March 29, 2009

Teck Resources faces Perfect Storm

I have taken a position in Teck Resources (TCK) @$4.65 betting that the company will be able to meet its debt obligations or at least restructure them. Investors have written off Teck after its ill timed acquisition of Fording Coal, which was financed mainly with short term debt. Then Teck faced the perfect storm:
1. collapse in commodity prices, and
2. a credit crunch that left most companies with short term debt maturities crushed, Teck is one of them.

As a result , Teck shares have gone from high of $48 per share to low of $2 per share.

Teck Resources assets are impressive and valuable. Teck is
....engaged in the exploration for and development
and production of natural resources. The Company’s principal products
are copper, metallurgical coal, zinc and gold. Lead, molybdenum,
various specialty and other metals, chemicals and fertilizers are
by-products produced at its operations. It also sells electrical power
that is surplus to its requirements at the Trail metallurgical
After it consolidated its ownership of Elk Valley by acquiring its Fording Coal, Teck has become a major producer of met coal. Also, Teck owns significant oil sands reserves in the Fort Hills project among other oil projects co-owned with UTS energy in Alberta.

The market has priced a strong possibility of Teck liquidation or bankruptcy. So all bad news is priced in which creates for good risk reward proposition, if Teck manages to restructure its debt. And I think it can for the following reasons:

  1. Asset sales that can cover some of its obligations. Its assets base is impressive and the value is there. The industry still sees real value in this company's assets, just not at the prices it paid. The company has already sold some none core assets and looking for more sales.
  2. operational cash flow in 2009 will cover some its debt as some commodities price have increased from the bottom observed in Q4 2008.
  3. Possible short term debt restructuring. I can't see any lender forcing Teck to liquidate. Teck as going concern can cover its obligation but it may need additional time. I am betting that banks will give it that time.

Teck still faces a daunting task of repaying short term debt of $7.7 Billion (CDN). I have calculated that from already announced assets sales, tax refunds and free cash flow, Teck will be able to repay $3.6 Billion, see table. This will leave the company with a balance of $4 billion to refinance or repay through further assets sales.

Teck still has multiple options to generate funds from asset sales. It can sell its partnership with UTS to Total, which has an offer outstanding to UTS shareholders. this can amount to $500-800 million. It can sell partial interest in its coal operations for $4 billion and take an impairment charge, as it will less than what it paid for Fording.

This is a speculative extreme outcome situation. If it recovers then the payout can be good but the downside is 100% loss of principal, however given the caliper of the company I think it will pull through.

March 28, 2009

Value Idea: BNI Analysis- part II

BNI the company (Google Finance):

The Company, through its subsidiaries, is engaged
primarily in the freight rail transportation business. BNSF Railway Company (BNSF Railway) is the Company’s principal operating subsidiary. BNSF Railway operates various facilities and equipment to support its transportation system, including its infrastructure and locomotives and freight cars.

Operational Analysis:

I do not want to spend much time here, but I want to highlight the following about BNI operations:

  • They have one of the best intermodal brokerage business in North America. Intermodal traffic is poised for good growth due lower costs of transport, Intermodal is when you combine several modes of transporting to get goods to its destination.

  • 65% of revenue is covered by long duration contractual agreements with customers. Some of these contracts will reprice higher in the coming few years. But this may be a point depending on the economy strength or normalizing before this happen.
  • BNI, more than any other rail company, have somewhat less economic sensitive freight. Review of their business mix shows the following:

    • automotive shipments mainly comes from foreign destination and the bulk of these shipments are parts, which to a large degree will increase or be stable as people will service their cars rather to buy new ones. Moreover the exposure to this sector is very small only 3% of revenue.
    • Industrial represent 24% of revenues . Their industrial products is heavily exposed to construction almost 14.5% of total freight revenue. However with infrastructure spending poised for new government initiatives this could see more growth. Most of this segment transport construction and building products used for infrastructure projects like steel, construction sand, gravel..etc. mostly used for public construction, which under Obama will increase as he will try to simulate the economy.
    • Coal for power generation is almost 25% of their revenue which is less economic sensitive than consumer goods. And the projection of coal use for power generation is posed for growth. ( see risks also)

    • The majority of its Agriculture freight for domestic consumption almost 3/4.

