Opportunity in oil spill

There has been a lot of talk of the opportunity in the energy sector as a result in the sell off of the Gulf of Mexico (GOM) producers, drillers, platform operators...etc. Most of these names have been halved in price; BP is offering 10% dividend yield, which is an amazing return by itself.

The question presenting itself, is the disaster an opportunity for stock pickers? Some think it is.

The disaster is a game changer. No one can argue that in a couple of years, and into the distant future, GOM operators will operate in the same manner as they did few years back. I do not think so. Costs are going to go up materially.

Insurance, security bonds, royalties, clean up funds, taxes...etc will be on the rise as a result of this disaster. Some suggest that platform operators like SeaHawk (HAWK), which I reviewed their spin-off and did not like, is a good value proposition as it is selling below liquidating value. However it was selling below liquidation value a year ago as well.

I think the smaller the player the more disadvantaged operationally and financially in the new and expected environment. Weak balance sheets will find it harder probably to comply with bond and clean up funds requirements and will be forced out by the bigger players, who ironically caused the disaster in the first place.

If I wanted to buy, I like McDermott International (MDR), which will spin off it is off-shore construction and management business. The company operates three businesses:

• off shore drilling project management,
• government operation: nuclear submarine building, and
• fossil fuel power construction

MDR will operate the off shore construction business and the spin-off will own the other two.

My idea is to buy on the spin off date MDR as it will be more than likely added to the several energy sector ETF and mutual funds. Those funds did not own it due to the complexities of the other two units and was not pure play energy equity.

1. MDR will be less complicated than the other unit from accounting, regulation and business is easier to understand,
2. growth potential in offshore drilling around the world; its Arabian Gulf operations is growing at a fast clip and will offset any weakness from GOM operations,
3. demand from energy index and sector ETFs as the company will become pure play energy service company. MDR is held in mid cap portfolios but not in sector specific ETF like energy funds; ishares Energy Service, Holders (OIH)...etc. Will the spinoff induce sector specific funds to buy the oil and gas segment to be part of energy ETF/ funds? A very high possibility.
4. The backlog of the company alone should provide good support for earnings growth.

To capitalize on the energy sell off, I will require more odds in my favour and I think MDR might do it.

CF Industries : The Perils of overpaying

I have detailed my thoughts on the Fertilizer buyout dance and how CF in its bid to stay independent overpaid. I expected the market to punish the company but the dramatic decline of CF stock exceeded my expectation. True the whole Ag space is under pressure but CF is down more than 30% compared to AGU, 12%.

This was easy short. Most of the time mergers destroy value but to overpay in such reckless fashion is a whole other story.

Value Idea: CCE implied spin off

A kind of a spin off in the works as a result of the buyout of Coke (KO) of it North American bottlers. The result of the transaction will be an independent bottler in Europe as KO will buy the NA division of CCE.

The transaction is very interesting. One thing is the transaction is not done growth. KO is buying NA bottling operation actually to limit competition in its distribution channel. The NA market is very mature and the competition is killing pricing and profitability in the system. That is why Pepsi and Coke have forked out billion to re-consolidate their own companies again. So the company being left behind is left alone not for economic issues. Actually CCE Europe is the better growth story of the two divisions.

CCE Europe or the New CCE is achieving 3% volume growth while NA coke case growth is experiencing a permanent decline. Profit growth and revenues are telling the same story. Europe is growing while NA is flat-lining at best.

So what is the valuation here?

1. KO paid 8.4 multiple ( Entp value/ EBITDA) for NA operations
2. the market is valuing CCE (Europe and NA) at 7.43 multiple
3. that leaves Europe, after some backward deduction, at 6.02 multiple, that is way to cheap. Bottlers overall has an average 8.7 multiple, while other European bottlers have 9 multiple.
4. doing some complex math the implied price per share of the new CCE will be $13.33, after $10 divined at the close of the transaction. The market may trade at $15, current price less the special dividend.
5. If we apply peers multiples then the new CCE value is ~$19 per share. Not enough margin of safety for me at this point ( if you buy at now $26, get $10 dividends and be left with $14 to15 worth in new CCE shares, about 27% upside potential to full valuation).

However if CCE follows a typical spinoff behaviour then it might get sold off at the close of the transaction and then it may be a good value. CCE will be 100% European and it may get taken out of the S&P500 ( management “expects” to stay in the index) conditions to have fund managers dump the stock.

So at this point it is on the radar screen to see the development and price action at the close, which is expected to happen in the 4th quarter of 2010.

The Value of Corporate Events

I started to realize that hunting for value is a strategy well suited for, mostly, undervalued markets. Generally these situations appear abundant in these markets, therefore increases the odds of positive performance. However, searching for undervalued companies ala Buffett in markets that seemed to be fairly valued is not a strategy I am willing to undertake. I reckon undervalued markets like the one we had in 2008 is like shooting fish in a barrel but otherwise you need to be really a sharpshooter with strong set of skills or a lot of luck to do well.

