback such as a funeral, medical bills, divorce, etc. then they may decide to stop paying their auto loan. Because subprime borrowers regularly default on their loans in a normal environment even when they have a job (e.g. a quarter of Santander Consumer’s loans have a deferral, implying a missed payment), the work-from-home factor could affect loan losses in an unprecedented way.

A last factor to consider is that subprime lenders have a tendency to inflict losses upon themselves. In the 2008/2009 recession, unemployment only increased about 5%. 5% multiplied by a loss severity of 55% means that subprime auto lenders should have only lost less than 2.75% on their loan book from unexpected unemployment. However, some lenders such as NICK and CACC did very well in ’08/’09 (CACC grew earnings, NICK remained profitable) while other lenders were hit very hard. This is probably because the marginal subprime lenders became more aggressive in their accounting and engaged in shoddy lending. (This is what NICK is currently doing. Its current losses are slightly understated in my opinion.) In recessions, poor underwriting practices will be revealed since the subprime lender cannot grow their loan book to hide their bad loans. Such losses have nothing to do with the rise in unemployment and existed before the job losses happened. To figure out where the subprime auto lenders are headed, you can make a guess about the effect of unemployment and analyze the level of bad loans being hidden in the loan book.

*Disclosure: Short CPSS, no position in the others.

Subprime lending to businesses

If a company is lending out money at an interest rate higher than 10%, their borrower is almost certainly a distressed business that cannot get cheaper financing elsewhere. Distressed businesses do not do well in recessions and often fail even if there is no recessiong going on.

*Disclosure: Short MRCC. I own PSEC puts.

Subprime mortgage servicing rights (NRZ, OCN/ASPS)

There are multiple ways in which MSRs can lose money:

Foreclosures. The non-agency MSR is designed so that the servicer loses money during a foreclosure and will lose less money if they resolve the foreclosure quickly (or if they modify the loan, if the MSR allows them to do so). If a mortgage is not paid on time, the servicer must make interest-free loans to the MBS investors equal to the missed mortgage payments. These are servicer advances. Once the mortgage is foreclosed upon, the servicer will receive all of their servicing advances back and the mortgage investors will eat a loss. However, the servicer will have to eat the cost of financing the advances. In a normal environment, there are few foreclosures and the mortgage servicer loses very little money on interest-free loans. Politicians changing the rules of the game. If homeowners skip their mortgage payments (politicians are making it easier for borrowers to do this so that borrowers can stay in their homes), the mortgage servicer has to lose money on interest-free loans to the MBS investors. Higher compliance costs. When there are many foreclosures, politicians may protect defaulting homeowners through new laws. This increases the mortgage servicers’ expenses as they must spend money related to complying with new laws. Any of the 40+ regulators. Servicers of subprime mortgage pools were prevented from buying new MSRs, effectively putting these companies into run-off. Ocwen and its servicing peers became melting ice cubes thanks to the NY DFS. Prepayments. When interest rates are low and lending restrictions loose, homeowners will refinance their mortgages. This makes the income stream from MSRs end earlier than they otherwise would.

If COVID-19 leads to many foreclosures or delayed mortgage payments, then mortgage servicers will suffer loses on their MSRs. It is highly unclear if there will be a wave of foreclosures comparable to the subprime housing bubble.

Homebuilders and non-bank mortgage servicers (e.g. COOP)

This article explains the current dilemma: AMERICA’S HOUSING FINANCE SYSTEM IN THE PANDEMIC, PART 3: Q&A ON THE UGLY FIGHT OVER SERVICER ADVANCES

To summarize the article, there is the possibility that non-bank mortgage servicers go bankrupt. This would be terrible for the housing industry because prospective homebuyers would not be able to get a mortgage. The government caused this problem and the government could fix it. However, at the current time, the government has taken a position that would push the non-bank mortgage servicers into bankruptcy or extreme financial distress. (My opinion: I don’t expect the US government to allow the non-bank mortgage servicers to go bankrupt, but I could be wrong.)

As far as housing prices go, massive unemployment would be bad for housing prices in the short term. In the long term, low interest rates should create a very strong housing market (or bubble). Low interest rates will push everyday people into riskier assets such as houses, mortgage REITs (“dividend stocks”), marijuana stocks, Chinese frauds, biotech scams, unicorn startups, tech stocks, etc.

EDIT (4/21/2020): Fannie and Freddie are giving mortgage servicers a break by capping their servicing advances at 4 months.

