Value Idea: CCE implied spin off

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

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

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

So what is the valuation here?

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

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

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

The Value of Corporate Events

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

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

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

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

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

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

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

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

CF/ TRA Merger- some thoughts

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

Takeover Frenzy:

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

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

Over Paying

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

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

Perils of Integration

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

BPO Properties REIT Conversion

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

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

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

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.