GLOI: Special Situations

This is a liquidation opportunity I have been following since they announce intention to sell their operating businesses. To see an overview of the opportunity, and to avoid repeating the deals, please see this post. What I will try to do here is to assess the liquidation value and answer if there is enough margin of safety to be considered a sound investment.

Valuation
Issues to consider:

• Dilution Issues: Management (CEO and CFO) will have 516,000 shares vested and granted under their long term compensation plans due to change of control. This will dilute my ownership by 3.5%. I reckon there is no potential for other dilution issues going forward.
• Taxes: As it stands right now there is tax issues as most sales occurred below book value. It will depend on the earn-outs amount but I think the taxes will be non issue.
• Management Payments: There is $3,381,000 to be paid CEO and CFO for change of control clauses, bonus, and Rabbi trust in their employment agreement.
• Real Estate leases: The company HQ is leased on month to month basis and will not pose any significant costs during the liquidation period.
• Burn rate: I estimate that the company to have a burn rate of 2000,000 by next year end between the following components:
• CEO/ CFO salaries: $955,000 (including bonus to CFO)
• HQ lease: : $225,000
• Legal fees : $200,000 (this separate from transaction fees as I netted those against the sales proceeds)
• Other: $600,000
• in the worst case scenario I will assume the burn rate will double to $4,000,000.
• The holding company will be be liable for the credit line, which as of June 30, 2010 was $4.1 Million. This is offset by cash on hand of $3.8 million. Please note that in June 30 statements they have already closed on Rosetti transaction so there is $2.9 million that has already received that need to be netted out.

The following is a listing of what amounts that will flow to GLOI from the all transactions:

Please note that earn out could be higher but I based it on rolling unit revenue over the last 4 quarters.

So if we put together all items above with the best and low case estimates I can have the following potential values of liquidation:

All these buyouts are management lead buyouts. that signifies to me that the business is good and the potential of the earn outs to materialize is solid.

Risks

• What I did not did not require any special insight or knowledge to unearth the potential. So what does the upside exist? I think the market is not discounting all the potential earn-outs. Current market value of the company is equal to the current distribution. Also I think the company is too small to be on any-one's radar.
• CEO and CFO share sale, why? The timing of the sale came before the Bode transaction announcement. However transactions do not materialize over night. so why did management sell if the potential to earn higher value for their share down the road? I tried to research as much as possible but could not get anything. the only thing left is to get in the mind of the CEO and CFO.
• There is no word on liquidation and how? so if management have a change of heart and decides to buy another business, then the thesis is over.
• WC adjustments that may go against the company.

Conclusion:
A 15 months opportunity that offers a good margin of safety. I estimate that if all earnouts are not received then you will receive 10-13% return. If some earn out materialize then the potential to earn north of 20% is an outcome with high probability.

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.
   

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.

Value idea: Peyto Energy Trust

Natural gas is at extreme lows as it should; there is tremendous supply in the system. Storage is almost full. There will be no where to put extra production. The reason is the vast discoveries of shale gas. North America is abundant with natural gas contrary to what was believed of North America peak gas. Even with a harsh winter I do not think the supply picture will improve.

However I believe that goods or assets can't sustain prices below its average production cost over the long term. Sure there will be some divergence in some periods but it should return to equilibrium eventually. The question is when. I am not going to speculate on that as it is going to be a crap chute at best.

However a good position if I can find a way to participate in the price recovery of natural gas, while I get some downside protection and a margin of safety. I think Peyto Energy Trust (Pey.un) gives me this proposition. Peyto is :

Canada-based energy trust. The Trust’s principal business activity is the exploration for, development and production of petroleum and natural gas in Western Canada. As of December 31, 2008, the total proved plus probable reserves were 998.3 billion cubic feet equivalent (166.4 million barrels of oil equivalent) with a reserve life of 23 years. Production is weighted approximately 85% natural gas and 15% natural gas liquids and oil.

