CHC Helicopter Buyout Status

I have invested in CHC Helicopter a buyout target for the home to earn an arbitrage profit in this mundane market. The uncertainty in the credit markets and the lack of risk taking investors made the price behaviour of this buyout out of the norm. I guess most buyout candidates are behaving in an abnormal way.

I have expected the stock to trend higher in a steady matter towards the buyout price, however it is stuck at the buyout announcement price level and it has been over 30 days since that day. As you can see in the chart the price fluctuated slightly around the current level.

The credit markets trouble is the prime culprit for this behaviour. Investors have decreased the probability of this deal being completed due to the credit market issues. An example of the unraveled deals is Clear channel buyout. The buyout is not happening any more and all parties involved in that transaction are in court trying to settle it. The volume of deals completed and announced has came to a trickle. As you can see in the table there was only 5 deals completed this quarter; a far cry from the volume a year ago.

However I still think this deal will get done as and I hold to my probabilities I outlined in my original post for the following reasons:

1. deal size is much smaller and banks can float the debt.


2. the deal was announced last months in the midst of the credit crises and I am sure all the financing terms and conditions have adjusted for the appropriate risks, so there is no covenant lite type of clauses.


3. there is a substantial equity component in the deal from the sponsor.

For those reasons I will continue holding onto my position in CHC. On April 3rd the underwriters will meet with CHC and their commitments are due by the end of April. So until then the price of CHC will continue to move up and down depending on the news on the credit markets.

Graco: Boring business with potential for good returns

Graco (GGG):

Graco offers systems, products and technology that set quality and production standards in a wide range of fluid handling applications including spray finishing and paint circulation, lubrication, sealant and adhesives, processing, as well as power application equipment for the contractor industry. Founded in 1926, Graco’s ongoing investment in fluid management and control will continue to provide innovative solutions to a diverse global market.

The company is not well known to main stream or to analysts; it only has 5 analysts' recommendations. Also it has a small size market cap of $2.7 Billion. However it has a wonderful business with strong return on investment. In my opinion, it has all the criteria to look for in an investment that will outperform the market in the long run. The company is also similar to some of the industrial businesses purchased by Buffett, that is very boring and steady business. A comparable company in his holding to this one is the recently purchased Iscarr.

The company fluid handling products sells mostly for commercial uses to two distinct user groups: the Housing Contractor and the industrial user. Its products are used for various applications in the industries mentioned including: painting, finishing and foam spraying and industrial greasing and lubrication in automotive shops and equipment building. The company operates, organizes and sells its products through 3 different divisions: Industrial, Contractor (housing), and Lubrication (industrial).

Business Economics

• International sales driven strategy: the company is pursuing International sales and distribution aggressively. Currently international sales accounts for 34% of its gross sales.
• Market share: established a factory in China to sell to its customer in the growing Asia Pacific segment of the business. the Chinese are adding 1000 cars a day to the their streets and the lubrication division sell products for service garages and car maintenance shops. The need in that market will be large. Although it assembles small part of the company products but I expect management to expand this strategy to include more products that specifically manufactured for Asia. The company has been expanding its distribution channels throughout the world by acquiring smaller companies. Most of these acquisition has solidified its market share and presence through the different application segments it operates in.
  
• Revenue growth: The company has experienced decline in 2007 sales in the contractor division on the basis of weaknesses in the housing market. Most of their sales channels, paint stores and home centres, were weak and it is expected to be weak until the housing market stabilizes. This division accounts for 36% of total sales in 2007 down from 39% in 2006. A combination of lower sales and growth in its industrial division. With slowing economy I expect that the industrial division to slow down as well. The industrial division has been offsetting the decline in its contractor division so far with good growth in revenues and operating profits.
• Product Development and R&D: The company maintains a healthy spending on research and development. The company spends 4% of sales on R&D annually. It also have a new product introduction cycle of 3 years, that means that there is a 3 year replacement cycle for existing customers.
• Operational efficiency: The company has managed to reduce its cost of manufacturing from 50% in 2001to 46% on TTM basis. Moreover net margins have grown from 13% in 2001 to 19% on TTM basis.
• Competitive Advantage in the quality and the brand the company has built over the years. Additional competitive advantage is the size of Graco in its target markets. The company has a size advantage over competitors and have actually bought some of its competitors in the past. Additional advantage is its extensive distribution network that the company has put through acquisitions.
  

Management Quality

The company management's track record has been outstanding and enriching to shareholders. The company's return on invested capital (ROIC) is consistent and higher than its peers. Currently its ROIC stands at 51% and if you refine it more for return on intangible assets the ratio shoots up to 90%.

A similar result can be obtained from its return on assets and equity. As you can see from chart, the 10 yr trend for its return on assets and equity is consistently strong.

The average growth rate in equity value over the last decade was 25% annually.

Recently there was a management change at the top. The new CEO is home grown, which is always a good sign. The new CEO has served 17 years with the company and has served in almost every department of the company. A good sign also as the experience will give him a complete understanding of the strength and weaknesses of the company so he can leverage them to peruse growth opportunities.

