This situation has three components to it:
1) Grupo Prisa (PRS.MC), which closed (10/7) at 1.68 euros, or $2.335 (at EUR to USD of 1.39:1)
2) Liberty warrants (LIAWS), $1.63
3) Liberty stock (LIA), $10.29
First some background:
Grupo Prisa was founded in 1972, as the editorial company of daily newspaper El País. Prisa's activities are classified under generalist press (El País), specialized press, radio (11%), educational publishing (17%), and television (18% Telecinco and 56% Digital+). Post recent transactions to reduce the group's debt pile, we think the group's most important assets are its holding in Digital+ and then Santillana, its educational publishing business. As such, it is less of an advertising play than historically.
Liberty Acquisition Holdings Corp. is a publicly traded company formed for the purpose of effecting a business combination with one or more operating businesses. Liberty completed its initial public offering of 103,500,000 units at $10.00 per unit in December 2007. Each unit was comprised of one share of common stock and one half (1/2) of one warrant to purchase a share of its common stock.
Prisa initially announced in March 2010 that they had reached an agreement with Liberty Acquisition Holdings in which Prisa would buy 100% of Liberty through an exchange of shares Prisa shares valued for a total consideration of €660m - implying that Liberty obtained a >50% stake in Prisa and the Prisa controlling shareholders would have been diluted to c30% (but according to the agreement would not lose control). Since then the deal has been amended twice. Below is the most recent iteration:
Prisa’s syndicate of banks had agreed to extend its current bridge loan (€1.9bn) to May 2013 if certain conditions were met; of which the most important, in our view, was a capital injection of at least €450m. The Liberty transaction assures a US$870m injection (€680m). Prisa announced on August 4, 2010 a revised structure to the Liberty deal
(initially announced in May 2010) that practically assures that the deal is approved.
In summary, in exchange for the US$870m cash, Prisa shall:
1) LIA shares: Issue 1.5 ordinary shares; 3.0 non-voting convertible shares (NVCS) and $0.50 cash for each LIBERTY share.
— For the NVCS, there is mandatory conversion in 3.5 years (Each NVCS converts to 1.33 shares of common stock for common prices below €1.50, 1.0 share for stock prices above €2.00, and a conversion ratio of [2.33 – (2 * Stock Price)/3)] for stock prices in between €1.50 and €2.00); they receive €0.175 minimum dividend per annum
2) LIA warrants: Issue 0.45 ordinary shares and $0.90 cash for each LIBERTY warrant
I am advocating a purchase of the warrant. Based on Prisa’s 10/8 close and the EUR/USD conversion rate at that time each LIA warrant receives:
$0.90 + (0.45 x (€1.68 x 1.39 (conversion rate))) = $1.95 vs. a current share price of $1.63. The current spread implies a profit of 20% - this can be increased should the underlying security (Prisa) move up in value.
The main risk to the warrants is if the deal falls through. The risk of the deal falling through is limited, as Prisa has secured US$500m interest and the deal terms are attractive to Liberty shareholders. In order for the deal to be approved, at least 70% of Liberty shareholders (excluding Sponsors) need to give their approval. With the secured US$500m only another 20% of shareholders need to give their consent.
The approval of the deal should enable Prisa to refinance its Balance Sheet and management (with the help of the Liberty management) to focus on its operating
business. Additionally free-float and disclosure should also increase – this last point is key as Prisa has been mired by a single dominant family owner who many believed was more interested in empire building than in maximizing shareholder value.
While the transaction does reduce the level of debt (through asset sales which are contingent upon the merger plus the large cash influx from LIA) the pro-forma entity will remain highly levered. A slide presentation has been provided that estimates net debt declines from €4.75 billion to €3.25 billion, equivalent to 5.2 times TTM EBITDA.
It can be seen here:
http://www.sec.gov/Archives/edgar/data/1407539/000095012310084024/g24574exv99w1.htm
It also gives a good overview and a recommend reading it.
On a total enterprise value basis it will trade around 7x EV/EBITDA not a screaming buy but fairly valued and its leaves room for upside as operational efficiencies and deleveraging occurs.
Overall you have a chance to lock in a good return – you could hedge if you wanted but I think Prisa’s stock is interesting enough that I would rather have the beta risk. I was going to expound more on this here but its late – just know that Prisa is a force to be reckoned with on the Spanish-language media scene. The conglomerate operates in newspaper and book publishing, radio broadcasting, and pay TV services in Spain and Latin America. They will benefit as ad rates and consumption returns to normal in Europe.
Friday, October 8, 2010
Complete Notes from Ira Sohn Research Conference West
Thanks to BTIG please find the complete notes to the Ira Sohn Research Conference West. Nothing earth shattering but some interesting ideas nonetheless.
Enjoy:
John H. Burbank III, Passport Capital.
Burbank’s presentation was titled the “Math of Democracy.” Burbank noted the progressive blow-ups in the U.S. economy over the past decade. First, equities, then credit and potentially today politically. As a result of the increasing sovereign risk of the United States, Burbank believes that from an investment perspective the U.S. should be viewed as an Emerging Market. In the current environment Washington D.C. has become a key area of his research focus, with frequent visits to stay on top of developments. For Burbank, who describes himself as apolitical, this has been a notable transition. He warns that we are caught investing in 2 year political cycles, very similar to the way one would study the political cycle and sovereign risk of an Emerging Market. Burbank noted that market prices do not tell you as much as investors believe them to, instead prices generally reflect the aspect and conditions of liquidity.
Burbank noted that in 2025 entitlements and spending in the U.S. budget are predicted to surpass revenues. He then asserted the market will not let it get to that point and the markets will react sooner, potentially in the next two years to prevent that occurrence. He then explained there are 6x as many lawyers in the House of Representatives than there are MBA’s and in the Senate there are 8x as many lawyers as MBA’s. His description was it appears Congress is filled with many arguers and policy people and not too many business people.
Burbank advised that there is hope that the composure Washington D.C. can change, additionally there is also the potential for it to change quickly. He noted the public should be looking for good candidates with traits like business experience, financial acumen and courage. Burbank then described the $115,000 investment. He explained that $115,000 is the largest amount of political donations that an individual can make for an election cycle. Of that $42,700 can go directly to candidates. Burbank then broke down the spending for the last congressional election. There was $1.238 Billion spent, which if divided by the maximum $42,700 a person can spend, then 28,994 people could have funded the entire election if all gave the maximum contribution. Burbank stated this potential for small numbers of people to exert influence in past elections made him hopeful that as more Americans became disappointed, they will become more active participants in the political process thus shifting the direction of the country.
After November’s election, he expects gridlock in Washington. Burbank expects gridlock to be a positive in the short term. Although current problems won’t be fixed, new problems won’t be created. Uncertainty should come down as should volatility, both move should be beneficial to markets.
As far as the future is concerned, Burbank believes the U.S. is at an inflection point where we must choose to head in the direction of either Argentina or Germany. The developed world must now be broken down into two categories: the Solvent and the Indebted. The solvent consist of New Zealand, Canada, Australia, Switzerland, Singapore and Hong Kong (NEW CASSH). Then there is “Big Debt” consisting of the U.S., Japan, U.K., Italy, France and Spain. There has been a decade long uptrend of the performance of being long New Cassh currencies versus being short Big Debt currencies. There was a correction in the ascension during a flight to quality bid during the crisis. The uptrend has since resumed hitting new highs and Burbank expects the trend to last another decade.
Barry Rosenstein, JANA Partners.
Rosenstein discussed the improving environment for activist investors in today’s market. Activist investing is meant to create a referendum on the best ideas for value creation. The opportunity set for activism is better than it has been for a long time. Today, boards of directors look for common ground. Staggered boards and shareholder rights plans have been a decade long downtrend. In the past credible industry operators would not work with activists, this has changed. The legal environment continues to push further in the direction of shareholder rights. Corporate cash is at record levels and corporate valuations are very attractive. Private equity has $500 Billion on the sidelines, $250 Billion of which needs to be used in the next 5 years or it must be returned.
Rosenstein likes the Netherlands based global transport company TNT (TNT NA). The company has a €7.5 Billion market capitalization and trades 6x EBITDA and 11x earnings. The company has an 18% market share in Europe. €1 Billion of revenues comes from rapidly growing businesses. The company’s Express business is highly strategic. It would be attractive to FedEx, because FedEx only has a 2% market share in Europe. It would also be attractive to UPS to prevent FedEx from acquiring it. It trades with a conglomerate discount, during the past 3 years it traded at an average of 10x earnings, a significant discount to its competitors. He expects the company to break up in the next 6-9 months, but even as a stand alone, he thinks it will go to €27 from today’s price of €20.