I like Peyto for the following:

• hedge book for half of their production of the next 12 months at an average price of $7.5 per mcf
• low debt to capitalization and good coverage of debt service and dividends
• low cost producer of natural gas. currently their operating costs per BOE is $2.56 as of their latest quarter
• long life reserves
• the cost structure for the most part is variable and gets reduced with lower revenues.
• cheap valuation where its Entp. Value to NPV is .57, a measure to value the company to its discounted cash flow from reserves in the ground.
• The current dividend yield is Distribution is 15.5%. The coverage of the distribution is good but if gas prices continue its decline it will be halved.
• I get good odds betting on natural gas plays. The upside is potentially large while the downside is limited. We are already at a decade low of natural gas price. Most Natural gas producer did not participate fully in the recent rally and lag the indices by a wide margin.
• And a very good management, extremely good management.
• My catalyst will be the revision to mean in natural gas prices as most likely it can't keep going down. We are in a period of supply and demand imbalance and there should be an equilibrium found in the next 12 months.

What can go wrong:

• Payout ratio is trending higher, which is understandable given the weak revenue figure. Peyto has already cut its distribution and it could a further cut is probable.
• Natural gas is the "widow maker" and can be very volatile. There is no reason it can't go to low $2s per mcf.
• Their operating lines can be shut or reduced if credit environment deteriorates further. Producers rely on operating lines to fund operations and exploration.
• Royalties are influx in the government of Alberta and can be very fickle to factor in analysing operations. Couple years ago royalties has been hiked on gas producers but once the bust has set in it was reconsidered.
• The conversion to corporate entity issue. Trusts will be subject to regular corporate taxes in 2011 so this is issue is hanging on Peyto and all trusts alike.

A note: This is a Canadian trust equivalent to master limited partnership in the US so it will have personal tax consequences that will have to be taken into consideration when purchasing

Value Idea: Pride's Spin off

Forced Sellers:

I think this will be dumped by investors because they will want Pride high margin business in the deep water drilling and not the shallow-water low margin and limited growth business. But the $64,000 question is are they forced sellers due to non economic reasons or are they justified in their actions?

Industry Fundamentals:

lower utilization rates and pressure on daily rates. Oil finds moving to deeper waters, which seahawk fleet is not capable of operating under. Their biggest customer are requiring more depth capable rigs, which prices them out of more business.

The disparity between the US Gulf of Mexico Shelf and deepwater rig markets continues to widen. Earlier this year, the jackup market reached its lowest level in 33 years, according to ODS-Petrodata figures, and slid downward from that point. Drilling contractors continued their exodus from the Gulf whenever possible, moving jackups to more lucrative areas. Despite a slowdown in some jackup markets, eight rigs will have mobilized from the Gulf by the end of July. As far as the deepwater Gulf, most people consider it a growth market. As many as 17 new-build deepwater rigs are scheduled to enter the region by the end of 2010. More deepwater rigs could mobilize there for a few wells, then mobilize back to other markets during this period. As a result the utilization rates have been coming down steadily over the last few quarters.

Rig Type	Current		Month Ago		6 Months Ago		1 Year Ago
Drill Barge	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)
Drillship	90.5%	(38/42)	92.7%	(38/41)	79.5%	(31/39)	78.4%	(29/37)
Jackup	74.9%	(275/367)	74.9%	(274/366)	82.5%	(296/359)	91.0%	(312/343)
Semisub	80.2%	(134/167)	82.5%	(137/166)	82.7%	(134/162)	83.9%	(130/155)
Submersible	50.0%	(1/2)	50.0%	(1/2)	100.0%	(2/2)	100.0%	(2/2)
Tender	80.8%	(21/26)	76.9%	(20/26)	92.3%	(24/26)	88.5%	(23/26)

Natural gas prices are weak and depressed. There is plenty of supply and surplus inventory to keep the pressure on prices for awhile. I do not want to try to forecast or predict the direction of natural gas because what if my baseline forecast did not materialize. Natural Gas prices are called the "widow maker" for a reason, they are very hard to call.

Overcapacity in the sector. There are several deliveries to take place for shallow water rigs. During the past several years, the supply of available jackup and semisubmersible rigs has been unable to meet the increasing demand of oil and gas companies on a global basis. As a result of this global supply and demand imbalance, various industry participants ordered the construction of over 180 new jackup and semisubmersible rigs, over 60 of which were delivered during the last three years. Approximately 60 additional jackup and semisubmersible rigs are scheduled for delivery in 2009.