Management has been buying back the stock at furious pace in the form of shares buybacks and insider buying. The company even leveraged an always pristine balance sheet from 0 debt to equity ratio to 43% to buy back its own stock. The company purchased 3.9 million shares or 6.4% of outstanding shares during the last two quarters of 2007.

Insiders control 0.84% of GGG through the 1,110,257 shares that they hold. This level of ownership is below the Machinery industry norm. However, insider trading has been bullish recently with net buying activity of 451.8K shares, which is above the 2-year quarterly average where insiders typically buy 125.6K shares.

Valuation

The company is not cheap or expensive. I beg it is fairly valued at current market prices. I missed my opportunity few weeks ago to buy it at a great price of $32 but I was still conducting my analysis. I hope it will revisit that price soon.

I have a valuation for the company between $36-$44 per share based on very conservative estimates of growth rates and operations. The company international growth rates if materialized ill justify higher valuation. Another upside for valuation is the recovery in the US housing market. The analyst community is estimating 15% growth rate in revenues over the next 5 years. I have used 4-10% growth rate range throughout my analysis.

The company has leveraged itself in Q4 to implement its repurchase program. I do not have a problem with leveraging the company to do acquisitions but the wisdom to leverage the company to implement a repurchase program is not the most optimal course of action to me. However some may argue that there is an optimal capital structure of debt to equity to maximize shareholders value and recapitalization of the firm capital structure is needed for companies with less than optimal debt.

I am a buyer of Graco at $33 or below. I am willing to buy at fair market value and sacrifice the margin of safety for an excellent run business.

Commercial Real Estate Debt

I have been writing about how irrational debt market is and how panic stricken it became, see my posts here and particularly about commercial real estate debt, see my posts here and here.



There are a lot of opportunities in debt due to the out of whack risk adjusted spreads on debt instruments. Investors stopped accepting risk and are avoiding uncertainty at all costs. However, successful investing, in my mind, is about accepting sufficient returns for risk in face of uncertainty. Now investors are accepting no returns or negative real returns, in case of treasuries, to avoid economic uncertainty. And that is creating several investing opportunities.




To zero in some of these opportunities, I will focus on the commercial real estate debt (CMBS) market. The irrationality in the pricing of these instruments and their credit default swaps, insurance against default of the debt, are perfectly illustrated here. Currently some of the most senior and triple AAA rated debt requires $170-200 of insurance premiums for each $100 of principal over the life of the debt. Lower rated bonds are trading at much higher spreads, ridiculously higher spreads, see the chart from Markit Group.



The market implicitly is saying that none of the commercial debt will make it to maturity and betting that they can collect on the swap sometime within the next few years, most CMBS debt is amortized over 10 years. To those buying credit protection, it is no longer a matter of if, it is a matter of when. An investor seeking a 10% return on a short position would, at current levels, need all 25 bonds underlying the CMBX index to lose all principal within 4 years.





But what kind of an economic realty will produce such default rates? In such an environment it means that most tenants of retail and office properties will have to stop paying rent in sufficient amounts to make the debt default, or a major economic catastrophe where most tenants are out of business.

Moreover, subordination levels on the super-senior tranches of CMBS deals typically run at 30%, a multiple of what the rating agencies require for their highest credit ratings. With 30% of subordination, the deal could suffer a cumulative default rate of 75% and average loss severities of 40% – well above the norm – before any dollar of principal would be at risk. To put it in perspective the current default rate on the average CMBS had a cumulative loan default rate of just under one tenth of one percent, and zero cumulative losses. The market is pricing in excess of 50% default rates and losses on the debt; this scenario have a low to zero chances of occurring.

Investors are confusing the residential debt market with the commercial real estate market sufficiently to anticipate a repeat of the problems of subprime in commercial real estate. The fact is the economics of the two markets are entirely different. I have discussed those economics in a previous post and defer you to it to understand my rationale.

I am actually somewhat bearish on Commercial real estate economics. The fundamentals are currently good but will deteriorate with a slowing economy sufficiently to increase default rates but nothing close to what the market is pricing. Once the "deleveraging" of the system is finished, some of those spreads have to narrow and once the clouds of the doom and gloom or uncertainty is cleared, CMBS prices will shoot up as investors will seek real returns on their capital. And that's why I see an opportunity in the the CMBS debt.

However for the retail investor to buy outright CMBS debt is a very difficult endeavour. I am currently searching for closed end funds with enough focus and good quality assets to invest in but so far I have not find any. If you have any names pass them along and I will review them here.

Treasury Market Bubble

The treasury market is so overvalued that some can actually call it a bubble. Since mid last year the long term yield have gone down from 5.13% , its peak since 2001, to currently multi year low of 4.16%. More importantly treasuries are yielding negative real returns.



Investors in the debt markets have actually given up on investing; they are accepting negative real returns for the safety of their principal. They are not willing to accept any risk or uncertainty for that matter. They are paying the US government to guard their money. As you can see in the chart the 30 year treasury real yield (30 yr bond less inflation) has turned negative towards the end of 2007. The last time treasuries had negative real returns was in the early 1970s when the US was battling high inflation rates.