Mortgage REITs

Many of these publicly-traded vehicles tend to chase yield because their fees depend on attracting the unsophisticated retail investor. Many dividend investors analyze investments entirely on their yield. This tends to push the mortgage REITs into taking on higher-risk mortgage-related assets, although they do own some safer agency-backed securities. In a COVID-19 environment, it seems that most types of mortgages are risky because non-agency residential mortgages will be affected by unemployment while commercial mortgages are affected by tenants going bankrupt (or not paying their rent as a way of dealing with their liquidity issues). All of this is magnified by leverage, which these REITs use to boost their yields.

I haven’t had the time to fully understand the different types of agency mortgages and the different rules between Fannie, Freddie, Ginnie, and non-agency. All of these mortgages have different rules and different types of risks.

Some of the mortgage REITs such as IVR have announced shocking and rapid declines in their book value:

The Company’s book value per diluted common share* is estimated to be in the range of $2.75 to $3.75

The $3.25 midpoint is a 80% drop from IVR’s last reported quarter’s book value of $16.42.

Oil

Less people driving during COVID-19 means that gasoline demand falls, causing oil prices to crash.

Some forms of oil production are inherently high cost- deepwater drilling, offshore drilling, oil sands, enhanced oil recovery, etc. Prior to COVID-19, these stocks were doing poorly as improvements in shale oil technology have been keeping the price of oil down and taking capital spending away from the less efficient ways of producing oil (hurting the demand for offshore drilling rigs). COVID-19 is now accelerating the bankruptcy process for those high-cost producers.

Many of the shale oil companies themselves are high-cost producers as they aren’t as efficient as their peers. For example, some companies borrow at 8%+ and acquire assets through public takeovers where they have to pay a takeover premium. OXY for example took a subprime loan from Warren Buffett. Borrowing expensive money to invest at low rates of return is not a winning combination. COVID-19 is also accelerating the bankruptcy process of these companies.

At the current strip pricing, most of the shale stocks have a negative DCF (discounted cash flow) value. You can refer to my post on how to quickly estimate the DCF of oil and gas assets. If you are highly sophisticated, then you can make more accurate DCF assumptions by pulling well production data from state records and building your own DCF model. You need to make your own type curve assumptions as the oil and gas companies typically use overly optimistic type/decline curve assumptions. (I do not build my own DCF models using well data because I don’t have the time or expertise.) Most of the publicly-traded shale E&Ps are headed to bankruptcy unless oil prices rise or something else saves them (e.g. bailouts). They are basically very expensive call options on the price of oil. If you want to hedge the price of oil, you probably do not want to do it through USO.

USO

In general, USO loses money to roll yield and to traders front running USO’s trading.

Currently, USO trades at a premium to its NAV. You can use the ticker UOI to get a sense of the NAV, although it likely isn’t accurate whenever USO changes the composition of its assets (because it can’t own more than 20% of the open interest on an oil futures contract, the fund has been buying futures contracts for other months). Whenever a fund’s creation mechanism is suspended (USO has filed an 8-K stating this), there is the possibility of an incredible short squeeze in the stock. It could go from $4 to $40. Just like shorting any stock, keep your position sizes small if you are shorting USO.

*Disclosure: I am shorting USO common shares and some oil stocks such as MEG.TO.

Restaurants

Restaurants will likely see a huge amount of pain because fixed cost leverage works against them. For example, if a restaurant has a 6% EBT margin (earnings before tax) and their fixed costs are 24% of revenues, revenues dropping to zero will mean that they have losses that are 4X what their profits were.

In terms of the revenue drop, some restaurants have menus that are suitable for takeout/takeaway business while other restaurants are not so lucky. This will affect whether or not the restaurant sees a moderate revenue drop or zero revenues.

If countries successfully suppress the virus like China, restaurants will still see a large drop in business. China imposes social distancing measures on restaurants so eateries aren’t great places to socialize and eat with your friends. In Hong Kong, some restaurants have chosen not to reopen because they simply can’t generate cash flow from being open. Culture may also play a role. In China, citizens see home-cooked meals as being safer than take-out or sit-down restaurant meals. People in Western countries may not have the same ideas about coronavirus safety so there may be a stronger rebound in take-out and delivery than in China. When citizens stop working from home and go back to the office, there will be a surge in lunchtime business.