Rosenstein also likes Charles River Labs (CRL). The company has a $2.3 Billion enterprise value and trades 10.8x after tax earnings. The company consistently has 30%+ margins and the revenue base is sticky. In 2008 preclinical spending in the pharma industry dropped and big pharma mergers hurt business. The company raised prices in 2009 and still gained market share. The company has a $500 million buyback program. Rosenstein says it is trading at a trough valuation on trough earnings. His price target is $46 versus the current price of $32. He also believes it has a breakup value above $50.
Brian Zied, Charter Bridge Capital Management.
Zied likes Sirius XM Radio (SIRI). Sirius and XMSR merged in 2008 and have 130 channels. The company has just under 20 million subscribers, 7 million retail subscribers and 12-13 million automotive. 60% of new cars sold today have built in satellite radios. 46% of those convert to become paid subscribers. The company has a low churn. It was only 1.8% last quarter. Zied analogizes the industry to the early stages of pay television rollout, now there are 100 million pay TV households in this country. There are 240 million cars on the road today and only 12-13 million have satellite radios. Depending upon the SAAR you use (current is 11.73 million) then 6-9 million cars are hitting the road every year with a factory installed radio. Auto sales rebounding will also help. Subscriber conversion and customer acquisition rates are improving.
Major capital expenditures are complete, thus most costs are fixed. For every incremental revenue dollar, sixty cents goes to the bottom line. Zied uses a conservative 10% subscriber growth, which he gets by multiplying the car conversion rates by SAAR and then accounting for the churn rate. SIRI is a $7.5 billion company with minimal sponsorship. John Malone is a significant shareholder. Today, fixed costs as a percentage of sales is 45%, in 2015 Zied believes it will be 30%. The company has $8 billion of net operating losses. The Net Present Value of them is $2 Billion. If Malone’s Liberty were to acquire SIRE, the NPV on the NOLs would be $3 Billion to them.
The company is levered, but Zied expects them to pay off debt sooner rather than later. There are also no major maturities until 2013. Although the company looks expensive on an EBITDA basis (10x), that is not the proper way to evaluate the company because the company does not have to pay taxes. Instead, it should be measured by the 14% free cash flow yield.
Mitch Julis, Canyon Partners.
Julis believes focusing upon the balance sheet evolution of a company is important. As balance sheet changes occur, they change the range of opportunities ahead for a company. Canyon practices value investing from a total return perspective as opposed to margin of safety. He noted equilibrium is the exception not the rule. Julis believes investments need both staying power and earnings power in order to build real wealth over time. When making investments, it is important to avoid focusing on the label of an instrument and instead focus on the underlying characteristics. You have to examine the bundles of rights in their entirety. Julis talked about the transition from Leveraged Buyout to Leveraged Die-out of Tribune company. Although he did not recommend them as an investment, Julis discussed the scenarios where the bond holders and term loan holders could see different levels of recoveries.
Jeffrey W. Ubben, ValueAct Capital.
ValuAct builds relationships with the companies it invests in, it is often invited to join the Board. They focus on the quality of the business. Ubben believes industry structure is important, in a 3 player industry there is often room for the number 2 or 3 player to make advances with the right changes. He looks for traits such as an oligopolistic industry and intellectual property, among other things. Industrires in transition often create opportunities when an industry matures. Often the business model is still in the growth phase mismatched with the environment, thus hurting share price and creating the opportunity for correcting course. An industry in transition today is Pharma. ValuAct saw its opportunity in Valiant Pharmaceuticals and acquired 20% of the company. Just last month, the company closed a deal with Biovail. Biovail became the acquirer because it allows the company to adopt Biovail’s tax regime. Valiant (VRX CN, VRX) was a turnaround story for ValueAct. ValuAct saw revenue diversity and customer opportunities in Valiant. They then hired Mike Pearson as CEO and the business model was transformed from focusing less on R&D and more on partnering with other drug developers and focusing on branded generics. The company dropped CapEx to $15 million per year and delivered $2.50 per share in Free Cash Flow. The impetus for the Biovail deal was that Biovail offered the same opportunity to restructure the business model in the same fashion and replicate the current success.
Robert M. Rosner, Buena Vista Fund Management.
Buena Vista focuses on Non-Japan Asia. Rosner likes Taiwan Semiconductor (2330 TT, TSM) the world’s largest foundry. The company has a $50 billion market cap and $11 Billion in revenues. He calls it a $50 Billion investment orphan. The company has been profitable every year since it came public in 1994. It has a 5% Free Cash Flow Yield. TSMC’s cash and equivalents more than double its total liabilities. Rosner explained how the CapEx in the Semi industry has transitioned from the pre-bubble to the post-bubble environment, form out of control to consistent and responsible. Rosner also pointed out the high level of asset turns and their importance. As long as the dominant player does not overcharge for their services, new competition has trouble entering the market because they cannot get up to scale quickly enough to survive. TSMC has 70% market share in advanced semi R&D giving it a strong competitive advantage.
John B. Taylor, Stanford University (The Taylor Rule).
Taylor talked about lessons learned from the financial crisis: what were the causes, why is it prolonged, why did it worsen and why is the recovery so slow. The common denominator in all aspects was government interference. During the Great Moderation, the Fed followed a rules based approach (Taylor Rule). In 2003-2005, the Fed abandoned this approach and created monetary excesses via an artificially low Fed Funds rate. The Great Deviation was taking the path that deviated from the rules based approach. He also notes that the stimulus did little good, having little to no effect on consumer spending. He concluded by highlighting what occurred in 3 month Libor-OIS in the pre-panic, panic and post panic phases of the crisis. He noted that the Libor- OIS spread only peaked when the public finally heard what the actual TARP policy was going to be - capital infusions for the banks. The policy confusion about the program before that created additional fear in the market place. Taylor believes we need to return to rules based policy and keep taxes low.
Christopher Chabris, Co-author The Invisible Gorilla.
Chabris is a cognitive psychologist and focuses on how humans have illusions about their own abilities and we often don’t recognize our lack of self awareness. He discussed inattentional blindness or the illusion of attention. He also discussed change blindness. Essentially, we can miss very important changes within mundane tasks. He also discussed the illusion of memory, in that we are often very imprecise in how we remember certain things. Chabris explained the illusion of confidence, where those who are unskilled are unaware of it and believe themselves to be much better at a task than they are. Similarly, those who are very skilled tend to believe they are better at a task than they are, but only by a very small margin.
Richard Farber, Kayne Anderson.
Farber started by discussing America’s key strengths: a powerful military, the higher education system, the patent system and Coal. Of the nearly $1 Trillion in coal reserves in the world, the U.S. has $260 Billion. That is 25%-30%, that compares to China’s 12% and Australia’s 8%. 6.5 billion tons of coal will be produced this year, half of it will be in China. The U.S. produces 3.8 tons of coal per person per year. 45%-50% of the electricity generated in the U.S. comes from coal. There are 250 years of recoverable coal reserves in the world as compared to 65 years of NatGas and 45 years of Oil. There are 3.6 billion people in the world who have no access to electricity. Farber likes the different aspects of the capital structure of Patriot Coal (PCX). It has a $1.3 billion enterprise value, $450 million in debt and $250 million in cash. The company has 1.8 billion tons of proven reserves and will extract 30-31 million tons this year. There is an 8.25% senior note maturing in 2018 that is attractive for fixed income investors. There is a 3.25% busted convert trading at a 7.5% yield to maturity. Farber believes the company will do $350-$450 million in EBITDA in 2012. Putting a modest 5x multiple on where he expects EBITDA to be, he believe the stock could double in the next 2-3 years.
Arthur Patterson, Accel Partners.
Patterson noted that IPO cycles traditionally peak every 15 years, 1969, 1983, 1999, 2014? From 1995 through 2000 there were 3000 ipos. Over the past 3 years there have been less than 150. There are still positive technological advances being driven by Moore’s law, decreasing storage costs, mobile broadband and other technologies. There has probably been a 10 fold productivity increase in the past 10 years. Due to the hostile public environment there is a pent up ipo supply. Convergent synergistic technologies continue to fuel one another. End markets continue to expand as they have done historically. Many companies are poised for growth in the current cycle. He does expect the current cycle to be milder than recent cycles. Patterson advocates IT businesses as investments because they are less capital intensive. Health Care and Cleantech have interesting opportunities, but are subject to additional regulations and can be capital intensive.
Kathryn A. Hall, Hall Capital Partners.