The situation in the credit markets is nothing less than sheer panic. It has thrown all sort of spreads on debt instruments to levels that borders on irrationality. Municipal bonds, which are tax free, are yielding better than the unfavourably taxed treasuries. Triple A rated corporate debt is yielding a healthy 2% spread over equivalent maturing treasuries. Commercial real estate triple AAA rated bonds are yielding unprecedented 3.35% spread. There are a lot of opportunities in the panic stricken credit market but treasuries are not one of them.


The credit market have to readjust and accept risk again and once it does treasuries are going to come down hard. I have sold a big percentage of my government bond holdings to stay away from the impending devaluation. Corporate debt and commercial real estate debt offer better risk adjusted returns as I am willing to accept the uncertainties of the debt "deleveraging" from the system.

Commodities Big Adjustment

Commodities have been on a tear lately and just over the last two days they have came down hard. For those who invested over the last year or longer the correction do not mean much, as you were up multi fold the decline of the last two days. But for those who got scared of the markets over the last two months and jumped on the commodities band wagon you paid dearly.

The speculative element of commodities is very hard to analyze or comprehend. It appears suddenly and disappears as fast as it came. That's why I am not a big fan of "speculating " in commodities or commodities business. I do not consider buying gold as an investment, it mere speculation on its future price due one reason or another.

If you think about it why would you invest in a company that has no control over the price of what it is selling or its ability to create demand for its products for that matter. One of the most fundamental aspects of value investing is to find companies that is free to pass along increase in costs to its customers and to expand its markets. Commodity producing companies are a miss on both aspects. They can not price their products at all, it is left to market forces. Also commodity producing businesses have no ability to increase demand for their products by executing on their business strategies, primarily demand is left for economic forces that is outside of the company control.

I do not see commodity as an investment from any aspect. Value investing in commodity producing stocks is an oxymoron sort of speak.

Investing Errors

If you're like me, your most valuable lessons came from first hand experiences rather learning from other people mistakes. Generally speaking people learn better through the mistakes they make. I have read about the same issues that I am writing about elsewhere but sometimes you need to make these errors to realize what it means.

In this post I will review some mistakes and how I adjust for them. I will go through these mistakes by category:

Valuation errors:

• Not accounting properly for the business cycles. I used to take 5 years average of EBIT margins to do my Earning Power Valuation, while 10 years average is more appropriate as it includes at least one full cycle of economic activity. A 5 year average can distort valuation by including either the most favorable margins of the economic cycle or the worst. A 10 year cycle will almost guarantee including a business cycle from bottom to peak and will reflect the most likely EBIT margins for the business going forward for the next decade.
  
• Relying too much on one valuation technique. Valuation is very illusive and can differ from one person to another. I used to use Discounted Free Cash Flow approach exclusively to determine a business intrinsic value, however the approach is as good as the estimate I use for it. Now I deploy several other approaches to validate my results. I use Earning Power Value, liquidation value if appropriate, and sum of the parts, again if appropriate.
• Not using IRR and ROE concepts to measure my return on investments. I use these concepts all the time when I evaluate capital decisions for my business, however I failed to use them to choose between stock investments. Buying a stock is no different from buying real estate or machinery for the business and should be treated as such. You need to buy the stock that will maximize your IRR and ROE ratios.
• Intrinsic valuation changes; it goes up or decline it never stays put. I started to update intrinsic values of my holdings and targets at least on an annual basis.
  

Business Analysis

• Now I understand the value of equity analysts. I used to dismiss their analysis altogether but I have learned to use the good parts. I completely ignore buy/ sell recommendations, price targets, and earning estimates, however some qualitative analysis and risk assessment contain value added information.
• Good businesses do not make for good investments. Investing in a well run company in the absence of a distress situation would not yield exceptional returns. If the same company came under selling pressures due to a crises of some sort, for example a product liability suit such as Merck's Viox, it will be far better investment potential.
  

Investment process

• Patience in establishing positions. I used to go all in, once I find a business I like, but now I am establishing my positions over time this way it will ensure that I may still get it cheaper over time.
• Straying away from my comfort zone into industries and companies that I do not understand or far way too complex for me to value. This will always prove detrimental to my returns.
• Not trusting my own analysis and thinking "I must be missing something". This happened several times, as I develop an investment thesis and arrive to my conclusion but I second guess myself because market prices do not provide me with any validation. However I learnt that market prices are the last place to look for any validation of any sort. If I have checked and double checked my analysis this is the only validation I need.
• I used to invest in undervalued business independent of the reason why it is undervalued. I have learnt what is meant of the term "value trap"; some businesses fall in this category for a reason or another. These are lousy investments. Now I focus on investment that became undervalued and distressed due to macro or micro circumstances.
• Concentration of holdings and portfolio. Having too many positions to track will dilute my analysis and increase the risk profile of my investment and make my actions more susceptible to emotions rather than logic. Deep and through assessment of a business gives you a piece of mind and an ability to analyse company specific events with more depth than the market.
  

Malls, Offices May Slump Less Steeply Than Homes - WSJ.com

Malls, Offices May Slump Less Steeply Than Homes - WSJ.com

Today's Wall Street journal article talks about commercial real estate and it reiterates what I have been writing about all last week, better written though, may be they read my blog, commercial real estate is not likely to suffer in the same manner as residential market.