Franchise systems

Franchisors may be safer than typical restaurants as they have less fixed cost leverage and they collect royalties on restaurant sales, so it is possible for the franchisor to be cash flow positive while the franchisees suffer terribly. While I could be completely wrong about the franchises being safe and not headed for bankruptcy court, some of their stocks may be underpriced.

Some (e.g. Jim Chanos) argue that franchisers have hidden leverage at the franchisee level. This hides the amount of debt underlying the franchise system.

My take is that many restaurant owners will try to hold onto their business until they have no more money left to lose. If you watch the UK version of Kitchen Nightmares, you will see that most of the restaurant owners in the show make terrible business decisions for weird social posturing reasons; their business is an incredibly expensive social tool. They will plow their life savings in their restaurant and mortgage their home. Some restaurant owners will turn to selling their business because they can’t take the financial pain anymore (and/or because they realize that working 80 hours a week is not the lifestyle that they want). Overall, I expect most franchisees to go to great lengths to hold onto their restaurant so franchisee closings may be lower than what most people expect.

However, some franchise systems do not have great economics. If the restaurant count of the entire system has been declining, it is usually a sign that restaurant owners are running out of money and putting their businesses up for sale. Another sign of bad economics are failed restaurateurs suing the franchisor to scapegoat them. For MTY Food group, somebody put up the websites MTYFoodGroupExposed.com and ColdStoneFranchiseExposed.org; the latter website explicitly states: “A deeper understanding of the Cold Stone Creamery franchise owner experience may save a family member or friend from financial ruin.” COVID-19 will have a bigger impact on the weak franchise systems than the strong ones as the weaker franchises will contain more owners who are close to financial ruin.

MTY Food Group

MTY buys cheap and has accumulated a collection of many second-rate franchise systems. MTY will likely see some portion of its franchisees go bankrupt, though this is far from certain as the government may flood the country with small business loans.

MTY also owns Papa Murphy’s, a concept that somewhat resembles a supermarket and somewhat resembles a restaurant. Customers call in to place their order and pick up an uncooked pizza. Not surprisingly, many people in its American markets are confused as to why this concept exists. You can think of it as a highly customized pizza that will be extremely fresh. Or, you can think of it like a better version of frozen supermarket pizza. Because the chain sells uncooked pizzas just like supermarkets, it should do fine in this COVID-19 environment. However, Papa Murphy’s generates somewhere around $17M+ of cash flow (before taxes and interest) compared to $18M+ in interest payments that MTY must make. MTY may experience some distress as the non-Papa Murphy part of MTY may experience some negative cash flow.

*Disclosure: I am long MTY.TO and I could be engaging in bagholder thinking. Please be careful about my bias. Also, I don’t think it’s that compelling of a long.

Royalties

The Canadian stock exchanges have publicly-traded royalties on the franchises Boston Pizza, A&W, and Pizza Pizza. While the underlying restaurants have fixed cost leverage that could really hurt them, the royalties don’t have fixed costs. The administration costs of these royalty funds are minimal. The royalty funds may have debt that could cause them some trouble however.

Remember to look into the tax implications of owning these vehicles; it is possible that your withholding tax on any future distributions will be high.

*Disclosure: Long Boston Pizza Royalties Income Fund (BPF-UN.TO), which is the riskiest of the three.

Banks

I don’t know enough about this industry to have an informed opinion. I happen to be shorting OZK (via puts), AX, Home Capital Group, and Equitable Bank.

Closing thoughts

In general, short selling is not a good way of making money; I explain that further in this blog post. So while overpriced stocks exist, trying to profit from the mispricings isn’t always that compelling. If you short common stock, you need to keep your position sizing very small (e.g. <=0.5% per position) so that you don’t blow up and your risk management doesn’t inflict losses on your portfolio. Even after you do that, you can still lose money. If you buy put options, you can lose money to the options premium / volatility.

At the same time, I am so incredibly uncomfortable about what’s happening in the world right now. Most investors don’t understand how their expectations of a quick COVID-19 recovery will not materialize, as I explained in my last blog post. I can’t help but argue with other investors by taking the other side of their trades.

Please don’t do anything crazy. I believe that diversification will work really well in the current markets. There are many seemingly-cheap stocks out there and you do not need to take concentrated positions in a single stock or to take on too much sector risk right now. At the same time, you should keep your overall exposure to COVID-19 down as you should avoid excessive “pandemic risk” in your portfolio. I wish you the best.