Hall builds global multi-asset class portfolios for families, endowments and private pensions. Her firm has $19 Billion in assets under managements. Themes dominating the tape today are macro uncertainties, government responses, high risk premiums and a burgeoning bond bubble as investors seek safety. Too often investors mistake price volatility with economic volatility. Additionally, quant trading is adding to the price volatility.
Hall believes in what she calls “First Principles” of investing. True diversification is important, that includes diversifying economic drivers and duration. An investors liquidity pool should be sized appropriately and everyone’s proper size is different. Investors should seek to take advantage of other peoples prejudices and pain. Be willing to seize an opportunity in markets where others are unwilling due to a complexity or lack of liquidity. She advocates looking for global exposure, particularly for equities. She also notes investors should not ignore inflation risk.
Thomas A. Russo, Gardner Russo & Gardner.
Russo talked about the ability to “do nothing well” and the “ability to suffer.” He described looking for companies that throw off bond like cash flow like a bond, but has the ability to reinvest it to grow their business (doing nothing well). He recalled some important wisdom Warren Buffett imparted when Russo was in business school.
“You only get 20 or so good investments in life so select them well.”
“Government is your partner in every investment (because you pay taxes), so take advantage of tax deferments.”
“Reduce agency costs (make sure the correct corporate culture).
When Russo explained the capacity to suffer, he talks about the ability to endure pain and setbacks for the purposes of investing in the future. Not only the ability to do it as an investor, but to also to find companies that were willing to endure the pain of upfront investment for the long term gain. He does not like companies that manage for the short term. When companies take the opportunity to invest for the long term and it hurts the share price, it provides the opportunity for the investor to buy at good prices. Most companies have trouble taking the short term suffering because management then faces control risk. He noticed that family owned companies often have a better capacity to withstand this control risk. The companies that he own that pursue this corporate culture are Nestle, Pernod-Ricard and SAB Miller. Nestle took the opportunity of the Russian debt crisis to invest in the country as others pulled out. SAB Miller has huge opportunities in Sub Saharan Africa (where GDP grows 10% per year) where the majority of beer is locally brewed and has a 40% market share in India. Pernod-Ricard took advantage of the largest international spirits distributer leaving China in 2000, to invest and lose in the short term for the long term gain. Now it is the number one international spirits company in China and it only has a fraction of the overall spirits market.
Enjoy:
John H. Burbank III, Passport Capital.
Burbank’s presentation was titled the “Math of Democracy.” Burbank noted the progressive blow-ups in the U.S. economy over the past decade. First, equities, then credit and potentially today politically. As a result of the increasing sovereign risk of the United States, Burbank believes that from an investment perspective the U.S. should be viewed as an Emerging Market. In the current environment Washington D.C. has become a key area of his research focus, with frequent visits to stay on top of developments. For Burbank, who describes himself as apolitical, this has been a notable transition. He warns that we are caught investing in 2 year political cycles, very similar to the way one would study the political cycle and sovereign risk of an Emerging Market. Burbank noted that market prices do not tell you as much as investors believe them to, instead prices generally reflect the aspect and conditions of liquidity.
Burbank noted that in 2025 entitlements and spending in the U.S. budget are predicted to surpass revenues. He then asserted the market will not let it get to that point and the markets will react sooner, potentially in the next two years to prevent that occurrence. He then explained there are 6x as many lawyers in the House of Representatives than there are MBA’s and in the Senate there are 8x as many lawyers as MBA’s. His description was it appears Congress is filled with many arguers and policy people and not too many business people.
Burbank advised that there is hope that the composure Washington D.C. can change, additionally there is also the potential for it to change quickly. He noted the public should be looking for good candidates with traits like business experience, financial acumen and courage. Burbank then described the $115,000 investment. He explained that $115,000 is the largest amount of political donations that an individual can make for an election cycle. Of that $42,700 can go directly to candidates. Burbank then broke down the spending for the last congressional election. There was $1.238 Billion spent, which if divided by the maximum $42,700 a person can spend, then 28,994 people could have funded the entire election if all gave the maximum contribution. Burbank stated this potential for small numbers of people to exert influence in past elections made him hopeful that as more Americans became disappointed, they will become more active participants in the political process thus shifting the direction of the country.
After November’s election, he expects gridlock in Washington. Burbank expects gridlock to be a positive in the short term. Although current problems won’t be fixed, new problems won’t be created. Uncertainty should come down as should volatility, both move should be beneficial to markets.
As far as the future is concerned, Burbank believes the U.S. is at an inflection point where we must choose to head in the direction of either Argentina or Germany. The developed world must now be broken down into two categories: the Solvent and the Indebted. The solvent consist of New Zealand, Canada, Australia, Switzerland, Singapore and Hong Kong (NEW CASSH). Then there is “Big Debt” consisting of the U.S., Japan, U.K., Italy, France and Spain. There has been a decade long uptrend of the performance of being long New Cassh currencies versus being short Big Debt currencies. There was a correction in the ascension during a flight to quality bid during the crisis. The uptrend has since resumed hitting new highs and Burbank expects the trend to last another decade.
Barry Rosenstein, JANA Partners.
Rosenstein discussed the improving environment for activist investors in today’s market. Activist investing is meant to create a referendum on the best ideas for value creation. The opportunity set for activism is better than it has been for a long time. Today, boards of directors look for common ground. Staggered boards and shareholder rights plans have been a decade long downtrend. In the past credible industry operators would not work with activists, this has changed. The legal environment continues to push further in the direction of shareholder rights. Corporate cash is at record levels and corporate valuations are very attractive. Private equity has $500 Billion on the sidelines, $250 Billion of which needs to be used in the next 5 years or it must be returned.
Rosenstein likes the Netherlands based global transport company TNT (TNT NA). The company has a €7.5 Billion market capitalization and trades 6x EBITDA and 11x earnings. The company has an 18% market share in Europe. €1 Billion of revenues comes from rapidly growing businesses. The company’s Express business is highly strategic. It would be attractive to FedEx, because FedEx only has a 2% market share in Europe. It would also be attractive to UPS to prevent FedEx from acquiring it. It trades with a conglomerate discount, during the past 3 years it traded at an average of 10x earnings, a significant discount to its competitors. He expects the company to break up in the next 6-9 months, but even as a stand alone, he thinks it will go to €27 from today’s price of €20.
Rosenstein also likes Charles River Labs (CRL). The company has a $2.3 Billion enterprise value and trades 10.8x after tax earnings. The company consistently has 30%+ margins and the revenue base is sticky. In 2008 preclinical spending in the pharma industry dropped and big pharma mergers hurt business. The company raised prices in 2009 and still gained market share. The company has a $500 million buyback program. Rosenstein says it is trading at a trough valuation on trough earnings. His price target is $46 versus the current price of $32. He also believes it has a breakup value above $50.
Brian Zied, Charter Bridge Capital Management.
Zied likes Sirius XM Radio (SIRI). Sirius and XMSR merged in 2008 and have 130 channels. The company has just under 20 million subscribers, 7 million retail subscribers and 12-13 million automotive. 60% of new cars sold today have built in satellite radios. 46% of those convert to become paid subscribers. The company has a low churn. It was only 1.8% last quarter. Zied analogizes the industry to the early stages of pay television rollout, now there are 100 million pay TV households in this country. There are 240 million cars on the road today and only 12-13 million have satellite radios. Depending upon the SAAR you use (current is 11.73 million) then 6-9 million cars are hitting the road every year with a factory installed radio. Auto sales rebounding will also help. Subscriber conversion and customer acquisition rates are improving.
Major capital expenditures are complete, thus most costs are fixed. For every incremental revenue dollar, sixty cents goes to the bottom line. Zied uses a conservative 10% subscriber growth, which he gets by multiplying the car conversion rates by SAAR and then accounting for the churn rate. SIRI is a $7.5 billion company with minimal sponsorship. John Malone is a significant shareholder. Today, fixed costs as a percentage of sales is 45%, in 2015 Zied believes it will be 30%. The company has $8 billion of net operating losses. The Net Present Value of them is $2 Billion. If Malone’s Liberty were to acquire SIRE, the NPV on the NOLs would be $3 Billion to them.
The company is levered, but Zied expects them to pay off debt sooner rather than later. There are also no major maturities until 2013. Although the company looks expensive on an EBITDA basis (10x), that is not the proper way to evaluate the company because the company does not have to pay taxes. Instead, it should be measured by the 14% free cash flow yield.
Mitch Julis, Canyon Partners.
