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.