February 28, 2009

Bond Vs Equity Market Action

The divergence between equities and debt is still striking. The disconnect between the two markets is astonishing. One of them is right and the other is wrong. My money is always on the debt market as it is run by professionals while the equities markets are run by armatures.

Debt markets in the last quarter of 2008 were shut and yields skyrocketed for any debt instrument expect for US treasuries while equities still reflected recovery in earnings in 2009. Debt prices correctly priced the deleveraging occurring in the world since beginning of 2008 while equities did not. Now it is almost the reverse. Debt has recovered and High yield and high quality deals are being made, in relative terms to no deals in late 2008. In addition yields on US treasuries have increased to above 3% recently from the lows of 2% in late 2008. Bond investors are beginning to look for buy more risk while equity investors are running from it.

There is a possible conclusion to draw from this is the bond investor is beginning to allocate funds to riskier assets classes as they are looking for things to normalize somewhat. The willingness to take risk by bond investors may indicate the sell offs in stock markets are overdone.

On equity valuation basis the market PE (adjusted for 10 year earnings and inflation) is around 12 now, far below the historical long term averages. However as noted before is some of my posts this can go to the single digit as market overshoot on the upside and the downside as well. From these levels it will not take much for the S&P PE ratio to be in the single digit territory, maybe another 20% from current levels.

The investing environment for the long term is looking better and better. Although there are many challenges, serious ones, I think selling or shorting now is a terrible risk/ reward proposition. I think it will take time for a return to a bull market but the market prices is setting the base line for favorable action for the long run.

The 10 year yield has gone up considerable from it lows in late December.

Please observe action of of the S&P 500 and the LQD, ETF for high grade corporate bonds. Equities have declined by more than20% while debt rallied by 7% over the same period. The same story can be found in high yield and bank loans.

February 22, 2009

Is the Software model relevant anymore?

Software is dead and companies who operate on pure software model will be be outdated if they do not change fundamentally and to be honest I do not see how would they. Change will come from the outside replacing outdated business models: the software license model.

Have you ever tried to get support from IBM or Oracle? It is has gotten very bad. No one knows how their products work anymore because they are been put together by acquisitions rather than by organic development. Companies like IBM and Oracle have pursued growth via acquisitions as it is cheaper than to grow organically. The cost of talent is high and more importantly talented professionals are not attracted to large bureaucratic entities.

If you look at Oracle and IBM financials you can see that the bulk of their revenues has shifted towards services and maintenance. Outfits like IBM and Oracle will be able to survive as services organizations but I doubt that they will be able to transform themselves to an application providers. The software culture is too much ingrained in their DNA to succeed.

Our company shifted towards open source components for all development as they offer faster and cheaper platforms. Open source and Saas (software-as-a-service) offer more efficient model for users. Most small and medium enterprises have adopted the model. Although large fortune 1000 companies are yet to get with it, they will. The cost and efficiencies of the Saas and open source will outweigh the control and security that large companies see in traditional software licenses.

Value Idea: Sears Canada Bonds

Another fixed income issue to put my cash to work. Right now the yields on debt issues offer more than satisfactory rate of returns with more security. There are two issues trading in Canadian dollars with a yield of 8-8.5% maturing in 2010. I am indifferent to both issues as they have the same structure except for the coupon, (7.05 vs. 7.45%). Both issues are senior secured offering fixed semi-annually coupon.

The bonds are good opportunity because:

  1. Short term to maturity with very good spread to treasuries,
  2. Sears Canada is a wonderful business with a sound collection of assets and hidden values,
  3. Strong balance sheet and coverage ratio. The company has 40% of its market capitalization in cash alone. This cash is more valuable in this deflationary environment.

Sears Canada Overview
Sears Canada much like SHLD is not just a retailer, rather it is a collection of home and consumer related services among real estate holdings. Sears Canada in addition to its main business, the department stores, it operates a number of successful businesses:
  • warranty servicing,
  • appliances maintenance,
  • home installations of floors, HVAC, and other things,
  • cleaning services,
  • travel agency,
  • transport and logistics distribution business and
  • it owns prime real estate holdings. Sears operates a total of 187 stores, 19 of which are Company-owned with the majority of the remainder held under long-term leases, which most likely have under market rental rates, so these leases are also valuable.
Most of these businesses are hidden assets that can be sold without affecting the essence of the retail operations. Actually Sears Canada has sold its credit card operation to JP Morgan Chase in 2005 to monetize that business for $2.3 billion, and until 2015 it will receive a 10% revenue stream from all sales charged to sears credit cards. Moreover it has been systematically selling its interest in mall ownership over the past several years. Those real estate holdings are way undervalued on their books due to historical accounting.

The company is 72.4% owned by SHLD through a Canadian subsidiary, while Pershing Capital owns 17.31%. Actually Ackman has successfully thwarted Lambert from acquiring the whole company few years ago based on low priced offer. I think that was in 2006.

SHLD and Ackman continue to buy Sears Canada stock. SHLD increased its stake from 70% in early 2008 to 72.4% by end of 2008. Pershing raised its stake from 15% to 17.31% by end of 2008.

I think sooner or later SHLD will have to buy Sears Canada as the majority of cash on its balance sheet is from the Canadian subsidiary. SHLD, at current market price, can pay $552 million for the remaining stake in Sears Canada and get access to $810 million in cash sitting in its coffers. I think the buyout of Sears Canada by SHLD is just a matter of time.