The new rig deliveries scheduled for 2009 include over 30 jackup rigs, the majority of which are not contracted for work upon delivery from the shipyard. These new drilling rigs will increase supply and likely reduce utilization and day rates as rigs are absorbed into the active fleet, especially in light of the recent decline in oil and natural gas prices and jackup rig demand. However, the current supply of jackup rigs is limited and it is time consuming to move offshore rigs between markets. Accordingly, as demand changes in a particular market, the supply of rigs may not adjust quickly. Utilization and day rates in specific markets could fluctuate significantly while utilization and day rates in other markets may be relatively unaffected. Additionally, several rig construction cancellations have been recently announced and the tightening credit market has created substantial uncertainty as to whether construction of other rigs will be completed.

Ok, you would say that weak industry fundamentals are cyclical and should adjust. Then seahawk would give you great risk/ reward proposition, assuming its price will fall to below liquidation value of its assets, which more likely it will. In this case company fundamentals has to be flawless to get me interested.

Company Fundamentals:

• Potential of fines regarding bribery charges and accounting irregularities, however there is limit to the fines paid to $1 million, any excess pride will take care of it.
• Mexico Oil company account for 60% of SeaHawk gross revenue. One customer dominate their business. This was not a problem when the company was a division of Pride but on a stand alone basis is very risky.
• accounting is a bit aggressive:
• changes to depreciation expenses by extending the useful lives of rigs, which means a boost to their earnings as depreciation expense get smaller. This annoys me to no end when companies change their depreciation policies or assumptions. It makes comparisons difficult and obviously management motives to boost earnings by hook or trick.
• already there is investigation for accounting irregularities by pride into Seahawk division.

• no debt and clean balance sheet, which a very good in this environment.

• SeaHawk Jackup rigs are shallow in the 200-250 feet range which does not work in the current industry dynamics. Their biggest customer are requesting deeper and deeper rigs, which prices Seahawk out.
• very capital intensive business. in order to expand more capex need to spent to buy new rigs. most free cash flow will go to acquisition of new PPE.
• most of its rigs are idle they have 40% utilization rate.
• most rigs are old so it may require some capex going further
• no unique competitive advantage that is very apparent that will distinguish their operations from others.

Management

SeaHawk's president and CEO was CEO of Hercules offshore, similar business to seahawk. He left the company in June 2008 and the company took a big impairment expenses due to large acquisition done on his watch, $2.3 Billion in cash and stock. As a result of the acquisition, Hero balance sheet is over leveraged and impairment charges mounted when the turn in the economy came.

Investment returns over his tenure were not overly outstanding.

	2004	2005	2006	2007	2008
ROE	11.35%	19.13%	38.98%	11.35%	(73.37%)

He spent $660.1 million in capex, not including the merger deal, cumulative over the 2004-2008, and generated $618.9 millions in cash from operations during the same period. During the same period cumulative earning were partly at $291.2 million, and if you include 2008 results it would be a significant loss.

Management Compensation Plan

This is a bright spot, somewhat, as the good chunk of compensation is in form of equity. I say somewhat because not all long term incentive compensation is equity. The better alternative is to have 100% of their long term compensation in restricted stock. From their filing:

The beginning value of the initial equity award is $4,800,000 for Mr. Stilley, $1,000,000 for Mr. Manz, $690,000 for Mr. Cestero and $575,000 for Mr. German. ....50% of the equity compensation will be in the form of restricted stock.

Competitive Position

The company is second lowest cost operators in the GOM region. Hero operates better cost structure than Seahawk. According to my analysis the operating the costs per available day is

Business	Notes	OE per avail Day
Seahawk	only GOM locations	$49,634
Hercules Off shore	very similar business to Hawk but diversified geographically	~$28,000
Ensco International Incorporated	shallow water but more specialized assets/ fleet. their GOM fleet water depth is 250-400 ft	$50,175
Rowan Companies	shallow water but more specialized assets/ fleet water depth 250-500
DO	deep water rigs- not very applicable
Nobel	deep water rigs- not very applicable	~$63,000
RIG	deep water rigs- not very applicable (55 standard jackups with depth from 250-400)

Conclusion:

There are so many strikes against the spin off and not too many positives even if valuation are ridiculously cheap, which I did not need to perform. This is a leveraged play on the prices of natural gas, which is very hard to call: will it stay depressed or take off? Weak sector fundamentals and potential liability and fines all are external to the company and can be manageable by good management team. However, I have my doubts about the new CEO hi track record in Hero is not encouraging. If there is any contrarian play on this name, I do not see it. I will pass on this spin off.

