my Value Idea

When the Risk/ Reward Proposition Changes

noreply@blogger.com (Sami) — Wed, 22 Sep 2010 23:19:00 +0000

Price is what makes an investment attractive or not. Price changes the risk reward proposition of any business even good ones. As such there is few issues that have to exist my portfolio: Dr. Pepper and some credit instruments.

I am going to sell some of the preferred issues that I bought during 2008 and early 2009. The risk reward proposition has changed significantly. I have discussed how investors are becoming yield pigs and I want to exist before the party is over. The low yield environment is forcing some instruments to trade higher artificially. Some of the credit issues like junk bonds, bank loans and preferred shares made sense in late 2008 and early 2009 but now it is

Here is an example of an issue I bought in November 2008, Brookfield Asset Management (BAM) issue BAM-O. I have bought additional issues from Brookfield as well like a yield floater, detailed here. The O issue gave me an IRR of 36% when I bought it, now it is yielding 2.5% to 6%, depending on the redemption or conversion of the issue. This issue trades at fair value now, if you consider the IRR to be the equivalent of YTM, then a BBB issuer like BAM is trading around the 6% mark. if I hold to maturity the upside is an expected rate of return of 4%, the downside is significantly more than that. I would never buy this issue now given its price so it is time to exist.

I am existing also most of my bonds positions however I am keeping a couple of floater preferred shares because they should do well in rising interest rate environment, given that there is no market surprise.

I sold Dr. Pepper (DPS ) as well for the same reason: risk reward profile changed. DPS is a spin off investment that was loathed by the market: too much debt, weak earnings and declining US carbonated volume sales. However, the reduced expectation and the strong brand portfolio made it a good investment. Now it is a good business but not a good investment. DPS has managed to drive efficiencies to its distribution and supply chain network, promote brands and gain market share, reduce debt and increase cash flows and dividends. The turnaround in operations made it a good business and share price followed. The risk reward profile changed. DPS is not fully valued at this point I reckon $40 is the mark but from where I sold it at $ 36 the upside potential is not significant to justify risk losing if they had a bad quarter.

Merger Arbitrage : TRBN/ EBS

noreply@blogger.com (Sami) — Sat, 11 Sep 2010 17:10:00 +0000

I usually do not get interested in risk arbitrage situation unless there is the potential to earn out-sized absolute return. Most risk arbitrage offer around 15-20% annualized returns, and actually less on large deals. However this one offers great odds for the price of participation.

The idea is not mine it was emailed to me from a reader so hat tip to G&B.

Emergent BioSolutions (EBS) is acquiring Trubion Pharmaceuticals (TRBN) in a deal valued at up to $135.5 million. Emergent will pay $96.8 million, or $4.55 per share in cash and stock, upfront for the company and issue milestone-based Contingent Value Rights (CVR) worth up to $38.7 million more. Milestones are based on mid- and late stage clinical trials of TRU-016 for the treatment of chronic lymphocytic leukemia and non-Hodgkin’s lymphoma, which is partnered with Abbott (ABT).

The math is simple for this merger arbitrage: there are no returns from the merger cash and stock consideration. However you will get the CVR for free at current prices, well close to it for 2 cents. SO effectively you have a cost free shot at earning $1.9 over the next 36 months. You can’t get better odds than these.

When the deal was announced the implied value of the CVR was 27 cents. However now it is 2 cents. See the progression of the implied value in the table below.

Risks

Will the merger close:

financing issues: cash consideration for the financing is $27 million only, while TRBN has cash and short term investment of $45 million on its balance sheet as of June 30, 2010. So EBS is actually getting paid to take the company to ensure its going concern.
TRBN shareholder’s vote. Management own is 5% of the company and I think there is abig likelihood that shareholders will vote yes for the deal
regulatory approval: already cleared.

Will the CVR pay out?

Pfizer potential for cancellation of their clinical studies as they have cancelled a program before merger announcement in July. The amount at risk is $12million. Pfizer decided to pare the dumped drug, TRU-015, comes as Trubion released trial results showing a higher than usual placebo response in a mid-stage trial, or not so exciting results. Pfizer picked up rights to both drugs as part of its 2009 acquisition of Wyeth. It is possible that Pfizer is paring rationalizing its R&D spending so some of these clinical studies will be canned.

Even a 5% probability of CVR payout will ensure to earn four times your invested capital. I was in at 3 cents CVR implied value.

GLOI: Special Situations

noreply@blogger.com (Sami) — Tue, 24 Aug 2010 17:13:00 +0000

This is a liquidation opportunity I have been following since they announce intention to sell their operating businesses. To see an overview of the opportunity, and to avoid repeating the deals, please see this post. What I will try to do here is to assess the liquidation value and answer if there is enough margin of safety to be considered a sound investment.

Valuation
Issues to consider:

Dilution Issues: Management (CEO and CFO) will have 516,000 shares vested and granted under their long term compensation plans due to change of control. This will dilute my ownership by 3.5%. I reckon there is no potential for other dilution issues going forward.
Taxes: As it stands right now there is tax issues as most sales occurred below book value. It will depend on the earn-outs amount but I think the taxes will be non issue.
Management Payments: There is $3,381,000 to be paid CEO and CFO for change of control clauses, bonus, and Rabbi trust in their employment agreement.
Real Estate leases: The company HQ is leased on month to month basis and will not pose any significant costs during the liquidation period.
Burn rate: I estimate that the company to have a burn rate of 2000,000 by next year end between the following components:
CEO/ CFO salaries: $955,000 (including bonus to CFO)
HQ lease: : $225,000
Legal fees : $200,000 (this separate from transaction fees as I netted those against the sales proceeds)
Other: $600,000
in the worst case scenario I will assume the burn rate will double to $4,000,000.
The holding company will be be liable for the credit line, which as of June 30, 2010 was $4.1 Million. This is offset by cash on hand of $3.8 million. Please note that in June 30 statements they have already closed on Rosetti transaction so there is $2.9 million that has already received that need to be netted out.

The following is a listing of what amounts that will flow to GLOI from the all transactions:

Please note that earn out could be higher but I based it on rolling unit revenue over the last 4 quarters.

So if we put together all items above with the best and low case estimates I can have the following potential values of liquidation:

All these buyouts are management lead buyouts. that signifies to me that the business is good and the potential of the earn outs to materialize is solid.

Risks

What I did not did not require any special insight or knowledge to unearth the potential. So what does the upside exist? I think the market is not discounting all the potential earn-outs. Current market value of the company is equal to the current distribution. Also I think the company is too small to be on any-one's radar.
CEO and CFO share sale, why? The timing of the sale came before the Bode transaction announcement. However transactions do not materialize over night. so why did management sell if the potential to earn higher value for their share down the road? I tried to research as much as possible but could not get anything. the only thing left is to get in the mind of the CEO and CFO.
There is no word on liquidation and how? so if management have a change of heart and decides to buy another business, then the thesis is over.
WC adjustments that may go against the company.

Conclusion:
A 15 months opportunity that offers a good margin of safety. I estimate that if all earnouts are not received then you will receive 10-13% return. If some earn out materialize then the potential to earn north of 20% is an outcome with high probability.

Yield Pigs

noreply@blogger.com (Sami) — Sat, 14 Aug 2010 13:19:00 +0000

Several blogs, here, here and here, talked about the “insanity” of the bond markets. I tend to agree with the analysis. However what I am noticing is the other dimension of the insanity in the credit market is the rally in government bonds at the same time as junk and corporate bonds.

In the recovery from the March lows last year, the long term yield t-bill went up, prices went down, as money shifted from safe and liquid treasuries to other credits as they were priced attractively. Several credit classes rallied; corporate debt, junk and municipal bonds. The inverse relationship between treasuries and risky asset classes work 9 out 10 times. However, there is something amiss here.

Treasuries are rallying but at the same time so is credit. Most funds are being crowded out from some of the deals hitting the market. Spreads are coming down yet 10 yr treasuries are yielding under 2.8%. Everyone is a yield pig today ( see post about Klarman).