Off course the obvious alternative is to stay on the sidelines waiting for those undervalued markets, but what if they do not materialize.

successful value investing requires significant diligence. Investing is not hard or rocket science but requires a lot of time and resources to come up with single idea. I reckon, based on my limited experience, to produce a single good idea you have to vet at least 10 with the same intensity and diligence. One of the most critical aspect of investing is generating ideas. Idea generation can't be random it has to be systematic otherwise you will never know what works. It is the pane of my investing existence is how to find those ideas? how to build a pipeline of company to analyse? do you start with A's and work down the alphabet? or do you run screens that will uncover good companies in the past? So needless to say it is important to have a "search technology", as Prof. Greenwald puts it in his book "Value Investing: from Graham to Buffett and beyond".

That is why event driven strategies is what I observed to be the best search strategy for individual investors. It is all about odds. Event driven investing puts the odds slightly in my favour. I get a concrete set of ideas with good probability of out performance. I have been concentrating on two events:

1. Spin-offs,
2. Post bankruptcy equity, and
3. Index Deletion.

For example, spin-offs offer great hunting ground. I do not use spin-offs investing as a blanket approach, although I wish I did I would be better off for it. I need to vet the presence of good business and competitive advantage. Spin-offs will have duds, that's why they are being spun off. However, the odds to pick good performers over the next 3 years are much better than picking from the entire market universe. Most of the time markets fear from the uncertainty of smaller and unproven companies are wildly exaggerated.

From the spin-offs I followed, I have invested in some but not all, it out performed the S&P by 23%. That is not unusual. Most studies find 15-20% out performance for spun off companies. The reasons for the out performance vary from better focus to better information transparency.

There is a busy calender for spin-offs this year, I will post if any seem interesting.

CF/ TRA Merger- some thoughts

Here are some thoughts on the drama that played over the last year in the fertilizer industry. Please note that these are thoughts and I am researching to what can be an investable idea.

Takeover Frenzy:

The year long dance between Terra, Agrium, Yara, and CF Industries came to an end. CF won the bidding for TRA and took it away from Yara and in the same breath fended Agrium advances.

• The acquisition of TRA is mostly a mechanism to fend off AGU hostile takeover. To defend against this unwanted advance CF overpaid. As Yara offered to buy TRA from underneath CF and CF struggling to find a white knight instead of Terra reaping a premium offer. In this vein, at least one person pointed out that once Yara did a deal with Terra, CF lost its white knight. CF was left facing a low bid by Agrium and its bidding here made sense in order to prevent a deal with Agrium for a low price forced by CF’s own coming election.
• The TRA acquisition is not a tuck in acquisition but almost a merger of equal. CF and TRA are of similar size in terms of market cap and Ent value. TRA had $1.5 B in sales as of 2009, $2.5b in 2008 while CF had $2.6B as of 2009.
• CF might got caught in a bidding frenzy for Terra that lead it to over bid for Terra. the increase in offers are as follow:
1. March 10, 2010 final and winning offer: $47 or $4.6 market cap. 37.15 in cash and the balance in CF shares
2. Dec 15, 2009 third offer: 45.91
3. Nov 1, 2009, second offer : $40.50
4. Jan 15, 2009 initial offer : $20.98 or $2.1 in market cap this was an all stock offer
• The peculiar thing is CF used its shares as a currency when it was beaten down in January 2009, however used an almost all cash offer in its winning offer in 2010 after its shares have a considerable run and traded at 52 week high. Why would the company uses its shares when it was trading at what it seems a large discount to intrinsic value while uses cash when the shares have recovered.
• Another peculiar aspect is CF has proclaimed that AGU offer undervalues the company but it was happy to use its own undervalued shares as a currency for takeover of TRA.
• The length of the merger process might have increased the mental investment and cost to CF executives making it harder to forgo those costs and walk away. although these costs should be considered sunk costs and not factor in making and acquisition in March 2010. Maybe it became win at all costs. I am not sure what changed in the span of 12 months to justify more than 100% increase in value paid to Terra.
• The merger announcement talked about being".. the largest nitrogen producer in the world among publicly traded companies as measured by production capacity". May be CF wants to the biggest and baddest at the exp of shareholders.

Over Paying

CF simply overbid for TRA to escape being bought by Agrium. Please consider:

• CF offer values Terra at $47 per share. The offer represents:
• 2.9 x sales (TRA highest achieved 2.2x at that market top in 2007)
• 9.5x book value
• 30.5 x earnings (highest achieved 25x in 2007)
• 22.7 x Cash Flow
• CF overpaid for the company as the DCF value of TRA as a stand alone company, assuming 10% growth rate for 10 yrs and 5% terminal rate for Cash Flow of $3.19 per share, is $41.68.
• CF claims that it paid 8x TRA's EBITDA (see merger presentation footnotes). That claim is more spin than reality for several reasons:
• CF averaged 3 years to get the EBITDA of 622 while 2009's is mere 402
• 2008 was an abnormal year for Ag where prices have shot up for Fertilizers and ag in general. CF includes 2008 to average out to 622 in EBITDA. TRA never approached that level in EBTDA or came close. would that be repeated again? so to include a record year in your EBITDA will increase average and lower the multiple to make the transaction more salable to shareholders, which by the way are precluded from voting on the transaction thank to CF management to not be bogged down with a limitation in their pursuit of TRA.
• CF claims "~$1.54Bn of combined EBITDA (including run-rate synergies): Based on 2010 CF management EBITDA guidance, excluding minority interests, of $752MM for CF (see non-GAAP reconciliation on p.6), plus $655MM of 2010 EBITDA per Terra (refer to Footnote 1 on prior page), plus $135MM of run-rate synergies" However, CF used its guidance for 2010 and the 3 year historical average for TRA to arrive at that number. Talk about apples and oranges.
• "I believe a $100/st nitrogen production margin ($3/MMBtu natural gas for 1 metric ton ammonia production in Yara's thinking) is as good as it will get going forward, and based on this, $600 million is the high water mark for earnings from this asset set. This is based on 6.5 million tons of annual nitrogen production, less SG&A. Terra's EBITDA hit $964 million in 2008, which was an extraordinary year for the company. "
• CF will pay about 6 percent of its entire market capitalization in fees. On a per share basis, I calculate this to be about $5.75 per CF share. This does not include the $123 million termination fee that CF is paying to Yara on Terra’s behalf as a result of TRA terminating with their merger agreement to accept CF's offer.
• CF will issue equity to fund TRA acquisition, lots of it; it can be dilutive. The company will issue $2 Billion worth of shares: $1B for TRA shareholders and another to the public. Total issuance represents 30% of current and new shares based on today's market price.
• TRA UK assets are declining due to pound devaluation
• valuation of integrated companies:
• what kind of return can CF garner on the acquisition? I reckon no more than 15% in ROIC, this is the best case scenario. The ROIC figure is covering assumed cot of capital of 12%, however, I have my doubts about their EBITDA and synergies claim as detailed here. If I start calculating more accurate ROIC figures using accurate EBITDA like better cycle than just 3 yrs and including an average of non recurring charges...etc I sure they do not earn their cost of capital.
• The invested capital is the cost of the acquisition which are:
1. offer: $4.6 Billion
2. termination fee to Yara: $123 million
3. bankers fee incurred by CF: $270 million
4. Grand total : ~ $5 Billion
• What is the return CF is going to get:
1. $622 (based on the 3 year average EBITDA of TRA)
2. $135 million in synergies

Perils of Integration

• Do CF have merger integration experience? CF did not make a large acquisition like this and was not a serial acquirer of smaller operations so that begs the question how will they integrate?
• I want to handicap CF management so lets look at their track record by calculating ROIC.
• CF has capacity to add debt as it has lower leverage . It will add $4.05 billion in financing to its balance sheet to complete the acquisition.
• what does the combined company look like?
• CF claims "flexible balance sheet with ~$1.7Bn of Net Debt by the end of 2010 (Based on CF management expectation of $2,034MM of debt less $321MM of cash (excluding $134MM of auction-rate securities)"
• CF claims that there is $135 million in annual synergies ( those synergies were $100 million at the time of the initial offer) from the elimination of:
• duplicate corporate functions: it should be very little if any to be considered material and worthy of synergy.
• optimization of transportation/ distribution : need to look closer at this claim
• greater economies of scale in purchasing and procurement: but 50% of their production cost is natural gas and the commodity is not driven by volume but rather by proximity to distribution network or closeness to production hubs. However natural gas is cheap at the moment given them larger margins and NG is expected to be low priced for the foreseeable future. Nevertheless it is an advantage that can be enjoyed by the entire industry rather from economies of scale as a result of the merger.
• It is hard to see exactly where CF is going to get the extra $75 million in synergies they asset they can deliver, over and above the $60 million that Yara said it can achieve, the latter being more evident.
• distribution channels are different since Terra's customer base is industrial and CF's is agricultural

BPO Properties REIT Conversion

BPO Properties, a public subsidiary of Brookfield Properties at 89%, will convert to a Reit in April 2010. The transaction does not really change the economics of Brookfield, however its implications are more subtle. Please note that I own Brookfield Properties.

1. Brookfield Properties will follow the same game plan of Brookfield Asset Management (BAM), its parent, by creating ownership structures floating them and earning management fees from them. Not only Brookfield Properties will de-leverage its balance sheet, which it badly need, but will establish high Return on equity revenue stream.
2. BPO Reits will be sold to less than 50% by Brookfield in the future as Brookfield will not want to consolidate debt of the Reit. Also conversion to a Reit mostly will benefit retail investors rather than corporate subsidiaries, as dividend income flows between corporation tax free.

Given that I am not sure why BPO Properties shot up 10% on the announcement? There will be more supply of BPO shares in the future and higher cost structure given all the fees the Brookfield Properties will earn from them.