The article mentions the controlled and measured construction of commercial properties as seen in graph. It also contrast the difference between commercial and residential debt and how the fundamentals of the commercial real estate stronger than the residential market. It also confirms that the decline in value of commercial debt is a capital market problem rather than properties fundamentals problem.

I think some REITs and commercial real estate debt can offer great opportunity for investment due to the unjust panic around them.

Credit Availability for Commercial Properties

I have two real estate related investment, well one being RioCan, a retail Reit, and Sears Holdings, which a large part of its value is driven from its commercial properties. As well as I continue to try to find valuable commercial investment operators to add to my portfolio. So the subject of commercial credit availability is of interest to me.

In an earlier post, I have wrote that the fundamentals of the commercial real estate as being good, however credit is vanishing from a key source which is the structured debt market. Commercial Mortgage Backed Securities (CMBS) is a key funding source for doing deals in the commercial real estate. This source, as you can imagine, along with other debt markets, is under a lot of stress. CMBS issuance has slowed down some in the last two quarters and it is expected to fall by 50% in 2008 according Prudential Real Estate. Prices of CMBS have fallen significantly which sent their yields higher.

Although some widening was appropriate given the incredibly thin spreads and loose underwriting at the start of 2007, the magnitude of the increases in CMBS spreads last year is surprising against, as discussed, a backdrop of generally healthy space market fundamentals and excellent credit performance. Upgrades of outstanding CMBS by the three major rating agencies outnumbered downgrades by nearly 9:1 last year, according to Morgan Stanley. Meanwhile, delinquencies among seasoned CMBS were just 0.4% as of November, well below the peak of nearly 2.5% during the space market weakness in 2002–03.
Delinquency rates will rise over the next year or two as the most aggressively underwritten loans originated at the peak of the market cycle encounter cash-flow problems due to weaker property market fundamentals and slower economic growth. However, current spreads likely have more to do with the crisis in investor confidence than increasing risk in the commercial real estate markets.

Media and investors unjustly link CMBS with residential backed securities, where fundamental are deteriorating rapidly. I think media do not understand the differences between the two products and began to speculate that CMBS will fall in the same manner residential did.

Aside from being secured by real estate property commercial and rresidential mortgages have almost nothing in common. Commercial properties generate income to their owners making them better collateral than residential properties. Analysis of the federal reserve flow of funds show that the commercial mortgage market is much smaller than home mortgages as you see in chart # 3. Residential mortgages almost depended on asset backed products but commercial mortgages have many other sources to fund deal.

I do not think the outlook is bleak for commercial properties as many paint it to be. There will be other sources in the market to fund deals and properties although they will be able to cherry pick those deals allowing for softer prices. The most likely scenario is some deterioration in commercial real estate values due to slow economy and tight credit but it will not be a collapse as media would have you believe. Off course the major risk, possible but less likely is the "de-leveraging" in the market turns into no leverage situation. If qualified and deserving entities can't secure funding then we are in a big mess not only in commercial space but in every thing else.

Powerful Discount to Asset Value

I have talked about Power Financial Corp (PWF) and Power Corporation (POW) in the past. These are holding companies of a collection of assets that range from insurance companies to asset management firms among other sizable stakes in public traded companies. POW owns 66% of PWF, among other assets, which in turns owns significant portion of Great West Life Insurance, IGM Financials, and Pargesa Holdings.

Typically these companies trade at a discount to their Net Asset Value (NAV). These two companies are no exception they usually trade at a discount of 9% for PWF and 14% for POW. These discounts have almost doubled in this market. POW is trading at 30% discount to its NAV and PWF at 16%. See my calculation in table below.


Both companies have gotten a downgrade by RBC as well as the impact of a law suite against Great West Life, one of their major holdings. In addition, most of their assets are financial service companies, which is under great deal of uncertainty. I think if the gap widened because of these risk, then it is overdone. The law suite maximum payment to the plaintiff is reflected in the stock of Great West life. Also the assets held by their subsidiaries are away from most of the credit problems.


Notwithstanding all these risks, I think the discount to NAV is ridiculously high. POW gives you 3% dividend yield and huge cushion in term of compounded discounts on their holdings. However the only problem I have with investing in such an idea is that I have to analyze all the underlying assets and their risk profile, which can be a huge undertaking.

The idea is enticing as I have to think about it some more.

Historical PE: revision to the mean

The revision to the mean is a concept where all asset prices must revert to their historical average returns. In today's market the inflation adjusted inflation adjusted Price Earnings ratio PE stands at 25 while its long term average is 17. The real PE has came down quite a lot from its peak in 2000, but to hold the revision to the mean concept it must come back even more.

You can see the chart that whenever the real PE peaked, a correction followed to restore historical averages. In every bull market with no exception, 1900s, 60's, 80-90's, PE has came back down to restore the average.

An excerpt of FairFax Financial shareholders letter touches on the issue:

Hyman Minsky, the father of the Financial Instability Hypothesis, said that
history shows that “stability causes instability”. Prolonged periods of
prosperity lead to leveraged financial structures that cause instability. We are
witnessing the aftereffects of the longest economic recovery (more than 20
years) in the U.S. with the shortest recession (2001). Regression to the mean
has begun – but only just begun!