Moreover if I look at the retail investor instruments such as Closed End Funds (CEF), I find huge premiums for high distribution CEFs. High yielding CEF are trading at large premiums, sometimes reaching 40 and 50%. I put the premium along with distribution yield and got the chart below. It shows a clear relationship between yield and the premium. Investors are bidding up funds with large yields.

Actually anything with yields have rallied. The Wallstreet Journal has a story about investor appetite for Master Limited Partnership (MLP) for their out-sized yield.

I usually will bet with those buying government bonds. Government bond market is the largest and the most sophisticated in any asset class. Usually the message sent by the government yield trumps all other. However it may be different this time.

The Globe & Mail reports” ...the government bond market has been flooded by retail investors seeking what they consider a safer harbour than stocks for their investment dollars. U.S. bond funds have posted net inflows for 72 of the past 73 weeks. according to data compiled by EPFR Global of Cambridge, Mass. The bulk of that money has been earmarked for government issues, including municipal debt.”

The rally in US treasuries are perplexing given the fiscal and monetary policies of the US. Spending and loose monetary policies over extended period of time should push yields higher. The US treasury is indicating that there are no policy issues to worry about, while clearly there are many structural issues that should push yields higher, not limited to:

Social Security obligations
Health care obligations
Public Pension future obligation
State and municipal deficits and debt

The article brings an interesting conclusion: “....Baby boomers have lived through two 50 per cent market crashes and they are just leaving [equities]” in the mistaken belief they can do better in bonds.”

Opportunity in oil spill

noreply@blogger.com (Sami) — Tue, 08 Jun 2010 17:50:00 +0000

There has been a lot of talk of the opportunity in the energy sector as a result in the sell off of the Gulf of Mexico (GOM) producers, drillers, platform operators...etc. Most of these names have been halved in price; BP is offering 10% dividend yield, which is an amazing return by itself.

The question presenting itself, is the disaster an opportunity for stock pickers? Some think it is.

The disaster is a game changer. No one can argue that in a couple of years, and into the distant future, GOM operators will operate in the same manner as they did few years back. I do not think so. Costs are going to go up materially.

Insurance, security bonds, royalties, clean up funds, taxes...etc will be on the rise as a result of this disaster. Some suggest that platform operators like SeaHawk (HAWK), which I reviewed their spin-off and did not like, is a good value proposition as it is selling below liquidating value. However it was selling below liquidation value a year ago as well.

I think the smaller the player the more disadvantaged operationally and financially in the new and expected environment. Weak balance sheets will find it harder probably to comply with bond and clean up funds requirements and will be forced out by the bigger players, who ironically caused the disaster in the first place.

If I wanted to buy, I like McDermott International (MDR), which will spin off it is off-shore construction and management business. The company operates three businesses:

off shore drilling project management,
government operation: nuclear submarine building, and
fossil fuel power construction

MDR will operate the off shore construction business and the spin-off will own the other two.

My idea is to buy on the spin off date MDR as it will be more than likely added to the several energy sector ETF and mutual funds. Those funds did not own it due to the complexities of the other two units and was not pure play energy equity.

MDR will be less complicated than the other unit from accounting, regulation and business is easier to understand,
growth potential in offshore drilling around the world; its Arabian Gulf operations is growing at a fast clip and will offset any weakness from GOM operations,
demand from energy index and sector ETFs as the company will become pure play energy service company. MDR is held in mid cap portfolios but not in sector specific ETF like energy funds; ishares Energy Service, Holders (OIH)...etc. Will the spinoff induce sector specific funds to buy the oil and gas segment to be part of energy ETF/ funds? A very high possibility.
The backlog of the company alone should provide good support for earnings growth.

To capitalize on the energy sell off, I will require more odds in my favour and I think MDR might do it.

CF Industries : The Perils of overpaying

noreply@blogger.com (Sami) — Tue, 11 May 2010 15:04:00 +0000

I have detailed my thoughts on the Fertilizer buyout dance and how CF in its bid to stay independent overpaid. I expected the market to punish the company but the dramatic decline of CF stock exceeded my expectation. True the whole Ag space is under pressure but CF is down more than 30% compared to AGU, 12%.

This was easy short. Most of the time mergers destroy value but to overpay in such reckless fashion is a whole other story.

Value Idea: CCE implied spin off

noreply@blogger.com (Sami) — Tue, 11 May 2010 00:10:00 +0000

A kind of a spin off in the works as a result of the buyout of Coke (KO) of it North American bottlers. The result of the transaction will be an independent bottler in Europe as KO will buy the NA division of CCE.

The transaction is very interesting. One thing is the transaction is not done growth. KO is buying NA bottling operation actually to limit competition in its distribution channel. The NA market is very mature and the competition is killing pricing and profitability in the system. That is why Pepsi and Coke have forked out billion to re-consolidate their own companies again. So the company being left behind is left alone not for economic issues. Actually CCE Europe is the better growth story of the two divisions.

CCE Europe or the New CCE is achieving 3% volume growth while NA coke case growth is experiencing a permanent decline. Profit growth and revenues are telling the same story. Europe is growing while NA is flat-lining at best.

So what is the valuation here?

KO paid 8.4 multiple ( Entp value/ EBITDA) for NA operations
the market is valuing CCE (Europe and NA) at 7.43 multiple
that leaves Europe, after some backward deduction, at 6.02 multiple, that is way to cheap. Bottlers overall has an average 8.7 multiple, while other European bottlers have 9 multiple.
doing some complex math the implied price per share of the new CCE will be $13.33, after $10 divined at the close of the transaction. The market may trade at $15, current price less the special dividend.
If we apply peers multiples then the new CCE value is ~$19 per share. Not enough margin of safety for me at this point ( if you buy at now $26, get $10 dividends and be left with $14 to15 worth in new CCE shares, about 27% upside potential to full valuation).

However if CCE follows a typical spinoff behaviour then it might get sold off at the close of the transaction and then it may be a good value. CCE will be 100% European and it may get taken out of the S&P500 ( management “expects” to stay in the index) conditions to have fund managers dump the stock.

So at this point it is on the radar screen to see the development and price action at the close, which is expected to happen in the 4th quarter of 2010.

The Value of Corporate Events

noreply@blogger.com (Sami) — Thu, 08 Apr 2010 22:43:00 +0000

I started to realize that hunting for value is a strategy well suited for, mostly, undervalued markets. Generally these situations appear abundant in these markets, therefore increases the odds of positive performance. However, searching for undervalued companies ala Buffett in markets that seemed to be fairly valued is not a strategy I am willing to undertake. I reckon undervalued markets like the one we had in 2008 is like shooting fish in a barrel but otherwise you need to be really a sharpshooter with strong set of skills or a lot of luck to do well.

Off course the obvious alternative is to stay on the sidelines waiting for those undervalued markets, but what if they do not materialize.

successful value investing requires significant diligence. Investing is not hard or rocket science but requires a lot of time and resources to come up with single idea. I reckon, based on my limited experience, to produce a single good idea you have to vet at least 10 with the same intensity and diligence. One of the most critical aspect of investing is generating ideas. Idea generation can't be random it has to be systematic otherwise you will never know what works. It is the pane of my investing existence is how to find those ideas? how to build a pipeline of company to analyse? do you start with A's and work down the alphabet? or do you run screens that will uncover good companies in the past? So needless to say it is important to have a "search technology", as Prof. Greenwald puts it in his book "Value Investing: from Graham to Buffett and beyond".

That is why event driven strategies is what I observed to be the best search strategy for individual investors. It is all about odds. Event driven investing puts the odds slightly in my favour. I get a concrete set of ideas with good probability of out performance. I have been concentrating on two events:

Spin-offs,
Post bankruptcy equity, and
Index Deletion.