Julis believes focusing upon the balance sheet evolution of a company is important. As balance sheet changes occur, they change the range of opportunities ahead for a company. Canyon practices value investing from a total return perspective as opposed to margin of safety. He noted equilibrium is the exception not the rule. Julis believes investments need both staying power and earnings power in order to build real wealth over time. When making investments, it is important to avoid focusing on the label of an instrument and instead focus on the underlying characteristics. You have to examine the bundles of rights in their entirety. Julis talked about the transition from Leveraged Buyout to Leveraged Die-out of Tribune company. Although he did not recommend them as an investment, Julis discussed the scenarios where the bond holders and term loan holders could see different levels of recoveries.
Jeffrey W. Ubben, ValueAct Capital.
ValuAct builds relationships with the companies it invests in, it is often invited to join the Board. They focus on the quality of the business. Ubben believes industry structure is important, in a 3 player industry there is often room for the number 2 or 3 player to make advances with the right changes. He looks for traits such as an oligopolistic industry and intellectual property, among other things. Industrires in transition often create opportunities when an industry matures. Often the business model is still in the growth phase mismatched with the environment, thus hurting share price and creating the opportunity for correcting course. An industry in transition today is Pharma. ValuAct saw its opportunity in Valiant Pharmaceuticals and acquired 20% of the company. Just last month, the company closed a deal with Biovail. Biovail became the acquirer because it allows the company to adopt Biovail’s tax regime. Valiant (VRX CN, VRX) was a turnaround story for ValueAct. ValuAct saw revenue diversity and customer opportunities in Valiant. They then hired Mike Pearson as CEO and the business model was transformed from focusing less on R&D and more on partnering with other drug developers and focusing on branded generics. The company dropped CapEx to $15 million per year and delivered $2.50 per share in Free Cash Flow. The impetus for the Biovail deal was that Biovail offered the same opportunity to restructure the business model in the same fashion and replicate the current success.
Robert M. Rosner, Buena Vista Fund Management.
Buena Vista focuses on Non-Japan Asia. Rosner likes Taiwan Semiconductor (2330 TT, TSM) the world’s largest foundry. The company has a $50 billion market cap and $11 Billion in revenues. He calls it a $50 Billion investment orphan. The company has been profitable every year since it came public in 1994. It has a 5% Free Cash Flow Yield. TSMC’s cash and equivalents more than double its total liabilities. Rosner explained how the CapEx in the Semi industry has transitioned from the pre-bubble to the post-bubble environment, form out of control to consistent and responsible. Rosner also pointed out the high level of asset turns and their importance. As long as the dominant player does not overcharge for their services, new competition has trouble entering the market because they cannot get up to scale quickly enough to survive. TSMC has 70% market share in advanced semi R&D giving it a strong competitive advantage.
John B. Taylor, Stanford University (The Taylor Rule).
Taylor talked about lessons learned from the financial crisis: what were the causes, why is it prolonged, why did it worsen and why is the recovery so slow. The common denominator in all aspects was government interference. During the Great Moderation, the Fed followed a rules based approach (Taylor Rule). In 2003-2005, the Fed abandoned this approach and created monetary excesses via an artificially low Fed Funds rate. The Great Deviation was taking the path that deviated from the rules based approach. He also notes that the stimulus did little good, having little to no effect on consumer spending. He concluded by highlighting what occurred in 3 month Libor-OIS in the pre-panic, panic and post panic phases of the crisis. He noted that the Libor- OIS spread only peaked when the public finally heard what the actual TARP policy was going to be - capital infusions for the banks. The policy confusion about the program before that created additional fear in the market place. Taylor believes we need to return to rules based policy and keep taxes low.
Christopher Chabris, Co-author The Invisible Gorilla.
Chabris is a cognitive psychologist and focuses on how humans have illusions about their own abilities and we often don’t recognize our lack of self awareness. He discussed inattentional blindness or the illusion of attention. He also discussed change blindness. Essentially, we can miss very important changes within mundane tasks. He also discussed the illusion of memory, in that we are often very imprecise in how we remember certain things. Chabris explained the illusion of confidence, where those who are unskilled are unaware of it and believe themselves to be much better at a task than they are. Similarly, those who are very skilled tend to believe they are better at a task than they are, but only by a very small margin.
Richard Farber, Kayne Anderson.
Farber started by discussing America’s key strengths: a powerful military, the higher education system, the patent system and Coal. Of the nearly $1 Trillion in coal reserves in the world, the U.S. has $260 Billion. That is 25%-30%, that compares to China’s 12% and Australia’s 8%. 6.5 billion tons of coal will be produced this year, half of it will be in China. The U.S. produces 3.8 tons of coal per person per year. 45%-50% of the electricity generated in the U.S. comes from coal. There are 250 years of recoverable coal reserves in the world as compared to 65 years of NatGas and 45 years of Oil. There are 3.6 billion people in the world who have no access to electricity. Farber likes the different aspects of the capital structure of Patriot Coal (PCX). It has a $1.3 billion enterprise value, $450 million in debt and $250 million in cash. The company has 1.8 billion tons of proven reserves and will extract 30-31 million tons this year. There is an 8.25% senior note maturing in 2018 that is attractive for fixed income investors. There is a 3.25% busted convert trading at a 7.5% yield to maturity. Farber believes the company will do $350-$450 million in EBITDA in 2012. Putting a modest 5x multiple on where he expects EBITDA to be, he believe the stock could double in the next 2-3 years.
Arthur Patterson, Accel Partners.
Patterson noted that IPO cycles traditionally peak every 15 years, 1969, 1983, 1999, 2014? From 1995 through 2000 there were 3000 ipos. Over the past 3 years there have been less than 150. There are still positive technological advances being driven by Moore’s law, decreasing storage costs, mobile broadband and other technologies. There has probably been a 10 fold productivity increase in the past 10 years. Due to the hostile public environment there is a pent up ipo supply. Convergent synergistic technologies continue to fuel one another. End markets continue to expand as they have done historically. Many companies are poised for growth in the current cycle. He does expect the current cycle to be milder than recent cycles. Patterson advocates IT businesses as investments because they are less capital intensive. Health Care and Cleantech have interesting opportunities, but are subject to additional regulations and can be capital intensive.
Kathryn A. Hall, Hall Capital Partners.
Hall builds global multi-asset class portfolios for families, endowments and private pensions. Her firm has $19 Billion in assets under managements. Themes dominating the tape today are macro uncertainties, government responses, high risk premiums and a burgeoning bond bubble as investors seek safety. Too often investors mistake price volatility with economic volatility. Additionally, quant trading is adding to the price volatility.
Hall believes in what she calls “First Principles” of investing. True diversification is important, that includes diversifying economic drivers and duration. An investors liquidity pool should be sized appropriately and everyone’s proper size is different. Investors should seek to take advantage of other peoples prejudices and pain. Be willing to seize an opportunity in markets where others are unwilling due to a complexity or lack of liquidity. She advocates looking for global exposure, particularly for equities. She also notes investors should not ignore inflation risk.
Thomas A. Russo, Gardner Russo & Gardner.
Russo talked about the ability to “do nothing well” and the “ability to suffer.” He described looking for companies that throw off bond like cash flow like a bond, but has the ability to reinvest it to grow their business (doing nothing well). He recalled some important wisdom Warren Buffett imparted when Russo was in business school.
“You only get 20 or so good investments in life so select them well.”
“Government is your partner in every investment (because you pay taxes), so take advantage of tax deferments.”
“Reduce agency costs (make sure the correct corporate culture).
When Russo explained the capacity to suffer, he talks about the ability to endure pain and setbacks for the purposes of investing in the future. Not only the ability to do it as an investor, but to also to find companies that were willing to endure the pain of upfront investment for the long term gain. He does not like companies that manage for the short term. When companies take the opportunity to invest for the long term and it hurts the share price, it provides the opportunity for the investor to buy at good prices. Most companies have trouble taking the short term suffering because management then faces control risk. He noticed that family owned companies often have a better capacity to withstand this control risk. The companies that he own that pursue this corporate culture are Nestle, Pernod-Ricard and SAB Miller. Nestle took the opportunity of the Russian debt crisis to invest in the country as others pulled out. SAB Miller has huge opportunities in Sub Saharan Africa (where GDP grows 10% per year) where the majority of beer is locally brewed and has a 40% market share in India. Pernod-Ricard took advantage of the largest international spirits distributer leaving China in 2000, to invest and lose in the short term for the long term gain. Now it is the number one international spirits company in China and it only has a fraction of the overall spirits market.
Friday, August 27, 2010
Owl Creek Q2 2010 Letter
In a similar light to my past post, I came across another quarterly letter that I thought was worth reading. Owl Creek is a macro hedge fund and they do a good job of explaining their thinking. Enjoy.