Recently, we came across an interesting observation by the man who provided the intellectual underpinnings of “long term value investing” and to whom we are ever indebted. BenGraham made the point that only 1 in 100 of the investors who were invested in the stockmarket in 1925 survived the crash of 1929 – 1932. If you didn’t see the risks in 1925 (very hard to do), it was very unlikely that you survived the crash! We think Ben’s observation may be relevant to what we have experienced in the past five years. We reminded you in our 2005 Annual Report that “Jeremy Grantham of Grantham Mayo said that of the 28 bubbles that they have studied in all asset categories (including gold, silver, Japanese equities and 1929), this recent bubble in the U.S. stock market is the only one that has not completely reversed itself (just as it was about to in 2003, it turned and rebounded).” Caveat emptor!!

In our 2005 Annual Report, we also discussed the Japanese experience from 1989 to 2004 when the Nikkei Dow dropped from 39,000 to 7,600 while yields on 10 year Japanese government bonds collapsed from 8.2% to 0.5%. With the Federal Reserve dropping the Fed Funds rate down to 3% from 5.25%, we might be witnessing a repeat in the U.S. of the Japanese experience. In spite of record low interest rates and record high fiscal deficits, Japan went through years of mild deflation. The feelings at the time in Japan were that they were different and would not allow stock prices and land prices to fall – not dissimilar to the sentiment currently prevailing in the U.S.!!

A review of real PE suggests three possible scenarios for market direction:

1. Market prices will be be flat for the next decade while real earnings need to grow by a compounded 4.4% annually, or


2. A swift correction of prices of 30% to align to the historic averages , or


3. some combination of both, which is the most likely scenario.

The implication of the above for investors is that value and stock picking skills are needed for the next chapter of the market. In the 1980'2 and 1990's those skills need not apply if you have simply held an index you did fine. That's why most index funds and ETFs proliferated in the last decade. Going forward I do not think it is a wise choice, if you need your money within 5 years. However if you have longer time horizon then index averaging is good strategy. That's why I am intending to reduce my index fund weighting to 30% of my portfolio and concentrate on selecting individual positions that meets my criteria of value.

Retail Real Estate Economics vs Credit Availability

Although the "de-leveraging" of credit from the system has put downward pressure on residential housing prices, commercial properties have fared much better in terms of asset values as opposed to REITs prices. However can commercial properties values hold given the lack of credit for long?

US REITs as a group have declined by more than 33% from their peak in the current market. Since 2000 to their peak in early 2007 they were up some 161% in price appreciation. In this post i will review some of the economics of commercial real estate and try to asses if the downward pressure on commercial properties reit is justified.

The retail commercial real estate fundamentals remain in relatively good shape. They posses a low vacancy rates, growing rent, and no huge construction overhang, unlike residential housing. Moreover there is not a huge development pipeline of future available space that can depress rent rates. even delinquencies on commercial debt is still very low compared to previous crises.

Granted that commercial and retail real estate metrics are lagging indicators. So you should see some decline in properties values, rise in delinquencies, and increase in vacancies following an economic activity slowdown. But is the calls by media for commercial real estate collapse in similar fashion to residential housing justified? I see these calls for the imminent commercial real estate crash as an overstretch right now. However, if this rescission is deeper and longer than your average recession then commercial real estate will suffer.

I always want to asses supply and demand for space to analyze values rather than credit availability, as credit adjustments are volatile to predict and eventually will stabilize allowing for deals to happen.

Supply & Demand
Commercial construction will add 125 million sq. ft. to the national retail inventory this year, down from 145 million sq. ft. built in 2007, according to Marcus & Millichap. Much of that space under development is pre-leased, with big-box retail and build-to-suit accounting for 40% of construction. The 125 million sq. ft represent 8% of the top 25 retail operators owned retail space and less than 4% of all available stock.

However there is increasing risk that can disrupt this picture as demand will decline as retailers pull back on expansion plans due to week economy. Some retailers like Lowe's, Wal-mart and others have reigned their expansion plans, others are closing under performing stores. But retailers are still demanding space although at slower pace. Wal-mart is opening new super centres almost on monthly basis, Lowe's are planning an additional 100-120 new stores in 2008; Target added 15 million sqr. ft. in the last quarter. Again retailers will cancel any plans for expansion if the economy deteriorates significantly.

Commercial Real Estate Deals

The question is does lack of availability of credit will put downward pressure on properties value? So far commercial properties are holding their values due to lack of deals. Sellers are holding out for better prices. January and February deal volume has almost came to a halt across all types of properties due to lack of availability of debt. Buyers are requesting lower prices to compensate for lack of leverage, while sellers are holding out for higher prices. So who will blink first: sellers or buyers?

My bet is sellers will agree to lower their prices, as they continue to put properties on the market. More than $10 billion of properties were put up for sale in January, the highest amount since September 2007. And based on listings so far, the volume of offerings in February will be even higher. There is a lot if capital to do deals from pension funds and other institutional investors that were shut out by Private Equity overbidding over the past few years. This capital is waiting to be deployed given some support for commercial real estate values as well.