For example, spin-offs offer great hunting ground. I do not use spin-offs investing as a blanket approach, although I wish I did I would be better off for it. I need to vet the presence of good business and competitive advantage. Spin-offs will have duds, that's why they are being spun off. However, the odds to pick good performers over the next 3 years are much better than picking from the entire market universe. Most of the time markets fear from the uncertainty of smaller and unproven companies are wildly exaggerated.

From the spin-offs I followed, I have invested in some but not all, it out performed the S&P by 23%. That is not unusual. Most studies find 15-20% out performance for spun off companies. The reasons for the out performance vary from better focus to better information transparency.

There is a busy calender for spin-offs this year, I will post if any seem interesting.

CF/ TRA Merger- some thoughts

noreply@blogger.com (Sami) — Tue, 23 Mar 2010 18:16:00 +0000

Here are some thoughts on the drama that played over the last year in the fertilizer industry. Please note that these are thoughts and I am researching to what can be an investable idea.

Takeover Frenzy:

The year long dance between Terra, Agrium, Yara, and CF Industries came to an end. CF won the bidding for TRA and took it away from Yara and in the same breath fended Agrium advances.

The acquisition of TRA is mostly a mechanism to fend off AGU hostile takeover. To defend against this unwanted advance CF overpaid. As Yara offered to buy TRA from underneath CF and CF struggling to find a white knight instead of Terra reaping a premium offer. In this vein, at least one person pointed out that once Yara did a deal with Terra, CF lost its white knight. CF was left facing a low bid by Agrium and its bidding here made sense in order to prevent a deal with Agrium for a low price forced by CF’s own coming election.
The TRA acquisition is not a tuck in acquisition but almost a merger of equal. CF and TRA are of similar size in terms of market cap and Ent value. TRA had $1.5 B in sales as of 2009, $2.5b in 2008 while CF had $2.6B as of 2009.
CF might got caught in a bidding frenzy for Terra that lead it to over bid for Terra. the increase in offers are as follow:

March 10, 2010 final and winning offer: $47 or $4.6 market cap. 37.15 in cash and the balance in CF shares
Dec 15, 2009 third offer: 45.91
Nov 1, 2009, second offer : $40.50
Jan 15, 2009 initial offer : $20.98 or $2.1 in market cap this was an all stock offer

The peculiar thing is CF used its shares as a currency when it was beaten down in January 2009, however used an almost all cash offer in its winning offer in 2010 after its shares have a considerable run and traded at 52 week high. Why would the company uses its shares when it was trading at what it seems a large discount to intrinsic value while uses cash when the shares have recovered.
Another peculiar aspect is CF has proclaimed that AGU offer undervalues the company but it was happy to use its own undervalued shares as a currency for takeover of TRA.
The length of the merger process might have increased the mental investment and cost to CF executives making it harder to forgo those costs and walk away. although these costs should be considered sunk costs and not factor in making and acquisition in March 2010. Maybe it became win at all costs. I am not sure what changed in the span of 12 months to justify more than 100% increase in value paid to Terra.
The merger announcement talked about being".. the largest nitrogen producer in the world among publicly traded companies as measured by production capacity". May be CF wants to the biggest and baddest at the exp of shareholders.

Over Paying

CF simply overbid for TRA to escape being bought by Agrium. Please consider:

CF offer values Terra at $47 per share. The offer represents:

2.9 x sales (TRA highest achieved 2.2x at that market top in 2007)
9.5x book value
30.5 x earnings (highest achieved 25x in 2007)
22.7 x Cash Flow
CF overpaid for the company as the DCF value of TRA as a stand alone company, assuming 10% growth rate for 10 yrs and 5% terminal rate for Cash Flow of $3.19 per share, is $41.68.

CF claims that it paid 8x TRA's EBITDA (see merger presentation footnotes). That claim is more spin than reality for several reasons:

CF averaged 3 years to get the EBITDA of 622 while 2009's is mere 402
2008 was an abnormal year for Ag where prices have shot up for Fertilizers and ag in general. CF includes 2008 to average out to 622 in EBITDA. TRA never approached that level in EBTDA or came close. would that be repeated again? so to include a record year in your EBITDA will increase average and lower the multiple to make the transaction more salable to shareholders, which by the way are precluded from voting on the transaction thank to CF management to not be bogged down with a limitation in their pursuit of TRA.
CF claims "~$1.54Bn of combined EBITDA (including run-rate synergies): Based on 2010 CF management EBITDA guidance, excluding minority interests, of $752MM for CF (see non-GAAP reconciliation on p.6), plus $655MM of 2010 EBITDA per Terra (refer to Footnote 1 on prior page), plus $135MM of run-rate synergies" However, CF used its guidance for 2010 and the 3 year historical average for TRA to arrive at that number. Talk about apples and oranges.
"I believe a $100/st nitrogen production margin ($3/MMBtu natural gas for 1 metric ton ammonia production in Yara's thinking) is as good as it will get going forward, and based on this, $600 million is the high water mark for earnings from this asset set. This is based on 6.5 million tons of annual nitrogen production, less SG&A. Terra's EBITDA hit $964 million in 2008, which was an extraordinary year for the company. "

CF will pay about 6 percent of its entire market capitalization in fees. On a per share basis, I calculate this to be about $5.75 per CF share. This does not include the $123 million termination fee that CF is paying to Yara on Terra’s behalf as a result of TRA terminating with their merger agreement to accept CF's offer.
CF will issue equity to fund TRA acquisition, lots of it; it can be dilutive. The company will issue $2 Billion worth of shares: $1B for TRA shareholders and another to the public. Total issuance represents 30% of current and new shares based on today's market price.
TRA UK assets are declining due to pound devaluation
valuation of integrated companies:
what kind of return can CF garner on the acquisition? I reckon no more than 15% in ROIC, this is the best case scenario. The ROIC figure is covering assumed cot of capital of 12%, however, I have my doubts about their EBITDA and synergies claim as detailed here. If I start calculating more accurate ROIC figures using accurate EBITDA like better cycle than just 3 yrs and including an average of non recurring charges...etc I sure they do not earn their cost of capital.
The invested capital is the cost of the acquisition which are:

offer: $4.6 Billion
termination fee to Yara: $123 million
bankers fee incurred by CF: $270 million
Grand total : ~ $5 Billion

What is the return CF is going to get:

$622 (based on the 3 year average EBITDA of TRA)
$135 million in synergies

Perils of Integration

Do CF have merger integration experience? CF did not make a large acquisition like this and was not a serial acquirer of smaller operations so that begs the question how will they integrate?
I want to handicap CF management so lets look at their track record by calculating ROIC.
CF has capacity to add debt as it has lower leverage . It will add $4.05 billion in financing to its balance sheet to complete the acquisition.

what does the combined company look like?
CF claims "flexible balance sheet with ~$1.7Bn of Net Debt by the end of 2010 (Based on CF management expectation of $2,034MM of debt less $321MM of cash (excluding $134MM of auction-rate securities)"

CF claims that there is $135 million in annual synergies ( those synergies were $100 million at the time of the initial offer) from the elimination of:

duplicate corporate functions: it should be very little if any to be considered material and worthy of synergy.
optimization of transportation/ distribution : need to look closer at this claim
greater economies of scale in purchasing and procurement: but 50% of their production cost is natural gas and the commodity is not driven by volume but rather by proximity to distribution network or closeness to production hubs. However natural gas is cheap at the moment given them larger margins and NG is expected to be low priced for the foreseeable future. Nevertheless it is an advantage that can be enjoyed by the entire industry rather from economies of scale as a result of the merger.

It is hard to see exactly where CF is going to get the extra $75 million in synergies they asset they can deliver, over and above the $60 million that Yara said it can achieve, the latter being more evident.
distribution channels are different since Terra's customer base is industrial and CF's is agricultural

BPO Properties REIT Conversion

noreply@blogger.com (Sami) — Sun, 28 Feb 2010 20:14:00 +0000

BPO Properties, a public subsidiary of Brookfield Properties at 89%, will convert to a Reit in April 2010. The transaction does not really change the economics of Brookfield, however its implications are more subtle. Please note that I own Brookfield Properties.

