John Paulson's, the founder of Paulson & Co. (huge subprime bets) started his career as a investment banker and then worked as a risk arbitrager with Gruss Partners. He learned a very important lesson here that I'd like to reiterate: "Watch the downside, the upside will take care of itself". He also wrote a paper titled, "The 'Risk' in Risk Arbitrage", and its a must read! A caveat here is in order, risk arbitrage is very risky and should not be tried at home (as Joel Greenblatt would put it). The BCE buyout deal has been a non-stop soap opera for anyone who's watching. Today it was announced that the deal might be in jeopardy and the stock dropped 40% from around $37 to $24; the buyout price is $42.75/share. Arbitrage spreads in general have been very very wide over the last 3-6 months and for a good reason as deals have imploded left and right. While I am not going to talk specifically about the BCE deal, but will talk about arbitrage at the tail end of the buyout boom (and its common sense!).
But first, all this reminds me of something I read in the 1988 Berkshire Hathaway shareholder letter (which is also a must read for risk arbitrage). In that letter Warren Buffett explains arbitrage and his approach with relevant examples. Here's a synopsis: "To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"
He goes on to explain a couple of transactions and but in the end the thing that I remember is, "Even if we had a lot of cash we probably would do little in arbitrage in 1989. Some extraordinary excesses have developed in the takeover field." He goes on further to talk about how he 'doesn't know' and 'no one knows', "We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders."
And this is the essence of it. Simply, do not engage in arbitrage at the tail end of the buyout boom. The ratio of collapsed deals to total deals has been very high this past year. It usually is when the buyout boom takes a form of its own, and the market values everything at private market valuations, exactly as WB said. It was high in 1988 and it was high in 2007 (read: Blackstone IPO). Michael Price once said that the folks who do risk arbitrage are the same ones that do distressed debt when the cycle turns, and this rings true today when a lot of hedge funds are unloading the risk arbitrage staff and beefing up their distressed debt teams (but just a little too late). If an investor as a rule refuses to participates in risk arbitrage during these times, a lot of pain and suffering can be avoided. When you are picking pennies (or dollars) in front of a road roller you really want to have the odds on your side.
Wednesday, November 26, 2008
Tuesday, November 25, 2008
Stock Idea: CBS Corporation
Although it is a monkey and a dartboard (stockboard?) market right now, you always hope you can beat the market. CBS Corp. (CBS), in my opinion is a safe and extremely cheap investment and if bought at these prices ($6.50/share) will beat the market and then some.
(1) Television - 66% of revenues, 60% of EBIT with 18% op margins;
(2) Radio - 12-14% of revenues, 24% of EBIT with 35% op margins;
(3) Outdoor - 16% of revenues, 14% of EBIT with 18% op margins;
(4) Publishing - 6% of revenues, 3% EBIT with 8% op margins.
CBS right now has a market cap of $4.5B and Long term debt ( 4.625% – 8.875% due 2010 – 2056) is $ 7.1B for a $11.1B in EV. With a TTM EBITDA of $2.9B the company is trading at a EV/EBITDA (ttm) multiple of 3.7x and a dividend yield of 16%. CBS is not a growth story, but a cash flow story and comes close to a Private Equity type investment. The company is a very stable cash generator and has generated, over the years on average around $2.6 billion in operating earnings (FCFF) and after $550 million in debt service around $2B in FCFE (not including growth capex) per year. So for a $4.5 B equity investment CBS is producing around $2 B in cash flow for a yield of 50%! The bull case is trivial, I will present the bear case here and try to refute the arguments.
Sumner Redstone: The CBS shares collapsed over the last few weeks and their collapse was made worse by the fact the company’s chairman and controlling shareholder, 85-year-old Sumner Redstone, was forced by lenders to sell a fifth of his family’s holdings in CBS to meet loan covenants for his holding company (NAI). He controls around 80% of the voting shares and therefore this company cannot be sold, unless he sells. I will not value CBS at a private market valuation. There is a concern that Sumner Redstone will take CBS private, but with margin calls n all, and the current debt refinancing environment, I don't think so! There is also an issue between Sumner Redstone and his daughter Shari Redstone. But really do I care? A part of the bid price today is because of 'forced selling', so this is a case of a broken stock not a broken company. I like I like.
