Pacer: Change of Mind

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:

1. 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.
2. Now Pacer does not have any pricing power or unique access to the UNP network so its advantage have disappeared.
3. 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.
4. 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%.
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.
6. 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.
7. 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.
8. 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.
9. A lot of insider selling. Not a good sign.
10. 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.
11. Also the credit facility is very strict and keeps Pacer on a tight leach.
12. 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

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:

1. 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.
   
2. 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.
   
3. 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:
1. CLO funds. Lear debt and loans was wildly held by CLOs. CLOs do not hold equity; their charter do not allow it.
2. Preferred stock conversion. Right now preferred are in the money and the company can force its conversion.
3. Warrants exercise also in the money.
   
4. Warrants and preferreds conversion will cause 35% dilution.
   
4. The quick exist from bankruptcy limits lawyers and advisers fees.

What is not good about the ideas:

1. 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.
2. Margins are very thin right now below historical norm. This may change with more sales.
3. GM and Ford make the bulk of its sales. Enough said.
   
4. Economic risks of decline as so far recovery is shaky.
5. 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?

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

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

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

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:

1. 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.
2. 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.