In conclusion I do not think that REITs deserve this huge discount to asset value. The discount to net asset value prices the worst case scenario in terms of the economic outlook. The space will present certain opportunities in the future to invest for the long term. There will probably be a general 10% correction just because of the liquidity factor. But in the urban centres where it have favorable demographics, the unique properties will probably experience no more than a 5% to 10% drop in value. The real problem will be in the second- and third-tier cities where there will be a real absence of financing.

To blog you need a lawyer

Carl Ichan can't seem to blog on his own. His lawyers are suppressing his creative juices. May be I should start passing my posts by his lawyers to see what they think.

Blunt-spoken financier Carl Icahn, who has amassed a fortune worth an estimated $14 billion during a combative Wall Street career that spanned nearly 50 years, disclosed last month that he’s joining the Internet age by starting a blog.

The blog, the 71-year-old Queens-born billionaire said, was aimed at sharing his often-scathing views about the state of corporate governance in this country, which he routinely disparages.

So far, however, readers wanting a fix of the latest Icahn blast on The Icahn Report, have been disappointed, with the site simply sporting a dour picture of Icahn with the notation, “blog coming soon.”

At a meeting last night, Icahn explained that he’s not suffering from writers’ block, but said his lawyers are stopping him. ”Every night, I write for an hour and they tear it up,” said Icahn with a sardonic laugh.

CHC Buyout Price Behaviour

I have invested in CHC Helicopter in hope to earn the spread between current price to the takeout price, read my analysis here. The price behavior is interesting so far. Although it has been increasing steadily from the buyout announcement, the rise in price is not as big as I expected.

I Have researched and researched any issues with the buyout there are none. The buyout have the following steps to complete:

1. regulatory approval from the EU, which the fund will satisfy.
   
2. shareholders approval, which is guaranteed by virtue of large ownership by CEO and a family trust.

However, it seems that as the equity markets sell off, the gap to the takeout price is increases, as seen in the graph above. It seems that investors will sell anything to meet their margin demands. there is the also added skepticism that financing is not going to be provided by banks. However as outlined part of this financing package is equity provided by First reserve.

De-leveraging that what "credit crises" is called

When yesterday I wrote about how current lending standards are becoming normal rather than lax, the correct technical term for this is "de-leveraging". Here are some of the results of this de-leveraging:

• Thornburg Mortgage Inc defaults on margin calls, actually some 233 mortgage operations failed since last year.
• Focus Capital, a $1bn New York hedge fund, has been forced to liquidate its portfolio after missing margin calls from banks
• Peloton Partners, a $3 billion hedge fund run by former Goldman Sachs star traders, was forced to liquidate its two investment funds
• And margin calls at the Bank of Montreal recently went unanswered from its SIV units.
  
• Carlyle Capital received a notice of default from one of the banks that helps finance its portfolio of Freddie Mac and Fannie Mae securities and it expects to receive at least one more default notice after falling short of margin requirements with four lenders.
• Many other hedge funds have liquidated holdings after facing margin calls from their banks, actually 31 hedge funds have completely imploded.
  

Before the credit crisis began, 4-5 times leverage was the norm rather than the exception for many hedge funds. Some estimate that most have now reduced their leverage to 1-2 times, some even lower.

Banks are now calling on their clients to pay back loans and to reduce credit facilities, which forces may of them to sell their holdings. Many of these operations typically will liquidate the most easy to sell positions first despite their quality and potential returns. So the selling can be indiscriminate.

The good news is the level of selling and depressed prices is related to technical factors of margin calls rather than fundamental reasons. The bad news is this can go for quite a while. That's why, as I wrote before, I think some areas of the debt market is attractive and offer good opportunities. I have wrote about bank and corporate loans. Many big hitters like Bill Gross and others have actually made big bets in the billions on the muni markets.

Credit Crises going on its 10 th Month

The credit crises started in June of last year; it has been dragging on for more than 9 months now. This is by far the longest any credit crises has lasted. The LTCM default, Russia debt default and the Mexican peso crises were way shorter in duration than this one. The bad news it seems that there is no ending in sight. Personal and Business defaults are increasing, municipal debt is being trashed, lending rates are moving in the opposite direction to the fed rates, and... you get the picture.

Some have given the explanation that the crises will go on until the consumer recovers or stop being exhausted as John Fitzsimons of American Securities said:

I think the [current market conditions] are going to be a long process, and I don't think it gets better until the consumer stops being exhausted,

I have an alternate theory to explain the "credit crises".

May be things are just getting back to normal lending practices; only those who deserve the credit get it. People and businesses alike got accustomed to easy and cheap money to buy, finance and do deals, so any thing other than that environment will feel as a crises.

I think the US got used to spending with no control and it is catching up to them; this will take some time to adjust to. But it will work it self through the system with time. Strict lending standards should be the norm and a "crises". Banks should be lend to those who will be able to pay it back with satisfactory return.

So may be this is the new environment that we should operated in and just stop calling it a "crises".

CHC Buyout

I just want to write a quick update on my buyout investment. So far the stock is inching up slowly to the buyout price as we approached the closing date. This is very typical of a buyout stock. As soon as they announce regulatory approval from EU, which should be routine, CHC will move higher by a point or so closer to the transaction price.

There were more deals announced by private equity into the energy infrastructure space like this one. First reserve was busy buying storage terminals and pipelines all over the world. More private equity firms have joined the race to deploy their capital as well.

