April 17, 2009

Bond vs Equity 

We are at economic inflection point; when business as usual returns and what is usual is being figured out as we go. How quickly the world economy returns to normal—and indeed, what “normal” is going to be—will depend on hard-to-predict factors such as the fluctuations of consumer and business confidence, the actions of governments, and the volatility of global capital markets.

Credit normalization is the key to equity performance over the next little while. Without access to financing equity prices will remain under pressure. If you believe that bond professionals are better than equity analysts, which I do, then yield behavior of credit instruments should provide some clues. In addition, cost of debt is an important metric for equity valuation, the higher the cost of capital the lower equity value should be. 

The bond and equity markets have diverged over the last few months. One was priced for hooverville and the other for normal recession. Then, the reverse occurred, equities woke up to the realities of the economy while the bond markets recovered some bit. Now with the market rallying some 25% since its lows, the question is does the bond market agree with equities?  

Well the answer this time is somewhat difficult than in the past. Debt markets have been mostly flat during the recent equity rally. Actually you can argue that the treasury yield rise is positive for equity, as investors shift money from non yielding assets to equities. Another point is the elevated spreads on corporate and other instruments are now pricing risks appropriately, as historical low spreads leading to the credit crises were an aberration.

The credit environment is much better than last November on all fronts:  
  • Corporate spreads have seen improvement since Dec 08 but did not participate in the recent equity rally and stayed mute for the most time.
  • High Yield spreads remain high as evidence of defaults and low recoveries are starting to appear in bankrupt company data. However the market is far better for Q4 2008 and deal are being done even for the riskiest companies, see here
  • Sovereign debt is stable and bodes well for Emerging Markets. Actually sovereign debt has been on a tear since Dec 2008.
  • Commercial mortgages spreads remain elevated except for AAA rated paper.  
  • Bank loan markets improved since last Dec 2008. Deals are being done, see here.

The consensus right now is we are going to have to revisit the lows and equity to head down. However, credit has improved so much form November of last year. Although I do not see any sustainable rally we may just languish in range bound market. Yet again who knows?? 

April 16, 2009

General Growth Properties Bankruptcy 

This is one of the biggest bankruptcies in commercial real estate history; Olympia & York is close second. This is also one of the most complex as well. The company is operating relatively well but is being crushed by a mountain of debt that can't be refinanced. Their operating metrics are not stellar but they are not bad either. 

Bill Ackman, the famed hedge fund manager, have bough into all levels of the capital structure. His fund not only bought sizable portion of the common but only some senior debt and he is the Debtor In Position financier. Many retail investors have been following him by buying the common. The question is: is there value in owning the common shares? 

Examining the most recent supplemental and 10K, we find 2008 total NOI (Net Operating Income) of $2,576.51M. Assuming a 5% decline in NOI in 2009, our NOI estimate is $2,447.2M. The 5% is realistic for two reasons: 
  1. their more recent quarter have seen their NOI drop by 4% from 2007 quarter and 
  2. The retail environment have gotten worse since the Q4 of 2008 with sever retail sales declines in Q1 2009  

To calculate the value of GGP we use potential cap rates that are appropriate in this environment. I think a range between 8-10% is appropriate. The value of commercial real estate is simply NOI/ Cap rate. Under the different cap rate the potential value for GGP is as follows:

Add: Other Assets3,8333,8333,833
Less Liabilities 30,50030,50030,500
Value per share $122-7

So unless market cap rates go up beyond 9.5% then there is value in the common equity. However there are many other considerations:
  • The bankruptcy will be a long process which most retail investor do not have the attention span for.
  • complex and not transparent process.
  • GGP's debt is owned by many CMBS holders that might not play ball like large lenders and could negatively affect the outcome of restructuring. 
  • Equity holders have no voice and no ownership in CH 11, so GGP's bond holders can strike deals that may wipe out equity regardless of value.
  • Legal fees and other bankruptcy fees will eat a lot of the cash generated from restructuring. Lehman Lawyers so far have reaped over $ 150 million. The fees alone can wipe out any value for the commons. Some other bankruptcies like Enron costs more than $250 million. 
  • Bill Acman can make good return on his debt even if the equity is wiped out so he is different from you and I owning only equity.
  • The game of distressed investing is a different ball game and require set of skills and legal expertise that many of us do not have.