Spin-off Idea: Pride International

Not a lot of spin offs came to the market lately. But I think that is about to change as companies will reorganize themselves and cut businesses that no one want to buy. There is two opportunities right now: Pride International Spin off of Seahawk Drilling and CableVision spin off of the Madison Square Garden business. I will introduce the Pride spin off and talk some other time about Cablevision.

Pride International (PDE) is spinning off its Gulf of Mexico operations to shareholders. Pride International is an offshore drilling company that leases rigs and vessels to producers. The company recently made strategic effort to focus on deep water and other high-specification drilling solutions. As a result the decision to spin-off its shallow water business. Jack-up revenues has been declining in over the last few quarters. Management thinks this GOM drilling is slow growth business and that's why they want to divest out of it.

The shallow water business or the leasing of jack-up rigs is concentrated in the Gulf of Mexico (GOM) only with no other international operations. The shallow waters of the GOM is a mature region that oil production has peaked some time ago. companies are moving deeper and deeper for new finds. Pride management is justified in dumping this low growth business to focus on the deep water. However, the questions is can an independent Seahawk make earnings grow on their own without the constraints of Pride management of investing in deep water segment?

The offshore and land drillers have been trading at very low valuation. The sector PE is around 10. some notable high margin and specialized businesses like DO, RIG and NE are selling at PE between 5-9. These businesses have very specialized field and very much have solid backlogs, unlike Seahawk, for years to come so the valuation seems puzzling?

The service companies are leveraged play on the price of oil and gas, particularly natural gas in the Gulf of Mexico. Currently Natural gas is at very low pricing levels that make some field uneconomical to operate. Most will making a call on the price of gas to invest in these GOM drillers. I want to avoid making such a call. I am not in the forecasting business but in the investing business.

This is an interesting proposition. The spin off will be completely debt free with management that is properly incentivized with restricted equity and options but the company operate in poor sector until Natural gas increase in value. The price of the commodity does not concern me a lot at the moment and will play a secondary factor in the decision making. I will look for more important things on the company level:

• management compensation plan
• management track record and prior accomplishments
• accounting practices and policies
• valuation once it is traded
• competitive position in the industry
• what are my risks
• Will there be forced sellers?

Not every spin off is an automatic investment; the economics of the company must make sense as well. I will work on my analysis to see if this is worth establishing a position in.

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.

Rate	%	Notes
Equity premium	5.75	Shiller 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	1.25	As 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	.5	I 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	.25	This is normal cost of doing business.
Other	1	I will make a catch all for risks that I did not capture
Equity required rate of return	8.75	I avoided the CAPM model and Beta because risk as defined in Beta is meaningless.
Avg. cost of debt	6.5	Based on BNI debt interest rates
WACC (weighted based on BNI capital structure) Discount rate	7.8	The 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%. 

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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 Millions	Notes
Revenue (TTM)	18,018
EBIT	3,747	I apply the normalized 10 year EBIT margins of 20.8% to arrive at a vague estimate of the perpetual EBIT assuming no growth.
Adjustments:
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: 19 for personal injuries  18 employee separation costs
Adjusted EBIT	3,687
Less: Taxes	(1,290)	Based on 35% marginal tax rate
Add: Depreciation	1,397	Historical 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 Earning	2,163
Earning Power Value	27,730	BNI'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 Debt	9,099
Add: cash	452	Adding cash above 1% of sales as most companies do not require that to operate.
EPV	19,083
BNI Mkt cap	20,000

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.  

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.

---

1. http://online.wsj.com/article/SB123004962563030199.html?mod=todays_us_money_and_investing

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.

Value Idea: Sears Canada Bonds

Another fixed income issue to put my cash to work. Right now the yields on debt issues offer more than satisfactory rate of returns with more security. There are two issues trading in Canadian dollars with a yield of 8-8.5% maturing in 2010. I am indifferent to both issues as they have the same structure except for the coupon, (7.05 vs. 7.45%). Both issues are senior secured offering fixed semi-annually coupon.

