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.

A Bid for Illiquidity

Back in November 2008 to January 2009 buying decisions were fairly easy. There was all kinds of opportunities to choose from. All you had to do was step up to the plate in any asset class or in any market and take a pitch. Right now buying any asset is not so easy. Credit and equities are fairly valued. I have not find anything of interest. I spoke about few ideas but nothing interesting materialized.

To find a good pitch I have to find a market where the level of professional analysis is a bit lower. So I will have to avoid the US markets. That means I have to find illiquid assets. That is fine by me. Liquidity is not worth a cent in my book. So I found the Canadian Debentures. Those are subordinated and unsecured, in some cases, debt instruments issued by companies of lower credit quality. I have sifted through dozens of these names and I have found two ideas. I tried to establish a position in both but I was unsuccessful and the price ran to the point it is no longer attractive to me, and that is why I am writing about them now.

Royal Host 2013 6.25% Debenture (RYL.DB.C)

Royal Host is a hotel owner and operator in Canada. It owns and operates economy hotels mainly in Ontario and Western Canada. I do not need to go into the hotel industry fundamentals as they are atrocious right now. It is worth noting that hotels performance is tied closely to the economy. But this is not a bet on the economy, it is a wager that I will get paid in 2013 at 100 cents on the dollar while purchasing the debenture at 68 cents on the dollar.

I have been stalking this issue for awhile but the price ran from me from $68 to $80 at the close Friday. I am no longer interested at that price but if it dips down I will try again. What makes it worthy? The issue is distressed debt in the hotel industry, where debt is selling at 68 cents on the dollar. If hotel vacancy and rent per room are stable at current level which is bottom of the cycle then debt is over collateralized at cap rate up to 11.5%, extremely low valuation even in the hotel industry. The Company have several liquidity generation abilities and should fund its obligation and debt maturities with no issues. The debenture offers the potential to generate IRR of 27%.

If you bought the issue at 68, the company will have no problem repaying you at 100 cents on the dollar even if cash flow from operations after debt service is negative, according to my analysis and valuation. The company have several options to generate funds:mortgage assets that are free and clearsell a sizable marketable securities portfoliocut its dividends
The only issue here is the company stock buybacks. The company is using its available funds and selling its portfolio to buy back its shares. It had tendered for 26% of its shares in December and going back for more in Jan 2010. Why is the company doing this while it cash flow from operation can barely service its debt. The answer is it may be setting up for going private transaction.

The company is 25% owned by Clarke Inc and its board are mostly controlled by Clarke. After the tender Clarke ownership will jump to 37% and potentially more after the additional tender offers by the company. Clarke obviously wants to take private Royal Host with little cash outlay on its part, particularly that Clarke's balance sheet is in worse condition than Royal Host. If the privatization takes place sooner than maturity the debentures will be redeemed at 101 cents on the dollar. However if the tenders keep coming it will compromise the collateralizing of the debt.

Still at high 60s or low 70s I think the issue is worth the risk. But now I will bite my time until either it comes down in price or look back and see how pretty my spreadsheets look like.

Next post I will tackle the second idea.

Pacer: Change of Mind

Pacer is in the right space; the intermodal space that is. However it might not be the right investment. There is good likelihood of business failure and permanent loss of capital. I have sold out of it earlier and took a 3% gain from my cost basis.

Why I do not think it is suitable for an investment because of several factors:

1. The company lost its wholesale business to HUB Group, as Union Pacific (UNP) renegotiated their long term contract, which gave Pacer a competitive advantage for a long time.
2. Now Pacer does not have any pricing power or unique access to the UNP network so its advantage have disappeared.
3. Pacer will try to establish it new business going to shippers rather than selling to other logistics businesses, which is unproven field for it. If management had showed better skills and better Return on Capital over the last 5 years, even with unique advantage it failed, I may have given it the benefit of the doubt. But there are no indications of superior skill.
4. Management have to win business and that will be a tall order its revenue growth over the last 7 years, the go go years of global trade, have been -5%.
5. Pacer with no trucking assets can get its margin really squeezed by truckers to complete the various legs of the intermodal trip. However most of its competitors either have their own trucking or have a larger under contract owner operator. This will decrease Pacer flexibility and attractiveness for customer needs.
6. Recent liquidity issues and reduced credit facilities can turn off customers from giving their business. Supply chain managers and shippers priority will always be reliability rather than price.
7. Pacer would not see any positive cash flow from operations for next year according to my model which will continue to raise solvency issues as it did this year.
8. CEO abruptly retired. The company felt the need to issue a press release to recently to emphasize that all was preplanned. That was very defensive move that leads to believe that there are something more o this issue.
9. A lot of insider selling. Not a good sign.
10. the new credit facilities the company negotiated limits capex at $6.5 million per year going forward. The company used to average $9.5 million per year and most of it is maintenance capex. Without investment in the business it could lead to deterioration in operations.
11. Also the credit facility is very strict and keeps Pacer on a tight leach.
12. If I assume mid cycle revenue level of $1680 and loss of $550 due to the new agreement with UP that will leave Pacer with revenue level of $1130. Further if I assume the average EBIT margin over the last 4 years that will give me an EBIT level of $19 million. However the new cost structure of Pacer due to its agreement with UP and loss of business will be higher so lets assume 1% margin, which will leave us with EBIT of $11.3 million. This translate Pacer Earning Power Value is $113 to $160. This does not factor capex, taxes or interest, so very much where the market is trading right now. Not an appealing valuation.

