This is somewhat of a tricky subject for Value investors. Warren Buffett (WB) doesn't short - for very good reasons. Most of the seasoned value investors that we emulate are long only portfolio managers. Berkshire Hathaway shareholder letters are said to be everything one needs to know in order to make money in the markets but WB lists no rules for shorting. Ben Graham on the other hand pair traded, but WB dint copy that practise because he observed that for every 4-5 'wins' there was a 'loss' which would more or less wipe out the 'wins'. On the other hand, there are many enterprising investors Paulson, Watsa et. all that successfully shorted in the past 2 years and made a killing. Anyone who was long only in the last 2 years has lost money. Anybody who was short anything has made money. This means that the outcome was favorable, but was the decision right? If the decision was right the process must have been right. On the other hand, if the decision was wrong, then 'luck' must have all the credit and not the process. Lets look at this.
Now why doesn't WB short? As Keynes said, "Markets can remain irrational longer than you can remain solvent". WB has said that, Charlie and him had identified a lot of securities which were overvalued and would correct, but could never determine when they will correct. This is the essence of it. When a bunch of long/short hedge fund managers were asked to identify some mistakes - 90% answered that one of their biggest mistakes have been shorts going against them (the thesis was that the security is overvalued). A very good example would be VolksWagen, u'd probably be having nightmares if you were short VolksWagen!
One thing is clear, with the advent of large pools of capital the markets have been and will be a lot more volatile. Long only portfolio managers will probably have to suffer short (or long) periods of under performance. (A) There is nothing wrong with this (B) Volatility is good for the value investor because it creates opportunity. The catch here is that you can take advantage of this opportunity only is you have dry powder. So a lesson here could be that holding some amount of cash is good, you don't have to be 100% invested all the time. A more aggressive lesson could be to find out ways to capitalize on the volatility - to learn from Paulson, Watsa and Ben Graham.
In Security Analysis, Ben Graham says that if a bond is trading for 100 and its callable at 102, it would be a mistake to go long at 100 as the downside is way more than the upside (opposite of what a value investor wants). Well, but what about shorting the bond at 100? The downside now is $2 plus the interest and the upside is $100 (the bond was trading in the mid 60's a few months later). If the whole idea here is to make 'bets' with heads I win and tails I don't loose that much, then this makes sense. Today credit default swaps (CDS) are available which isolate the credit risk in the bond which is exactly what we are interested in. In a lot of these cases the downside to these instruments for a lot of companies in early 2007 was very little and the upside much much greater. It is a neat way to bet against a company or a sector, given that the CDS's are cheaply priced. Anybody thinking should study Paulson, Watsa and Ackman and their trades over the years.
Another possible solution here is LEAPS. Having determined that shorting a stock is a bad idea, a PUT might be useful in achieving the desired trade. This however reminds me of the guy who bought PUTs on Yahoo! in 1999 just to have them expire one month before the 2000 crash. In addition, yours truly shorted Countrywide Financial (CFC) in 2007 when it was at $35 using PUTs just to sell at a loss (around $38) on rumors that Bank of America will acquire them at around $45. But if one is convinced that a particular stock is a good short, a put strategy can be devised whereby the person starts with the small position and increase the 'bet' if the stock goes higher, use the increasing weight of bets to your favor - Kelly formula. These are also, heads I win and tails I don't loose that much investments, albeit if done properly.
In my opinion, shorting should be done very selectively and when the odds are greatly in your favor. Yes, same applies to going long, so maybe super selective is the right word. Another takeaway here could thinking about shorting stocks vs. shorting sectors (wherever your circle of competence falls). Having said all this, I am a novice when it comes to shorting and what is involved is another post. This post was meant to argue that shorting is within the value investing framework.
Friday, February 13, 2009
Thursday, January 1, 2009
Stock Analysis: Domtar (UFS)
Domtar (UFS: $1.70) is a manufacturer and marketer of uncoated freesheet paper in North America. The Company also manufactures papergrade, fluff and specialty pulp. This is not to be confused with newsprint where the demand is steadily declining and there seems to be no light at the end of the tunnel. Uncoated freesheet is the paper that you and I use in our printers, envelopes and books. Look around you and you will see a lot of it lying around, we will always need it! use it! Do you remember how much it cost you the last time you purchased a stack? How many times have we heard the phrase, "blah is not worth the paper it is written on"? It is definitely an expense for corporate America but one that does not hold much weight in terms of cost; it will probably be the last thing that is cut from corporate and household budgets alike.