    The freight mix is diverse but for the most part will fare well in slow economy due to long term contracts and less economic sensitive freight.

What could go wrong (Risk Analysis)?:

BNI along with other rails have enjoyed revenue and earnings growth even in lousy economic drop. This growth was mainly from lagging fuel surcharges and lower fuel costs. Going forward the surcharges will disappear and revenue will come under some pressure. However lower fuel costs will soften the impact on earnings.

Risk of Government Intervention

At recent government hearings, shippers from agriculture, coal, chemicals, and other

bulk-commodity industries expressed their dissatisfaction with what they perceive to be a decline in the quality of railroad service and “monopolistic” rates. Actually a recent judgment was levied against BNI for excessive rates; the company is appealing the ruling.

Government intervention in rate setting by rail may happen. Rates for rail roads have been deregulated in 1980 but now there are many senate bills and committee to look in this matter as lobbies for coal and Ag businesses are not satisfied with the prices they are getting from rail operators.

I do no view a return to price setting by government agencies but the risk of increase in litigation costs and litigation reserves should be factored in valuation.

Maintenance and Capital needs

Capital needed to build and operate. Railroad maintenance is very capital intensive because it
involves adding new ballast and replacing worn track and damaged ties.

Trucking companies has an advantage over railroads because they pay only for infrastructure capital and maintenance costs when they use the system, helping to insulate them financially from changes in freight transportation demand. Railroads, on the other hand, bear the full cost of building and maintaining their infrastructure, and a large fraction of this cost is independent of traffic volume. Consequently, railroads are more highly exposed to financial risk from economic changes and are also more conservative about investing in additional capacity.

However, BNI maintenance capex as a percentage of revenues have been consistent over the years compared with other rail operators, which some has been falling behind. In valuation I am not going to deduct the normal maintenance capex percentage of revenue as BNI's network seems to be well maintained.

Risks to Coal shipments

Coal represent a critical element of BNI business mix. There is a risk that Coal shipments may moderate or decline. This will impact BNI very negatively. The new US administration will introduce new measures to penalize carbon emissions, which coal fired plants produces twice as much natural gas fired plants. Coal fired plants produce cheaper energy than gas but with the new expected measures it may equalize the equation making coal produced energy more expensive therefore less demand for coal and more demand for natural gas. This new dynamic may slow BNI shipments. The only mitigating factor here is BNI ships mostly low sulfur coal, which produced lower emission. An additional risk mitigating factor is BNI ships to power plants in regions were nat gas and nuclear power plants are scarce (south central and north central), therefore coal fired plants can maintain pricing power and demand for coal.1 However coal powered plants in the northeast may lower demand for coal as their pricing power will shift to natural gas fired plants and nuclear plants.

Also demand for coal will be stable due to nature of coal shipped (PRB) and prices have not shot up like met coal.

This will get a lot of media but honestly given that 50% of electricity is produced from coal I do not see any replacement over the horizon.

Trade Shift from west Coast to East Coast

Global Trade lanes are shifting constantly. Traditionally the pacific coats ports are the main entry hub from Asia and handles the bulk of total import/export into and out of the US. This may change. The widening of the Panama canal allows ship operators to bypass the busy and congested west coast ports for the the east coats ports reducing their overall shipment delivery. Ship operators used to face wait times at the west coast that far exceeds the travel time through the panama canal to the east coast. Moreover, other trade lanes though the Suis Canal is also preferred by ship operators.

If this materialize BNI will see volume declines as its network link west coast ports with hubs in mid US.

Another shift of trade lies to where is the cheapest ocean freight rates can be sources. This may take volume away from BNI to other carriers. The following is Analyst estimate of the risk:

The spread in ocean rates (i.e., spread between ocean rates from the Gulf to Japan and the Pacific North West to Japan) for bulk shipments of grain was only $10
per metric ton. The ocean spread reached its high of $69 per metric ton in mid-May. The decline in ocean spreads has come as bulk ocean freight rates have declined to their lowest levels in years. The Gulf-to-Japan rate of $29 per metric ton is the lowest level since February 2003 and 79% below the high in May 2008. The Pacific North West-to-Japan rate of $19 per metric ton is the lowest level since December 2002 and 76% below the high in May 2008.