Owl Creek - 8-17-10
Owl Creek - 8-17-10
Pershing Square Q2 2010 Letter
Here is Pershing Square's Q2 2010 letter. In it, among other things, they discuss their position in BP CDS (basically a bet the company will have hard times ahead). I felt this would be good for readers to see the counter point to my original BP trade posted a while back. Enjoy.
Pershing Square - 8-26-10
Pershing Square - 8-26-10
Tuesday, August 24, 2010
GM
With all the chatter about the upcoming GM IPO. I thought now would be a good time to post up a recent idea I read on investing in GM Bonds. It does a good job of walking through the framework of how to evaluate distressed debt and shows how powerful catalyst investing can be. Enjoy:
Introduction:
The distressed market is often inefficient due to the complicated nature of the product, lack of information and illiquid trading. In some cases, this allows for significant arbitrage, and an investment in the bonds of Motors Liquidation Company (“MLC”), the former General Motors, allows for just such an opportunity. Understanding a couple of key distressed concepts – namely accrued interest and how foreign currency is treated in bankruptcy – reveals that one can generate a gross return of 11% (less borrowing cost) and an IRR of over 20% based on current market levels by establishing a long / short position in the bonds of MLC. Specifically, we advocate a long position in the Euro Notes and a short position in the Dollar Notes at a ratio of 1.000:1.123 in terms of capital invested, which results in a neutral position on a claim basis, and given that both the long and short sides of the trade involve the same claim in bankruptcy, we believe this return involves no real fundamental risk.
Situation Overview:
The former General Motors filed for bankruptcy in June 2009. The governments of the United States and Canada sponsored an asset sale of the company in bankruptcy under Section 363 of the bankruptcy code by capitalizing a new company to purchase most of the assets. This “new” General Motors is currently private, with the equity owned by the US and Canadian governments, an employee benefit trust and MLC. When the 363 sale was completed, the “old” General Motors was renamed Motors Liquidation Company and is being wound down over time as part of the bankruptcy estate. The unsecured claims at MLC are set to receive common stock and warrants of the new General Motors, and it is this value of new GM equity that comprises the vast majority of MLC’s value and will determine the price of the bonds.
Bond Valuation and Trade Details:
The proposed trade requires the purchase of Euro Notes (offered at 34.50%) and the short sale of Dollar Notes (bid at 31.50%). Despite the optically higher price of the Euro Notes, they are cheaper than the Dollar Notes by 11% on a claim basis. The reason for this is two-fold:
• The pre-petition accrued interest, which is part of the bankruptcy claim, is much higher in the Euro Note than in the Dollar Note. Since these bonds trade flat (i.e. without accrued interest), the buyer does not pay for accrued interest as with a current-pay bond, but bond prices should generally reflect this. In this case, part of the arbitrage is that the difference in accrued interest is not fully accounted for in the prices of these bonds. Euro-denominated bonds generally pay interest annually, as opposed to the domestic market, where the convention is to pay interest semi-annually, as is the case with each of these bonds. The last interest payment made on the Euro Note was on July 5, 2008, and there are ~7.58 points of pre-petition accrued interest in that note (8.375% coupon * 326 days from last payment to bankruptcy filing / 360 days used for bond year). However, since the Dollar Note last paid interest on January 15, 2009, the pre-petition accrued interest is only ~3.16 points (8.375% coupon * 136 days from last payment to bankruptcy filing / 360 days used for bond year).
• A weaker Euro has benefited the Euro Notes since a claim denominated in foreign currency is fixed at $1.4159 / Euro (exchange rate as of the date of filing, pursuant to section 502(b) of the U.S. Bankruptcy Code) but the notes are bought at the current exchange rate ($1.2000 / Euro).
Each Euro Note (face value of €1,000) is bought for $414 (€1,000 face value * 34.50% price * 1.200 current USD / EUR exchange rate), and what is purchased is a claim of $1,523 (€1,000 face value * 1.0758 to account for pre-petition accrued interest * 1.4159 USD / EUR exchange rate at time of filing). Therefore, the claim-adjusted price is 27.2% via purchase of the Euro Note.
Each Dollar Note (face value of $1,000) is bought for $315 ($1,000 face value * 31.50% price), and what is purchased is a claim of $1,032 ($1,000 face value * 1.0316 to account for pre-petition accrued interest). Therefore, the claim-adjusted price is 30.5% via purchase of the Dollar Note.
By investing the amount of dollars required to be neutral on a claim basis (a capital invested ratio of short $1.123 in Dollar Notes for each $1.000 purchased of Euro Notes), one will collect the difference in spread when the bonds are cancelled and new securities are issued. As an example, in conducting a short sale of $1,000 worth of claim via the Dollar Note, $305 in proceeds would be collected ($1000 * 30.5% claim-adjusted price). In order to satisfy the $1,000 of claim being borrowed, an investment in the Euro Notes of $272 ($1000 * 27.2% claim-adjusted price) is required. The difference of $33 would then be left over once the borrowed position on the Dollar Notes is covered using the claim proceeds from the Euro Notes.
Risks:
While we do not believe there is fundamental risk associated with this position, there are several risks to be aware of:
• Availability of borrow on the Dollar Notes
o There is currently ample borrow on the Dollar Notes – it is a $3 billion issue and generally the most liquid of the MLC bonds that trade. However, there is always the risk that the borrow might become unavailable in the future, and a short position may be called. If this occurs, and the other side of the trade (long Euro Notes) needs to be closed, it may be at an unattractive level. The borrow rate on the bonds is currently 2% per annum (or 1% over our estimated holding period).
• Timing and form of securities
o There is no definitive end date for the trade, as it requires a distribution of value based on claims in order to close. This will occur when the equity of new GM is distributed from MLC to the bondholders and other unsecured claimants. Press reports indicate that new GM will likely try and file for an IPO in early Q4 2010, although there may not be a full distribution at that time as MLC may hold back some value until it is wound down. We assume a scenario where 70-80% of the stock is distributed immediately, with the remaining stock to be distributed at a later date. There is a chance that the bonds could remain outstanding after this distribution, and so the trade may not fully close, but MLC is incentivized to wind down and claimants could instead receive new equity in a liquidating trust. This has been done in previous bankruptcies and could collapse the proposed trade even without a full distribution of new GM shares. We believe a full collapse of the trade before year-end is the most likely outcome.
• Mark to market risk on Euro Notes
o Holding the trade to completion should not result in any foreign currency issues, but in the interim there is risk that the price of the Euro Notes does not reflect the change in the value of the Euro (which has been very volatile and may continue to be so). This may result in some interim mark-to-market fluctuations, but should not be material over time.
Alternative Trade:
Depending on the viewpoint one has on new GM stock, the trade can be set up in a different ratio to create “free” shares in the new GM when the long and short ends of the trade collapse and new securities are issued. This can be accomplished by investing the same amount of dollars on each side of the trade (a capital invested ratio of short $1.000 in Dollar Notes for each $1.000 purchased of Euro Notes). As an example, investing $1,000 in Euro Notes buys $3,679 of claim value ($1,000 invested / 27.2% claim-adjusted price), while shorting $1,000 in Dollar Notes results in being short $3,275 of claim value ($1,000 invested / 30.50% claim-adjusted price). The difference, $404, is what would be kept in claim value once the trade closes and the GM stock is received, and at a market price of 27% (based on the price paid for the claim), is worth $110 against $1,000 invested in the long position.
While we believe that we are creating GM equity cheaply based on current bond prices, as we believe there is 50% upside from current levels, we acknowledge that the investment is speculative and may not be for everyone. The trade also requires significant capital to be put to work on a gross basis. However, investing in the equity theoretically removes the timing risk involved in the trade – to the extent that the trade takes longer than expected, the company should continue to accrue equity value as the operations are improving at a very fast rate. This is offset by the fundamental risks associated with owning the equity, rather than receiving cash. We have included a very brief valuation discussion on the new GM for those interested.
New GM Valuation:
The main source of value at GM is its auto manufacturing operations. With a streamlined focus on four brands (Buick, Cadillac, Chevrolet and GMC), an improved cost structure and positive outlook on vehicle sales, we estimate GM will generate $13 billion of EBITDA in 2011. We gain comfort in this estimate not only from our top-down model but also based on projections from GM’s financial advisor and recent performance. In May 2009, Evercore estimated that GM would be able to achieve $13 billion in EBITDA in 2012, but since that time, results have been much stronger than anticipated, so we do not consider achieving those results a year ahead of schedule to be significantly optimistic (disclosure statement projections, especially recently, have also historically proven to be conservative). Moreover, GM generated $3 billion of EBITDA in Q1 2010, so on a run-rate basis is already tracking close to our 2011 estimate a year ahead of schedule, and this was achieved with European operations being a drag on earnings.