So GGP may have value but the margin of safety and parameters are out of the scope of my competence. And if this is the same for you you should stay away.

April 2, 2009

Consumer Brands as Competitive Advantage

Brands names have been considered as a competitive advantage for companies. Companies like Kraft, Heinz, P & G, Coke, Pepsi...etc all own the who's who in consumer brands. But do all brands count as a competitive advantage? The answer is no.

Case Study: Packaged Foods Brands

Packaged or consumer food products have limited value or competitive advantage on its own. In order for brands to be a competitive advantage it must be coupled with any of the following (see my earlier post here):

  • low cost producer or economies of scale,
  • high switching costs, or
  • consumption habits.

However with the exception of soft drinks, the brand is coupled with consumption habit, most consumer branded food items lack any competitive advantages. Most brands are higher in price because companies want to bill the quality in the minds of the consumer, it is expensive then it must be better mentality. But that is not the case and consumer are better informed and can't afford not to be.

P&G products, for example, are about 40% more than the store brand, but perform the same. If you shop compare, for example, laundry detergents Tide is nearly $20 for 96 loads(used to be $14), Costco's store brand, Kirkland, was $12 for ~120 loads with similar quality.

The Kirkland Butter is $1.44 per pound and as good as Land O Lakes that goes for $3.24 at the supermarket. The Kroger, Meijer and Spartan brand butter is gross and still over $2 per pound, all three come from the same plant, 324 is I remember the label correctly where Kirkland comes out of 55-307.

The proof is in market share and consumer buying habits.

  • Kroger  has had significant success with its private-label program, with 27 % of its grocery sales and 35% of unit volume coming from its store brands in the fourth quarter, up from 26% and 32%, respectively, in the prior year.
  • Safeway  intends to drive corporate brands harder if packaged food companies do not lower their prices.
  • Wal-Mart is revamping its Great Value brand by introducing new products and reformulating 750 other products. Great Value is the country’s largest food brand in both sales and volume.
  • ConAgra's consumer-foods segment, sales volume -- the amount of food sold -- fell 4ConAgra Foods had to cut the prices of its Pam cooking sprays, Wesson cooking oils, Egg Beaters and some other products to compete.
  • Kraft Foods Inc. lost about 2.5% of its sales volume in the fourth quarter because people bought fewer of its products. Since then, the Northfield, Ill., company has lowered prices on some nuts, cheeses and coffee.
  • Sales volume at H.J. Heinz Co. declined 6% in its most recent quarter as consumers and retailers bought fewer Heinz products.
  • Nielsen data from the Private Label Manufacturers Association ahsows that private-label sales of food and other grocery products in the U.S. grew 10.3% to $82.9 billion in the twelve months ended in November.

Moreover, packaged foods are at a disadvantage as...
All the major packaged food companies make at least 10% of their sales to Wal-Mart, so it is a concern that as Wal-Mart increases shelf space for its own products, it is likely to reduce space for national brands from packaged food companies.
Packaged foods companies need a shift in their product strategies. There has to be a revamp in their marketing and operations to  address the following:
  • Rethink their pricing strategies. A clear question need to be answered is what is their value to consumers, a brand is not value that can command a premium; it must be combined with something.
  • Infinite customer segmentation that drives costs higher and leads to lower sales. Store brands are generic and one size fits all and they seem to be taking share from branded foods.
  • How to deal with excess capacity? Brand companies make private label goods to fill in excess capacity at factories; even at a loss. The problem is that this is very low margin business and sales go to retailers who go bankrupt with regular frequency. Message to branded firms: use capacity to lower the costs of your products.

April 1, 2009

Value Idea: Valuation Analysis: BNI -part III

Valuation Analysis:
The business franchise of BNI is worth the investment as a core holding for the long run. Its earning power is solid if averaged over the economic cycle. You simply can't reproduce BNI franchise. It is one of those businesses than no amount of resources will enable any entity to reproduce it. P&G, J&J, Coke, Pepsi..etc with enough resources can be reproduced but I can argue that BNI and other rail roads have high barriers to entry, or rather impossible to entry.