Industry:
Demand is decreasing because of the digitization of everything. We don't need as much paper anymore - we use the internet, use kindle/iphone to read e-books, advertisers/retailers are not demanding much paper for pamphlets/catalogs. The demand has been declining at a 2-3% rate since 2000, I expect the demand to be flat to slightly positive going forward. The good thing is the industry saw this coming - they consolidated! Domtar is the largest producer of Uncoated Freesheet Paper inNorth America with market share of 34%; while International Paper has 26%, Boise Cascade has 9%, Georgia Pacific has 7% and Glatfleter has 4% market share. The top 5 companies control more than 80% of the market and that means a lot of pricing power.
Uncoated Freesheet paper is a commodity market. In a commodity market where price determines market share, it is important to be the low cost producer - Domtar is! The price setting mechanism at the margin is the cost of production of the highest cost producer. The paper industry is one of the most capital intensive industries in the US. As a comparison, per dollar of output, it takes twice as much investment in PP&E to produce paper as it does cars. In addition, manufacturers have to deal with strict environmental and health safety issues. Aldabra (a blank check company for UFS) notes that there hasn't been a new mill built in the last 12 years. Aldabra estimates that it is paying about $1.625 billion to purchase manufacturing assets that would cost in excess of $4 billion to build new. In other words, returns on capital for new capacity are so low that it's economically impossible to build new capacity. These costs create high barriers to entry making it unlikely that new players will emerge. In essence the view is this:
(1) New competitors will not come in as there are high barriers to entry
(2) The industry has consolidated and collusion can take place in terms of price increases
(3) Yes, demand is declining but prices can be passed to the customers (the view is that this is akin to the tobacco industry where they initiated price increases to combat declining demand - keeping the top line fairly constant)
Company Valuation:
Domtar has a market capitalization of $870 million and EV of $2.8 billion for a ttm EV/EBITDA of 3.5x. Domtar is producing around $800 million in EBITDA/year, which I will assume as fairly constant as the lack of demand in the short term will be taken care of by the savings from the synergies from the merger (yes synergies are real here!). Domtar's capex is around 30% of the D&A expense and it has been aggressively paying down debt (does not have immediate maturities) from the cash flow generated. We can value Domtar anywhere between 6-8x EBITDA conservatively and at those valuations I get around $5.20/share - $8.26/share.
I also did a DCF on this and without posting my model here - assuming no growth, capex equal to 30% of D&A and a 10% WACC I get around $7-8/share. Domtar also has some NOL's (from years of losses) which I will not bring into the equation to be conservative. What I guess I am trying to say here is that Domtar is grossly undervalued and it is obvious! It can be an absolute home run if the competitors keep behaving rationally - keep demand and supply in check and Domtar keeps paying down debt.
But I am not buying and here's why:
(1) A major major assumption is that the competitors will behave rationally and keep demand and supply in check. It has been happening, but will it keep happening? Game theory says otherwise!
(2) They only have pricing power to a point. According to some experts, it costs about 10%-20% more to import uncoated freesheet paper than to manufacture it domestically. So firms have room to raise prices but not by much - eventually imports will start kicking in!! The only thing that is keeping the industry profitable is consolidation. If there is excess supply, they will again be led back to their old unprofitable ways. Also in a soft market if the suppliers hold the line, firms from Asia or Latin America who themselves might be facing economic headwinds might 'dump' their paper in the NA market.
(3) Abitibi-BoWater is marketing a new kind of paper made from mechanical pulp. They also commissioned a study which found that this paper has a lower environmental impact than the paper from traditional chemical pulp.
(4) This is a company (and industry) that has huge operating leverage and in a scenario where soft demand persists the fixed costs will eat into any profits they might make. Although Domtar is a low cost producer and the price is essentially set by the high cost producers; the price of uncoated freesheet paper has to be around $ 500-$550 (it is at around $1000 right now) for them to break even.
In essence, I don't see what the team at Baupost is seeing. They have a 7.9% position in Domtar and are one of the biggest shareholders so they must be really convinced? Does anyone else see things differently?