We value GM on a sum-of-parts basis and use the valuation of Ford as a blueprint. While Ford is a better-run company with a stronger lineup over the next few years, we believe that GM has significant cost-cutting opportunities (particularly in Europe) and top-line projections also have more upside, so a similar multiple to Ford on our projections is warranted. Additionally, there will be some technical support for GM shares upon issuance, as it will likely be added to major indices.
• GM’s core OEM operations are worth $65 billion, based on a 5x multiple on 2011 EBITDA. This multiple is in line with Ford, after adjusting for that company’s non-core assets in a similar sum-of-parts methodology (Toyota also trades at a similar multiple based on consensus estimates).
• JV interests in Asian operations generated over $500 mm in net income in the second half of 2009 and over $400 mm in Q1 2010 – these results are not consolidated in GM’s income statement and so are not included in its reported EBITDA. Assuming that on a full-year basis these operations can contribute $1.6 billion in net income (based on Q1 2010 run-rate) and applying a 12.5x P/E multiple indicates $20 billion of value
• GM owns an equity stake in Delphi. While information on Delphi’s performance is private, we know that GM invested $2.8 billion in cash in November 2009 to purchase Delphi equity, and value the stake at the purchase price.
• GM also has a stake in both the common and preferred equity of Ally Financial (formerly GMAC). As of March 31, 2010, GM estimated the fair value of the common stock to be $1.093 billion and the preferred to be $1.002 billion, for a total value of $2.1 billion.
• GM was overcapitalized given the difficulty in obtaining financing in the markets, and thus has a strong balance sheet. As of March 31, 2010, the company had cash and investments of $23.5 billion, as well as restricted cash related to the US Treasury credit agreement of $11.3 billion (since the loans were repaid in April 2010 these funds are no longer subject to restriction, and so should be included on a pro forma basis as available cash), for a total of $34.7 billion. This amount excludes ~$1.5 billion of other restricted cash, much of which is related to a Canadian health care trust. With respect to debt, the company shows total debt of $14.2 billion as of March 31, 2010, but we believe this includes a discount of $1.6 billion and have added that amount to the balance (this was included in disclosures in the 10-K for the period ended December 31, 2009 and we have no reason to believe this number has changed). Additionally, the company had $9 billion of preferred stock. In aggregate, the company has a net cash position of $10 billion (while some debt was repaid after the reporting period, this will not change the net debt figure).
• New GM has significant underfunded pension and OPEB liabilities – as of December 31, 2009, these broke down as follows:
o $17.1 billion in underfunded U.S. pension
o $10.3 billion in underfunded non-U.S. pension
o $5.8 billion in underfunded U.S. OPEB
o $3.8 billion in underfunded non-U.S. OPEB
We do not believe that General Motors will end up being liable for this entire amount, particularly with respect to some non-U.S. and/or OPEB liabilities. Additionally, were the amounts to be paid off, the company would generate a massive deferred tax asset. Our base case conservatively assumes the entire liability is paid and discounts both the U.S. and non-U.S. amounts by 35% to account for the value of the tax shield. This results in a total liability of $24 billion.
Adding up these numbers gets to a total equity value of $75.8 billion. Based on an estimated $37 billion in unsecured claims (this is the amount estimated in the company’s SEC filings, although its monthly operating reports filed with the bankruptcy courts show liabilities subject to compromise of $32.2 billion), MLC is entitled to 52.9 million shares of new GM stock, as well as two series of warrants to purchase 45.5 million shares at implied equity values of $15 billion and $20 billion, respectively. Using the treasury method (the warrants are well in-the-money and so we ignore option value), MLC will own 115.9 million shares of new GM at an implied share price (based on total equity value of $75.8 billion) of $134, resulting in total value of $15.4 billion. Based on a total claims pool of $37 billion, this implies a recovery of 41.7%, against the current claim-adjusted price of the Euro Notes of 27.2%. In May 2009, Evercore estimated a recovery of 26.5% - however, they assumed cash at GM would be $15.3 billion, while the company has nearly $20 billion more than that. This would imply a recovery of 37.3%, holding all else equal, and performance has also been better than expected in the year since that analysis was done. While there is a wide range of opinions on what the ultimate recovery will be worth, we note that Street estimates have recovery values as high as 47 to 50%.
Introduction:
The distressed market is often inefficient due to the complicated nature of the product, lack of information and illiquid trading. In some cases, this allows for significant arbitrage, and an investment in the bonds of Motors Liquidation Company (“MLC”), the former General Motors, allows for just such an opportunity. Understanding a couple of key distressed concepts – namely accrued interest and how foreign currency is treated in bankruptcy – reveals that one can generate a gross return of 11% (less borrowing cost) and an IRR of over 20% based on current market levels by establishing a long / short position in the bonds of MLC. Specifically, we advocate a long position in the Euro Notes and a short position in the Dollar Notes at a ratio of 1.000:1.123 in terms of capital invested, which results in a neutral position on a claim basis, and given that both the long and short sides of the trade involve the same claim in bankruptcy, we believe this return involves no real fundamental risk.
Situation Overview:
The former General Motors filed for bankruptcy in June 2009. The governments of the United States and Canada sponsored an asset sale of the company in bankruptcy under Section 363 of the bankruptcy code by capitalizing a new company to purchase most of the assets. This “new” General Motors is currently private, with the equity owned by the US and Canadian governments, an employee benefit trust and MLC. When the 363 sale was completed, the “old” General Motors was renamed Motors Liquidation Company and is being wound down over time as part of the bankruptcy estate. The unsecured claims at MLC are set to receive common stock and warrants of the new General Motors, and it is this value of new GM equity that comprises the vast majority of MLC’s value and will determine the price of the bonds.
Bond Valuation and Trade Details:
The proposed trade requires the purchase of Euro Notes (offered at 34.50%) and the short sale of Dollar Notes (bid at 31.50%). Despite the optically higher price of the Euro Notes, they are cheaper than the Dollar Notes by 11% on a claim basis. The reason for this is two-fold:
• The pre-petition accrued interest, which is part of the bankruptcy claim, is much higher in the Euro Note than in the Dollar Note. Since these bonds trade flat (i.e. without accrued interest), the buyer does not pay for accrued interest as with a current-pay bond, but bond prices should generally reflect this. In this case, part of the arbitrage is that the difference in accrued interest is not fully accounted for in the prices of these bonds. Euro-denominated bonds generally pay interest annually, as opposed to the domestic market, where the convention is to pay interest semi-annually, as is the case with each of these bonds. The last interest payment made on the Euro Note was on July 5, 2008, and there are ~7.58 points of pre-petition accrued interest in that note (8.375% coupon * 326 days from last payment to bankruptcy filing / 360 days used for bond year). However, since the Dollar Note last paid interest on January 15, 2009, the pre-petition accrued interest is only ~3.16 points (8.375% coupon * 136 days from last payment to bankruptcy filing / 360 days used for bond year).
• A weaker Euro has benefited the Euro Notes since a claim denominated in foreign currency is fixed at $1.4159 / Euro (exchange rate as of the date of filing, pursuant to section 502(b) of the U.S. Bankruptcy Code) but the notes are bought at the current exchange rate ($1.2000 / Euro).
Each Euro Note (face value of €1,000) is bought for $414 (€1,000 face value * 34.50% price * 1.200 current USD / EUR exchange rate), and what is purchased is a claim of $1,523 (€1,000 face value * 1.0758 to account for pre-petition accrued interest * 1.4159 USD / EUR exchange rate at time of filing). Therefore, the claim-adjusted price is 27.2% via purchase of the Euro Note.
Each Dollar Note (face value of $1,000) is bought for $315 ($1,000 face value * 31.50% price), and what is purchased is a claim of $1,032 ($1,000 face value * 1.0316 to account for pre-petition accrued interest). Therefore, the claim-adjusted price is 30.5% via purchase of the Dollar Note.
By investing the amount of dollars required to be neutral on a claim basis (a capital invested ratio of short $1.123 in Dollar Notes for each $1.000 purchased of Euro Notes), one will collect the difference in spread when the bonds are cancelled and new securities are issued. As an example, in conducting a short sale of $1,000 worth of claim via the Dollar Note, $305 in proceeds would be collected ($1000 * 30.5% claim-adjusted price). In order to satisfy the $1,000 of claim being borrowed, an investment in the Euro Notes of $272 ($1000 * 27.2% claim-adjusted price) is required. The difference of $33 would then be left over once the borrowed position on the Dollar Notes is covered using the claim proceeds from the Euro Notes.