... the sharp decline in ocean spreads will encourage shippers to move grain exports out of the Gulf rather than the Pacific North West. This trend has negative implications for Burlington Northern Santa Fe because it is the biggest rail beneficiary of moving long-haul export grain to the Pacific North West.

Economic Risks

North American railways are increasingly feeling the pain of the recession and erosion of global trade, prompting a leading executive to caution that it's hard to predict the timing of an economic recovery.

Freight carriers across the continent saw cargo shipments such as lumber, metallic ores and autos decline an average of 16.1 per cent in the first 10 weeks of this year, compared with the same period last year. Intermodal business for consumer goods and other items fell 15.2 per cent.


March 25, 2009

Investment Paralysis

On Investment paralysis by GMO's Jeremy Grantham
those who were over-invested will be catatonic and just sit and pray. Those few who look brilliant, oozing cash, will not want to easily give up their brilliance. So almost everyone is watching and waiting with their inertia beginning to set like concrete.
What to do?
You absolutely must have a battle plan for reinvestment and stick to it.

March 22, 2009

Internet Economics -part III

Computers stripped down:

I do not see hardware companies with exclusive consumer offerings doing very well in the long term. End user computers will be so stripped down of any horse power or might as most of its computing power shift to the Internet, as I have discussed in my earlier post. Look at some of the strategic actions of the following companies:

  • IBM divested from all things consumer hardware.
  • HP have boosted its data centre management with the purchase of EDS.
  • Dell is struggling to regain market share.

Remember Sun's "the network is the computer" tag line; it makes a lot of sense now. Moreover the computing infrastructure is ready for it. I see computer makers designing and selling for utility providers, to the Google and Amazons of the world. Consumers will use Net-books to access their computing power. Those thin terminals have not taken off before because the utility model was not mature. Now I think it is a better environment. Currently I do most of my applications from online providers, whether business or personal. I hardly use any application from my hard drive. Once my laptop kicks the bucket I am in for a net-book that will cost me $200 or so.

So my conclusion here is to stay away from computer makers who are making heavy investment in distribution channels and goods geared to consumers and look for those with good distribution network with utility businesses.

Free Labour:

The Internet has introduced free labour to many industries like media and software. Think of the contribution of bloggers and content on YouTube. Also, think the volume of applications being used thanks to open source code and other free software used on the Internet like Google Docs...etc. Many have created profitable businesses using this model whether by supplying the infrastructure like YouTube and Blogger applications or by providing the content like blog posts. Participants are benefiting mainly by attracting advertising revenue. I am arguing that this model is unsustainable.

The Internet and computing power over the years have lead to two hard trends:

  1. globalization: the shifting of manufacturing jobs to low cost producing countries, and
  2. automation: the replacement of routine task by machines

Both trends have resulted and continue to result in jobs displacement. Job displacement will have to reach a limit where it will affect people who supply the free labour to the Internet eco-system. This will have two outcomes:
  1. loss of advertising dollars as advertisers do not want to advertise to unemployed people who can't purchase their goods, and
  2. the labourer will be so occupied about their livelihood that will consume most of their time to prevent them from being a participant in the Internet free labour force.

The idea that you can give things away online, and hope that advertising revenue will somehow materialise later on, undoubtedly appeals to users, who enjoy free services as a result. There is business logic to it, too. The nature of the internet means that the barrier to entry for new companies is very low—indeed, thanks to technological improvements, it is even lower in the Web 2.0 era than it was in the dotcom era. The internet also allows companies to exploit network effects to attract and retain users very quickly and cheaply. So it is not surprising that rival search engines, social networks or video-sharing sites give their services away in order to attract users, and put the difficult question of how to make money to one side. If you worry too much about a revenue model early on, you risk being left behind.Ultimately, though, every business needs revenues—and advertising, it transpires, is not going to provide enough.

Free content and services were a beguiling idea. But the lesson of two internet bubbles is that somebody somewhere is going to have to pick up the tab for lunch.
Source: Economist 2009

Today it is a new phenomena that it will take time to play out but the economics of the Internet will impact us and soon it will force us to change our social behaviour yet again.