Disclosure: No Position
Industry:
Demand is decreasing because of the digitization of everything. We don't need as much paper anymore - we use the internet, use kindle/iphone to read e-books, advertisers/retailers are not demanding much paper for pamphlets/catalogs. The demand has been declining at a 2-3% rate since 2000, I expect the demand to be flat to slightly positive going forward. The good thing is the industry saw this coming - they consolidated! Domtar is the largest producer of Uncoated Freesheet Paper in
Uncoated Freesheet paper is a commodity market. In a commodity market where price determines market share, it is important to be the low cost producer - Domtar is! The price setting mechanism at the margin is the cost of production of the highest cost producer. The paper industry is one of the most capital intensive industries in the US. As a comparison, per dollar of output, it takes twice as much investment in PP&E to produce paper as it does cars. In addition, manufacturers have to deal with strict environmental and health safety issues. Aldabra (a blank check company for UFS) notes that there hasn't been a new mill built in the last 12 years. Aldabra estimates that it is paying about $1.625 billion to purchase manufacturing assets that would cost in excess of $4 billion to build new. In other words, returns on capital for new capacity are so low that it's economically impossible to build new capacity. These costs create high barriers to entry making it unlikely that new players will emerge. In essence the view is this:
(1) New competitors will not come in as there are high barriers to entry
(2) The industry has consolidated and collusion can take place in terms of price increases
(3) Yes, demand is declining but prices can be passed to the customers (the view is that this is akin to the tobacco industry where they initiated price increases to combat declining demand - keeping the top line fairly constant)
Company Valuation:
Domtar has a market capitalization of $870 million and EV of $2.8 billion for a ttm EV/EBITDA of 3.5x. Domtar is producing around $800 million in EBITDA/year, which I will assume as fairly constant as the lack of demand in the short term will be taken care of by the savings from the synergies from the merger (yes synergies are real here!). Domtar's capex is around 30% of the D&A expense and it has been aggressively paying down debt (does not have immediate maturities) from the cash flow generated. We can value Domtar anywhere between 6-8x EBITDA conservatively and at those valuations I get around $5.20/share - $8.26/share.
I also did a DCF on this and without posting my model here - assuming no growth, capex equal to 30% of D&A and a 10% WACC I get around $7-8/share. Domtar also has some NOL's (from years of losses) which I will not bring into the equation to be conservative. What I guess I am trying to say here is that Domtar is grossly undervalued and it is obvious! It can be an absolute home run if the competitors keep behaving rationally - keep demand and supply in check and Domtar keeps paying down debt.
But I am not buying and here's why:
(1) A major major assumption is that the competitors will behave rationally and keep demand and supply in check. It has been happening, but will it keep happening? Game theory says otherwise!
(2) They only have pricing power to a point. According to some experts, it costs about 10%-20% more to import uncoated freesheet paper than to manufacture it domestically. So firms have room to raise prices but not by much - eventually imports will start kicking in!! The only thing that is keeping the industry profitable is consolidation. If there is excess supply, they will again be led back to their old unprofitable ways. Also in a soft market if the suppliers hold the line, firms from Asia or Latin America who themselves might be facing economic headwinds might 'dump' their paper in the NA market.
(3) Abitibi-BoWater is marketing a new kind of paper made from mechanical pulp. They also commissioned a study which found that this paper has a lower environmental impact than the paper from traditional chemical pulp.
(4) This is a company (and industry) that has huge operating leverage and in a scenario where soft demand persists the fixed costs will eat into any profits they might make. Although Domtar is a low cost producer and the price is essentially set by the high cost producers; the price of uncoated freesheet paper has to be around $ 500-$550 (it is at around $1000 right now) for them to break even.
In essence, I don't see what the team at Baupost is seeing. They have a 7.9% position in Domtar and are one of the biggest shareholders so they must be really convinced? Does anyone else see things differently?
Disclosure: No Position
Wednesday, December 10, 2008
Seth Klarman's Inflation hedge
People far and near have wondered what Seth Klarman's inflation hedge is! In a Columbia Business School conference he said (along with other nibbles n bits), "We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges."