Energy infrastructure and service investment should earn better returns over the years than pure energy plays. Their services are needed more and more as oil gets harder to produce.

An interesting observation on CHC stock behaviour due to its listing on NYSE and the TSX. The NYSE listing has outperformed the TSX performance since the deal was announced by a small margin, adjusting for the exchange rate.

CHC on NYSE appreciated 4.41% while CHC on the TSX rose only 1.48%, while the Canadian Dollar appreciated by 2.89% since Feb 25. That leaves .04% of probably liquidity performance on the table. I guess the TSX is less liquid than the NYSE to explain the difference which should be identical in this situation.

Sears Holding Valuation: Another Attempt

I have wrote about SHLD being a value idea, read my earlier post here. I have attempted a back of the envelop valuation to see if I should go deeper into my analysis. In this post I will present a better attempt to value Sears Holdings.

I still hold that Sears as a retailer has a sub-par retail experience than its peers. And I also still think that the business economics and operations are inferior compared to competitors. However, the value potential is in its real estate holdings, which is the main attraction to this idea.

I will argue that the proper valuation technique for SHLD is the use of liquidation value. In this approach I assume no on-going concern for its retail operation and the company will cease those activities fr no return. I also assume that SHLD will be sold in pieces; the pieces being: real estate, working capital items less current debt, brands, and Sears Canada stake. My reasoning to value SHLD this way is mainly because retail turnarounds are long and hard to accomplish. Moreover they have high probability of failure in a competitive environment where competitors are better at merchandising and have strong capital positions.

The table below is a summary of the sum of the value drivers for SHLD. I estimate that SHLD can have $19.26 Billion in intrinsic value. SHLD commands a market cap of $13 Billion, which represents 48% discount from my calculated intrinsic value. The discount is adequate for several reasons:

• I did not assign any value to the retail operation. The retail operation can be the margin of safety for this idea. The valuation arrived using this technique will be my floor value and if retail operations are turned around then it becomes the icing on the cake.
  
• Also I did not count in this valuation several peices of SHLD holdings. I did not count the real estate value of SHLD's distribution centres, Kmart offices and the Hoffman estate, which can add additional margin to my intrinsic value.
  

Item	Value ($ Millions)
Net Working Capital	542
Brands	2,000
Sears Canada Stake	1,590
Real Estate	20,000
Less: LTM Debt	2,606
Less: Taxes	2,300
SHLD Intrinsic Value	19,226

Here is my explanation how I arrived to this valuation, I begin with the easy items and progress to the more difficult ones:

Net Working Capital:

Before I itemized this list, please note that you have to back out Sears Canada accounts from SHLD financials as we will value Sears Canada stake separately. Off course you know that due to SHLD 70% ownership of Sears Canada it has to consolidate both companies in its financials.

Account	Assigned Value Million $	Note
Cash	745	No adjustment
Accounts receivable	595.5	Less allowance of $30 M for bad debts
Inventory	7,286	I reduce the inventory by 20% for several reasons. SHLD inventory turnover was getting low, meaning inventory is sitting in their warehouses longer and longer compared to competitors. This leads to obsoletes and leakage. The other factor is SHLD uses RIM to value its inventory which opens the door for management biased estimates, so to be conservative you need to reduce this item by some margin due to possible high valuation by management.
Deferred Taxes	0	In a liquidation scenario it is unlikely that this item will ever be used.
Other	256.6	I make no adjustment here.
Less Current Liabilities	8,342	No adjustment here as debtors will get their money if their is a surplus and in this case there is.
Net Working Capital Value	542	This is what shareholders can expect in liquidation scenario.

Brands

SHLD owns good brands like Kenmore, Craftsman, Land's End, Diehard among others. However SHLD owns just the brand name with no ownership of the designs, IP or manufacturing of the items. Valuation here gets a bit tricky and uncertain. SHLD does not provide sales by category that we can apply multiples from other companies like Whirlpool, Energizer and other comparable to get a value for such brands. It even gets tougher as SHLD does not manufacture them, so how much do you discount this compared to Maytag, who is vertically integrated.

SHLD designated trademarks on its balance sheet to be worth $3.3 Billion and that will be a good starting point. In a liquidation value the sale will receive a hair cut lets ball park it as 40%. Therefore I will assign a value for the brands at $2 Billion.

SHLD in the past has transferred the ownership of Diehard, Kenmore, and Craftsman into a separate entity and issued bonds against them worth $1.8 Billion. Think of it as securitization of brands rather than sub prime. The value of that transaction is close to my estimate valuation so I will go with the $2 Billion as value in a liquidation scenario.

Sears Canada

The logical value to assign to this component is the publicly traded price of the entity. Sears Canada market cap is $2.23 Billion Canadian. SHLD owns 70% of Sears Canada making its ownership worth $1.59 Billion (adjusting for the exchange rate).

Real Estate

The major element of SHLD value driver is its real estate value. There are several ways to estimate the market value, obviously the best way is to hire a good commercial real estate agent to give you an estimate of ongoing transaction value for SHLD properties. Since all the agents I know are busy at the moment, I will take a stab at it in several ways:

1. Compare SHLD to publicly traded REITS.
2. Apply average market Net Income per square foot (PSF), arrived by averaging comparable retail REITS operators statistics, and apply the market observed cap rates.
3. Apply price sale per Sqrft on recent retail transactions to SHLD real estate.
4. Use SHLD's recent sale of some of its properties in 2004 and apply it to the entire portfolio adjusting to commercial real estate appreciation using S&P commercial property index.