Risks:
While we do not believe there is fundamental risk associated with this position, there are several risks to be aware of:
• Availability of borrow on the Dollar Notes
o There is currently ample borrow on the Dollar Notes – it is a $3 billion issue and generally the most liquid of the MLC bonds that trade. However, there is always the risk that the borrow might become unavailable in the future, and a short position may be called. If this occurs, and the other side of the trade (long Euro Notes) needs to be closed, it may be at an unattractive level. The borrow rate on the bonds is currently 2% per annum (or 1% over our estimated holding period).
• Timing and form of securities
o There is no definitive end date for the trade, as it requires a distribution of value based on claims in order to close. This will occur when the equity of new GM is distributed from MLC to the bondholders and other unsecured claimants. Press reports indicate that new GM will likely try and file for an IPO in early Q4 2010, although there may not be a full distribution at that time as MLC may hold back some value until it is wound down. We assume a scenario where 70-80% of the stock is distributed immediately, with the remaining stock to be distributed at a later date. There is a chance that the bonds could remain outstanding after this distribution, and so the trade may not fully close, but MLC is incentivized to wind down and claimants could instead receive new equity in a liquidating trust. This has been done in previous bankruptcies and could collapse the proposed trade even without a full distribution of new GM shares. We believe a full collapse of the trade before year-end is the most likely outcome.
• Mark to market risk on Euro Notes
o Holding the trade to completion should not result in any foreign currency issues, but in the interim there is risk that the price of the Euro Notes does not reflect the change in the value of the Euro (which has been very volatile and may continue to be so). This may result in some interim mark-to-market fluctuations, but should not be material over time.
Alternative Trade:
Depending on the viewpoint one has on new GM stock, the trade can be set up in a different ratio to create “free” shares in the new GM when the long and short ends of the trade collapse and new securities are issued. This can be accomplished by investing the same amount of dollars on each side of the trade (a capital invested ratio of short $1.000 in Dollar Notes for each $1.000 purchased of Euro Notes). As an example, investing $1,000 in Euro Notes buys $3,679 of claim value ($1,000 invested / 27.2% claim-adjusted price), while shorting $1,000 in Dollar Notes results in being short $3,275 of claim value ($1,000 invested / 30.50% claim-adjusted price). The difference, $404, is what would be kept in claim value once the trade closes and the GM stock is received, and at a market price of 27% (based on the price paid for the claim), is worth $110 against $1,000 invested in the long position.
While we believe that we are creating GM equity cheaply based on current bond prices, as we believe there is 50% upside from current levels, we acknowledge that the investment is speculative and may not be for everyone. The trade also requires significant capital to be put to work on a gross basis. However, investing in the equity theoretically removes the timing risk involved in the trade – to the extent that the trade takes longer than expected, the company should continue to accrue equity value as the operations are improving at a very fast rate. This is offset by the fundamental risks associated with owning the equity, rather than receiving cash. We have included a very brief valuation discussion on the new GM for those interested.
New GM Valuation:
The main source of value at GM is its auto manufacturing operations. With a streamlined focus on four brands (Buick, Cadillac, Chevrolet and GMC), an improved cost structure and positive outlook on vehicle sales, we estimate GM will generate $13 billion of EBITDA in 2011. We gain comfort in this estimate not only from our top-down model but also based on projections from GM’s financial advisor and recent performance. In May 2009, Evercore estimated that GM would be able to achieve $13 billion in EBITDA in 2012, but since that time, results have been much stronger than anticipated, so we do not consider achieving those results a year ahead of schedule to be significantly optimistic (disclosure statement projections, especially recently, have also historically proven to be conservative). Moreover, GM generated $3 billion of EBITDA in Q1 2010, so on a run-rate basis is already tracking close to our 2011 estimate a year ahead of schedule, and this was achieved with European operations being a drag on earnings.
We value GM on a sum-of-parts basis and use the valuation of Ford as a blueprint. While Ford is a better-run company with a stronger lineup over the next few years, we believe that GM has significant cost-cutting opportunities (particularly in Europe) and top-line projections also have more upside, so a similar multiple to Ford on our projections is warranted. Additionally, there will be some technical support for GM shares upon issuance, as it will likely be added to major indices.
• GM’s core OEM operations are worth $65 billion, based on a 5x multiple on 2011 EBITDA. This multiple is in line with Ford, after adjusting for that company’s non-core assets in a similar sum-of-parts methodology (Toyota also trades at a similar multiple based on consensus estimates).
• JV interests in Asian operations generated over $500 mm in net income in the second half of 2009 and over $400 mm in Q1 2010 – these results are not consolidated in GM’s income statement and so are not included in its reported EBITDA. Assuming that on a full-year basis these operations can contribute $1.6 billion in net income (based on Q1 2010 run-rate) and applying a 12.5x P/E multiple indicates $20 billion of value
• GM owns an equity stake in Delphi. While information on Delphi’s performance is private, we know that GM invested $2.8 billion in cash in November 2009 to purchase Delphi equity, and value the stake at the purchase price.
• GM also has a stake in both the common and preferred equity of Ally Financial (formerly GMAC). As of March 31, 2010, GM estimated the fair value of the common stock to be $1.093 billion and the preferred to be $1.002 billion, for a total value of $2.1 billion.
• GM was overcapitalized given the difficulty in obtaining financing in the markets, and thus has a strong balance sheet. As of March 31, 2010, the company had cash and investments of $23.5 billion, as well as restricted cash related to the US Treasury credit agreement of $11.3 billion (since the loans were repaid in April 2010 these funds are no longer subject to restriction, and so should be included on a pro forma basis as available cash), for a total of $34.7 billion. This amount excludes ~$1.5 billion of other restricted cash, much of which is related to a Canadian health care trust. With respect to debt, the company shows total debt of $14.2 billion as of March 31, 2010, but we believe this includes a discount of $1.6 billion and have added that amount to the balance (this was included in disclosures in the 10-K for the period ended December 31, 2009 and we have no reason to believe this number has changed). Additionally, the company had $9 billion of preferred stock. In aggregate, the company has a net cash position of $10 billion (while some debt was repaid after the reporting period, this will not change the net debt figure).
• New GM has significant underfunded pension and OPEB liabilities – as of December 31, 2009, these broke down as follows:
o $17.1 billion in underfunded U.S. pension
o $10.3 billion in underfunded non-U.S. pension
o $5.8 billion in underfunded U.S. OPEB
o $3.8 billion in underfunded non-U.S. OPEB
We do not believe that General Motors will end up being liable for this entire amount, particularly with respect to some non-U.S. and/or OPEB liabilities. Additionally, were the amounts to be paid off, the company would generate a massive deferred tax asset. Our base case conservatively assumes the entire liability is paid and discounts both the U.S. and non-U.S. amounts by 35% to account for the value of the tax shield. This results in a total liability of $24 billion.
Adding up these numbers gets to a total equity value of $75.8 billion. Based on an estimated $37 billion in unsecured claims (this is the amount estimated in the company’s SEC filings, although its monthly operating reports filed with the bankruptcy courts show liabilities subject to compromise of $32.2 billion), MLC is entitled to 52.9 million shares of new GM stock, as well as two series of warrants to purchase 45.5 million shares at implied equity values of $15 billion and $20 billion, respectively. Using the treasury method (the warrants are well in-the-money and so we ignore option value), MLC will own 115.9 million shares of new GM at an implied share price (based on total equity value of $75.8 billion) of $134, resulting in total value of $15.4 billion. Based on a total claims pool of $37 billion, this implies a recovery of 41.7%, against the current claim-adjusted price of the Euro Notes of 27.2%. In May 2009, Evercore estimated a recovery of 26.5% - however, they assumed cash at GM would be $15.3 billion, while the company has nearly $20 billion more than that. This would imply a recovery of 37.3%, holding all else equal, and performance has also been better than expected in the year since that analysis was done. While there is a wide range of opinions on what the ultimate recovery will be worth, we note that Street estimates have recovery values as high as 47 to 50%.
Friday, July 16, 2010
Additional Thoughts on BP
I felt a nice compliment to the T2 Presentation might be an explanation of a trade that I beleive could yield a nice return. Would love any feedback.
Now that BP has put the cap on the well its all gravy from here. Well....maybe not but the good news is this idea doesn't really depend on stellar out-performance. I am recommending a 1X1 vertical call spread. I would advise using the 1/20/2012 Calls at strikes of 42.5 and 45 (to avoid confusion I am advocating buying the 42.50s and selling the 45s at a 1:1 ratio). Based on midpoint pricing as of close on 7/15/10 the 42.50s trade at 6.90 and the 45s are at 6.13 this represents a $0.77 spread. So using simple math if at anytime up until 1/20/2012 BP's equity goes to 45 or above the position will have an intrinsic value of $2.50/share versus a cost of $0.77 or a nice profit of 3.25x invested capital. For frame of reference BP's equity closed trading today at $38.92. That means we have the potential to make 3.25x our money if the stock just goes up by 15.6% by 1/20/2012 - sounds like a pretty manageable gap to me.