Only a part of his portfolio is disclosed publicly, a lot of his portfolio consists of distressed debt and derivatives which do not have to be disclosed. But from what he has disclosed I think I might have an answer! The popular view is that there will be some deflation, followed by massive inflation (the printing press is in overdrive). Now to be clear, I have no idea what the macro situation would be tomorrow or in 3-5 years (too many variables!), I am just making a humble attempt - trying to analyze his comment.
Energy MLP's, I think is the answer. He owns Linn Energy (LINE), Breitburn Energy (BBEP) and Atlas Pipeline Partners (APL). Why? I will explain the picks later, but the short answer is this: These MLP's have yields of around 20-50% right now and their oil production is hedged 5 years forward at oil prices of around $80/bbl and gas prices of around $8.50/mcf. This means the yield is 'safe' (if its really safe can only be determined by extensive DD) and that if we have any amount of deflation, the yield will more than make up for it. Now in 3-5 years if we have inflation the USD will probably depreciate and oil - priced in USD (and perhaps gold and other commodities) will appreciate as we saw in the last few years. The MLP's will again be able to lock in high oil prices and might increase in value. Again, this is a cheap inflation hedge, not a core strategy! There is a difference. Cheap inflation hedge means that if things don't work out as you expected you will loose, albeit less - the MLP's have a payback period of around 3-5 years because of the yield.
There is a lot of information on MLP's out there, not a lot with investors thou (they've been busy with the crisis). The MLP structure requires a steady and dependable revenue stream. For this reason, MLPs have traditionally been oil and gas pipeline companies. However, in recent years, a number of upstream oil and gas producing MLPs have come to market. These companies use extensive hedging to assure a steady revenue stream from an otherwise unpredictable commodity market. They are income vehicles which avoid both federal and state corporate income taxes by passing through expenses and income to the investor (Canadian energy trusts anyone?). To be sure, these are business and should be analyzed as such, the management, capital structure, finding costs, risks etc. should be thoroughly analyzed. I looked at LINE and BBEP and they looked decent (I have not done extensive DD), Leon Cooperman of Omega Advisors has been pumping the Atlas series of MLPs for a while. During 'normal' times they have yields of around 8-15%.
An interesting factor here (an one that value investors love) is that Lehman Brothers was big in MLPs (As of June, Lehman Brothers Asset Management owned $1.1 billion of MLP equities). So when it went under there was massive selling pressure on these vehicles! To be sure, many small oil and gas MLPs also used Lehman as the counterparty to their oil and natural gas hedges. In addition, Lehman provided lines of credit to some of these companies. But net-net this was a case of broken stocks and not broken companies (LINE terminated the contracts before Lehman bankruptcy) and therefore these MLPs are priced at a discount of around 30% to where Seth Klarman bought. Again, there is a lot of information on MLPs on the internet and if someone thinks they fit their portfolio, please do your due diligence before buying.
Only a part of his portfolio is disclosed publicly, a lot of his portfolio consists of distressed debt and derivatives which do not have to be disclosed. But from what he has disclosed I think I might have an answer! The popular view is that there will be some deflation, followed by massive inflation (the printing press is in overdrive). Now to be clear, I have no idea what the macro situation would be tomorrow or in 3-5 years (too many variables!), I am just making a humble attempt - trying to analyze his comment.
Energy MLP's, I think is the answer. He owns Linn Energy (LINE), Breitburn Energy (BBEP) and Atlas Pipeline Partners (APL). Why? I will explain the picks later, but the short answer is this: These MLP's have yields of around 20-50% right now and their oil production is hedged 5 years forward at oil prices of around $80/bbl and gas prices of around $8.50/mcf. This means the yield is 'safe' (if its really safe can only be determined by extensive DD) and that if we have any amount of deflation, the yield will more than make up for it. Now in 3-5 years if we have inflation the USD will probably depreciate and oil - priced in USD (and perhaps gold and other commodities) will appreciate as we saw in the last few years. The MLP's will again be able to lock in high oil prices and might increase in value. Again, this is a cheap inflation hedge, not a core strategy! There is a difference. Cheap inflation hedge means that if things don't work out as you expected you will loose, albeit less - the MLP's have a payback period of around 3-5 years because of the yield.