Debt Maturity: $1,585.5 million in long term debt is due June 2010 and another $950 million is due 2011. CBS generates around $400-500 million of FCF every quarter and there are seven quarters left till the June 2010 maturity. With $500 million in cash and potential $2.8 B in FCF they should be more than able to pay the debt. One caveat thou: the dividend will have to be cut! The company is paying around $700 in dividends every year and that will need some cutting going forward (the market has already priced this in). This is all assuming the company cannot refinance at favorable terms in 2010.
Advertising environment: CBS is heavily dependent on advertising and this is supposed to be the worst advertising environment over the last 40 years (and the world is ending). CBS operates in segments that give advertisers the greatest bang for their buck and the stronger companies will advertise more in order to gain market share so net-net the effect would be minimal. These networks are like toll roads, where will the companies go? Even if I assume a 40% cut to the operating earnings (way too rich, management is expecting mid teens decline) the company will produce $1.56 B in FCFF and $1B in FCFE per year, and even this will be good enough to take care of the debt maturity and then some. The management is good, has good incentives to execute and is experienced and they know whats coming and have been and will manage the business accordingly. The loans seem covenant lite and I could not find anything in the 10K.
Pension Liabilities: This is a bummer, CBS has around $1.7 B in unfunded pension liabilities. The point here is that these are not loans and do not have a bullet payment. CBS is assuming a 7% long term return with 5.9% discount rate and has more than 80% of the assets in fixed income securities. I am not saying it does not matter, but this issue existed before the current decline. There is around $200-300 million that CBS will need to contribute to the plan every year, I've looked at the footnote and there is nothing that overly concerns me (esp. looking at the kind of cash flows they are producing).
I am sure there is something else, but net-net CBS is the number 1 rated network, is a strong cash flow generator which has produced strong returns on invested capital. Media companies have traditionally traded for around 10-12x EBITDA, have private market values of around 12-14x and after discounting the control by Sumner Redstone I am comfortable valuing CBS around 9x. In around 3-5 years, at 9x, the EV would be $27 B, and after debt and residual corporate costs (pension, operating liabilities) of around $11B (assuming moderate cash payments over 5 years) gives me an an equity value of around $16B - $18B or $22-25/share. The media sector is trading at very depressed valuations and these companies are cash flow cows. Prem Watsa recently increased his investment in Canwest Global, which is a similar investment but more levered. So in essence, more than the upside the important thing to consider in this type of an investment is what can impair your capital (and the upside will take care of itself)? In CBS's case I found no scenario (or only very low probability scenarios) that that could 'kill my investment'.
Disclosure: Long CBS
(1) Television - 66% of revenues, 60% of EBIT with 18% op margins;
(2) Radio - 12-14% of revenues, 24% of EBIT with 35% op margins;
(3) Outdoor - 16% of revenues, 14% of EBIT with 18% op margins;
(4) Publishing - 6% of revenues, 3% EBIT with 8% op margins.
CBS right now has a market cap of $4.5B and Long term debt ( 4.625% – 8.875% due 2010 – 2056) is $ 7.1B for a $11.1B in EV. With a TTM EBITDA of $2.9B the company is trading at a EV/EBITDA (ttm) multiple of 3.7x and a dividend yield of 16%. CBS is not a growth story, but a cash flow story and comes close to a Private Equity type investment. The company is a very stable cash generator and has generated, over the years on average around $2.6 billion in operating earnings (FCFF) and after $550 million in debt service around $2B in FCFE (not including growth capex) per year. So for a $4.5 B equity investment CBS is producing around $2 B in cash flow for a yield of 50%! The bull case is trivial, I will present the bear case here and try to refute the arguments.