Please note that I am excluding from my analysis all the speciality stores as that are independently owned and operated and Sears Canada store as I am evaluating it as a separate company.

These methods will give me a wide range of value, which should be close to each other, I will settle on the average and assign it as the valuation measure for SHLD properties.

Value Approach	Value Billions	Notes
As a REIT	$19.48	Sears owns 266 Million square foot of retail space. The average market value of retail REIT per owned square foot is $73.8 (end of 2007 figures) I can apply this market value per owned and leased SHLD space to arrive at an estimate of what would the market value SHLD if it operated as REIT generating income from rental properties.
Using Market Cap rates to assumed NI	$11.6	Retail REITs have an average Net Income PSF of $2.63. (end of 2007 figures) I will assume if SHLD converts its real estate into a REIT it will achieve the average NI PSF of $2.63. Then SHLD will have NI of $699.5 Million. DDR, Kimco, Regency Centers and Equity all said they're seeing cap rates on high-quality assets trading from 6% to 6.5%, and in some cases even lower. I will assign to SHLD a cap rate of high-quality assets as observed by other developers. Off course SHLD might have better average NI as its mall space will command higher premium but I will stick with my blended rate for the Kmart stores that are of a lower quality.
Recent Transactions	$18.6	I surveyed Retail REITS recent acquisition and averaged the purchase price of those transactions PSF; the average purchase price is $123 PSF. REITS surveyed: Kimco Realty, developers Diversified Realty, Simon Group, and others I will apply the PSF to the owned store space by SHLD and I will use a discount factor of 60% of the leased space. I used 50% factor as an arbitrary number for the assignment of leased properties. SHLD owns 94.6 million SqrFt while leases the balance. As such its owned value is $11.6 Billion and 7 Billion for assignment of the leased properties. This approach may be conservative due to the discount factor I used. Actual transaction of lease assumption can be higher.
Appreciation since 2004 sale	$47	SHLD/ Kmart in 2004 have entered with Home depot and each other to sell and assign stores. I will use the per store value of that deal and apply it to the current owned SHLD stores adjusting for appreciation from 2004 using the S&P commercial real estate index. The value per store in that transaction was $12.6 Million The retail real estate appreciation from 2004 to end of 2007 was 35% The adjusted per store value of the 2004 transactions is $17 Million SHLD owns and leases 2,817 stores Obviously this is a very high valuation that I am not sure it will be realized and may have been biased by a small data points in the 2004 transaction, which might have been for primer space and it would be unfair to apply to the rest of the portfolio.

I will use $20 Billion as the market value for SHLD real estate. It is a value that have been repeated by other value investor and confirmed by approach 1 and 2.

Taxes

Given that SHLD liquidation yields a greater value compared to its book value, a payment to the IRS is due. How big of a tax liability is assumed, that is a good questions. It really depends on the method of the disposition and sale. But in the most likely scenario there will be a tax liability. I will use a rough estimate of corporate tax rate of 35% and SHLD current book value of $11 Billion, I estimate a tax liability of $2.3 Billion (sum of all of the sales proceeds in table 1 less book value times a corporate rate of 35%).

Risks

• If Mr Lambert begins liquidating tomorrow I will put my entire networth in SHLD, but if this is not the case then how the value will be realized is big question and poses a big risk. A piece mail liquidation is not advantageous as slow sub par retail operation will eventually produce negative cash flows and start eating into the value being realized from the real estate sales. If SHLD liquidate all of its holdings at once they will receive a hair cut of the value of their holdings as real estate prices will drop with such a size of an offering. Another alternative is not to realize the real estate value and SHLD continues to attempt its turnaround, then the big returns from real estate is not monetized and the investment will earn returns on low margin business.
• Commercial real estate construction has held up well, but there are clear signs this is about to come to an end, as lending for commercial real estate is becoming harder to get. Indexes which track commercial real estate are softening and commercial real estate credit default swap prices are soaring. Prices for credit default swaps have almost tripled in the last four months for highly rated investment-grade commercial paper. I can't do the math quickly, but the back-of-my-napkin analysis of CDS rates for the lowest-quality commercial paper (junk bond levels) suggests default rates approaching 50%. It means the securitization market for commercial mortgages is drying up, which means available capital for new construction is going to be much harder to find. This is going to be a drag on growth and the ability to do deals in the coming quarters.
• Commercial real estate prices are dropping with the credit crises. This means that the intrinsic value of SHLD is declining each month until the credit crises is behind us. Retail real estate has been dropping in prices since they peaked earlier in 2007. The S&P commercial real estate index as shown in the graph illustrate the point. The index dropped more than 2% in very short few months. Off course this risk will be work itself out once we pass the crises but there is always the probability that the crises can deepen and worsen.
• Litigation risks. SHLD is engaged is several litigation suits stemming from the Kmart bankruptcy and other issues. The outcome can dilute the value further.