The bonds are good opportunity because:

1. Short term to maturity with very good spread to treasuries,
   
2. Sears Canada is a wonderful business with a sound collection of assets and hidden values,
   
3. Strong balance sheet and coverage ratio. The company has 40% of its market capitalization in cash alone. This cash is more valuable in this deflationary environment.
   

Sears Canada Overview
Sears Canada much like SHLD is not just a retailer, rather it is a collection of home and consumer related services among real estate holdings. Sears Canada in addition to its main business, the department stores, it operates a number of successful businesses:

• warranty servicing,
  
• appliances maintenance,
  
• home installations of floors, HVAC, and other things,
  
• cleaning services,
  
• travel agency,
  
• transport and logistics distribution business and
  
• it owns prime real estate holdings. Sears operates a total of 187 stores, 19 of which are Company-owned with the majority of the remainder held under long-term leases, which most likely have under market rental rates, so these leases are also valuable.

Most of these businesses are hidden assets that can be sold without affecting the essence of the retail operations. Actually Sears Canada has sold its credit card operation to JP Morgan Chase in 2005 to monetize that business for $2.3 billion, and until 2015 it will receive a 10% revenue stream from all sales charged to sears credit cards. Moreover it has been systematically selling its interest in mall ownership over the past several years. Those real estate holdings are way undervalued on their books due to historical accounting.

The company is 72.4% 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.

SHLD vs Sears Canada Bonds?
A natural question the reader may ask why Sears Canada bonds offering 8.5% yield and not the SHLD bonds trading at anywhere from 14-19%? I have looked at those bonds and they are issues by Sears Roebuck Acceptance Corp. It is a wholly owned subsidiary by SHLD. The Company's principal activity is to
acquire short-term notes of parent company. The Company raises funds
from its unsecured short-term borrowing programs and long-term debt.
Short-term borrowings include commercial papers and long term debt
includes medium-term notes and discrete underwritten debt. The subsidiary may be a bankruptcy remote enity, i.e, the bonds will not be covered by SHLD other assets. Actually SHLD shelters several of its assets in similar manner. SHLD's brands are owned by a bankruptcy remote subsidiary as well. That's why I own the common rather the bonds in SHLD. Another thing I want to be aligned with Edward Lambert interests in case of liquidation.

Back to Sears Canada. The first thing to ensure my margin of safety is figure out the liquidation value of Sears Canada. I will do that by restating its most recent balance sheet

Balance Sheet Analysis
The balance sheet undervalues Sears economic assets. The biggest revision to assets values is in its real estate holdings.

• Cash balances are significant and represent about $8 per share, the stock trade at $19. The balances is expected to increase as a result of continues sales of the company's assets and positive cash flow from operations.
  
• Real estate: The company had joint venture interests in 12 shopping centres across Canada at Nov. 1, 2008. Joint venture interests range
  from 15% to 50%, and are co-owned with major shopping centre owners and institutional investors.
  
• Long term leases in a liquidation scenario will be valuable to other
  retailers looking to take over prime space cheaply. The value of these
  leases have not been factored into my analysis.
• Pension plan: sears is underfunding its assets plan but nothing significant but what is more importantly is the composition of its plan: 80% in fixed income, which should limit sears future contributions and expenses. Moreover its assumptions are conservative to actually give a far valuation of its future obligations.

On a liquidation scenario Sears Canada at the moment can cover most of its obligation and even give its shareholders 85 cents on the dollar. I feel Sears Canada has significant margin of safety to warrant the investment in its bonds.

On the strength of the company balance sheet alone, valuing its assets at their economic values rather than book value, Sears Canada should be trading at twice the market cap that it is trading currently.

Can the company pay me back?
The company have very decent coverage ratios as below. The company can cover all of its debt from cash on hand or by about 18 months from free cash flows.

Coverage Ratios	2007	2008
TTM EBITDA/ Total Interest	7.1	13.2
TTM EBITDA/ Total Interest+Rent	3.2	4
TTM EBITDA-Capex/ Interest	6.2	11.9
TTM EBITDA-Capex/ Interest+Rent	2.9	3.7

The operations may deteriorates from slow consumer spending but its results of Q3 did not show it. Their Q4 results are expected to be release by the end of Feb 09.