March 21, 2009

Value Idea: Train left the station and I got onboard

I work in supply chain process management applications industry. As a result part of my limited knowledge in this life is in the logistics and transportation field, and as limited as it may be, it gives me certain insight and ability to look for investment themes that I can exploit in this sector. Now, if you look into my holdings there are not any business I own that operates in this sector. This is by design so far, as a large part of my net worth is tied in the business I started with my partners a year ago. However I may add some stocks as there are very compelling opportunities.

I have added Burlington Northern Santa FE (BNI) to my portfolio at adjusted cost basis of $
65. I was looking at third party logistics and intermodal companies but the more I researched them the more compelling BNI and the rail roads case became. First I will make the
case for rail roads and their competitive advantage against trucking. Second I will make the case for BNI, the risks it faces and its valuation.

Rails vs Trucks

Railroads have made huge productivity improvements over the last few years. Railroads are more fuel efficient as they can travel about double the distance they used to travel in 1980 on the same amount of fuel. Moreover they can transport more, see diagram below. Another
strong point for railroads is shift in pricing power to their favour with high fuel charges.
An increased use of rail freight could allow the supply chain to accommodate these increased volumes while minimizing highway congestion and improving energy efficiency in the transportation sector. Shippers and policymakers are concerned that the existing infrastructure — much diminished after decades of track
abandonment — lacks sufficient capacity to accommodate the increased
demand for rail freight.

Railroads have improved their productivity in the past three decades,
mitigating immediate concerns about capacity, but concerns about future
capacity constraints appear to be justified.
The competitive advantage for rail roads over trucks:
  • Fuel remains historically high at these levels and will favour rail over trucks. Moreover, oil marginal production cost is much higher than what it is trading at, $35-45, with such dynamic you should see oil higher in the future.
  • Trains are becoming faster and more fuel efficient than road, due to severe congestion on highways and deteriorating transport infrastructure.
  • Capacity is being sucked from the trucking industry at an alarming rate. More than 45,000 trucks left the market in the second quarter in 2008 and more is expected due to high fuel costs. Truckers average fleet size fell to 2725 trucks in 2008 from 2946 in 2007 (source:inbound logistics 2008) Capacity shortage is imminent. Rail will be the main beneficiary of this trend.
  • shippers are beginning to shift from the need of fast delivery due to the re-engineering of their supply chains. Most companies are opening smaller but many distribution centres closer to their markets, doing away with hub and spoke model of centrally located warehousing. This reduced the need for fast cross country shipping so shippers are ok with
    longer but cheaper mode of transportation. Again rail will benefit from this trend.
  • competition can be fierce in trucking while rail not so much. it is almost impossible to enter the rail business.
As a result the rail Pricing power is significant. The railroad industry is highly concentrated in the hands of seven railroads. Competition is further limited by their geographical concentration, with rail transport in the East predominantly carried by CSX and NS and, in the West, by Union Pacific and BNSF. There are significant barriers to potential competitors entering the market, and this gives existing railroads pricing power.

Railroads can also price discriminate between commodities and are attempting to specialize in their fastest growing businesses—predominantly coal and intermodal unit trains. Railroads occasionally choose to limit the amount of traffic they will accept from some customers because that traffic generates low profits or the operating requirements reduce the capacity of the network and profitability is reduced.
U.S. rail industry transports about 40 percent of the nation’s goods, in terms of tons handled and distance moved, for only 13 percent of the overall transportation cost.

Next Post will tackle the specifics of BNI operations and its risks.

March 20, 2009

The Internet Economics- Part II

Software: Not the same game anymore

Software used to be a wonderful business. It did have many of the attributes of strong competitive advantage. It tied users with high switching and search costs therefore enjoying a great pricing power. Software companies were able to up sell users on ongoing maintenance contract in perpetuity as a percentage of the original sale. Those days are over.

The Internet is turning itself to be the computer for all. It does not matter if you are a small business or large organization, your software use will change. Open source and software as a service applications has almost replaced all kinds of software applications. 

Consider our company, we have cut drastically all types of software purchases compared to few years ago. Please consider:

  • We began a year ago to use Google Docs as our email server, office tools and as collaboration and knowledge management platform. 
  • As for our Customer Relationship Management we use 
  • Accounting is done through online packages.
  • Open source for many development components. 

What is the effect of such transformation:
  1. reduction of need for capital expenditure, improving our cash flows
  2. reduction of our technical resources to maintain infrastructure to host all these application
  3. ability to scale operations easily
  4. we can level the playing filed with large organization by using similar technologies to manage our business.