SHLD vs Sears Canada Bonds?
A natural question the reader may ask why Sears Canada bonds offering 8.5% yield and not the SHLD bonds trading at anywhere from 14-19%? I have looked at those bonds and they are issues by Sears Roebuck Acceptance Corp. It is a wholly owned subsidiary by SHLD. The Company's principal activity is to
acquire short-term notes of parent company. The Company raises funds
from its unsecured short-term borrowing programs and long-term debt.
Short-term borrowings include commercial papers and long term debt
includes medium-term notes and discrete underwritten debt. The subsidiary may be a bankruptcy remote enity, i.e, the bonds will not be covered by SHLD other assets. Actually SHLD shelters several of its assets in similar manner. SHLD's brands are owned by a bankruptcy remote subsidiary as well. That's why I own the common rather the bonds in SHLD. Another thing I want to be aligned with Edward Lambert interests in case of liquidation.

Back to Sears Canada. The first thing to ensure my margin of safety is figure out the liquidation value of Sears Canada. I will do that by restating its most recent balance sheet

Balance Sheet Analysis
The balance sheet undervalues Sears economic assets. The biggest revision to assets values is in its real estate holdings.
  • Cash balances are significant and represent about $8 per share, the stock trade at $19. The balances is expected to increase as a result of continues sales of the company's assets and positive cash flow from operations.
  • Real estate: The company had joint venture interests in 12 shopping centres across Canada at Nov. 1, 2008. Joint venture interests range
    from 15% to 50%, and are co-owned with major shopping centre owners and institutional investors.
  • Long term leases in a liquidation scenario will be valuable to other
    retailers looking to take over prime space cheaply. The value of these
    leases have not been factored into my analysis.
  • Pension plan: sears is underfunding its assets plan but nothing significant but what is more importantly is the composition of its plan: 80% in fixed income, which should limit sears future contributions and expenses. Moreover its assumptions are conservative to actually give a far valuation of its future obligations.

On a liquidation scenario Sears Canada at the moment can cover most of its obligation and even give its shareholders 85 cents on the dollar. I feel Sears Canada has significant margin of safety to warrant the investment in its bonds.

On the strength of the company balance sheet alone, valuing its assets at their economic values rather than book value, Sears Canada should be trading at twice the market cap that it is trading currently.

Can the company pay me back?
The company have very decent coverage ratios as below. The company can cover all of its debt from cash on hand or by about 18 months from free cash flows.
Coverage Ratios
TTM EBITDA/ Total Interest
TTM EBITDA/ Total Interest+Rent3.2
TTM EBITDA-Capex/ Interest
TTM EBITDA-Capex/ Interest+Rent2.9

The operations may deteriorates from slow consumer spending but its results of Q3 did not show it. Their Q4 results are expected to be release by the end of Feb 09.

What Could go wrong?

  1. refinancing risks in this tight market but the company has enough cash on hand to do repay debt and satisfy its working capital needs.
  2. the issue gets called by sears.
  3. rapid deterioration in operation over the next 10 months to deplete its strong balance sheet. This is a possibility where collapse in sales would result in the company to use its cash on hand to pay for expenses.

February 10, 2009

Hidden Liabilities: Pension Plans

The recent market decline along with population demographics posts huge liabilities to corporate America. The defined benefit pension plans will face severe underfunding due to the decline in financial assets coupled with the fast approaching retirement of baby boomers. These hidden liabilities will pose serious issues to valuations and must be accounted for when valuing a potential investment.

Consider this, as the baby boomers start to retire en masse, beginning in 2010, you could see combined pension and health-care costs representing a huge percentage of total gross domestic product. In 2008, companies and their employees have seen their pension assets plummet by some 40-50%. The pension deficits in the S&P 1500 companies have reached $409 Billion by the end of 2008, down from some $100 Billion in mid 2007. And most plans are underfunded by 25% (Source: Washington post).

In a bull markets the problem of pension plans are forgotten due to high rate of return will ensure that companies do not have to contribute to their plans. However, in a declining markets such as this one and in the prospect of deflation in financial assets, corporations who will underfund these plans significantly introducing large debt onto their balance sheets.

Corporate America used aggressive assumptions in its pension plan calculation (aggressive assumptions like high rate of return and high discount rates tend to reduce liabilities and cash contribution by corporations). I dislike seeing assumed rate of returns around 9-10% but many corporations used these figures in good times and was supported by their actuaries, Now these assumptions will be tough to pass the mustard sort of speak.

Moreover corporations used favourable market conditions to be aggressive in their assets allocations. Many have increased equity exposure to more than 50% of the plan assets. No doubt to lessen their expenses and boost earnings. Now these with larger exposure to equities will have pay dearly.

The problem gets worse for corporate America. The increasing life expectancy of people will compound its liabilities. In the old economy, the average employee would work for the same
company for 35 years. In their pension calculations, actuaries of pension plans would make the assumptions that male and female workers would retire at 65, and the majority would die by 68 and 72. Now actuaries of these same plans need to factor in that today a minimum of 10% of all
male pensioners will live beyond 91, and female pensioners beyond 94.

I always looked at reasonable assumptions from the companies I own. What are reasonable assumptions? The most important one is the assumed long-term annual rate of return to be around 5.5-6.5%. That is the big one. Then you go down the line to the discount rate used to calculate net present value of the benefits, in this case the lower the better. Other assumptions to pay attention to is the salary and benefit increases is an important one.

The implication is to look for companies with conservative assumptions about their plans. Look also for their asset allocations. Plans that have larges percentage of its assets in debt are much better than those with more tilt towards equities. Conservative assumptions about their pension plans will translate into lower cost of debt and more capital structure flexibility.
PS. for good overview of the subject see this primer.