What Could go wrong?

1. refinancing risks in this tight market but the company has enough cash on hand to do repay debt and satisfy its working capital needs.
   
2. the issue gets called by sears.
   
3. rapid deterioration in operation over the next 10 months to deplete its strong balance sheet. This is a possibility where collapse in sales would result in the company to use its cash on hand to pay for expenses.
   

What does well in slow economy?

I have two ideas for slow economic times: prisons and schools.

If you think about it you have two choices when you are out of a job:

1. go to school to upgrade your skills and get a better job, or
2. commit crime

I hope the majority will pick the first choice. But the reality is both are growth industries in this economic climate.

Enrollments in both are growing. Schools like ITT and Devry are doing very well and recording record growth in revenues. The market seems to reward their shareholders as most of school companies are hitting 52 week highs. The performance of schools industry is on fire and the market does not seem to care that some are over leveraged.

As for prisons, it is also a growth industry. The government is running out of space in the federal prison system so they are contracting out this to companies like Prisons of America. That segment should see growth in its revenue as well.

I have better business proposition. Convert many of the hotel projects that have flooded the markets lately into prisons. The hotel industry have seen a flood of new hotels and over capacity in new rooms. What to do with them? Convert them into prisons. If you think about it prisons are just like hotels but you do not have the luxury of checking out when you want.

Value Idea: Bombardier Preferred

I have bought another preferred issue. The issue is BBD.PR.D trading on the TSX. It pays $1.31 or 13% yield. The issue pays fixed dividend until August 2012 then it exchanged for a floater paying dividends equal to the prime rate. I have managed to buy a small position on Friday@ $10.26 on the TSX, waiting to add more.

Business Overview
The company manufactures jets and train systems; its revenues almost split evenly between the two divisions.

The majority of its sales comes from Europe, while sales in Emerging markets are growing at a healthy clip. BBD has been announcing major contract wins over the last 6 months. The company will be further aided by the rapid decline in the Canadian dollar as it will lower the cost of BBD's goods to foreigners. The Canadian dollar is expected to remain subdued if a weak recovery and the pressure on commodities that would likely accompany it follows the global economic slowdown. After all, the loonie is 96% correlated to commodities, according to UBS. The company has a huge backlog of orders and potential for margin improvements; its backlog of $52 Billion.

Credit Assessment
The debt has been reduced by strong cash flow from operations. BBD's total debt in 2005 was $5.7 billion in the latest quarter it was $3.8. The company financial position continues to improve and coverage and leverage ratios are improving. In addition, the improving business fundamentals and growing revenues will allow for more improvements.

BBD's cash flow are strong and improving:

• The company has cash position of $3.3 US. almost equal to its long term debt.
• Free Cash flow to total debt have risen from 17% in 2005 to 42%.
• Cash From Operation (CFO) has grown from $768 million in 2005 to $2 Billion in 2008.

While its Balance Sheet continues to de-leverage:

• From table above liquidation value of assets is almost twice of BBD's total borrowings.
  
• If I apply the same calculation from table above to historical figures we can good improvement. The liquidation value has undergone a drastic improvement in the quality of the collateral that secures BBD's debt and preferreds over time. (see chart)
• Coverage ratios are also been improving
  

Valuation
The BBD.PR.D issue price action does not make any sense over the last few months. The preferred should have some downside protection compared to the common. The preferreds with better security and dividends have mirrored the price performance of the common. The preferred is down 35% just the same as the common over the last 12 months.

Moreover the preferred dividend yield of 13% is higher than the common expected earning yields of 8.6% (P/E inverted).

What can go wrong?

• BBD out of business: In this event I think there are good odds that the liquidation value of its assets can cover liabilities and unfunded pension benefits and spill over to common equity.
  
• interest rates: higher rates in the future can decrease the preferred value, but it will be a floater in 2012 offsetting such risk. In the meantime I enjoy fixed rate.
  
• liquidity of the issue: The issue has low volume so entering and exiting has to be done slowly. I still have not accumulated my full position but I am waiting opportunistically for good entry prices like the one I got today.
  