There is a lot of information on MLP's out there, not a lot with investors thou (they've been busy with the crisis). The MLP structure requires a steady and dependable revenue stream. For this reason, MLPs have traditionally been oil and gas pipeline companies. However, in recent years, a number of upstream oil and gas producing MLPs have come to market. These companies use extensive hedging to assure a steady revenue stream from an otherwise unpredictable commodity market. They are income vehicles which avoid both federal and state corporate income taxes by passing through expenses and income to the investor (Canadian energy trusts anyone?). To be sure, these are business and should be analyzed as such, the management, capital structure, finding costs, risks etc. should be thoroughly analyzed. I looked at LINE and BBEP and they looked decent (I have not done extensive DD), Leon Cooperman of Omega Advisors has been pumping the Atlas series of MLPs for a while. During 'normal' times they have yields of around 8-15%.
An interesting factor here (an one that value investors love) is that Lehman Brothers was big in MLPs (As of June, Lehman Brothers Asset Management owned $1.1 billion of MLP equities). So when it went under there was massive selling pressure on these vehicles! To be sure, many small oil and gas MLPs also used Lehman as the counterparty to their oil and natural gas hedges. In addition, Lehman provided lines of credit to some of these companies. But net-net this was a case of broken stocks and not broken companies (LINE terminated the contracts before Lehman bankruptcy) and therefore these MLPs are priced at a discount of around 30% to where Seth Klarman bought. Again, there is a lot of information on MLPs on the internet and if someone thinks they fit their portfolio, please do your due diligence before buying.
Friday, December 5, 2008
What were the signs?
I have read about a few booms and bust, but this is my first bust in real time (and what a bust it is). Now going back to my notes, I see a few things coming back. what were the signs? Now I am not saying that I could see all these signs, but the next time I see something similar brewing, I'll know what will follow!
Exhibit A: Housing
This has been talked about in depth, everyone and their dog know now what exactly took place here. But looking back 2-3 years, some of the signs could be: anyone with a pulse getting a loan, 20 year old realtors, 2-4 shows on TV dedicated to flipping houses, flipping houses a 'sure' thing for making money to name a few. Going back to Charlie Mungers's power of incentives, if one just analyzed the incentives in the housing securitization chain, the fallout becomes really easy to predict. No one, and I mean no one had an incentive to keep the quality of the mortgages sane, everyone was concerned about volume (and that is obviously not good!).
Exhibit B: Private equity
Endowment and Pension funds are funny creatures. They employ the best of the best, manage insane amount of capital and serially fall prey to 'glamour' investments. In the late 1970's they lobbied to change the regulations so that they could hold more gold; this time it was Private Equity that took them down. Endowment and pension funds couldn't get enough of their cash in PE funds. Now consider the recent dumping of PE stakes by investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion. Interests in funds managed by KKR, Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent. Now ain't that smart! In addition, when in any field things get large, the likes of which have never been seen before you know that an access is developing. In PE's case the buyouts became larger and larger. In the late 1980's it was RJR Nabisco deal by KKR that signaled the end in that era, and this time it was BCE - the Canadian telecommunications giant that was to be taken over for $52 billion. Furthermore, they say that when you cant determine who the sucker on the table is, it is usually you. This was the case with the various Private Equity/Hedge Fund IPO's. When Stephen Schwartzman is selling, buying would be a bad idea! This was in my opinion the most obvious sign that the party is coming to an end.
Exhibit C: Risk..What Risk?
Yes, unfortunately that was what the world had come to believe. This was not just true this time, but every time people are feeling joyous. The spread between the treasuries and the junk bonds becomes smaller and smaller, the covenants become looser (pik toggles anyone) and investors just need yield, any yield as long as it higher than the treasuries (and they don't care how much more risk they are taking!).
Exhibit D: Net-Nets
Now method this is proprietary I must say, and is one that roughly works. One just needs to look at the number of net-nets available in the market and its as simple as that. You don't have to buy them, but as a rule when there are a few (or no) net-nets available in the market, you know some excesses have developed and its time to be cautious.
Now I can't (and no one can) tell you exactly when the kindgom will come, or what the catalyst would be, and none of the things mentioned above is precise but I rather be roughly right and be cautious than be precisely wrong and do nothing (or short it all).
Wednesday, November 26, 2008
BCE: Risky Arbitrage
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.
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.
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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