Brookfield Properties will follow the same game plan of Brookfield Asset Management (BAM), its parent, by creating ownership structures floating them and earning management fees from them. Not only Brookfield Properties will de-leverage its balance sheet, which it badly need, but will establish high Return on equity revenue stream.
BPO Reits will be sold to less than 50% by Brookfield in the future as Brookfield will not want to consolidate debt of the Reit. Also conversion to a Reit mostly will benefit retail investors rather than corporate subsidiaries, as dividend income flows between corporation tax free.

Given that I am not sure why BPO Properties shot up 10% on the announcement? There will be more supply of BPO shares in the future and higher cost structure given all the fees the Brookfield Properties will earn from them.

A Bid for Illiquidity

noreply@blogger.com (Sami) — Sat, 16 Jan 2010 19:31:00 +0000

Back in November 2008 to January 2009 buying decisions were fairly easy. There was all kinds of opportunities to choose from. All you had to do was step up to the plate in any asset class or in any market and take a pitch. Right now buying any asset is not so easy. Credit and equities are fairly valued. I have not find anything of interest. I spoke about few ideas but nothing interesting materialized.

To find a good pitch I have to find a market where the level of professional analysis is a bit lower. So I will have to avoid the US markets. That means I have to find illiquid assets. That is fine by me. Liquidity is not worth a cent in my book. So I found the Canadian Debentures. Those are subordinated and unsecured, in some cases, debt instruments issued by companies of lower credit quality. I have sifted through dozens of these names and I have found two ideas. I tried to establish a position in both but I was unsuccessful and the price ran to the point it is no longer attractive to me, and that is why I am writing about them now.

Royal Host 2013 6.25% Debenture (RYL.DB.C)

Royal Host is a hotel owner and operator in Canada. It owns and operates economy hotels mainly in Ontario and Western Canada. I do not need to go into the hotel industry fundamentals as they are atrocious right now. It is worth noting that hotels performance is tied closely to the economy. But this is not a bet on the economy, it is a wager that I will get paid in 2013 at 100 cents on the dollar while purchasing the debenture at 68 cents on the dollar.

I have been stalking this issue for awhile but the price ran from me from $68 to $80 at the close Friday. I am no longer interested at that price but if it dips down I will try again. What makes it worthy? The issue is distressed debt in the hotel industry, where debt is selling at 68 cents on the dollar. If hotel vacancy and rent per room are stable at current level which is bottom of the cycle then debt is over collateralized at cap rate up to 11.5%, extremely low valuation even in the hotel industry. The Company have several liquidity generation abilities and should fund its obligation and debt maturities with no issues. The debenture offers the potential to generate IRR of 27%.

If you bought the issue at 68, the company will have no problem repaying you at 100 cents on the dollar even if cash flow from operations after debt service is negative, according to my analysis and valuation. The company have several options to generate funds:mortgage assets that are free and clearsell a sizable marketable securities portfoliocut its dividends
The only issue here is the company stock buybacks. The company is using its available funds and selling its portfolio to buy back its shares. It had tendered for 26% of its shares in December and going back for more in Jan 2010. Why is the company doing this while it cash flow from operation can barely service its debt. The answer is it may be setting up for going private transaction.

The company is 25% owned by Clarke Inc and its board are mostly controlled by Clarke. After the tender Clarke ownership will jump to 37% and potentially more after the additional tender offers by the company. Clarke obviously wants to take private Royal Host with little cash outlay on its part, particularly that Clarke's balance sheet is in worse condition than Royal Host. If the privatization takes place sooner than maturity the debentures will be redeemed at 101 cents on the dollar. However if the tenders keep coming it will compromise the collateralizing of the debt.

Still at high 60s or low 70s I think the issue is worth the risk. But now I will bite my time until either it comes down in price or look back and see how pretty my spreadsheets look like.

Next post I will tackle the second idea.

Pacer: Change of Mind

noreply@blogger.com (Sami) — Wed, 23 Dec 2009 01:14:00 +0000

Pacer is in the right space; the intermodal space that is. However it might not be the right investment. There is good likelihood of business failure and permanent loss of capital. I have sold out of it earlier and took a 3% gain from my cost basis.

Why I do not think it is suitable for an investment because of several factors:

The company lost its wholesale business to HUB Group, as Union Pacific (UNP) renegotiated their long term contract, which gave Pacer a competitive advantage for a long time.
Now Pacer does not have any pricing power or unique access to the UNP network so its advantage have disappeared.
Pacer will try to establish it new business going to shippers rather than selling to other logistics businesses, which is unproven field for it. If management had showed better skills and better Return on Capital over the last 5 years, even with unique advantage it failed, I may have given it the benefit of the doubt. But there are no indications of superior skill.
Management have to win business and that will be a tall order its revenue growth over the last 7 years, the go go years of global trade, have been -5%.
Pacer with no trucking assets can get its margin really squeezed by truckers to complete the various legs of the intermodal trip. However most of its competitors either have their own trucking or have a larger under contract owner operator. This will decrease Pacer flexibility and attractiveness for customer needs.
Recent liquidity issues and reduced credit facilities can turn off customers from giving their business. Supply chain managers and shippers priority will always be reliability rather than price.
Pacer would not see any positive cash flow from operations for next year according to my model which will continue to raise solvency issues as it did this year.
CEO abruptly retired. The company felt the need to issue a press release to recently to emphasize that all was preplanned. That was very defensive move that leads to believe that there are something more o this issue.
A lot of insider selling. Not a good sign.
the new credit facilities the company negotiated limits capex at $6.5 million per year going forward. The company used to average $9.5 million per year and most of it is maintenance capex. Without investment in the business it could lead to deterioration in operations.
Also the credit facility is very strict and keeps Pacer on a tight leach.
If I assume mid cycle revenue level of $1680 and loss of $550 due to the new agreement with UP that will leave Pacer with revenue level of $1130. Further if I assume the average EBIT margin over the last 4 years that will give me an EBIT level of $19 million. However the new cost structure of Pacer due to its agreement with UP and loss of business will be higher so lets assume 1% margin, which will leave us with EBIT of $11.3 million. This translate Pacer Earning Power Value is $113 to $160. This does not factor capex, taxes or interest, so very much where the market is trading right now. Not an appealing valuation.

The shorts are having a big field day with this; it is been shorted heavily with a good reason. Management need big effort to turn around, cost cutting can do only so much.

Lear: Post bankruptcy Equity

noreply@blogger.com (Sami) — Fri, 18 Dec 2009 01:51:00 +0000

This is a very interesting idea. Lear (LEA) has just emerged from bankruptcy that it entered early in summer of 2009. The bankruptcy was voluntary.

Lear is a supplier of car seating and some electronics to car makers. Lear has a very dominant position in the seating market. However GM and Ford makes the bulk of its sales. In fact GM makes 23% of its sales while ford makes up 19%. Management is focused on diversifying this mix. They are focusing on sales into Asian countries where sales growth did not skip a beat in the last 2 years, unlike European and North American which sales plummeted.

What is good about the company is the following:

Bankruptcy. Although it sounds bad but Lear has shed a lot of debt that was kept on its balance sheet after sales of some units to Wilbur Ross.
Management owns a lot of stock. In fact management owns 2.4% of shares on fully diluted basis upon exit from Ch. 11 and the CEO has a big chunk of it. I think management will do whatever it takes to increase business value.
There will be a lot of forced selling and a lot of technical overhang that could pressure the stock in the next 12 months. the selling pressure will be from:

CLO funds. Lear debt and loans was wildly held by CLOs. CLOs do not hold equity; their charter do not allow it.
Preferred stock conversion. Right now preferred are in the money and the company can force its conversion.
Warrants exercise also in the money.
Warrants and preferreds conversion will cause 35% dilution.