The economic assets of BNI are significantly understated by historical accounting. For example, land is under valued on the BNI balance sheet. BNI land value is booked at $1.7 Billion only, while land prices have inflated tremendously over the life of BNI operating history. 

If you want to understand how significantly understated just use recent M&A data in the rail industry and apply the multiples. One way to do it is to calculate the market value for each mile of track BNI owns. Canadian natural Railway just purchased 300 mile track in the city of Chicago. Also, in 2003 BNI sold 18 miles of track for $260 million or $14.4 million per mile. If you apply purchase price for each mile of track to BNI the figure will be astronomical. 

I will not delve into the asset valuation approach because the figures, however you value them, will be off the charts. Instead I will focus on the earning power value of the company. For valuation i will need to adjust BNI's TTM EBIT and figure an appropriate discount rate. 

Discount Rate
To determine the appropriate discount rate to calculate BNI's future free cash flows I will start with their average cost of debt. Then I will add expected equity premium and company specific risks as identified in the previous post.

Equity premium5.75Shiller observed equity premium based on data from 1871-1999
Adjustments for Risk:

I will add basis point based on the specific risks i identified in post 2
Risk of price gouging litigation 1.25As economic situation deteriorates, government will be sympathetic to industries about high shipping prices and will likely intervene on their behalf in forms of legislation and such.
Risk of government policies on coal shipments.5I will keep this low as I really do not see any alternative for coal over the horizon. Coal will still make up 50%, and will grow, as a source of electricity generation
Trade shift non BNI coverage.25This is normal cost of doing business.
Other1I will make a catch all for risks that I did not capture
Equity required rate of return8.75I avoided the CAPM model and Beta because risk as defined in Beta is meaningless. 
Avg. cost of debt6.5 Based on BNI debt interest rates
WACC (weighted based on BNI capital structure) Discount rate7.8The discount rate looks low due to almost zero risk free rate. 

EBIT Margins
BNI business is cyclical and tied to the economy as evident by its EBIT margins, see chart. Margins have compressed as a result of the 2001-2003 rescission and expanded since then. in order to estimate its earning power it is better to average its EBIT margins across 10 year period to normalize cyclical variations. The 10 year EBIT average is 20.8%. 

If you compare EBIT margins with industry peers you will conclude that BNI transport much less economic sensitive business as discussed in part 2. BNI's margins are less volatile during the economic business cycle compared to industry peers due to its business mix. 

Below I will attempt to arrive to Economic Power Value based on no growth scenario. I will adjust EBIT for some elements that I feel should impact earnings going forward. 

Item$ in MillionsNotes
Revenue (TTM)18,018
EBIT3,747I apply the normalized 10 year EBIT margins of 20.8% to arrive at a vague estimate of the perpetual EBIT assuming no growth.

Pension Plan Costs(23)BNI have a pension plan deficit so we need to adjust for further hits to its earnings as its contribution must increase. 
Adjusting for reserves (environmental, injury)(37)BNI does a good job in reserving for contingent outcome like personal injuries and environmental cleanups. However I feel the two items below is under reserved based on recent payments by the company:
  1. 19 for personal injuries 
  2. 18 employee separation costs
Adjusted EBIT3,687
Less: Taxes(1,290)Based on 35% marginal tax rate
Add: Depreciation1,397Historical depreciation do not represent a meaningful economic concept.
Less: maintenance Capex(1,631)Maintenance Capex is higher than depreciation and makes the bulk of BNI Capex figures. the average maint. Capex is about 75% of total capes spending over the last 4 years.
Adjusted Earning2,163
Earning Power Value27,730BNI's worth assuming no growth in revenues: a present value of a perpetual stream of earnings (Adjusted Earnings from previous step / discount rate)
Less: LTD Debt9,099
Add: cash452Adding cash above 1% of sales as most companies do not require that to operate.
EPV 19,083
BNI Mkt cap20,000

As we can see BNI is fairly valued currently based on very conservative assumptions. However, The company does offer more than adequate margin of safety through its balance sheet, prospect for growth and competitive advantage. Therefore I do not have any problem owning it at these prices.