In an opposite dynamic to the unbundling of media on the Internet, software and hardware are getting bundled. Software and hardware have converged and bundled by Saas companies. Saas companies are providing businesses with the application and the hardware along with the technical expertise to manage them. Businesses will only focus and concentrate on their core functions of converting raw material to products that customer wants rather than worry about supporting functions like IT.  

Google, Amazon and Salesforce are becoming a utility companies distributing computing power to users in same fashion power companies are distributing electric power to households and businesses. Companies like Google, Amazon and Salesforce are investing billions to construct data centres with huge computing power to sell and distribute to the masses, similar to constructing power plants. 

If you look at financials you will see very similar return on sales and investment to utility companies. The reason is Salesforce and Google are not the software company like Microsoft and Oracle in its day, but it is a capital intensive business. It needs large sums of money to build computing capacity and real estate to be able to be successful in the Internet time. 

Microsoft and Oracle who are traditional software companies will face an uphill battle going forward. The culture of software is so entrenched to change easily. I do not see the merit in investing in software companies anymore, but I like utility companies like Google and Amazon.

March 18, 2009

Sears Canada: Potential buyout Candidate

SHLD continues to buy shares of Sears Canada. I think it will be a matter of time before it buys the whole company outright. From the national Post:

Sears Holdings Corp. continues to add to its nearly 73% stake in Sears Canada Inc. The U.S. retailing giant bought 29,600 shares of its Canadian subsidiary for around $17.85 per share between March 9 and March 10, 2009. This brought SHLD Acquisition Corp.’s holdings in the Canadian retailer to 20,756,173 shares. The transactions follow Sears Holdings Corp.’s purchase of 32,000 shares on Dec. 1, 2008.

In November 2006, Sears Canada shareholders rejected an $888-million bid by its parent after some investors said the $17.97 per share takeover price was too low. However, the potential deal sent Sears Canada shares nearly 50% higher since the offer was made to almost $30 per share.

The stock is now trading around $20

The company is now 73% 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.

The buyout now is more likely as, if remember correctly, Dec 31, 2008 marks the date where SHLD do not need to make whole Bank of novascotia and royal bank for their shares tender in the original failed buyout few years ago.

SCC now has very small float and average trading volume so these purchases affect the price significantly. In the last 2 days the stock has moved by 12%. 

March 17, 2009

The Internet Economics - Part 1

You may think this post is few years too late but I believe there is some relevant issues to discuss. The Internet have been quite a force and I think we do not yet understand its full impact. I did not say potential, because its has a positive implication, I'd rather use impact because we really do not know.

Its impact on our social behaviour is still developing, but its impact on some industries is felt deeply by all. I want to share some thoughts on the affects of the Internet on the following industries( I will do so over several posts so I do not bore you to death, or bore you several times):
  1. Media, news papers in particular,
  2. software,
  3. computer hardware, and
  4. Free labour, not an industry but there are many profit from it.

Media, the first casualty:
Newspapers are going into bankruptcy and shutting down exponentially these days. Some, to mitigate the impact, are shifting their distribution model to online only model. I think that will fail as well.

Newspapers will be burdened with legacy costs of their traditional operating model. Once they are online only they will discover that news papers on the Internet are unbundled. People read one article at a time independent of the source. And that will lead to their demise yet again.

The economics are totally different and culture is too instilled in traditional news papers to adapt to the Internet economics. Traditional news papers are sold as a bundle making some sections profits subsidizing others, i.e., classified are actually a subsidy for investigative reports, which costs a lot of money but produce no interest from advertisers. I think newspapers, who consider their reporters to be the starts of the system, will overpay those reporters with no benefit to show for their work. As a result, it saddens me to say that the investigative journalist job may disappear and society will be lose the knowledge and content they produce.

This brings me to bloggers and their content as a substitute for traditional news papers. Bloggers have self-proclaimed that their content is as good as traditional news papers. I say that is a total arrogant bullshit. Most blogs out there would have no content to create if it was not for traditional media. The content generated by blogs are mostly reactive to what is written in traditional media by providing opinion and off-the-cuff analysis.

In my next post I will detail my observations on the software industry.

"Big Switch", Nicholas Carr