Now for the nitty-gritty. Obviously BP will have to pay substantial sums for the damage they have caused to the Gulf Coast. Given our populist president and the current business hating environment I imagine these fees will be quite large. The ultimate cost to BP is impossible to know currently. The 1989 Exxon Valdez spill of 250 kbls cost Exxon US$3.8 bn. Assuming that a spill of similar size in the GoM could today cost $10 bn, allowing for inflation and the greater impact of this spill (a more highly populated and more economically relevant area). However, this estimate is subject to great uncertainty, as there is no useful recent comparison for a spill of this size in such a populated area. To be conservative we assume that BP (as an operator) bears 100% of the clean-up and legal costs, despite owning only 65% of the license. However, this is another key area of uncertainty; we do not know yet the exact reasons for the failures that led to the spill and which company might be responsible for it.
Just for fun lets make some nice round estimates on what the spill could ultimately cost. At $40,000 per barrel spilt, or $10 bn per 250 kbls (backed into by inflating Exxon’s US$3.8 bn costs relating to the Valdez spill in 1989 by 5% pa). Then a apply this cost to the total number of barrels spilt, and do not adjust for those barrels
that have been dispersed or evaporated, which could be as much as 50% of the total
volume. We also attribute 100% of this cost to BP, as the operator of the license, although it owns only a 65% stake in the block (and bless BP's heart they have been sending bills to their partners as incurred - payment of such bills is another topic all together). Lets be draconian, the well leaked for 85 days, lets assume the well leaked all in 1.65mbls (about 19kbls per day while there have been a number of outliers on estimates out there I decided to shoot the middle on this one). We then take that number multiplied by our $40,000 per barrel split to arrive at a total cost of $66B. Quite a staggering sum. However even using this amount the stock the stock would trade on an EV/DACF of 5.5x in 2010E and 4.5x in 2011E.
How would BP pay for this: BP has announced an intention to raise $10bn from non-core asset divestments over the next 12-months. This compares to BP's 'normal course' level of non-core divestments of $3-4bn per annum. There is an overhang of unsold refineries on the market - we count at least 25 with a capacity of 2.9 million bopd. So, we doubt BP will seek to compete in that oversupplied asset market. Retail asset divestments are always an option – given the damage to BP’s brand, it is possible that a buyer may see greater value by rebranding some outlets. Excluding Russia, BP has 22,400 retail sites. An exit from specialty (acetyls and aromatics) chemicals is possible – given capital employed of $5-6bn, this could be a useful ticket which would complete BP's exit from the chemicals segment following the sale of Innovene. Upstream, we sense that it more a buyer’s market for gas oriented assets and we doubt BP will U-turn following its recent build up in the US gas shale ($3.7bn acquisitions in H2 2008). This leaves oil biased upstream assets. We doubt BP will want to sell growth oriented (undeveloped) assets; we suspect it should rather sell more mature producing positions which are more straightforward to value and for which there is a relatively buoyant market. Such assets could include pieces in the UK North Sea, the Lower 48 (onshore USA), Canada and perhaps Colombia. We very much doubt BP will look to reduce its exposure to Angola or TNK-BP given their resource depth and long term growth potential. BP has three listed investments which have an aggregate market value of approximately $2.6bn that it might consider selling – a 1.3% stake in Rosneft (market value $880m), a 20% stake in China Aviation Oil Singapore (market value $150m) and a 71% stake in Castrol India (market value $1,600m). Aside from just the raw cashflow producing power of BP there are a number of avenues for additional cash.
There is a lot more I could talk about on the company and its cash producing prospects but I will leave that to the reader to discover.
While the dynamics may be unappealing to some - 100% loss versus 325% upside. I personally find a 3:1 trade with reasonable safety and a long life quite appealing.
Now that BP has put the cap on the well its all gravy from here. Well....maybe not but the good news is this idea doesn't really depend on stellar out-performance. I am recommending a 1X1 vertical call spread. I would advise using the 1/20/2012 Calls at strikes of 42.5 and 45 (to avoid confusion I am advocating buying the 42.50s and selling the 45s at a 1:1 ratio). Based on midpoint pricing as of close on 7/15/10 the 42.50s trade at 6.90 and the 45s are at 6.13 this represents a $0.77 spread. So using simple math if at anytime up until 1/20/2012 BP's equity goes to 45 or above the position will have an intrinsic value of $2.50/share versus a cost of $0.77 or a nice profit of 3.25x invested capital. For frame of reference BP's equity closed trading today at $38.92. That means we have the potential to make 3.25x our money if the stock just goes up by 15.6% by 1/20/2012 - sounds like a pretty manageable gap to me.
Now for the nitty-gritty. Obviously BP will have to pay substantial sums for the damage they have caused to the Gulf Coast. Given our populist president and the current business hating environment I imagine these fees will be quite large. The ultimate cost to BP is impossible to know currently. The 1989 Exxon Valdez spill of 250 kbls cost Exxon US$3.8 bn. Assuming that a spill of similar size in the GoM could today cost $10 bn, allowing for inflation and the greater impact of this spill (a more highly populated and more economically relevant area). However, this estimate is subject to great uncertainty, as there is no useful recent comparison for a spill of this size in such a populated area. To be conservative we assume that BP (as an operator) bears 100% of the clean-up and legal costs, despite owning only 65% of the license. However, this is another key area of uncertainty; we do not know yet the exact reasons for the failures that led to the spill and which company might be responsible for it.
Just for fun lets make some nice round estimates on what the spill could ultimately cost. At $40,000 per barrel spilt, or $10 bn per 250 kbls (backed into by inflating Exxon’s US$3.8 bn costs relating to the Valdez spill in 1989 by 5% pa). Then a apply this cost to the total number of barrels spilt, and do not adjust for those barrels
that have been dispersed or evaporated, which could be as much as 50% of the total
volume. We also attribute 100% of this cost to BP, as the operator of the license, although it owns only a 65% stake in the block (and bless BP's heart they have been sending bills to their partners as incurred - payment of such bills is another topic all together). Lets be draconian, the well leaked for 85 days, lets assume the well leaked all in 1.65mbls (about 19kbls per day while there have been a number of outliers on estimates out there I decided to shoot the middle on this one). We then take that number multiplied by our $40,000 per barrel split to arrive at a total cost of $66B. Quite a staggering sum. However even using this amount the stock the stock would trade on an EV/DACF of 5.5x in 2010E and 4.5x in 2011E.
How would BP pay for this: BP has announced an intention to raise $10bn from non-core asset divestments over the next 12-months. This compares to BP's 'normal course' level of non-core divestments of $3-4bn per annum. There is an overhang of unsold refineries on the market - we count at least 25 with a capacity of 2.9 million bopd. So, we doubt BP will seek to compete in that oversupplied asset market. Retail asset divestments are always an option – given the damage to BP’s brand, it is possible that a buyer may see greater value by rebranding some outlets. Excluding Russia, BP has 22,400 retail sites. An exit from specialty (acetyls and aromatics) chemicals is possible – given capital employed of $5-6bn, this could be a useful ticket which would complete BP's exit from the chemicals segment following the sale of Innovene. Upstream, we sense that it more a buyer’s market for gas oriented assets and we doubt BP will U-turn following its recent build up in the US gas shale ($3.7bn acquisitions in H2 2008). This leaves oil biased upstream assets. We doubt BP will want to sell growth oriented (undeveloped) assets; we suspect it should rather sell more mature producing positions which are more straightforward to value and for which there is a relatively buoyant market. Such assets could include pieces in the UK North Sea, the Lower 48 (onshore USA), Canada and perhaps Colombia. We very much doubt BP will look to reduce its exposure to Angola or TNK-BP given their resource depth and long term growth potential. BP has three listed investments which have an aggregate market value of approximately $2.6bn that it might consider selling – a 1.3% stake in Rosneft (market value $880m), a 20% stake in China Aviation Oil Singapore (market value $150m) and a 71% stake in Castrol India (market value $1,600m). Aside from just the raw cashflow producing power of BP there are a number of avenues for additional cash.
There is a lot more I could talk about on the company and its cash producing prospects but I will leave that to the reader to discover.
While the dynamics may be unappealing to some - 100% loss versus 325% upside. I personally find a 3:1 trade with reasonable safety and a long life quite appealing.
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