The quick exist from bankruptcy limits lawyers and advisers fees.

What is not good about the ideas:

The auto market has a lot of capacity still. even after all the bankruptcies not a single car maker disappeared, well only one Saturn but Saturn is made by GM so capacity is still there. We need to see some liquidation in the space.
Margins are very thin right now below historical norm. This may change with more sales.
GM and Ford make the bulk of its sales. Enough said.
Economic risks of decline as so far recovery is shaky.
Valuation is not cheap enough. I figure a good entry is between $48 and the high estimate of $55. If I am right about the selling overhang it will get there within a year, although it does not look like it as the stock price is on a tear lately.

What is wrong with this picture?

noreply@blogger.com (Sami) — Thu, 03 Dec 2009 15:46:00 +0000

Natural gas producers have rallied and continue to do so although the underlying commodity is suffering. Natural gas producers represented by index for natural gas producers have returned some 45% on YTD basis while the underlying commodity has declined by 62% on YTD basis.

Normally that relationship have a high correlation. Natural gas producers price returns go the way of the commodity. However the relationship seem to have been broken since March of this year.

Is buying in this market indiscriminate? May be, but this is a question that can not be answered with full certainty. You can only attempt to guess as one would never have complete information to ascertain the validity of a claim.

Cloud Peak Energy...not so Peak Value

noreply@blogger.com (Sami) — Tue, 01 Dec 2009 15:57:00 +0000

Rio Tinto IPO of Cloud Peak Energy (CLD), sort of a spin off, came with no great fan fare. The IPO has gone down some 10% so far. There are good reasons why the stock is down. Some are due to industry dynamics and other, in my opinion, is due to the corporate structure of the mines.

Industry Dynamic

Demand

Coal demand is growing. There is no secret that coal is under pressure from environmentalists and regulators due to global warming issues. CLD mines thermal coal used by utilities for electricity generation. The US generated 50% of its electricity from coal. So there is no escaping coal no matter what politicians say or do. Coal will be still be used during my lifetime and even during my sons lifetime. Coal demand will grow as long as we use electricity.

Supply

There is a glut of supply right now evident by increasing stock piles at utilities, but I reckon that will be short lived:

Miners are cutting coal production in 2010 due to decrease in demand that will stabilize pricing
Mountain top mining in the states is in jeopardy as a source of cheap thermal coal due to environmental issues.
Mountaintop mining in West Virginia, Kentucky, Virginia, Tennessee and parts of Pennsylvania and Ohio accounts for 6 percent of U.S. coal production.
The end of mountaintop mining in Appalachia would remove about 70 million tons a year from the market, increasing demand for coal from Colorado, Montana and Wyoming.
EPA has been holding mining permits with more frequency under new president.Natural gas pricing, is it firms up then utilities that switched to nat gas will switch back to the cheaper fuel, coal.

On balance the downturn in coal is cyclical rather than permanent. So when a distressed seller like Rio Tinto, it needs cash to repair it over leveraged balance sheet, off load its coal business at these levels, it piqued my interest.

Transaction Specific Issues

My issue is with how the split off is structured. There are many issues that makes me hesitate pursuing this business.

Rio Tinto still owns some 49% of the mines. However its ownership is at the limited partnership level rather than the holding company CLD. The public owns 100% of the holding company which in turn owns 51% of the limited partnership. That will make for conflict of interest between the public holders of CLD and Rio.
Pretty much CLD is controlled by Rio as its board of directors is made of RIO executives. Moreover, CLD is governed by agreements that needs Rio's consent.
Funds from operation will go to Rio and the holding company, CLD, but not to shareholders. I would rather see RIO and the public holders get the same treatment makes for better alignment of interest.
Tax reimbursement agreement where CLD pays Rio any tax savings due to higher assets base level making depreciation and amortization higher thereby reducing taxes on income.
Debt that got loaded onto CLD'd balance sheet to pay Rio for the assets is a bit high and will saddle the CLD with interest payments for some time to come.Most of the proceeds of the IPO goes to Rio.

So as you can see the deck is stacked in favour of Rio at the expense of CLD holders. However, there are some good qualities for CLD being low cost producer, cheap, and good reserves.

In conclusion, I will wait for a better entry point or when Rio floats the reset of its ownership in these mines.

Liquidity made me do it

noreply@blogger.com (Sami) — Sat, 14 Nov 2009 17:52:00 +0000

The rationale for the market rally since March 09 has been liquidity pumped by the Fed. The interesting point is that the market decline from summer 2008 to March 2009 has been also explained by the disappearance of liquidity. The disappearance of liquidity was caused by over levered banks.

I am not going to agree or disagree about the causes of the market rally because I can't. I distinguish between causation and correlation. The latter is easy to detect by statistical methods, however the former is almost impossible to prove. So arguing that point is irrelevant. One suffice to note is liquidity can disappear overnight but can't appear in same speed. It takes time.

Most investors, as evident by the decline and rally of the market, value liquidity. They attach a premium to it making liquid assets somewhat expensive to illiquid ones. I am agnostic to liquidity therefore I am not willing to bid more for it. However price is more important. I was a willing buyer from October till May, although in retrospect, regrettably, not enough. Now I am not. Back then the cyclically adjusted PE was around 10, now it is 19, above the long term average of 17. See chart courtesy of Dr. Robert Schiller.

At these levels I am more risk averse. I have sold several positions over the past few weeks for a summary see here and here. I have also wrote calls in American Express (AXP) at $40 which should take out of that position by it expiration next week. Moreover, Burlington BNI have been taken over by Berkshire which should close by early next year. So my cash position is rising so what to do.

In an fair valued or overvalued market I concentrate exclusively on event driven positions, like takeovers, spinoffs, bankruptcies and reorganization and liquidations. My favorite is spin-offs. Some of the opportunities I am looking at:

AOL spinoff from Time Warner
Madison Square Garden (MSG) spinoff from Cablevision
Cloud Peak Energy coal spinoff from metals giant Rio Tinto
Pharmaceutical Product Development, Inc. (PPDI) Spinoff of Compound Partnering Business.
SixFlags post bankruptcy equity
Lear Corp post bankruptcy equity

In an over valued market where you look can be different than an undervalued one, where businesses sell far below their normal earning power value.

Exit from Peyto

noreply@blogger.com (Sami) — Wed, 11 Nov 2009 00:41:00 +0000

I sold out of Peyto Energy @ $12.26 (35% return) due to changes in competitive structure of gas supply. Pipelines are raising significantly their fees to carry natural gas. This will spell increased operating costs for gas producers and will lower asset values.

Demand for natural gas occurs in the north eastern of this continent and supply, typically, comes from western provinces like Alberta. So transportation costs is big chunk. TransCanada pipeline will raise fees by some 50% next year, which will make western Canada gas uncompetitive compared to closer sources. In the past there was not many sources close to the northeastern market but now they are abundant. There is two new sources that can supply that market maybe at lower costs with transportation costs are rising signifiacntly:

New shale gas basins that are coming online are much closer to northeastern states like natural gas from the mega Marcellus shale play that extends to west virginia, is likely to grow to 1.0 Bcf/d.
LNG gas coming from overseas as Europe does not need as much gas as previous years due to economic slow down.

The reduced operating profits at gas producers as Peyto will lead to lower credit as bankers set credit lines based on estimates of their NAV or reserves in the ground. Those estimates are facing a double whammy: lower gas prices and higher operating costs. Many will see their credit lines reduces in March 2010 and will scramble for liquidity.

I will come back to Peyto as it is my favourite in the space once something changes in the fundamentals.

BNI buyout by Berkshire

noreply@blogger.com (Sami) — Sat, 07 Nov 2009 18:03:00 +0000

Berkshire acquired BNI earlier in the week for $100 consideration. I will not detail the offer as most media have done it with better detail. However the post is about my view and my future action.