The shorts are having a big field day with this; it is been shorted heavily with a good reason. Management need big effort to turn around, cost cutting can do only so much.

Lear: Post bankruptcy Equity

This is a very interesting idea. Lear (LEA) has just emerged from bankruptcy that it entered early in summer of 2009. The bankruptcy was voluntary.

Lear is a supplier of car seating and some electronics to car makers. Lear has a very dominant position in the seating market. However GM and Ford makes the bulk of its sales. In fact GM makes 23% of its sales while ford makes up 19%. Management is focused on diversifying this mix. They are focusing on sales into Asian countries where sales growth did not skip a beat in the last 2 years, unlike European and North American which sales plummeted.

What is good about the company is the following:

1. Bankruptcy. Although it sounds bad but Lear has shed a lot of debt that was kept on its balance sheet after sales of some units to Wilbur Ross.
   
2. Management owns a lot of stock. In fact management owns 2.4% of shares on fully diluted basis upon exit from Ch. 11 and the CEO has a big chunk of it. I think management will do whatever it takes to increase business value.
   
3. There will be a lot of forced selling and a lot of technical overhang that could pressure the stock in the next 12 months. the selling pressure will be from:
1. CLO funds. Lear debt and loans was wildly held by CLOs. CLOs do not hold equity; their charter do not allow it.
2. Preferred stock conversion. Right now preferred are in the money and the company can force its conversion.
3. Warrants exercise also in the money.
   
4. Warrants and preferreds conversion will cause 35% dilution.
   
4. The quick exist from bankruptcy limits lawyers and advisers fees.

What is not good about the ideas:

1. The auto market has a lot of capacity still. even after all the bankruptcies not a single car maker disappeared, well only one Saturn but Saturn is made by GM so capacity is still there. We need to see some liquidation in the space.
2. Margins are very thin right now below historical norm. This may change with more sales.
3. GM and Ford make the bulk of its sales. Enough said.
   
4. Economic risks of decline as so far recovery is shaky.
5. Valuation is not cheap enough. I figure a good entry is between $48 and the high estimate of $55. If I am right about the selling overhang it will get there within a year, although it does not look like it as the stock price is on a tear lately.
   

What is wrong with this picture?

Natural gas producers have rallied and continue to do so although the underlying commodity is suffering. Natural gas producers represented by index for natural gas producers have returned some 45% on YTD basis while the underlying commodity has declined by 62% on YTD basis.

Normally that relationship have a high correlation. Natural gas producers price returns go the way of the commodity. However the relationship seem to have been broken since March of this year.

Is buying in this market indiscriminate? May be, but this is a question that can not be answered with full certainty. You can only attempt to guess as one would never have complete information to ascertain the validity of a claim.

Cloud Peak Energy...not so Peak Value

Rio Tinto IPO of Cloud Peak Energy (CLD), sort of a spin off, came with no great fan fare. The IPO has gone down some 10% so far. There are good reasons why the stock is down. Some are due to industry dynamics and other, in my opinion, is due to the corporate structure of the mines.

Industry Dynamic

Demand

Coal demand is growing. There is no secret that coal is under pressure from environmentalists and regulators due to global warming issues. CLD mines thermal coal used by utilities for electricity generation. The US generated 50% of its electricity from coal. So there is no escaping coal no matter what politicians say or do. Coal will be still be used during my lifetime and even during my sons lifetime. Coal demand will grow as long as we use electricity.

Supply

There is a glut of supply right now evident by increasing stock piles at utilities, but I reckon that will be short lived:

• Miners are cutting coal production in 2010 due to decrease in demand that will stabilize pricing
• Mountain top mining in the states is in jeopardy as a source of cheap thermal coal due to environmental issues.
• Mountaintop mining in West Virginia, Kentucky, Virginia, Tennessee and parts of Pennsylvania and Ohio accounts for 6 percent of U.S. coal production.
• The end of mountaintop mining in Appalachia would remove about 70 million tons a year from the market, increasing demand for coal from Colorado, Montana and Wyoming.
• EPA has been holding mining permits with more frequency under new president.Natural gas pricing, is it firms up then utilities that switched to nat gas will switch back to the cheaper fuel, coal.

On balance the downturn in coal is cyclical rather than permanent. So when a distressed seller like Rio Tinto, it needs cash to repair it over leveraged balance sheet, off load its coal business at these levels, it piqued my interest.

Transaction Specific Issues

My issue is with how the split off is structured. There are many issues that makes me hesitate pursuing this business.

• Rio Tinto still owns some 49% of the mines. However its ownership is at the limited partnership level rather than the holding company CLD. The public owns 100% of the holding company which in turn owns 51% of the limited partnership. That will make for conflict of interest between the public holders of CLD and Rio.
• Pretty much CLD is controlled by Rio as its board of directors is made of RIO executives. Moreover, CLD is governed by agreements that needs Rio's consent.
• Funds from operation will go to Rio and the holding company, CLD, but not to shareholders. I would rather see RIO and the public holders get the same treatment makes for better alignment of interest.
• Tax reimbursement agreement where CLD pays Rio any tax savings due to higher assets base level making depreciation and amortization higher thereby reducing taxes on income.
• Debt that got loaded onto CLD'd balance sheet to pay Rio for the assets is a bit high and will saddle the CLD with interest payments for some time to come.Most of the proceeds of the IPO goes to Rio.

So as you can see the deck is stacked in favour of Rio at the expense of CLD holders. However, there are some good qualities for CLD being low cost producer, cheap, and good reserves.

In conclusion, I will wait for a better entry point or when Rio floats the reset of its ownership in these mines.