• Sales backlog can be delayed by customers. However the train division will keep churning revenue and grow at high rates as government around the world spend on infrastructure to stimulate their economies; the company will be a beneficiary.
  
• Pension plan unfunded liabilities. The company has a relatively large unfunded pension liabilities.

Given these risks, I think at this price and coverage ratios detailed above I have enough margin of safety not to risk any permanent loss of capital.

Conclusion
Over the past few posts I have been saying that fixed income is a huge opportunity these days. I can invest and compound my money at 12-18% in issues with better security than common stock. Some of these issues have a margin of safety that ensures there is no permanent loss of capital. I expect to make more investment like these. And to those who invest in treasuries earning less than 2% because it is risk-free, guess again!

Value Idea: Senior Debt

“There are no bad bonds, only bad prices,” the saying goes. And at these yields fixed income is a better opportunity than equities.

Although I was on the right track in my previous two posts, see here and here, about debt being a good opportunity, junk bond is not the right class at this time. I need better margin of safety either in promised yield or better recovery rate, which I can achieve by buying more senior debt in the capital structure. This can be accomplished by investing in senior bank loans.

Senior bank loans are

...close relative of its better known cousin - the high yield bond market. Both are bi-products of the busy private equity calendar of recent years. There are several types of loans in the market today. In the following I will focus on only the highest quality loans - the so-called senior secured loans (also known as first lien loans) which are essentially fully collateralized bank loans provided to companies which have restructured their balance sheets - often in connection with a leveraged buyout. The loans run for 4-5 years, sometimes longer, and are usually priced to yield Libor + 50-300 bps. They are issued at par, they mature at par (barring a default situation), and the typical loan-to-value is less than 50%, so the loans are usually very well protected. In a default situation, equity, high yield bonds, mezzanine debt and second lien debt all stand in front of senior secured loans when the creditors knock on the door.
Source: www.arpllp.com.

What is your credit risk with these loans? The bank debt is, by and large, "senior," in the sense that in a crisis it would be paid off before junk bonds from the same issuer. Unlike junk Bonds they have better collateral and recovery rate making my thesis for investing in high yield debt a better one. Unlike junk, which can see recovery rate of 40%, senior loans historically achieved 74% recovery rate (Source: Credit Suisse). The seniority of the bank debt makes up for some of the weakness in the borrowers' balance sheets. The long-term default rate on these loans is in the 2.5% range but was higher during the dark days, not so dark compared to today, of 2001 and 2002 (Source: Eaton Vance, asset management firm Annual report). However we are coming out of a credit bubble and historical average will be blown out of the water.

Valuation:
At the beginning of the month, senior secured loans traded around 80 cents to the dollar. Four weeks later the average price had dropped to 50-60 cents to the dollar.

The worst default rate for senior secured loans on record is 8% and the average historical recovery rate in bankruptcy situations is 74%. If you assume a 35% annual default rate and a 50% recovery rate, at current prices, the IRR to maturity is 22%.

How to invest in these Loans?
Loan participation closed end funds (like EVF or BHL and many others) -- which buy bank loans to the companies, as opposed to bonds issued by them -- are less risky than high-yield bond
funds in two key respects: seniority, as explained above and loans have floating rates. When interest rates rise, bonds lose value because their fixed interest rates become below-market. But loans hold their value because their interest rates follow the market higher, allowing loan participation funds to raise their dividends. Of course, when interest rates are declining, the interest rates on the loans go down, leading loan participation funds to cut their dividends.

There are risks inherit in owning the funds that own these loans. The same aspect of making these loans attractive, high recoveries in the event of default, typically is not being taken advantage by fund managers. I think most funds would sell tanking loans rather than ride them through a likely default/lengthy bankruptcy process.

Another issue is the leverage employed by these funds. Typically Closed end funds issue leverage from 25% to 50% of assets under management to juice returns. If assets value fall below 200% coverage, then dividends and distribution will be halted until asset coverage is restored.

So selection of which fund to invest in is paramount. Actually you can argue that to take advantage of this opportunity closed end funds is not the proper tool. I would consider it if I was given a good discount to NAV as a margin of safety.

I have the following issues to choose from: PHD, BHL, EVF. I have presented the case for this investment, the only question now is how to monetize this idea, which will a topic for another post.