First my view on the transaction. I am really disappointed that BNI is going private, you can read my posts on the company here. I had visions 10 years down the road to see my investment in BNI to have risen by 1000% or more, so to be deprived from such investment, to say the least, is disappointing, albeit my return from holding BNI is 50% plus dividends, so I am always thankful.

The price is low relative to the value of BNI. BNI has tremendous land holdings that are not realized in its balance sheet. Also, BNI is not just a good business with competitive advantage, it is a protection against inflation and oil prices. BNI does well when oil is high or low. When oil is high their rates go up in lock step however if oil prices are declining so is their costs. BNI also is a good hedge against inflation as it rates and assets can compensate investors for rise in prices.

Second, I will opt to take the cash. I do not understand Berkshire and Buffett is not going to last forever. To preempt any comments, I did not say Berkshire is bad business but it is too complicated for me, that is all.

Thrid, I will tender my shares for cash rather than sell due to several factors:

I want to postpone my capital gains till next year,
in the unlikely event the acquisition fails,
I am not leaving $3 on the table, and
There is a dividend payout coming up before closing that I want.

Fourth, BNI represented more than 10% of my portfolio so I will have a lot of cash coming back to me to reinvest and that creates some problems. First, the market is at fair value which makes finding ideas a bit difficult. Moreover, the risk in this market is to the downside currently. Second, most railroads have shot up on the acquisition so replacing BNI with another will be difficult as a lot of people are emulating Buffett and bidding their prices. I do not like crowded trades. But I will follow some railroads to take advantage of any weakness. Two of my favorites are Canadian National (CNR) and Union Pacific (UNP). I am also looking at Canadian Pacific, where it could see some improvements in margins with better management. Third, good ideas like BNI are rare.

The other alternative is to invest in Intermodal companies. Those companies use multi modes of transportation on behalf of shippers to get goods to their destination. Intermodals obviously need access to the rail networks through agreements with railroads. Some Intermodal companies own a fleet of trucks to handle what is called last mile transport or the final link from rail to the buyer, or can contract this out to independent truckers.

Pacer International (PACR) is

...asset-light North American logistics provider. The Company provides transportation and logistics services to numerous Fortune 500 and multi-national companies. The Company provides its transportation services from two operating segments, its intermodal segment, which provides intermodal transportation services principally to transportation intermediaries, beneficial cargo owners and international shipping companies who utilize intermodal transportation, and its logistics segment, which provides truck brokerage, truck transport, supply chain management services, freight forwarding, ocean shipping and warehousing and distribution services to a range of end user customers.

Pacer had a bad run lately as its contract extension with Union Pacific, where the majority of its freight revenue come from, was uncertain and weighted on the stock heavily. I liked that situation. I bought at $3.16 last week to take advantage of investors flight due to uncertainty. Although the stock has shot up some 50% since their earnings and contract renewal two days ago, I think the potential to move to $8-10 per share is reasonable.

I admit I did not finish buying to establish my desired position and rather to have bought before the move but the risk/ reward thesis is still valid. The stock should drift higher as investor buy again into it after the uncertainty has been removed.

I will share more thoughts on Pacer some other time.

IFRS implementation in Brookfield Properties

noreply@blogger.com (Sami) — Fri, 09 Oct 2009 18:00:00 +0000

Brookfield Properties (BPO) will adopt IFRS, new accounting standards that most US and Canadian companies will transition into, ahead of schedule according to their press release. You will see most real estate operators opt to adopt IFRS early, particularly those with properties acquired more than 5 years ago. That is because it will decrease their leverage and increase book value.

IFRS allows companies to adopt fair value measures of their assets. It is advantageous for owners with older properties to account under IFRS this way their leverage ratio will be much better. Also I think in this cycle where commercial real estate have been clobbered you will see many years in the future of up revaluation of properties and steady increase in book values.

The accounting changes will move BPO book value from $9 to about $14 making Price/ book value less than 1.

Also they will be compare more favorably now that leverage is reduced. Most analyst do not like BPO because it has higher leverage ratios compared to other office owners.

Practice Investing

noreply@blogger.com (Sami) — Sun, 04 Oct 2009 11:59:00 +0000

Investing is just like any other discipline you need practice to develop the skills to be good at it. For awhile I have been thinking about a framework of skills and how do I practice to improve my game. I have broken it down to three elements that need to be developed and worked at constantly:

Knowledge
Skills
Behaviour

Knowledge:

If you have read Poor Charlie's Almanac, which I recommend highly, you will see that he harps on what he calls "mental models". This is the equivalent to knowledge in my framework. However, I want to further detail these models into two elements:

Systems Knowledge: similar to Munger's description, it is your knowledge of the necessary sciences to enable you to decipher your way through events, readings and decisions:

Accounting
Mathematics
Psychology
Language

Domain Knowledge: Munger did not explicitly break out this element as a distinct "mental model" but he emphasized reading a lot. Domain knowledge is the structure of information and data or "insights" about a specific industry. You can't be knowledgeable sufficiently about several domains so you have to keep your efforts focused on few ones, the less the better investor you will be.

How do you practice your knowledge building capacity? By writing down notes about what you read. What you need to write is not a summary of the information but an answer to the questions: so what? What will be the impact of the news item on you, your business and the companies involved?

Skills

To develop the knowledge required, you will need to read and read a lot, this has to be evident by now. Here are the skills that you need to work at as well to be more effective and efficient:

Speed reading: you need to read quickly because knowledge has one limitation and that is time. The skill is hard but you need to work at it to continuously improve the yield on your time by acquiring more knowledge for each unit of time spent.
Memory: what is the point of reading if you can't remember the information you need to analyze a particular situation or identify a unique opportunity. This is a skill that can be improved by practice as well.
Creativity: Munger in his book said to "invert, always invert" well to do so you need imagination. Creativity is needed in order to develop future scenarios and imagine possible risk for business.

Behaviour

I have identified three behaviours or personality characteristics that need to be nurtured as well:

Passion: your passion should be about the process not the outcome. If you are passionate about the process you will think and have perspective on how to improve it rather than use it in a mechanical fashion.
Adaptation: one of the most valuable traits of humans is their ability to adapt to their circumstances and learn from their mistakes. But this require that you take responsibility and internalize errors and mistakes rather than blaming it on chance or others.
Determination: because you will fail but you need a combination of strong will, ambition, and discipline to keep going as what I outlined here is a lot of hard work.

Train hard!!!!

Positions Revisited

noreply@blogger.com (Sami) — Wed, 23 Sep 2009 15:37:00 +0000

I want to revisit some of my stock decisions and see what was the outcome and analyze if there is anything I should have done better. I will try to be intellectually honest with my assessments and recognize my errors. Also i want to look back and see if there are any mental traps that affected my decisions and recognize when i fall for these psychological biases.

Below is all the positions that I have talked about on this blog for over a year or so. All are businesses that I looked to own but did not or I bought and sold.

General Growth (GGPWQ): I have dismissed the value in this name when it was trading at $.35. now the stock is over $4.5 an impressive 600%+ return. Was I wrong? Off course I was. Would I do the same decision again? Probably yes. There is nothing inherently wrong in how I analysed the situation. I came to the conclusion that there is a probability of permanent loss of capital; this probability excluded the equity of GGP right away.

I honestly can live with the consequences of such decisions. I prefer to err on the side of preserving capital than take a speculative position like General Growth.

Coach (COH): I liked the business and its management but I decided I will only buy at $18 or below to give me enough margin of safety. Coach is trading at $33; some 80% return if I have gone ahead and bough at my buy decision.

My inaction cost me here. This one hurts more than General Growth because there was no reason not to buy. I scummed to the fear and paralysis during the market tumble earlier this year. My bias for the status-quo and regret avoidance have cost me.