Sumner Redstone: The CBS shares collapsed over the last few weeks and their collapse was made worse by the fact the company’s chairman and controlling shareholder, 85-year-old Sumner Redstone, was forced by lenders to sell a fifth of his family’s holdings in CBS to meet loan covenants for his holding company (NAI). He controls around 80% of the voting shares and therefore this company cannot be sold, unless he sells. I will not value CBS at a private market valuation. There is a concern that Sumner Redstone will take CBS private, but with margin calls n all, and the current debt refinancing environment, I don't think so! There is also an issue between Sumner Redstone and his daughter Shari Redstone. But really do I care? A part of the bid price today is because of 'forced selling', so this is a case of a broken stock not a broken company. I like I like.
Debt Maturity: $1,585.5 million in long term debt is due June 2010 and another $950 million is due 2011. CBS generates around $400-500 million of FCF every quarter and there are seven quarters left till the June 2010 maturity. With $500 million in cash and potential $2.8 B in FCF they should be more than able to pay the debt. One caveat thou: the dividend will have to be cut! The company is paying around $700 in dividends every year and that will need some cutting going forward (the market has already priced this in). This is all assuming the company cannot refinance at favorable terms in 2010.
Advertising environment: CBS is heavily dependent on advertising and this is supposed to be the worst advertising environment over the last 40 years (and the world is ending). CBS operates in segments that give advertisers the greatest bang for their buck and the stronger companies will advertise more in order to gain market share so net-net the effect would be minimal. These networks are like toll roads, where will the companies go? Even if I assume a 40% cut to the operating earnings (way too rich, management is expecting mid teens decline) the company will produce $1.56 B in FCFF and $1B in FCFE per year, and even this will be good enough to take care of the debt maturity and then some. The management is good, has good incentives to execute and is experienced and they know whats coming and have been and will manage the business accordingly. The loans seem covenant lite and I could not find anything in the 10K.
Pension Liabilities: This is a bummer, CBS has around $1.7 B in unfunded pension liabilities. The point here is that these are not loans and do not have a bullet payment. CBS is assuming a 7% long term return with 5.9% discount rate and has more than 80% of the assets in fixed income securities. I am not saying it does not matter, but this issue existed before the current decline. There is around $200-300 million that CBS will need to contribute to the plan every year, I've looked at the footnote and there is nothing that overly concerns me (esp. looking at the kind of cash flows they are producing).
I am sure there is something else, but net-net CBS is the number 1 rated network, is a strong cash flow generator which has produced strong returns on invested capital. Media companies have traditionally traded for around 10-12x EBITDA, have private market values of around 12-14x and after discounting the control by Sumner Redstone I am comfortable valuing CBS around 9x. In around 3-5 years, at 9x, the EV would be $27 B, and after debt and residual corporate costs (pension, operating liabilities) of around $11B (assuming moderate cash payments over 5 years) gives me an an equity value of around $16B - $18B or $22-25/share. The media sector is trading at very depressed valuations and these companies are cash flow cows. Prem Watsa recently increased his investment in Canwest Global, which is a similar investment but more levered. So in essence, more than the upside the important thing to consider in this type of an investment is what can impair your capital (and the upside will take care of itself)? In CBS's case I found no scenario (or only very low probability scenarios) that that could 'kill my investment'.
Disclosure: Long CBS
Monday, November 17, 2008
Bonds: Here's the Glory
There is a lot to be said about these instruments. They are 'safer' than equity no doubt, but do not offer the glory of equity returns (ok I admit that you have to look at more than a 10 year period). Distressed Debt investing however has its own charms, it offers 'lower' risk than equities but equity type returns. Looking at the quarterly filings by some of the gurus, there's one common element: distressed bonds.
I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)
Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.
Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.
In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.
Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.
I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)
Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.
Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.
In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.
Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.
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