Hawk Drilling (HAWK): I did not like this spin-off for various reasons. However, the stock has gone from $22 to $35 in the span of several weeks. The business has a lot of ugly factors in it, which is what you want to buy in a spin-off. But again this one I can live with. The price has gone up not to the specifics of the company but because of movement in natural gas as evident of a similar move by its competitor Hero Drilling as seen in the chart; Natural Gas has also moved from $2.7 mcf to $3.7 during the same period. I concluded that this was a leveraged play on Natural Gas and I did not want to call its direction.

Switch of Bank of America to American Express: After BofA bought Merill Lynch I decided to get out and switch to AMEX. My analysis were right that BofA would have tough time with Merill and I am better with a company that have a great brand name and much more easily understood and analysed than a bank. AMEX return 65% from the switch to BofA -14%.

In this instance I did not have any status-quo bias I acted and I did not have a loss aversion bias. I hope I can have the same capacity to perform the same decision in similar situations.

Preferreds (Brookfield and Bombardier) and Senior Loans Positions: I have bought several positions with the credit theme to be a better proposition than equity. All worked very well with most of them 70% gains plus their yield.

However, equity performed very well since its March lows. All my buying from late 2008 to early 2009 has been tilted toward credit instruments rather than equities. There were several companies that I liked that could have provided me with handsome returns over the last six months. Again, some paralysis on my part to pull the trigger on stocks with attractive prices, similar to Coach above.

Teck Resources (TCK): This position has worked as I expected. The assets were too valuable. When it was trading at $4, I did not think there was any chance of loss of capital. Now that the stock is trading at $30 it still has some room to high 30s.

However I made a silly mental error. I sold too early and left a lot of profit on the table by halving my position. The business did not hit my value estimate and I reacted to the price run and I fell to regret avoidance mode. I should have asked what is the value?

FirstService (FSV): I sold at 8% loss when I realized I made several errors in valuation and business model assessment. My mistake here is that those assessment should have been made before hand not afterwards. I rushed to take advantage of price decline before the opportunity escapes me. Little I know the price declined further. Here it was a process violation; the position should have never been established and because of the error I am 8% poorer.

NorthStar Realty (NRF): I am down some 50% on this one. I can be wrong on this one but I followed my process and my thesis still good. I am willing to hang onto it until I see another opportunity with better return profile.

Sears Holding (SHLD): I am down 30% on this position. Again so far I am wrong and the intrinsic value has declined with the name as its real estate assets have went down in value. Moreover, I realize now that valuation discount alone is not enough it has to be coupled with good business model and economics.

Cardinal Health, Peyto Energy, and Burlington Northern: All of these positions are recent and any analysis is not worth its trouble.

I just wonder how this post would have been different if the market have not rallied. I come to remember the quote " rising tide lifts all boats". So I am thankful that I did well but I always think that there is an element of luck in my decisions.

Value idea: Peyto Energy Trust

noreply@blogger.com (Sami) — Sat, 12 Sep 2009 18:39:00 +0000

Natural gas is at extreme lows as it should; there is tremendous supply in the system. Storage is almost full. There will be no where to put extra production. The reason is the vast discoveries of shale gas. North America is abundant with natural gas contrary to what was believed of North America peak gas. Even with a harsh winter I do not think the supply picture will improve.

However I believe that goods or assets can't sustain prices below its average production cost over the long term. Sure there will be some divergence in some periods but it should return to equilibrium eventually. The question is when. I am not going to speculate on that as it is going to be a crap chute at best.

However a good position if I can find a way to participate in the price recovery of natural gas, while I get some downside protection and a margin of safety. I think Peyto Energy Trust (Pey.un) gives me this proposition. Peyto is :

Canada-based energy trust. The Trust’s principal business activity is the exploration for, development and production of petroleum and natural gas in Western Canada. As of December 31, 2008, the total proved plus probable reserves were 998.3 billion cubic feet equivalent (166.4 million barrels of oil equivalent) with a reserve life of 23 years. Production is weighted approximately 85% natural gas and 15% natural gas liquids and oil.

I like Peyto for the following:

hedge book for half of their production of the next 12 months at an average price of $7.5 per mcf
low debt to capitalization and good coverage of debt service and dividends
low cost producer of natural gas. currently their operating costs per BOE is $2.56 as of their latest quarter
long life reserves
the cost structure for the most part is variable and gets reduced with lower revenues.
cheap valuation where its Entp. Value to NPV is .57, a measure to value the company to its discounted cash flow from reserves in the ground.
The current dividend yield is Distribution is 15.5%. The coverage of the distribution is good but if gas prices continue its decline it will be halved.
I get good odds betting on natural gas plays. The upside is potentially large while the downside is limited. We are already at a decade low of natural gas price. Most Natural gas producer did not participate fully in the recent rally and lag the indices by a wide margin.
And a very good management, extremely good management.
My catalyst will be the revision to mean in natural gas prices as most likely it can't keep going down. We are in a period of supply and demand imbalance and there should be an equilibrium found in the next 12 months.

What can go wrong:

Payout ratio is trending higher, which is understandable given the weak revenue figure. Peyto has already cut its distribution and it could a further cut is probable.
Natural gas is the "widow maker" and can be very volatile. There is no reason it can't go to low $2s per mcf.
Their operating lines can be shut or reduced if credit environment deteriorates further. Producers rely on operating lines to fund operations and exploration.
Royalties are influx in the government of Alberta and can be very fickle to factor in analysing operations. Couple years ago royalties has been hiked on gas producers but once the bust has set in it was reconsidered.
The conversion to corporate entity issue. Trusts will be subject to regular corporate taxes in 2011 so this is issue is hanging on Peyto and all trusts alike.

A note: This is a Canadian trust equivalent to master limited partnership in the US so it will have personal tax consequences that will have to be taken into consideration when purchasing

Changes to portfolio

noreply@blogger.com (Sami) — Mon, 07 Sep 2009 18:20:00 +0000

Reducing EEM stake by more than half. I have been holder of Emerging Market index for a while in an effort to diversify internationally. The call was to hold the index for the long term but as my style of investing changes, more focus on event driven investing, I find my emotions rule how I view this position. I get swayed by economic analysis from various sources. I do not have any insight or edge.

Also, I have bought in the EEM when all were selling in Sep of last year. Valuation then made sense. Now emerging market funds are loaded with capital as money flow into them like crazy. Valuation has increased from 10 x earning to 20 time earnings now. People have high expectation of emerging market due to growth potential. I think it is a likely scenario that economic dominance will shift to some emerging economies like China and India but the odds that the market gives me for returns are not favorable. So I am taking my profits here and I will set tight.

I am also selling out of FirstService(FSV). I am existing this position with a small loss of 7%. I have made this call based on valuation alone. the value of the sum of the parts were higher than the market cap of the company. However as I started to look at the business details, a step I should have done before buying, I started to change my mind and cheap valuation does not cut it alone. I sold because:

high compensation to CEO and management compared to peers and level of earnings growth.
rollup strategy that is empirically destroys value
ROIC is on par with the cost of capital
bulk of the growth is attributed to acquisitions. what will happen if they can't acquire anymore?

Another sell decision TSX index: too much concentration in Natural resources and financials. Actually between the two sectors it makes up to 75% of the index. And those two areas where I do not have a lot of insight. Another small loss of 4%.

Spin-off Idea: Cardinal Health

noreply@blogger.com (Sami) — Mon, 31 Aug 2009 18:44:00 +0000

By end of business today Cardinal health, CAH, will spin-off its medical care division, Carefusion, CFN, and it will focus on drug distribution. The spin off is very interesting midst all the talk of health-care reform because whenever there is uncertainty it pays to go long.

The market is very hot for the CFN spin off. Although CFN accounts for only a small portion of CAH's revenue, maybe less than 7%, it makes third of its profit. The business is very high margin and its potential for growth is solid. The independent company will be able to focus on new products and free to allocate capital to R&D. But it is fully valued when the when issued shares trade at $19. I figure its value is around $20-$23.

What is interesting is the parent company. The market is betting against it. Short volume has increased significantly over the last month or so. Wagers against health-care shares rose more than 7 percent, the most of 10 groups, to 890.3 million as President Barack Obama proposed an industry overhaul. Shorts thesis is earnings will come be under pressure due to health-care reforms. May be it is true. But CAH margins will stay intact and it will be part of the solution.

Once the spin off is complete, CAH is no more than a logistics provider to drug makers. It provides supply chain services to them and have no R&D commitments. Drugs like goods funnel in and through its distribution network reaches customers. So if health-care reforms lead to reduced costs of drugs, CAH's input costs and revenue will come down in tandem. Its margins will not be affected. Sure the absolute level of revenue and earnings will decline but the company value will be still intact.

I am liking going long CAH rather than CFN, it gives better odds.

Value Idea: Pride's Spin off

noreply@blogger.com (Sami) — Wed, 19 Aug 2009 14:38:00 +0000

Forced Sellers:

I think this will be dumped by investors because they will want Pride high margin business in the deep water drilling and not the shallow-water low margin and limited growth business. But the $64,000 question is are they forced sellers due to non economic reasons or are they justified in their actions?

Industry Fundamentals:

lower utilization rates and pressure on daily rates. Oil finds moving to deeper waters, which seahawk fleet is not capable of operating under. Their biggest customer are requiring more depth capable rigs, which prices them out of more business.

The disparity between the US Gulf of Mexico Shelf and deepwater rig markets continues to widen. Earlier this year, the jackup market reached its lowest level in 33 years, according to ODS-Petrodata figures, and slid downward from that point. Drilling contractors continued their exodus from the Gulf whenever possible, moving jackups to more lucrative areas. Despite a slowdown in some jackup markets, eight rigs will have mobilized from the Gulf by the end of July. As far as the deepwater Gulf, most people consider it a growth market. As many as 17 new-build deepwater rigs are scheduled to enter the region by the end of 2010. More deepwater rigs could mobilize there for a few wells, then mobilize back to other markets during this period. As a result the utilization rates have been coming down steadily over the last few quarters.

Rig Type	Current		Month Ago		6 Months Ago		1 Year Ago
Drill Barge	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)
Drillship	90.5%	(38/42)	92.7%	(38/41)	79.5%	(31/39)	78.4%	(29/37)
Jackup	74.9%	(275/367)	74.9%	(274/366)	82.5%	(296/359)	91.0%	(312/343)
Semisub	80.2%	(134/167)	82.5%	(137/166)	82.7%	(134/162)	83.9%	(130/155)
Submersible	50.0%	(1/2)	50.0%	(1/2)	100.0%	(2/2)	100.0%	(2/2)
Tender	80.8%	(21/26)	76.9%	(20/26)	92.3%	(24/26)	88.5%	(23/26)

Natural gas prices are weak and depressed. There is plenty of supply and surplus inventory to keep the pressure on prices for awhile. I do not want to try to forecast or predict the direction of natural gas because what if my baseline forecast did not materialize. Natural Gas prices are called the "widow maker" for a reason, they are very hard to call.

Overcapacity in the sector. There are several deliveries to take place for shallow water rigs. During the past several years, the supply of available jackup and semisubmersible rigs has been unable to meet the increasing demand of oil and gas companies on a global basis. As a result of this global supply and demand imbalance, various industry participants ordered the construction of over 180 new jackup and semisubmersible rigs, over 60 of which were delivered during the last three years. Approximately 60 additional jackup and semisubmersible rigs are scheduled for delivery in 2009.

The new rig deliveries scheduled for 2009 include over 30 jackup rigs, the majority of which are not contracted for work upon delivery from the shipyard. These new drilling rigs will increase supply and likely reduce utilization and day rates as rigs are absorbed into the active fleet, especially in light of the recent decline in oil and natural gas prices and jackup rig demand. However, the current supply of jackup rigs is limited and it is time consuming to move offshore rigs between markets. Accordingly, as demand changes in a particular market, the supply of rigs may not adjust quickly. Utilization and day rates in specific markets could fluctuate significantly while utilization and day rates in other markets may be relatively unaffected. Additionally, several rig construction cancellations have been recently announced and the tightening credit market has created substantial uncertainty as to whether construction of other rigs will be completed.

Ok, you would say that weak industry fundamentals are cyclical and should adjust. Then seahawk would give you great risk/ reward proposition, assuming its price will fall to below liquidation value of its assets, which more likely it will. In this case company fundamentals has to be flawless to get me interested.

Company Fundamentals:

Potential of fines regarding bribery charges and accounting irregularities, however there is limit to the fines paid to $1 million, any excess pride will take care of it.
Mexico Oil company account for 60% of SeaHawk gross revenue. One customer dominate their business. This was not a problem when the company was a division of Pride but on a stand alone basis is very risky.
accounting is a bit aggressive:

changes to depreciation expenses by extending the useful lives of rigs, which means a boost to their earnings as depreciation expense get smaller. This annoys me to no end when companies change their depreciation policies or assumptions. It makes comparisons difficult and obviously management motives to boost earnings by hook or trick.
already there is investigation for accounting irregularities by pride into Seahawk division.

no debt and clean balance sheet, which a very good in this environment.

SeaHawk Jackup rigs are shallow in the 200-250 feet range which does not work in the current industry dynamics. Their biggest customer are requesting deeper and deeper rigs, which prices Seahawk out.
very capital intensive business. in order to expand more capex need to spent to buy new rigs. most free cash flow will go to acquisition of new PPE.
most of its rigs are idle they have 40% utilization rate.
most rigs are old so it may require some capex going further
no unique competitive advantage that is very apparent that will distinguish their operations from others.

Management

SeaHawk's president and CEO was CEO of Hercules offshore, similar business to seahawk. He left the company in June 2008 and the company took a big impairment expenses due to large acquisition done on his watch, $2.3 Billion in cash and stock. As a result of the acquisition, Hero balance sheet is over leveraged and impairment charges mounted when the turn in the economy came.

Investment returns over his tenure were not overly outstanding.

	2004	2005	2006	2007	2008
ROE	11.35%	19.13%	38.98%	11.35%	(73.37%)

He spent $660.1 million in capex, not including the merger deal, cumulative over the 2004-2008, and generated $618.9 millions in cash from operations during the same period. During the same period cumulative earning were partly at $291.2 million, and if you include 2008 results it would be a significant loss.

Management Compensation Plan

This is a bright spot, somewhat, as the good chunk of compensation is in form of equity. I say somewhat because not all long term incentive compensation is equity. The better alternative is to have 100% of their long term compensation in restricted stock. From their filing:

The beginning value of the initial equity award is $4,800,000 for Mr. Stilley, $1,000,000 for Mr. Manz, $690,000 for Mr. Cestero and $575,000 for Mr. German. ....50% of the equity compensation will be in the form of restricted stock.

Competitive Position

The company is second lowest cost operators in the GOM region. Hero operates better cost structure than Seahawk. According to my analysis the operating the costs per available day is

Business	Notes	OE per avail Day
Seahawk	only GOM locations	$49,634
Hercules Off shore	very similar business to Hawk but diversified geographically	~$28,000
Ensco International Incorporated	shallow water but more specialized assets/ fleet. their GOM fleet water depth is 250-400 ft	$50,175
Rowan Companies	shallow water but more specialized assets/ fleet water depth 250-500
DO	deep water rigs- not very applicable
Nobel	deep water rigs- not very applicable	~$63,000
RIG	deep water rigs- not very applicable (55 standard jackups with depth from 250-400)

Conclusion:

There are so many strikes against the spin off and not too many positives even if valuation are ridiculously cheap, which I did not need to perform. This is a leveraged play on the prices of natural gas, which is very hard to call: will it stay depressed or take off? Weak sector fundamentals and potential liability and fines all are external to the company and can be manageable by good management team. However, I have my doubts about the new CEO hi track record in Hero is not encouraging. If there is any contrarian play on this name, I do not see it. I will pass on this spin off.